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This Document Contains Chapters 12 to 15 CHAPTER 12 RISK, RETURN, AND CAPITAL BUDGETING CHAPTER IN PERSPECTIVE This chapter continues to build the bridge between asset investment, capital budgeting, and financial markets. This chapter continues the risk measurement focus, starting with calculation of beta. Students with their new financial/statistical calculator are able to crank out a regression line. Just give them a worksheet with the numbers. Ask them to plot the regression line and be surprised at the variety of graphics packages located in computers in the student dorms or at the part-time job site. The concepts of the risk/return tradeoff are cemented in this chapter. Later in the chapter, risk and capital budgeting concepts are combined in a short but important discussion of the project cost of capital. In your chapter presentation, this last section is the connecting link of CAPM to the asset side of the balance sheet. Help the student make the connection! CHAPTER OUTLINE 12.1 MEASURING MARKET RISK Measuring Beta Betas for Cameco and Royal Bank Total Risk and Market Risk Portfolio Betas 12.2 RISK AND RETURN AND CAPITAL ASSET PRICING MODEL, CAPM Why the CAPM Makes Sense The Security Market Line How Well Does the CAPM Work? 12-1 This Document Contains Chapters 12 to 15 Using the CAPM to Estimate Expected Return 12.3 CAPITAL BUDGETING AND PROJECT RISK Company Risk versus Project Risk Determinants of Project Risk Don’t Add Fudge Factors to Discount Rates 12.4 SUMMARY TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 12.1 MEASURING MARKET RISK A. Only “macro” events affect the value of the market portfolio, or a portfolio of all assets in the economy. B. A broad market base, such as the S&P/TSX Composite, is often used as a proxy for the market portfolio. C. Firm specific or unique risk are averaged out or diversified away when considering the market portfolio. D. A measure of a stock’s risk relative to the risk of the market portfolio is called the stock’s beta, and is expressed as the Greek letter, β. Measuring Beta A. Investors with diversified portfolios are not concerned about the specific or unique risk of a stock, only the impact of the stock on the risk of the entire portfolio. B. The relative risk of the stock compared to the portfolio risk or beta is the relevant risk to consider when a new stock is added to the portfolio. C. Defensive stocks historically tend to vary less than the market portfolio; aggressive stocks have a history of more variation relative to the market portfolio. D. Beta is the slope of the regression line of the individual stock returns relative to the market portfolio returns. If the slope indicates a change in historical stock returns similar to the market, the beta has a value close to 1. If the variation in the stock return, given a 1 percent variation in the market returns, is less than the market variation, the beta is less than 1 and the stock is noted as a “defensive” 12-2 stock. If the slope of the line through the points found by plotting the stock’s returns relative to a 1 percent change in the market portfolio is greater than 1, the beta has a value greater than 1. The stock is called “aggressive”. E. Any stock’s return is comprised of two parts. The first is explained by the macro events in the market or the market rate of return. The second part of the return is related to the specific or unique risk of the stock relative to the market rate of return, or the stock beta. F. The beta is calculated by (1) observing monthly rates of return for the stock and the market; (2) plotting the observations as in Figure 12.1 and 12.2; and (3) fitting a regression line showing the average returns to the stock (dependent variable) at different market returns (independent variable). The slope of the line, beta, relates the change in stock returns, given a change in market return. G. The Slope function in Excel will calculate the beta if the data for the stock returns and market returns are input into the spreadsheet. H. Another way to calculate the beta of the stock is to calculate the correlation between the return on stock A and the market portfolio, Corr(A,M) multiply it by the standard deviation of stock A’s returns, Std(A), and divide by the standard deviation of the market portfolio return, Std(M): Beta of stock A = Corr(A,M) × Std(A) Std(M) I. Yet another way to calculate beta of a stock is to divide its covariance with the market portfolio, Cov(A,M), by the variance of the market, Var(M): Beta of stock A = Cov(A,M) Var(M) Betas for Cameco and Royal Bank A. Betas for Cameco and Royal Bank are calculated in Figure 12.2. Sixty months’ return of the stocks and market are plotted and a regression line is calculated and drawn. 12-3 B. The beta is the “b” in the (a + bx) function of the straight line drawn or the slope of the line. It indicates the change in the stock return, given a change in the market rate of return. C. Cameco had a beta of 1.51, or a stock variation 51% higher than the market variability over the period (1.51% change for every 1% change in market rate of return). Royal Bank tended to vary less than the market in the same period (beta of 12-4 .63 or .63% for any 1% change in the market rate of return). Total Risk and Market Risk A. The standard deviation of the returns on a firm stock, which is the total variability of the stock, is not the same as market risk . B. Back in Chapter 11 Table 11.6 shows the standard deviations for selected Canadian common stocks for a specific period, January 2006–December 2010. C. Now in Table 12.1 shows the standard deviations and betas of the same stock as in Table 11.6 measured over the same specific period. This data makes it so evident that standard deviation and beta are very different measures of risk. For example, the stock with the highest standard deviation (IMAX) does not have the highest beta. Portfolio Betas A. Diversification decreases the variability from unique risk but not from market risk. B. The beta of a portfolio with stocks all with betas of 1.51 like Cameco’s would have a beta of `.51. Its variability would be 1.51 times as variable as the market. We can estimate the standard deviation of the well-diversified portfolio – it will be 1.78 times the standard deviation of the market portfolio. The historical average standard deviation of the market portfolio is about 19%, giving the standard deviation of the well-diversified but riskier portfolio of 1.51 × 19%, or 28.7%. C. Royal Bank tended to vary less than the market in the same period (beta of .63). A 12-5 well-diversified portfolio of stocks with betas of .63 would have a standard deviation of about .63×19%, or 12%. D. A large portfolio of diversified stocks would approximate the market index and have a portfolio beta around one. The standard deviation of this large, well- diversified portfolio would be about 19%, the standard deviation of the market portfolio. An index mutual fund is a “market portfolio” of stocks with a beta close to the value of one. 12.2 RISK AND RETURN AND CAPITAL ASSET PRICING MODEL, CAPM A. Government of Canada Treasury bills have very low risk and a beta of zero, or no relationship with the variations of the market portfolio of stocks that has a beta of 1.0. Although Treasury bills have very low risk, they still pay investors a rate of return. This rate of return compensates investors for giving up the pleasure of spending their money on goods and services. This risk-free return is compensation for the time-value of money. B. The difference between the return on the market and the T-bill rate is called the market risk premium (MRP), or the risk premium demanded by investors to hold the market portfolio rather than T-bills. C. Over the past 852 years, the market risk premium has averaged 7 percent per year. With the risk-free rate of 3%, the expected return on the market is 3% + 7%, or 10%. See Figure 12.4 (a). D. The expected rate of return on any portfolio combining T-bills and the market portfolio lies on a straight line between all T-bills (3%) and all stocks of the market portfolio (10%). See Figure 12.4 (b). 12-6 E. The risk premium is proportional to the portfolio beta. A portfolio with one-half T-bills and one-half the market portfolio of stocks would have a beta of .5, and a risk premium of one-half the market portfolio risk premium. F. The market risk premium is the market return less the return on T-bills, or: Market Risk Premium = rm - rf = 10% - 3% = 7% The market risk premium determines the extra return needed to compensate per unit of risk. G. Beta measures risk of the stock relative to the market. Thus beta is the measure of the quantity of risk a stock has. The expected risk premium on an individual stock is the stock return less the risk-free rate or beta times the market risk premium, or: Risk Premium on any asset = r - rf = β × (rm - rf) The risk premium depends on both the quantity of risk, β, and the extra compensation needed per unit of risk, the market risk premium, rm - rf . H. The total expected return on a stock is the risk-free rate plus the risk premium of the stock or: Expected Return on stock = risk-free rate + risk premium, or: r = rf + β × (rm - rf) = rf + β × MRP I. The above formula relating the expected return as the sum of the risk-free rate plus the risk premium is called the capital asset pricing model (CAPM). The rate of return on an individual stock is dependent upon the risk-free rate and the stock’s risk premium. The stock’s risk premium is determined by the market risk premium and the risk of the stock relative to the market portfolio, its beta. 12-7 Why the CAPM Makes Sense A. The CAPM assumes the market is dominated by well-diversified investors; market risk is the only relevant risk. B. The expected return on a portfolio is equal to the risk-free interest rate plus the expected portfolio risk premium. The Security Market Line A. A plot of expected rates of return of varied risk (beta) portfolios is called the security market line. B. According to the CAPM, expected rates of return for all securities and all portfolios lie on this line. C. The required risk premium for any investment is given by the security market line. D. A stock with a given beta that is expected to earn a return higher than that on the security market line will be purchased by investors, bidding up the stock price and lowering the expected rate of return to the security market line. Investors keep expected returns on the security market line. How Well Does the CAPM Work? A. The security market line is the risk-return trade-off of investors. B. The CAPM states that the expected risk premium on an investment should be proportional to its beta. Stocks with betas of .5 should, on average, earn a risk premium half as large as stocks with beta of 1. C. The CAPM explains the risk-return trade-off well in the period 1931 to 1991, though the SMA tends to understate low risk returns and overstate high beta portfolio returns. In the period 1966-1991, however, there is little relationship between portfolio betas and the return on the portfolio. Other variables outside the simplified CAPM are involved in establishing returns besides beta. D. The CAPM explains the risk-return trade-off in broad terms. Figure 12.6 shows that higher beta portfolios earned higher return than lower beta portfolios in the period 1931 to 2005. However, the high beta stocks did not earn as much return as predicted by the CAPM and low beta stocks tended to earn too much. Furthermore, in the period 1966-2002, there is little relationship between portfolio betas and the return on the portfolio. Other variables outside the simplified CAPM are involved in establishing returns besides beta. 12-8 E. Other models of stock returns include the multi-factor CAPM and the Arbitrage Pricing Theory (APT). These models argue that stock returns depend on the return on the market portfolio but on also other factors, such as the growth rate of the economy, the yield spread on between long and short term bonds. F. The CAPM, though not the only model of the risk-return trade-off, is a good practical rule of thumb. It presents a simplified approach noting that extra returns are required by investors to take added risk, and investors are primarily concerned with market risk that cannot be diversified away. Using the CAPM to Estimate Expected Returns A. To estimate expected investor rate of return for a selected stock, three numbers are needed: (1) the current risk-free rate of interest, (2) the expected market risk premium, and (3) the beta of the stock, or the historical variation in stock risk premium relative to the market risk premium. B. The CAPM may also be used to estimate the discount rate for new capital investments when calculating net present value. The security market line provides a standard for investment project acceptance. If the internal rate of return on a project exceeds the opportunity rate of return (investor returns in a portfolio of equal risk securities), the firm should make the investment. C. For any risk level or beta, project returns below the security market line are unacceptable and have negative NPVs. 12.3 CAPITAL BUDGETING AND PROJECT RISK A. Before the CAPM, financial manager’s intuition indicated that riskier projects are less desirable than safe projects and that riskier investments must have higher expected rates of return relative to safe projects. Company Risk versus Project Risk A. The estimated required rate of return of investors in a firm’s securities is called the company cost of capital. The cost of capital is the discount rate used in calculating the NPV of investment projects and is the minimum acceptable rate of return when compared to the internal rate of return (IRR). B. The cost of capital is determined by the average risk of a company’s assets and operations. The cost of capital is applicable as a discount rate only on projects with the average risk of the business. C. The project cost of capital is a risk-adjusted minimum acceptable rate of return used as a discount rate on a specific project. The project cost of capital depends on 12-9 project risk, not the company cost of capital. Only if the risk of the project happens to equal the average risk of the company’s existing businesses will the company’s cost of capital be appropriate for the project’s required rate of return. D. When assessing the riskiness of a project, a good question to ask is what would be the required rate of return if this project were a separate firm. It is the risk of the project or the investment that determines the appropriate cost of capital for the project. Determinants of Project Risk A. Project risk is usually assumed to be associated with the variability of cash flow of the project itself, but what matters is the relationship between the project’s cash flows and the total firm (portfolio) variability or the project’s beta. B. Projects that tend to have high operating leverage (high fixed costs) tend to have high project betas. C. One way to estimate the riskiness of a project is to look for existing companies engaged in the same type of project. Estimating project risk by finding equivalent risk businesses solely involved in that business is the pure play approach. Don’t Add Fudge Factors to Discount Rates A. Concern over the downside features of risk encourages managers to add risk premiums to discount rates in project analyses, thus forsaking many value- creating projects. B. Special risk factors should be incorporated into the cash flow estimation, not the discount rate. Special risks are often unique risks that are diversified away with other projects. 12.4 SUMMARY PEDAGOGICAL IDEAS General Teaching Note - The security market line, presented in Figure 12.5, is often referred to as the risk/return trade-off. What is the relevance of the line and why might that be the “path” of the risk/return trade-off? Consider taking a point above and/or below the security market line. Why does the market tend to price the security back to the line? With a higher return than securities with the same risk, investors will quickly bid the price up and the yield down to the security market line. Student Career Planning - Encourage your students to take a trip to a financial 12-10 center, where financial market places such as exchanges are located. Many will provide tours and lectures. Alumni contacts are useful for providing tours and hosting student organization trips. While technology is lessening the geographic importance of financial services, there is always a concentration of financial firms in urban areas. Encourage the urban trip with a career planning focus. Internet Exercises - Finding the calculated beta of a company is often a challenge to students. MarketGuide.com provides a company’s beta along with many other ratios under the “profile” link. Yahoo Finance provides MarketGuide data, discussed below. http://finance.yahoo.com http://ca.finance.yahoo.com Yahoo Finance is an excellent site for many finance and company financial research questions. Students in your business finance class are probably studying/applying their research skills to one or more public companies. Ask them to find the beta of their companies or of a list of companies that you have selected. If you give them a list, include the stock symbol. It is easier to get around the Internet and research companies by entering the stock symbol than the name. Give them or show them the URL above, enter the stock symbol (you can look it up by clicking “symbol lookup”), then link to the “profile” listed to the right of the stock quote. For example, for Quaker Oats, enter OAT, and then click “profile.” The profile offers a vast array of company research. Scroll down to the “Statistics at a Glance,” and the beta of .69 is listed under the Price and Volume statistics. Once they have a collection of betas of companies known to your students, a classroom or small group discussion about the relative “riskiness” of the companies and “why” provides a way to reinforce the major topics of the chapter. You can use the U.S. Yahoo site for betas on Canadian stocks. However, no betas are provided at the Canadian Yahoo site, ca.finance.yahoo.com. See the textbook internet questions for ways to get the names of Canadian stocks that are listed in the U.S., and for whom beta data is available at finance.yahoo.com, the U.S. Yahoo site. 12-11 CHAPTER 13 THE WEIGHTED-AVERAGE COST OF CAPITAL AND COMPANY VALUATION CHAPTER IN PERSPECTIVE This chapter, like the entire section, continues to bridge the relationship between investor concerns and required minimum returns and the internal decision-making processes of a business. The cost of capital or required rate of return concepts are covered in this chapter. While the opportunity rate of return concept was introduced generally several chapters ago, the specific theory and processes involved in estimating the cost of capital are covered in this chapter. The opportunity cost of capital is involved in the NPV and IRR evaluation of investment opportunities. This shareholder involvement or perspective in the investment process says that if the cost of capital return is generated as the return on investment, shareholders will receive their minimally acceptable rate of return. What determines this rate? The market- determines the cost of capital; management only estimates what it will be, based on a current evaluation. This market-determined rate of return required on one business is the rate forgone on similar investments of similar risk (opportunity cost). Like the NPVs and IRRs of the capital budgeting chapters, the reasonable accuracy is a function of the quality of inputs. Like the cash flow estimates in capital budgeting, estimating the required rate of return today and over the life of the investment requires considerable insight in addition to technique. Remember, there is no cost of capital independent of where (riskiness) funds are invested. Keep reinforcing the general overview relationship between capital budgeting and financial markets to the students. They are likely to get mired in the details and fail to keep a broad perspective. CHAPTER OUTLINE 13.1 GEOTHERMAL’S COST OF CAPITAL 13.2 THE WEIGHTED-AVERAGE COST OF CAPITAL Calculating Company Cost of Capital as a Weighted Average 13-1 Use Market Weights, Not Book Weights Taxes and the Weighted-Average Cost of Capital What If There Are Three (or More) Sources of Financing? Wrapping Up Geothermal Checking Our Logic 13.3 MEASURING CAPITAL STRUCTURE 13.4 CALCULATING REQUIRED RATES OF RETURN The Expected Return on Bonds The Expected Return on Common Stock The Expected Return on Preferred Stock 13.5 CALCULATING THE WEIGHTED-AVERAGE COST OF CAPITAL Real Company WACC 13.6 INTERPRETING THE WEIGHTED-AVERAGE COST OF CAPITAL When You Can And Can’t Use WACC Some Common Mistakes How Changing Capital Structure Affects WACC when the Corporate Tax Rate is Zero How Changing Capital Structure Affects Debt and Equity when the Corporate Tax Rate is Zero What Happens if Capital Structure Changes and the Corporate Tax Rate is Not Zero? Revisiting the Project Cost of Capital 13.7 VALUING ENTIRE BUSINESSES Calculating the Value of the Concatenator Business 13-2 13.8 SUMMARY TOPIC OUTLINE, KEY LECTURE TERMS, AND CONCEPTS 13.1 GEOTHERMAL’S COST OF CAPITAL A. The cost of capital for an all-equity financed firm, such as Geothermal, is the required return on the firm’s assets. Owning all the shares is the same as owning all the assets and the expected return on the stock is the expected return on the assets. B. Note the following identities for an all-equity financed firm: Value of business = value of stock Risk of business = risk of stock Rate of return on business = rate of return on stock Investors’ required return from business = investors’ required return from stock C. The capital structure is the market value mix of debt and equity securities used to finance the company. Think about the sources of financing as a portfolio of securities funding a portfolio of assets. D. With both equity and debt financing, the following identities hold: Value of business = value of portfolio of all of the firm’s debt and equity securities Risk of business = risk of portfolio of securities Rate of return on business = rate of return on portfolio of securities Investors’ required return from business = investors’ required return on portfolio E. The cost of capital is the weighted average of returns (weighted by market value) on debt and equity and that is equal to the expected rate of return on the portfolio of assets. F. The cost of capital is the discount rate for evaluating new, similar risk asset investments. 13.2 THE WEIGHTED AVERAGE COST OF CAPITAL A. The cost of capital is the opportunity cost of capital for the firm’s existing assets. 13-3 The cost of capital is used to assess or value new assets with risks similar to existing assets. B. In the following sections, cost of capital concepts are discussed as is the weighted average cost of capital, a method for estimating the company cost of capital when debt capital is present, and an after-tax cost of debt capital must be calculated. Calculating Company Cost of Capital as a Weighted Average A. When only equity is financing a business, the CAPM may be used to calculate the company cost of capital. B. When debt securities finance a portion of assets, the cost of capital is a weighted average of the returns demanded on the debt and equity securities. It is the expected return on the portfolio of all the firm’s securities, which in turn is driven by the expected return on the business assets, or V = D + E. C. The cost of capital is the expected return on assets, rassets, which is equal to the expected income returns to the debt portion of total assets, (D × rdebt), plus the expected income returns to equity portion of total assets, (E× requity). Use Market Weights, Not Book Weights A. The cost of capital is the expected rate of return that investors require on the business assets, based on the market value of the securities of the firm. B. The market value of securities rather than the book values should be used as weights when calculating the weighted average cost of capital. Taxes and the Weighted-Average Cost of Capital A. Taxes are important considerations in the cost of capital calculation because interest payments on debt are deductible. At a 35% tax rate, the after-tax cost of $1 of interest paid is $1× (1-.35) or $.65. This interest tax shield of $1 × 35% or $.35 on $1 reduces the pre-tax cost of debt by (1- tax rate). The after-tax cost of debt with a required pre-tax return of 8% is 8%×(1-.35) = 5.2%. B. The after-tax version of the company cost of capital is called the weighted cost of capital (WACC), which is the expected rate of return on a portfolio of all the securities of the firm and the discount rate for the NPV evaluation of new investments of similar risk. What If There Are Three (or More) Sources of Financing? A. Even if the company has many different types of financing, the approach is the 13-4 same: calculate the weighted average, after-tax cost (required rate of return) for each type of financing. B. For example, if the company has debt, preferred share and common share financing, find the market value of each type of financing. Add the market values together to get the total firm value. Calculate the weight for each type of financing as the ratio of its market value to the total firm market value. Multiply each weight by its estimated required rate of return and add them up. Wrapping Up Geothermal A. The use of lower cost, tax-deductible debt lowers Geothermal’s cost of capital below that of an all-equity firm. B. The WACC is the minimum acceptable rate of return on Geothermal’s investment. The expected internal rate of return (IRR) exceeds the WACC and the NPV analysis indicates that the new project will add $9.5 million to the net wealth of Geothermal’s owners. Checking Our Logic A. If Geothermal earns the cost of capital on assets, 11.4%, the debt security holders will earn their required rate of return, 8%, and shareholders will earn their required rate of return of 14%. B. If Geothermal earns an IRR greater than (less than) the cost of capital, shareholders will earn a return higher (lower) than their required rate of return of 14%. Creditors will earn only their fixed rate, required rate of return of 8% in all periods. C. Projects with actual NPVs greater than zero will earn shareholders a return greater than the required rate of return on equity. Projects earning (IRR) less than the cost of capital will produce actual NPVs less than zero and returns to equity below the required rate of return. 13.3 MEASURING CAPITAL STRUCTURE A. Some of the practical problems involved in measuring the cost of capital include (1) identifying sources of financing (2) assessing market values, and (3) determining the current market value of securities. B. Use the firm’s financial statements to identify how the firm is financed. Look for financing that the firm has raised. If the security pays interest or dividends, it should be included in the firm’s cost of capital. 13-5 C. Market value weights are preferred over book value weights. Publicly traded share prices may be found on the websites of financial newspapers. Also traded debt and preferred shares prices may be found on the web. Market value estimates of debt, preferred and common equity may be calculated by finding the present value of future cash flows discounted at the current interest rates. D. The market value of equity may be estimated by multiplying the current share price by the number of shares outstanding. 13.4 CALCULATING REQUIRED RATES OF RETURN A. Estimate the current, required rate of return on each security the firm has outstanding. For bonds, the current yield to maturity is a good proxy; for stocks, estimates using the CAPM or dividend discount model are reasonable numbers. The Expected Return on Bonds A. The yield to maturity, or the yield calculated to equate future cash flows with the price of the bond, is a good proxy for expected bond returns for healthy firms. The Expected Return on Common Stock A. The cost of equity capital may be estimated using the CAPM, where the expected return on equity is equal to the sum of the risk-free, T-bill rate plus the firm’s beta times the market risk premium. B. The dividend discount model may be used to estimate the required rate of return on equity, Po = DIV1/(requity - g), where Po is the current price, DIV1 is the expected first year’s dividend, and g is the expected growth rate. Solving for requity, the equation is transformed into the sum of the dividend yield plus the dividend growth rate or: requity = DIV1 Po + g The Expected Return on Preferred Stock A. The estimated market value of preferred stock is found by dividing the constant dividend by the current required rate of return on similar risk preferred stock in the market. The price is equal to expected annual dividend divided by rpfd. B. Solving for the required rate of return on the preferred, use the following estimates: 13-6 rpfd = price Dividend of the preferred 13.5 CALCULATING THE WEIGHTED-AVERAGE COST OF CAPITAL A. The weighted average cost of capital is the weighted sum of the after-tax cost of debt plus the cost of equity. B. Many students find Table 13.4 a convenient way to keep track of the components of the firm’s WACC. 13.6 INTERPRETING THE WEIGHTED AVERAGE COST OF CAPITAL When You Can and Can’t Use WACC A. The WACC is the rate of return that the business must expect to earn on its average-risk investments in order to provide the opportunity rate of return to all its investors, debt and equity. B. Investment projects under consideration with higher or lower risk than average business risk should be discounted with rates above or below the WACC. Some Common Mistakes A. Because debt is tax deductible and its after-tax cost is far less than the cost of equity, one may reason that funding the project with increased proportions of debt will lower the WACC. B. However, as the debt ratio increases, the incremental cost of debt, both explicit interest rates and implicitly through increases in the cost of equity capital, raises the WACC. Adding debt makes equity riskier, increasing the required return to equity. How Changing Capital Structure Affects WACC When the Corporate Tax Rate is Zero A. If there are no corporate taxes, a change in the capital structure does not affect the WACC, though it does affect the incremental cost of each component of the capital structure. B. The shareholder’s required rate of return increases as the debt/equity ratio is increased. This occurs because as the company becomes more highly leveraged, 13-7 the shareholders’ risk increases. We deal with this topic in more detail in Chapter 15. How Changing Capital Structure Affects Debt and Equity When the Corporate Tax Rate is Zero A. The beta of the assets of a company must equal the weighted average of the beta of its debt and the beta of its equity. B. If the corporate tax rate is zero, when the company changes its financing mix, the assets of the company do not change. Consequently, the beta of its assets does not change. C. Given that the beta of the assets does not change when the mix of financing is changed, it must be the case that the weighted average of debt and equity betas also does not change. D. Typically we first figure out the new beta of the debt and then use equation 13.13 to determine the new beta of the equity. For the case of riskfree or zero beta debt, equation 13.14 is used. What Happens If Capital Structure Changes and the Corporate Tax Rate is Not Zero? A. Interest is tax-deductible for corporations. When a company borrows, it pays less tax than it would be if it were all equity financed. This creates an incentive to use debt: to reduce taxes. We explore this more fully in Chapter 16. B. The equity of a firm with no debt is called the unlevered beta. It measures the business risk borne by shareholders. C. As the company increases its leverage, the risk of equity increases. The shareholders bear both business risk and financial risk. This was seen in the previous subsection. We call this the levered equity beta. D. Equation 13.15 gives the formula for calculating the levered equity beta when the company pays taxes. E. Equations 13.15 and 13.16 are used by financial analysts and investment bankers when determining the impact on the risk of equity of a change in the company's leverage. Revisiting the Project Cost of Capital A. The project cost of capital is the required rate of return investors require to be 13-8 compensated for the risk of the project. B. The project cost of capital must not only reflect the riskiness of the project but also the best way to finance the project in order to minimize the required rate of return. We will deal with the question of the optimal capital structure in Chapter 16. C. When using the pure-play approach to estimating a cost of capital for a project, often the weighted-average cost of capital of the comparison company is used. You now know that this assumes that the comparison company’s capital structure of the comparison company is also the best financing mix for the project. Whether this is a sensible assumption depends on whether the comparison company capital structure makes sense. 13.7 VALUING ENTIRE BUSINESSES A. Treat the whole company as one big project and discount the company’s cash flows by the weighted-average cost of capital. B. The operating cash flow less investment expenditures is the free cash flow, which is the amount of cash that the business can pay out to investors after paying for all investments necessary for growth. Calculating the Value of the Concatenator Business A. The value of the concatenator business is equal to the discounted value of all future cash flows, i.e., the free cash flows (FCFs) out to a horizon year plus the forecasted value of the business at the horizon and discounted back to the present B. At the end of the chapter we discuss a few other issues when determining WACC for valuation. One is the fact that the risk-free rate in the CAPM can be either a short-term or long-term bond. Many practitoners use a long-term government bond for their risk-free security because they are discounting cash flows over time. The crucial teaching point is that the market risk premium used in CAPM must correspond to the chosen risk-free security. 13.8 SUMMARY PEDAGOGICAL IDEAS General Teaching Note - One important cost of capital perspective that students often overlook is the time dimension of the cost of capital concept. While the ROA, 13-9 ROE, and accounting rate of return were good historical performance measures, they were not acceptable decision criteria. Just as historical costs of debt funds and historical rates of return on equity are important historical performance information, they are not good decision criteria. The cost of capital or required rate of return concept, like the NPV and IRR, are relevant to decision making and value creation for they are focused on the future, not the past. The NPV considers future cash flows and includes a variable, cost of capital, which estimates the required rate of return of investors in the future. Make sure students have a clear perspective as to performance indicators versus decision criterion. One is historical; the other, future oriented. Student Career Planning - One of the key strategies in career planning at a young age is flexibility. The student’s graduation date is usually unrelated to the state of the economy and job market in a field of interest. One alternative career path is graduate school, perhaps a Masters of Business Administration. For some students that graduate school option should be sitting on the shelf just in case, but there are a couple of “small” considerations. One, the time lag in graduate school planning is just as long as a successful job search, and two, one must have sufficient credentials to be admitted to most “accredited” graduate programs. Suggest to students that if graduate school is one of their options, they ought to take the GMAT or LSAT at the beginning of their fourth year. Many schools will honor these scores for four or five years, if graduate school is postponed. Further, the student is used to studying and taking exams, so it may be in their favour to take their tests early. The test preparation courses, advertised on every wall on campus, are very helpful, provide the discipline to prepare for the exam, and offer effective, specific test-taking techniques. Suggest that a graduate program be evaluated based on at least the following: 1. Overall quality of the program—see published reviews or offer advice to interested students. Is the business school accredited by AACSB? Why not? 2. Quality of a specific program—not all universities have uniform quality among their programs. 3. Area of country, region, or specific city—one way to get a job in New York City where they may want to live, is to attend a university in New York. 4. Source of graduate assistantships or scholarships, which pay tuition and more. Internet Exercises - This chapter is a great place to discuss the concepts associated with economic value added (EVA), a popular value-based management system espoused by Stern Stewart and Company and heartily supported by Fortune magazine. Below are two very good sites that can provide an overview of EVA to both professors and students. See also Chapter 4, section 4.2, Economic Value Added and Accounting Rates of Return. http://www.sternstewart.com 13-10 Go to the source! Stern Stewart and Company consulting firm takes credit for developing and applying (selling) the economic value added concept to the world. Many have copied it! Stern Stewart’s Internet site provides a good tutorial of EVA concepts, research studies, and client case studies. The Journal of Applied Corporate Finance, supported by Stern Stewart, is another source of continued EVA discussion. Read the pages associated with “About EVA.” For papers and further research, review the “Research Reports.” For case studies of EVA applications, review the “EVA in Action” materials. For further study, review the Stern Stewart “Bookshelf.” Overall, this is the best site to begin your EVA research. http://www.evanomics.com/etusivu.shtml The Evanomics Internet site, by Esa Makelainen of the Helsinki School of Economics and Business Administration, is an excellent focal point for professors and students who wish to develop their knowledge of economic value added (EVA). The Evanomics site provides extensive links to other EVA materials and access to Prof. Makelainen’s Economic Value Added as a Management School Publication. Some of these EVA presentation materials may be adapted, and of course cited, for the classroom. Students with special project title needs find that a study of EVA provides a good reinforcement of finance concepts and a practical tool for interview discussion and business applications. 13-11 CHAPTER 14 INTRODUCTION TO CORPORATE FINANCING AND GOVERNANCE CHAPTER IN PERSPECTIVE This second chapter related to business financing covers the many varieties of financing alternatives available in financial markets. There is an in-depth discussion of common stock, preferred stock, and debt securities. Much of the discussion focuses on the standard terms of common stock and other capital market securities. Discuss the risk/return considerations of each of the characteristics, features, or covenants with your students. Each feature affects the future cash flows, their timing, and variability. Keep this valuation theme in students’ minds as they look at the details. At the end of the chapter historical patterns of corporate financing is discussed. CHAPTER OUTLINE 14.1 CREATING VALUE WITH FINANCING DECISIONS 14.2 COMMON STOCK Book Value versus Market Value Dividends Ownership of the Corporation Voting Procedures Classes of Stock Corporate Governance in Canada and Elsewhere 14.3 PREFERRED STOCK 14.4 CORPORATE DEBT 14-1 Debt Comes in Many Forms Innovation in the Debt Market 14.5 CONVERTIBLE SECURITIES 14.6 PATTERNS OF CORPORATE FINANCING Do Firms Rely Too Heavily on Internal Funds? External Sources of Capital 14.7 SUMMARY APPENDIX 14 A THE BOND REFUNDING DECISION TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 14.1 CREATING VALUE WITH FINANCING DECISIONS A. Financial managers are likely to create value in less-efficient product markets, not in very competitive financial markets. Managers should focus on investment decisions for value creation, not financing. 14.2 COMMON STOCK A. Corporations issue common shares of ownership. Shareholders or stockholders own the shares and may trade the shares. B. Common stock has several classifications or “sets” of shares. The total possible number of shares that the company may issue is the shares authorized by a vote of the common stock. Of the authorized, usually a large proportion is issued or issued and outstanding, and the rest are authorized. C. The number of outstanding shares is used to calculate dividends and earnings per share. D. When a share is issued or sold it is recorded or “booked” usually at a nominal value. Earlier, shares would be issued at par value which was an arbitrarily set number and almost always lower than the actual sale price of the new shares. The 14-2 difference was recorded as additional paid-in capital, paid-in surplus, or capital surplus. The Canadian Business Corporations Act has since been changed to stop this practice and today common shares mostly do not have a par value, although some still do as a remnant from the old system.1 E. Cumulative earnings, not paid out in dividends, but reinvested in the firm, are accounted for in the retained earnings account. F. Sometimes a company may repurchase some of its own shares. In Canada, any shares repurchased must be cancelled. This is done by reducing the company’s net equity account to the extent of the amount paid for any shares repurchased.2 The common shares account is reduced by the average issue price. Any amount in excess of the average issue price is subtracted from retained earnings or, sometimes, from the paid-in surplus account. G. Net common stockholders equity is the sum of the common stock account recorded at par value, the paid-in surplus, and the retained earnings, less the amount of repurchased or treasury stock. The amount represents the historical value of money raised from the sale of stock plus earnings retained over the past, less the amount of shares repurchased. Book Value versus Market Value A. Net common stockholders equity is recorded at original, historical book value. B. The market value of common equity is the product of the number of shares outstanding times the current market value per share. C. The market value is determined in the market based on the prospects of future cash flows, their timing, and the riskiness of the cash flow. D. Market value is usually greater than book value if the managers have been investing in positive, value creating, net present value investments. If actual NPVs are negative for the business over time, the economic or market value will be less than the accounting or book value. Dividends A. The board of directors declares dividends. These are not contractual like interest payments to creditors. 1The practice of setting par value and using the additional paid-in capital account is still followed in the United States. For this reason, in Canada the number of shares issued always equals the number outstanding. 14-3 B. Unlike interest expense, dividends are deemed a return on capital by Canada Customs and Revenue Agency, and are not a deductible expense. Ownership of the Corporation A. Stockholders, as owners of the corporation, have ultimate responsibility for the actions of the company. B. Shareholders delegate most decisions to the board of directors they elect, and the management which is appointed by the board. Some decisions related to the number of authorized shares, mergers, etc., are retained by shareholders. C. The board, comprised of inside, corporate officers, and outside directors, appoints top managers and provides an overview of managerial activities and performance for the shareholders. Ownership of the Corporation A. Shareholders, as owners of the corporation, have ultimate responsibility for the actions of the company. B. Shareholders delegate most decisions to the board of directors they elect, and the management, which is appointed by the board. Some decisions related to the number of authorized shares, mergers, etc., are retained by shareholders. C. The board, comprised of inside, corporate officers, and outside directors, appoints top managers and provides an overview of managerial activities and performance for the shareholders. Voting Procedures A. Shareholders vote for members of the board of directors, using one of two voting methods. B. When each vacant board seat is voted upon one at a time, with one vote per share, a majority vote is needed for election. Under this majority voting method, a dominant shareholder group, electing one board member at a time, can usually elect their candidates to all positions. C. Under the cumulative voting procedure all directors are elected in one vote. Minority group shareholders may cumulate their votes (number of shares times directors elected) and cast a block of votes. The largest block of votes appoints the first director and so on. D. Shareholders may delegate or proxy their vote to others, usually management- oriented shareholders or dissident shareholder groups. A proxy contest occurs when shareholder groups compete with existing management for control of the 14-4 board and the corporation. Classes of Stock A. While a single class of common stock is prevalent, some corporations have “A” or “B” stock, restricting the voting rights or dividend rights of one of the classes. B. Common shares without full voting rights are called restricted shares. If the restricted shares have no votes, they are called non-voting. If they have fewer votes per share than another class of common shares, they are called subordinate voting. Multiple voting shares carry multiple votes. C. Canadian securities regulators are also making it more difficult for a firm to convert an existing common share class into two share classes with different voting rights. In order to convert, most of the minority shareholders must approve. Also, the stock exchanges will not list a new class of non-voting or subordinate voting shares unless the shares have the right to participate in takeover bids. This right is called a coattail provision. Corporate Governance in Canada and Elsewhere A. The separation between ownership (principals) and management (agents) may create a potential conflict of interest between owners and managers. The study of this conflict and resolutions is called agency theory. B. The Japanese structure of holding companies and interlocking directorships and share ownership is called a kiretsu. The combination of industrial and financial firms provides for less “public” borrowing or financing and a better focus on long- term versus short-term performance. 14.3 PREFERRED STOCK A. The terms of preferred stock, especially the priority of claims on the declared dividend pool and the claim on assets in case of liquidation, are ahead of those of common stock. B. In exchange for the above preferred treatment, preferred stockholders usually waive their full voting rights and accept a limited dividend return. C. The net worth of a corporation is the sum of the common and preferred stockholders equity accounts. When no preferred is outstanding, net worth and common stockholders equity are the same. D. Preferred dividends, like common dividends, are not tax deductible. Preferred 14-5 dividend income, like common dividend income, if received by a corporation, is exempt from income tax. E. If declared, preferred dividends are paid before common dividends are paid, and usually are cumulative. Cumulative preferred requires that if the board of directors decides to skip a dividend payment, the unpaid dividend will be in arrears which will have to be paid up in full in the future. If, on the other hand, a preferred share is non-cumulative then the investor is only entitled to payment of a dividend if the board of directors declares a dividend. Arrears do not accrue on non-cumulative preferred shares. F. Redeemable preferred shares enable the company to acquire the shares at a set amount known as the call price. Sometimes, preferred shares can also be retractable, in which case the investor can force the company to buy back the share at a specified date. G. Some preferred shares are convertible, which means that the shares can be converted into another class of shares - usually common shares - at a predetermined price (the exercise price), and for a certain period of time. H. Some preferred stock is floating-rate preferred with their dividend varying or floating with the change in a specific index or interest rate level. 14.4 CORPORATE DEBT A. Common and preferred stock represented ownership and voting control in a corporation; corporate borrowings are nonownership contractual obligations to receive amounts of capital for corporate investment projects, pay a usually fixed cost interest rate on the debt, and repay the principal at maturity or in payments (sinking fund). B. Interest expense on debt is tax deductible, unlike common and preferred dividends. A company with a 35 percent tax rate would effectively pay (1-.35) or 65 cents on any dollar of interest expense. Debt Comes in Many Forms A. There are many variations of interest rates, terms, repayment provisions, seniority of claims in case of liquidation, collateral, and risk. B. The interest rate paid, or coupon rate, is the going market rate at the time the money is borrowed. Some bonds are zero coupon, discount bonds; others have rates that are adjustable. The bank prime rate or LIBOR varies with market interest rates. 14-6 C. Funded debt is debt payable after one year; unfunded debt is short-term bank loans, a current liability. Funded debt such as bonds often has long maturities. D. Debt comes due! Repayment may be at maturity, but more commonly is paid-off in installments or payments. A sinking fund is an arrangement for periodic payments to a fund, or to reduce the amount outstanding (buy back bonds). E. Callable bonds are able to be paid-off early, the price stipulated in the contract, at the discretion of the borrower. Firms are more likely to call bonds when interest rates have fallen or when their investments have generated high levels of cash flows. F. Some unsecured, general creditors may, for a higher interest rate, be positioned as subordinated debt, which means if the firm defaults the senior general creditors are paid-off from the dissolution of assets before the subordinated creditors. G. If collateral, such as plant and equipment, railroad cars, or land is pledged backing the debt obligation, the bonds are secured bonds. H. Funded debt may, at the corporation’s option, be rated by rating services such as Canadian Bond Rating Service, Standard and Poor’s or Moody’s. If the securities have minimum default risk, they will be awarded an investment grade. Below investment grade, securities have the infamous title of junk bonds. I. Securities may be issued in specific currency denominations, such as eurodollar, dollar denominated short-term deposits held in foreign banks. A bond that is denominated in the currency of one country, but issued to investors in other countries called a eurobond. Sometimes, companies may issue foreign bonds which are issued in another country and denominated in the currency of that country. J. Securities may be sold to the broad general public class of investors called a public offering, or “placed” with a small group of investors, usually financial institutions, called a private placement. The publicly offered, and later publicly traded securities, are more likely to have a ready market in case investors wish to sell the securities. K. Lenders impose a number of contract conditions on borrowing companies, called protective covenants. L. Variations of debt, such as a lease, are common. Instead of borrowing and buying a productive asset, such as machinery, the business may lease, not own, paying lease payments instead of debt installments. 14-7 An Example: The Terms of Rio-Tinto Alcan’s Bond Issue A. See Table 14.4 for a description of Rio-Tinto Alcan’s bond issue. Note the above mentioned terminology and characteristics of the bonds. Innovation in the Debt Market A. As conditions and needs of investors and corporations change, new types of funding contracts arise. B. In areas, such as South America, where inflation is often high, price level indexed bonds are often sold. Other bonds’ return may be indexed to the price or value of a commodity or interest rate, such as Treasury rates. C. In recent years billions of dollars of house and commercial mortgages, credit card loans, personal lines of credit and receivables were packaged each year, or securitized, and resold as asset-backed bonds. Even two years ago, asset backed securities were considered to be high quality investments with good credit ratings. However, since then, the sector has suffered a meltdown globally. Problems arose in the market for sub-prime mortgages in the United States with a slowdown in the housing market and higher interest rates.3 Subprime lenders had sold their loans to other investors, including financial institutions such as commercial banks, hedge funds or pension funds looking to earn high returns. When large numbers of subprime borrowers began defaulting, these investments suddenly became bad and hit hard on many financial institutions. As investor losses mounted, they refused further loans or began asking for much higher interest rates, causing a global credit crunch. D. Pay in kind bonds (PIK) pay interest and, in the early years, some other form of return (commodity or product), thus giving the issuer or borrower more flexibility in case cash flows lag for a time. E. Reverse floaters are variable rate bonds that pay a higher rate when other interest rates fall, and vice versa. 14.5 CONVERTIBLE SECURITIES A. Some bonds may be issued with options that grant the investor the right to buy shares of common stock (warrants) or the option to trade the bond for a stated number of shares of common stock (convertible). 3 Subprime mortgages were generally provided to less credit-worthy borrowers who were charged higher interest rates for these relatively risky loans. 14-8 14.6 PATTERNS OF CORPORATE FINANCING A. Funds for investment may be raised from external (debt or equity security issues) or internal sources, such as cash flows from operations. B. Internally generated funds, derived mostly from net income retained in the period plus non-cash depreciation expenses (cash flow from operations) are a major source of funds for both Canadian corporations and businesses of other countries. See Figure 14.1. Do Firms Rely Too Heavily on Internal Funds? A. Research by Gordon Donaldson indicates that a business’ growth or investment growth rate is determined by the growth rate of internally generated funds, rather than the quantity of positive NPV investments. B. Managers that do not wish to be critically assessed or monitored by the financial markets and financial institutions when financing externally might follow this strategy. C. The costs of financing externally are avoided when internally generated funds are used as is the possible downward movement in stock prices when a new equity issue is announced. Investors feel managers “signal” lower expected profits when new equity is issued, rather than a debt issue announcement where expectations are for higher profits in the future. External Sources of Capital A. The financing trends of the late1990s reveal that internal funds and debt issues were popular and stock buy-backs were popular. See Figures 14.2 to 14.4 14.7 Summary 14-9 APPENDIX 14A: THE BOND REFUNDING DECISION. The Conventional Call A. Corporate bonds often include a call provision that allows the company to pay back the debt early. If interest rates fall and bond prices rise, the option to buy back the bond at a fixed price can be very attractive to the company. The company can buy back the existing bond and issue a new one at a higher price and a lower interest rate. B. The refunding decision involves an analysis of whether it is profitable for the firm to replace an existing issue of higher interest cost bonds with a new issue of lower interest cost bonds. The approach used is similar to the analysis done in a replacement capital budgeting situation. This involves determining the net present value (NPV) of the proposed refunding after considering incremental after-tax cash flows from the new issue relative to the old issue. The analysis will typically be conducted for the period remaining until the maturity of the existing issue. A refunding project yielding a positive net present value would be taken up, while a negative net present value project will be rejected. C. We compare present values of the net investment required to refund the bond issue with the incremental savings generated from lower interest payments on the new issue. To arrive at present values, we would discount all such after-tax cash flows by the after-tax cost of the new issue. D. We look at the analysis conducted by the finance manager of Strike-a-Deal Inc. (Example 14.A1). E. In our analysis, we consider the net after-tax investment costs. These include: Call Premium: This is not a tax-deductible expense to the firm. Flotation costs: For tax purposes, these are amortized over the life of the new bond or 5 years, whichever is less. Additional Interest: If the new bond issue is sold before the old bonds are replaced, the company has to incur interest costs on both issues. This interest is tax deductible. Of course, the proceeds of the new issue can also be invested so we compute the after-tax interest earned. The net after-tax additional interest cost is the difference between the after-tax additional interest paid on the old issue and the after-tax interest earned on the new issue. F. We then look at the present value of net savings associated with refunding. G. The net present value of refunding = present value of net savings - net investment cost. If NPV is positive, it will be profitable for the company to refund 14-10 the existing bond issue. H. The analysis of bond refunding is tailor-made for spreadsheets. The Canada Call or Doomsday Call A. So far, the discussion has assumed a conventional call provision and a fixed call price. We also examine the bond refunding decision in the context of a Canada Call or Doomsday Call, which is a common feature for Canadian corporate bond issues. B. With the Canada call (or Doomsday call) feature, if a bond is called back by the issuer before its maturity, it can be redeemed at an yield that is equivalent to the yield on a Canada bond of the same maturity plus a premium for default risk determined at the time of the bond issue. C. The bondholder is paid the Canada yield price which is the higher of (a). the price calculated on the basis of the Canada bond yield plus default risk premium or (b). its par value. When interest rates fall, the call price goes up resulting in a higher call premium. D. With the Canada call feature, therefore, any savings to the issuer from refunding associated with a decline in interest rates is traded-off with a commensurate increase in the call premium. E. Canada calls rarely get called. F. We rework the Strike-A-Deal example in the context of the Canada Call. 14.6 SUMMARY PEDAGOGICAL IDEAS General Teaching Note - A useful way to present this chapter is to compare and contrast common stock, preferred stock, and debt in relation to (1) maturity, (2)claim on income, (3) claim on assets in liquidation, (4) voting rights and, (5) on the risk/return scale (security market line). Student Career Planning - Almost all business colleges and programs have professional student organizations available for students. Encourage them to join and take an active role. For most students, especially the full-time student, these organizations are an important part of the pre-business preparation. Not only are these organizations often affiliated with the students’ area of interest, but they provide a place to develop and 14-11 exhibit their organizational and leadership skills. Most organizations have guest speakers, tours, and business/student events which offer an opportunity to network and discuss career paths with little or no time or monetary cost. Employers are interested in the students’ active involvement in campus organizations. It exhibits their sociability, energy, leadership skills, and efforts toward personal development. Note that active involvement is more than just joining to put a line on the resume. It is not the number, it is the exhibited leadership and activity in a few that is effective. Internet Exercises - The better business magazines include Business Week, Canadian Business, Fortune and Forbes. While Canadian Business focusses on Canadian business features, the other three are U.S. based and have largely U.S. stories. These magazines cover business issues and news very effectively, and their web sites provide their current issue cover stories. Business students should learn about the businesses that are their potential employer. They should seek them out and not wait until they come to campus. Students should study companies as they proceed through college and prepare a target list of 10 to 15 companies/agencies for internships, informational interviews, and networking as they reach their senior year. One great place to study companies is to review the lists provided by these fine business magazines. http://www.canadianbusiness.com/ The website of Canadian business magazine provides detailed information on a variety of business-related topics. The website also includes selections from special issues of the magazine, such as the popular annual survey of Canadian MBA programs or the top 100 IT companies. http://www.businessweek.com/ This is the website of one of the most respected U.S. based business magazines. The websites is very informative. You can check out regular feature stories at this site as well as numerous surveys and special reports. The website also includes a special feature on MBA programs. http://money.cnn.com/magazines/fortune/ Fortune ranks near the top in terms of in-depth analysis of business news and issues. The writing is excellent and provides a model for business writing. The Fortune web site offers a wide range of research topics for assignments. Its lists of the Fortune 500, Global 500, Most Admired Companies, Top Employers to Work For, Fortune 1000, Top Performing Companies, and Top Performing Industries provide a starting point for serious students (or assignment), who should begin researching companies early in their undergraduate studies. Each issue features a number of companies in full-length articles. The web site features several articles from each issue and maintains an archive of interesting company articles. While accessing the Fortune 500 list, students can click on a 14-12 company and be forwarded to a company profile page with summary facts, links to the company home page, and a list of companies in the industry. This latter list is important for students who target a company based on their product or service. If they are interested in mining, they should look at a number of mining companies, not just one. The Investor link provides an opportunity to research a company by entering the stock symbol and reviewing a very good stock performance chart. The Careers page provides good articles related to working in business and links to potential employers. Overall, this is an excellent site where the professor can find many “student assignments.” http://www.forbes.com A tremendous business magazine, Forbes has an excellent Internet site that gets better each month. Forbes also has some interesting “lists,” such as the Richest Americans, Celebrity 100 (Hollywood and sports idols), 500 Companies, and Best Mutual Funds. These lists are the “bait” that attracts the undergraduate. While prowling around the site, students can research companies, gain some tips in the Career Center, and scan the lead story from the current Forbes magazine. Click the Forbes Lists thread and go wild! This thread also provides a long list of practical financial calculators and, under “Financial,” a complete glossary of financial terms, Company Profiles (extensive financial ratios and listing of companies by industry, company home page, and more), and Mutual Fund Guide. Research the companies listed in the Company Profiles. Overall an excellent site for finding new companies to add to the student employer “target” list! Go to http://www.bondsonline.com. The site has a wealth of information on bond issues. For details regarding the regulation of securities including bonds a visit to the website of the Ontario Securities Commission, http://www.osc.gov.on.ca/, is well worth the while. 14-13 CHAPTER 15 VENTURE CAPITAL, IPOS, AND SEASONED OFFERINGS CHAPTER IN PERSPECTIVE For students this section is one of the most interesting and exciting. The initial public offering (IPO) is where all the sweat-equity of a business cumulates in riches. In this chapter the process of going public, the role of investment banking in the process, and a discussion of venture capitalists, angel investors and other organizations involved with new venture creation are presented. There are always a number of interesting current events from The Globe and Mail or National Post and other sources to enrich this well- written chapter. See the “Pedagogical Ideas” section at the end of this chapter. CHAPTER OUTLINE 15.1 VENTURE CAPITAL Venture Capital Companies 15.2 THE INITIAL PUBLIC OFFERING Arranging a Public Issue 15.3 THE UNDERWRITERS Who Are the Underwriters? 15.4 LISTING ON THE STOCK MARKET 15.5 RIGHTS ISSUES AND GENERAL CASH OFFERS BY PUBLIC COMPANIES Rights Issues General Cash Offers Costs of the General Cash Offer Market Reaction to Stock Issues 15-1 15.6 THE PRIVATE PLACEMENT 15.7 SUMMARY APPENDIX 15A: THE FINANCING OF NEW AND SMALL ENTERPRISES Venture Capital in Canada Types of Venture Capital Funds Stages of Development Financed by Canadian Venture Capital Firms Recent Venture Capital Investment Activity Venture Capital Exits Angel Investing Other Sources of Small Business Financing APPENDIX 15B: HOTCH POT’S NEW ISSUE PROSPECTUS TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 15.1 VENTURE CAPITAL A. Equity capital provided to a promising new business is called venture capital. Venture capital is provided by specialist venture capital firms, financial and investment institutions such as banks and pension funds, and government agencies. B. Very early stage financing for new enterprises can also be sought from an angel investor. Angels are wealthy individual investors who can play a critical role in the creation of new ventures by making small scale investments in local start-ups and early stage ventures, and bringing a significant hands-on contribution to such business ventures. C. The success of the new business is directly related to the entrepreneur who originated the business. D.. The big payoff for the entrepreneur and venture capitalist (or angel) is when the firm goes public. d 15-2 Venture Capital Companies A. Some young businesses generate the entrepreneur’s capital along with capital contributed by venture capitalists and angel investors. B. Many young businesses raise capital from specialist venture capital companies, which pool funds from a variety of investors, seek out fledging businesses to invest in, and then work with these businesses as they try to grow. 15.2 THE INITIAL PUBLIC OFFERING A. If the developing business is going well, it is time for the original investors to cash in by selling stock to the investing public for the first time, called an initial public offering (IPO). B. When newly issued shares are sold to the investor public, it is called a primary issue (money raised by the firm). When original shareholders sell a number of their shares in an IPO, it is called a secondary offering (money raised goes to the selling stockholders). Arranging a Public Issue A. Before the IPO, an underwriter is selected to assist in arranging the procedural requirements, to buy the issue from the firm, and finally, to sell the issue to the investor public. B. Under a firm commitment, the underwriter pays a fixed price to the firm for the stock then sells the stock to the public for, hopefully, a higher amount. The difference is called the spread. If it is too risky to offer a firm commitment, the underwriter may sell the stock for the firm at the best price, called a best efforts underwriting. C. Before any stock can be sold to the public, the company must satisfy the requirements of provincial securities laws and regulations. Five provinces including Ontario, Quebec, Alberta, Manitoba and British Columbia have commissions while other provinces have securities acts. The stock may have to be registered with an appropriate securities commission. For instance, companies listed on the Toronto Stock Exchange (TSX) come under the purview of the Ontario Securities Commission (OSC) which administers the Ontario Securities Act. A registration statement detailing the facts of the company and issue is filed with the relevant provincial commission. A summary of the registration statement called a prospectus, both a preliminary, “red herring” (that is, a printed disclaimer statement in red letters to the effect that it is not a final document and is subject to 15-3 amendment since the securities commission has neither approved nor disapproved the registration statement) or final copy after all terms are finalized, is given to all investors considering the investment. D. In order to sell all the stock quickly, underpricing or selling the securities below the true value of the security, is practiced by the underwriter. For the Toronto Stock Exchange, the simple average of the underpricing is about 10 percent, and is higher for the American exchanges. Underpricing is a significant cost of a stock underwriting. Other costs of the underwriting include administrative (legal, accounting) costs and the spread taken by the underwriter. The underwriter gets the spread, the public investor the underpricing, the professionals get their take, and the firm gets the remaining cash. 15.3 THE UNDERWRITERS A. The underwriter has three functions: providing advice (pricing and timing), buying the issue from the company (risk taking), and selling the issue to the public. B. A group of underwriters, or a syndicate, is usually formed to share the risk of buying the issue. A larger selling group of underwriters and broker/dealers is formed to sell the issue quickly. The spread is split among the lead underwriter, syndicate, and selling group. Who Are the Underwriters? A. Underwriters comprise the large investment dealers and banking firms listed in Tables 15.1 to 15.3 and thousands of other investment banks, brokers, dealers located domestically, and increasingly, internationally. B. Most underwriting involves a negotiated price with the firm and in a few utility holding companies and governmental bodies, competitive bidding determines which investment dealer will handle the issue and what price/yield will be paid. 15.4 LISTING ON THE STOCK MARKET A. When a firm decides on an initial public offering of its stocks, it has to decide where its newly issued shares should be traded. B. Most trading in the shares of large Canadian corporations takes place on the Toronto Stock Exchange (TSX) while shares of smaller and emerging companies are traded through the TSX Venture Exchange (formerly, Canadian Venture Exchange, or CDNX). Electronic trading in shares can also be done through Nasdaq Canada. 15-4 C. In order to list its stock issue on a stock exchange, the firm will have to meet the exchange’s listing requirements and also to pay the requisite listing fee. Table 15.5 summarizes major listing requirements of the TSX for profitable industrial companies. 15.5 RIGHTS ISSUES AND GENERAL CASH OFFERS BY PUBLIC COMPANIES Rights Issues A. After the IPO, additional common stock issues may be sold by businesses seeking financing. This is called a seasoned offering. The stock may be offered to existing shareholders, called a rights issue, or sold to the general public. B. In a rights issue, shareholders would be able to purchase additional shares at a price below current market price. A 25 percent increase in shares would entitle a shareholder to buy one share at the lower price for every four that they own. C. Rights issues are less common in Canada and the U.S. than in other countries. D. Through a rights issue, a company could hope to save on issuing and underwriting expenses. Also, shareholders do not run a risk of dilution of their proportional shareholding and are able to retain their voting position on the company’s major business decisions. E. To protect against the possibility of the share price falling below the subscription price (which takes away the shareholder’s incentive to participate in the rights issue), the firm may enter into a standby underwriting agreement with an investment dealer. Under this arrangement, the underwriter stands ready to purchase any unsold shares and receives a standby fee and possible additional amounts depending on the extent of unsold shares. Also, the company may give its shareholders an oversubscription privilege under which they will be able to purchase any unsold shares at the subscription price. General Cash Offers A. If a rights issue is not elected, additional stock may be sold to the general investing public, called a general cash offer. B. In a general cash offer, the issue must be registered in compliance with the regulations of relevant provincial commissions. The issue is then sold to an underwriter (or syndicate of underwriters) who, in turn, offers the securities to the 15-5 public. C. Many underwriting agreements may contain a market-out clause which limits the underwriters’ risk. This clause enables the underwriter to terminate the underwriting agreement without penalty under extraordinary circumstances or if the state of the financial market is not deemed good for the security issue. D. Bought deals are often used by established companies for their seasoned equity issues. Here, the investment dealer buys the entire offering from the issuing company and then decides on how to sell it to investors. E. Usually the large issuers in Canada who go for bought deals can also take advantage of the Prompt Offering Prospectus (POP) system which allows short- form filing since much of the information contained in the regular prospectus is already expected to have been filed annually. Thus, under the POP system only material changes and financial statements have to be provided to regulators who are able to give their clearance within about five days instead of several weeks required for a full prospectus. Costs of the General Cash Offer A. The costs of an underwriting include the underpricing of the issue, the spread to the underwriters, and the administrative costs. B. From Figure 15.3, the costs of underwriting common stock as a percent of the proceeds, has averaged about 6 percent, has been around 14-15 percent for small issues and decreases to around 4 percent for large issues. C. Issue costs are lower for debt securities than for equity, often around 1 percent for large firm bond issues. Market Reaction to Stock Issues A. Does adding more shares depress stock prices below their true value and decrease the motivation to sell stock? The answer is no. If a stock’s price were to drop just because of added supply, the yield on the stock would be higher than alternative risky investments, and investors would bid the stock price back up to the investor required rate of return. B. Research indicates that prices do drop slightly (3 percent) after the announcement of a stock offering and that is a considerable amount of funds each year for business. If supply alone does not explain the causes for the market to depreciate the stock, what is it? The announcement of a stock issue could signal to investors that management feels the stock is overpriced by the market and are rushing in to sell stock. If they thought the stock was undervalued, they would probably sell 15-6 debt or forgo the investment, rather than drop the stock price to investors by an announcement of a stock offer. 15.6 THE PRIVATE PLACEMENT A. Instead of a public offering of securities, a firm may negotiate a private placement of the securities with a small number of investors, such as an insurance company. B. Since the general public is not involved, security laws do not require registration, prospectus, etc. The issue may be placed quickly and at a lower cost of financing. C. Since the investor has purchased a security with little or no marketability, the yield demanded by the investor will likely be higher. D. The usually small and medium firms and investors can custom tailor the issue so that both are satisfied. APPENDIX 15A: THE FINANCING OF NEW AND SMALL ENTERPRISES Venture Capital in Canada: A. We saw earlier that venture capital is an important source of equity for start-up companies that have the potential to develop into significant economic contributors. Venture capitalists make risky investments with the expectation of earning high rewards if the young ventures become successful. Table 15.A1 lists some of the important attributes of classic venture capital investing. Table 15.A1 Attributes of Classic Venture Capital Investing 1. Create new businesses or expand or revitalize existing ones. 2. The investor, usually the venture capital (VC) fund’s general manager and associates, are involved in the management of their portfolio companies, providing a great deal of “value-added” to their companies . 3. The potential return from the investment is quite large due to investing in high risk/high reward situations. 4. Only a few investments are made each year after many candidates have been screened and a handful has been fully analyzed. 5. Negotiate appropriate financial structures using individualized investment instruments. 6. Take a long-term orientation towards their portfolio companies because of the illiquidity of their investments. 7. Try to maximize the growth of their funds since the VC receives as incentive, compensation as a percentage of the capital gains after return of capital. 8. Venture capitalists often diversify their risk by syndicating their investment with other VC funds. (Based on information in K.W. Rind, “The Role of Venture Capital In Corporate Development” Strategic Management Journal 15-7 (April-June 1981), pages 169-180). Source: A. Best and D. Mitra, “The Venture Capital Industry in Canada,” Journal of Small Business Management, (April 1997) Vol. 35, No. 2, pages 105-110. Types of Venture Capital Funds: A. Canada’s venture capital funds can be grouped into one of 5 categories: private independent, labour-sponsored, corporate, government and hybrid. B. Private independent firms typically have no affiliations with any other financial institution. C. Labour-sponsored (or retail) funds are venture capital pools formed with the help of provincial and federal governments and are structured in a similar fashion to mutual funds. Individuals buy shares in the fund, which pools the money with the objective of investing in enterprises that have yet to go public. Presently, investors receive a 15 percent tax credit from both the federal government and participating provincial governments. Moreover, the investment is Registered Retirement Savings Plan (RRSP) eligible, and, therefore, provides the investor an additional tax benefit in the form of a tax deferral depending on her income level. D. A number of Corporate Venture Capital Funds also exist in Canada. Goals of these funds tend to be strategically tied to the parent organization; they often prefer to invest in ventures that will give them access to new technologies or provide a competitive advantage. E. Federal or provincial governments run government funds through employing professional venture capital fund managers. For instance, the federal Business Development Corporation (BDC) has an active venture capital division, as do somen crown corporations such as the Export Development Corporation. F. Institutional funds are typically formed by pension funds, insurance companies or large endowments and have profit-maximizing objectives similar to private or labour-sponsored funds. Stages of Development Financed by Canadian Venture Capital Firms A. New enterprises can be at different stages of development, described below: Seed Stage: very early stage when the new enterprise may seek to test a concept or build a product prototype and develop a product. Start-up Stage: the enterprise may have a product being developed, but not yet marketed and sold commercially; 15-8 Expansion Stage: the firm requires significant capital for plant expansion, marketing, and to initiate full commercial production and sales. Acquisition/Buyout Stage: the management of the firm acquires a product line, a division, or a company; Turnaround Stage: the firm was once profitable but is now earning less than its cost of capital; B. Generally the seed and start-up stages are considered to be the early stages of development. During their life cycle, all firms will go through the seed, start-up and expansion stages, but not all will experience the buyout or turnaround stages. Venture Capital Exits: A. In addition to providing financial capital, venture capitalists also help companies in which they invest with a variety of advisory services. B. The investee firm also benefits indirectly when a reputed venture capital organization invests in it. By making the investment, the venture capitalist is signalling its approval of the firm’s business plan, growth and profit potential, and future prospects. C. As the investee firm matures and becomes more established, the value of services provided to it by the venture capitalist diminishes. It becomes important, therefore, for the venture capitalist to exit from the firm and to recycle its investment into another young venture.1 D. The venture capitalist can exit from an investment through a variety of means including (a) acquisition by a third party, (b) company buyback by the entrepreneur, (c) initial public offering, (d) merger with another entity and, in the event that all other options fail, (e) write off. E. Company buybacks by entrepreneur/managers from venture capitalists appear to be the predominant mode of venture capital exits in Canada followed by initial public offerings.2 Acquisition by a third party is also a popular exit route. F. Unfortunately, a sizeable number of exits occur through write-offs as well. The 1 For further discussion, see B.S. Black and R. J. Gilson (1998). “Venture Capital and the Structure of Capital Markets: Banks Versus Stock Markets”, Journal of Financial Economics, Vol. 47, 243-277. 2 See D.J. Cummings and J.G. MacIntosh “A cross-country comparison of full and partial venture capital exits”, Journal of Banking and Finance 27 (2003), pp. 511-548. 15-9 average duration of successful venture capital investments before exiting through a company buyback or an initial public offering is close to six years. G. Venture capitalists appear to be able to spot failures earlier on; the average duration of investments that are written-off is a little over 4 years. Angel Investing: A. Although the organized venture capital industry plays an important role in the creation of new ventures, those seeking very early stage financing for small and new enterprises often have to resort to informal financing sources. Here, wealthy individual investors, or angels can play a critical role by making small scale investments in local start-ups and early stage ventures, and bringing a significant hands-on contribution. B. Angels can play either active or passive roles in the investee firms “Active” angels are often highly motivated ex-entrepreneurs who are skilled at picking good management teams and good ideas. “Passive” angels provide only money but rarely monitor the firm closely. Other Sources of Small Business Financing: A. Financing under the Canada Small Business Financing Act is available in the form of term loans of up to 10 years through all chartered banks, most credit unions and caisses populaires, and many trust and insurance companies. Such loans are guaranteed by the federal government if taken for specific purposes and limits. B. The Business Development Bank of Canada (BDC), a Crown financial institution, specializes in providing financial and other support services to small and medium sized businesses in Canada. BDC’s major activities include term lending, giving loan guarantees and providing venture capital financing. It is also involved in lease financing and providing consultancy services. C. There are a number of regional agencies across Canada which have lending and other assistance programs designed to nurture and grow small businesses. These include Atlantic Canada Opportunities Agency (ACOA), Federal Economic Development Initiative in Northern Ontario (FedNor), Canada Economic Development for Quebec Regions: Financing, and Western Economic Diversification Canada: Financing. 15-10 15.7 SUMMARY PEDAGOGICAL IDEAS General Teaching Note—As noted above, students are very interested in this chapter, and hence, it offers a chance to bring the excitement of the IPO as close to the student as possible. Collect a stack of prospectus from local brokers, take them into class, and assign an overnight research project. The inquiry may be simply finding facts in the prospectus, such as the lead underwriter, the number of firms in the underwriting syndicate, the spread relative to the funds raised (more for equity and small equity issues), types of offering (IPO or secondary), etc. Other research outside the prospectus may include a comparison of the initial offering price and the current price, the current performance of the firm, request for annual reports from the firm, etc. While a number of chapters are conceptual, this is one that the student can see going on right now. The SEDAR Database, available at www.SEDAR.com, provides access to filings by public corporations. See Internet Exercises below. Student Career Planning—“Related” part-time work experience is becoming an important part of student career preparation today. Having some sales or financial service experience, in addition to exhibiting leadership skills in student organizations, makes that first full-time entry-level job search much easier. Internships or co-op opportunities exist on every campus for obtaining “related” experience. Encourage your students to consider this time in a professional business program as part of their career, where the work ethic, skills, etc., are developed. The responsibility for learning and personal development then is shifted to the student and career planning slowly becomes accepted as something for now, rather than for later. Internet Exercises - Investment dealing and IPOs are always popular with students, and the students always do Internet research in this area with enthusiasm. There are many sites that focus on the IPO when the term is entered in a search engine. I have asked students to research two sites related to IPOs, and their results provide excellent small group discussion and class discussion. Three sites listed below, FreeEDGAR and Merrill Lynch, offer the opportunity to research recent IPOs and investigate a leader in investment banking. www.sedar.com and www.freeEDGAR.com Both the SEDAR and FreeEDGAR sites are excellent for researching companies, topics, and reviewing security filings of companies; the SEDAR site includes Canadian companies with filings to the Ontario securities Commission while the FreeEDGAR site includes U.S. firms with SEC filings. In either webiste you can enter a company name or stock symbol and review the security filings. Consider selecting a company, listing the SEC filings, and by “show and tell” discussing the variety of SEC reports filed via EDGAR. If you click the Standard Industrial Code (SIC) number, a list of companies with 15-11 similar product/service lines is displayed, enabling students to study companies in an “industry.” FreeEDGAR has a research “push” capability or “Watchlist” that reports via email any filings made by specific companies. For this chapter, the IPO Express link from the home page is an excellent database of recent IPOs, their performance, and links to SEC filing information on each company. In the last few years, IPOs have been common WSJ news stories, and students like to discuss them. Here’s a chance for them to do some research on recent IPOs. Review the site and design an assignment for small groups or individual class assignments. This is an excellent site for students studying finance and businesses. www.ml.com Merrill Lynch, has historically always been at the top or near it in value of new underwriting, provides an excellent case example for examining the scope of operations of this worldwide company. While in recent years, this firm has fallen prey to the current financial crisis, its home page still has a number of timely articles, and this site is the portal to their varied proprietary sites. The “Corporations & Institutions” link provides a list of achievements of Merrill Lynch, offers statistics about their role and rankings in investment banking activity, and provides an excellent world map of ML’s business operations around the world. The Financial Education link displays a series of articles on financial planning, risk assessment, asset allocation, liquidity, and more. The “eCommerce” link provides a full page of links to ML’s favorite e-commerce sites. ML’s site is an excellent “show and tell” source for outlining the variety of business operations of the large investment companies listed in the chapter. Each has excellent sites that could serve as examples. Check them out or, better, ask your students to write a one-page review of two of the companies listed in the chapter. http://www.rbccm.com/ The website of RBC Capital Markets, Canada’s largest investment dealer and member of the RBC Financial group, may be useful to access, although some information may be accessible to clients only. http://www.cba.ca/ To get general information, including regularly updated statistics, about the Canadian banking industry, you can visit the website of Canadian Bankers’ Association. The site includes a number of features on different topics. It also provides access to its free publications which are generally quite informative. 15-12 Instructor Manual for Fundamentals of Corporate Finance Richard A. Brealey, Stewart C. Myers, Alan J. Marcus, Elizabeth Maynes, Devashis Mitra 9780071320573, 9781259272011

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