This Document Contains Chapters 8 to 13 8 Sources of Short-Term Financing Author's Overview The instructor has the opportunity to cover the various sources of short-term financing with an eye toward the borrower's size and the relative cost of doing business. Since banking is such a rapidly changing area, the instructor may wish to highlight some of the changes that are taking place. The student should also get some exposure to the various considerations in computing interest costs. Throughout the chapter, there are ample opportunities to indicate the advantages and drawbacks of trade credit, bank credit, commercial paper, foreign borrowing and collateralized borrowing arrangements. Chapter Concepts LO1. Trade credit from suppliers is normally the most available form of short-term financing. LO2. Bank loans are usually short-term in nature and should be paid off from funds from the normal operations of the firm. LO3. Commercial paper represents a short-term, unsecured promissory note issued by the firm. LO4. By using accounts receivable and inventory as collateral for a loan, the firm may be able to borrow larger amounts. LO5. Hedging may be used to offset the risk of interest rates rising. Annotated Outline and Strategy I. Trade Credit A. Usually the largest source of short-term financing B. A spontaneous source of financing that changes as sales expand or contract C. Credit period is set by terms of credit but firms may be able to "stretch" the payment period. D. Cash discount policy 1. Suppliers may provide a cash discount for early payment. 2. Foregoing discounts can be very expensive. The cost of failing to take a discount is computed as follows: Cost of failing Discount % 360 = to take discount 100%−Discount % Final due date−Discount period 3. Whether a firm should take a discount depends on the relative costs of alternative sources of financing. E. Net Credit Position 1. The relationship between a firm's level of accounts receivable and its accounts payable determines its net credit position. 2. If the firm's average receivables exceed average payables, it is a net provider of credit. If payables exceed receivables, the firm is a net user of trade credit. II. Bank Credit Perspective 8-1: Discuss how financial institutions have changed over time. The GrammLeach-Bliley Act in 1999 allowed banks and investment banks to merge and created a more competitive market place but also created institutions that were “too big to fail.” The financial crisis of the 2007-2008 period that resulted in the Dodd-Frank Act in 2011 impacted the way banks are regulated. A. Banks prefer short-term, self-liquidating loans B. Bank loan terms and concepts 1. Prime rate: The interest rate charged the most credit-worthy borrowers. a. The prime rate serves as a base in determining the interest rate for various risk classes of borrowers. b. The prime rate of New York banks receives much attention from government officials in managing the economy. c. The prime rate has been more volatile in the last couple of decades than in previous decades. PPT Movement of the Prime Rate versus LIBOR (Figure 8-1) d. The London Interbank Offer Rate (LIBOR) on U.S. dollar deposits is being used worldwide as a base lending rate on dollar loans. Perspective 8-2: The Finance in Action Box “LIBOR Price Fixing Scandal” is a good lesson in ethics. Although the decision came too late to include in the text, in 2013 The New York Stock Exchange won the right to supervise and administer the calculation of LIBOR. 2. Compensating Balances a. As a loan condition, a borrower may be required to maintain an average minimum account balance in the bank equal to a percentage of loans outstanding or a percentage of future commitments and/or pay a fee for services. b. Compensating balances raise the cost of a loan and compensate the bank for its services. c. If a compensating balance is required, the borrower must borrow more than the amount needed. 3. Maturity Provisions a. Most bank loans are short-term and mature within a year. b. In the last decade more banks have extended intermediate-term loans (one to seven years) that are paid in installments. 4. Costs of Commercial Bank Financing - The effective interest rate depends on the loan amount, interest paid, length of the loan, and method of repayment. Perspective 8-3: Review Formulas 8-2 through 8-6 including a comparison of the effective costs of a loan under varying assumptions. C. Annual Percentage Rate 1. The Truth in Lending Act enacted by Congress in 1968 requires that the annual percentage rate (APR) be given to the borrower. The thrust of the legislation was to protect unwary individuals from paying more than the stated rate without his or her knowledge. 2. The APR requires the use of the actuarial method of compounded interest and corresponds to the effective rate used throughout the text. D. Bank Credit Availability Tends to Cycle 1. Credit crunches seem to appear every 3-5 years. 2. The pattern of the credit crunch has been as follows: a. The Federal Reserve tightens the money supply to fight inflation. b. Lendable funds shrink, interest rates rise. c. Business loan demand increases due to price-inflated inventories and receivables. d. Depositors withdraw savings from banks seeking higher return elsewhere, further reducing bank credit availability. e. In the early 1990s, the U.S. saw a different kind of credit crunch from too many bad loans. The supply of funds dwindled and caused record bankruptcies for bank and savings and loans. III. Financing through Commercial Paper A. Short-term, unsecured promissory notes issued to the public in minimum units of $25,000. B. Issuers 1. Finance companies such as General Motors Acceptance Corporation (GMAC) that issue paper directly. Such issued are referred to as finance paper or direct paper. 2. Industrial or utility firms that issue paper indirectly through dealer. This type of issue is called dealer paper. 3. Asset backed commercial paper was primarily bundled mortgage- backed securities which increased in popularity until the banking crises in 2007. C. There has been very rapid growth in the commercial paper market in the last few decades. Using Figure 8-2, emphasize how the commercial paper market collapsed in 2007 and continued on a downhill slide. Only non-financial paper began to recover in early 2010. PPT Total Commercial Paper Outstanding (Figure 8-2) D. Traditionally, commercial paper has been a paper certificate issued to the lender to signify the lender's claim to be repaid. There is a growing trend among companies that sell and buy commercial paper to handle the transaction electronically. Actual paper certificates are not created. Documentation of the transactions is provided by computerized book-entry transactions and transfers of money are accomplished by wiring cash between lenders and commercial paper issuers. E. Advantages 1. Commercial paper may be issued at below the prime rate at commercial banks. 2. No compensating balances are required, though lines of credit are necessary. 3. Prestige. The primary limitation is the possibility that the commercial paper market might "dry up" unexpectedly as it does whenever an investment grade company has its credit rating lowered by Standard & Poor’s, Moody’s or Fitch. PPT Comparison of Commercial Paper Rate to Bank Prime Rate (Table 8-1) F. IV. Foreign Borrowing A. Loans from foreign banks are an increasing source of funds for U.S. firms. B. Foreign loans denominated in U.S. dollars are called Euro-dollar loans. These loans are usually short to intermediate term in maturity. C. A possibly cheaper alternative to borrowing Euro-dollars is the borrowing of foreign currencies which are converted to dollars and forwarded to the U.S. parent company. V. Use of Collateral in Short-Term Financing A. The lending institution may require collateral to be pledged when granting a loan. B. Lenders lend on the basis of the cash-flow capacity of the borrower. Collateral is an additional but secondary consideration. VI. Accounts Receivable Financing 1. Pledging accounts receivable as collateral a. Convenient means of financing. Receivables levels are rising as the need for financing is increasing. b. May be relatively expensive and preclude use of alternative financing sources. c. Lender screens accounts and loans a percentage (60% - 80%) of the acceptable amount. d. Lender has full recourse against borrower. e. The interest rate, which is usually well in excess of the prime rate, is based on the frequently changing loan balance outstanding. 2. Factoring Receivables a. Receivables are sold, usually without recourse, to a factoring firm. b. A factor provides a credit-screening function by accepting or rejecting accounts. c. Factoring costs. 1) Commission of 1% - 3% of factored invoices 2) Interest on advances 3. Asset-backed public offerings a. Public offerings of securities backed by receivables as collateral are a means of short-term financing. b. Several problems must be resolved: 1) Image: Historically, firms that sold receivables were considered to be in financial trouble. 2) Computer upgrading to service securities. 3) Regulatory roadblocks limiting bank participation. VII. Inventory Financing A. The collateral value of inventory is based on several factors. 1. Marketability a. Raw materials and finished goods are more marketable than goods-in-process inventories. b. Standardized products or widely traded commodities qualify for higher percentage loans. 2. Price Stability 3. Perishability 4. Physical Control a. Blanket inventory liens: Lender has general claim against inventory of borrower. No physical control. b. Trust receipts: Also known as floor planning; the borrower holds specifically identified inventory and proceeds from sale in trust for the lender. c. Warehousing: Goods are physically identified, segregated, and stored under the director of an independent warehousing company. Inventory is released from warehouse openly upon presentation of warehouse receipt controlled by the lender. 1) Public warehouse -- facility on the premises of the warehousing firm. 2) Field warehouse -- independently controlled facility on the premises of borrower. B. Inventory financing and the associated control methods are standard procedures in many industries. Finance in Action: How About Going to the Internet to Borrow Money? This article discusses a form of internet social-lending that shows promise as a source of financing. To avoid high interest rates from traditional lenders, borrowers are finding lower rate loans on the internet through loan brokerage sites such as prosper.com. Like e-bay or other auction sites, borrowers register their loan needs including the amount needed, the length of time the funds will be needed, and the interest rate they are willing to pay. Lenders register the amount they have to loan starting with as little as $50 and the rate they want to receive. Loans can then be compiled from several small lenders so the risk to any one lender is minimized. VIII. Hedging to Reduce Borrowing Risk A. Firms that continually borrow to finance operations are exposed to the risk of interest rate changes. B. Hedging activities in the financial futures market reduces the risk of interest rate changes. C. Hedging involves entering into a contract to buy or sell treasury bonds in the future, at a price negotiated in the present. Changes in the interest rate will drive changes in the future purchase price of the investment and result in a profit or loss. Perspective 8-4: Hedging and the use of derivative products is one of the hottest topics in finance. This example helps explain the general concept of hedging. Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 9, Pierce Control System (bank financing) 9 The Time Value of Money Author's Overview This is one of the most important chapters in the book as far as student comprehension is concerned. The instructor should first determine how much prior knowledge of time value of money the students have acquired from accounting or lower mathematics. While most students are generally familiar with the concepts of future value and present value, they often lack the ability to identify and categorize the nature of the problem before them. The material in this chapter will serve as a springboard to the remaining chapters in this section on valuation, cost of capital and capital budgeting related topics. A good background in time value of money will ease the transition. The authors suggest a liberal use of homework problems and a quiz to reinforce the importance of this material. This chapter has in-text acetate overlays that should be particularly helpful to more visuallyoriented students. We feel these overlays are very good at relating future value to present value, present value to the present value of annuities, and future value to future value of annuities. For faculty who want to emphasize Excel spreadsheets and calculator keystrokes, this chapter provides an excellent opportunity to develop both skills. Using spreadsheets with time-value exercises can be especially instructive in understanding the concept of how higher discount rates generate lower cash flows and visa versa. Chapter Concepts LO1. Money has a time value associated with it and therefore a dollar received today is worth more than a dollar received in the future. LO2. The future value is based on the number of periods over which the funds are to be compounded at a given interest rate. LO3. The present value is based on the current value of funds to be received. LO4. Not only can future value and present value be computed, but other factors such as yield (rate of return) can be determined as well. LO5. Compounding or discounting may take place on a less than annual basis such as semiannually or monthly. Annotated Outline and Strategy I. Relationship to the Capital Outlay Decision: Capital budgeting involves the analysis of whether or not funds invested today will be more than offset by the value of the funds received from the investment in the future. II. Future Value -- Single Amount A. In determining future value, we measure the value of an amount that is invested now and allowed to grow at a given interest rate over a specified period of time. FV = PV(1+i)n B. The relationship may be expressed by the following formula: FV = PV FV IF The FVIF term is found using the calculator keystrokes. We use a $1,000 example rather than $1 (also see Appendix A). C. Using a financial calculator to derive the future value of a single payment, enter the known values for the following: N enter the number of interest periods I enter the annual interest rate PV enter the present value amount PMT enter zero FV leave blank Then press the CPT key and then the FV key (The resulting value will appear as a negative number.) PPT Future Value of $1,000 Using the Spreadsheet Example Perspective 9-1: One or two numerical examples using this spreadsheet are helpful. III. Present Value -- Single Amount A. The present value of a future sum is the investment required today, at a given interest rate that will equal the future sum at a specified point in time. PPT Relationship of Present Value and Future Value (Figure 9-1) Perspective 9-2: Use Figure 9-1 to demonstrate the relationship between present and future value. B. The relationship may be expressed in the following formula: 1 PV = FV n (1+i) C. The formula may be restated as: PV = FV PV IF The PVIF term is found using calculator keystrokes. We use $1,000 rather than $1 in our example (also see Appendix B). D. Using a financial calculator to derive the present value of a single future payment, enter the known values for the following: N enter the number of interest periods I enter the annual interest rate PV leave blank PMT enter zero FV enter the future value amount Then press the CPT key and then the PV key (The resulting value will appear as a negative number.) Perspective 9-3: We would suggest using the Excel spreadsheet example on page 261 to show the relationship of the present value to the discount rate and time period. IV. Interest Rate – Single Amount A. When we know the future value, the present value, and the time period, we can solve for the interest rate or the rate of return on an investment. B. Using Formula 9-3 we find that: 1 i = PVFV n −1 C. We can use calculator keystrokes or the Excel spreadsheet to solve for the interest rate. V. Number of Periods – Single Amount A. Following up on the interest rate example, we can use Formula 9-4 to solve for the number of periods it takes to grow (compound) $1,000 to $1,464.10 if we know the rate of return is 10%. B. Once again, using the spreadsheet example on page 263 or the calculator keystrokes, you can demonstrate how many years it takes to compound $1,000 to $1,464.10. VI. Future Value – Annuity A. An annuity represents consecutive payments or receipts of equal amounts over equal time intervals. B. The annuity value is normally assumed to take place at the end of each period. C. The future value of an annuity represents the sum of the future value of the individual flows. PPT Compounding Process for Annuity (Figure 9-2) D. The formula for the future value for an annuity is given in Formula 9-5: FVA = A FVIFA The FVIFA term is found using the calculator keystrokes or the Excel spreadsheet on page 265 (also see Appendix C). E. Using a financial calculator to derive the future value of an annuity, enter the known values for the following: N enter the number of interest periods I/Y enter the annual interest rate PV enter zero PMT enter the periodic payment FV leave blank Then press the CPT key and then the FV key (The resulting value will appear as a negative number.) Finance in Action: Starting Salaries 50 Years from Now – Will $298,494 Be Enough? The rate of inflation will determine the acceptable levels of salary in the future. Although inflation did increase in the U.S. to double digits, 3-4% is the historical average. This box demonstrates a real world example of how money compounds. VII. Present Value -- Annuity A. The present value of an annuity represents the sum of the present value of the individual cash flows. B. The formula for the present value of an annuity is presented in Formula 9-6 (also see Appendix D for PVIFA) PVA = A PVIFA C. Using a financial calculator to derive the present value of an annuity, enter the known values for the following: N enter the number of interest periods I/Y enter the annual interest rate PV leave blank PMT enter the periodic payment FV enter zero Then press the CPT key and then the PV key (The resulting value will appear as a negative number.) D. The annuity value associated with a present value is often associated with withdrawal of funds from an initial deposit or the repayment of a loan. Perspective 9-4: An example that might ring true with the students is to have them use the Excel spreadsheet on page 267 to calculate their annual or monthly student loan repayment once they graduate from college and have a job. It might be an eye-opening exercise. VIII. Graphical Presentation of Time Value Relationships A. Use Exhibits 9-1 and 9-2 to show that present value and future value are inversely related. B. Use Exhibits 9-3 and 9-4 to demonstrate how annuities are the sums of single period values. IX. Determining the Annuity Value (The amount of the periodic payment that would grow to the requisite future value or be discounted to the requisite present value) A. Annuity Equaling a Future Value 1. The formula for the future value for an annuity is found in Formula 9-7: FVA A = n (1+i) −1 i PPT Relationship of Present Value to Annuity (Table 9-1) Perspective 9-3: Demonstrate how annuities work in everyday situations. PPT Payoff Table for Loan (Amortization Table) (Table 9-2) 2. Using a financial calculator to derive the annuity value required to achieve a future amount, enter the known values for the following: N enter the number of interest periods I/Y the periodic interest rate PV enter zero PMT leave blank FV enter the future value amount Then press the CPT key and then the PMT key (The resulting annuity value will appear as a negative value.) B. Annuity Equaling a Present Value 1. The formula for the present value of an annuity is presented in Formula 98: 2. Using a financial calculator to derive the annuity value required to achieve a present amount, enter the known values for the following: N enter the number of interest periods I/Y the periodic interest rate PV enter the present value amount PMT leave blank FV enter zero Then press the CPT key and then the PMT key (The resulting annuity value will appear as a negative value.) 3. Finding annuity payments using Excel’s PMT function: The PMT function assumes the each payment is at the end of a period. Either the PV or FV argument must be entered. See the example on page 276. X. Finding Interest Rates and the Number of Payments A. Finding Annuity Interest Rates Using Calculator Keystrokes or Excel: See discussion on page 276. B. Finding the Number of Annuity Payments Using Calculator Keystrokes or Excel: See discussion on page 277. C. Patterns of Payment with a Deferred Annuity 1. Sometimes an annuity does not start being received until several years in the future, and under these conditions, we need to calculate the present value of each payment. There are several ways to do the calculation. D. Annuities Due: Annuities that start at the beginning of the period rather than at the end of the period. Use the Excel spreadsheet on page 281 to demonstrate both present value and future values of annuities due. XI. Alternative Calculations Using Time Value of Money Tables A. Future Value -- Single Amount 1. In determining future value, we measure the value of an amount that is invested now and allowed to grow at a given interest rate over a specified period of time. FV = PV(1+i)n 2. The relationship may be expressed by the following formula: FV = PV FV IF The FVIF term is found in Table 9-3 (also see Appendix A). B. Present Value -- Single Amount 1. The present value of a future sum is the investment required today at a given interest rate that will equal the future sum at a specified point in time. 2. The relationship may be expressed in the following formula: 1 PV = FV n (1+i) The PVIF term is found in Table 9-4 (also see Appendix B). C. Future Value -- Annuity 1. An annuity represents consecutive payments or receipts of equal amounts over equal time intervals. 2. The annuity value is normally assumed to take place at the end of each period. 3. The future value of an annuity represents the sum of the future value of the individual flows. 4. The formula for the future value for an annuity is: FVA = A FVIFA The FVIFA term is found in Table 9-5 (also see Appendix C). D. Present Value -- Annuity 1. The present value of an annuity represents the sum of the present value of the individual cash flows. 2. The formula for the present value of an annuity is: PVA = A PVIFA The PVIFA term is found in Table 9-6 (also see Appendix D). Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 10, Allison Boone, M.D. (time value of money) Case 11, Billy Wilson, All American (time value of money) Case 12, Sarah Gilbert, Retiree (time value of money) 10 Valuation and Rates of Return Author's Overview The student can clearly see that the material covered in the previous chapter on time value of money is now being applied. The recurring theme throughout the chapter is that valuation is based on the present value of benefits to be received in the future. The instructor should establish this point at the outset and then repeatedly demonstrate it in the evaluation of bonds, preferred stock, and common stock. The instructor should also emphasize the relationship of the discount rate in present value analysis to the required rate of return demanded by security holders. The authors suggest that the instructor go through the process of defining the investor's required return in terms of a real rate of return, an inflation premium, and a risk premium. The instructor can then vary one of these components and show the impact on overall required return and valuation. Not all professors wish to use an example of supernormal growth, so we have included Appendix 10A to cover this topic. This model is good at demonstrating that Ke (the required rate of return on equity) has to be greater than g (the expected growth rate) in order to use the constant divided growth model. When growth is greater than the required rate of return, the supernormal growth model is appropriate. This appendix will help solidify the concepts of uneven cash flow before getting into the capital budgeting section. Appendix 10B is an optional discussion on using calculators in financial analysis. Both a Texas Instruments algebraic calculator and the Hewlett Packard HP12C are used to demonstrate how to use the calculators to calculate the present value, the future value, the bond values, present value of an annuity, the present value of an uneven cash flow and the internal rate of return. We suggest that you refer your students to this appendix. It will help reinforce the concepts in Chapter 9 and Chapter 10 as well as being useful for the chapters that follow. Chapter Concepts LO1. The valuation of a financial asset is based on the present value of future cash flows. LO2. The required rate of return in valuing an asset is based on the risk involved. LO3. Bond valuation is based on the process of determining the present value of interest payments plus the present value of the principal payment at maturity LO4. Preferred stock valuation is based on the dividend paid and the market required return LO5. Stock valuation is based on determining the present value of the future benefits of equity ownership. I. Valuation Concepts A. The value of an asset is the present value of the expected cash flows associated with the asset. In order to compute the present value of an asset, an investor must know or estimate the amount of expected cash flows, the timing of expected cash flows and the risk characteristics of the expected flows. B. Actually, the price (present value) of an asset will be based on the collective assessment of the asset's cash flow characteristics by the many capital market participants. II. Valuation of Bonds A. The value of a bond is derived from cash flows composed of periodic interest payments and a principal payment at maturity. B. The present value (price) of a bond is equal to the present value of the interest payments plus the present value of the principal (Face Value or Par Value) payment. It is given in Formula 10-1 as follows: n Pb =t=1 (1+IYt )t + (1+PYn )n where: Pb = the market price of the bond It = the periodic interest payments Pn = the principal payment at maturity t = the period from 1 to n n = the total number of periods Y = the yield to maturity (required rate of return) 1. The present value of interest payments can be calculated using Formula 9-6 from the previous chapter. 2. The present value of the principal payment (par value) at maturity may be computed by applying Formula 9-2 from the previous chapter. 1 PV = FV (1+ n i) 3. The present value (price) of the bond will be the sum of the present value of the interest payments plus the present value of the principal. C. Bond valuation using a financial calculator or an Excel spreadsheet is presented on page 301 of the text. The Excel spreadsheet is a very instructive way to do sensitivity testing by varying the years to maturity and the required rate of return. D. Concept of Yield to Maturity 1. Three factors influence an investor's required rate of return on a bond. a. The required real rate of return: the rate of return demanded for giving up current use of funds on a no-risk, non-inflation adjusted basis. b. An inflation premium: a premium to compensate the investor for the effect of inflation on the value of the dollar. c. Risk premium: all financial decisions are made within a riskreturn framework. An astute investor will require compensation for risk exposure. There are two types of risk associated with the required rate of return (yield to maturity) on a bond: (1) Business risk is the possibility of a firm not being able to sustain its competitive position and growth in earnings. (2) Financial risk is the possibility that a firm will be unable to meet its debt obligations as they come due. 2. Bond prices are inversely related to required rates of return. A change in the required rate of return will cause a change in the bond price in the opposite direction. PPT Bond Price Table (Table 10-1) Perspective 10-2: Table 10-1 illustrates the impact of differences between yield to maturity and coupon rates on bond prices. 3. The impact of the change in required rate of return on the bond price is dependent upon the remaining time to maturity. The impact will be greater as the time to maturity increases. PPT Impact of Time to Maturity on Bond Prices (Table 10-2) Perspective 10-3: Table 10-2 shows the critical effect of time to maturity on bond price sensitivity. PPT Relationship between Time to Maturity and Bond Price (Figure 102) Perspective 10-4: The critical effect of time to maturity on bond price sensitivity is further supported by this figure. E. Determining Yield to Maturity from the Bond Price 1. If the bond price, coupon rate, and number of years to maturity are known, the yield to maturity (market determined required rate of return) can be computed. 2. The yield to maturity can most easily be found using a financial calculator. The keystrokes are as follows: N number of years to maturity PV Present value of the bond (current bond price) PMT Interest payment (annuity) FV Future value (par value at maturity) Function CPT I/Y The example in the text gives a yield of 12 percent 3. The yield to maturity can also be found by using the Goal Seek function in Excel. The Goal Seek function can be found in the most recent version of Excel on the Data tab, in the Data Tools group under What-If Analysis. Examples of this spreadsheet are found on page 308 in the text. F. Often interest payments are made more frequently than once a year. Semiannual interest payments are common. To compute the price of such a bond, we divide the annual amount of interest and the yield to maturity by two and multiply the number of years to maturity by two. For example, 10 years would be 20 semi-annual periods. Annual coupon payments of $60 would be semi-annual payments of $30, and an annual yield to maturity of 8% would become a semi-annual yield to maturity of 4%. Perspective 10-5: Students have the opportunity to use both the annual and semiannual approaches in working problems at the back of the chapter. III. Valuation of Preferred Stock A. Preferred stock is usually valued as a perpetual stream of fixed dividend Pp = Dp 1 + Dp 2 + Dp 3 .... + + Dp n (1+K p) (1+K p) (1+K p) (1+K ) payments . where: Pp = the price of preferred stock Dp = the annual dividend for preferred stock Kp = the required rate of return (discount rate) applied to preferred stock dividends B. Since the dividend stream is a perpetuity, the preferred stock valuation formula can be reduced to a more usable form Pp =Dp K p C. If Kp changes after preferred stock is issued, Pp will change in an inverse fashion. Since preferred stock theoretically has a perpetual life, it is highly sensitive to changes in the required rate of return (Kp). D. If the market price of preferred stock and the annual dividend are known, the market determined required rate of return may be computed by using the valuation equation and solving for Kp. IV. Pp =Dp then K p Dp = K p Pp Valuation of Common Stock A. The value of a share of common stock is the present value of an expected stream of dividends. P0 = ( 1+DK1 e ) + ( 1+DK2e )2 + ( 1+DK3e )3 .... + + ( 1+DKne )n where: P0 = price of the stock at time zero (today) D = dividend for each year Ke = the required rate of return for common stock B. Unlike dividends on most preferred stock, common stock dividends may vary. The valuation formula may be applied, with modification, to three different circumstances: no growth in dividends, constant growth in dividends, and variable growth in dividends. 1. No Growth in Dividends. Common stock with constant (no growth) dividends is valued in the same manner as preferred stock. P0 =D0 Ke where: P0 = price of common stock D0 = current annual dividend on common stock = D1 (Expected to remain the same in the future) Ke = required rate of return for common stock 2. Constant Growth in Dividends. The price of common stock with constant growth in dividends is the present value of an infinite stream of growing dividends. Fortunately, in this circumstance the basic valuation equation can be reduced to the more usable form below if the discount rate (Ke) is assumed to be greater than the growth rate. where:D1 = dividend expected at the end of the first year = D0(1 + g) g = constant growth rate in dividends P0 = price of common stock Ke = required rate of return for common stock a. The above formula can also be thought to represent the present value of dividends for a period of time (such as n = 3) plus the present value of the stock price after a period of time (such as P3). Since P3 represents the present value of dividends from D4 through Dn, P0 will still represent the present value of all future dividends. b. The value of P0 is quite sensitive to any change in Ke (required rate of return) and g (the growth rate). 3. Rearrangement of the constant growth equation allows the calculation of the required rate of return, Ke, when P0, D1, and g are given. Ke = +D1 g P0 The first term represents the dividend yield that the stockholder expects to receive and the second term represents the anticipated growth in dividends, earnings and stock price. 4. The Price Earnings Ratio Concept and Valuation. Stock valuation may also be linked to the concept of price-earnings ratios discussed in Chapter 2. Although this is a less theoretical, more pragmatic approach than the dividend valuation models, the end results may be similar because of the common emphasis on risk and growth under either approach. 5. Variable Growth in Dividends. The most likely variable growth case is one of supernormal growth followed by constant growth. a. Value can be found through taking the present value of the dividends during the supernormal growth period plus the price of the stock at end of the supernormal growth period. Since growth is then constant, Formula 10-8 can be used. b. Another type of variable growth is where the firm is assumed to pay no dividends for a period of time and then begins paying dividends. In this case, the present value of deferred dividends can be computed as a representation of value. Perspective 10-7: The use of the Appendix10A is optional. c. If no dividends are ever intended, then valuation may rest solely on the present value of future earnings and the present value of a future stock price. Finance in Action: Valuation of High Technology Companies − Throw Away the Book This box discusses how alternative measures of valuation replaced more traditional measures when it came to non-dividend-paying high-technology Internet-related companies in the late 1990s and 2000. In retrospect, alternative valuation methods led to overvaluation of numerous high technology companies, and investors suffered severely during the subsequent collapse. Finance in Action: An Important Question – What’s a Small Business Really Worth? This box presents some of the practical issues faced in valuing a small business and serves as a contrast to the formulas presented in the text. PPT Stock Valuation under Supernormal Analysis (Figure 10C-1) Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 13, Gilbert Enterprises (stock valuation) 11 Cost of Capital Author's Overview Chapter 11 on "Cost of Capital" naturally follows Chapter 10 on "Valuation and Rates of Return." The instructor should emphasize, at the outset, that the investors' required rate of return translates into the cost of financing for the firm. There should be a dual emphasis on properly determining the aftertax cost for each type of financing and on determining the appropriate weights to be assigned to the various sources of financing. The cost of debt and the cost of preferred stock are reasonably straightforward, but additional guidance is required in determining the cost of common equity. The instructor should indicate the firm's ability to acquire equity capital through retained earnings or through new common stock and the associated cost of each. The cost of retained earnings should be explained as an opportunity cost for the use of the stockholders' funds. For that reason, it is assumed the stockholders can earn as much on these funds, if distributed, as they are currently earning in the firm. Thus, the cost of retained earnings is also equal to Ke (the firm's return on common equity). After the various costs are computed, the instructor can direct more attention to the weighting scheme given to the components in the capital structure. The instructor may wish to refer to the authors' example in which the increased use of debt initially decreases the cost of capital, but then ultimately increases it. The interdependent nature (of costs and weights) should be stressed in discussing the optimal capital structure. The instructor has the option of introducing the student to the capital asset pricing model in the text and more fully in Appendix 11A. There the concepts of regression analysis, the beta coefficient, and the security market line are introduced and related to previously discussed material on the cost of capital. This chapter as well as subsequent chapters is fully comprehensible without the use of this material. The appendix is available, however, for those instructors who wish to go over the capital asset pricing model in detail. Chapter Concepts LO1. The cost of capital represents the weighted average cost of all of the sources of financing to the firm. LO2. The cost of capital is normally the discount rate to use in analyzing an investment. LO3. The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds, preferred stock and common stock. LO4. A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. LO5. The cost of capital may eventually increase as larger amounts of financing are utilized. Annotated Outline and Strategy I. The Overall Concept A. A business firm must strive to earn at least as much as the cost of the funds that it uses. B. Usually a firm has several sources of funds and each source may have a different cost. C. The overall cost of the funds employed is a proportionate average of the various sources. D. The firm's required rate of return that will satisfy all suppliers of capital is called its cost of capital. E. There are several steps in measuring a firm's cost of capital. 1. Compute the cost of each source of capital. 2. Assign weights to each source. 3. Compute the weighted average of the component costs. PPT Cost of Capital-Baker Corporation (Table 11-1) II. Cost of Debt A. The basic cost of debt to the firm is the effective yield to maturity. The yield to maturity is a market determined rate and can be found by examining the relationships of security price, periodic interest payments, maturity value, and length of time to maturity. The yield to maturity for a corporate bond may be found by solving for YTM in the following calculator keystrokes: N Number of periods to maturity PV Current price of the bond PMT Periodic coupon payment FV Maturity value of bond (usually1000)Function CPT I/Y Yield to maturity Table 11-2 on page 345 uses an Excel Spreadsheet to calculate the yield to maturity using the RATE function. B. Since interest is tax deductible, the actual cost of debt to the firm is less than the yield to maturity C. The after-tax cost of debt is: Kd = −Y(1 T) Where: Y = The yield to maturity T = The firm’s effective tax rate Thus the after-tax cost to a firm of bonds issued at par paying $100 annually in interest would be 6.6 percent if the firm's marginal tax rate were 34 percent. K d =.10(1 .34) − =.066 D. The example of KeySpan Corporation in Table 11-3 presents the opportunity for the professor to expose the students to the information found in the Standard & Poor’s Capital IQ Net Advantage. Perspective 11-1: Explain that since the cost of preferred stock and common stock are calculated on an aftertax basis, the cost of debt is adjusted for taxes so all three sources of capital are on an aftertax cost basis. III. Cost of Preferred Stock A. Preferred stock is similar to debt in that the preferred dividend is fixed but dissimilar in that dividends are not tax deductible. B. The cost of preferred stock to a firm may be determined by examining the relationship of its annual (usually fixed) dividend and its market determined price. Preferred stock, unlike debt, has no maturity and therefore the dividends are expected to be perpetual. C. The cost of preferred stock Kp is computed by dividing the annual dividend payment by the net proceeds received by the firm in the sale of preferred stock. D K p = (Formula 11-2) (P F− ) where: Kp = Cost of preferred stock D = Preferred stock dividend F = Flotation costs per share Pp = Market price of preferred stock IV. Cost of Common Equity A. The basis of computation of the price of common stock is the Dividend Valuation Model. = D1 (Formula 10-8) P0 (K e )−g P0 = Price per share of stock at the beginning of the first year D1 = Expected dividend at the end of the first year (or period) Ke = Required rate of return g = Constant growth rate in dividends B. Assuming constant growth, the Dividend Valuation Model can be manipulated to represent the required rate of return: K e = +D1 g (Formula 11-3) Po C. The equation for the cost of common equity Ke is equal to the total of the dividend yield rate plus capital gains on the original investment. D1/P0 represents the dividend yield. Since the original investment must grow at the same rate as the dividends, the capital gains on the investment is achieved by adding g, the dividend growth rate. D. Alternative Calculation of the Required Return on Common Stock using the Capital Asset Pricing Model (CAPM). 1. Under the CAPM, the required return for common stock can be described by the following formula: K j = +R f ( Km − R f ) Where: Kj = Required return on common stock Rf = Risk-free rate of return; usually the current rate on Treasury bill securities = Beta coefficient. The beta measures the historical volatility of an individual stock's return relative to a stock market index. A beta greater than 1 indicates greater volatility (price movements) than the market, while the reverse would be true for a beta less than 1. Km = Return in the market as measured by an appropriate index 2. Both Kj and Ke should be equal under the case of market equilibrium. 3. Appendix 11A presents the capital asset pricing model in more detail for those who wish to expand the textbook coverage on this concept. Perspective 11-2: It is helpful to point out that the Kj in the capital asset pricing model is often used in the dividend valuation model because if you plug Ke from Formula 11-3 into the dividend valuation model, you will always get the current price of the stock as the value. By developing Ke (Kj) independently from the dividend valuation model, you eliminate using a circular reference. E. Common stock financing is available through the retention of earnings belonging to present stockholders or by issuing new common stock. 1. The cost of retained earnings is equivalent to the rate of return on the firm's common stock. This is the opportunity cost. Thus the cost of common equity in the form of retained earnings is: K e = +D1 g P0 Where: Ke = Required rate of return D1 = Expected dividend at the end of the first year P0 = Price per share of stock at the beginning of the first year g = Constant growth rate in dividends 2. The cost of new common stock is higher than the cost of retained earnings because the firm's proceeds from sale of the stock are less than the price paid by the stockholder due to flotation costs (F). The cost of new common stock, Kn is: Kn = D1 +g (Formula 11-6) (P F0 )− Where: Kn = Required rate of return on new common shares D1 = Expected dividend at the end of the first year first year P0 = Price per share of stock at the beginning of the first year g = Constant growth rate in dividends F = Flotation costs per share V. Optimal Capital Structure - Weighing Costs A. The firm should seek to minimize its cost of capital by employing the optimal mix of capital financing. B. Weighted Average Cost of Capital can be calculated by the summation of the product of each element of capital multiplied by its relative weight or mix. C. The Baker Corporation example on page 351 and 352 demonstrates the concept of weighted average cost of capital numerically while Figure 11-1 does so graphically. PPT Cost of Capital Curve (Figure 11-1) D. Although debt is the cheapest source of capital, there are limits to the amount of debt capital that lenders will provide (recall the Debt/Equity (D/E) relationships discussed in Chapter 3). The cost of both debt and equity financing rise as debt becomes a larger portion of the capital structure. E. Traditional financial theory maintains that the weighted average cost of capital declines as lower costing debt is added to the capital structure. The optimum mix of debt and equity corresponds to the minimum point on the average cost of capital curve. The optimal debt-to-equity mix varies among industries. The more cyclical the business, the lower the D/E ratio would be required. PPT Debt as a Percentage of Total Assets (Table 11-4) F. G. The weights applied in computing the weighted average cost should be market value weights. VI. Capital Acquisition and Investment Decision Making A. The discount rate used in evaluating capital projects should be the weighted average cost of capital. B. If the cost of capital is earned on all projects, the residual claimants of the earnings stream, the owners, will receive their required rate of return. If the overall return of the firm is less than the cost of capital, the owners will receive less than their desired rate of return because providers of debt capital must be paid. C. For most firms, the cost of capital is fairly constant within a reasonable range of debt-equity mixes (flat portion of curve in Figure 11-2). Changes in money and capital market conditions (supply and demand for money), however, cause the cost of capital for all firms to vary upward and downward over time. Perspective 11-3: Discuss the impact of economic cycles on the cost of capital. The shifts that occur in costs of capital demonstrate that companies raise capital in an uneven fashion, often raising capital before it is all needed in anticipation of rising costs. The low cost of debt between 2008-2013 is a good example of a low interest rate environment. PPT Cost of Capital Over Time (Figure 11-2) D. Cost of Capital in the Capital Budgeting Decision 1. It is the current cost of each source of funds that is important. 2. The cost of each source of capital will vary with the amount of capital derived from that source. 3. The required rate of return or discount rate for capital budgeting decisions will be the weighted average cost of capital. PPT Investment Projects Available to the Baker Corporation (Table 11-5) PPT Cost of Capital and Investment Projects for the Baker Corporation (Figure 11-3) Finance In Action: Big Bond are “Liquid Bonds” Bond issues of $500 million or more may have a lower cost of debt than smaller bond issues. $500 million seems to be the threshold for creating a market for a company’s bonds where there are enough investors to create a continuous market of buyers and sellers. Smaller bond issues carry what is called a liquidity risk because there is not an active market and bid and ask prices can have wide spreads. The Dodd-Frank Act made it more difficult for U.S. banks to carry an inventory of small bond issues and thus larger bond issues have become more common. Ventas, a real estate investment trust, is used in to illustrate this new paradigm. VII. Marginal Cost of Capital A. The marginal cost of debt (the cost of the last amount of debt financing) will rise as more debt financing is used. The marginal cost of equity also rises when the shift from retained earnings to external (common stock) equity financing is necessary. PPT Cost of Capital for Different Amounts of Financing (Table 11-6) and PPT Cost of Capital for Increasing Amounts of Financing (Table 11-7) PPT Marginal Cost of Capital and Baker Corporation Projects (Figure 11-4) Perspective 11-4: Comparing Figure 11-4 with Figure 11-3 graphically shows how an increased marginal cost of capital eliminates Project E from the acceptable range. VIII. Appendix 11A: Cost of Capital and the Capital Asset Pricing Model A. The Capital Asset Pricing Model (CAPM) relates the risk-return tradeoffs of individual assets to market returns. B. The CAPM encompasses all types of assets but is most often applied to common stock. C. The basic form of the CAPM is a linear relationship between returns on individual stocks and the market over time. Using least squares regression analysis, the return on an individual stock Kj is: K j = + Km +e where: Kj = Return on individual common stock of company = Alpha, the intercept on the y-axis = Beta, the coefficient Km = Return on the stock market (an index of stock returns is used, usually the Standard & Poor's 500 Index) e = Error term of the regression equation PPT Performance of PAI and the Market (Table 11A-1) PPT Linear Regression of Returns between PAI and the Market (Figure 11A-1) D. Using historical data, the beta coefficient is computed. The beta coefficient is a measurement of the return performance of a given stock relative to the return performance of the market. E. The CAPM is an expectational model. There is no guarantee that historical data will be repeated. F. The CAPM evolved into a risk premium model. 1. Investors expect higher returns if higher risks are taken. 2. The minimum return expected by investors will never be less than can be obtained from a riskless asset (usually considered to be U.S. Treasury bills). The relationship is expressed as follows: K Rj = +f (K Rm - f ) where: Rf = Risk-free rate of return = Beta coefficient from Formula 11A-1 Km = Return on the market index Km - Rf = Premium or excess return of the market versus the risk-free rate (since the market is riskier than Rf, the assumption is that the expected Km will be greater than Rf) (Km - Rf) = Expected return above the risk-free rate for the stock of Company j, given the level of risk 3. Beta measures the sensitivity of an individual security's return relative to the market. a. By definition, the market beta = 1. b. A security with a beta = 1, is expected to have returns equal to and as volatile as the market. One with a beta of 2 is twice as volatile (up or down). 4. Beta measures the impact of an asset on an individual's portfolio of assets. G. A risk-return graph can be derived from the risk premium model. The graphed relationship between risk (measured by beta) and required rates of return is called the Security Market Line (SML). PPT The Security Market Line (SML) (Figure 11A-2) H. Cost of capital considerations 1. If required returns rise, prices of securities fall to adjust to the new equilibrium return level and as required returns fall, prices rise. 2. A change in required rates of return is represented by a shift in the SML. PPT The Security Market Line and Changing Interest Rates (Figure 11A-3) a. The new SML will be parallel to the previous one if investors attempt to maintain the same risk premium over the risk-free rate. b. If investors attempt to maintain purchasing power in an inflationary economy, the slope of the new SML may be greater than before due to an inflation premium. c. An investor's required rate of return and thus a firm's cost of capital will also change if investors risk preferences change. The slope of the SML would change even if the risk-free rate remained the same. PPT The Security Market Line and Changing Investor Expectations (Figure 11A-4) Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 16, Berkshire Instruments, (Cost of Capital) Case 17, Galaxy Systems, Inc. (Divisional Cost of Capital) The Capital Budgeting Decision 12 Author's Overview While early comments on administrative procedures and accounting considerations are helpful, the major thrust of Chapter 12 is on the various methods for ranking investment proposals. The basic selection methods are established, mutually exclusive versus non-mutually exclusive events are compared, and the reinvestment assumption, capital rationing and the net present value profile are presented. The chapter continues with a comprehensive discussion of procedures for depreciation write-off and integrates the resultant cash flow determination with the capital budgeting decision. There is also a presentation of a replacement decision which examines the process of selling an old piece of equipment and replacing it with a new version. The tax consequences of replacement are carefully examined and included in the example presented. Chapter Concepts LO1. A capital budgeting decision represents a long-term investment decision. LO2. Cash flow rather than earnings is used in the capital budgeting decision. LO3. The payback method considers the importance of liquidity, but fails to consider the time value of money. LO4. The net present value and the internal rate of return are generally the preferred methods of capital budgeting analysis. LO5. The discount or cut-off rate is normally the cost of capital. Annotated Outline and Strategy I. Introduction A. Capital expenditures are outlays for projects with lives extending beyond one year and perhaps for as many as 25 years for utilities and oil and gas companies. B. Intensive planning is required. C. Capital expenditures usually require initial cash flows, often large, with the expectation of future cash inflows. The differing time periods of inflows and outflows require present-value analysis. D. The longer the time horizon associated with a capital expenditure, the greater the uncertainty. Areas of uncertainty are: 1. Annual costs and inflows. 2. Product life. 3. Interest rates. 4. Economic conditions. 5. Technological change. II. Administrative Considerations PPT Capital Budgeting Procedures (Figure 12-1) A. Search and discovery of investment opportunities B. Collection of data C. Evaluation and decision making D. Reevaluation and adjustment III. Accounting Flows versus Cash Flows A. The capital budgeting process focuses on cash flows rather than income. Income figures do not reflect the cash available to a firm due to the deduction of noncash expenditures such as depreciation. PPT Cash Flow for Alston Corporation (Table 12-1) and PPT Revised Cash Flow for Alston Corporation (Table 12-2) B. Accounting flows are not totally disregarded in the capital budgeting process. 1. Investors' emphasis on earnings per share may, under certain conditions, require use of income rather than cash as the decision criterion. 2. Top management may elect to glean the short-term personal benefits of an income effect rather than the long-run cash-flow effects which are more beneficial, from the owner's viewpoint. IV. Methods for Ranking Investment Proposals A. Payback Method 1. The payback period is the length of time necessary for the sum of the expected annual cash inflows to equal the cash investment. A cutoff period is established for comparison. Capital proposals with a payback in excess of the cutoff are rejected. 2. Deficiencies of the method a. Inflows after the payback period are ignored. b. The pattern of cash flows is ignored, therefore, time value of money is not considered. 3. Though not conceptually sound, the payback method is frequently used. a. Easy to use b. Emphasizes liquidity c. Quick return is important to firms in industries characterized by rapid technological development. PPT Investment Alternatives (Table 12-3) Perspective 12-1: During periods of high inflation, a quick payback on a project indicates a rapid return of funds for reinvestment at perhaps even higher inflated returns which some companies prefer over the superior IRR and NPV methods. B. Net Present Value (NPV) 1. In this method, the cash inflows are discounted at the firm's cost of capital or some variation of that measure. 2. If the present value of the cash inflows equals or exceeds the present value of the cash investment, the capital proposal is acceptable. 3. We use the NPV function of Excel to demonstrate the difference in net present value between Investments A and B. The use of Excel provides the opportunity to use sensitivity testing with various discount rates to demonstrate the change in NPV. C. Internal Rate of Return (IRR) 1. The IRR method requires calculation of the rate that equates the cash investment with the cash inflows. 2. The calculation procedure is the same as the yield to maturity computation presented in Chapter 9. 3. An investment option where the IRR exceeds the minimum return on investment (usually the firm's cost of capital or some variation of that measure) is a candidate for approval. 4. To fully comprehend the meaning of the internal rate of return, the student needs to understand how IRR relates to NPV, and so it is important to show that the IRR is the discount rate (interest rate) that makes NPV = 0. 5. We use the IRR function of Excel to demonstrate the difference between the rates of return for Investments A and B. 6. You can show that the “Goal Seek” function in Excel that was used in Chapter 10 to calculate the yield to maturity can also be used to calculate an IRR since the yield to maturity on a bond is nothing more than the bond’s internal rate of return. 7. A financial calculator can also be used to determine the IRR for both annuities and uneven cash flows. We demonstrate the keystrokes needed to solve for IRR with uneven cash flows PPT Capital Budgeting Results (Table 12-6) Selection A. Strategy All non-mutually exclusive projects having an NPV >= 0 (which also means IRR >= cost of capital) should be accepted under normal conditions. If the NPV = 0, it means that the company will earn its cost of capital on the project. B. The NPV method and the IRR method always agree on the “accept” or “reject” decision on non-mutually exclusive projects. C. A disagreement may arise between the NPV and IRR methods when a choice must be made between mutually exclusive proposals or when all acceptable proposals cannot be taken due to capital rationing. 1. The primary cause of disagreement is the differing reinvestment assumptions. The NPV method inherently assumes reinvestment of cash inflows at the cost of capital. The IRR method assumes reinvestment of cash inflows at the internal rate of return. 2. The more conservative net present value technique is usually the recommended approach when a conflict in ranking arises. PPT The Reinvestment Assumption—Net Present Value ($10,000 Investment) (Table 12-7) V. D Modified internal rate of return is an alternative calculation to the IRR and NPV methods. 1. All cash outflows are discounted to the present at the firms cost of capital. 2. All cash inflows are converted to a terminal value by compounding them at the firm’s cost of capital out to the end of the project. 3. The discount rate that equates the future value of the inflows growing at the cost of capital with the amount invested is the MIRR. 4. Table 12-9 demonstrates the method for calculating MIRR using the RATE function on Excel. Perspective 12-2: This can be exemplified by the reinvestment of funds from certificates of deposit as they come due. VI. Capital Rationing A. Management may implement capital rationing by artificially constraining the amount of investment expenditures. PPT Capital Rationing (Table 12-10) B. Under capital rationing, some acceptable projects may be declined due to management's fear of growth or hesitancy to use external financing. C. Under capital rationing, projects are ranked by NPV and accepted until the rationed amount of capital is exhausted. VII. Net Present Value Profile A. The characteristics of an investment may be summarized by the use of the net present value profile. Perspective 12-3: The net present value profile can be used to reinforce the inverse nature of required rates of return and present value interest factors and the resultant impact on discounted cash flow streams. B. The NPV profile provides a graphical representation of an investment at various discount rates. C. Three characteristics of an investment are needed to apply the net present value profile: 1. The net present value at a zero discount rate. 2. The net present value of the project at the normal discount rate (cost of capital). 3. The internal rate of return for the investment. PPT Net Present Value Profile (Figure 12-2) D. The NPV profile is particularly useful in comparing projects when they are mutually exclusive or under conditions of capital rationing. E. The NPV profile demonstrates that the IRR method is not an acceptable decision criterion when the WACC lies to the left of the cross-over point of two mutually exclusive investment proposals. PPT Net Present Value Profile with Crossover (Figure 12-3) VIII. Combining Cash Flow Analysis and Selection Strategy A. The Rules for Depreciation: The Tax Reform Act of 1986 created classified eight different categories that determine the allowable rate of depreciation. Each class is referred to as an "MACRS category" or Modified Accelerated Cost Recovery Range. Finance in Action: Real Options Add a New Dimension to Capital Budgeting This article discusses real options not considered under traditional capital budgeting decisions. These real options include intermittent decision points throughout the project. These decision points provide the opportunity for the firm to continue or revise project plans or abandon the project altogether. This sophisticated technique is not widely used but is expected to increase in the future. PPT Categories for Depreciation Write Off (Table 12-11) PPT Depreciation Percentages (Table 12-12) PPT Depreciation schedule (Table 12-13) IX. Actual Investment Decision: This section includes an example of calculating the NPV of an investment proposal that includes the use of MACRS depreciation which results in an uneven cash flow stream and the calculation of the after-tax cash flow. PPT Cash Flow Related to the Purchase of Machinery (Table 12-14) PPT Net Present Value Analysis (Table 12-15) X. The Replacement Decision A. Sale of Old Asset B. Incremental Depreciation C. Cost Savings PPT Analysis of Incremental Depreciation Benefits (Table 12-18) PPT Analysis of Incremental Cost Savings Benefits (Table 12-19) PPT Present Value of the Total Incremental Benefits (Table 12-20) XI. Elective Expensing: Under the 2008 Economic Stimulus Act, firms have the option to write off the purchase of equipment, furniture, tools, and computers for up to $250,000 in the year they are purchased. This provides a cash flow advantage by deferring taxes to future periods. The allowance is phased out dollar for dollar when total property purchases exceed $800,000 in a year. Finance in Action: Capital Budgeting Practices Utilized by Smaller, Privately Held Businesses This article discusses the capital budgeting techniques used by smaller less sophisticated businesses. Most such firms uses the payback method for two reasons: 1) It is less complicated and 2) The primary providers of funds for small businesses, conventional banks, base their lending decisions on how soon funds will be repaid. Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 18, Aerocomp, Inc. (Methods of Investment Evaluation) Case 19, Phelps Toy Company (Capital Budgeting and Cash Flow) Risk and Capital Budgeting 13 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. 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. Decision trees are introduced after simulation models to path dependent outcomes combined with probability estimates. 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 titled “Risk-Return Trade-Offs.” Chapter Concepts LO1. The concept of risk is based on uncertainty about future outcomes. It requires the computation of quantitative measures as well as qualitative considerations. LO2. Most investors are risk averse, which means they dislike uncertainty. LO3. Because investors dislike uncertainty, they will require higher rates of return from risky projects. LO4. Simulation models and decision trees can be used to help assess the risk of an investment. LO5. Not only must the risk of an individual project be considered, but also how the project affects the total risk of the firm. Annotated Outline and Strategy I. Definitions of 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. The wider the distribution of possible outcomes for a particular investment, the greater is its risk. C. Risk aversion is a basic assumption of financial theory. Investors require a higher expected return the riskier an investment is perceived to be. II. The Concept of Risk Averse Perspective 13-1: We provide a brief statistical but most students should not have to spend too much time on the statistics. Instead, focus on applying these measures to financial decision making. PPT Variability and Risk (Figure 13-1) A. The basic risk measurement is the standard deviation, which is a measure of dispersion around an expected value. 1. The expected value is a weighted average of the possible outcomes of an event times their probabilities. D (expected value) = DnPn 1−n 2. The formula for computing the standard deviation is: (standard deviation) = (Dn − D Pn)2 1−n 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. $10,000 $10,000 VA = .20 = VB = .10= $50,000 $100,000 Coefficient of variation ( ) V = D PPT Probability distribution with differing degrees of risk (Figure 13-3) 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.) PPT Betas for a five-year period (ending January 2013) (Table 13-2) Perspective 13-2: Table 13-2 allows for a good discussion of industry/company factors that may cause risk. III. Risk and the Capital Budgeting Process A. The expected inflows from capital projects are usually risky and uncertain. B. Cash flows of projects bearing a normal amount of risk undertaken by the firm should be discounted at the cost of capital. C. As the risk of a proposal increases, the rate of return required by lenders and investors increases. D. The cost of capital is composed of two components: the risk free rate the inflation adjusted real rate of return) plus a risk premium (risk associated with usual projects of a business). E. Adjustments must be made in the evaluation process for projects bearing other than (more or less) normal risk levels. 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. 2. Risk adjusted discount rates may be based on several measures of risk such as: the standard deviation, coefficient of variation or beta. PPT 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 Risk Categories and Associated Discount Rates (Table 13-3) PPT Capital Budgeting Analysis (Table 13-4) Finance in Action: Energy: A High Risk Industry The focus of the discussion should be on the risk assigned by energy companies to the many variable that affect cash flow such as: the uncertainty of oil prices, the adoption of alternative energy sources, government regulations, political turmoil in the Middle East, oil spills, and dry wells. 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 Capital Budgeting Decision Adjusted for Risk (Table 13-5) A. Simulation Models 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, revise, or even cancel investment plans) 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. PPT 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 Decision Trees (Figure 13-8) IV. V. The Portfolio Effect A. A risky project may actually reduce the total risk of the firm through the portfolio effect. B. Projects that move in opposite directions in response to the same economic stimulus are said to be negatively correlated. Since the movement of negatively correlated projects is in opposite directions, the total deviation is less than the deviations of the projects individually. C. 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. D. 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 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. E. 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. F. The various optimal combinations of projects are located along a risk-return line referred to as the "efficient frontier." PPT Risk-Return Trade-Offs (Figure 13-11) 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. Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 20, Global Resources. (Risk-Adjusted Discount Rates) Case 21, Inca, Inc. (Capital Budgeting with Risk) Instructor Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley R. Danielsen 9780077861612, 9781260013917, 9781259277160
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