CH-16-19 Debt Policy – Fundamentals of Corporate Finance : Chapter Notes

This Document Contains Chapters 16 to 19 CHAPTER 16 DEBT POLICY CHAPTER IN PERSPECTIVE Does capital structure affect the value of a business? We discuss this issue and examine conditions in which the firm’s debt policy does not matter? Modigliani and Miller (hereafter, MM) were presented the Nobel Prize for their work in this area. Just as the pure competitive model provides us a look at market conditions where price is minimized and output is maximized, an early review of the MM thesis is an important step before looking at an economy with taxes, agency costs, bankruptcy, etc. As the simplistic assumptions are relaxed, the student finds that capital structure mix does affect investor cash flows, required rates of return, and value. While some finance texts are reluctant to mention the MM thesis, we treat the MM hypothesis as the bedrock and try to provide a clear and thorough presentation of this subject. Discussing the MM thesis with beginning finance students provides a connection to early chapters (value is in assets), provides conditions necessary where capital structure is irrelevant, and finally links the contributing factors that may affect value: investment, debt, and maybe dividend decisions. CHAPTER OUTLINE 16.1 HOW BORROWING AFFECTS VALUE IN A TAX-FREE ECONOMY MM’s Argument How Borrowing Affects Earnings per Share How Borrowing Affects Risk and Return Debt and the Cost of Equity 16.2 CAPITAL STRUCTURE AND CORPORATE TAXES Debt and Taxes at River Cruises How Interest Tax Shields contribute to the Value of Shareholder’s Equity Corporate Taxes and the Weighted-Average Cost of Capital The Implications of Corporate Taxes for Capital Structure 16-1 This Document Contains Chapters 16 to 19 16.3 COSTS OF FINANCIAL DISTRESS Bankruptcy Costs Evidence on Bankruptcy Costs Direct versus Indirect Costs of Bankruptcy Financial Distress without Bankruptcy Costs of Distress Vary with Type of Asset 16.4 EXPLAINING FINANCIAL CHOICES The Trade-Off Theory A Pecking Order Theory The Two Faces of Financial Slack 16.5 BANKRUPTCY PROCEDURES The Choice between Liquidation and Reorganization 16.6 SUMMARY TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 16.1 HOW BORROWING AFFECTS VALUE IN A TAX-FREE ECONOMY A. The value of business assets, assuming there is no tax deductibility of interest, is not affected by the capital structure mix of debt and equity. B. The present value of expected cash flows from assets, or the value of assets, is equal to the value of securities issued by the business. Changing the mix of securities does not affect the value of the assets. C. The right-hand side of the balance sheet, assets, determines the size of the pizza; the mix of securities on the left-hand side of the balance sheet determines how the pizza is sliced. The only way to increase the amount of the pizza is to increase the value of assets (pizza), not slicing (financing) in a new combination of pieces. D. This theory or idea won Franco Modigliani and Merton Miller (MM) a Nobel Prize. 16-2 MM’s Argument A. The value of business assets is not affected by the capital structure mix. This is known as MM’s proposition I (debt irrelevance proposition). Debt policy should not matter to shareholders. It is the assets that count for value. B. Why should leveraging, or substituting debt for equity in the capital structure, affect the value of assets? Investors do not need businesses to add leverage to their investment portfolios. Financial institutions will lend investors money if they want, so adding debt to the business capital structure is no big thing, or certainly nothing of value to investors. How Does Borrowing Affect Earnings per Share? A. Borrowing almost always increases earnings per share if revenues increase. See Figure 16.1. Figure 16.1 B. “Slump” conditions would decrease earnings per share. C. Debt financing increases the variability of earnings per share for any change in revenues. How Borrowing Affects Risk and Return A. Increasing the amount of debt versus equity, called restructuring, does increase shareholder’s expected return. If leverage is favourable with the return on assets exceeding the cost of debt, earnings and returns to shareholders will increase. 16-3 Borrowing reduces earnings per share if economy is heading for a recession. However, borrowing does increase the expected earnings per share. See Table 16.2 and 16.3. B. These higher expected returns are not without a cost. The cost is increased risk to the shareholders, for now with debt, there is a prior claim (creditors) on their income stream and assets, in case of failure. C. Shareholders in the leveraged firm have prospects for higher returns, but also added risk. The net effect is that the expected future cash flows have gone up, with the use of debt, but so has the shareholder required rate of return. The increased cash flows in the valuation function have increased, but are offset by the increased discount rate. There is no change in the value of the assets or the stock of the shareholders. D. The operating risk or business risk, or the risk or variability of the operating income or earnings before interest and taxes (earnings before distributions are made to sources of funds) is not affected by the capital structure mix. E. While the operating risk is not affected by increased proportions of debt or use of financial leverage, the financial risk, or risk (variability of returns) to shareholders has increased with increased use of debt. With increased financial leverage and increased financial risk, shareholder required rates of return increase. The higher expected value from the use of debt is canceled out by the higher discount rate applied to the higher cash flows. The value of the assets is left unchanged or is not affected by changing the mix of debt and equity. Debt and the Cost of Equity A. The weighted average cost of capital (WACC) is the expected return on the assets, 16-4 and correspondingly, the securities of a business and is the required rate of return on any new average risk investment project. B. In an all equity business the WACC = rassets = requity, or the expected return on assets equals the expected rate of return on equity. C. When debt is added or the capital structure mix changed, the cost of debt, and equity, must be weighted by their relative market value proportions so that: WACC = rassets = rdebt[D/(D+E)] + requity[E/(D+E)] D. The WACC or the rassets does not change as debt is added to the capital structure. This concept is MM’s proposition II which states that the expected return on the common stock increases as the debt/equity ratio increases. Why doesn’t the WACC change? As more low cost debt is added to the capital structure, the required rate of return on equity increases to offset the advantage of low cost debt. The WACC does not change; the market value of the firm does not change. Debt does not matter in this situation where the tax-deductibility of interest is not a factor. E. Debt has an explicit cost in the form of an interest rate, and an incidental, implicit cost impact on the required rate of return on equity as debt is added to the capital structure. Debt is no “cheaper” than equity and the use of debt does not affect the WACC, or the value of the firm. F. Figure 16.3 shows the offsetting effects of lower cost debt, even if risk-free, added to the capital structure relative to the increasing required rate of return of equity of greater financial leverage. One offsets the other and the expected return on assets, rassets, is not affected by changing the capital structure mix. Figure 16.3 16-5 G. Adding a bit of reality does not change the conclusion. In Figure 16.4 risky debt is considered, where with increases in the debt/equity ratio, the cost of debt increases as creditors get edgy about sharing the income stream, and the rate of increase in the shareholder’s required rate of return begins to slow as bondholders begin to bear a greater share of the risk. The conclusion is the same: the WACC or expected return on assets or the cost of the package of debt and equity (WACC) does not change. Debt does not affect the value of the assets! 16.2 CAPITAL STRUCTURE AND CORPORATE TAXES A. Reality says that financial managers are concerned about finding that “right” mix of capital structure that produces the lowest or optimal cost of capital. This suggests that there are other factors working beyond MM’s assumptions. B. The presence of taxes, bankruptcy costs, and potential conflicts of interests between creditors and shareholders, and ways that financial decisions could affect investment decisions do affect the value of assets. C. If this is true, what is the value of the MM propositions? How did they win a Nobel Prize with a theory with such limiting assumptions? Their propositions provided the foundation upon which we study reality or the real-world situation as it exists. Just as the pure competitive model studied in microeconomics was used as a basis for evaluating existing market structure, MM’s basic theories provide a basis for explaining how these other variables affect asset or business values. Debt and Taxes at River Cruises A. Interest expense is deductible against taxable income, which means that the combined income available for debt and equity is increased with the use of debt. See Table 16.6. B. The added value is the interest tax shield, or the tax savings resulting from the deductibility of interest payments. C. The annual interest tax shield is the product of the interest paid, (rdebt x D), times 16-6 the tax rate, Tc. Since the creditors or bond holders receive their same interest payment and no more, the added annual value of the tax shield accrues to shareholders. D. Assuming a constant level of debt, the value over time of the tax shield is the annual tax shield capitalized or divided by the current cost of debt capital, or put another way, is the product of the amount of debt, D, times the corporate tax rate, Tc: PV of tax shield = annual tax shield/ rdebt = Tc x (rdebt x D)/rdebt = Tc D How Interest Tax Shields contribute to the Value of Stockholder’s Equity A. There are three claims on the operating income of business: creditors, shareholders, and government. B. The deductibility of interest is a tax shield that diverts government taxes to the shareholders. Thus the use of debt increases the value of an all-equity business by the amount equal to the value of the tax shield, TcD, or: Value of levered firm = value if all-equity financed + TcD. See Figure 16.5. Figure 16.5 Corporate Taxes and the Weighted-Average Cost of Capital A. The value of the corporate tax shield is represented in the lower after-tax cost of debt. Lower after-tax costs of debt lowers the WACC and increases the present value of stream of asset cash flows. 16-7 B. The value of the tax shield is represented in the value of the assets. The Implications of Corporate Taxes for Capital Structure A. If the value of the tax shield increases as the debt/equity ratio increases, as in Figure 16.5, why don’t all businesses borrow as much as they can? B. There are other factors, such as the increased costs of possible financial distress that offset the value of the tax shield at high debt/equity ratios. 16.3 COSTS OF FINANCIAL DISTRESS A. As the debt/equity ratio increases, the costs of financial distress, or the costs of possible bankruptcy, increases. B. The market value of the business is equal to the value of an all-equity business plus the present value of the tax shield less the present value of financial distress. C. The added costs of financial distress overtakes the added value of the tax shield at some point and may lower the value of the firm at some high debt/equity ratio. See Figure 16.7. This is called the trade-off theory of optimal capital structure. D. The theoretical optimum capital structure is the debt/equity level in which the PV of the tax shield is just offset by the PV costs of financial distress. This debt/equity level will maximize market value of the business. Figure 16.7 16-8 E. An enterprise which maximizes firm value should also minimize its weighted average cost of capital. It follows that a particular debt to equity ratio represents the optimal capital structure if it results in the lowest possible weighted average cost of capital, keeping in mind the potential costs of financial distress and bankruptcy that can result from excessive debt. We see this in figure 16.8. Bankruptcy Costs A. Bankruptcy occurs as the value of a business declines. Bankruptcy does not cause the value of a business to decrease. It is a court-directed legal process that occurs when the value or the financial conditions of a business deteriorate to the point where the bills are not paid or the value of the equity is zero. B. If bankruptcy occurs the costs are deducted from the remaining value of the business and shareholders are the last in line for any proceeds. Shareholders are likely to lose their investment in this situation. Evidence on Bankruptcy Costs A. Research indicates that the costs of bankruptcy for large firms is a relatively small proportion of the value of the securities. Direct versus Indirect Costs of Bankruptcy A. While direct bankruptcy costs are relatively small, the indirect costs associated with bankruptcy related to managerial limitations and efforts to correct the economic problems may be significant. Financial Distress without Bankruptcy A. As long as bills are paid, a firm in financial distress may avoid bankruptcy, reduce costs, and begin a turnaround. B. Often a valueless firm may take added risk to bet on a turnaround, or linger for a significantly long time before an interest payment is missed or some other act that may lead to bankruptcy occurs. C. Until bankruptcy occurs, owners still control investment and operating strategy. With little remaining to lose, managers/owners may bet the creditor’s money in a risk turnaround venture, thus increasing the costs of financial distress. D. Added equity invested in a financial distressed situation for a reasonable project 16-9 may reward creditors, not reward owners, and the project may be ignored. E. Positive NPV projects that tend to be in the creditors’ interest and not shareholders’ may be avoided, especially if close to bankruptcy. Shareholders may be interested in getting their money out, not putting more into the business that may go to creditors. F. It is in stockholders’ interest to avoid high-debt situations where “betting games” may occur because stockholders generally lose. Borrowing contracts are generally in favour of creditors if problems should occur. Thus owners’ required rates of return for investment in high-debt firms may keep debt/equity ratios in the moderate range. Costs of Distress Vary with Type of Asset A. Real asset firms tend to lose less value in bankruptcy than firms with significant intangible assets, such as research and development firms which depend upon human capital. B. From the arguments above, companies with safe, tangible assets such as real estate and high taxable income should have high debt ratios, while people- oriented firms with little or no taxable income should have low debt ratios. C. While all firms suffer in times of financial trouble, manufacturers of relatively expensive durable products requiring regular after-sales service, such as automobile or computer companies can have particularly high costs associated with financial distress. Similarly, the perception that an airline company is in financial trouble may scare away customers who may be concerned about the maintenance and safety of its aircraft and about its ability to honour frequent flier programs. 16.4 EXPLAINING FINANCING CHOICES The Trade-Off Theory A. The theory that there is an optimum debt/ratio ratio that maximizes market value, offsetting the benefits of the tax shield against the increasing costs of financial distress, is called the trade-off theory of optimal capital structure. B. The support of the trade-off theory is evidenced by a wide variety of debt/equity ratios between industries and companies, but with some consistent with the trade- off theory and some operating inconsistently with the theory. C. Utilities and retailers tend to borrow heavily and their assets are tangible and 16-10 relatively safe, but the most successful companies, such as Merck, with very high taxable profits, tend to forgo the tax shield advantage of debt. A Pecking Order Theory A. Research has shown that stock sales announcements tend to drive stock prices down, indicating that investors think managers feel the stock price is overvalued if they attempt to sell equity. B. Likewise, the announcement of a debt issue has little or no affect upon equity prices. C. The above observations indicate a pecking order theory of capital structure. D. Businesses prefer to issue debt rather than equity if internally generated cash flow is insufficient. Use of internally generated funds does not have the signaling effect, positively or negatively, as external funding does. E. If external funds must be raised, equity will be used reluctantly, reserved as the residual in the financing pecking order. F. Under the pecking order theory there is no target debt/equity ratio because there are two kinds of equity: internally generated earnings retained and external stock sales. Internal equity is the first choice for financing ahead of debt, and finally, external equity funding. G. Profitable firms have sufficient internally generated capital to fund their high NPV investments. Hence, they have all equity or low debt ratios. H. Less profitable firms tend to issue more debt as they run out of internally generated funds quickly and turn to debt as the next source of funding in the pecking order. The Two Faces of Financial Slack A. Financial slack, ready access to cash from the sale of assets or debt financing, provides flexibility and is valuable to the financial manager. B. Excessive financial slack encourages excessive expenditure, limited dividends, and low NPV investments. C. Use of debt and the accompanying interest and principal payments require use of cash to service debt, thus reducing excessive cash. D. The optimal level of financial slack is just enough cash to satisfy liquidity needs 16-11 and to finance all positive NPV investments. Bankruptcy Procedures. Regulations pertaining to bankruptcies are provided in the Bankruptcy and Insolvency Act, 1992. Some companies are also governed by the Companies’ Creditors Arrangement Act and the Winding-up and Restructuring Act. A. A problem business and its creditors have a range of options before bankruptcy, including extension of time for payment, or a possible composition of obligations which reduces the amount to be paid by some proportion. B. These informal arrangements above, taken before bankruptcy, are referred to as a workout. C. Bankruptcy results in either a liquidation or sale of a business’ assets to generate money for claimants, or a reorganization, which restructures the financial claims on a business in an attempt to keep it operating. D. In a bankruptcy liquidation, there is an official order of claimants. E. During bankruptcy, the creditor claims and individual efforts to collect are suspended and the operation of the business, through management or a court appointed trustee, are monitored by the bankruptcy court. F. A reorganization plan evaluates and selects the higher of the value of the business as liquidated or as a reorganized business. G. A reorganization plan must be approved by creditors and confirmed by the bankruptcy court. The Choice between Liquidation and Reorganization A. In theory, the liquidation/reorganization decision should be based on which produces the higher value. B. Other factors, including tax considerations, cash flow considerations of reorganization, and time delays are variables in the court decisions. 16-12 16.5 SUMMARY PEDAGOGICAL IDEAS General Teaching Note—In teaching business finance to beginning finance students, the corporation or business is often an intangible unrealistic model for them. Focus the model on the student, or the personal financial decision, and the students shift forward on their seats. Here is a good chapter to make the transition and perk up interest. Does debt matter? Matter to whom? Your capitalized value, lifestyle, credit risk, etc. Government tax policy encourages home investments with significant borrowing; personal interest is now not deductible. More debt accelerates the standard of living at the increased likelihood of financial distress and a lower standard of living when repayment occurs. Does debt really increase one’s value, income, or wealth, or just readjust its timing? Make the “transition” from corporate finance to personal finance in the course and watch the attitude toward “finance” change in your students. Student Career Planning—Encourage students to work hard on their computer skills while in college. Many curriculums have considerable computer training included and class applications are found in a few courses. A good guess is that most programs are not providing “enough” skills development per the rate of computer development in the workplace. Many jobs are lost today because of the lack of not just general computer skills, but because one area is weak. Proficiency exams are common before hiring and will proliferate in the future. Encourage students to keep their skills sharp in the area of internet research, word processing, spread sheet programming, graphics, presentation (Power Point), and possibly, interprogram networking skills, such as importing files from EXCEL to WORD. Such skill might be found in a part-time job or, pushing the limits, by providing something new, never tried in the next assignment, such as designing a personal home page for their resume and favorite links. There is a return on the time invested. As with the MM hypothesis, investment produces value! Internet Exercises - The analysis of debt policy begs a look at an example of the credit rating services, such as Dominion Bond Rating Service, Moody’s and Standard & Poor’s. The Moody’s Manuals and S&P Corporate Reports have long served business students searching for company financial data. These two rating services now offer Internet-based services to their investing and company clients. A review of the Internet sites of these two rating agencies provides professors with information for class presentation or student assignments. http://www.dbrs.com The Dominion Bond Rating Service site offers a range of information including details about their rating methodologies for different types of securities as well as actual corporate ratings. 16-13 http://www2.standardandpoors.com/portal/site/sp/en/ca/page.home/home/0,0,0,0,0,0,0,0,0, 0,0,0,0,0,0,0.html The Standard and Poor’s site offers both the professor and the student an excellent overview of their services, considerable information about the debt rating process, and a generous sampling of their research reports and publications. From the home page, click “Rating Services Home” link, review the latest ratings in a variety of sectors, read feature articles from the latest CreditWeek publication and archived editions, and review the S&P credit rating methodology. From the Ratings Inquiry link, request the current rating of companies you are studying. A good assignment is to request the definitions of the various S&P ratings and find a current corporate ratings report. What are the criteria by which S&P determines a rating? The Ratings Reports present the material with the following headings: Rationale for the Rating, Outlook, Business Description, Business Profile, Financial Profile, and more. While only the more recent ratings reports are listed (precludes looking up a specific company), the students will find a company to their liking to make their report. From the main S&P page, review the DRI site for case analyses, industry and general economic reports, and much more. The S&P Internet site is very extensive and is expanding. http://www.moodys.com Moody’s Investor Service offers professors and students a wealth of “show and tell” and research opportunities. From the latest rating actions (with detailed explanations) to recent analyses of the economy and financial markets, the site provides an opportunity for many student research assignments. Under the Credit Research Highlights, abbreviated highlights of recently released reports are presented. Ask students to find a research report of interest to them and write a one-page report. Under Rating Methodologies, you can find a long list of specific industry reports. For anyone studying an industry or a company in an industry, the reports provide an approach to analyzing the key economic and financial factors. This is another section where student research, focused around the process of analyses, can be directed. Overall this is an excellent Internet site for student assignments. 16-14 CHAPTER 17 LEASING CHAPTER IN PERSPECTIVE Leases are complex contractual arrangements to grant the use of specific fixed assets for a specified time in exchange for a series of payments. There are several types of leases: operating lease, financial lease, sale and leaseback, and leveraged lease. This chapter focuses mainly on the study of financial leases. Lease contracts are analyzed using the net present value approach. The analysis is done both from the lessee’s point of view and lessor’s point of view. The analysis of a financial lease focuses first on the identification of the cash flows from leasing, rather than borrowing to acquire the asset. This requires an understanding of capital cost allowance, CCA. You will want to review the material on valuing the tax savings from CCA presented in Chapter 8 as necessary. Students must be reminded that the approach taken presumes that the company’s management has already decided that the asset is needed and now are considering whether to borrow to finance it or to lease it. The focus of the analysis is on the incremental cash flows from leasing rather than borrowing. That is, how are the cash flows changed if the company switches from borrowing to leasing? The study of financial leases is an opportunity to review NPV and CCA calculations and also to talk about alternatives to debt financing. A logical place to introduce leasing is after the discussion of other forms of financing in Chapter 14. Students will have seen the cost of capital, from Chapter 13, and have an understanding of debt financing. However, instructors may prefer to wait until after covering the capital structure decision, Chapter 16, before dealing with lease financing. We feel that including the discussion on lease financing just after the discussion on debt financing improves the logical flow of topics. The topic of “Leasing” has, therefore, now been moved to Chapter 17. CHAPTER OUTLINE 17.1 WHAT IS A LEASE? Leasing Industry 17.2 WHY LEASE? Sensible Reasons for Leasing 17-1 Some Dubious Reasons for Leasing 17.3 VALUING LEASES Operating Leases Financial Leases Cash Flows of a Financial Lease Who Really Owns the Leased Asset? Leasing the Canada Revenue Agency (CRA) First Pass at Valuing a Financial Lease Contract Financial Lease Evaluation Using Formulas to Evaluate Financial Leases 17.4 WHEN DO FINANCIAL LEASES PAY? 17.5 SUMMARY TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 17.1 WHAT IS A LEASE? A. Leases, rental agreements for the use of an asset extending for more than 1 year and involving a series of fixed payments, are commonly used by businesses and individuals. B. The owner of the asset is the lessor. The user of the asset is the lessee. C. When the lease is terminated, the leased asset reverts to the lessor. D. Leases can be divided into two broad groups: operating leases and financial leases. E. Operating leases provide for the temporary use of an asset and often allow the lessee to cancel the lease during the contract period. The asset is returned to the lessor who is responsible for re-leasing or selling the off-lease asset. The lessor bears the bulk of the risk of owning the asset. 17-2 F. Financial leases provide for the use of the asset for essentially all of the economic life of the asset and typically are not cancellable during the contract period. At the end of the lease, the asset is returned to the lessor or bought by the lessee. However, the asset is largely worn out by that time. Thus, the lessee bears the bulk of the risk of owning the asset. G. Leases differ in a variety of other ways. In a full-service, or rental, lease the lessor is responsible for maintenance of the asset. In a net lease, the lessee agrees to maintain the asset. A sale and lease-back arrangement, the lessor buys the asset from the lessee and then leases the asset back to the lessee. Leasing Industry A. Leases are provided by many different companies including the manufacturers of equipment, large financial institutions and specialized leasing companies. 2.2 WHY LEASE? Sensible Reasons for Leases A. Short-term leases (operating leases) are convenient – they provide a cheaper way to have the use of an asset for short periods of time than buying the asset and reselling it. B. The option to cancel may be valuable. C. Maintenance may be provided at lower cost than user could provide, due to the benefits of specialization. D. Standardized lease contracts can reduce the transactions cost of borrowing. E. Lease can be used to pass tax shields generated by capital cost allowance (CCA) from the lessee to the lessor. If the lessee cannot fully use the CCA on the asset, total taxes may be reduced. Some Dubious Reasons for Leasing A. Leasing to avoid capital expenditure controls may lead to bad financial decisions, although politically it may make sense. B. Leasing provides “100% financing” of an asset. The suggestion is that by leasing, the company avoids using its cash to purchase the asset. Borrowing provides the same cash preserving benefit. In both leasing and borrowing, the company accepts a liability to repay the company (lender or lessor) who provides financing for the purchase the asset. 17-3 C. Leasing provides “off-balance-sheet financing”, suggesting that leasing makes the financial statements of companies “look better”. However, companies must disclose lease obligation in the notes and astute analysts figure out the impact of the lease financing on the firm’s financial situation. D. Leasing increases book income and/or lowers book asset value, increasing rates of return, when the leases are off-balance sheet financing. However, in an efficient market such facts will have no impact on firm value. 17.3 VALUING LEASES Operating Leases A. When assessing an operating lease, figure out if you can lease the asset to yourself more cheaply than the lessor can. This means figure out the equivalent annual cost of buying the asset. See Chapter 8 for a discussion of equivalent annual cost. Only lease if it is less expensive than the equivalent annual cost. Financial Leases A. The decision to enter a financial (long-term) lease should be compared with the alternative of borrowing to financing the purchase of the asset. Thus we say the financial lease decision is really a “lease versus borrow” decision. B. The lease payments are fixed obligations equivalent to debt service, the payment of interest and repayment of principal, on a loan. Lease only if the present value of the lease payments is less than the present value of the equivalent loan. Cash Flows of a Financial Lease A. The first step of the lease versus borrow analysis is to identify the change in the cash flows: no cash outflow to buy the asset but after-tax lease payments are made and the CCA tax shield is given up. Who Really Owns the Leased Asset? A. Since a financial lease lasts for most of the economic life of the asset, the lessee bears most of the risk of ownership without having the legal right to ownership. The risk is economic – if the asset becomes obsolete during the lease contract, or becomes very expensive to maintain, it is the problem of the lessee not of the 17-4 lessor. B. The legal right of ownership does have some bearing, however. If at the end of the lease, the asset has residual (or salvage) value, it is the benefit of the lessor. If the user were the asset owner too, then the residual benefit would be his to keep. C. In a bankruptcy, the lessor can seize the asset. However, if the asset’s value is less than present value of the outstanding lease payments, the lessor has little recourse except to join with the other unsecured creditors. By contrast, the secured lender has the right to receive the present value of the unpaid interest and principal and can sell the asset to recover what is owed. If the asset is worth less than the principal and interest, the secured lender is entitled to make a claim for the shortfall and stands ahead of the unsecured creditors. Leasing and the Canada Revenue Agency (CRA) A. Not just any old arrangement is a lease. The CRA will only accept certain arrangements as a genuine lease. Otherwise, the CRA will not allow the lessee to deduct the full lease payment, forcing part of the payment to be deemed return of principal and not tax-deductible. First Pass at Valuing a Financial Lease Contract A. When thinking about the discount rate for the incremental cash flows of leasing rather than borrowing, think about the risk of the cash flows. B. The lease payments themselves are like payment of interest and principal and should be discounted at the after-tax cost of secured borrowing. C. The discount rate for the CCA tax savings is often also taken to be the after-tax cost of borrowing. The best answer is to assess the riskiness of those tax savings – if the company is sure to be able to use them, then the after-tax cost of secured debt is a reasonable discount rate. If they are more uncertain, then use the company’s cost of capital (WACC). Lease if the present value of the incremental cash flows from leasing is positive. D. Another way to analyze the lease is to figure out its equivalent loan. In other words, if the company made principal and interest payments identical to the incremental lease cash outflows, what size of loan would the bank offer? Lease only if the first period cash inflows from leasing is greater than the equivalent loan. 17-5 Financial Lease Evaluation A. The evaluation of a financial lease is always done in the context of the decision to acquire the use of the asset. The total NPV of acquiring a piece of equipment is the NPV of the investment in the equipment (as we did in Chapters 8 and 9) PLUS the NPV of the lease. B. Example 17.3 illustrates how the analysis would be changed if the lessor offered a full-service lease, rather than a net lease, and if the salvage value were greater than zero. The key is the select the appropriate discount rate for each of the incremental cash flows. Using Formulas to Evaluate Financial Leases A. The NPV of the lease can be evaluated using annuity formulas and CCA tax shield formulas. Equation 17.1 shows the basic components of the lease value. 17.4 WHEN DO FINANCIAL LEASES PAY? A. When evaluating the lease from the lessor’s perspective, the criterion is reversed: offer a lease when it more expensive to than borrowing. B. If the lessee and the lessor are in the same tax bracket, then the lessor’s cash flows are simply the negative of the lessee’s. Likewise, if the lease has a positive NPV for the lessee, it must be a negative NPV for the lessor. C. Only when the tax rate of the lessee is less than the tax rate of the lessor can both benefit from leasing. Leasing is most advantageous when the tax rate of the lessor is substantially higher than the lessee’s tax rate. D. Other factors making leasing more attractive include: a higher CCA rate and a higher interest rate. 17.5 SUMMARY PEDAGOGICAL IDEAS General Teaching Note - Some students have a tough time understanding the valuation of a financial lease. One source of confusion is that students want to assess the lease the following way: “Compare the cost of leasing with the cost of borrowing”. The following example illustrates how you can approach the leasing decision this way: 17-6 A company has decided that it needs a piece of equipment that will cost $50,000 and last 5 years. Assume zero salvage value at the end of 5 years. The company can either arrange a loan and then buy the asset, or arrange a lease. Assume that the lease is a net lease, making the company responsible for all maintenance, insurance etc. Step 1: What is the cost of borrowing? Answer: Figure out the present value of the cash flows on the loan. The company must repay principal and interest on the loan. Smart students should be able to figure out that the present value of the interest and principal repayment is the amount borrowed, $50,000. It works using both the after-tax interest payments and principal and discounting at the after-tax cost of borrowing, or using the before-tax debt service and the before-tax cost of borrowing. Remember this is a cost, it is a negative number. Step 2: What is the cost of leasing? Answer: Figure out the present value of the lease payments. Discount the after-tax lease payments at the after-tax cost of borrowing. Remember this is a cost, it is a negative number. Now some students might think that they are done: compare the cost of borrowing (the present value of the loan payments) with the cost of leasing (the present value of the lease payments) and pick the one with the lower cost. However, we have missed the key difference between leasing and borrowing/buying: if you borrow/buy, you own the asset and you get to take CCA on it and therefore you get the tax savings. Or, to put it in a negative light, when you lease you give up the bonus of the tax savings from the CCA. Whatever way you look at it, you must figure out the present value of the CCA tax savings from owning the asset. However you must only count it once!!! Step 3: What is the present value of the CCA tax savings from owning the asset? Answer: Use the formulas from Chapter 9 or calculate directly. Remember this is a benefit, a positive number. Putting the pieces together: The total cost of borrow/buy = present value of principal and interest plus the CCA tax savings. Total cost of leasing = present value of the after-tax lease payments. Pick the lower cost alternative: Lease only if the present value of the lease payments is less than the present value of the loan (which also equals the cost of the equipment), minus the CCA tax shield. You can show the equivalence of this approach to the one in the text. Replace the present value of the loan with the purchase cost of the equipment. The net cost of leasing, rather than borrowing = cost of leasing – cost of borrowing = - PV(after-tax lease payments) – [ - cost of equipment + PV(tCCA)] = cost of equipment – PV(after-tax lease payments) – PV(tCCA) 17-7 If the cost of leasing is less than the cost of borrowing, then the above equation will be positive, just as we showed in the text. Internet Exercises - There are a wide variety of leasing calculators on the web. However, most of them do not evaluate leases the way we do. http://www.lease-vs-buy.com/ Have your students check out www.lease-vs-buy.com, and ask them to look at what the lease calculator is doing. Notice that it does allow CCA rates – you can tell them that the MACRS is the U.S. equivalent to CCA. 17-8 CHAPTER 18 PAYOUT POLICY CHAPTER IN PERSPECTIVE In finance, we are fairly convinced that investment decisions are the key to value creation. In the last chapter, we saw that the government tax shield adds to this value by the use of debt, but to some limit. In this second of “do capital structure decisions matter?” chapters, students are provided an excellent coverage of an area that many of us do not think is relevant: dividend policy. As in the last chapter, starting with the conditions under which dividends are irrelevant, then adding more realistic assumptions is a proven method for teaching the concepts. The valuation theme, and the factors affecting value, connects this chapter with the valuation theme of the text. It should add another piece of the puzzle for the student, who by now in the course should be adding the small pieces to complete the puzzle, or is really puzzled! CHAPTER OUTLINE 18.1 HOW DIVIDENDS ARE PAID Cash Dividends Some Legal Limitations on Dividends Stock Dividends, Stock Splits and Reverse Splits Dividend Reinvestment Plans and Share Purchase Plans 18.2 SHARE REPURCHASES Why Repurchases are like Dividends The Role of Share Repurchases Repurchases and Share Valuation 18.3 HOW DO COMPANIES DECIDE ON HOW MUCH TO PAY OUT? 18-1 The Role of Share Repurchase Decisions The Information Content of Dividends and Repurchases 18.4 WHY PAYOUT POLICY SHOULD NOT MATTER Payout Policy Is Irrelevant in Efficient Financial Markets The Assumptions behind Dividend Irrelevance 18.5 WHY DIVIDENDS MAY INCREASE FIRM VALUE Market Imperfections 18.6 WHY DIVIDENDS MAY REDUCE FIRM VALUE Why Pay any Dividends at all? Dividends versus Capital Gains Dividend Clientele Effects 18.7 SUMMARY TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 18.1 HOW DIVIDENDS ARE PAID Cash Dividends A. Cash Dividends, the payment of cash by the firm to shareholders, are declared by the board of directors on the declaration date. B. A regular dividend is a level the board hopes to maintain in the future; a dividend payment called a special or extra dividend is viewed as a one-time payment. C. The dividend is paid on the payment date to all shareholders of record on the record date which could be over a month before the record date. D. To be a shareholder of record, and thus receive a dividend, one must have purchased the stock before the ex-dividend date, which is four business days before the record date. 18-2 E. The stock price should drop by the amount of the dividend on the ex-dividend date. F. Instead of cash dividends, many companies have automatic reinvestment plans in which additional shares of stock are purchased. The business keeps the cash and shares are given to shareholders. Some Legal Limitations on Dividends A. The Canadian Business Corporations Act as well as provincial acts may include provisions prohibiting firms from paying dividends under certain conditions. The intent of such provisions is to protect the firm’s creditors against excessive dividend payments which could push the firm towards insolvency. B. Limit may be imposed on dividend payments (which reduce cash, reduce retained earnings) if the payments would lower capital below the amount of retained earnings, thus impairing original paid in capital. Stock Dividends, Stock Splits and Reverse Splits A. A stock dividend is distribution of additional shares to shareholders. The cash is kept in the firm for investment; shareholders receive added shares. A ten percent stock dividend would issue one share per ten owned by stockholders. B. A stock split is an issuance of added shares to shareholders. No cash is exchanged, only a change in the number of shares issued and the par value. C. A stock dividend is a mini-stock split. No cash is involved and the book value of shareholder’s equity does not change. They are accounting entries; a recapitalization. With more shares outstanding, the market value per share drops because more shares are outstanding, but the total market value of the firm does not change. D. A reverse split effectively reduces the firm’s number of outstanding shares. For instance, in a one-for-two reverse split, shareholders would exchange two existing shares for one new share. Reverse splits are more infrequent than stock splits. Dividend Reinvestment Plans and Share Purchase Plans: A. A Dividend Reinvestment Plan (DRIP) enables shareholders to reinvest dividends into additional new shares. B. A Share Purchase Plan (SPP) allows shareholders to make cash contributions toward the acquisition of new shares. C. By investing through DRIP’s or SPP’s, investors are able to save on brokerage 18-3 costs. Costs associated with administering the plans are typically borne by the firms. 18.2 SHARE REPURCHASE A. A share repurchase occurs when the company buys back stock from shareholders. Why Repurchases Are like Dividends B. A share repurchase has the same impact of a dividend: The cash account in the business is reduced and the shareholders as a group have more cash. The book value of the equity is reduced in both cases. Repurchases and Share Valuation A. Share repurchases have increased substantially and are now a larger amount each year than dividends paid. Share repurchase is more volatile than dividends, increasing during boom times, falling in recession. B. Share repurchases are similar to an extra or bumper dividend and are not a substitute for dividends. Mature, over-capitalized companies/industries tend to have more share repurchase programs when investment (+NPV's) opportunities are limited. C. Share repurchase, at market value, has the same value impact as cash dividends. 18.3 HOW DO COMPANIES DECIDE ON HOW MUCH TO PAY OUT? A. Survey research of business indicates that dividend payments may be determined a variety of ways: 1. The business may have a predetermined long-run dividend payout ratio, which establishes the percentage of earnings to be paid in dividends. 2. Managers tend to focus on dividend changes rather than absolute levels. 3. Dividend changes follow shifts in long-run, sustainable levels of earnings, rather than short-run fluctuations in earnings. 4. Managers are reluctant to make changes in dividend payments that are likely to be reversed in the future. The Information in Dividends and Repurchases A. A constant payout ratio means that dividends will vary as earnings vary. 18-4 Companies tend to change dividends steadily in response to a sustainable increase in earnings. Cash dividends per year tend to be more stable than earnings. See Figure 18.3. B. Future earnings prospects by managers are built into dividend policy. Higher earnings tend to follow higher dividends and lower earnings follow low dividends. C. Share repurchases, unlike cash dividends, are often a one-off event. A one-time repurchase has no implications on the firm’s future earnings. D. Stock repurchase implies that the firm has accumulated more cash than they can invest profitably. The lack of positive NPV projects is not good news. However, it is good news that the firm pays out the excess cash rather than squanders. So repurchases are usually positively correlated with stock price. 18.4 WHY PAYOUT POLICY SHOULD NOT MATTER A. If markets are efficient, dividend policy should not affect shareholder value. Assuming that a business’ capital budgeting decision (accept all positive NPVs) and borrowing decisions have been made, it then becomes a choice as to how to raise equity capital: internally from earnings or financing externally from the sale of stock? B. Dividend policy, with the capital budgeting and debt policy established, is then the choice between internal equity or paying dividends and using external equity. C. This area of dividend policy has a variety of opinions as to how or if dividend policy affects the value of the business. Some are of the opinion that value is affected by dividend policy, some such as the MM proposition in the next paragraph suggest that dividend policy has no effect on value, and finally, some think that dividends cost the shareholders added taxes to the point where dividends may have a negative impact upon value. Payout Policy Is Irrelevant in Efficient Financial Markets A. If efficient, competitive markets exist, then the MM dividend-irrelevance theory is reasonable. Given an investment program and debt policy, the equity portion of the financing may come internally, from retained income, or raised externally and at low cost in equity markets. B. If earnings exceed the necessary equity funding for the capital budget, the residual can be paid in dividends. If the equity capital needed for investment exceeds the internally generated earnings, external equity can be raised inexpensively in financial markets. 18-5 C. The existing shareholders’ value will remain the same if external debt is sold for they now have their dividends plus the now diluted market value of their shares. D. If dividends are not paid, how can existing shareholders generate cash if needed? MM’s answer for those who need cash is to sell a few shares of stock in efficient markets. The added value created by positive NPVs and financed with retained earnings, will be represented in higher stock prices. After selling a few shares each period, the investor’s total net worth has not changed. E. With efficient markets, it does not matter if earnings are retained and, with expected positive NPVs, shareholder value is built up via capital gains, or if dividends are paid out and the equity needed is raised in financial markets. The investor’s net worth (value) is only affected by the prospects of expected NPVs from the new investments. Value comes from assets, not financing, with efficient markets. Dividend Irrelevance – An Illustration A. The shareholders’ value at Pickwick Paper Company is the same regardless of which dividend policy is followed (pay or not pay dividends). B. The investor’s value remains the same because, in the case of no dividends, the efficient financial markets are able to provide, via capital gains, shareholders with the added value of expected positive NPV investment funded by retained earnings. Calculating Share Price A. When dividends, which serve as a residual to fund the equity portion of the capital budget, are low or not paid in a period, investors with current cash needs can easily sell appreciated (investments were made in positive NPV investments) shares at a fair price to provide them cash. B. When dividends are paid, the firm must fund the equity-contributed cash from the sale of new equity providing the funds needed to finance all positive NPV projects. The total value of the firm does not change because of the dividend policy. The Assumption behind Dividend Irrelevance A. Given efficient capital markets, MM argues that dividends do not affect the value of the business. In this section, other arguments counter the MM ideas. B. One argument is that dividends now have added value over capital gain maybe later. Managers can stabilize dividends, but not the market price of the firm’s 18-6 stock. But, as long as investment debt policy is held constant, the overall cash flows of the business are the same regardless of the dividend policy. The risks that shareholders bear are related to the investment and debt policies, not the dividend policy. Investors, by themselves with efficient markets, can adjust any riskiness associated with the dividends now versus appreciation later argument by altering their investment portfolios between risky common stock and cash assets. C. An efficient market provides, at fair prices, for transfers in ownership created by shifts in dividend policy all the while the total value of the business is unaffected by dividend policy, only investment and debt policy through the tax shield. 18.5 WHY DIVIDENDS MAY INCREASE FIRM VALUE Market Imperfections A. When markets are less than efficient, dividend policy may affect firm value. The impact of dividend policy upon firm value then depends on the extent of market inefficiency. B. Given high proportional transaction costs on the sale of stock, investors may be better off if the company constantly pays the dividend. C. Firm value is not increased by increased dividends; firm value increases if management’s increase in dividends signals the presence of high NPV opportunities. D. In markets where there is little information, increased dividends portend increased future cash flows or dividend policy is a form of communications to the market about future prospects. E. Just as dividend increases add expectations of favorable future prospects, dividend cuts are assumed by the market as a signal of bad news to come. 18.6 WHY DIVIDENDS MAY REDUCE FIRM VALUE A. There is an argument that, just as corporate deductibility of interest affects value, that differential taxation of cash dividends and capital gains may provide a value edge of one dividend policy (dividends) over another (no dividends, capital gains). 18-7 B. If cash dividends are taxed at a rate higher than capital gains, shareholder’s after- tax return is higher if no dividend is paid, earnings are retained and invested, and the return is taken as a capital gain. Why Pay any Dividends at all? A. If dividends are taxed at a high rate, and they have been in the past, why pay dividends at all? B. The CRA would penalize companies that retain all earnings in lieu of dividends as tax evaders. C. With the higher tax rate on dividends, firms should attempt to retain earnings and minimize the extent to which they issue stock, as long as all positive NPV investments are being pursued. Dividends versus Capital Gains A. If dividends are taxed more heavily than capital gains, investors would be attracted to companies which can convert dividends to capital gains by shifting their dividend policies. Firms should then pay the lowest cash dividend they can get away with. Available cash should be retained and reinvested or used to repurchase shares. B. Canadian public corporations do not pay any tax on dividend income received from another Canadian corporation whereas individual investors receive some tax relief through a dividend tax credit (DTC). The dividend tax credit reduces the burden of double taxation on shareholder income that occurs because the cash flows that produce such income are taxed at the corporate and personal levels (see Chapter 2). C. Corporations and individual investors pay tax on capital gains that are realized when the asset is sold. Presently, only 50 percent of such realized capital gains are taxable. D. Also, taxes on dividends have to be paid immediately, but taxes on capital gains can be deferred until shares are sold and capital gains are realized. Stockholders can choose when to sell their shares and thus when to pay the capital gains tax. E. Overall, for some investors dividends are taxed more heavily than capital gains whereas for others capital gains suffer more tax than dividends. Some investors have a tax reason for preferring income from dividend instead of capital gains. These would include investors in low tax brackets and Canadian corporations. Dividend Clientele Effects A. Different investor groups, or clienteles, therefore prefer different payouts; this is 18-8 the dividend clientele effect. The dividend clientele effect argument is that changing the dividend policy of the firm would attract a new investor clientele but may not change the value of the firm. 18.7 SUMMARY PEDAGOGICAL IDEAS General Teaching Note—An important aspect of the training of business aspirants is developing an ability to work in a team setting, something a few academics never have learned. A good exercise is a classroom assignment, such as a problem or issue not yet assigned. Working in teams of four or five, perhaps by rows, ask the students to solve the problem with a given time deadline. While the answer is important for learning finance, how the problem was solved and the small group dynamics are important too. Return the group to their small groups and ask them to discuss the process by which their group came to the conclusion, how the spokesperson was chosen, how work was divided, etc. This offers each a chance to view themselves in a team situation. Is the role they played a common one for them (leader or wallflower)? They were a team of peers. Do another problem and as the instructor, join one of the teams. Does the presence of an authority figure change the group processes? Financial decision making is seldom a one person exercise at any level, and the ability to work in teams, to be able to present and convince one of your NPV based on your assumptions is all a part of financial management. Student Career Planning—At the end of the last chapter, computer skill development ideas were discussed. For most business students, knowledge and skills in the fields of economics and accounting, unless their major, are not likely to be their favorite subjects. Why? They are tough, rigorous courses, usually! The trend in curriculums is to give more free and business electives. What does the student take versus what skills do they need? A few basket-weaving courses may develop the “person” in the student, but in a professional program, intermediate macroeconomics or accounting courses will turn recruiters’ heads. Just as the business curriculum is focused on professional development, students should make a personal skills inventory to see if their skills are competitive for today’s job market. Upon evaluation, they should consider courses in languages, effective writing, public speaking, computer-applications and others related to personal skills. A record of these types of courses on a student’s transcript indicate a desire for personal development and professionalism, and like the computer discussion, tends to build value for the future. Internet Exercises - If your students are following the performance of one or more companies, they likely have periodic reports to write. Importing graphics from the Internet into word processing files is relatively easy, and there are many sources of stock performance graphing on the Internet. Stockpoint.com and Bigcharts.com are two very useful sites for students who want to submit charts with their company reports. Make sure 18-9 they discuss the charts and try to explain the “why” behind them. http://www.bloomberg.com Bloomberg.com is a very good site for the latest news about the performance of the stock market. You can get information on the current level of the major stock indices around the world. For excellent time series charts on specific companies and market indices, you can click on the “CHART” icon. To get information on a company you could, for instance, input a stock symbol. A variety of other financial information is also available on this site. http://www.bigcharts.com Bigcharts.com provides the capability for adding a stock performance graph to a student’s report very quickly, anything from a “Basic Chart” to “Interactive Chart” with a vast array of plotting capability. BigCharts has been the leader in providing free stock charting on the Internet. Enter a stock symbol, such as DBD (Diebold), and click for a Basic Chart. The default setting presents a year’s daily range of prices with volume plotted below the primary graphic. The Interactive Chart is very extensive, allowing you to make a number of adaptations to the chart from a menu at the left of the screen. You can set the time period (one day to one decade) and frequency of the plot (from one minute to yearly). Please note that all frequency options are not available for some time periods. You can compare the company’s stock performance with other companies and various indices, including industry groups. You can also plot several other statistical indicators over the same time period. Once you have customized your charting needs, you can save the format for return visits. If Internet connectivity is part of your classroom, this site, with a little practice, can provide a “razzle-dazzle” show for your class! 18-10 CHAPTER 19 LONG-TERM FINANCIAL PLANNING CHAPTER IN PERSPECTIVE This first of two planning chapters is dedicated to the concepts of financial planning. Beginning with an assumption of volume (sales, production), the financial planning process, top-down or down-up, focuses all estimates and iterations in financial terms to a certain point in the future (statement of financial position or balance sheet) or during the period (income statement or statement of cash flows). Every businessperson becomes involved in the planning process, formally or informally, so the financial planning concepts covered here have considerable value to all majors. Just like other chapters, the concepts of this chapter are easily applied to personal financial planning. After an introduction to the planning process, we use the percentage of sales financial planning model to demonstrate the general framework of a financial plan. Estimating the amount and timing of the funds needed gives valuable insights to the financial manager. The key issue is not the single right estimate of what will exactly take place, but reviewing and understanding a series of likely financial results under varying assumptions is the real value of planning for the financial manager. The last section of the chapter interrelates investment policy, debt policy, dividend policy, and growth policy into a financial planning format. The concepts of internal growth rate (maximum sales or asset growth rate without external financing) and the sustainable growth rate (maximum growth rate within specific debt and dividend policy) are valuable concepts that tie several important financial policy areas together and provide connective tissue among the chapters. CHAPTER OUTLINE 19.1 WHAT IS FINANCIAL PLANNING? Financial Planning Focuses on the Big Picture Why Build Financial Plans? 19.2 FINANCIAL PLANNING MODELS Components of a Financial Planning Model Percentage of Sales Models 19-1 An Improved Model 19.3 TIPS FOR PLANNERS Pitfalls in Model Design The Assumptions in Percentage-of-Sales Models Forecasting Interest Expense The Role of Financial Planning Models 19.4 EXTERNAL FINANCING AND GROWTH 19.5 SUMMARY TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 19.1 WHAT IS FINANCIAL PLANNING? A. Financial planning is a process consisting of: 1. Analyzing the investment and financing choices available to the business. 2. Projecting the future consequences of current decisions under varying scenarios. 3. Deciding which alternative to undertake. 4. Later, measuring performance or results with the goals of the financial plan— the planning and control cycle. B. The time line of financial planning includes both short-term planning, perhaps the next twelve months with a focus on cash flow timing, and long-term financial planning where the planning horizon or time associated with the plan is around five years or longer. This chapter focuses on long-term planning. Chapter 20 focuses on short-term planning. Financial Planning Focuses on the Big Picture A. Financial plans include the strategic plan of the business or a “big picture” perspective, rather than the implications of individual investments and other decisions. B. Alternative business plans might consider three scenarios relating to best case, normal growth, or worst case or retrenchment. 19-2 C. Planning may consider a variety of alternative opportunities or future options. D. Financial plans often interrelate a level of activity such as sales to the level of assets needed, which in turn determines the amount of funds needed to finance the added investment. E. Added sales increases the need for current assets, increases some current liabilities (accounts payable) or netting the two determines an added level of net working capital needed to fund asset growth. F. Dividend policy is a factor in a financial plan, for the dividend/retention decision affects the level of earnings paid out or retained in the business to finance new assets needed. G. A firm has financial slack if the level of expected financing is greater than the funds needed for a period. Debt may be repaid, dividends increased, or stock repurchased when long-term financial slack exists. H. Businesses estimating rapid sales and asset growth beyond the ability of funding ability of earnings, must prepare to raise external capital from banks, bonds, or common stock issues. Why Build Financial Plans? A. Forecasting attempts to estimate the most likely future outcome, such as a level of sales. Contingency Planning considers a variety of future outcomes and prepares for each should they occur. “What if” analysis is a major part of financial planning from changing a single variable in a plan (sensitivity analysis) and noting the effect on funds needed, to scenario analysis, where a situation involving a number of variables (recession) is analyzed to estimate the ability to serve customers and earn expected returns to equity should the scenario develop. B. The three requirements for effective planning include forecasting, the process of choosing the best or optimal plan, and watching the plan unfold, comparing actual to the plan and addressing variances. Forecasting focuses on the most likely outcome and is not financial planning. However, a good forecast always is a good start for the financial plan. Anticipating competitive responses should be considered in the plan. After considering several scenarios, the financial manager must choose a plan, which will direct the efforts of the business. Financial plans are often in accounting terms, not shareholders, such as total return. Shareholder interests should be represented in decisions and strategy, not accounting performance indicators. Financial plans are dated with the short passage of time, so a plan must be easily adapted as events and opportunities occur. Plans may 19-3 serve a standard to compare experience. C. Financial planning provides an opportunity to consider options and evaluate options available, such as expansion, plant closure, etc. Real options are valuable and should be part of a financial plan. D. Financial plans provide a connection between growth, profitability, dividend policy, and financing requirements, and thus financial plans force consistency and tease out any inconsistencies in the firm’s goals. E. Accounting ratios should serve as performance measures; a focus on value creation (cash flows, risk, and timing) is the primary focus. 19.2 FINANCIAL PLANNING MODELS A. Financial planning models are most useful if they can be used to explore what might happen. B. A financial planning model establishes relationships between economic activity (sales), business policies, such as a credit policy, and the resulting resources needed, including assets, employees, or financial capital. C. The equations or relationships in the financial model may be derived from past relationships (correlations) or expected relationships based on forecasts. D. Financial models using spreadsheet programs enable the planner to quickly and conveniently study a wide range of possible outcomes and prepare the firm to handle what may occur. Components of a Financial Planning Model A. Financial plans include three components: inputs, the planning model, and outputs. See Figure 19.1. B. The inputs include current financial statements and forecasts. In most financial plans, expected sales are the major independent variable that drives the plan. Inputs Current financial statements. Forecasts of key variables such as sales and interest rates. Planning Model Equations specifying key relationships, such as the cost of producing the forecasted sales and asset investment Outputs Projected financial statements (pro formas). Financial ratios. Sources and uses of cash 19-4 Other variables, such as assets, are related to expected sales. C. Macroeconomic and industry forecasts can be valuable inputs to the planning process. A plan that reflects the forecasts of the general level of economic activity and the anticipated actions of competitors will be a more useful plan. D. The planning model, with the established relationships between sales and assets, etc., calculates the estimated levels of resources needed, the expected amount of financing needed, and the expected profit and cash flow. E. The equations or relationships in the financial model may be derived from past relationships (correlations) or expected relationships based on forecasts. F. The output of the financial plans includes estimated financial statements based on the assumptions and relationships of the plan, called pro forma financial statements. Financial ratios, based on the pro forma financial statements, are usually calculated. Percentage of Sales Models A. The percentage of sales model is a financial planning model in which the future level of asset investment, and subsequent financing needs, is a function of forecasted sales. The assumption is that sales drives asset requirements and asset requirements drive the financing needed. See Tables 18.1 and 18.2. 19-5 B. A simple percentage of sales model assumes no spare capacity in the asset (production) structure, so increased sales will require added current assets, fixed assets, perhaps some spontaneous financing from current liabilities, and added equity financing via addition to retained earnings (net income minus dividends). C. The pro forma balance sheet associated with the percentage of sales financial planning model uses any one of a number of ledger accounts as a variable to “balance” the balance sheet. Dividends paid, a financing decision, may be the balancing item as might the debt/equity ratio, bank financing, or a generic “funds needed” liability account. An Improved Model A. The Yummy Food Company pro forma example, Tables 19.4 to 19.5, is a good example of the percentage of sales financial planning model. B. A relationship between sales and specific balance sheet dependent variables are established before the planning begins. This in Table 19.4. One point to be made is the net operating working capital (operating current assets minus operating current liabilities) as the first line on the asset side of the balance sheet. This means that certain current liabilities, such as trade payables, are assumed to vary with sales just like operating current assets. C. Sales are estimated for the coming periods. Sales, the independent variable, drive the level of assets needed and the estimated required external financing needed. See Table 19.5. D. The next stage of the plan focuses on the debt/equity mix and specific types of financing the firms may seek. See Table 19.6. E. Alternative estimates of financing needed, given varied sales estimates, provide a range of possible outcomes that the financial manager should be prepared to handle. Using the Excel spreadsheet, such as Figure 19.2, makes it easy to assess the impact of variations in forecasting assumptions. F. The statement of cash flow can be forecasted along with the income statement and balance sheet. Looking at cash flow from assets helps to see where cash is being used and where is it coming from. See Tables19.7, 19.8 and 19.9. 19-6 19.3 TIPS FOR PLANNERS Pitfalls in Model Design A. Will a more sophisticated financial planning model give the financial manager an improved forecast of funds needed in the future? Is having “the” right forecast the real purpose of financial planning, or is financial planning really about estimating the range of possible outcomes? B. The value of the financial plan is to prepare for a variety of outcomes, not build the ultimate, realistic financial planning model. The Assumptions in Percentage-of-Sales Models A. Do not naively assume that the percentage-of-sales forecast factors must be based on the previous year's financial statements. Think of the previous year as a starting point for determining appropriate forecast factors. If the firm is undergoing major change, it may be inappropriate to assume that the relationship between sales and costs will not change. B. Though a good “rough” first estimate for financial planning, the percentage-of- sales model is limited in that many estimated variables, such as assets, are not or are not always proportional to sales. C. Long-term assets are not easily added in small amounts, but are more economically added in large investments. Thus, the firm must plan based on expected production utilization rates. Asset investment is not usually proportional to sales in a shorter time span, and is better related over a longer planning horizon. Forecasting Interest Expense A. Interest expense can be forecasted in a variety of ways. One of the simplest ways is to simply assuming it will increase at the same rate of sales increase. However, this does not take into consideration how the firm chooses to finance its growth. B. So the other way to forecast interest expense is to multiply the amount of debt times the interest rate. Then the main decision is whether to use debt at the start of the year, the debt at the end of the year or the average of the starting and ending debt in the calculation of the interest expense. C. Different assumptions have implications for using Excel. If debt at the end of the year or average debt is used Excel must be accommodate “circular reference”. The debt at the end of the year depends on the need for financing but that also depends on addition to retained earnings and that depends on interest expense. Details about the circular reference option is provided in the chapter. 19-7 The Role of Financial Planning Models A. Financial planning models estimate accounting statements, and do not focus on financial decision tools such as incremental cash flows, time value, market risk etc. B. Financial planning models are not focused on financial decisions that would increase market value, though the debt/equity standards of the firm and the dividend policy of the business are built into financial planning. 19.4 EXTERNAL FINANCING AND GROWTH A. Financial planning produces consistency between growth, investment, and financing goals of the business, for all are included in the plan. This section studies the relationships between growth objectives and requirements for external financing. B. The general idea is that the faster the firm grows, the more financing, and probably more external financing, will be needed. The extent of external financing will be related to the asset intensity of the firm, the profitability of the firm and the debt/equity and dividend policies of the firm. C. Sales growth drives asset growth drives funds needed. The higher the sales growth, the more assets/sales needed, the lower the profitability of the firm, the higher the dividend payout, the greater the more likely external funds (debt or equity) will be needed. D. The internal growth rate of the firm is the maximum rate of growth without external financing. See Figure 19.5. Where the upward sloping (slope related to profitability and dividend policy) line intersects the horizontal line (growth rate scale) is the internal growth rate, or the maximum growth rate at which the firm can grow and finance all its needs from internal sources (equity). The internal growth rate is the ratio of the addition to retained earnings divided by assets. The higher the historic contribution of retained earnings to finance assets, the higher is the growth rate the firm can maintain without external capital. See Figure 19.5. 19-8 E. The internal growth rate is the product of the plowback ratio times the ROE times the leverage ratio or: Internal growth rate = addition to retained earnings net income × net income equity × equity assets = plowback ratio × ROE × equity assets The higher the plowback ratio (lower dividend payout), the higher the profitability (ROE) and the higher the proportion of assets financed by equity, the greater the internal growth rate. F. The sustainable growth rate is the maximum growth rate (sales or assets) the firm can maintain without changing the debt/equity ratio and without any external equity financing (sale of stock). While the internal growth rate is the maximum growth rate without any external financing (debt or equity), the sustainable growth rate is the maximum growth rate sustainable without any external equity financing. G. The sustainable growth rate will be greater than the internal growth rate for the former considers added debt financing along with added equity financing provided by earnings retained (not paid in dividends) in the period. H. The sustainable growth rate is the product of the plowback ratio (proportion of net income retained in the firm) times the return on equity (ROE). When using this formula calculate as net income dividend by equity at the start of the year. 19.5 SUMMARY PEDAGOGICAL IDEAS 19-9 General Teaching Note—The return on equity performance ratio was discussed as a profitability ratio in Chapter 4. Further, the products of the component factors of the ROE, profit margin, asset turnover, and leverage ratio, were discussed at some length. The ROE, and its components, are important profit performance ratios, but are important “financing” and financial planning ratios as well. The ROE is an important component of the internal and sustainable growth rate concepts discussed in this chapter. Multiplying the ROE times the plowback ratio gives an indication of the sustainable growth rate, the rate of growth of sales or assets sustainable while maintaining a given debt/asset ratio. The internal growth rate is the product of the sustainable growth rate times the ratio of equity/assets, another variation of debt policy. The sustainable growth rate, combining the concepts from this and the last chapter, becomes dependent upon (for performance review and planning) the operating profit margin, the efficient utilization of assets (asset turnover), the firm’s debt policy, and dividend policy. Growth beyond the sustainable growth rate must depend on external financing, the subject of Part SIX of the book. Student Career Planning—Since this is a planning chapter, a discussion related to career planning may be appropriate. Most of your students’ career planning has been very informal, occasional, or when they are in a crunch and had to plan. It is time for them to assign planning as a high priority on their “To Do” list. Time is running out! All their focus for the past eight years has been toward their college or university degree. Aside from clearing up some details, such as passing your course, they can assume that they will graduate. What then? A lot of uncertainty? Job? Marriage? Many students say that planning is useless because “anything can happen.” The response is that “anything will happen” if they do not take the time to (1) force their thoughts into the future, (2) develop some specific goals, and (3) prepare a written, time-based plan to get there. Just as in a business, career planning, if not structured, will be assigned a low priority. To structure means a regular time, place, and possibly a small notebook to jot down brainstorming ideas and eventually, their plan. Encourage them to place their notebook by their bed, on their desk, or anywhere in sight. Eventually, hopefully sooner than later, the planning focus will begin, and the sight of the notebook will signal a “do something today” idea. They can apply an old time management idea when an overwhelming project is at hand. Apply the “Swiss cheese process” to it. Rather than wait for forty uninterrupted hours to do the task, poke holes in the project. There are many ten-minute blocks of time before bed or at morning coffee to work on their overwhelming projects. Suggest that they start by visualizing a day in their life five years from now, write it in their notebook, and never go to bed without writing something in the notebook, even if it is their “To Do” career planning list. Internet Exercises - Along about this time of the semester, you need a great “show and tell” to increase your credibility and lift your students’ spirits. Dilbert is perhaps your answer. Scott Adam’s creation, Dilbert, provides the highlights and lowlights of business activities in the newspaper and on the Internet. Check out the features of Dilbert’s home page. Open this page from the classroom, and the class will think you 19-10 are a “real” person after all! http://www.dilbert.com You can read Scott Adam’s blog and also go to “See How It Works” (http://www.dilbertfiles.com/) If you or your students have need for a current issue topic, CFO has an excellent Internet site. It is designed to serve practicing financial executives and provides both academics and students with the current “financial manager” issues. The site also supports an excellent professional publication, CFO, probably found in your library. http://www.cfo.com The CFO site, supported by CFO Publishing Corporations, publishers of CFO and the new e-CFO, provides current issues and articles of interest to financial managers, summaries of current and past issues of CFO, and a Research Center focusing on topics such as Banking & Finance, Careers & Compensation, Insurance & Risk Management, and Performance Measures. A look at the site map reveals many links to SEC data, new filings, upcoming conferences (students are often amazed at the continuing education activities of senior managers), surveys, and so on. This is an excellent site for academics who would like to keep up with the practice of financial management and provide a balance of finance theory and practice for their students. 19-11 Instructor Manual for Fundamentals of Corporate Finance Richard A. Brealey, Stewart C. Myers, Alan J. Marcus, Elizabeth Maynes, Devashis Mitra 9780071320573, 9781259272011