CH-13-16 Risk and Capital Budgeting – Foundations of Financial Management : Chapter Notes

This Document Contains Chapters 13 to 16 Chapter 13 Risk and Capital Budgeting Author's Overview Though risk is discussed throughout the text, Chapter 13 provides the most explicit portrayal of its impact on the decision-making process of the firm. The actual measurement of risk through the computation of the mean, standard deviation, and coefficient of variation is presented in detail. The introduction of the risk-adjusted discount rate brings together the key material in Chapter 12 and this chapter. Other methods for handling risk are outlined. Simulation analysis also is introduced to emphasize how complicated decision variables can be reduced to a more manageable scale through examining, in advance, outcomes and probabilities of outcomes. Finally, the portfolio effect of an investment is introduced. The coefficient of correlation is defined in a general sense that should prove quite workable to the student. An example of the efficient frontier is demonstrated in Figure 13-11. Learning Objectives 1. Describe the concept of risk based on the uncertainty of future cash flows. 2. Characterize most investors as risk averse. 3. Analyze risk as standard deviation, coefficient of variation, or beta. 4. Integrate the basic methodology of risk adjusted discount rates for dealing with risk in capital budgeting analysis. 5. Describe and apply the techniques of certainty equivalents, simulation models, sensitivity analysis, and decision trees to help assess risk. 6. Discuss how a project’s risk may be considered in a portfolio context. Annotated Outline and Strategy I. Risk in Capital Budgeting A. Management's ability to achieve the goal of owner's wealth maximization will largely depend on success in dealing with risk. B. Definition: Variability of possible outcomes. Therefore the wider the distribution of possible outcomes for a particular investment, the greater its risk. PPT 6 of 31 Variability and risk (Figure 13-1) C. Risk aversion is a basic assumption of financial theory. Investors require a higher expected return the riskier an investment is perceived to be. Certainty is preferred to uncertainty. Finance in Action: The Risky Skies Risk and risk perceptions of investors and managers in the airline business is discussed. Specific reference is made to Westjet. www.westjet.com . II. The Measurement of Risk Perspective 13-1: Depending on the prerequisite statistics knowledge of the student, this chapter could be easy or difficult mathematically. We provide a brief statistical review of standard deviations, mean, variance, etc., but most students should not have to spend too much time on the statistics. Instead, focus on applying of these measures to financial decision making. A. The basic risk measurement is the standard deviation, which is a measure of dispersion around an expected value. A numerical example appears on page 452. 1. The expected value is a weighted average of the possible outcomes of an event times their probabilities. (expected value) =  DP (13-1; page 432) The formula for computing the standard deviation is: (13-2; page 432) PPT 9 of 31 Probability distribution with differing degrees of risk (Figure 13-3) B. The Coefficient of Variation 1. The standard deviation is limited as a risk measure for comparison purposes. Two projects A and B may both be characterized by a standard deviation of $10,000 but A may have an expected value of $50,000 and B $100,000. 2. The size problem is eliminated by employing the coefficient of variation, V, which is the ratio of the standard deviation of an investment to its expected value. The higher the coefficient of variation: the higher the risk. (13-3; page 434) C. Beta () is another measure of risk that is widely used in portfolio management. Beta measures the volatility of returns on an individual stock relative to a stock market index of returns. (See Appendix 11A for a thorough discussion.) Finance in Action: Bankers: Getting Risk Averse A discussion of the many risks faced by the banking industry and their management of that risk. Liquidity risk, credit risk and foreign exchange risk are mentioned, as is the banking industry’s heavy use of the derivatives market to reduce risk as it lost sight of due diligence. PPT 12 of 31 Betas, July 2011 (Table 13-2) Perspective 13-2: A discussion of industry/company factors that may cause risk is useful. Table 13-2 covers stable banks to more volatile industries such as telecommunications. Students generally like to explore what causes these differences III. Risk and the Capital Budgeting Process A. The expected inflows from capital projects usually are risky: they are not certain. B. Cash flows of projects bearing a normal amount of risk undertaken by the firm should be discounted at the cost of capital. C. The required rate of return of lenders and investors increases as the risk they are subjected to increases. D. The cost of capital is composed of two components: the risk free rate (time value of money only) and a risk premium (risk associated with usual projects of a business). E. Adjustments must be made in the evaluation process for projects bearing risk levels (more or less) other than normal. 1. Risk adjusted discount rate approach: The discount rate is adjusted upward for a more risky project and downward for projects bearing less than normal risk. A firm may establish a risk adjusted discount rate for each of various categories of investment such as new equipment, new market, etc. Finance in Action: 2008, U.S. Government Default 2011: How Do You Get a Risk Reading? A brief discussion of the re-pricing of risk in 2008, the possibility of the U.S. Government’s debt default in 2011 and various sources of information. www.standardandpoors.com 2. The CAPM may be helpful in establishing an appropriate discount rate based on a project’s risk. 3. Certainty equivalent approach: recognition of differing risk levels is made by multiplying the expected cash flow by a percentage figure indicating degree of certainty and discounting at the risk-free rate. 4. ‘Seat of the pants’ approach is based on experience and preference of the decision-maker. PPT 14 of 31 Relationship of risk to discount rate (Figure 13-5) Perspective 13-3: Discuss foreign projects and how they are evaluated based on risk. International capital budgeting often has higher risks associated with emerging market systems or political instability. F. Increasing risk over time: Our ability to forecast diminishes as we forecast farther out in time. G. Qualitative measures may mean that management makes up various risk classes for projects having similar characteristics. PPT 15 of 31 Risk classes and associated discount rates (Table 13-3) Perspective 13-4: Tables 13-4 and 13-5 bring back Investments A and B from Chapter 12 and demonstrate how a different decision would be made if Investment B had been adjusted for risk. PPT 16 of 31 Capital budgeting analysis (Table 13-4) PPT 17 of 31 Capital budgeting decision adjusted for risk (Table 13-5) IV. Simulation Models A. The uncertainty associated with a capital budgeting decision may be reduced by projecting and preparing for the various possible outcomes resulting from the decision. Simulation models and decision trees enhance management's initial capital budget decision efforts and also expedite intermediate decisions (Whether to continue, etc.) once the initial decision has been made. B. Simulation models: various values for economic and financial variables affecting the capital budgeting decision are randomly selected and used as inputs in the simulation model. Although the process does not ensure that a manager's decision will be correct (in terms of actual events), decisions can be made with a greater understanding of possible outcomes. Sensitivity analysis adjusts our analytical model one variable at a time to identify key variables for possible further investigation. PPT 19 of 31 Simulation flow chart (Figure 13-7) C. Decision trees: the sequential pattern of decisions and resulting outcomes and associated probabilities (managerial estimates based on experience and statistical processes) are tracked along the branches of the decision tree. Tracing the sequence of possible events in this fashion is a valuable analytical tool in the decision making process. PPT 20 of 31 Decision trees (Figure 13-8) V. The Portfolio Effect A. A risky project may actually reduce the total risk of the firm through the portfolio effect. Finance in Action: Go By Country or By Corporation & Diversifying Product Lines These two boxes explore two interesting questions on diversification. B. The calculations for the portfolio effect: C. Projects that move in opposite directions, in response to the same economic stimulus, are described as negatively correlated. Since negatively correlated projects move in opposite directions, the total deviation is less than the deviations of the projects individually. D. The relationship between project movements is expressed by the coefficient of correlation, which varies from the extremes of ̶ 1 (perfectly negative) to +1 (perfectly positive) correlation. Non-¬correlated projects have a correlation coefficient of zero. E. Although projects with correlation coefficients of ̶ 1 are seldom found, some risk reduction will occur, however minor, when projects are negatively correlated or have low positive correlation. PPT 27 of 31 Rates of return for Conglomerate, Inc., and two merger candidates (Table 13-7) Perspective 13-5: Table 13-7 is a good example of how negatively correlated projects can reduce risk when combined. Since students often have difficulty understanding this concept, all three companies have the same standard deviation and the two merger candidates also have identical mean returns. After the merger, the two rates of return are the same but the risk levels are quite different. F. The firm should strive to achieve two objectives in combining projects according to their risk return characteristics. 1. Achieve the highest possible return at a given risk level. 2. Allow the lowest possible risk at a given return level. G. The various optimal combinations of projects are located along a risk-return line referred to as the ‘efficient frontier.’ PPT 30 of 31 Risk-return trade-offs (Figure 13-11) H. The possible benefit of the portfolio effect suggests that an adjustment to the discount rate used in capital budgeting (particularly the cost of capital) may be in order. VI. The Share Price Effect A. Higher earnings do not necessarily contribute to the firm's goal of owner's wealth maximization. The firm's earnings may be discounted at a higher rate because investors perceive that the firm is pursuing riskier projects to generate the earnings. B. The risk aversion of investors is verified in the capital market. Firms that are very sensitive to cyclical fluctuations tend to sell at lower P/E multiples. Summary Listing of Suggested PowerPoint Slides PPT 6 Variability and risk (Figure 13-1) PPT 9 Probability distribution with differing degrees of risk (Figure 13-3) PPT 12 Betas, July 2004 (Table 13-2) PPT 14 Relationship of risk to discount rate (Figure 13-5) PPT 15 Risk classes and associated discount rates (Table 13-3) PPT 16 Capital budgeting analysis (Table 13-4) PPT 17 Capital budgeting decision adjusted for risk (Table 13-5) PPT 19 Simulation flow chart (Figure 13-7) PPT 20 Decision trees (Figure 13-8) PPT 27 Rates of return for Conglomerate, Inc., and two merger candidates (Table 13-7) PPT 30 Risk-return trade-offs (Figure 13-11) PowerPoint Presentation The Chapter 13 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 31 frames. Chapter 14 Capital Markets Author's Overview This chapter on capital markets is basic to the understanding of the flow of funds through the economy and the relationship of capital markets to corporate bonds, stocks, and preferred stock. Students often view bonds as uninteresting and unimportant securities, so special emphasis has been placed on them to show their dominant positions as a source of external capital. The instructor may wish to stress the point that corporations do not operate in a vacuum but in a competitive capital market with government units. Although much of this chapter is descriptive, it reinforces the concepts of risk and return and wealth maximization by describing the markets that create wealth and either reward or penalize the investor for assuming risk. The allocation of capital in a capitalistic economy is crucial to the understanding of our economic system, and the securities markets are a key in this allocation process. Also, the ever-increasing role of international capital markets should be stressed. Canada only represents about 2 percent of the world’s capital market. Markets trade securities around the clock. We have taken the opportunity to include a section on market efficiency. There is a discussion of efficiency in the more traditional sense of liquidity, stability, and continuity, and this is linked with the concept of the efficient markets hypothesis in the weak, semi-strong and strong forms. The important matter of securities market regulation is also covered in the chapter. Learning Objectives 1. Define primary, secondary, money and capital markets. 2. Outline the primary participants raising funds in the capital markets. 3. Characterize the Canadian economy as three major sectors allocating funds among themselves. 4. Outline the organization of the securities markets. 5. Assess the concept of market efficiency and its benefits to the economic system. 6. Examine the changing financial regulatory environment. Annotated Outline and Strategy I. The Structure A. Primary market: The first issue of securities (financial assets) to raise capital. B. Secondary markets: Where securities are traded providing liquidity and value determination. C. Money market: Short term market for securities maturing in a year or less. D. Capital market: Long term market for securities with maturities greater than one year. PPT 7 of 33 Canadian money and capital market securities outstanding, 2011 (Figure 14-1) E. More often, companies search all capital markets including world markets for capital at the lowest cost. (Figure 14-2 for world equity markets) F. The markets allocate funds to the most efficient users on the best perceived risk-return tradeoffs. Perspective 14-1: Though this is a descriptive chapter, we feel the institutional relationships are quite important to most students who most likely only have limited experience with the financial system. II. Competition for Funds in the Capital Markets Perspective 14-2: The student needs to understand that finding financial capital is a very competitive game. Not only do companies compete among themselves but also with the federal government and provincial governments. A. Overall 1. Corporations compete for funds in the capital and money markets with the federal and provincial governments. 2. Longer capital funding [equity, bonds] have more securities outstanding as compared to the money markets, but have less relative turnover. PPT 9 of 33 Canadian money market: securities outstanding (Figure 14-3) 3. The money market has grown in sophistication with more commercial paper and asset backed securities although Treasury bills still dominant. 4. In the last decade corporations have increased their outstanding bond obligations significantly, relative to governments. PPT 10 of 33 Canadian bond market: securities outstanding (Figure 14-4) 5. The Canadian equity market, centred in Toronto, is somewhat larger in size to the bond market in value of securities outstanding. 6. The Canadian bond market represents only about 2 percent of the world bond market. Therefore we find foreign currency bond obligations equal to domestic obligations for corporations. PPT 11 of 33 Canadian bonds outstanding: foreign currencies (Figure 14-5) B. Government Securities 1. The federal debt approximated $576 billion in 2011, 32% of GDP. Non-residents hold less than 24% of federal debt. Less Treasury bills outstanding with longer term government financing caused some liquidity problems in the money markets. The average term of federal debt has lengthened to 6 years. Finance in Action: Bond Auctions Information on the latest Government of Canada bond auctions is available at the Bank of Canada web site. www.bankofcanada.ca 2. Provincial governments collectively had accumulated debt of $560 billion in 2011, 40 percent denominated in foreign currencies. Traditionally long term borrowers, the provinces have borrowed short term through treasury bills. 3. Municipal governments are small borrowers in the capital markets and their issues are relatively illiquid. C. Corporate Securities 1. New bond financings have been volatile from one year to the next, varying with market conditions. In 2001 bonds dominated, but in later years financings were relatively equal with the equity markets. Large financings have been done outside of Canada. PPT 14 of 33 Net new corporate financing by type of security (Figure 14-6) 2. Preferred stock is a relatively important source of corporate financing in Canada. The tax treatment of dividends and holding company ownership account for this prevalence of preferred stock. Tax changes and disruptions in corporate ownership have seen preferred financings decline. 3. Common stock is a significant source of corporate financing, varying with market conditions. More equity capital is being raised abroad. (A concern). D. It appears that managers tend to time their issue of common stock to take advantage of higher valuations. This accounts for the large variances in funding sources from year to year. 1. Corporate managers don’t appear to believe in rational markets and their behavior suggests they believe underpricing/ overpricing occurs. 2. With increased market value, more debt is possible, yet managers substitute equity for debt PPT 16 of 33 Debt-to-equity ratios for nonfinancial private corporations (Figure 14-7) E. Historically, internally generated funds (retain earnings and amortization) have been the major source of funds to the corporation. Global growth have accounted for greater reliance on external financing. PPT 17of 33 Funding sources of non-financial private corporations (Figure 14-8) F. The majority of internally generated funds are not included in reported earnings. Funds from operations, but not included in reported earnings through the amortization process (CCA), provide the primary source of internal funding. III. The Supply of Capital Funds A. Business and government have been net demanders of funds and the household sector the major supplier of funds in our three sector economy. PPT 19 of 33 Flow of funds through the economy (Figure 14-9) B. Household sector savings are usually channeled to the demanders of funds through financial intermediaries such as chartered banks, trust companies, mortgage companies, and credit unions. PPT 20 of 33 Total assets of financial intermediaries (Figure 14-10) C. Other intermediaries in the flow of funds process include mutual funds, pension plans, and insurance firms. D. The international saver/ investor has become a very important supplier of capital to the Canadian economy. IV. The Role of the Security Markets A. Securities markets aid the allocation of capital between the sectors of the economy. The money and bond markets dwarf the stock market in daily trading volumes. PPT 24 of 33 Secondary Market: Annual value of trading (Figure 14-11) B. Security markets enable the demanders of capital to issue securities by providing the necessary liquidity for investors in two ways: 1. Corporations are able to sell new issues of securities rapidly at fair competitive prices. 2. The markets allow the purchaser of securities to convert the securities to cash with relative ease and speed in the secondary market. V. The Organization of the Security Markets A. The Organized Exchanges: Exchanges facilitate the trading of various securities through a competitive auction market that establishes prices by supply and demand conditions. Registered brokers transact orders on behalf of buyers and sellers. Fairness, transparency, liquidity and integrity are important. B. Canadian Exchanges 1. The Toronto Stock Exchange (TSX) is Canada’s most important exchange with about 1,500 listings. The Bourse de Montreal is a derivatives exchange, owned by the TSX. The TSX Venture Exchange also owned by the TSX is a junior exchange. 2. To be listed on the TSX, firms must meet certain minimum requirements pertaining to pretax cash flow, working capital, net tangible, number of shareholders, number of publicly held shares, and market value. Finance in Action: Moving to the ‘Show’ & Listing Requirements These boxes direct our attention to moving from Canada’s Venture Exchange to the senior TSX, and direct us to the listing requirements of exchanges. www.tmx.com C. Foreign Exchanges 1. Canada represents about 2% of the world’s capital market value. Many Canadian companies are listed on foreign exchanges. Daily trading volumes rank the TSX 11th in the world for stock exchanges. PPT 25 of 33 World equity markets: Annual value traded, 2010 (Figure 14-12) D. Over the Counter Markets (OTC) 1. The OTC market is a network of brokers and dealers linked by computer display terminals, telephones, and teletypes. 2. Few OTC stocks could obtain listing on the TSX and because of lower average prices trading volume on the OTC is much less than the organized exchanges. 3. A reporting system on designated unlisted stocks is maintained by the Investor Dealers Association and the Toronto Stock Exchange (www.candeal.ca ). 4. Bonds and debentures trade in the OTC market. Bond and money market securities volumes are at least 10 times the volume (each) of equities on the organized exchanges. VI. Challenges for the Canadian Exchanges PPT 28 of 33 Money and capital market investments, 20011(Figure 14-13) A. The Canadian securities markets face several challenges. 1. Competition from the liquid capital markets of the world, in particular the U.S. 2. ‘Upstairs trading’, bypassing the stock exchanges. 3. Alternative trading platforms (ATS and ECN) using the Internet. 4. Worldwide consolidation of exchanges and TSX takeover by financial institutions. B. Securities markets are more competitive. 1. Commissions are no longer fixed. Discount brokers now execute a significant amount of trades. 2. Chartered banks and foreign investment houses operate brokerage services in Canada. C. There are efforts to make the markets more liquid. 1. Floor trading no longer occurs at the TSX and it is fully automated 2. Dealers are acting more as principals rather than brokers as the Canadian markets have had few buyers and sellers relatively; they are ‘thin.’ 3. Markets now operate 24 hours a day. 4. The TSX is a public company. VII. Market Efficiency Finance in Action: Enronitis – Now Sino-Forest! Do firm’s that manipulate the markets do harm to the capitalist system? A. Criteria of Efficiency 1. Rapid adjustment of prices to new information 2. Continuous market; successive prices are close 3. Market is capable of absorbing large dollar amounts of securities without destabilizing the price B. The more certain the income stream, the less volatile price movements will be and the more efficient the market will be. This is because of the tremendous liquidity and volume of trades in these securities. Finance in Action: Do Mutual Funds Achieve Superior Returns? A study by B.G. Malkiel reveals that mutual funds under-perform the market average. Trading between different market sectors generates excess transaction costs and triggers more tax burdens. C. The efficiency of the stock market is stated in three forms. 1. Weak form: Past price information is unrelated to future prices; trends cannot be predicted and taken advantage of by investors. 2. Semi strong form: Prices reflect all public information. 3. Strong form: Prices reflect all public and private information. D. A fully efficient market, if it exists, precludes insiders and large institutions from making profits from security transactions in excess of the market in general. Transactions in an efficient market are said to have an NPV = 0. That is, investors are appropriately compensated for the risk they assume in purchasing a financial asset. E. The efficiency of the market is debatable, but most would agree that the movement is toward greater efficiency. This suggests that the possibility of abnormal returns should be investigated carefully. These returns should not be obtainable in an efficient market. Finance in Action: Be Careful What You Say and How You Say It! An efficient market relies on information being impounded into prices. Poorly conceived messages on the Internet have lead to volatility in share prices. VIII. Securities Regulation A. Regulation of the securities industry is a provincial responsibility. Regulations of the Ontario Securities Commission (OSC) tend to be adopted by most provinces. The stock exchanges and the Investment Industry Regulatory Organization of Canada (IIROC) carry out self-regulation. B. There has been erosion of the separate functions of the four pillars of Canadian finance; banking, trust companies, insurance companies and securities dealers. As well, the real sector and financial sector have now overlapped under one corporate roof in some instances. C. Banks now dominate the securities business in Canada and seek to remain competitive in the world financial markets. D. Foreign interests can also own up to 100 percent of the investment dealers and do play a significant role in the underwriting of issues by Canadian firms. E. There is a need for a coordinated approach to securities regulation amongst governments and for greater deregulation across investment sectors. F. Good regulation and governance practices can be discussed. Perspective 14-3: Discussing the ethical questions related to the timely release of reliable information should prove worthwhile. The saga of several companies related to their financial statements in recent years has damped market interest. Summary Listing of Suggested PowerPoint Slides PPT 6 Canadian money and capital market: securities outstanding 2011 (Figure 14-1) PPT 9 Canadian money market: securities outstanding (Figure 14-3) PPT 10 Canadian bond market: securities outstanding (Figure 14-4) PPT 11 Canadian bonds outstanding: foreign currencies (Figure 14-5) PPT 14 Net new corporate financing by type of security (Figure 14-6) PPT 15 Debt-to-equity ratios for nonfinancial private corporations (Figure 14-7) PPT 16 Funding sources of non-financial private corporations (Figure 14-8) PPT 19 Flow of funds through the economy (Figure 14-9) PPT 20 Total assets of financial intermediaries (Figure 14-10) PPT 24 Secondary market: Annual value of trading (Figure 14-11) PPT 25 World equity markets: Annual value traded, 2010 (Figure 14-12) PPT 28 Money and capital market investments, 2011 (Figure 14-13) PowerPoint Presentation The Chapter 14 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 33 frames. Chapter 15 Investment Underwriting Author's Overview This chapter presents a detailed account of the functions of the investment dealer. By making maximum use of material covered under the "distribution process," the instructor can present a good picture of the marketing channels and pricing mechanisms that are frequently utilized in a public distribution. Such topics as the underwriter spread, pricing of the security, market stabilization, and aftermarket considerations are usually interesting to the student. The changing investment industry with Canadian banks and foreign investment houses is outlined. The global scope of the investment business is discussed. The advantages and disadvantages of going public are considered. A goal of every small firm may be to grow large enough to one day be public, there are some very sound reasons to challenge this objective. Initial public offerings are differentiated from ‘seasoned’ offerings. The continuing importance of private placement can be viewed from statistical data in the chapter and its impact on traditional investment dealers can be considered. Also, the instructor should cover the phenomenon of the leveraged buyout, a significant development of the 1980s that has had a significant impact on the capital markets. Learning Objectives 1. Characterize investment dealers as intermediaries between corporations and government in need of funds and the investing public. 2. Classify the various roles of investment dealers. 3. Outline the distribution process, the allocation of securities amongst syndicate participants and the calculation of the spread as a cost or a return. 4. Analyze the dealer’s role in the pricing of corporate securities. Evaluate the influence of issued securities on earnings per share and share market price. 5. Appraise the pros and cons of going public versus going private when raising funds. 6. Describe a leveraged buyout. Annotated Outline and Strategy I. The Role of Investment Underwriting. A. The investment dealer serves as a middleperson in channeling funds from the investor to the corporation. Also acts on occasion as broker. II. Functions of the Investment Dealer. A. Underwriter: The risk taking function. The underwriter bears the risk of fluctuations in the selling price of the security issue. 1. Best efforts (marketed deal) or bought deal 2. Seasoned of initial public offering Finance in Action: To Market! To Market! Details of public offerings are available at SEDAR. www.sedar.com B. Market maker: The investment dealer may engage in buying and selling of a security to ensure an available market. C. Advising: Corporations may seek an investment dealer's advice on the size, timing, and marketability of security issues. Advice is also rendered pertaining to merger and acquisi¬tion decisions, leveraged buyouts, and corporate restructuring. D. Agency functions: As an agent, the investment dealer assists in the private placement of security issues and in the negotiating process of merger and acquisition transactions. Perspective 15-1: Explain that RBC Dominion Securities, BMO Nesbitt Burns and other Bay Street firms are financial conglomerates that do everything from retail brokerage, investment underwriting, market making in OTC securities, manage mutual funds and so forth. Students should differentiate between the underwriting function and retail brokerage services. III. The Distribution Process. A. The managing investment dealer forms an underwriting syndicate of investment dealers to increase marketability of the issue and spread the risk. B. Syndicate members, acting as wholesalers, sell the securities to brokers and dealers who eventually sell the securities to the public. PPT 8 of 20 Distribution process for an investment deal (Figure 15-1) C. The spread is the difference in the price of a security to the public and the amount paid to the issuing firm and represents the compensation of those participating in the distribution or the cost to the issuer. 1. The spread is divided among the distribution participants. The lower a party falls in the distribution hierarchy, the lower the portion of the spread received. 2. Usually, the larger the dollar value of an issue, the smaller the spread. 3. The spread on equity issues is greater than on debt issues because of the greater price uncertainty. 4. A corporation will also incur other flotation costs such as printing and legal expenses in raising funds. 5. Spread is calculated with the public price as the base, although the return to the underwriter should be calculated on the base of funds received (page 503). IV. Pricing the Security A. Several factors must be considered by the managing investment dealer when negotiating the issue price of a security of a first time issuer: 1. Experience of the firm in the market 2. Financial position of the issuing firm 3. Expected earnings and dividends 4. P/E multiples of firms in the same industry 5. Anticipated public demand Perspective 15-2: Some time can be spent discussing the pricing of new share issues and their relation to the valuation material in Chapter 10. Investment dealers get paid to take price risk but they are motivated to price issues low so that they sell out the issue without being stuck with unsold issues. Corporations have the objective of getting the highest price possible and thereby selling fewer shares. This would create less dilution of earnings. The conflict between the investment dealer and client may create interesting situations and is worthy of discussions. B. The issue price of securities of firms with existing securities outstanding is usually determined by ‘underpricing.’ 1. Price is set slightly below current market value. 2. Underpricing is partially a result of the dilutive effect of spreading earnings over a greater number of common shares. C. Dilution: When new common stock is sold, the new shares issued immediately reduce earnings per share until the earnings can be increased from the investment of new funds. Three (3) stages of dilution from a new issue are calculated on page 495. D. Market Stabilization: The managing investment dealer seeks to stabilize the market (keep the sales price up) by repurchasing securities while at the same time selling them. E. Aftermarket: Research has indicated that initial public offerings often do well in the immediate aftermarket. V. The Securities Industry in Canada A. Growth 1. The growth in functions other than underwriting has been a major source of increased revenues in recent years. These include corporate finance, mergers and acquisitions, derivatives and bond trading. Development of discount brokerage operation. 2. In addition to domestic growth, many investment firms are expanding their international operations. B. Consolidation 1. Need for larger capital bases (Canadian dealers are small internationally). 2. Investment dealers going public: entry of Canadian banks and foreign financial institutions into markets: The consolidation of investment and banking operations within the chartered banks. 3. The development of financial conglomerates. 4. Combining the trading operations of banks on immense trading floors. 5. Global trading units, particularly U.S. expansion. VI. Underwriting Activity in Canada A. Equity underwritings have recovered from the weak equity markets of 2001 and 2008. Debt financings are significant particularly in foreign capital markets. B. Asset backed securities and income trusts have become significant underwritings, with some setbacks. PPT 13 of 20 New corporate issues underwritten in 2010, in Canada (Figure 15-3) VII. Public versus Private Financing A. Advantages of being public: 1. Greater availability of funds 2. Prestige 3. Higher liquidity for shareholders 4. Established price of public issues aids a shareholder's estate planning 5. Enables a firm to engage in merger activities more readily B. Disadvantages of being public: 1. Company information must be made public through Securities Commissions 2. Accumulating and disclosing information is expensive ($$$ and time) 3. Short term pressure from security analysts and investors 4. Embarrassment from public failure 5. High cost of going public C. Venture Capital a subset of private equity. VIII. Initial Public Offerings (IPOs) A. As distinguished from seasoned offerings, IPOs are when a corporation first goes public in the market by selling equity. The price performance of these shares is particularly volatile because of the minimal information available in comparison to shares already trading in the markets. Finance in Action: IPO a Plus 5N Plus Inc. goes public on the TSX in 2007. www.5nplus.com IX. Private Placement A. Private placement refers to selling securities directly to insurance companies, pension funds, and others rather than going through security markets. 1. Used more for debt than equity issues. 2. Advantages. a. Eliminates the lengthy, expensive registration process with the Securities Commissions. b. Greater flexibility in negotiating terms of issue. c. Costs of issue are less. 3. The usually higher interest cost on a privately placed debt instrument is a disadvantage. PPT 17 of 20 New equity financing, Toronto Stock Exchange, 2000-2010 (Figure 15-4) B. Firms that elect to go private are usually small companies that are seeking to avoid large auditing and reporting expenses. However, larger firms have gone private to avoid the pressure of pleasing analysts in the short term. There are two basic ways to go private. The public firm can be purchased by a private firm or the company can repurchase all publicly traded shares from the shareholders. C. Many firms have gone private through leveraged buyouts. Management or some external group borrows the needed cash to repurchase all the shares of the company. Frequently the management of the private firm must sell off assets in order to reduce the heavy debt load. D. Several firms that have gone privately have restructured and returned to the public market at an increased market value. In some cases the firm was divided and the divisions were sold separately. The “breakup value” of some firms was substantially higher than the market value of the unified entity. E. The lack of leveraged buyout activity in Canada can be attributed to more tightly controlled corporations (as to ownership) and the cyclical nature of the cash flow of the corporations. X. Mergers, Acquisitions and Privatization A. Privatization: The 1990s were a decade for many state owned companies around the world issuing ownership securities to private individuals. Summary Listing of Suggested PowerPoint Slides PPT 8 of 20 Distribution process for an investment deal (Figure 15-1) PPT 10 of 20 Allocation of underwriting spread (Figure 15-2) PPT 13 of 20 New corporate issues underwritten in 2010, in Canada (Figure 15-3) PPT 17 of 20 New equity financing, Toronto Stock Exchange, 2000-2010 (Figure 15-4) PowerPoint Presentation The Chapter 15 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 20 frames. Chapter 16 Long-Term Debt and Lease Financing Author's Overview Corporate debt and government debt are not going away. Debt covers secured versus unsecured debt, sinking fund provisions, bond prices, yields, and rating, and conversion and call features. Junk bonds are discussed. The student gets a good indoctrination into the various influences on bond prices, which can be strongly reinforced by problems at the back of the chapter. Table 16-3 summarizes various points about bond pricing such as coupon rate versus market yield and the influence of bond ratings. The bond refunding decision is covered from the approach of a capital budgeting problem and leasing is examined as a special form of debt, rather than as a separate type of financing. The reasons for a lease arrangement are clearly enumerated. The lease versus purchase decision, a capital budgeting decision, is outlined. Financial alternatives for distressed times are covered in Appendix 16A, with a discussion of out-of-court and in-court settlements. Disposal of assets under liquidation is examined in this appendix. Learning Objectives 1. Identify and describe the key features of long term debt. 2. Differentiate bond yields and prices as influenced by how corporations and governments are rated by major bond rating services. 3. Analyze the decision of whether or not to call in and reissue debt (refund the obligation) when interest rates have declined. 4. Outline some of the innovative forms of raising long-term financing, including zero-coupon rate bonds, floating rate bonds, and real return bonds. 5. Outline the characteristics of long-term lease financing that make it an alternative form of long-term financing. 6. Analyze a lease-versus-borrow-to-purchase decision. Annotated Outline and Strategy I. The Expanding Role of Debt Perspective 16-1: The expanding role of debt is not just an issue for corporations but also for governments and consumers as we saw in 2008/09. We reached record debt levels across the economy in early 1990s but by the mid-1990s rising stock prices and profits gave companies the chance to increase the amount of equity on their balance sheet. In the new millennium, companies have had much healthier capital structures. A. Corporate debt has expanded dramatically over the years, although firms have been holding historically high cash balances. B. The rapid expansion of corporate debt is the result of: 1. Rapid business expansion 2. Inflation in earlier years 3. At times, inadequate funds generated from the internal operations of business firms. 4. A relatively weak stock market at times. C. Interest coverage (formula 3-12) has generally remained health and conservative. PPT 5 of 35 Interest coverage – Canadian nonfinancial corporations (1981 – 2011) (Figure 16-1) II. Debt Contract Terminology and Provisions A. Par Value: the face value of a bond. B. Coupon Rate: the actual interest rate on a bond; annual interest/ par value (semiannual installments usually). C. Maturity Date: the final date on which repayment of the debt principal is due. D. Indenture: lengthy, legal agreement detailing the issuer's obligations pertaining to a bond issue. An independent trustee administers the indenture. Finance in Action: Continental Airline Bonds: Don’t Forget to Read the Fine Print Continental Airlines issued $350 million of bonds that were secured by 53 planes and 55 spare engines having a total appraised value of $467 million. With bankruptcy many investors realized they failed to read the fine print in the bond indenture. This remains a good lesson! E. Restrictive covenants: promises that limit management flexibility but protect investor, contained in indenture. Also known as negative pledges. F. Security provisions 1. Secured claim: specific assets are pledged to bondholders in the event of default. 2. Mortgage agreement: real property is pledged as security for loan. 3. Senior claims require satisfaction in liquidation proceedings prior to junior claims. 4. New property may become subject to a security provision by an ‘after acquired property clause.’ PPT 11 of 35 Priority of claims (Figure 16-2) G. Unsecured debt 1. Debenture: an unsecured, long term corporate bond 2. Subordinated debenture: an unsecured bond in which payment will be made to the bondholder only after the holders of designated senior debt issues have been satisfied. 3. Junk bond: debt obligation of lower quality and speculative in nature with a high expected yield that is sometimes used in leveraged buyouts. Technically a bond with a rating below investment grade (BBB). Finance in Action: Junk or High-Yield Bonds? The development of a Canadian high yield debt market, a term preferred to a junk bond market, is limited. There is still a lack of depth to the market sometimes forcing Canadian corporations to sell their bonds south of the border, where the bonds get a better reception. H. Methods of Repayment of Principal 1. Lump sum payment at maturity 2. Serial payments: bonds are paid off in installments over the life of the issue; each bond has a predetermined maturity date. 3. Sinking fund: the issuer is required to make regular contributions to fund under the trustee's control. The trustee purchases (retires) bonds in the market with the contributions. 4. Conversion: retirement by converting bonds into common stock; this is the option of the holder but it may be forced. (See Chapter 19.) 5. Call Feature: an option of the issuing corporation allowing it to retire the debt issue prior to maturity. Requires payment of a call premium over par value of 5 percent to 10 percent to the bondholder. The firm often exercises the call when interest rates have fallen. I. Generally the greater the protection afforded the bondholder (security, protective covenants), the lower the interest rate (yield) they must accept. III. Bond Prices, Yields, and Ratings A. Bond prices are largely determined by the relationship of their coupon rate to the going market rate and the number of years until maturity. 1. If the market rate for the bond exceeds the coupon rate, the bond will sell below par value. If the market rate is less than the coupon rate, the bond will sell above par value. 2. The more distant the maturity date of a bond, the farther below or above par value the price will be given the coupon rate and market rate relationship. PPT 15 of 35 Long-term yields on debt (Figure 16-3) B. Bond yields are quoted on three different bases. Assume a $ 1,000 par value bond pays $ 100 per year interest for 10 years. The bond is currently selling at $900 in the market. Perspective 16-2: It is important for students to understand the difference between the various bond yields. The most important yield is the yield to maturity, which is a function of price change as well as annual cash flow. 1. Coupon rate (nominal yield): Stated interest payment divided by par value $100/$1,000 = 10%. 2. Current yield: Stated interest payment divided by the current price of the bond, $100/$900 = 11.11%. 3. Yield to Maturity: The interest rate that will equate future interest payments and payment at maturity to current market price (the internal rate of return). The yield to maturity may be computed by the following formula and solving for Y: With a calculator: C. Bond ratings 1. There are two major bond rating agencies: Dominion Bond Rating Service and Standard and Poor’s. 2. The higher the rating, the lower the interest rate that must be paid. 3. The ratings are based on: a. the firm's ability to make interest payments b. it’s consistency of performance c. it’s size d. it’s debt/equity ratio e. it’s working capital position f. other factors PPT 18 of 35 Outstanding debt issues, August 2011 (Table 16-3) D. Examining actual bond ratings: See Table 16-3 (page 522) and discussion. Finance in Action: Before the Fall The spectacular failure of Enron and the potential for bankruptcy of Greek are highlighted. IV. The Refunding Decision A. The process of calling outstanding bonds and replacing them with new ones is termed refunding. This action is most likely to be pursued by businesses during periods of declining interest rates. B. Interest savings from refunding can be substantial over the life of a bond but the costs of refunding can also be very large. Perspective 16-3: Compare the refunding decision with paying off a high-cost mortgage early and refinancing it at a lower rate with all the resultant costs of financing, points, closing fees, lawyers, etc. C. A refunding decision is a capital budgeting problem. The refunding costs constitute the investment and the net reduction in annual cash expenditures is the inflow. D. A major difference in evaluating a capital expenditure for refunding is that the discount rate applied is the after-tax cost of debt rather than the cost of capital because the annual savings are known with greater certainty. PPT 21 of 35 Summary of bond refunding decision (page 525) E. Calculation of NPV 1. Investment costs include a. Call premium, non-tax deductible. b. Issue expenses (underwriting, legal, accounting, printing) are tax deductible at 20 percent a year over 5 years. c. Overlap interest costs less interest revenue, both on an after-tax basis. 2. Annual cost savings a. The annual interest savings from a lower interest rate on an after-tax basis (1 – tax rate) discounted at the appropriate rate (AFTERTAX COST OF NEW DEBT) 3. Issue discounts are tax deductible at the time of redemption. Finance in Action: CN Rail Sells Redeemable Debentures The Canadian bond market is less transparent than the equity market although details of issues are available such as this callable debenture. www.sedar.com V. Other Forms of Bond Financing A. Zero Coupon Rate Bonds 1. Do not pay interest: sold at deep discounts from face value. 2. These bonds provide immediate cash inflow to the corporation (sell bonds) without any outflow (interest payments) until the bonds mature. 3. Since the difference between the selling price and the maturity value is amortized for tax purposes over the life of the bond, a tax reduction benefit occurs without a current cash outflow. 4. Although these have limited appeal in Canada because of tax rulings, the Eurobond market has been more receptive. B. Stripped bond 1. The investment dealer strips coupons from face value of bond and sells differing maturities to investors based on their time preferences. 2. No reinvestment rate risk. 3. An illustration is given in the text on pages 527. Finance in Action: Strips or Real Returns Descriptions of strip and real return bonds are highlighted C. Floating rate bond 1. The interest rate varies with market conditions. 2. Unless market rates move beyond floating rate limits, the price of the floating rate bond should not change, therefore, the investor is assured (within limits) of the market value of his investment. D. Real return bond 1. These securities provide a return above the inflation rate. E. Revenue bond 1. In 1996 Nav Canada issued the first revenue bonds in Canada, based on its stream of cash flows from controlling air traffic within Canada, not based on its assets. VI. Eurobond Market A. A Eurobond is a bond in a unit of currency other than the currency of that country in which the bond is issued. Usually denominated in U.S. dollars but not always. Disclosure is less stringent than in domestic country. B. Allows access to the large international capital market for Canadian corporations. VII. Corporate Debt for the Medium Term A. Financial intermediaries may extend credit to a corporation by way of a term loan based on a capital asset as security. The loan is not payable on demand unless the legal covenants are violated. B. MTN (Medium term note) financings have maturities in the 3 – 10 year range. Their significance is identified in Figure 15-3. These notes allow corporations to raise funds on a shorter time frame, through the capital markets. C. Asset-backed securities are generally of medium term and are based on the security of assets of the firm (receivables and the like) traditionally financed through banks, but backing securities sold directly to the public. VIII. Mortgage Financing A. Criteria for approval, requirements, term and amortization are discussed. IX. Advantages and Disadvantages of Debt A. Benefits of Debt 1. Tax deductibility of interest. 2. The financial obligation is specific and fixed (with the exception of floating rate bonds). 3. In an inflationary economy, debt may be repaid with ‘cheaper dollars.’ 4. Prudent use of debt may lower the cost of capital. B. Drawbacks of Debt 1. Interest and principal payments must be met when due regardless of the firm's financial position. 2. Burdensome bond indenture restrictions. 3. Imprudent use of debt may depress share prices. X. Leasing as a Form of Debt A. A long term, noncancellable lease has all the characteristics of a debt obligation. B. The Canadian Institute of Chartered Accountants (CICA) requires that certain types of long-term lease obligations be included on the balance sheet as if the asset was purchased and a long-term debt obligation incurred. C. Leases that substantially transfer all the benefits and risks of ownership from the owner to the lessee must be capitalized. A capital lease is required whenever any one of the following conditions exists. 1. Ownership of the property is transferred to the lessee by the end of the lease term. 2. The lease contains a bargain purchase price (sure to be purchased) at the end of the lease. 3. The lease term is equal to 75 percent or more of the estimated life of the leased property. 4. The present value of the minimum lease payments equals or exceeds 90 percent of the fair value of the leased property at the beginning of the lease. D. A lease that does not meet any of the four criteria is an operating lease: 1. Usually short term 2. Often cancelable at the option of the lessee 3. The lessor frequently provides maintenance 4. Capitalization and presentation on the balance sheet is not required E. Impact of capital lease on the income statement 1. The intangible leased property under capital lease (asset) amount is amortized and written off over the life of the lease. 2. The obligation under capital lease (liability) is written off through amortization with an "implied" interest expense on the remaining balance. F. Advantages of leasing 1. Lessee may not have sufficient funds to purchase or have borrowing capability. 2. Provisions of lease may be less restrictive. 3. May be no down payment. 4. Expert advice of leasing (lessor) company. 5. Creditor claims on certain types of leases are restricted in bankruptcy and reorganization procedures. 6. Tax considerations a. Obtain maximum benefit of tax advantages. b. Tax deductibility of lease payments for land. 7. An infusion of capital can occur through a sale leaseback. Finance in Action: Sale and Leaseback in the Airline Business Airplanes require huge capital investments and many airlines lease the planes through large international leasing companies, rather than tying up their own capital. www.aircanada.com G. Lease versus Purchase Decision 1. Leasing as a means of financing is often compared to borrow purchase arrangements when assets are to be acquired. This procedure is particularly appropriate for comparing an operating lease to purchasing. Most capital leases are treated the same for tax purposes as borrowing to purchase. 2. The present value of all after tax cash outflows associated with each form of financing is computed. The procedure requires consideration of all tax shields for each method. Since all outflows are fixed by contract, the discount rate employed in computing the present value of the outflows is the after-tax cost of debt. A possible salvage value has greater uncertainty as a cash flow, and the cost of capital is used to acknowledge this greater uncertainty within the analysis. 3. Although qualitative factors must be considered, the usual decision criterion is to accept the financing method, leasing or borrow purchase, which has the lowest present value of cash outflows. The cash inflows should be the same whether the asset is leased or purchased. 4. PV of CCA tax shield PPT 28 of 35 Net present value of borrow-purchase (Table 16-7) PPT 29 of 35 Net present value of operating lease outflows (Table 16-8) XI. Appendix 16A: Financial Alternatives for Distressed Firms A. Financial Distress 1. Technical Insolvency: firm has positive net worth but is unable to pay its bills as they come due. 2. Bankruptcy: a firm's liabilities exceed the value of its assets-negative net worth. Finance in Action: Survival: Failure In early 2002 Algoma Steel came out of protection under the Company’s creditors Arrangement Act. In 2006 Stelco came out of bankruptcy protection of the CCAA and then was bought out in 2007. In 2009 Canwest sought protection under CCAA and subsequently sold in parts. www.algoma.ca www.aircanada.com www.ussteelcanada.com B. Out of court Settlements 1. Extension: creditors allow the firm more time to meet its financial obligations. 2. Composition: creditors agree to accept a fractional settlement on their original claim. 3. Creditor committee: a creditor committee is established to run the business in place of the existing management. 4. Assignment: a liquidation of the firm's assets without going through formal court action. C. In court Settlements Formal Bankruptcy 1. Bankruptcy proceedings may be initiated voluntarily by the firm or forced by the creditors: involuntary bankruptcy. 2. The decisions of a court appointed referee who arbitrates the bankruptcy proceedings are final subject to court review. 3. Reorganization: a fair and feasible plan to reorganize the bankrupt firm. a. Internal reorganization: necessitates an evaluation of existing management and policies. An assessment and possible redesign of the firm's capital structure is also required. b. External reorganization: a financially strong and managerially competent merger partner is found for the bankrupt firm. 4. Liquidation: if reorganization of the firm is determined to be infeasible, the assets of the firm will be sold to satisfy creditors. Common shareholders rank last in bankruptcy. Summary Listing of Suggested PowerPoint Slides PPT 5 of 35 Interest coverage ̶ Canadian nonfinancial corporations (Figure 16-1) PPT 11 of 35 Priority of claims (Figure 16-2) PPT 15 of 35 Long term yields on debt (Figure 16-3) PPT 18 of 35 Outstanding debt issues, August 2011 (Table 16-3) PPT 21 of 35 Summary of bond refunding decision (page 550) PPT 28 of 35 Net present value of borrow-purchase (Table 16-7) PPT 29 of 35 Net present value of operating lease outflows (Table 16-8) PowerPoint Presentation The Chapter 16 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 35 frames. Instructor Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen, Doug Short, Michael Perretta 9780071320566, 9781259268892, 9781259261015