十一 Corporate Finance: Corporate Investing and Financing Decisions
A: An Overview of Financial Management
a: Discuss potential agency problems of stockholders versus 1) managers and 2) creditors.
An agency relationship is created when decision-making authority is delegated to an agent without the agent being fully responsible for the decision that is made. An agency relationship occurs in two common corporate scenarios:
the company’s stockholders delegate decision-making authority to the managers (agents), but the managers do not receive the full benefit or cost of their performance,
the company’s debtholders delegate authority to managers who act on behalf of the shareholders. In the first scenario, management will not bear the full impact of their decisions since they do not own 100 percent of company.
In the second scenario, agency relationship may occur when creditors lend money to corporations. Creditors lend based on specific business and financial risk expectations. The stockholders/management will benefit from risky strategies that simultaneously increase the probability of success and bankruptcy. The manager receives the full benefit of success, but the creditor bears the responsibility for the bankruptcy. This is one reason loans include many restrictive covenants on the corporation’s behavior.
b: Describe four mechanisms used to motivate managers to act in stockholders' best interests.
Managerial compensation. The total managerial salary package must compensate managers for their performance. This is commonly done through annual performance bonuses and long-term stock options, in addition to an annual salary. There are two main methods that are used to grant shares to management:
Performance shares: The manager receives a certain number of shares based on the company achieving predefined performance benchmarks.
Executive stock options: Management is granted an option to buy the firm’s shares at a pre-specified price on a specific future date. Executive stock options are typically issued ¡°out-of-the-money¡± to give management the incentive to take actions that will boost the company’s stock price.
Direct intervention by shareholders. As large institutions increasingly own shares, these institutions have the power and sophistication to persuasively intervene on corporate issues.
The threat of firing. Shareholders can nominate and elect their own board of directors or persuade the board to ¡°encourage¡± the current management to quit or be fired.
The threat of takeovers. If management’s poor performance is reflected in a low stock price, a competitor may buy enough shares to have a controlling interest. At that point, the acquirer can replace management with their own management team.
: The Cost of Capital
a: Explain why the cost of capital used in capital budgeting should be a weighted average of the costs of various types of capital the company uses.
How a company raises capital and how they budget or invest it are considered independently. Most companies have separate departments for the two tasks. The financing department is responsible for keeping costs low and using a balance of funding sources: common equity, preferred stock, and debt. Generally, it is necessary to raise each type of capital in large sums. The large sums may temporarily overemphasize the most recently issued capital, but in the long run, the firm will ascribe to target weights for each capital type. Because of these and other financing considerations, the investment decision must be made assuming a weighted average cost of capital including each of the different sources of capital and using the long-run target weights.
b: Define and calculate the component cost of: 1) debt 2) preferred stock 3) retained earnings (3 different methods) and 4) newly issued stock or external equity.
The after-tax cost of debt [kd (1- t)] is used to compute the weighted average cost of capital. It is the interest rate on new debt (kd) less the tax savings due to the deductibility of interest (kdt).
After-tax cost of debt = interest rate- tax savings = kd- kd (t)
After tax cost of debt = kd (1- t)
Example: Ink Inc. is planning to issue new debt at an interest rate of 8%. Ink is in the 40% marginal federal-plus-state tax rate. What is Ink’s cost of debt capital?
kd (1- t) = 8% (1- .4) = %
Note: the cost of debt is the interest rate on new (marginal) debt, not the interest rate paid on existing or old debt. Also note that if it weren’t for the increasing risk of bankruptcy with ever increasing leverage, the tax deductibility of interest would lead to 100% debt in the capital structure.
Preferred stock is a perpetuity that pays a fixed dividend (Dps) forever. The cost of preferred stock (kps) is:
Cost of preferred stock = kps = Dps / Pnet
Where:
Dps = preferred dividends.
Pnet = net issuing price after deducting flotation costs.
Example: Suppose Ink has preferred stock that pays an $8 dividend per share and sells for $100/share. If Ink were to issue new shares of preferred, it would incur a flotation (or underwriting) cost of 5%. What is Ink’s cost of preferred stock?
kps = Dps / Pnet
Pnet = 100 (1- .05) = $95
kps = $8 / $95 = .084 = %
The cost of retained earnings (ks) is the rate of return stockholders require on the equity capital the firm retains from earnings. ks is the opportunity cost of retaining earnings. You should know that if a stock is in equilibrium, the rate of return investors require is to equal the rate of return they expect to get. In equilibrium: required rate of return (ks) = expected rate of return (ks)
The CAPM approach:
Step 1. Estimate the risk-free rate, kRF. The short-term T-Bill rate is usually used but some analysts feel the long-term treasury rate should be used.
Step 2: Estimate the stock’s beta (B). This is the stock’s risk measure.
Step 3: Estimate the expected rate of return on the market (kmarket).
Step 4: Use the CAPM equation to estimate the required rate of return, ks = kRF + (kmarket- kRF) Beta
Example: Suppose kRF = 6%, kmarket = 11% and Ink has a beta of . Then the required rate of return for Ink’s stock is ks = 6% + (11%- 6%) () = %
The cost of retained earnings (ks) is the rate of return stockholders require on the equity capital the firm retains from earnings. ks is the opportunity cost of retaining earnings. You should know that if a stock is in equilibrium, the rate of return investors require is to equal the rate of return they expect to get. In equilibrium: required rate of return (ks) = expected rate of return (ks)
The bond-yield plus risk-premium approach:
Analysts often use an ad-hoc approach to estimate the required rate of return. They add a risk-premium (3 to 5 percentage points) to the interest rate of the firm’s long-term debt.
Example: Ink’s interest rate on long-term debt is 8%. Suppose the risk-premium is estimated to be 5%. Then Ink’s cost of equity estimate is:
ks = 8% + 5% = 13%
The cost of retained earnings (ks) is the rate of return stockholders require on the equity capital the firm retains from earnings. ks is the opportunity cost of retaining earnings. You should know that if a stock is in equilibrium, the rate of return investors require is to equal the rate of return they expect to get. In equilibrium: required rate of return (ks) = expected rate of return (ks)
The discounted cash flow or dividend yield plus growth rate approach:
If dividends are expected to grow at a constant rate ¡°g¡± then the current price of the stock is given by the dividend growth model: P0 = D1 / (ks- g), where D1 = next year’s dividend, ks = the investor’s required rate of return, and g = the firm’s expected constant growth rate. Rearranging the terms you can solve for ks: ks = (D1 / P0) + g. In order to use ks = (D1 / P0) + g you have to estimate the expected growth rate (g).
Example: Suppose Ink’s stock sells for $21, next year’s dividend is expected to be $1, Ink’s expected ROE is 12% and Ink is expected to pay out 40% of its earnings. What is Ink’s cost of equity? g = (ROE) (Retention Rate), g = (.12) (1- .4) = .072 = %, and ks = (1/21) + .072 = .12 or 12%.
The cost of new common equity (ke) will be higher than the cost of retained earnings because of the existence of flotation costs. Cost of new common equity is given by:
ke = [D1 / (P0 (1- F))] + g, where F = the percentage flotation cost incurred in selling new stock.
F = (current stock price- funds going to company) / current stock price
Example: Assume that Ink Inc has a flotation cost of 10%. Then the cost of new equity for Ink is:
ke = [1 / (21 (1- .1))] + .072 = .125 or %
Note that the cost of new equity (%) is higher than the cost of retained earnings (12%). Remember because of flotation costs ke > ks.
C: The Basics of Capital Budgeting
a: Define capital budgeting.
Capital budgeting is the process of analyzing projects for inclusion in fixed assets. Capital budgeting is perhaps the most important function a financial manager must perform for a number of reasons. First, since a capital budgeting decision involves the purchase of a long-term asset with a life of many years, the firm loses some flexibility in terms of being ¡®locked in’ for the duration of the asset’s life. Second, an acquisition of an asset to expand operations is based on its expected future revenues, so a decision to buy an asset will require forecasts of revenue over the asset’s life. Finally, a firm’s capital budgeting decisions define its strategic plan.
b: Describe and calculate four methods used to evaluate capital projects: payback period, discounted payback period, net present value (NPV), and internal rate of return (IRR).
Example: Evaluate the cash flows for the following two projects: Note that the cumulative net cash flow is just the running total of the cash flows at the end of each time period. Payback will occur when the cumulative NCF equals zero. Project A has net after-tax cash flows of -2,000, 1000, 800, 600, and 200, respectively for years 0 through 4, and Project B has net after-tax cash flows of -2,000, 200, 600, 800, and 1200, respectively for years 0 through 4.
To find the paybacks construct the following table:
Year (t)
0
1
2
3
4
Project A Net Cash Flow
-2000
1000
800
600
200
Cumulative NCF
-2000
-1000
-200
400
600
Project B Net Cash Flow
-2000
200
600
800
1200
Cumulative NCF
-2000
-1800
-1200
-400
800
The payback period is determined from the cumulative net cash flow table in the lower right-hand corner. Decision rule: The shorter the payback period the better. To decide which project to accept the firm must first establish a benchmark payback period to compare the projects to. Suppose the firm requires a payback period of three and a half years. If A and B were independent, accept Project A and Project B. If A and B are mutually exclusive, then A would be accepted over B.
Payback period A = 2 + (200 / 600) = years, and Payback period B = 3 + (400 / 1200) = years
As an improvement over the payback method, the discounted payback method discounts the estimated cash flows by the project’s cost of capital.
Example: The firm’s cost of capital is 10%.
Year (t)
0
1
2
3
4
Project A Net Cash Flow
-2000
1000
800
600
200
Discounted NCF
-2000
910
661
451
137
Cumulative DNCF
-2000
-1090
-429
22
159
Project B Net Cash Flow
-2000
200
600
800
1200
Discounted NCF
-2000
182
496
601
820
Cumulative DNCF
-2000
-1818
-1322
-721
99
Discounted payback A = 2 + 429/451 = years. Discounted payback B = 3 + 721/820 = years. Assume the firm’s maximum discounted payback period is 4 years. Decision rule: payback < the benchmark payback, accept the project payback > the benchmark payback, reject the project. If A and B are independent projects, accept both projects. If A and B are mutually exclusive, accept A over B. Drawback: the discounted payback does not consider any cash flows beyond the payback period.
Net present value (NPV) method: Given the flaws in the payback methods of ranking projects a more effective way for project evaluations is the net present value (NPV) method which relies on discounted cash flows (DCF).
Example: Given the cash flows above and a cost of capital of 10%., determine NPV of both projects.
NPVA = –2000 + 1000/()1 + 800/()2 + 600/()3 + 200/()4 = $
NPVB = –2000 + 200/()1 + 600/()2 + 800/()3 + 1200/()4 = $
Decision rule: if projects A and B are independent accept both. If projects A and B are mutually exclusive, A has the highest rank and would therefore be accepted.
If the projects are independent then: IRR > the Cost of Capital (hurdle rate), accept the project or IRR < the Cost of Capital (hurdle rate), reject the project. If projects are mutually exclusive, the projects are ranked on the basis of their IRRs.
Example: Given the cash flows above, and a cost of capital of 10%, calculate the IRR. 0 = –2000 + 1000/(1+IRRA)1 + 800/(1+IRRA)2 + 600/(1+IRRA)3 + 200/(1+IRRA)4 and 0 = –2000 + 200/(1+IRRB)1 + 600/(1+IRRB)2 + 800/(1+IRRB)3 + 1200/(1+IRRB)4 . Trial and error gives IRRA = % and IRRB = %.
Decision rule: If A and B are independent accept both. Both their IRRs > 10%, the cost of capital. If A and B are mutually exclusive then project A would be ranked higher than project B since its IRR of % > B’s % > the cost of capital 10%.
c: Explain the NPV profile.
A project’s NPV profile is a graph that plots the project’s NPV as calculated using different discount rates. Remember, when you change the discount rate you change the NPV calculation. The NPV profile is just a graphical representation of the change in NPV relative to the change in the discount rate. The discount rates are on the x-axis and the corresponding NPVs are plotted on the y-axis. The points are joined in a smooth curve. Note that where the NPV profile intersects the horizontal x-axis you have the project’s IRR.
d: Explain the relative advantages and disadvantages of the NPV and IRR methods, particularly with respect to independent versus mutally exclusive projects.
NPV is generally considered to be better than the IRR. The IRR is, however, used by many corporate executives.
For independent projects, the IRR and NPV methods always give the same accept or reject decision. For mutually exclusive projects, sometimes the IRR and NPV methods give different accept or reject decisions. The NPV method is the one that selects the project that maximizes shareholders wealth.
e: Describe and calculate the modified IRR (MIRR).
Assume the following information for project A and project B:
Expected Net After-Tax Cash Flows
Year (t)
Project A
Project B
0 (cost)
($2000)
($2000)
1
1000
200
2
800
600
3
600
800
4
200
1200
Example: Calculate the MIRR for project A (Cost $2,000) and project B (Cost $2,000). Calculation appears below. The decision rule for the MIRR is the same as the IRR method. For mutually exclusive projects of equal size and the same life expectancy the MIRR provides the same decision as the NPV method. For mutually exclusive projects of equal size but with different lives the MIRR also gives the same decision as the NPV method. Unfortunately, if the two mutually exclusive projects differ in size there will be conflicting results, so the NPV method is superior to the MIRR method. superior to the IRR method.
Year (t)
FV of A's Cash Inflows
FV of B's Cash Inflows
1
1000()3 = 1331
200()3 = 266
2
800()2 = 968
600()2 = 726
3
600()1 = 660
800()1 = 880
4
200()0 = 200
1200()0 = 1200
Terminal value :C1 to C4 = 3159
=3074
PV = 2000, FV = 3159
PV = 2000, FV = 3074
n = 4, compute (I/Y) MIRR = %
n = 4, compute (I/Y) MIRR = %
f: Explain the "multiple IRR problem" and the cash flow pattern that causes the problem.
Multiple IRRs: If a project has cash outflows during its life or at the end of its life (where the sign of the net cash flow goes from minus to plus back to minus) the project is said to have a non-normal cash-flow pattern. Projects with such cash flows may have multiple IRRs. This problem doesn’t exist with the NPV method.
In conclusion, the net present value method is considered to be the best method since it leads to conceptually correct capital budgeting decisions.
g: Explain why NPV, IRR, and MIRR methods can produce conflicting rankings for capital projects.
NPV is thought to be better than IRR and MIRR because NPV measures profitability in dollars added to shareholder value. IRR and MIRR measure profitability as a rate of return. MIRR improves on the IRR by assuming a reinvestment rate equal to the cost of capital and by more effectively dealing with non-normal cash flows. IRR and NPV agree except on mutually exclusive projects, where the cost of capital is greater than the crossover rate. MIRR and NPV agree except possibly on mutually exclusive projects of different size.
h: Describe the role of the post-audit in the capital budgeting process.
It is important to follow up all capital budgeting decisions a firm makes. You should compare the actual results to the projected results. The project managers should explain why their projections did or didn't match up to actual performance. The capital budgeting process is only as good as the input estimates used to calculate the cash flows. The function of the post audit is to improve forecasting and operations.
D: Cash Flow Estimation and Other Topics in Capital Budgeting
a: Distinguish between cash flows and accounting profits.
Cash flows versus accounting income: In capital budgeting we use annual net cash flows and not accounting income to make our decision. We can define net cash flow as:
Net Cash Flow (NCF) = Net Income + Depreciation = Return on Capital + Return of Capital.
Note: Net cash flows should reflect all non-cash changes, not just depreciation. Depreciation is usually the largest non-cash change for a firm.
b: Define the following terms and discuss their relevance to capital budgeting; incremental cash flow, sunk cost, opportunity cost, externality, and cannibalization.
Incremental cash flows can be defined as cash flows that occur if and only if the project is accepted. These cash flows represent the change in the firm’s total cash flow that occurs due to the acquisition of the project.
Sunk costs are a cash outlay that has already been committed or has occurred. Since these costs are not incremental they should not be included in the analysis. An example of sunk costs is a consulting fee paid to a marketing research firm to estimate demand for a new product.
Opportunity costs are cash flows that a firm is passing up by acquiring the asset in question. In other words, these are cash flows that could be generated from an asset the firm already owns provided they are not used for the project in question. Example: when building a plant if the firm already owns the land, the cost of the land is an opportunity cost and should be charged to the project.
Externalities refer primarily to cannibalization. Cannibalization is when a new project takes sales from an existing product. When considering externalities, the full implication of the new project (loss in sales of existing products) should be taken into account.
.: Appendix 11A
a: Define MACRS, half-year convention, and depreciable basis.
Under the Modified Accelerated Cost Recovery System (MACRS) assets are classified into 3-year, 5-year, 7-year, or 10-year classes.
The half-year convention under MACR assumes that the asset is placed in service in the middle of the first year. The effect of this is to extend the recovery period of a 3-year class asset to 4 calendar years (33%, 45%, 15%, 7%) and a 5-year asset to 6 calendar years (20%, 32%, 19%, 12%, 11%, 6%).
Depreciable basis is a critical element of MACRS. It is equal to the purchase price plus any shipping or handling and installation costs. The basis is not adjusted for salvage value regardless of whether the accelerated or straight-line method is used.
Most firms use MACRS for tax reporting and straight-line for financial reporting. However, for capital budgeting purposes MARCS should be used since capital budgeting analysis is based on actual cash flows and not reported income.
b: Calculate depreciation for an asset using MACRS.
Example: Calculate the annual depreciation for a 3-year asset that costs $8,000 and has $2,000 worth of installation costs. At the end of the project it is estimated that the asset will have a $1,000 salvage value.
Year
Initial cost
Recovery %
Depreciation change
1
$10,000
33%
$3,300
2
$10,000
45%
$4,500
3
$10,000
15%
$1,500
4
$10,000
7%
$ 700
Note that the depreciation basis includes shipping and installation costs, salvage is not considered in determining depreciation.
E: Risk Analysis and the Optimal Capital Budget
a: Distinguish among three types of project risk; stand-alone, corporate, and market.
Stand-alone risk is the project’s individual risk. This risk ignores the fact that a project is a part of the firm’s portfolio of assets and is measured by the variability of the project’s expected returns. It is easier to measure than corporate or beta risk.
Corporate or within-firm risk is the project’s contribution to the firm’s total risk. It takes into account that the project is part of the firm’s portfolio of assets. This risk is measured by the impact of the project on the uncertainty of the firm’s future earnings. Corporate risk is important to undiversified stockholders, small business owners, and the firm’s managers, employees, suppliers and creditors. Empirical studies show that both corporate and market risk affect stock prices.
Market or beta risk is the riskiness of the project as viewed by a well-diversified stockholder. Market risk is measured by the project’s effect on the firm’s beta. Stand-alone risk, corporate risk and market risk are highly correlated.
b: Distinguish among sensitivity analysis, scenario analysis, and Monte Carlo simulation as risk analysis techniques.
Sensitivity analysis is the altering or changing of an input (independent) variable to see how sensitive the dependent variable is to the input variable. For example: you could determine how sensitive a project’s net present value is to changes in sales, assuming that all other factors are held constant, by varying sales. In sensitivity analysis, you start with the base-case scenario. Base case would be the NPV you determined by using the project’s input estimates.
Scenario analysis is a risk analysis technique that considers both the sensitivity of the dependent variable (for example NPV) to changes in a key independent input variable (for example, sales) and the likely range of the variable’s values (the variable¡®s probability distribution). In scenario analysis, you study the different possible scenarios, worst case, best case, and base case.
Monte Carlo simulation uses simulation techniques to tie together sensitivities and probability distributions of input variables like sales, variable cost per unit, etc. Random values of input variables are generated and then the NPV’s are computed. This procedure is repeated for as many as 1,000 times and from this set of 1,000 NPV values, the mean and standard deviation of a project’s NPV is computed.
c: Describe how the security market line is used in the capital budgeting process.
Example: Suppose Ink Inc. has a beta of and uses only equity capital. If kRF = 8% and kMarket = 13%, then Ink’s cost of equity is: ks = kRF + (kMarket - kRF)Betacompany.
ks = 8% + (13% - 8%) = 14%
Since Ink’s required return on retained equity is 14%, Ink must invest in projects that will return 14% on equity before any adjustment for risk. Now suppose Ink is planning to build an integrated printing plant. Further suppose that other firms who operate such plants have an average beta of . Then the project’s cost of capital would be: kproject equity = 8 + 5() = %. Hence the printing plant should be evaluated with a % cost of capital. You can use the SML to determine the firm’s weighted average cost of capital for a project. Assume Ink has a debt / total asset ratio of 20% and plans to finance the new plant with 20% debt with a pre-tax cost of 10% and 80% retained earnings equity. Ink has a 40% tax rate. The project WACC would be:
kWACCp = wdkd (1- t) + wskproject equity = (.2)(.10)(.6) + (.8)(.155) = %
d: Describe the pure play and accounting beta methods for estimating individual project betas.
In the pure-play method the company would look for other companies with single product lines similar to that of the project being evaluated. An average of all the betas is then used to estimate the project’s beta and then its cost of capital.
The accounting beta method runs a regression of the company’s accounting return on assets against the S&P return on assets. The slope coefficient of this regression is called the accounting beta. The accounting beta can be used to estimate the firm’s beta and then the project’s cost of capital.
e: Define and discuss the procedure for developing a risk-adjusted discount rate.
The other approach to incorporating project risk into capital budgeting is called the risk adjusted discount rate approach. Here the discount rate is adjusted upward or downward from the firm's normal cost of capital to adjust for the project's risk. In this approach, the firm must first determine the division's cost of capital based on the division's risk. Then individual projects will be defined as high risk, average risk, or low risk. The cost of capital is then adjusted upward or downward from the base cost of capital.
F: Capital Structure and Leverage
a: Define target capital structure and optimal capital structure.
A firm’s target capital structure is the debt to equity ratio that the firm tries to maintain over time. Should the firm’s current debt ratio fall below the target level, new capital needs will be satisfied by issuing debt. On the other hand, if the debt ratio is greater than the target level the firm will raise new capital by retaining earnings or issuing new equity. When setting its target capital structure the firm must weigh the tradeoff between risk and return associated with the use of debt. The use of debt increases the risk borne by shareholders, however, using debt leads to higher expected rates of return by shareholders. The higher risk associated with debt will depress stock prices while the higher expected return will increase stock prices. Thus the firm’s optimal capital structure is the one that balances the influence of risk and return and thus maximizes the firm’s stock price. The optimal debt ratio will be the firm’s target capital structure.
b: Describe and state the impact of changes in factors that influence a company's capital structure decision.
Business risk. This is the riskiness inherent in the firm’s operations assuming no debt. The greater the firm’s business risk, the lower its optimal debt ratio.
The firm’s tax position. One of the reasons for using debt is the tax deductibility of interest payments. The tax deductibility of interest lowers the effective cost of using debt. You should note, however, when a firm already has a low tax rate because its income is sheltered from taxes by depreciation, interest on current debt, or tax loss carry-forwards, additional debt will not be as advantageous as it would be to firms with higher effective tax rates.
Financial flexibility. This is the firm’s ability to raise capital with reasonable terms under adverse conditions.
The conservatism or aggressiveness of management. Firms with aggressive managers are more inclined to use debt in an effort to boost profits.
c: Explain business risk and financial risk and discuss factors that influence each risk.
Business risk is defined as the uncertainty inherent in a firm’s return on assets (ROA). Business risk is the most important determinant in setting capital structure. The main factors affecting business risk are:
Demand (unit sales) variability. The more variable a firm’s sales, the higher the firm’s business risk.
Sales (output) price variability. Volatile market prices will expose a firm to more business risk than that experienced by firms whose output prices are stable.
Input price variability. Firms with uncertain input costs, including product development costs, are exposed to high business risk.
Ability to adjust output prices for changes in input prices. Firms that can quickly raise their selling price when input costs rise have low business risk.
Operating leverage (the extent to which costs are fixed). The higher the percentage of a firm’s costs that are fixed, the greater the firm’s business risk.
Financial leverage refers to the use of fixed income securities (debt and preferred stock). Financial risk refers to the additional risk common stockholders have to bear because of financial leverage. Financial leverage magnifies the variability of earning per share due to the existence of the required interest payments.
d: Explain and calculate the effects of changes in sales or earnings before interest and taxes (EBIT) on earnings per share for companies with differing amounts of debt financing.
Financial leverage takes over where operating leverage leaves off, magnifying the effect changes in sales have on earnings per share. For this reason, operating leverage is sometimes referred to as first-stage leverage and financial leverage as second-stage leverage. The degree of financial leverage (DFL) is defined as the percentage change in earnings per share that results from a given percentage change in earnings before interest and taxes (EBIT), and it is calculated as follows:
DFL= [percentage change in EPS] / [percentage change in EBIT] or DFL = EBIT / [EBIT -I].
e: Define operating leverage and explain how it affects a project's or company's expected rate of return.
Operating leverage is the trade off between variable costs and fixed costs. If a high percentage of a firm’s total costs are fixed, the firm is said to have high operating leverage. In business terms, high operating leverage, other things held constant, means that a relatively small change in sales will result in a large change in operating income.
f: Calculate the breakeven quantity of sales and determine the company's gain or loss at various sales levels.
Breakeven point: sales = costs
(Price)(quantity) = (variable cost)(quantity) + fixed costs
At breakeven: PQ- VQ- F = 0
QBE = (F) / (P- V)
Project X
Project Y
Price
$
$
Variable costs
$
$
Fixed costs
$40,000
$120,000
Assets
$400,000
$400,000
Tax rate
40%
40%
For Project X: QBE = $40,000 / ($- $) = 40,000 units
For Project Y: QBE = $120,000 / ($- $) = 60,000 units
g: Define financial leverage.
Financial leverage refers to the use of fixed income securities (debt and preferred stock).
h: Calculate degree of operating leverage, degree of financial leverage, and degree of total leverage.
Example: Assume the quantity produced for the two firms below is 100,000 units.
Project X
Project Y
Price
$
$
Variable costs
$
$
Fixed costs
$40/000
$120/000
Assets
$400/000
$400/000
Tax rate
40%
40%
For Project X:
DOLQ = Q(P- V) / [Q(P- V)- F] = [100,000(4- 3)] / [100,000(4- 3)- 40,000]
DOLQ = 100,000 / 60,000 =
For Project Y:
DOLQ = Q(P- V) / [Q(P- V)- F] = [100,000(4- 2)] / [100,000(4- 2)- 120,000]
DOLQ =200,000 / 80,000 =
The results suggest that if Project Y has a Z percent increase in sales, it’s EBIT will increase by Z percent, while for Project X the increase in EBIT will be Z percent.
Degree of financial leverage (DFL). The degree of financial leverage (DFL) is defined as the percentage change in earnings per share that results from a given percentage change in earnings before interest and taxes (EBIT), and it is calculated as follows:
DFL= [percentage change in EPS] / [percentage change in EBIT]
DFL = EBIT / [EBIT- I]
Example: Ink has $2 million in sales, variable costs of 70% of sales, fixed costs of $100,000, and annual interest expense of $50,000. If Ink’s EBIT increases by 10% how much will its earning per share increase by?
Sales $2,000,000
Operating cost (1,400,000)
Fixed cost (100,000)
EBIT 500,000
DFL = EBIT/(EBIT- I) = $500,000/($500,000 - $50,000) = . %EPS = (DFL)(%EBIT). Hence earnings per share will increase by: ()(.1) = or %
If a firm uses a considerable amount of both operating leverage and financial leverage then a slight change in sales will lead to wide fluctuations in EPS.
DTL = (DOL)(DFL) = (%?EBIT / %?Sales)(%?EPS / %?EBIT) = %?EPS / %?Sales
DTL = [Q(P - V)] / [Q(P - V) - F - I]
DTL = [S - VC] / [S - VC - F - I]
Example: Given the following data for Ink Inc. Ink has $2 million in sales, variable costs of 70% of sales, fixed costs of $100,000, and annual interest expense of $50,000 (implying a DFL os ), how much will Ink’s EPS increase if the company’s sales increase by 10%? We need to estimate DTL.
DOL = (S- VC) / (S- VC- F)
DOL = ($2,000,000- $1,400,000) / ($2,000,000- $1,400,000- $100,000)
DOL = $600,000/$500,000 =
Thus, DTL = (DOL) (DFL) = ()() =
EPS = (DTL)(%?Sales), EPS will increase by: ()(.10) = .1333 or %
i: Describe the relationship between financial leverage and financial risk.
As financial leverage increases the expected rate of return will increase, but at the cost of increased risk. This tradeoff in using debt raises two related questions:
Is the higher expected rate of return associated with debt sufficient to compensate for the increased risk?
What is the optimal amount of debt?
The answer to both questions is essentially the same. If the issuance of debt increases the value of the firm, then debt should be used and the debt ratio that maximizes the firm’s value is the optimal capital structure.
j: Discuss why the use of greater amounts of debt in the capital strucure can raise both the cost of debt and the cost of equity capital.
The optimal capital structure is the one that maximizes the firm’s stock price and not the one that maximizes the firm’s EPS. With the increased use of debt the cost of debt increases. This is because lenders recognize that other things held constant, firms with higher debt levels are more likely to experience financial distress, so they require higher rates of return. Now you are going to have to investigate what the stockholders want. A stock’s beta coefficient measures its relative volatility or risk compared to the stock market portfolio.
As a firm increases its uses of debt its WACC declines. However, as the debt ratio increases the cost of debt and equity rise and the increasing costs of the two components begin to offset the fact that larger amounts of low cost debt are being used.
k: Describe how changes in the use of debt can cause changes in the company's earnings per share and in the stock price.
The optimal capital structure is the one that maximizes the firm’s stock price and not the one that maximizes the firm’s EPS. With the increased use of debt the cost of debt increases. This is because lenders recognize that other things held constant, firms with higher debt levels are more likely to experience financial distress, so they require higher rates of return. Now you are going to have to investigate what the stockholders want. A stock’s beta coefficient measures its relative volatility or risk compared to the stock market portfolio.
As a firm increases its uses of debt its WACC declines. However, as the debt ratio increases the cost of debt and equity rise and the increasing costs of the two components begin to offset the fact that larger amounts of low cost debt are being used.
l: Distinguish between the value of a company and the value of the company's common stock.
This is a pretty straightforward LOS. The answer is that the company's common stock represents the valuation of the residual claim on the company whereas the value of a company is determined by the sum of the value of the debtholder's stake, the preferred shareholder's stake, and the value of the common equity.
m: Explain the effect of taxes and bankruptcy costs on the cost of capital, the optimal capital structure, and the Modigliani and Miller (MM) capital structure irrelevance proposition.
These learning outcome statements want you to realize that there is a difference between the firm’s assets and what investors may be willing to pay for the shares that represent the assets. That is the essence of M&M and capital structure theory that follows.
The effect of taxes. In a subsequent paper M&M relaxed the assumption of no corporate taxes. The tax code allows firms to deduct interest payments as an expense but dividend payments to stockholders are not deductible. This differential tax treatment encourages firms to use more debt in their capital structures. The more the firm borrows the greater the tax benefits that will accrue to the remaining stockholders. M&M demonstrate that if their other assumptions hold, the optimal capital structure in a tax world will be 100% debt.
The effect of bankruptcy costs. The WACC will fall at first as small amounts of debt are added to the capital structure. As the firm continues to add debt to the capital structure the lender’s threshold level of risk is hit and they start to raise interest rates, slowly at first and then more rapidly. This means the WACC will fall, then bottom out, and finally start to rise.
n: Compare the MM capital structure irrelevance proposition and the trade-off theory of leverage.
The trade-off theory of leverage states that the optimal capital structure is attained at that amount of leverage where the benefits of additional debt (tax shelter) are equal to the costs (bankruptcy risk).
Since the interest payments on debt are tax-deductible, additional debt provides increased firm value via a tax shelter.
As debt increases, the probability and expected costs of bankruptcy increase exponentially.
Theoretically, the debt rate where the marginal benefits of the tax shelter equal the marginal cost of increased bankruptcy risk dictates the optimal capital structure.
Empirically, many corporations are found to have less debt than the trade-off theory of leverage would suggest.
Compared to MM irrelevance:
MM assumes no taxes and no bankruptcy; Trade-off assumes both.
Under MM, capital structure is irrelevant¡ª it has no impact on firm value.
Trade-off suggests a value-maximizing debt level where the marginal benefits of a tax shield equal the marginal costs of bankruptcy (The size of the pie can be maximized).
o: Describe how a company signals its prospects through its financing choices.
One of the assumptions M&M made was symmetric information. This means that investors have the same information about the firm’s future investment prospects as do the managers. However, managers are supposed to have better information than outside investors. This implies asymmetric information. If managers are supposed to behave as if they are maximizing current shareholders’ wealth by maximizing stock prices then the announcement of a stock offering will generally be taken as a signal that the firm’s prospects (as seen by its management) are not good. Why is a stock offering a bad signal? Assume a firm has a new product that will increase its profitability but to go into production the firm needs to raise capital. If the firm sells new stock, then as the profits from the new product start flowing into the firm, the price of the stock will rise. The current shareholders will do well but not as well as they would have had the company not sold more stock before the share price increased. So there is motivation on the firm’s part to avoid selling new stock when it has exceptional prospects. Rather, the firm will try to raise the new capital by other means, including using debt. So when a firm willingly issues new shares it must mean that prospects are not exceptional.
G: Dividend Policy
a: Describe the dividend irrelevance theory, the "bird-in-the-hand" theory, and the tax-preference theory.
The dividend irrelevance theory:
Merton Miller and Franco Modigliani maintain that dividend policy has no effect on the firm’s stock price or its cost of capital, hence dividend policy is irrelevant.
The bird-in-the-hand theory:
Myron Gordon and John Lintner argue that ks decreases as the dividend payout increases. Why? Because investors are less certain of receiving future capital gains from the reinvested retained earnings than they are of receiving current certain dividend payments. Gordon and Lintner argue that investors value a dollar of expected dividends more highly than a dollar of expected capital gains because the dividend yield component (D/P) is less risky than the growth component (g).
The tax preference theory:
There are three tax related reasons why investors might prefer the shares of firms offering a low payout:
Capital gains are taxed at a lower rate than dividend income.
Capital gains taxes are not paid until they are realized. Thus, retentions are allowed to accumulate in a tax-free environment.
If stock is held until the owner's death, the stock's basis is increased and no capital gains taxes are due.
b: Explain Modigliani and Miller's (MM) dividend irrelevance theory in the context of the determinants of the value of the company.
M&M’s argument of dividend irrelevance is based on their concept of homemade dividends. Assume, for example, that you are a stockholder and you don’t like the firm’s dividend policy. If the firm’s cash dividend is too big, you can just take the excess cash received and use it to buy more of the firm’s stock. If the cash dividend you received was too small, you can just sell a little bit of your stock in the firm to get the cash flow you want. In either case, the combination of your investment in the firm and your cash in hand will be the same.
You should note that the dividend irrelevance theory only holds in a perfect world with no taxes, no brokerage costs, and infinitely divisible shares.
You should also note that M&M are discussing the firm’s dividend policy (payout verses retention) and not the actual payout (current and future cash flow potential).
c: Discuss the principal conclusion for dividend policy of MM's dividend irrelevance theory.
Assume, for example, that you are a stockholder and you don’t like the firm’s dividend policy. If the firm’s cash dividend is too big, you can just take the excess cash received and use it to buy more of the firm’s stock. If the cash dividend you received was too small, you can just sell a little bit of your stock in the firm to get the cash flow you want. In either case, the combination of your investment in the firm and your cash in hand will be the same.
d: Describe how any shareholder can construct his or her own dividend policy.
This LOS is essentially the same as LOS the previous two LOSs to understand this one.
e: Calculate, assuming a constant return on equity, a company's dividend growth rate, given the company's dividend payout rate.
Suppose Ink Inc. has a ROE of 12% and pays 30% of its earnings in dividends. What is the expected growth rate in earnings?
g = (1- Payout)(ROE)
g = ()(12%).
g = %.
By stabilizing g the firm stabilizes its cost of capital since kS = D/P + g.
f: Describe how managers signal their company's earnings forecast through changes in dividend policy.
Stock prices normally fall when companies announce a dividend cut and stock prices normally rise when companies announce a dividend increase. Why does this happen? When a firm cuts its dividends, it usually signals that management does not think the current dividend payment can be maintained. As a result, expectations of future dividends are generally revised downward. The present value of expected future dividends falls and so does the stock’s price. This price reaction can be attributed to expected changes in the future dividends themselves, not to a change in the dividend payout policy. Again, dividends and dividend policy are two different things. The information content hypothesis refers to the market’s reaction to changes in corporate dividend payouts and not the firm’s dividend policy.
g: Describe the clientele effect.
The term clientele refers to the different groups of investors, such as individuals, institutions, and corporations that buy stocks.
The dividend clientele effect states that high tax bracket investors (like individuals) prefer low dividend payouts and low tax bracket investors (like corporations and pension funds) prefer high dividend payouts. So different groups desire different levels of dividends.
Through the law of supply and demand, investors will select companies with the dividend policies that meet their own needs. After everyone has made their selection the markets will be in equilibrium and all investors will be satisfied. This being the case, an individual firm won’t be able to boost its share price by changing its dividend payout. So the firm’s dividend policy does not matter.
h: Describe the residual dividend model and discuss the model's possible advantages or disadvantages to the company.
For a given firm, the optimal payout ratio is a function of the following four factors:
Investors’ preferences for dividends versus capital gains.
The firm’s investment opportunity schedule (IOS).
The firm’s target capital structure.
The availability and cost of external capital to the firm. The last three items constitute the residual dividend model.
Here the firm follows four steps to determine its target payout ratio:
Determine the firm’s optimal capital budget.
Determine the amount of equity needed to finance that capital budget given the firm’s target capital structure.
Use retained earnings to meet equity requirements to the greatest extent possible.
Pay dividends only if more earnings are available than are needed to support the optimal capital budget.
i: Describe dividend payment procedures, including the declaration, holder-of-record, ex dividend, and payment dates.
The actual payment procedure is as follows:
The declaration date is the date the board of directors approves payment.
The ex-dividend date is the cut-off date for receiving the dividend. The ex-dividend date is four business days before the date of record. (Note: It’s now two days.) If you buy the share on or after the ex-dividend date, you will not receive the dividend.
Holder-of-record date is the date on which the shareholders of record are designated.
Date of payment is the date the dividend checks are mailed out.
Stocks are traded ex-dividend on and after the ex-dividend date. So, theoretically, stock prices should fall by the amount of the dividend on the ex date. Because of taxes, however, the drop in price may be closer to the after-tax value of dividends.
j: Describe stock dividends and stock splits and explain their likely pricing effects.
Stock dividends are dividends paid out in new shares of stock rather than cash. In this case, there will be more shares outstanding, but each one will be worth less. Stock dividends are commonly expressed as a percentage. A 20 percent stock dividend means every shareholder gets 20 percent more stock.
Stock splits divide up each existing share into multiple shares, thus creating more shares. There are now more shares, but the price of each share will drop correspondingly to the number of shares created. So there is no change in the owner’s wealth. Splits are expressed as a ratio. In a three-for-one stock split, each old share is split into three new shares. Because of bookkeeping problems, stock splits are more common today than stock dividends.
Some firms use stock splits and dividends to keep stock prices within a perceived optimal trading range. What does academic research have to say about this?
Stock prices tend to rise after a split or dividend.
Price increases appear to be due to signaling about future earnings.
If good news doesn’t follow, prices tend to revert back to their original level.
Stock splits and dividends tend to reduce liquidity due to higher brokerage fees on lower priced stocks.
k: Discuss the advantages and disadvantages of stock repurchases and calculate the price effect of stock repurchase.
Advantages of repurchase:
A repurchase is viewed as a positive signal by investors. Investors see repurchases as a statement by management that their shares are undervalued.
A repurchase gives stockholders a choice. With a cash dividend stockholders must accept the payment and pay the taxes.
A repurchase can remove a large block of stock ¡°overhanging¡± the market keeping the price per share down.
A repurchase gives the firm flexibility. If a firm’s excess cash flows are thought to be only temporary. management can make the distribution in the form of a share repurchase rather than paying higher cash dividends that cannot be maintained.
Repurchases can be used to produce large-scale changes in capital structures.
Disadvantages of repurchases:
Stockholders may not be indifferent between dividends and capital gains.
Selling stockholders may not understand the implications of a repurchase.
The corporation may pay too high a price for the repurchased stock.
Price effect of repurchases: Black and Smith is expected to have $88 million in earnings and plans to distribute $44 million to shareholders through dividends or stock repurchases. Currently, the stock price is $20 and there are 22 million shares outstanding. A large repurchase could be executed at $22 per share:
EPS0 = $88 million/ 22 million shares = $, Shares repurchased: $44 million/ $22 = 2 million shares; EPS1 = $88 million/ 20 million shares = $, New Share Price = EPS1 * P/E = $ * 5 = $.
2.: Discounted Cash Flow Applications
a: Calculate the net present value and internal rate of return of a capital investment project.
Example: Calculate the NPV of an investment project with an initial cost of $5 million (CF0 = -5 million), and positive cash flows of CF1 = million at the end of year 1, CF2 = million at the end of year 2, and CF3 = million at the end of year 3. Use 12% as the discount rate.
NPV = [-5 + / ()] +[ / ()2] + [ / ()3] = $332,130
Example: Using the same investment project, calculate IRR.
0 = -5 + [ / (1 + IRR)] + [ / (1 + IRR)2] + [ / (1 + IRR)3] = %
b: Explain the decision rule for making investment decisions under the net present value and internal rate of return methods.
NPV Decision Rule:
If an investment's NPV is positive, it will increase shareholder wealth and we should accept the project.
If an investment's NPV is negative, it will decrease shareholder wealth and we should not undertake the project.
If we have two projects for investment, but can only choose one (meaning the projects are mutually exclusive), choose the investment with the higher positive NPV.
IRR Decision Rule:
If the investment's IRR is greater than the required rate of return, accept the project.
If the investment's IRR is less than the required rate of return, reject the project.
c: Discuss problems associated with the internal rate of return method.
For independent projects, the IRR and NPV methods always give the same accept or reject decision.
For mutually exclusive projects, the NPV and IRR methods can give different accept or reject decisions.
Mathematically, the NPV method assumes the reinvestment of cash flows is at the cost of capital while the IRR assumes the reinvestment rate to be the IRR. As a result, the NPV methods selects the project that maximizes shareholder wealth. Because shareholder wealth is the bottom line, always use the NPV rule when the IRR and NPV rules conflict.
