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Fiance Finance Corporate Volume 1 David Whitehurst UMIST McGraw-Hill/Irwin abc McGraw-Hill Primis ISBN: 0-390-32000-5 Text: Corporate Finance, Sixth Edition Ross-Westerfield-Jaffe This book was printed on recycled paper. Finance http://www.mhhe.com/primis/online/ Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without prior written permission of the publisher. This McGraw-Hill Primis text may include materials submitted to McGraw-Hill for publication by the instructor of this course. The instructor is solely responsible for the editorial content of such materials. 111 FINA ISBN: 0-390-32000-5 Finance Volume 1 Ross-Westerfield-Jaffe Corporate Finance, Sixth Edition Front Matter 1 1 8 8 9 29 51 51 52 72 108 146 175 206 225 225 226 248 291 313 343 343 345 377 396 428 474 501 539 539 540 Preface I. Overview Introduction 1. Introduction to Corporate Finance 2. Accounting Statements and Cash Flow II. Value and Capital Budgeting Introduction 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) 4. Net Present Value 5. How to Value Bonds and Stocks 6. Some Alternative Investment Rules 7. Net Present Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value III. Risk Introduction 9. Capital Market Theory: An Overview 10. Return and Risk: The Capital-Asset-Pricing Model 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory 12. Risk, Cost of Capital, and Capital Budgeting IV. Capital Structure and Dividend Policy Introduction 13. Corporate-Financing Decisions and Efficient Capital Markets 14. Long-Term Financing: An Introduction 15. Capital Structure: Basic Concepts 16. Capital Structure: Limits to the Use of Debt 17. Valuation and Capital Budgeting for the Levered Firm 18. Dividend Policy: Why Does It Matter? V. Long-Term Financing Introduction 19. Issuing Securities to the Public iii 20. Long-Term Debt 21. Leasing VI. Options, Futures, and Corporate Finance 569 592 617 617 618 656 680 701 736 736 737 751 776 803 820 820 821 859 877 Introduction 22. Options and Corporate Finance: Basic Concepts 23. Options and Corporate Finance: Extensions and Applications 24. Warrants and Convertibles 25. Derivatives and Hedging Risk VII. Financial Planning and Short-Term Finance Introduction 26. Corporate Financial Models and Long-Term Planning 27. Short-Term Finance and Planning 28. Cash Management 29. Credit Management VIII. Special Topics Introduction 30. Mergers and Acquisitions 31. Financial Distress 32. International Corporate Finance iv Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition Front Matter Preface The McGraw-Hill Companies, 2002 1 Preface The teaching and the practicing of corporate finance are more challenging and exciting than ever before. The last decade has seen fundamental changes in financial markets and financial instruments. In the early years of the 21st century, we still see announcements in the financial press about such matters as takeovers, junk bonds, financial restructuring, initial public offerings, bankruptcy, and derivatives. In addition, there is the new recognition of "real" options (Chapters 21 and 22), private equity and venture capital (Chapter 19), and the disappearing dividend (Chapter 18). The world's financial markets are more integrated than ever before. Both the theory and practice of corporate finance have been moving ahead with uncommon speed, and our teaching must keep pace. These developments place new burdens on the teaching of corporate finance. On one hand, the changing world of finance makes it more difficult to keep materials up to date. On the other hand, the teacher must distinguish the permanent from the temporary and avoid the temptation to follow fads. Our solution to this problem is to emphasize the modern fundamentals of the theory of finance and make the theory come to life with contemporary examples. Increasingly, many of these examples are outside the United States. All too often, the beginning student views corporate finance as a collection of unrelated topics that are unified largely because they are bound together between the covers of one book. As in the previous editions, our aim is to present corporate finance as the working of a small number of integrated and powerful institutions. THE INTENDED AUDIENCE OF THIS BOOK This book has been written for the introductory courses in corporate finance at the MBA level, and for the intermediate courses in many undergraduate programs. Some instructors will find our text appropriate for the introductory course at the undergraduate level as well. We assume that most students either will have taken, or will be concurrently enrolled in, courses in accounting, statistics, and economics. This exposure will help students understand some of the more difficult material. However, the book is self-contained, and a prior knowledge of these areas is not essential. The only mathematics prerequisite is basic algebra. NEW TO THE SIXTH EDITION Following are the key revisions and updates to this edition: A complete update of all cost of capital discussions to emphasize its usefulness in capital budgeting, primarily in Chapters 12 and 17. 2 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition Front Matter Preface The McGraw-Hill Companies, 2002 Preface vii A new appendix on performance evaluation and EVA in Chapter 12. A new section on liquidity and the cost of capital in Chapter 12. New evidence on efficient markets and CAPM in Chapter 13. New treatment on why firms choose different capital structures and dividend policies: the case of Qualcomm in Chapters 16 and 18. A redesign and rewrite of options and derivatives chapters into a new Part VI. Extension of options theory to mergers and acquisitions in Chapter 22. An expanded discussion of real options and their importance to capital budgeting in Chapter 23. New material on carveouts, spinoffs, and tracking stocks in Chapter 30. Many new end-of-chapter problems throughout all chapters. ATTENTION TO PEDAGOGY Executive Summary Each chapter begins with a "roadmap" that describes the objectives of the chapter and how it connects with concepts already learned in previous chapters. Real company examples that will be discussed are highlighted in this section. Case Study There are 10 case studies that are highlighted in the Sixth Edition that present situations with real companies and how they rationalized the decisions they made to solve various problems. They provide extended examples of the material covered in the chapter. The cases are highlighted in the detailed Table of Contents. In Their Own Words Boxes Located throughout the Sixth Edition, this unique series consists of articles written by distinguished scholars or practitioners on key topics in the text. Concept Questions Included after each major section in a chapter, Concept Questions point to essential material and allow students to test their recall and comprehension before moving forward. Key Terms Students will note that important words are highlighted in boldface type the first time they appear. They are also listed at the end of the chapter, along with the page number on which they first appear, as well as in the glossary at the end of the book. Demonstration Problems We have provided worked-out examples throughout the text to give students a clear understanding of the logic and structure of the solution process. These examples are clearly called out in the text. Highlighted Concepts Throughout the text, important ideas are pulled out and presented in a copper box--signaling to students that this material is particularly relevant and critical for their understanding. Numbered Equations Key equations are numbered and listed on the back end sheets for easy reference. The end of-chapter material reflects and builds on the concepts learned from the chapter and study features: Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition Front Matter Preface The McGraw-Hill Companies, 2002 3 viii Preface Summary and Conclusions The numbered summary provides a quick review of key concepts in the chapter. List of Key Terms A list of the boldfaced key terms with page numbers is included for easy reference. Suggested Readings Each chapter is followed by a short, annotated list of books and articles to which interested students can refer for additional information. Questions and Problems Because solving problems is so critical to a student's learning, they have been revised, thoroughly reviewed, and accuracy-checked. The problem sets are graded for difficulty, moving from easier problems intended to build confidence and skill to more difficult problems designed to challenge the enthusiastic student. Problems have been grouped according to the concepts they test on. Additionally, we have tried to make the problems in the critical "concept" chapters, such as those on value, risk, and capital structure, especially challenging and interesting. We provide answers to selected problems in Appendix B at the end of the book. Minicase This end-of-chapter feature, located in Chapters 12 and 30, parallels the Case Study feature found in various chapters. These Minicases apply what is learned in a number of chapters to a real-world type of scenario. After presenting the facts, the student is given guidance in rationalizing a sound business decision. SUPPLEMENTS PACKAGE As with the text, developing supplements of extraordinary quality and utility was the primary objective. Each component in the supplement package underwent extensive review and revision. FOR THE INSTRUCTOR Instructor's Manual (0-07-233882-2) Prepared by John Stansfield, University of Missouri, Columbia, this instructor's tool has been thoroughly revised and updated. Each chapter includes a list of transparencies/ PowerPoint slides, a brief chapter outline, an introduction, and an annotated outline. The annotated outline contains references to the transparencies/PowerPoint slides, additional explanations and examples, and teaching tips. PowerPoint Presentation System (0-07-233883-0) This presentation system was developed in conjunction with the Instructor's Manual by the same author, allowing for a complete and integrated teaching package. These slides contain useful outlines, summaries, and exhibits from the text. If you have PowerPoint installed on your PC, you have the ability to edit, print, or rearrange the complete transparency presentation to meet your specific needs. Test Bank (0-07-233885-7) The Test Bank, prepared by David Burnie, Western Michigan University, includes an average of 35 multiple-choice questions and problems per chapter, and 5 essay questions per 4 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition Front Matter Preface The McGraw-Hill Companies, 2002 Preface ix chapter. Each question is labeled with the level of difficulty. About 3040 percent of these problems are new or revised. Computerized Testing Software (0-07-233881-4) This software includes an easy-to-use menu system which allows quick access to all the powerful features available. The Keyword Search option lets you browse through the question bank for problems containing a specific word or phrase. Password protection is available for saved tests or for the entire database. Questions can be added, modified, or deleted. Available in Windows version. Solutions Manual (0-07-233884-9) The Solutions Manual, prepared by John A. Helmuth, University of Michigan, contains worked-out solutions for all of the problems, and has been thoroughly reviewed for accuracy. The Solutions Manual is also available to be purchased for your students. Instructor CD-ROM (0-07-246238-8) You can receive all of the supplements in an electronic format! The Instructor's Manual, PowerPoint, Test Bank, and Solutions Manual are all together on one convenient CD. The interface provides the instructor with a self-contained program that allows him or her to arrange the visual resources into his or her own presentation and add additional files as well. Videos (0-07-250741-1) These finance videos are 10-minute case studies on topics such as Financial Markets, Careers, Rightsizing, Capital Budgeting, EVA (Economic Value Added), Mergers and Acquisitions, and International Finance. Questions to accompany these videos can be found on the book's Online Learning Center. FOR THE STUDENTS Standard & Poor's Educational Version of Market Insight. If you purchased a new book, you will have received a free passcode card that will give you access to the same company and industry data that industry experts use. See www.mhhe.com/edumarketinsight for details on this exclusive partnership! PowerWeb If you purchased a new book, free access to PowerWeb--a dynamic supplement specific to your corporate finance course--is also available. Included are three levels of resource materials: articles from journals and magazines from the past year, weekly updates on current issues, and links to current news of the day. Also available is a series of study aids, such as quizzes, web links, and interactive exercises. See www.dushkin.com/powerweb for more details and access to this valuable resource. Student Problem Manual (0-07-233880-6) Written by Robert Hanson, Eastern Michigan University, the Student Problem Manual is a direct companion to the text. It is uniquely designed to involve the student in the learning process. Each chapter contains a Mission Statement, an average of 20 fill-in-the-blank Concept Test questions and answers, and an average of 15 problems and worked-out solutions. This product can be purchased separately or packaged with the text. Online Learning Center Visit the full web resource now available with the Sixth Edition at www.mhhe.com/rwj. The Information Center includes information on this new edition, and links for special offers. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition Front Matter Preface The McGraw-Hill Companies, 2002 5 x Preface The Instructor Center includes all of the teaching resources for the book, and the Student Center includes free online study materials--such as quizzes, study outlines, and spreadsheets--developed specifically for this edition. A feedback form is also available for your questions and comments. ACKNOWLEDGMENTS The plan for developing this edition began with a number of our colleagues who had an interest in the book and regularly teach the MBA introductory course. We integrated their comments and recommendations throughout the Sixth Edition. Contributors to this edition include: R. Aggarwal, John Carroll University Christopher Anderson, University of MissouriColumbia James J. Angel, Georgetown University Kevin Bahr, University of WisconsinMilwaukee Michael Barry, Boston College William O. Brown, Claremont McKenna College Bill Callahan, Southern Methodist University Steven Carvell, Cornell University Indudeep S. Chhachhi, Western Kentucky University Jeffrey L. Coles, Arizona State University Raymond Cox, Central Michigan University John Crockett, George Mason University Robert Duvic, The University of Texas at Austin Steven Ferraro, Pepperdine University Adlai Fisher, New York University Yee-Tien Fu, Stanford University Bruno Gerard, University of Southern California Frank Ghannadian, Mercer UniversityAtlanta John A. Helmuth, University of MichiganDearborn Edith Hotchkiss, Boston College Charles Hu, Claremont McKenna College Raymond Jackson, University of MassachusettsDartmouth Narayanan Jayaraman, Georgia Institute of Technology Dolly King, University of WisconsinMilwaukee Ronald Kudla, The University of Akron Dilip Kumar Patro, Rutgers University Youngsik Kwak, Delaware State University Youngho Lee, Howard University Yulong Ma, Cal State--Long Beach Richard Miller, Wesleyan University Naval Modani, University of Central Florida Robert Nachtmann, University of Pittsburgh Edward Nelling, Georgia Tech Gregory Niehaus, University of South Carolina Ingmar Nyman, Hunter College Venky Panchapagesan, Washington UniversitySt. Louis Bulent Parker, University of WisconsinMadison Christo Pirinsky, Ohio State University Jeffrey Pontiff, University of Washington N. Prabhala, Yale University Mao Qiu, University of UtahSalt Lake City Latha Ramchand, University of Houston Gabriel Ramirez, Virginia Commonwealth University Stuart Rosenstein, University of Colorado at Denver Bruce Rubin, Old Dominion University Jaime Sabal, New York University Andy Saporoschenko, University of Akron William Sartoris, Indiana University Faruk Selcuk, University of Bridgeport Sudhir Singh, Frostburg State University John S. Strong, College of William and Mary Michael Sullivan, University of NevadaLas Vegas Andrew C. Thompson, Virginia Polytechnic Institute Karin Thorburn, Dartmouth College Satish Thosar, University of MassachusettsDorchester Oscar Varela, University of New Orleans Steven Venti, Dartmouth College Susan White, University of TexasAustin Over the years, many others have contributed their time and expertise to the development and writing of this text. We extend our thanks once again for their assistance and countless insights: 6 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition Front Matter Preface The McGraw-Hill Companies, 2002 Preface xi Hugh Hunter, Eastern Washington University James Jackson, Oklahoma State University Prem Jain, Tulane University Brad Jordan, University of Kentucky Jarl Kallberg, New York University Jonathan Karpoff, University of Washington Paul Keat, American Graduate School of International Management Brian Kluger, University of Cincinnati Narayana Kocherlakota, University of Iowa Nelson Lacey, University of Massachusetts Gene Lai, University of Rhode Island Josef Lakonishok, University of Illinois Dennis Lasser, SUNYBinghamton Paul Laux, Case Western Reserve University Bong-Su Lee, University of Minnesota James T. Lindley, University of Southern Mississippi Dennis Logue, Dartmouth College Michael Long, Rutgers University Ileen Malitz, Fairleigh Dickinson University Terry Maness, Baylor University Surendra Mansinghka, San Francisco State University Michael Mazzco, Michigan State University Robert I. McDonald, Northwestern University Hugh McLaughlin, Bentley College Larry Merville, University of TexasRichardson Joe Messina, San Francisco State University Roger Mesznik, City College of New YorkBaruch College Rick Meyer, University of South Florida Richard Mull, New Mexico State University Jim Musumeci, Southern Illinois UniversityCarbondale Peder Nielsen, Oregon State University Dennis Officer, University of Kentucky Joseph Ogden, State University of New York Ajay Patel, University of MissouriColumbia Glenn N. Pettengill, Emporia State University Pegaret Pichler, University of Maryland Franklin Potts, Baylor University Annette Poulsen, University of Georgia Latha Ramchand, University of Houston Narendar Rao, Northeastern Illinois University Steven Raymar, Indiana University Stuart Rosenstein, Southern Illinois University James J. Angel, Georgetown University Nasser Arshadi, University of MissouriSt. Louis Robert Balik, Western Michigan University John W. Ballantine, Babson College Thomas Bankston, Angelo State University Swati Bhatt, Rutgers University Roger Bolton, Williams College Gordon Bonner, University of Delaware Brad Borber, University of CaliforniaDavis Oswald Bowlin, Texas Technical University Ronald Braswell, Florida State University Kirt Butler, Michigan State University Andreas Christofi, Pennsylvania State UniversityHarrisburg James Cotter, University of Iowa Jay Coughenour, University of MassachusettsBoston Arnold Cowan, Iowa State University Mark Cross, Louisiana Technical University Ron Crowe, Jacksonville University William Damon, Vanderbilt University Sudip Datta, Bentley College Anand Desai, University of Florida Miranda Lam Detzler, University of MassachusettsBoston David Distad, University of CaliforniaBerkeley Dennis Draper, University of Southern California Jean-Francois Dreyfus, New York University Gene Drzycimski, University of WisconsinOshkosh Robert Eldridge, Fairfield University Gary Emery, University of Oklahoma Theodore Eytan, City University of New YorkBaruch College Don Fehrs, University of Notre Dame Andrew Fields, University of Delaware Paige Fields, Texas A&M Michael Fishman, Northwestern University Michael Goldstein, University of Colorado Indra Guertler, Babson College James Haltiner, College of William and Mary Delvin Hawley, University of Mississippi Hal Heaton, Brigham Young University John Helmuth, Rochester Institute of Technology Michael Hemler, University of Notre Dame Stephen Heston, Washington University Andrea Heuson, University of Miami Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition Front Matter Preface The McGraw-Hill Companies, 2002 7 xii Preface Patricia Ryan, Drake University Anthony Sanders, Ohio State University James Schallheim, University of Utah Mary Jean Scheuer, California State University at Northridge Lemma Senbet, University of Maryland Kuldeep Shastri, University of Pittsburgh Scott Smart, Indiana University Jackie So, Southern Illinois University John Stansfield, Columbia College A. Charlene Sullivan, Purdue University Timothy Sullivan, Bentley College R. Bruce Swensen, Adelphi University Ernest Swift, Georgia State University Alex Tang, Morgan State University Richard Taylor, Arkansas State University Timothy Thompson, Northwestern University Charles Trzcinka, State University of New YorkBuffalo Haluk Unal, University of MarylandCollege Park Avinash Verma, Washington University Lankford Walker, Eastern Illinois University Ralph Walkling, Ohio State University F. Katherine Warne, Southern Bell College Robert Whitelaw, New York University Berry Wilson, Georgetown University Thomas Zorn, University of NebraskaLincoln Kent Zumwalt, Colorado State University For their help on the Sixth Edition, we would like to thank Linda De Angelo, Dennis Draper, Kim Dietrich, Alan Shapiro, Harry De Angelo, Aris Protopapadakis, Anath Madhevan, and Suh-Pyng Ku, all of the Marshall School of Business at the University of Southern California. We also owe a debt of gratitude to Edward I. Altman, of New York University; Robert S. Hansen, of Virginia Tech; and Jay Ritter, of the University of Florida, who have provided several thoughtful comments and immeasurable help. Over the past three years, readers have provided assistance by detecting and reporting errors. Our goal is to offer the best textbook available on the subject, so this information was invaluable as we prepared the Sixth Edition. We want to ensure that all future editions are error-free and therefore we will offer $10 per arithmetic error to the first individual reporting it. Any arithmetic error resulting in subsequent errors will be counted double. All errors should be reported using the Feedback Form on the Corporate Finance Online Learning Center at www.mhhe.com/rwj. In addition, Sandra Robinson and Wendy Wat have given significant assistance in preparing the manuscript. Finally, we wish to thank our families and friends, Carol, Kate, Jon, Jan, Mark, and Lynne for their forbearance and help. Stephen A. Ross Randolph W. Westerfield Jeffrey F. Jaffe 8 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview Introduction The McGraw-Hill Companies, 2002 PART I Overview 1 Introduction to Corporate Finance 2 2 Accounting Statements and Cash Flow 22 T O engage in business the financial managers of a firm must find answers to three kinds of important questions. First, what long-term investments should the firm take on? This is the capital budgeting decision. Second, how can cash be raised for the required investments? We call this the financing decision. Third, how will the firm manage its day-to-day cash and financial affairs? These decisions involve short-term finance and concern net working capital. In Chapter 1 we discuss these important questions, briefly introducing the basic ideas of this book and describing the nature of the modern corporation and why it has emerged as the leading form of the business firm. Using the set-of-contracts perspective, the chapter discusses the goals of the modern corporation. Though the goals of shareholders and managers may not always be the same, conflicts usually will be resolved in favor of the shareholders. Finally, the chapter reviews some of the salient features of modern financial markets. This preliminary material will be familiar to students who have some background in accounting, finance, and economics. Chapter 2 examines the basic accounting statements. It is review material for students with an accounting background. We describe the balance sheet and the income statement. The point of the chapter is to show the ways of converting data from accounting statements into cash flow. Understanding how to identify cash flow from accounting statements is especially important for later chapters on capital budgeting. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 9 1 CHAPTER Introduction to Corporate Finance EXECUTIVE SUMMARY T he Video Product Company designs and manufactures very popular software for video game consoles. The company was started in 1999, and soon thereafter its game "Gadfly" appeared on the cover of Billboard magazine. Company sales in 2000 were over $20 million. Video Product's initial financing of $2 million came from Seed Ltd., a venture-capital firm, in exchange for a 15-percent equity stake in the company. Now the financial management of Video Product realizes that its initial financing was too small. In the long run Video Product would like to expand its design activity to the education and business areas. It would also like to significantly enhance its website for future Internet sales. However, at present the company has a short-run cash flow problem and cannot even buy $200,000 of materials to fill its holiday orders. Video Product's experience illustrates the basic concerns of corporate finance: 1. What long-term investment strategy should a company take on? 2. How can cash be raised for the required investments? 3. How much short-term cash flow does a company need to pay its bills? These are not the only questions of corporate finance. They are, however, among the most important questions and, taken in order, they provide a rough outline of our book. One way that companies raise cash to finance their investment activities is by selling or "issuing" securities. The securities, sometimes called financial instruments or claims, may be roughly classified as equity or debt, loosely called stocks or bonds. The difference between equity and debt is a basic distinction in the modern theory of finance. All securities of a firm are claims that depend on or are contingent on the value of the firm.1 In Section 1.2 we show how debt and equity securities depend on the firm's value, and we describe them as different contingent claims. In Section 1.3 we discuss different organizational forms and the pros and cons of the decision to become a corporation. In Section 1.4 we take a close look at the goals of the corporation and discuss why maximizing shareholder wealth is likely to be the primary goal of the corporation. Throughout the rest of the book, we assume that the firm's performance depends on the value it creates for its shareholders. Shareholders are better off when the value of their shares is increased by the firm's decisions. A company raises cash by issuing securities to the financial markets. The market value of outstanding long-term corporate debt and equity securities traded in the U.S. financial markets is in excess of $25 trillion. In Section 1.5 we describe some of the basic features of the financial markets. Roughly speaking, there are two basic types of financial markets: the money markets and the capital markets. The last section of the chapter provides an outline of the rest of the book. 1 We tend to use the words firm, company, and business interchangeably. However, there is a difference between a firm and a corporation. We discuss this difference in Section 1.3. 10 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 Chapter 1 Introduction to Corporate Finance 3 1.1 WHAT IS CORPORATE FINANCE? Suppose you decide to start a firm to make tennis balls. To do this, you hire managers to buy raw materials, and you assemble a workforce that will produce and sell finished tennis balls. In the language of finance, you make an investment in assets such as inventory, machinery, land, and labor. The amount of cash you invest in assets must be matched by an equal amount of cash raised by financing. When you begin to sell tennis balls, your firm will generate cash. This is the basis of value creation. The purpose of the firm is to create value for you, the owner. The firm must generate more cash flow than it uses. The value is reflected in the framework of the simple balance-sheet model of the firm. The Balance-Sheet Model of the Firm Suppose we take a financial snapshot of the firm and its activities at a single point in time. Figure 1.1 shows a graphic conceptualization of the balance sheet, and it will help introduce you to corporate finance. The assets of the firm are on the left-hand side of the balance sheet. These assets can be thought of as current and fixed. Fixed assets are those that will last a long time, such as buildings. Some fixed assets are tangible, such as machinery and equipment. Other fixed assets are intangible, such as patents, trademarks, and the quality of management. The other category of assets, current assets, comprises those that have short lives, such as inventory. The tennis balls that your firm has made but has not yet sold are part of its inventory. Unless you have overproduced, they will leave the firm shortly. Before a company can invest in an asset, it must obtain financing, which means that it must raise the money to pay for the investment. The forms of financing are represented on the right-hand side of the balance sheet. A firm will issue (sell) pieces of paper called debt I F I G U R E 1.1 The Balance-Sheet Model of the Firm Current assets Net working capital Current liabilities Long-term debt Fixed assets 1. Tangible fixed assets 2. Intangible fixed assets Shareholders' equity Total value of the firm to investors Left side, total value of assets. Right side, total value of the firm to investors, which determines how the value is distributed. Total value of assets Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 11 4 Part I Overview (loan agreements) or equity shares (stock certificates). Just as assets are classified as longlived or short-lived, so too are liabilities. A short-term debt is called a current liability. Short-term debt represents loans and other obligations that must be repaid within one year. Long-term debt is debt that does not have to be repaid within one year. Shareholders' equity represents the difference between the value of the assets and the debt of the firm. In this sense it is a residual claim on the firm's assets. From the balance-sheet model of the firm it is easy to see why finance can be thought of as the study of the following three questions: 1. In what long-lived assets should the firm invest? This question concerns the lefthand side of the balance sheet. Of course, the type and proportions of assets the firm needs tend to be set by the nature of the business. We use the terms capital budgeting and capital expenditures to describe the process of making and managing expenditures on longlived assets. 2. How can the firm raise cash for required capital expenditures? This question concerns the right-hand side of the balance sheet. The answer to this involves the firm's capital structure, which represents the proportions of the firm's financing from current and long-term debt and equity. 3. How should short-term operating cash flows be managed? This question concerns the upper portion of the balance sheet. There is often a mismatch between the timing of cash inflows and cash outflows during operating activities. Furthermore, the amount and timing of operating cash flows are not known with certainty. The financial managers must attempt to manage the gaps in cash flow. From a balance-sheet perspective, short-term management of cash flow is associated with a firm's net working capital. Net working capital is defined as current assets minus current liabilities. From a financial perspective, the short-term cash flow problem comes from the mismatching of cash inflows and outflows. It is the subject of short-term finance. Capital Structure Financing arrangements determine how the value of the firm is sliced up. The persons or institutions that buy debt from the firm are called creditors.2 The holders of equity shares are called shareholders. Sometimes it is useful to think of the firm as a pie. Initially, the size of the pie will depend on how well the firm has made its investment decisions. After a firm has made its investment decisions, it determines the value of its assets (e.g., its buildings, land, and inventories). The firm can then determine its capital structure. The firm might initially have raised the cash to invest in its assets by issuing more debt than equity; now it can consider changing that mix by issuing more equity and using the proceeds to buy back some of its debt. Financing decisions like this can be made independently of the original investment decisions. The decisions to issue debt and equity affect how the pie is sliced. The pie we are thinking of is depicted in Figure 1.2. The size of the pie is the value of the firm in the financial markets. We can write the value of the firm, V, as V B S where B is the value of the debt and S is the value of the equity. The pie diagrams consider two ways of slicing the pie: 50 percent debt and 50 percent equity, and 25 percent 2 We tend to use the words creditors, debtholders, and bondholders interchangeably. In later chapters we examine the differences among the kinds of creditors. In algebraic notation, we will usually refer to the firm's debt with the letter B (for bondholders). 12 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 Chapter 1 Introduction to Corporate Finance 5 I F I G U R E 1.2 Two Pie Models of the Firm 25% debt 50% debt 50% equity 75% equity Capital structure 1 Capital structure 2 debt and 75 percent equity. The way the pie is sliced could affect its value. If so, the goal of the financial manager will be to choose the ratio of debt to equity that makes the value of the pie--that is, the value of the firm, V--as large as it can be. The Financial Manager In large firms the finance activity is usually associated with a top officer of the firm, such as the vice president and chief financial officer, and some lesser officers. Figure 1.3 depicts a general organizational structure emphasizing the finance activity within the firm. Reporting to the chief financial officer are the treasurer and the controller. The treasurer is responsible for handling cash flows, managing capital-expenditures decisions, and making financial plans. The controller handles the accounting function, which includes taxes, cost and financial accounting, and information systems. We think that the most important job of a financial manager is to create value from the firm's capital budgeting, financing, and liquidity activities. How do financial managers create value? 1. The firm should try to buy assets that generate more cash than they cost. 2. The firm should sell bonds and stocks and other financial instruments that raise more cash than they cost. Thus the firm must create more cash flow than it uses. The cash flows paid to bondholders and stockholders of the firm should be higher than the cash flows put into the firm by the bondholders and stockholders. To see how this is done, we can trace the cash flows from the firm to the financial markets and back again. The interplay of the firm's finance with the financial markets is illustrated in Figure 1.4. The arrows in Figure 1.4 trace cash flow from the firm to the financial markets and back again. Suppose we begin with the firm's financing activities. To raise money the firm sells debt and equity shares to investors in the financial markets. This results in cash flows from the financial markets to the firm (A). This cash is invested in the investment activities of the firm (B) by the firm's management. The cash generated by the firm (C) is paid to shareholders and bondholders (F). The shareholders receive cash in the form of dividends; the bondholders who lent funds to the firm receive interest and, when the initial loan is repaid, principal. Not all of the firm's cash is paid out. Some is retained (E), and some is paid to the government as taxes (D). Over time, if the cash paid to shareholders and bondholders (F) is greater than the cash raised in the financial markets (A), value will be created. Identification of Cash Flows Unfortunately, it is not all that easy to observe cash flows directly. Much of the information we obtain is in the form of accounting statements, and Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 13 6 Part I Overview I F I G U R E 1.3 Hypothetical Organization Chart Board of Directors Chairman of the Board and Chief Executive Officer (CEO) President and Chief Operations Officer (COO) Vice President and Chief Financial Officer (CFO) Treasurer Controller Cash Manager Credit Manager Tax Manager Cost Accounting Manager Capital Expenditures Financial Planning Financial Accounting Manager Data Processing Manager much of the work of financial analysis is to extract cash flow information from accounting statements. The following example illustrates how this is done. E XAMPLE The Midland Company refines and trades gold. At the end of the year it sold 2,500 ounces of gold for $1 million. The company had acquired the gold for $900,000 at the beginning of the year. The company paid cash for the gold when it was purchased. Unfortunately, it has yet to collect from the customer to whom the gold was sold. The following is a standard accounting of Midland's financial circumstances at year-end: 14 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 Chapter 1 Introduction to Corporate Finance 7 I N T HEIR O WN W ORDS Skills Needed for the Chief Financial Officers of eFinance.com Chief strategist: CFOs will need to use real-time financial information to make crucial decisions fast. Chief dealmaker: CFOs must be adept at venture capital, mergers and acquisitions, and strategic partnerships. Chief risk officer: Limiting risk will be even more important as markets become more global and hedging instruments become more complex. Chief communicator: Gaining the confidence of Wall Street and the media will be essential. Source: Business Week, August 28, 2000, p. 120. THE MIDLAND COMPANY Accounting View Income Statement Year Ended December 31 Sales Costs ______ Profit $1,000,000 900,000 __________ $ 100,000 By generally accepted accounting principles (GAAP), the sale is recorded even though the customer has yet to pay. It is assumed that the customer will pay soon. From the accounting perspective, Midland seems to be profitable. However, the perspective of corporate finance is different. It focuses on cash flows: THE MIDLAND COMPANY Corporate Finance View Income Statement Year Ended December 31 Cash inflow Cash outflow 0 900,000 __________ $900,000 $ The perspective of corporate finance is interested in whether cash flows are being created by the gold-trading operations of Midland. Value creation depends on cash flows. For Midland, value creation depends on whether and when it actually receives $1 million. Timing of Cash Flows The value of an investment made by the firm depends on the timing of cash flows. One of the most important assumptions of finance is that individuals prefer to receive cash flows earlier rather than later. One dollar received today is worth more than one dollar received next year. This time preference plays a role in stock and bond prices. E XAMPLE The Midland Company is attempting to choose between two proposals for new products. Both proposals will provide additional cash flows over a four-year period and will initially cost $10,000. The cash flows from the proposals are as follows: Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 15 8 Part I Overview I F I G U R E 1.4 Cash Flows between the Firm and the Financial Markets Firm issues securities (A) Firm invests in assets (B) Current assets Fixed assets Financial markets Retained cash flows (E) Cash flow from firm (C) Taxes Dividends and debt payments (F) Short-term debt Long-term debt Equity shares Total value of assets Government (D) Total value of the firm to investors in the financial markets (A) (B) (C) (D) (E) (F) Firm issues securities to raise cash (the financing decision). Firm invests in assets (capital budgeting). Firm's operations generate cash flow. Cash is paid to government as taxes. Retained cash flows are reinvested in firm. Cash is paid out to investors in the form of interest and dividends. Year 1 2 3 4 Total New Product A 0 0 0 20,000 _______ $20,000 $ New Product B $ 4,000 4,000 4,000 4,000 _______ $16,000 At first it appears that new product A would be best. However, the cash flows from proposal B come earlier than those of A. Without more information we cannot decide which set of cash flows would create the most value to the bondholders and shareholders. It depends on whether the value of getting cash from B up front outweighs the extra total cash from A. Bond and stock prices reflect this preference for earlier cash, and we will see how to use them to decide between A and B. Risk of Cash Flows The firm must consider risk. The amount and timing of cash flows are not usually known with certainty. Most investors have an aversion to risk. E XAMPLE The Midland Company is considering expanding operations overseas. It is evaluating Europe and Japan as possible sites. Europe is considered to be relatively safe, whereas operating in Japan is seen as very risky. In both cases the company would close down operations after one year. 16 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 Chapter 1 Introduction to Corporate Finance 9 After doing a complete financial analysis, Midland has come up with the following cash flows of the alternative plans for expansion under three equally likely scenarios--pessimistic, most likely, and optimistic: Pessimistic Europe Japan $75,000 0 Most Likely $100,000 150,000 Optimistic $125,000 200,000 If we ignore the pessimistic scenario, perhaps Japan is the best alternative. When we take the pessimistic scenario into account, the choice is unclear. Japan appears to be riskier, but it also offers a higher expected level of cash flow. What is risk and how can it be defined? We must try to answer this important question. Corporate finance cannot avoid coping with risky alternatives, and much of our book is devoted to developing methods for evaluating risky opportunities. QUESTIONS CONCEPT ? What are three basic questions of corporate finance? Describe capital structure. How is value created? List the three reasons why value creation is difficult. 1.2 CORPORATE SECURITIES AS CONTINGENT CLAIMS ON TOTAL FIRM VALUE What is the essential difference between debt and equity? The answer can be found by thinking about what happens to the payoffs to debt and equity when the value of the firm changes. The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount by a certain date. E XAMPLE The Officer Corporation promises to pay $100 to the Brigham Insurance Company at the end of one year. This is a debt of the Officer Corporation. Holders of the debt will receive $100 if the value of the Officer Corporation's assets is equal to or more than $100 at the end of the year. Formally, the debtholders have been promised an amount F at the end of the year. If the value of the firm, X, is equal to or greater than F at year-end, debtholders will get F. Of course, if the firm does not have enough to pay off the promised amount, the firm will be "broke." It may be forced to liquidate its assets for whatever they are worth, and the bondholders will receive X. Mathematically this means that the debtholders have a claim to X or F, whichever is smaller. Figure 1.5 illustrates the general nature of the payoff structure to debtholders. Suppose at year-end the Officer Corporation's value is equal to $100. The firm has promised to pay the Brigham Insurance Company $100, so the debtholders will get $100. Now suppose the Officer Corporation's value is $200 at year-end and the debtholders are promised $100. How much will the debtholders receive? It should be clear that they will receive the same amount as when the Officer Corporation was worth $100. Suppose the firm's value is $75 at year-end and debtholders are promised $100. How much will the debtholders receive? In this case the debtholders will get $75. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 17 10 Part I Overview I F I G U R E 1.5 Debt and Equity as Contingent Claims Payoff to debtholders Payoff to equity shareholders Payoffs to debtholders and equity shareholders Payoff to equity shareholders F Value of the firm (X ) F Value of the firm (X ) Payoff to debtholders F F Value of the firm (X ) F F F is the promised payoff to debtholders. X payoff is 0. F is the payoff to equity shareholders if X 0. Otherwise the The stockholders' claim on firm value at the end of the period is the amount that remains after the debtholders are paid. Of course, stockholders get nothing if the firm's value is equal to or less than the amount promised to the debtholders. E XAMPLE The Officer Corporation will sell its assets for $200 at year-end. The firm has promised to pay the Brigham Insurance Company $100 at that time. The stockholders will get the residual value of $100. Algebraically, the stockholders' claim is X F if X F and zero if X F. This is depicted in Figure 1.5. The sum of the debtholders' claim and the stockholders' claim is always the value of the firm at the end of the period. The debt and equity securities issued by a firm derive their value from the total value of the firm. In the words of finance theory, debt and equity securities are contingent claims on the total firm value. When the value of the firm exceeds the amount promised to the debtholders, the shareholders obtain the residual of the firm's value over the amount promised the debtholders, and the debtholders obtain the amount promised. When the value of the firm is less than the amount promised the debtholders, the shareholders receive nothing and the debtholders get the value of the firm. QUESTIONS CONCEPT ? What is a contingent claim? Describe equity and debt as contingent claims. 1.3 THE CORPORATE FIRM The firm is a way of organizing the economic activity of many individuals, and there are many reasons why so much economic activity is carried out by firms and not by individuals. The theory of firms, however, does not tell us much about why most large firms are corporations rather than any of the other legal forms that firms can assume. 18 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 Chapter 1 Introduction to Corporate Finance 11 A basic problem of the firm is how to raise cash. The corporate form of business, that is, organizing the firm as a corporation, is the standard method for solving problems encountered in raising large amounts of cash. However, businesses can take other forms. In this section we consider the three basic legal forms of organizing firms, and we see how firms go about the task of raising large amounts of money under each form. The Sole Proprietorship A sole proprietorship is a business owned by one person. Suppose you decide to start a business to produce mousetraps. Going into business is simple: You announce to all who will listen, "Today I am going to build a better mousetrap." Most large cities require that you obtain a business license. Afterward you can begin to hire as many people as you need and borrow whatever money you need. At year-end all the profits and the losses will be yours. Here are some factors that are important in considering a sole proprietorship: 1. The sole proprietorship is the cheapest business to form. No formal charter is required, and few government regulations must be satisfied for most industries. 2. A sole proprietorship pays no corporate income taxes. All profits of the business are taxed as individual income. 3. The sole proprietorship has unlimited liability for business debts and obligations. No distinction is made between personal and business assets. 4. The life of the sole proprietorship is limited by the life of the sole proprietor. 5. Because the only money invested in the firm is the proprietor's, the equity money that can be raised by the sole proprietor is limited to the proprietor's personal wealth. The Partnership Any two or more persons can get together and form a partnership. Partnerships fall into two categories: (1) general partnerships and (2) limited partnerships. In a general partnership all partners agree to provide some fraction of the work and cash and to share the profits and losses. Each partner is liable for the debts of the partnership. A partnership agreement specifies the nature of the arrangement. The partnership agreement may be an oral agreement or a formal document setting forth the understanding. Limited partnerships permit the liability of some of the partners to be limited to the amount of cash each has contributed to the partnership. Limited partnerships usually require that (1) at least one partner be a general partner and (2) the limited partners do not participate in managing the business. Here are some things that are important when considering a partnership: 1. Partnerships are usually inexpensive and easy to form. Written documents are required in complicated arrangements, including general and limited partnerships. Business licenses and filing fees may be necessary. 2. General partners have unlimited liability for all debts. The liability of limited partners is usually limited to the contribution each has made to the partnership. If one general partner is unable to meet his or her commitment, the shortfall must be made up by the other general partners. 3. The general partnership is terminated when a general partner dies or withdraws (but this is not so for a limited partner). It is difficult for a partnership to transfer ownership without dissolving. Usually, all general partners must agree. However, limited partners may sell their interest in a business. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 19 12 Part I Overview 4. It is difficult for a partnership to raise large amounts of cash. Equity contributions are usually limited to a partner's ability and desire to contribute to the partnership. Many companies, such as Apple Computer, start life as a proprietorship or partnership, but at some point they choose to convert to corporate form. 5. Income from a partnership is taxed as personal income to the partners. 6. Management control resides with the general partners. Usually a majority vote is required on important matters, such as the amount of profit to be retained in the business. It is very difficult for large business organizations to exist as sole proprietorships or partnerships. The main advantage is the cost of getting started. Afterward, the disadvantages, which may become severe, are (1) unlimited liability, (2) limited life of the enterprise, and (3) difficulty of transferring ownership. These three disadvantages lead to (4) the difficulty of raising cash. The Corporation Of the many forms of business enterprises, the corporation is by far the most important. It is a distinct legal entity. As such, a corporation can have a name and enjoy many of the legal powers of natural persons. For example, corporations can acquire and exchange property. Corporations can enter into contracts and may sue and be sued. For jurisdictional purposes, the corporation is a citizen of its state of incorporation. (It cannot vote, however.) Starting a corporation is more complicated than starting a proprietorship or partnership. The incorporators must prepare articles of incorporation and a set of bylaws. The articles of incorporation must include the following: Name of the corporation. Intended life of the corporation (it may be forever). Business purpose. Number of shares of stock that the corporation is authorized to issue, with a statement of limitations and rights of different classes of shares. 5. Nature of the rights granted to shareholders. 6. Number of members of the initial board of directors. The bylaws are the rules to be used by the corporation to regulate its own existence, and they concern its shareholders, directors, and officers. Bylaws range from the briefest possible statement of rules for the corporation's management to hundreds of pages of text. In its simplest form, the corporation comprises three sets of distinct interests: the shareholders (the owners), the directors, and the corporation officers (the top management). Traditionally, the shareholders control the corporation's direction, policies, and activities. The shareholders elect a board of directors, who in turn selects top management. Members of top management serve as corporate officers and manage the operation of the corporation in the best interest of the shareholders. In closely held corporations with few shareholders there may be a large overlap among the shareholders, the directors, and the top management. However, in larger corporations the shareholders, directors, and the top management are likely to be distinct groups. The potential separation of ownership from management gives the corporation several advantages over proprietorships and partnerships: 1. Because ownership in a corporation is represented by shares of stock, ownership can be readily transferred to new owners. Because the corporation exists independently of those who own its shares, there is no limit to the transferability of shares as there is in partnerships. 1. 2. 3. 4. 20 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 Chapter 1 Introduction to Corporate Finance 13 2. The corporation has unlimited life. Because the corporation is separate from its owners, the death or withdrawal of an owner does not affect its legal existence. The corporation can continue on after the original owners have withdrawn. 3. The shareholders' liability is limited to the amount invested in the ownership shares. For example, if a shareholder purchased $1,000 in shares of a corporation, the potential loss would be $1,000. In a partnership, a general partner with a $1,000 contribution could lose the $1,000 plus any other indebtedness of the partnership. Limited liability, ease of ownership transfer, and perpetual succession are the major advantages of the corporation form of business organization. These give the corporation an enhanced ability to raise cash. There is, however, one great disadvantage to incorporation. The federal government taxes corporate income. This tax is in addition to the personal income tax that shareholders pay on dividend income they receive. This is double taxation for shareholders when compared to taxation on proprietorships and partnerships. CASE STUDY: Making the Decision to Become a Corporation: The Case of PLM International, Inc.3 I n 1972, several entrepreneurs agreed to start a company they called PLM (Professional Lease Management, Inc.).Their idea was to sponsor, syndicate, and manage public and private limited partnerships with the purpose of acquiring and leasing transportation equipment.They created an operating subsidiary called FSI (Financial Services, Inc.) to be the general partner of each of the partnerships. PLM had limited success in its early years, but during the period 1981 to 1986 more than 27 public partnerships were formed. Each partnership was set up to acquire and lease transportation equipment, such as aircraft, tractors and trailers, cargo containers, and railcars, to transportation companies. Until the Tax Reform Act of 1986, PLM enjoyed considerable success with its partnerships. It became one of the largest equipment-leasing firms in the United States.The partnerships appealed to high-tax-bracket individuals because unlike corporations, partnerships are not taxed. The partnerships were set up to be self-liquidating (i.e., all excess cash flow was to be distributed to the partners), and no reinvestment could take place. No ready market for the partnership units existed, and each partnership invested in a narrow class of transportation equipment. PLM's success depended on creating tax-sheltered cash flow from accelerated depreciation and investment tax credits. However, the 1986 Tax Reform Act had a devastating impact on tax-sheltered limited partnerships. The act substantially flattened personal tax rates, eliminated the investment tax credit, shortened depreciation schedules, and established an alternative minimum tax rate.The act caused PLM to think about different types of equipment-leasing organizational forms.What was needed was an organization form that could take advantage of potential growth and diversification opportunities and that wasn't based entirely upon tax sheltering. In 1987 PLM, with the advice and assistance of the now-bankrupt Drexel Burnham Lambert investment banking firm, terminated its partnerships and converted consenting partnerships to a new umbrella corporation called PLM International.After much legal maneuvering, PLM International publicly announced that a majority of the partnerships had consented to the consolidation and incorporation. (A majority vote was needed for voluntary termination and some partnerships decided not to incorporate.) On February 2, 1988, PLM International's common stock began trading on the American Stock Exchange (AMEX) at about $8 per share. However, PLM International did not perform well, despite its conversion to a corporation. In April 2000, its stock was trading at only $5 per share. 3 The S4 Registration Statement, PLM International, Inc., filed with the Securities and Exchange Commission, Washington, D.C., August 1987, gives further details. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 21 14 Part I Overview A COMPARISON OF PARTNERSHIP AND CORPORATIONS Corporation Liquidity and marketability Shares can be exchanged without termination of the corporation. Common stock can be listed on stock exchange. Usually each share of common stock entitles the holder to one vote per share on matters requiring a vote and on the election of the directors. Directors determine top management. Corporations have double taxation: Corporate income is taxable, and dividends to shareholders are also taxable. Corporations have broad latitude on dividend payout decisions. Partnership Units are subject to substantial restrictions on transferability.There is usually no established trading market for partnership units. Some voting rights by limited partners. However, general partner has exclusive control and management of operations. Voting rights Taxation Partnerships are not taxable. Partners pay taxes on distributed shares of partnership. Partnerships are generally prohibited from reinvesting partnership cash flow.All net cash flow is distributed to partners. Limited partners are not liable for obligations of partnerships. General partners may have unlimited liability. Partnerships have limited life. Reinvestment and dividend payout Liability Shareholders are not personally liable for obligations of the corporation. Continuity of existence Corporations have perpetual life. The decision to become a corporation is complicated, and there are several pros and cons. PLM International cited several basic reasons to support the consolidation and incorporation of its transportation-equipmentleasing activities. Enhanced access to equity and debt capital for future growth. The possibility of reinvestment for future profit opportunities. Better liquidity for investors through common stock listing on AMEX. These are all good reasons for incorporating, and they provided potential benefits to the new shareholders of PLM International that may have outweighed the disadvantages of double taxation that came from incorporating. However, not all the PLM partnerships wanted to convert to the corporation. Sometimes it is not easy to determine whether a partnership or a corporation is the best organizational form. Corporate income is taxable at the personal and corporation levels. Because of this double taxation, firms having the most to gain from incorporation share the following characteristics: Low taxable income. Low marginal corporate tax rates. Low marginal personal tax rates among potential shareholders. In addition, firms with high rates of reinvestment relative to current income are good candidates for the corporate form because corporations can more easily retain profits for reinvestment than partnerships.Also, it is easier for corporations to sell shares of stock on public stock markets to finance possible investment opportunities. 22 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 Chapter 1 QUESTIONS CONCEPT Introduction to Corporate Finance 15 ? Define a proprietorship, a partnership, and a corporation. What are the advantages of the corporate form of business organization? 1.4 GOALS OF THE CORPORATE FIRM What is the primary goal of the corporation? The traditional answer is that managers in a corporation make decisions for the stockholders because the stockholders own and control the corporation. If so, the goal of the corporation is to add value for the stockholders. This goal is a little vague and so we will try to come up with a precise formulation. It is also impossible to give a definitive answer to this important question because the corporation is an artificial being, not a natural person. It exists in the "contemplation of the law."4 It is necessary to precisely identify who controls the corporation. We shall consider the set-of-contracts viewpoint. This viewpoint suggests the corporate firm will attempt to maximize the shareholders' wealth by taking actions that increase the current value per share of existing stock of the firm. Agency Costs and the Set-of-Contracts Perspective The set-of-contracts theory of the firm states that the firm can be viewed as a set of contracts.5 One of the contract claims is a residual claim (equity) on the firm's assets and cash flows. The equity contract can be defined as a principal-agent relationship. The members of the management team are the agents, and the equity investors (shareholders) are the principals. It is assumed that the managers and the shareholders, if left alone, will each attempt to act in his or her own self-interest. The shareholders, however, can discourage the managers from diverging from the shareholders' interests by devising appropriate incentives for managers and then monitoring their behavior. Doing so, unfortunately, is complicated and costly. The cost of resolving the conflicts of interest between managers and shareholders are special types of costs called agency costs. These costs are defined as the sum of (1) the monitoring costs of the shareholders and (2) the costs of implementing control devices. It can be expected that contracts will be devised that will provide the managers with appropriate incentives to maximize the shareholders' wealth. Thus, the set-of-contracts theory suggests that managers in the corporate firm will usually act in the best interest of shareholders. However, agency problems can never be perfectly solved and, as a consequence, shareholders may experience residual losses. Residual losses are the lost wealth of the shareholders due to divergent behavior of the managers. Managerial Goals Managerial goals may be different from those of shareholders. What goals will managers maximize if they are left to pursue their own rather than shareholders' goals? Williamson proposes the notion of expense preference.6 He argues that managers obtain value from certain kinds of expenses. In particular, company cars, office furniture, office location, and funds for discretionary investment have value to managers beyond that which comes from their productivity. 4 These are the words of Chief Justice John Marshall from The Trustees of Dartmouth College v. Woodward, 4, Wheaton 636 (1819). 5 M. C. Jensen and W. Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure," Journal of Financial Economics 3 (1976). 6 O. Williamson, "Managerial Discretion and Business Behavior," American Economic Review 53 (1963). Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 23 16 Part I Overview Donaldson conducted a series of interviews with the chief executives of several large companies.7 He concluded that managers are influenced by two basic motivations: 1. Survival. Organizational survival means that management will always try to command sufficient resources to avoid the firm's going out of business. 2. Independence and self-sufficiency. This is the freedom to make decisions without encountering external parties or depending on outside financial markets. The Donaldson interviews suggested that managers do not like to issue new shares of stock. Instead, they like to be able to rely on internally generated cash flow. These motivations lead to what Donaldson concludes is the basic financial objective of managers: the maximization of corporate wealth. Corporate wealth is that wealth over which management has effective control; it is closely associated with corporate growth and corporate size. Corporate wealth is not necessarily shareholder wealth. Corporate wealth tends to lead to increased growth by providing funds for growth and limiting the extent to which new equity is raised. Increased growth and size are not necessarily the same thing as increased shareholder wealth. Separation of Ownership and Control Some people argue that shareholders do not completely control the corporation. They argue that shareholder ownership is too diffuse and fragmented for effective control of management.8 A striking feature of the modern large corporation is the diffusion of ownership among thousands of investors. For example, Table 1.1 shows that 3,700,000 persons and institutions own shares of AT&T stock. One of the most important advantages of the corporate form of business organization is that it allows ownership of shares to be transferred. The resulting diffuse ownership, however, I TA B L E 1.1 Some of the World's Largest Industrial Corporations, 2000 Company Microsoft General Electric Intel IBM AT&T Merck Pfizer Toyota Coca Cola Market Value* (in $ billions) $525.7 434.0 400.1 188.8 173.2 138.7 134.6 119.2 112.5 Shares Outstanding (in millions) 5209 3714 3555 1875 3194 2968 4138 1875 3464 Number of Shareholders 92,130 534,000 203,000 616,000 3,700,000 269,600 105,000 100,000 366,000 Sources: Value Line, Business Week, and Standard & Poor's Security Owners Stock Guide. *Market price multiplied by shares outstanding. 7 G. Donaldson, Managing Corporate Wealth: The Operations of a Comprehensive Financial Goals System (New York: Praeger Publishers, 1984). Recent work by Gerald T. Garvey and Peter L. Swan, "The Economics of Corporate Governance: Beyond the Marshallian Firm," Journal of Corporate Finance 1 (1994), surveys literature on the stated assumption of shareholder maximization. 8 24 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 Chapter 1 Introduction to Corporate Finance 17 brings with it the separation of ownership and control of the large corporation. The possible separation of ownership and control raises an important question: Who controls the firm? Do Shareholders Control Managerial Behavior? The claim that managers can ignore the interests of shareholders is deduced from the fact that ownership in large corporations is widely dispersed. As a consequence, it is often claimed that individual shareholders cannot control management. There is some merit in this argument, but it is too simplistic. When a conflict of interest exists between management and shareholders, who wins? Does management or the shareholders control the firm? There is no doubt that ownership in large corporations is diffuse when compared to the closely held corporation. However, several control devices used by shareholders bond management to the self-interest of shareholders: 1. Shareholders determine the membership of the board of directors by voting. Thus, shareholders control the directors, who in turn select the management team. 2. Contracts with management and arrangements for compensation, such as stock option plans, can be made so that management has an incentive to pursue the goal of the shareholders. Another device is called performance shares. These are shares of stock given to managers on the basis of performance as measured by earnings per share and similar criteria. 3. If the price of a firm's stock drops too low because of poor management, the firm may be acquired by another group of shareholders, by another firm, or by an individual. This is called a takeover. In a takeover, the top management of the acquired firm may find themselves out of a job. This puts pressure on the management to make decisions in the stockholders' interests. Fear of a takeover gives managers an incentive to take actions that will maximize stock prices. 4. Competition in the managerial labor market may force managers to perform in the best interest of stockholders. Otherwise they will be replaced. Firms willing to pay the most will lure good managers. These are likely to be firms that compensate managers based on the value they create. The available evidence and theory are consistent with the ideas of shareholder control and shareholder value maximization. However, there can be no doubt that at times corporations pursue managerial goals at the expense of shareholders. There is also evidence that the diverse claims of customers, vendors, and employees must frequently be considered in the goals of the corporation. QUESTIONS CONCEPT ? What are the two types of agency costs? How are managers bonded to shareholders? Can you recall some managerial goals? What is the set-of-contracts perspective? 1.5 FINANCIAL MARKETS As indicated in Section 1.1, firms offer two basic types of securities to investors. Debt securities are contractual obligations to repay corporate borrowing. Equity securities are shares of common stock and preferred stock that represent noncontractual claims to the Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 25 18 Part I Overview residual cash flow of the firm. Issues of debt and stock that are publicly sold by the firm are then traded on the financial markets. The financial markets are composed of the money markets and the capital markets. Money markets are the markets for debt securities that will pay off in the short term (usually less than one year). Capital markets are the markets for long-term debt (with a maturity at over one year) and for equity shares. The term money market applies to a group of loosely connected markets. They are dealer markets. Dealers are firms that make continuous quotations of prices for which they stand ready to buy and sell money-market instruments for their own inventory and at their own risk. Thus, the dealer is a principal in most transactions. This is different from a stockbroker acting as an agent for a customer in buying or selling common stock on most stock exchanges; an agent does not actually acquire the securities. At the core of the money markets are the money-market banks (these are large banks in New York), more than 30 government securities dealers (some of which are the large banks), a dozen or so commercial-paper dealers, and a large number of money brokers. Money brokers specialize in finding short-term money for borrowers and placing money for lenders. The financial markets can be classified further as the primary market and the secondary markets. The Primary Market: New Issues The primary market is used when governments and corporations initially sell securities. Corporations engage in two types of primary-market sales of debt and equity: public offerings and private placements. Most publicly offered corporate debt and equity come to the market underwritten by a syndicate of investment banking firms. The underwriting syndicate buys the new securities from the firm for the syndicate's own account and resells them at a higher price. Publicly issued debt and equity must be registered with the Securities and Exchange Commission. Registration requires the corporation to disclose all of the material information in a registration statement. The legal, accounting, and other costs of preparing the registration statement are not negligible. In part to avoid these costs, privately placed debt and equity are sold on the basis of private negotiations to large financial institutions, such as insurance companies and mutual funds. Private placements are not registered with the Securities and Exchange Commission. Secondary Markets After debt and equity securities are originally sold, they are traded in the secondary markets. There are two kinds of secondary markets: the auction markets and the dealer markets. The equity securities of most large U.S. firms trade in organized auction markets, such as the New York Stock Exchange, the American Stock Exchange, and regional exchanges, such as the Midwest Stock Exchange. The New York Stock Exchange (NYSE) is the most important auction exchange. It usually accounts for more than 85 percent of all shares traded in U.S. auction exchanges. Bond trading on auction exchanges is inconsequential. Most debt securities are traded in dealer markets. The many bond dealers communicate with one another by telecommunications equipment--wires, computers, and telephones. Investors get in touch with dealers when they want to buy or sell, and can negotiate a deal. Some stocks are traded in the dealer markets. When they are, it is referred to as the over-the-counter (OTC) market. In February 1971, the National Association of Securities Dealers made available to dealers and brokers in the OTC market an automated quotation system called the National Association of Securities Dealers Automated Quotation (NASDAQ) system. The market value of shares of OTC stocks in the NASDAQ system at the end of 1998 was about 25 percent of the market value of the shares on the NYSE. 26 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 Chapter 1 Introduction to Corporate Finance 19 Exchange Trading of Listed Stocks Auction markets are different from dealer markets in two ways: First, trading in a given auction exchange takes place at a single site on the floor of the exchange. Second, transaction prices of shares traded on auction exchanges are communicated almost immediately to the public by computer and other devices. The NYSE is one of the preeminent securities exchanges in the world. All transactions in stocks listed on the NYSE occur at a particular place on the floor of the exchange called a post. At the heart of the market is the specialist. Specialists are members of the NYSE who make a market in designated stocks. Specialists have an obligation to offer to buy and sell shares of their assigned NYSE stocks. It is believed that this makes the market liquid because the specialist assumes the role of a buyer for investors if they wish to sell and a seller if they wish to buy. Listing Firms that want their equity shares to be traded on the NYSE must apply for listing. To be listed initially on the NYSE a company is expected to satisfy certain minimum requirements. Some of these for U.S. companies are as follows: 1. Demonstrated earning power of either $2.5 million before taxes for the most recent year and $2 million before taxes for each of the preceding two years, or an aggregate for the last three years of $6.5 million together with a minimum in the most recent year of $4.5 million (all years must be profitable). 2. Net tangible assets equal to at least $40 million. 3. A market value for publicly held shares of $40 million. 4. A total of a least 1.1 million publicly held shares. 5. A total of at least 2,000 holders of 100 shares of stock or more. The listing requirements for nonU.S. companies are somewhat more stringent. Table 1.2 gives the market value of NYSE-listed stocks and bonds. I TA B L E 1.2 Market Value of NYSE-Listed Securities End-ofYear NYSE-listed stocks* 1999 1998 1997 1996 NYSE-listed bonds 1999 1998 1997 1996 Number of Companies 3025 3114 3047 2907 416 474 533 563 Market Value ($ millions) 12,296,057 10,864,472 9,413,109 7,300,351 2,401,605 2,554,122 2,625,357 2,862,382 *Includes preferred stock and common stock. Includes government issues. Source: Data from the New York Stock Exchange Fact Book 1999, published by the New York Stock Exchange. In the case of bonds, in some instances we report the face value. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 27 20 QUESTIONS CONCEPT Part I Overview ? Distinguish between money markets and capital markets. What is listing? What is the difference between a primary market and a secondary market? 1.6 OUTLINE OF THE TEXT Now that we've taken the quick tour through all of corporate finance, we can take a closer look at this book. The book is divided into eight parts. The long-term investment decision is covered first. Financing decisions and working capital are covered next. Finally a series of special topics are covered. Here are the eight parts: Part I Part II Part III Part IV Part V Part VI Part VII Part VIII Overview Value and Capital Budgeting Risk Capital Structure and Dividend Policy Long-Term Financing Options, Futures, and Corporate Finance Financial Planning and Short-Term Finance Special Topics Part II describes how investment opportunities are valued in financial markets. This part contains basic theory. Because finance is a subject that builds understanding from the ground up, the material is very important. The most important concept in Part II is net present value. We develop the net present value rule into a tool for valuing investment alternatives. We discuss general formulas and apply them to a variety of different financial instruments. Part III introduces basic measures of risk. The capital-asset pricing model (CAPM) and the arbitrage pricing theory (APT) are used to devise methods for incorporating risk in valuation. As part of this discussion, we describe the famous beta coefficient. Finally, we use the above pricing models to handle capital budgeting under risk. Part IV examines two interrelated topics: capital structure and dividend policy. Capital structure is the extent to which the firm relies on debt. It cannot be separated from the amount of cash dividends the firm decides to pay out to its equity shareholders. Part V concerns long-term financing. We describe the securities that corporations issue to raise cash, as well as the mechanics of offering securities for a public sale. Here we discuss call provisions, warrants, convertibles, and leasing. Part VI discusses special contractual arrangements called Options. Part VII is devoted to financial planning and short-term finance. The first chapter describes financial planning. Next we focus on managing the firm's current assets and current liabilities. We describe aspects of the firm's short-term financial management. Separate chapters on cash management and on credit management are included. Part VIII covers two important special topics: mergers and international corporate finance. 28 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 1. Introduction to Corporate Finance The McGraw-Hill Companies, 2002 Chapter 1 Introduction to Corporate Finance 21 KEY TERMS Capital budgeting 4 Capital markets 18 Capital structure 4 Contingent claims 10 Corporation 12 Money markets 18 Net working capital 4 Partnership 11 Set-of-contracts viewpoint Sole proprietorship 11 15 SUGGESTED READINGS Evidence is provided on the tax factor in choosing to incorporate in: Mackie-Mason, J. K., and R. H. Gordon. "How Much Do Taxes Discourage Incorporation?" Journal of Finance (June 1997). Do American managers pay too little attention to shareholders? This is the question posed in: M. Miller. "Is American Corporate Governance Fatally Flawed?" Journal of Applied Corporate Finance (Winter 1994). What are the patterns of corporate ownership around the world? This is the question posed by: La Porta, R., F. Lopez-De-Silanes, and A. Shleiter. "Corporate Ownership Around the World." Journal of Finance 54 (1999). Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 29 2 CHAPTER Accounting Statements and Cash Flow EXECUTIVE SUMMARY C hapter 2 describes the basic accounting statements used for reporting corporate activity. The focus of the chapter is the practical details of cash flow. It will become obvious to you in the next several chapters that knowing how to determine cash flow helps the financial manager make better decisions. Students who have had accounting courses will not find the material new and can think of it as a review with an emphasis on finance. We will discuss cash flow further in later chapters. 2.1 THE BALANCE SHEET The balance sheet is an accountant's snapshot of the firm's accounting value on a particular date, as though the firm stood momentarily still. The balance sheet has two sides: on the left are the assets and on the right are the liabilities and stockholders' equity. The balance sheet states what the firm owns and how it is financed. The accounting definition that underlies the balance sheet and describes the balance is Assets Liabilities Stockholders' equity We have put a three-line equality in the balance equation to indicate that it must always hold, by definition. In fact, the stockholders' equity is defined to be the difference between the assets and the liabilities of the firm. In principle, equity is what the stockholders would have remaining after the firm discharged its obligations. Table 2.1 gives the 20X2 and 20X1 balance sheet for the fictitious U.S. Composite Corporation. The assets in the balance sheet are listed in order by the length of time it normally would take an ongoing firm to convert them to cash. The asset side depends on the nature of the business and how management chooses to conduct it. Management must make decisions about cash versus marketable securities, credit versus cash sales, whether to make or buy commodities, whether to lease or purchase items, the types of business in which to engage, and so on. The liabilities and the stockholders' equity are listed in the order in which they must be paid. The liabilities and stockholders' equity side reflects the types and proportions of financing, which depend on management's choice of capital structure, as between debt and equity and between current debt and long-term debt. When analyzing a balance sheet, the financial manager should be aware of three concerns: accounting liquidity, debt versus equity, and value versus cost. Accounting Liquidity Accounting liquidity refers to the ease and quickness with which assets can be converted to cash. Current assets are the most liquid and include cash and those assets that will be turned into cash within a year from the date of the balance sheet. Accounts receivable are 30 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 Chapter 2 Accounting Statements and Cash Flow 23 I TA B L E 2.1 The Balance Sheet of the U.S. Composite Corporation U.S. COMPOSITE CORPORATION Balance Sheet 20X2 and 20X1 (in $ millions) Assets Current assets: Cash and equivalents Accounts receivable Inventories Other Total current assets Fixed assets: Property, plant, and equipment Less accumulated depreciation Net property, plant, and equipment Intangible assets and others Total fixed assets 20X2 $ 140 294 269 58 ______ $ 761 20X1 $ 107 270 280 50 ______ $ 707 Liabilities (Debt) and Stockholders' Equity Current liabilities: Accounts payable Notes payable Accrued expenses Total current liabilities Long-term liabilities: Deferred taxes Long-term debt1 Total long-term liabilities Stockholders' equity: Preferred stock Common stock ($1 par value) Capital surplus Accumulated retained earnings Less treasury stock2 Total equity Total liabilities and stockholders' equity3 20X2 $ 213 50 223 ______ $ 486 20X1 $ 197 53 205 ______ $ 455 $1,423 $1,274 (550) ______ (460) ______ 873 814 245 221 ______ ______ $1,118 $1,035 ______ ______ $ 117 471 ______ $ 588 39 55 347 390 (26) ______ $ 805 ______ $1,879 ______ ______ $ $ 104 458 ______ $ 562 39 32 327 347 (20) ______ $ 725 ______ $1,742 ______ ______ $ Total assets $1,879 ______ ______ $1,742 ______ ______ Notes: 1 Long-term debt rose by $471 million$458 million $13 million. This is the difference between $86 million new debt and $73 million in retirement of old debt. 2 Treasury stock rose by $6 million. This reflects the repurchase of $6 million of U.S. Composite's company stock. 3 U.S. Composite reports $43 million in new equity. The company issued 23 million shares at a price of $1.87. The par value of common stock increased by $23 million, and capital surplus increased by $20 million. amounts not yet collected from customers for goods or services sold to them (after adjustment for potential bad debts). Inventory is composed of raw materials to be used in production, work in process, and finished goods. Fixed assets are the least liquid kind of assets. Tangible fixed assets include property, plant, and equipment. These assets do not convert to cash from normal business activity, and they are not usually used to pay expenses, such as payroll. Some fixed assets are not tangible. Intangible assets have no physical existence but can be very valuable. Examples of intangible assets are the value of a trademark or the value of a patent. The more liquid a firm's assets, the less likely the firm is to experience problems meeting short-term obligations. Thus, the probability that a firm will avoid financial distress can be linked to the firm's liquidity. Unfortunately, liquid assets frequently have lower rates of return than fixed assets; for example, cash generates no investment income. To the extent a firm invests in liquid assets, it sacrifices an opportunity to invest in more profitable investment vehicles. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 31 24 Part I Overview Debt versus Equity Liabilities are obligations of the firm that require a payout of cash within a stipulated time period. Many liabilities involve contractual obligations to repay a stated amount and interest over a period. Thus, liabilities are debts and are frequently associated with nominally fixed cash burdens, called debt service, that put the firm in default of a contract if they are not paid. Stockholders' equity is a claim against the firm's assets that is residual and not fixed. In general terms, when the firm borrows, it gives the bondholders first claim on the firm's cash flow.1 Bondholders can sue the firm if the firm defaults on its bond contracts. This may lead the firm to declare itself bankrupt. Stockholders' equity is the residual difference between assets and liabilities: Assets Liabilities Stockholders' equity This is the stockholders' share in the firm stated in accounting terms. The accounting value of stockholders' equity increases when retained earnings are added. This occurs when the firm retains part of its earnings instead of paying them out as dividends. Value versus Cost The accounting value of a firm's assets is frequently referred to as the carrying value or the book value of the assets.2 Under generally accepted accounting principles (GAAP), audited financial statements of firms in the United States carry the assets at cost.3 Thus the terms carrying value and book value are unfortunate. They specifically say "value," when in fact the accounting numbers are based on cost. This misleads many readers of financial statements to think that the firm's assets are recorded at true market values. Market value is the price at which willing buyers and sellers trade the assets. It would be only a coincidence if accounting value and market value were the same. In fact, management's job is to create a value for the firm that is higher than its cost. Many people use the balance sheet although the information each may wish to extract is not the same. A banker may look at a balance sheet for evidence of accounting liquidity and working capital. A supplier may also note the size of accounts payable and therefore the general promptness of payments. Many users of financial statements, including managers and investors, want to know the value of the firm, not its cost. This is not found on the balance sheet. In fact, many of the true resources of the firm do not appear on the balance sheet: good management, proprietary assets, favorable economic conditions, and so on. QUESTIONS CONCEPT ? What is the balance-sheet equation? What three things should be kept in mind when looking at a balance sheet? 1 Bondholders are investors in the firm's debt. They are creditors of the firm. In this discussion, the term bondholder means the same thing as creditor. 2 Confusion often arises because many financial accounting terms have the same meaning. This presents a problem with jargon for the reader of financial statements. For example, the following terms usually refer to the same thing: assets minus liabilities, net worth, stockholders' equity, owner's equity, and equity capitalization. 3 Formally, GAAP requires assets to be carried at the lower of cost or market value. In most instances cost is lower than market value. 32 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 Chapter 2 Accounting Statements and Cash Flow 25 2.2 THE INCOME STATEMENT The income statement measures performance over a specific period of time, say, a year. The accounting definition of income is Revenue Expenses Income If the balance sheet is like a snapshot, the income statement is like a video recording of what the people did between two snapshots. Table 2.2 gives the income statement for the U.S. Composite Corporation for 20X2. The income statement usually includes several sections. The operations section reports the firm's revenues and expenses from principal operations. One number of particular importance is earnings before interest and taxes (EBIT), which summarizes earnings before taxes and financing costs. Among other things, the nonoperating section of the income statement includes all financing costs, such as interest expense. Usually a second section I TA B L E 2.2 The Income Statement of the U.S. Composite Corporation U.S. COMPOSITE CORPORATION Income Statement 20X2 (in $ millions) Total operating revenues Cost of goods sold Selling, general, and administrative expenses Depreciation Operating income Other income Earnings before interest and taxes (EBIT) Interest expense Pretax income Taxes Current: $ Deferred: $ Net income Retained earnings: Dividends: $2,262 (1,655) (327) (90) ______ $ 190 29 ______ $ 219 (49) ______ $ 170 (84) 71 13 ______ $ 86 ______ ______ $ 43 $ 43 Notes: 1. There are 29 million shares outstanding. Earnings per share and dividends per share can be calculated as follows: Earnings per share Net income Total shares outstanding $86 29 $2.97 per share Dividends Total shares outstanding $43 29 $1.48 per share Dividends per share Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 33 26 Part I Overview reports as a separate item the amount of taxes levied on income. The last item on the income statement is the bottom line, or net income. Net income is frequently expressed per share of common stock, that is, earnings per share. When analyzing an income statement, the financial manager should keep in mind GAAP, noncash items, time, and costs. Generally Accepted Accounting Principles Revenue is recognized on an income statement when the earnings process is virtually completed and an exchange of goods or services has occurred. Therefore, the unrealized appreciation in owning property will not be recognized as income. This provides a device for smoothing income by selling appreciated property at convenient times. For example, if the firm owns a tree farm that has doubled in value, then, in a year when its earnings from other businesses are down, it can raise overall earnings by selling some trees. The matching principle of GAAP dictates that revenues be matched with expenses. Thus, income is reported when it is earned, or accrued, even though no cash flow has necessarily occurred (for example, when goods are sold for credit, sales and profits are reported). Noncash Items The economic value of assets is intimately connected to their future incremental cash flows. However, cash flow does not appear on an income statement. There are several noncash items that are expenses against revenues, but that do not affect cash flow. The most important of these is depreciation. Depreciation reflects the accountant's estimate of the cost of equipment used up in the production process. For example, suppose an asset with a fiveyear life and no resale value is purchased for $1,000. According to accountants, the $1,000 cost must be expensed over the useful life of the asset. If straight-line depreciation is used, there will be five equal installments and $200 of depreciation expense will be incurred each year. From a finance perspective, the cost of the asset is the actual negative cash flow incurred when the asset is acquired (that is, $1,000, not the accountant's smoothed $200-peryear depreciation expense). Another noncash expense is deferred taxes. Deferred taxes result from differences between accounting income and true taxable income.4 Notice that the accounting tax shown on the income statement for the U.S. Composite Corporation is $84 million. It can be broken down as current taxes and deferred taxes. The current tax portion is actually sent to the tax authorities (for example, the Internal Revenue Service). The deferred tax portion is not. However, the theory is that if taxable income is less than accounting income in the current year, it will be more than accounting income later on. Consequently, the taxes that are not paid today will have to be paid in the future, and they represent a liability of the firm. This shows up on the balance sheet as deferred tax liability. From the cash flow perspective, though, deferred tax is not a cash outflow. Time and Costs It is often useful to think of all of future time as having two distinct parts, the short run and the long run. The short run is that period of time in which certain equipment, resources, and commitments of the firm are fixed; but the time is long enough for the firm to vary its output by using more labor and raw materials. The short run is not a precise period of time that will be the same for all industries. However, all firms making decisions in the short run have 4 One situation in which taxable income may be lower than accounting income is when the firm uses accelerated depreciation expense procedures for the IRS but uses straight-line procedures allowed by GAAP for reporting purposes. 34 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 Chapter 2 Accounting Statements and Cash Flow 27 some fixed costs, that is, costs that will not change because of fixed commitments. In real business activity, examples of fixed costs are bond interest, overhead, and property taxes. Costs that are not fixed are variable. Variable costs change as the output of the firm changes; some examples are raw materials and wages for laborers on the production line. In the long run, all costs are variable.5 Financial accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs. Product costs are the total production costs incurred during a period--raw materials, direct labor, and manufacturing overhead--and are reported on the income statement as cost of goods sold. Both variable and fixed costs are included in product costs. Period costs are costs that are allocated to a time period; they are called selling, general, and administrative expenses. One period cost would be the company president's salary. QUESTIONS CONCEPT ? What is the income statement equation? What are three things to keep in mind when looking at an income statement? What are noncash expenses? 2.3 NET WORKING CAPITAL Net working capital is current assets minus current liabilities. Net working capital is positive when current assets are greater than current liabilities. This means the cash that will become available over the next 12 months will be greater than the cash that must be paid out. The net working capital of the U.S. Composite Corporation is $275 million in 20X2 and $252 million in 20X1: Current assets ($ millions) $761 707 Current liabilities ($ millions) $486 455 Net working capital ($ millions) $275 252 20X2 20X1 In addition to investing in fixed assets (i.e., capital spending), a firm can invest in net working capital. This is called the change in net working capital. The change in net working capital in 20X2 is the difference between the net working capital in 20X2 and 20X1; that is, $275 million $252 million $23 million. The change in net working capital is usually positive in a growing firm. QUESTIONS CONCEPT ? What is net working capital? What is the change in net working capital? 2.4 FINANCIAL CASH FLOW Perhaps the most important item that can be extracted from financial statements is the actual cash flow of the firm. There is an official accounting statement called the statement of cash flows. This statement helps to explain the change in accounting cash and equivalents, 5 When one famous economist was asked about the difference between the long run and the short run, he said, "In the long run we are all dead." Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 35 28 Part I Overview which for U.S. Composite is $33 million in 20X2. (See Appendix 2B.) Notice in Table 2.1 that Cash and equivalents increases from $107 million in 20X1 to $140 million in 20X2. However, we will look at cash flow from a different perspective, the perspective of finance. In finance the value of the firm is its ability to generate financial cash flow. (We will talk more about financial cash flow in Chapter 7.) The first point we should mention is that cash flow is not the same as net working capital. For example, increasing inventory requires using cash. Because both inventories and cash are current assets, this does not affect net working capital. In this case, an increase in a particular net working capital account, such as inventory, is associated with decreasing cash flow. Just as we established that the value of a firm's assets is always equal to the value of the liabilities and the value of the equity, the cash flows received from the firm's assets (that is, its operating activities), CF(A), must equal the cash flows to the firm's creditors, CF(B), and equity investors, CF(S): CF(A) CF(B) CF(S) The first step in determining cash flows of the firm is to figure out the cash flow from operations. As can be seen in Table 2.3, operating cash flow is the cash flow generated by business activities, including sales of goods and services. Operating cash flow reflects tax payments, but not financing, capital spending, or changes in net working capital. In $ Millions Earnings before interest and taxes Depreciation Current taxes Operating cash flow $219 90 ____ (71) $238 Another important component of cash flow involves changes in fixed assets. For example, when U.S. Composite sold its power systems subsidiary in 20X2 it generated $25 in cash flow. The net change in fixed assets equals sales of fixed assets minus the acquisition of fixed assets. The result is the cash flow used for capital spending: Acquisition of fixed assets Sales of fixed assets Capital spending $198 (25) ____ $173 ( $149 $24 increase ____ ____ in property, plant, and equipment increase in intangible assets) Cash flows are also used for making investments in net working capital. In the U.S. Composite Corporation in 20X2, additions to net working capital are Additions to net working capital $23 Total cash flows generated by the firm's assets are the sum of Operating cash flow Capital spending Additions to net working capital Total cash flow of the firm $238 (173) (23) ____ $42 ____ ____ 36 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 Chapter 2 Accounting Statements and Cash Flow 29 I TA B L E 2.3 Financial Cash Flow of the U.S. Composite Corporation U.S. COMPOSITE CORPORATION Financial Cash Flow 20X2 (in $ millions) Cash Flow of the Firm Operating cash flow (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total Cash Flow to Investors in the Firm Debt (Interest plus retirement of debt minus long-term debt financing) Equity (Dividends plus repurchase of equity minus new equity financing) Total $ 36 $238 (173) (23) ____ $ 42 ____ ____ 6 ____ $ 42 ____ ____ The total outgoing cash flow of the firm can be separated into cash flow paid to creditors and cash flow paid to stockholders. The cash flow paid to creditors represents a regrouping of the data in Table 2.3 and an explicit recording of interest expense. Creditors are paid an amount generally referred to as debt service. Debt service is interest payments plus repayments of principal (that is, retirement of debt). An important source of cash flow is from selling new debt. U.S. Composite's long-term debt increased by $13 million (the difference between $86 million in new debt and $73 million in retirement of old debt.6) Thus, an increase in long-term debt is the net effect of new borrowing and repayment of maturing obligations plus interest expense. Cash Flow Paid to Creditors (in $ millions) Interest Retirement of debt Debt service Proceeds from long-term debt sales Total $49 73 ____ 122 (86) ____ $36 ____ ____ 6 New debt and the retirement of old debt are usually found in the "notes" to the balance sheet. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 37 30 Part I Overview Cash flow of the firm also is paid to the stockholders. It is the net effect of paying dividends plus repurchasing outstanding shares of stock and issuing new shares of stock. Cash Flow to Stockholders (in $ millions) Dividends Repurchase of stock Cash to stockholders Proceeds from new stock issue Total $43 6 ____ 49 (43) ____ $ 6 ____ ____ Some important observations can be drawn from our discussion of cash flow: 1. Several types of cash flow are relevant to understanding the financial situation of the firm. Operating cash flow, defined as earnings before interest and depreciation minus taxes, measures the cash generated from operations not counting capital spending or working capital requirements. It should usually be positive; a firm is in trouble if operating cash flow is negative for a long time because the firm is not generating enough cash to pay operating costs. Total cash flow of the firm includes adjustments for capital spending and additions to net working capital. It will frequently be negative. When a firm is growing at a rapid rate, the spending on inventory and fixed assets can be higher than cash flow from sales.7 2. Net income is not cash flow. The net income of the U.S. Composite Corporation in 20X2 was $86 million, whereas cash flow was $42 million. The two numbers are not usually the same. In determining the economic and financial condition of a firm, cash flow is more revealing. QUESTIONS CONCEPT ? How is cash flow different from changes in net working capital? What is the difference between operating cash flow and total cash flow of the firm? 2.5 SUMMARY AND CONCLUSIONS Besides introducing you to corporate accounting, the purpose of this chapter has been to teach you how to determine cash flow from the accounting statements of a typical company. 1. Cash flow is generated by the firm and paid to creditors and shareholders. It can be classified as: a. Cash flow from operations. b. Cash flow from changes in fixed assets. c. Cash flow from changes in working capital. 7 Sometimes financial analysts refer to a firm's free cash flow. Free cash flow is the cash flow in excess of that required to fund profitable capital projects. We call free cash flow the total cash flow of the firm. 38 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 Chapter 2 Accounting Statements and Cash Flow 31 2. Calculations of cash flow are not difficult, but they require care and particular attention to detail in properly accounting for noncash expenses such as depreciation and deferred taxes. It is especially important that you do not confuse cash flow with changes in net working capital and net income. KEY TERMS Balance sheet 22 Cash flow 27 Change in net working capital 27 Free cash flow 30 Generally accepted accounting principles (GAAP) 24 Income statement 25 Noncash items 26 Operating cash flow 30 Total cash flow of the firm 30 SUGGESTED READING There are many excellent textbooks on accounting. The one that we have found helpful is: Kieso, D. E., and J. J. Weygandt. Intermediate Accounting, 7th ed. New York: John Wiley. 1992. QUESTIONS AND PROBLEMS The Balance Sheet 2.1 Prepare a December 31 balance sheet using the following data: Cash Patents Accounts payable Accounts receivable Taxes payable Machinery Bonds payable Accumulated retained earnings Capital surplus $ 4,000 82,000 6,000 8,000 2,000 34,000 7,000 6,000 19,000 The par value of the firm's common stock is $100. 2.2 The following table presents the long-term liabilities and stockholders' equity of Information Control Corp. of one year ago. Long-term debt Preferred stock Common stock Retained earnings $50,000,000 30,000,000 100,000,000 20,000,000 During the past year, Information Control issued $10 million of new common stock. The firm generated $5 million of net income and paid $3 million of dividends. Construct today's balance sheet reflecting the changes that occurred at Information Control Corp. during the year. The Income Statement 2.3 Prepare an income statement using the following data. Sales Cost of goods sold Administrative expenses Interest expense The firm's tax rate is 34 percent. $500,000 200,000 100,000 50,000 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 39 32 Part I Overview 2.4 The Flying Lion Corporation reported the following data on the income statement of one of its divisions. Flying Lion Corporation has other profitable divisions. 20X2 Net sales Cost of goods sold Operating expenses Depreciation Tax rate (%) $800,000 560,000 75,000 300,000 30 20X1 $500,000 320,000 56,000 200,000 30 a. Prepare an income statement for each year. b. Determine the operating cash flow during each year. Financial Cash Flow 2.5 What are the differences between accounting profit and cash flow? 2.6 During 1998, the Senbet Discount Tire Company had gross sales of $1 million. The firm's cost of goods sold and selling expenses were $300,000 and $200,000, respectively. These figures do not include depreciation. Senbet also had notes payable of $1 million. These notes carried an interest rate of 10 percent. Depreciation was $100,000. Senbet's tax rate in 1998 was 35 percent. a. What was Senbet's net operating income? b. What were the firm's earnings before taxes? c. What was Senbet's net income? d. What was Senbet's operating cash flow? 2.7 The Stancil Corporation provided the following current information. Proceeds from short-term borrowing Proceeds from long-term borrowing Proceeds from the sale of common stock Purchases of fixed assets Purchases of inventories Payment of dividends $ 6,000 20,000 1,000 1,000 4,000 22,000 Determine the cash flow for the Stancil Corporation. 2.8 Ritter Corporation's accountants prepared the following financial statements for year-end 20X2. RITTER CORPORATION Income Statement 20X2 Revenue Expenses Depreciation Net income Dividends Balance Sheets December 31 $400 250 50 ____ $100 $ 50 RITTER CORPORATION 20X2 Assets Current assets Net fixed assets Total assets Liabilities and Equity Current liabilities Long-term debt Stockholders' equity Total liabilities and equity $150 200 ____ $350 $ 75 75 200 ____ $350 20X1 $100 100 ____ $200 $ 50 0 150 ____ $200 40 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 Chapter 2 Accounting Statements and Cash Flow 33 a. Determine the change in net working capital in 20X2. b. Determine the cash flow during the year 20X2. Appendix 2A FINANCIAL STATEMENT ANALYSIS The objective of this appendix is to show how to rearrange information from financial statements into financial ratios that provide information about five areas of financial performance: 1. 2. 3. 4. 5. Short-term solvency--the ability of the firm to meet its short-run obligations. Activity--the ability of the firm to control its investment in assets. Financial leverage--the extent to which a firm relies on debt financing. Profitability--the extent to which a firm is profitable. Value--the value of the firm. Financial statements cannot provide the answers to the preceding five measures of performance. However, management must constantly evaluate how well the firm is doing, and financial statements provide useful information. The financial statements of the U.S. Composite Corporation, which appear in Tables 2.1, 2.2, and 2.3, provide the information for the examples that follow. (Monetary values are given in $ millions.) Short-Term Solvency Ratios of short-term solvency measure the ability of the firm to meet recurring financial obligations (that is, to pay its bills). To the extent a firm has sufficient cash flow, it will be able to avoid defaulting on its financial obligations and, thus, avoid experiencing financial distress. Accounting liquidity measures short-term solvency and is often associated with net working capital, the difference between current assets and current liabilities. Recall that current liabilities are debts that are due within one year from the date of the balance sheet. The basic source from which to pay these debts is current assets. The most widely used measures of accounting liquidity are the current ratio and the quick ratio. Current Ratio To find the current ratio, divide current assets by current liabilities. For the U.S. Composite Corporation, the figure for 20X2 is Current ratio Total current assets Total current liabilities 761 486 1.57 If a firm is having financial difficulty, it may not be able to pay its bills (accounts payable) on time or it may need to extend its bank credit (notes payable). As a consequence, current liabilities may rise faster than current assets and the current ratio may fall. This may be the first sign of financial trouble. Of course, a firm's current ratio should be calculated over several years for historical perspective, and it should be compared to the current ratios of other firms with similar operating activities. Quick Ratio The quick ratio is computed by subtracting inventories from current assets and dividing the difference (called quick assets) by current liabilities: Quick ratio Quick assets Total current liabilities 492 486 1.01 Quick assets are those current assets that are quickly convertible into cash. Inventories are the least liquid current assets. Many financial analysts believe it is important to determine a firm's ability to pay off current liabilities without relying on the sale of inventories. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 41 34 Part I Overview Activity Ratios of activity are constructed to measure how effectively the firm's assets are being managed. The level of a firm's investment in assets depends on many factors. For example, Toys 'R Us might have a large stock of toys at the peak of the Christmas season; yet that same inventory in January would be undesirable. How can the appropriate level of investment in assets be measured? One logical starting point is to compare assets with sales for the year to arrive at turnover. The idea is to find out how effectively assets are used to generate sales. Total Asset Turnover The total asset turnover ratio is determined by dividing total operating revenues for the accounting period by the average of total assets. The total asset turnover ratio for the U.S. Composite Corporation for 20X2 is Total asset turnover8 Average total assets Total operating revenues Total assets average 1,879 2 1,742 1,810.5 2,262 1,810.5 1.25 This ratio is intended to indicate how effectively a firm is using all of its assets. If the asset turnover ratio is high, the firm is presumably using its assets effectively in generating sales. If the ratio is low, the firm is not using its assets to their capacity and must either increase sales or dispose of some of the assets. One problem in interpreting this ratio is that it is maximized by using older assets because their accounting value is lower than newer assets. Also, firms with relatively small investments in fixed assets, such as retail and wholesale trade firms, tend to have high ratios of total asset turnover when compared with firms that require a large investment in fixed assets, such as manufacturing firms. Receivables Turnover The ratio of receivables turnover is calculated by dividing sales by average receivables during the accounting period. If the number of days in the year (365) is divided by the receivables turnover ratio, the average collection period can be determined. Net receivables are used for these calculations.9 The receivables turnover ratio and average collection period for the U.S. Composite Corporation are Receivables turnover Average receivables Average collection period Total operating revenues 2,262 8.02 Receivables average 282 294 270 282 2 365 Days in period 45.5 days Receivables turnover 8.02 The receivables turnover ratio and the average collection period provide some information on the success of the firm in managing its investment in accounts receivable. The actual value of these ratios reflects the firm's credit policy. If a firm has a liberal credit policy, the amount of its receivables will be higher than would otherwise be the case. One common rule of thumb that financial analysts use is that the average collection period of a firm should not exceed the time allowed for payment in the credit terms by more than 10 days. 8 Notice that we use an average of total assets in our calculation of total asset turnover. Many financial analysts use the end of period total asset amount for simplicity. 9 Net receivables are determined after an allowance for potential bad debts. 42 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 Chapter 2 Accounting Statements and Cash Flow 35 Inventory Turnover The ratio of inventory turnover is calculated by dividing the cost of goods sold by average inventory. Because inventory is always stated in terms of historical cost, it must be divided by cost of goods sold instead of sales (sales include a margin for profit and are not commensurate with inventory). The number of days in the year divided by the ratio of inventory turnover yields the ratio of days in inventory. The ratio of days in inventory is the number of days it takes to get goods produced and sold; it is called shelf life for retail and wholesale trade firms. The inventory ratios for the U.S. Composite Corporation are Inventory turnover Average inventory Days in inventory Cost of goods sold 1,655 6.03 Inventory average 274.5 269 280 274.5 2 Days in period 365 60.5 days Inventory turnover 6.03 The inventory ratios measure how quickly inventory is produced and sold. They are significantly affected by the production technology of goods being manufactured. It takes longer to produce a gas turbine engine than a loaf of bread. The ratios also are affected by the perishability of the finished goods. A large increase in the ratio of days in inventory could suggest an ominously high inventory of unsold finished goods or a change in the firm's product mix to goods with longer production periods. The method of inventory valuation can materially affect the computed inventory ratios. Thus, financial analysts should be aware of the different inventory valuation methods and how they might affect the ratios. Financial Leverage Financial leverage is related to the extent to which a firm relies on debt financing rather than equity. Measures of financial leverage are tools in determining the probability that the firm will default on its debt contracts. The more debt a firm has, the more likely it is that the firm will become unable to fulfill its contractual obligations. In other words, too much debt can lead to a higher probability of insolvency and financial distress. On the positive side, debt is an important form of financing, and provides a significant tax advantage because interest payments are tax deductible. If a firm uses debt, creditors and equity investors may have conflicts of interest. Creditors may want the firm to invest in less risky ventures than those the equity investors prefer. Debt Ratio The debt ratio is calculated by dividing total debt by total assets. We can also use several other ways to express the extent to which a firm uses debt, such as the debt-toequity ratio and the equity multiplier (that is, total assets divided by equity). The debt ratios for the U.S. Composite Corporation for 20X2 are Debt ratio Debt-to-equity ratio Equity multiplier Total debt Total assets Total debt Total equity Total assets Total equity 1,074 1,879 1,074 805 1,879 805 0.57 1.33 2.33 Debt ratios provide information about protection of creditors from insolvency and the ability of firms to obtain additional financing for potentially attractive investment opportunities. However, debt is carried on the balance sheet simply as the unpaid balance. Consequently, Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 43 36 Part I Overview no adjustment is made for the current level of interest rates (which may be higher or lower than when the debt was originally issued) or risk. Thus, the accounting value of debt may differ substantially from its market value. Some forms of debt may not appear on the balance sheet at all, such as pension liabilities or lease obligations. Interest Coverage The ratio of interest coverage is calculated by dividing earnings (before interest and taxes) by interest. This ratio emphasizes the ability of the firm to generate enough income to cover interest expense. This ratio for the U.S. Composite Corporation is Interest coverage Earnings before interest and taxes Interest expense 219 49 4.5 Interest expense is an obstacle that a firm must surmount if it is to avoid default. The ratio of interest coverage is directly connected to the ability of the firm to pay interest. However, it would probably make sense to add depreciation to income in computing this ratio and to include other financing expenses, such as payments of principal and lease payments. A large debt burden is a problem only if the firm's cash flow is insufficient to make the required debt service payments. This is related to the uncertainty of future cash flows. Firms with predictable cash flows are frequently said to have more debt capacity than firms with high, uncertain cash flows. Therefore, it makes sense to compute the variability of the firm's cash flows. One possible way to do this is to calculate the standard deviation of cash flows relative to the average cash flow. Profitability One of the most difficult attributes of a firm to conceptualize and to measure is profitability. In a general sense, accounting profits are the difference between revenues and costs. Unfortunately, there is no completely unambiguous way to know when a firm is profitable. At best, a financial analyst can measure current or past accounting profitability. Many business opportunities, however, involve sacrificing current profits for future profits. For example, all new products require large start-up costs and, as a consequence, produce low initial profits. Thus, current profits can be a poor reflection of true future profitability. Another problem with accounting-based measures of profitability is that they ignore risk. It would be false to conclude that two firms with identical current profits were equally profitable if the risk of one was greater than the other. The most important conceptual problem with accounting measures of profitability is they do not give us a benchmark for making comparisons. In general, a firm is profitable in the economic sense only if its profitability is greater than investors can achieve on their own in the capital markets. Profit Margin Profit margins are computed by dividing profits by total operating revenue and thus they express profits as a percentage of total operating revenue. The most important margin is the net profit margin. The net profit margin for the U.S. Composite Corporation is Net profit margin Gross profit margin Net income 86 Total operating revenue 2,262 Earnings before interest and taxes Total operating revenues 0.038 3.8% 219 2,262 0.097 9.7% In general, profit margins reflect the firm's ability to produce a product or service at a low cost or a high price. Profit margins are not direct measures of profitability because they are based on total operating revenue, not on the investment made in assets by the firm or the equity investors. Trade firms tend to have low margins and service firms tend to have high margins. 44 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 Chapter 2 Accounting Statements and Cash Flow 37 Return on Assets One common measure of managerial performance is the ratio of income to average total assets, both before tax and after tax. These ratios for the U.S. Composite Corporation for 20X2 are Net return on assets Gross return on assets 86 Net income 0.0475 4.75% Average total assets 1,810.5 Earnings before interest and taxes 219 0.121 12.1% Average total assets 1,810.5 One of the most interesting aspects of return on assets (ROA) is how some financial ratios can be linked together to compute ROA. One implication of this is usually referred to as the DuPont system of financial control. This system highlights the fact that ROA can be expressed in terms of the profit margin and asset turnover. The basic components of the system are as follows: ROA ROA (net) 0.0475 ROA (gross) 0.121 Profit margin Net income Total operating revenue 0.038 Earnings before interest and taxes Total operating revenue 0.097 Asset turnover Total operating revenue Average total assets 1.25 Total operating revenue Average total assets 1.25 Firms can increase ROA by increasing profit margins or asset turnover. Of course, competition limits their ability to do so simultaneously. Thus, firms tend to face a trade-off between turnover and margin. In retail trade, for example, mail-order outfits such as L. L. Bean have low margins and high turnover, whereas high-quality jewelry stores such as Tiffany's have high margins and low turnover. It is often useful to describe financial strategies in terms of margins and turnover. Suppose a firm selling pneumatic equipment is thinking about providing customers with more liberal credit terms. This will probably decrease asset turnover (because receivables would increase more than sales). Thus, the margins will have to go up to keep ROA from falling. Return on Equity This ratio (ROE) is defined as net income (after interest and taxes) divided by average common stockholders' equity, which for the U.S. Composite Corporation is ROE Net income Average stockholders' equity Average stockholders' equity 86 0.112 11.27% 765 805 725 765 2 The most important difference between ROA and ROE is due to financial leverage. To see this, consider the following breakdown of ROE: ROE Profit margin Net income Total operating revenue 0.112 0.038 Asset turnover Total operating revenue Average total assets 1.25 Equity multiplier Average total assets Average stockholders' equity 2.36 From the preceding numbers, it would appear that financial leverage always magnifies ROE. Actually, this occurs only when ROA (gross) is greater than the interest rate on debt. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 45 38 Part I Overview Payout Ratio The payout ratio is the proportion of net income paid out in cash dividends. For the U.S. Composite Corporation Payout ratio Cash dividends Net income 43 86 0.5 The retention ratio for the U.S. Composite Corporation is Retention ratio Retained earnings Retained earnings 43 Net income 86 Net income Dividends 0.5 The Sustainable Growth Rate One ratio that is very helpful in financial analysis is called the sustainable growth rate. It is the maximum rate of growth a firm can maintain without increasing its financial leverage and using internal equity only. The precise value of sustainable growth can be calculated as Sustainable growth rate ROE Retention ratio For the U.S. Composite Company, ROE is 11.2 percent. The retention ratio is 1/2, so we can calculate the sustainable growth rate as Sustainable growth rate 11.2 (1/2) 5.6% The U.S. Composite Corporation can expand at a maximum rate of 5.6 percent per year with no external equity financing or without increasing financial leverage. (We discuss sustainable growth in Chapters 5 and 26.) Market Value Ratios We can learn many things from a close examination of balance sheets and income statements. However, one very important characteristic of a firm that cannot be found on an accounting statement is its market value. Market Price The market price of a share of common stock is the price that buyers and sellers establish when they trade the stock. The market value of the common equity of a firm is the market price of a share of common stock multiplied by the number of shares outstanding. Sometimes the words "fair market value" are used to describe market prices. Fair market value is the amount at which common stock would change hands between a willing buyer and a willing seller, both having knowledge of the relevant facts. Thus, market prices give guesses about the true worth of the assets of a firm. In an efficient stock market, market prices reflect all relevant facts about firms, and thus market prices reveal the true value of the firm's underlying assets. The market value of IBM is many times greater than that of Apple Computer. This may suggest nothing more than the fact that IBM is a bigger firm than Apple (hardly a surprising revelation). Financial analysts construct ratios to extract information that is independent of a firm's size. Price-to-Earnings (P/E) Ratio One way to calculate the P/E ratio is to divide the current market price by the earnings per share of common stock for the latest year. The P/E ratios of some of the largest firms in the United States and Japan are as follows: 46 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 Chapter 2 Accounting Statements and Cash Flow P/E Ratios 2000 39 United States AT&T General Motors Hewlett Packard 24 8 43 Japan Nippon Telegraph & Telephone Toyota Motor Sony 53 44 72 As can be seen, some firms have high P/E ratios (Sony, for example) and some firms have low ones (General Motors). Dividend Yield The dividend yield is calculated by annualizing the last observed dividend payment of a firm and dividing by the current market price: Dividend yield Dividend per share Market price per share The dividend yields for several large firms in the United States and Japan are: Dividend Yield (%) 2000 United States AT&T General Motors Hewlett Packard 0.9 2.0 0.6 Japan Nippon Telegraph & Telephone Toyota Motor Sony 0.4 0.5 0.3 Dividend yields are related to the market's perception of future growth prospects for firms. Firms with high growth prospects will generally have lower dividend yields. Market-to-Book (M/B) Value and the Q ratio The market-to-book value ratio is calculated by dividing the market price per share by the book value per share. The market-to-book ratios of several of the largest firms in the United States and Japan are: Market-to-Book Ratios 2000 United States AT&T General Motors Hewlett Packard 1 2.4 8 Japan Nippon Telegraph & Telephone Toyota Motor Sony 3.4 2.8 3.5 There is another ratio, called Tobin's Q, that is very much like the M/B ratio.10 Tobin's Q ratio divides the market value of all of the firm's debt plus equity by the replacement value of the firm's assets. The Q ratios for several firms are: Q Ratio11 High Qs Low Qs Coca-Cola IBM National Steel U.S. Steel 4.2 4.2 0.53 0.61 10 Kee H. Chung and Stephen W. Pruitt, "A Simple Approximation of Tobin's Q," Financial Management Vol 23, No. 3 (Autumn 1994). 11 E. B. Lindberg and S. Ross, "Tobin's Q and Industrial Organization," Journal of Business 54 (January 1981). Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 47 40 Part I Overview The Q ratio differs from the M/B ratio in that the Q ratio uses market value of the debt plus equity. It also uses the replacement value of all assets and not the historical cost value. It should be obvious that if a firm has a Q ratio above 1 it has an incentive to invest that is probably greater than a firm with a Q ratio below 1. Firms with high Q ratios tend to be those firms with attractive investment opportunities or a significant competitive advantage. SUMMARY AND CONCLUSIONS Much research indicates that accounting statements provide important information about the value of the firm. Financial analysts and managers learn how to rearrange financial statements to squeeze out the maximum amount of information. In particular, analysts and managers use financial ratios to summarize the firm's liquidity, activity, financial leverage, and profitability. When possible, they also use market values. This appendix describes the most popular financial ratios. You should keep in mind the following points when trying to interpret financial statements: 1. Measures of profitability such as return on equity suffer from several potential deficiencies as indicators of performance. They do not take into account the risk or timing of cash flows. 2. Financial ratios are linked to one another. For example, return on equity is determined from the profit margins, the asset turnover ratio, and the financial leverage. Appendix 2B STATEMENT OF CASH FLOWS There is an official accounting statement called the statement of cash flows. This statement helps explain the change in accounting cash, which for U.S. Composite is $33 million in 20X2. It is very useful in understanding financial cash flow. Notice in Table 2.1 that cash increases from $107 million in 20X1 to $140 million in 20X2. The first step in determining the change in cash is to figure out cash flow from operating activities. This is the cash flow that results from the firm's normal activities producing and selling goods and services. The second step is to make an adjustment for cash flow from investing activities. The final step is to make an adjustment for cash flow from financing activities. Financing activities are the net payments to creditors and owners (excluding interest expense) made during the year. The three components of the statement of cash flows are determined below. Cash Flow from Operating Activities To calculate cash flow from operating activities we start with net income. Net income can be found on the income statement and is equal to 86. We now need to add back noncash expenses and adjust for changes in current assets and liabilities (other than cash). The result is cash flow from operating activities. 48 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 Chapter 2 Accounting Statements and Cash Flow U.S. COMPOSITE CORPORATION Cash Flow from Operating Activities 20X2 (in $ millions) 41 Net income Depreciation Deferred taxes Change in assets and liabilities Accounts receivable Inventories Accounts payable Accrued expense Notes payable Other Cash flow from operating activities 86 90 13 (24) 11 16 18 (3) (8) ___ 199 ___ ___ Cash Flow from Investing Activities Cash flow from investing activities involves changes in capital assets: acquisition of fixed assets and sales of fixed assets (i.e., net capital expenditures). The result for U.S. Composite is below. U.S. COMPOSITE CORPORATION Cash Flow from Investing Activities 20X2 (in $ millions) Acquisition of fixed assets Sales of fixed assets Cash flow from investing activities (198) 25 ____ (173) ____ ____ Cash Flow from Financing Activities Cash flows to and from creditors and owners include changes in equity and debt. U.S. COMPOSITE CORPORATION Cash Flow from Financing Activities 20X2 (in $ millions) Retirement of debt (includes notes) Proceeds from long-term debt sales Dividends Repurchase of stock Proceeds from new stock issue Cash flow from financing activities $(73) 86 (43) (6) 43 ____ $ 7 ____ ____ The statement of cash flows is the addition of cash flows from operations, cash flows from investing activities, and cash flows from financing activities, and is produced in Table 2.4. There is a close relationship between the official accounting statement called the statement of cash flows and the total cash flow of the firm used in finance. The difference between cash flow from financing activities and total cash flow of the firm (see Table 2.3) is interest expense. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 49 42 Part I Overview I TA B L E 2A.4 Statement of Consolidated Cash Flows of the U.S. Composite Corporation U.S. COMPOSITE CORPORATION Statement of Cash Flows 20X2 (in $ millions) Operations Net income Depreciation Deferred taxes Changes in assets and liabilities Accounts receivable Inventories Accounts payable Accrued expenses Notes payable Other Total cash flow from operations Investing activities Acquisition of fixed assets Sales of fixed assets Total cash flow from investing activities Financing activities Retirement of debt (including notes) Proceeds of long-term debt Dividends Repurchase of stock Proceeds from new stock issues Total cash flow from financing activities Change in cash (on the balance sheet) $ 86 90 13 (24) 11 16 18 (3) (8) _____ $ 199 _____ _____ $(198) 25 _____ $(173) _____ _____ $ (73) 86 (43) (6) 43 _____ $ 7 _____ _____ $ 33 _____ _____ Appendix 2C U.S. FEDERAL TAX RATES As of the printing date of this text, the following United States federal tax rules apply. 1. The top marginal rate for corporations is 39 percent (see Table 2.5). The highest marginal rate for individuals is 39.6 percent (see Table 2.6). 2. Short-term realized capital gains and ordinary income are taxed at the corporation's or individual's marginal rate. 3. For individuals, long-term capital gains (in excess of long-term and short-term capital losses) are taxed at a preferential rate. Generally, the top rate for long-term capital gains is 20 percent for capital assets held more than 18 months and 28 percent for capital assets held between one year and 18 months. For taxpayers in the 15 percent bracket, the rate is 15 percent for capital assets held between 12 and 18 months and 10 percent for assets held longer than 18 months. 50 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition I. Overview 2. Accounting Statements and Cash Flow The McGraw-Hill Companies, 2002 Chapter 2 Accounting Statements and Cash Flow 43 I TA B L E 2A.5 Corporation Income Tax Rates for 2000 Corporations Taxable Income Over 0 50,000 75,000 100,000 335,000 10,000,000 15,000,000 18,333,333 $ Not Over $ 50,000 75,000 100,000 335,000 10,000,000 15,000,000 18,333,333 -- Tax Rate 15% 25 34 39 34 35 38 35 I TA B L E 2A.6 Tax Rates for Married Individuals Filing Jointly and Surviving Spouses--2000 Taxable Income But Not Over $ 41,200 99,600 151,750 271,050 -- $ Percent on Excess 15% 28 31 36 39.6 Of the Amount Over $ 0 41,200 99,600 151,750 271,050 Over $ 0 41,200 99,600 151,750 271,050 Pay 0 6,180.00 22,532.00 38,698.50 81,646.50 4. Dividends received by a U.S. corporation are 100 percent exempt from taxation if the dividend-paying corporation is fully owned by the other corporation. The exemption is 80 percent if the receiving corporation owns between 20 and 80 percent of the paying corporation. In all other cases, the exemption is 70 percent. Alternative Minimum Tax (AMT) Corporations and individuals must pay either their regularly calculated tax or an alternative minimum tax, whichever is higher. The alternative minimum tax is calculated with lower rates (either 26 or 28 percent for individuals or 20 percent for corporations) applied to a broader base of income. The broader base is determined by taking taxable income and adding back certain tax preference items, e.g., accelerated depreciation, which reduce regular taxable income. A corporation which had average gross receipts of less than $5 million for calendar years 1998 through 2000 is exempt from the alternative minimum tax as long as average gross receipts do not exceed $7.5 million. Tax Operating Loss Carrybacks and Carryforwards The federal tax law permits corporations to carry back net operating losses two years and to carry forward net operating losses for 20 years. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting Introduction The McGraw-Hill Companies, 2002 51 PART II Value and Capital Budgeting 3 4 5 6 7 8 Financial Markets and Net Present Value: First Principles of Finance (Advanced) 46 Net Present Value 66 How to Value Bonds and Stocks 102 Some Alternative Investment Rules 140 Net Present Value and Capital Budgeting 169 Strategy and Analysis in Using Net Present Value 200 F and individuals invest in a large variety of assets. Some are real assets such as machinery and land, and some are financial assets such as stocks and bonds. The object of an investment is to maximize the value of the investment. In the simplest terms, this means to find assets that have more value to the firm than they cost. To do this we need a theory of value. We develop a theory of value in Part II. Finance is the study of markets and instruments that deal with cash flows over time. In Chapter 3 we describe how financial markets allow us to determine the value of financial instruments. We study some stylized examples of money over time and show why financial markets and financial instruments are created. We introduce the basic principles of rational decision making. We apply these principles to a two-period investment. Here we introduce one of the most important ideas in finance: net present value (NPV). We show why net present value is useful and the conditions that make it applicable. In Chapter 4 we extend the concept of net present value to more than one time period. The mathematics of compounding and discounting are presented. In Chapter 5 we apply net present value to bonds and stocks. This is a very important chapter because net present value can be used to determine the value of a wide variety of financial instruments. Although we have made a strong case for using the NPV rule in Chapters 3 and 4, Chapter 6 presents four other rules: the payback rule, the accounting-rate-of-return rule, the internal rate of return (IRR), and the profitability index. Each of these alternatives has some redeeming features, but these qualities aren't sufficient to let any of the alternatives replace the NPV rule. In Chapter 7 we analyze how to estimate the cash flows required for capital budgeting. We start the chapter with a discussion of the concept of incremental cash flows-- the difference between the cash flows for the firm with and without the project. Chapter 8 focuses on assessing the reliability and reasonableness of estimates of NPV. The chapter introduces techniques for dealing with uncertain incremental cash flows in capital budgeting, including break-even analysis, decision trees, and sensitivity analysis. IRMS 52 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 3 CHAPTER Financial Markets and Net Present Value: First Principles of Finance (Advanced) EXECUTIVE SUMMARY F inance refers to the process by which special markets deal with cash flows over time. These markets are called financial markets. Making investment and financing decisions requires an understanding of the basic economic principles of financial markets. This introductory chapter describes a financial market as one that makes it possible for individuals and corporations to borrow and lend. As a consequence, financial markets can be used by individuals to adjust their patterns of consumption over time and by corporations to adjust their patterns of investment spending over time. The main point of this chapter is that individuals and corporations can use the financial markets to help them make investment decisions. We introduce one of the most important ideas in finance: net present value. 3.1 THE FINANCIAL MARKET ECONOMY Financial markets develop to facilitate borrowing and lending between individuals. Here we talk about how this happens. Suppose we describe the economic circumstances of two people, Tom and Leslie. Both Tom and Leslie have current income of $100,000. Tom is a very patient person, and some people call him a miser. He wants to consume only $50,000 of current income and save the rest. Leslie is a very impatient person, and some people call her extravagant. She wants to consume $150,000 this year. Tom and Leslie have different intertemporal consumption preferences. Such preferences are personal matters and have more to do with psychology than with finance. However, it seems that Tom and Leslie could strike a deal: Tom could give up some of his income this year in exchange for future income that Leslie can promise to give him. Tom can lend $50,000 to Leslie, and Leslie can borrow $50,000 from Tom. Suppose that they do strike this deal, with Tom giving up $50,000 this year in exchange for $55,000 next year. This is illustrated in Figure 3.1 with the basic cash flow time chart, a representation of the timing and amount of the cash flows. The cash flows that are received are represented by an arrow pointing up from the point on the time line at which the cash flow occurs. The cash flows paid out are represented by an arrow pointing down. In other words, for each dollar Tom trades away or lends, he gets a commitment to get it back as well as to receive 10 percent more. In the language of finance, 10 percent is the annual rate of interest on the loan. When a dollar is lent out, the repayment of $1.10 can be thought of as being made up of two parts. First, the lender gets the dollar back; that is the principal repayment. Second, the lender receives an interest payment, which is $0.10 in this example. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 53 Chapter 3 Financial Markets and Net Present Value: First Principles of Finance (Advanced) 47 I F I G U R E 3.1 Tom's and Leslie's Cash Flow Tom's cash flows Cash inflows Time Cash outflows 0 $55,000 1 $50,000 Leslie's cash flows Cash inflows Time Cash outflows $50,000 0 1 $55,000 Now, not only have Tom and Leslie struck a deal, but as a by-product of their bargain they have created a financial instrument, the IOU. This piece of paper entitles whoever receives it to present it to Leslie in the next year and redeem it for $55,000. Financial instruments that entitle whoever possesses them to receive payment are called bearer instruments because whoever bears them can use them. Presumably there could be more such IOUs in the economy written by many different lenders and borrowers like Tom and Leslie. The Anonymous Market If the borrower does not care whom he has to pay back, and if the lender does not care whose IOUs he is holding, we could just as well drop Tom's and Leslie's names from their contract. All we need is a record book, in which we could record the fact that Tom has lent $50,000 and Leslie has borrowed $50,000 and that the terms of the loan, the interest rate, are 10 percent. Perhaps another person could keep the records for borrowers and lenders, for a fee, of course. In fact, and this is one of the virtues of such an arrangement, Tom and Leslie wouldn't even need to meet. Instead of needing to find and trade with each other, they could each trade with the record keeper. The record keeper could deal with thousands of such borrowers and lenders, none of whom would need to meet the other. Institutions that perform this sort of market function, matching borrowers and lenders or traders, are called financial intermediaries. Stockbrokers and banks are examples of financial intermediaries in our modern world. A bank's depositors lend the bank money, and the bank makes loans from the funds it has on deposit. In essence, the bank is an intermediary between the depositors and the ultimate borrowers. To make the market work, we must be certain that the market clears. By market clearing we mean that the total amount that people like Tom wish to lend to the market should equal the total amount that people like Leslie wish to borrow. Market Clearing If the lenders wish to lend more than the borrowers want to borrow, then presumably the interest rate is too high. Because there would not be enough borrowing for all of the lenders at, say, 15 percent, there are really only two ways that the market could be made to clear. One is to ration the lenders. For example, if the lenders wish to lend $20 million when interest 54 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 48 Part II Value and Capital Budgeting rates are at 15 percent and the borrowers wish to borrow only $8 million, the market could take, say, 8/20 of each dollar, or $0.40, from each of the lenders and distribute it to the borrowers. This is one possible scheme for making the market clear, but it is not one that would be sustainable in a free and competitive marketplace. Why not? To answer this important question, let's go back to our lender, Tom. Tom sees that interest rates are 15 percent and, not surprisingly, rather than simply lending the $50,000 that he was willing to lend when rates were 10 percent, Tom decides that at the higher rates he would like to lend more, say $80,000. But since the lenders want to lend more money than the borrowers want to borrow, the record keepers tell Tom that they won't be able to take all of his $80,000; rather, they will take only 40 percent of it, or $32,000. With the interest rate at 15 percent, people are not willing to borrow enough to match up with all of the loans that are available at that rate. Tom is not very pleased with that state of affairs, but he can do something to improve his situation. Suppose that he knows that Leslie is borrowing $20,000 in the market at the 15 percent interest rate. That means that Leslie must repay $20,000 on her loan next year plus the interest of 15 percent of $20,000 or 0.15 $20,000 $3,000. Suppose that Tom goes to Leslie and offers to lend her the $20,000 for 14 percent. Leslie is happy because she will save 1 percent on the deal and will need to pay back only $2,800 in interest next year. This is $200 less than if she had borrowed from the record keepers. Tom is happy too, because he has found a way to lend some of the money that the record keepers would not take. The net result of this transaction is that the record keepers have lost Leslie as a customer. Why should she borrow from them when Tom will lend her the money at a lower interest rate? Tom and Leslie are not the only ones cutting side deals in the marketplace, and it is clear that the record keepers will not be able to maintain the 15 percent rate. The interest rate must fall if they are to stay in business. Suppose, then, that the market clears at the rate of 10 percent. At this rate the amount of money that the lenders wish to lend is exactly equal to the amount that the borrowers desire. We refer to the interest rate that clears the market, 10 percent in our example, as the equilibrium rate of interest. In this section we have shown that in the market for loans, bonds or IOUs are traded. These are financial instruments. The interest rate on these loans is set so that the total demand for such loans by borrowers equals the total supply of loans by lenders. At a higher interest rate, lenders wish to supply more loans than are demanded, and if the interest rate is lower than this equilibrium level, borrowers demand more loans than lenders are willing to supply. QUESTIONS CONCEPT ? What is an interest rate? What are institutions that match borrowers and lenders called? What do we mean when we say a market clears? What is an equilibrium rate of interest? 3.2 MAKING CONSUMPTION CHOICES OVER TIME Figure 3.2 illustrates the situation faced by a representative individual in the financial market. This person is assumed to have an income of $50,000 this year and an income of $60,000 next year. The market allows him not only to consume $50,000 worth of goods this year and $60,000 next year, but also to borrow and lend at the equilibrium interest rate. The line AB in Figure 3.2 shows all of the consumption possibilities open to the person through borrowing or lending, and the shaded area contains all of the feasible choices. Let's look at this figure more closely to see exactly why points in the shaded area are available. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 55 Chapter 3 Financial Markets and Net Present Value: First Principles of Finance (Advanced) 49 I F I G U R E 3.2 Intertemporal Consumption Opportunities Consumption next year $115,000 A Slope = (1 + r ) Lending $71,000 $60,000 $49,000 Borrowing C Y D B $40,000 $60,000 $50,000 Consumption this year $104,545 We will use the letter r to denote the interest rate--the equilibrium rate--in this market. The rate is risk-free because we assume that no default can take place. Look at point A on the vertical axis of Figure 3.2. Point A is a height of A $60,000 [$50,000 (1 r)] For example, if the rate of interest is 10 percent, then point A would be A $60,000 [$50,000 $60,000 $55,000 $115,000 (1 0.1)] Point A is the maximum amount of wealth that this person can spend in the second year. He gets to point A by lending the full income that is available this year, $50,000, and consuming none of it. In the second year, then, he will have the second year's income of $60,000 plus the proceeds from the loan that he made in the first year, $55,000, for a total of $115,000. Now let's take a look at point B. Point B is a distance of B $50,000 [$60,000/(1 r)] along the horizontal axis. If the interest rate is 10 percent, point B will be B $50,000 [$60,000/(1 $50,000 $54,545 $104,545 0.1)] (We have rounded off to the nearest dollar.) Why do we divide next year's income of $60,000 by (1 r), or 1.1 in the preceding computation? Point B represents the maximum amount available for this person to consume this year. To achieve that maximum he would borrow as much as possible and repay the loan from the income, $60,000, that he was going to receive next year. Because $60,000 will be available to repay the loan next year, we are asking how much he could borrow this year at an interest rate of r and still be able to repay the loan. The answer is $60,000/(1 r) 56 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 50 Part II Value and Capital Budgeting because if he borrows this amount, he must repay it next year with interest. Thus, next year he must repay [$60,000/(1 r)] (1 r) $60,000 no matter what the interest rate, r, is. In our example we found that he could borrow $54,545 and, sure enough, $54,545 1.1 $60,000 (after rounding off to the nearest dollar). Furthermore, by borrowing and lending different amounts the person can achieve any point on the line AB. For example, point C is a point where he has chosen to lend $10,000 of today's income. This means that at point C he will have Consumption this year at point C and Consumption next year at point C $60,000 [$10,000 (1 r)] $71,000 $50,000 $10,000 $40,000 when the interest rate is 10 percent. Similarly, at point D, the individual has decided to borrow $10,000 and repay the loan next year. At point D, then, Consumption this year at point D and Consumption next year at point D $60,000 [$10,000 (1 r)] $49,000 $50,000 $10,000 $60,000 at an interest rate of 10 percent. In fact, this person can consume any point on the line AB. This line has a slope of (1 r), which means that for each dollar that is added to the x coordinate along the line, (1 r) dollars are subtracted from the y coordinate. Moving along the line from point A, the initial point of $50,000 this year and $60,000 next year, toward point B gives the person more consumption today and less next year. In other words, moving toward point B is borrowing. Similarly, moving up toward point A, he is consuming less today and more next year and is lending. The line is a straight line because the individual has no effect on the interest rate. This is one of the assumptions of perfectly competitive financial markets. Where will the person actually be? The answer to that question depends on the individual's tastes and personal situation, just as it did before there was a market. If the person is impatient, he might wish to borrow money at a point such as D, and if he is patient, he might wish to lend some of this year's income and enjoy more consumption next year at, for example, a point such as C. Notice that whether we think of someone as patient or impatient depends on the interest rate he or she faces in the market. Suppose that our individual was impatient and chose to borrow $10,000 and move to point D. Now suppose that we raise the interest rate to 20 percent or even 50 percent. Suddenly our impatient person may become very patient and might prefer to lend some of this year's income to take advantage of the very high interest rate. The general result is depicted in Figure 3.3. We can see that lending at point C yields much greater future income and consumption possibilities than before.1 1 Those familiar with consumer theory might be aware of the surprising case where raising the interest rate actually makes people borrow more or lowering the rate makes them lend more. The latter case might occur, for example, if the decline in the interest rate made the lenders have so little consumption next year that they have no choice but to lend out even more than they were lending before just to subsist. Nothing we do depends on excluding such cases, but it is much easier to ignore them, and the resulting analysis fits the real markets more closely. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 57 Chapter 3 Financial Markets and Net Present Value: First Principles of Finance (Advanced) 51 I F I G U R E 3.3 The Effect of Different Interest Rates on Consumption Opportunities Consumption next year $135,000 $115,000 A A Slope = 1.5 $75,000 $71,000 $60,000 $49,000 $45,000 C Lending C Y D D Borrowing Slope = 1.1 B 0 $40,000 $60,000 $50,000 B Consumption this year $90,000 $104,545 QUESTIONS CONCEPT ? How does an individual change his consumption across periods through borrowing and lending? How do interest rate changes affect one's degree of impatience? 3.3 THE COMPETITIVE MARKET In the previous analysis we assumed the individual moves freely along the line AB, and we ignored--and assumed that the individual ignored--any effect his borrowing or lending decisions might have on the equilibrium interest rate itself. What would happen, though, if the total amount of loans outstanding in the market when the person was doing no borrowing or lending was $10 million, and if our person then decided to lend, say, $5 million? His lending would be half as much as the rest of the market put together, and it would not be unreasonable to think that the equilibrium interest rate would fall to induce more borrowers into the market to take his additional loans. In such a situation the person would have some power in the market to influence the equilibrium rate significantly, and he would take this power into consideration in making his decisions. In the modern financial market, however, the total amount of borrowing and lending is not $10 million; rather, as we saw in Chapter 1, it is closer to $10 trillion. In such a huge market no one investor or even any single company can have a significant effect (although a government might). We assume, then, in all of our subsequent discussions and analyses that the financial market is competitive. By that we mean no individuals or firms think they have any effect whatsoever on the interest rates that they face no matter how much borrowing, lending, or investing they do. In the language of economics, individuals who respond to rates and prices by acting as though they have no influence on them are called price takers, and this assumption is sometimes called the price-taking assumption. It is the condition of perfectly competitive financial markets (or, more simply, perfect markets). The following conditions are likely to lead to this: 58 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 52 Part II Value and Capital Budgeting 1. Trading is costless. Access to the financial markets is free. 2. Information about borrowing and lending opportunities is available. 3. There are many traders, and no single trader can have a significant impact on market prices. How Many Interest Rates Are There in a Competitive Market? An important point about this one-year market where no defaults can take place is that only one interest rate can be quoted in the market at any one time. Suppose that some competing record keepers decide to set up a rival market. To attract customers, their business plan is to offer lower interest rates, say, 9 percent. Their business plan is based on the hope that they will be able to attract borrowers away from the first market and soon have all of the business. Their business plan will work, but it will do so beyond their wildest expectations. They will indeed attract the borrowers, all $11 million worth of them! But the matter doesn't stop there. By offering to borrow and lend at 9 percent when another market is offering 10 percent, they have created the proverbial money machine. The world of finance is populated by sharp-eyed inhabitants who would not let this opportunity slip by them. Any one of these, whether a borrower or a lender, would go to the new market and borrow everything he could at the 9-percent rate. At the same time he was borrowing in the new market, he would also be striking a deal to lend in the old market at the 10-percent rate. If he could borrow $100 million at 9 percent and lend it at 10 percent, he would be able to net 1 percent, or $1 million, next year. He would repay the $109 million he owed to the new market from the $110 million he receives when the 10-percent loans he made in the original market are repaid, pocketing $1 million profit. This process of striking a deal in one market and an offsetting deal in another market simultaneously and at more favorable terms is called arbitrage, and doing it is called arbitraging. Of course, someone must be paying for all this free money, and it must be the record keepers because the borrowers and the lenders are all making money. Our intrepid entrepreneurs will lose their proverbial shirts and go out of business. The moral of this is clear: As soon as different interest rates are offered for essentially the same risk-free loans, arbitrageurs will take advantage of the situation by borrowing at the low rate and lending at the high rate. The gap between the two rates will be closed quickly, and for all practical purposes there will be only one rate available in the market. QUESTIONS CONCEPT ? What is the most important feature of a competitive financial market? What conditions are likely to lead to this? 3.4 THE BASIC PRINCIPLE We have already shown how people use the financial markets to adjust their patterns of consumption over time to fit their particular preferences. By borrowing and lending, they can greatly expand their range of choices. They need only to have access to a market with an interest rate at which they can borrow and lend. In the previous section we saw how these savings and consumption decisions depend on the interest rate. The financial markets also provide a benchmark against which proposed investments can be compared, and the interest rate is the basis for a test that any proposed investment must pass. The financial markets give the individual, the corporation, or even the government a standard of comparison for economic decisions. This benchmark is critical when investment decisions are being made. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 59 Chapter 3 Financial Markets and Net Present Value: First Principles of Finance (Advanced) 53 The way we use the financial markets to aid us in making investment decisions is a direct consequence of our basic assumption that individuals can never be made worse off by increasing the range of choices open to them. People always can make use of the financial markets to adjust their savings and consumption by borrowing or lending. An investment project is worth undertaking only if it increases the range of choices in the financial markets. To do this the project must be at least as desirable as what is available in the financial markets.2 If it were not as desirable as what the financial markets have to offer, people could simply use the financial markets instead of undertaking the investment. This point will govern us in all our investment decisions. It is the first principle of investment decision making, and it is the foundation on which all of our rules are built. QUESTION CONCEPT ? Describe the basic financial principle of investment decision making. 3.5 PRACTICING THE PRINCIPLE Let us apply the basic principle of investment decision making to some concrete situations. A Lending Example Consider a person who is concerned only about this year and the next. She has an income of $100,000 this year and expects to make the same amount next year. The interest rate is 10 percent. This individual is thinking about investing in a piece of land that costs $70,000. She is certain that next year the land will be worth $75,000, a sure $5,000 gain. Should she undertake the investment? This situation is described in Figure 3.4 with the cash flow time chart. A moment's thought should be all it takes to convince her that this is not an attractive business deal. By investing $70,000 in the land, she will have $75,000 available next year. Suppose, instead, that she puts the same $70,000 into a loan in the financial market. At the 10-percent rate of interest this $70,000 would grow to (1 0.1) $70,000 $77,000 next year. It would be foolish to buy the land when the same $70,000 investment in the financial market would beat it by $2,000 (that is, $77,000 from the loan minus $75,000 from the land investment). I F I G U R E 3.4 Cash Flows for Investment in Land Cash inflows Time Cash outflows 0 $75,000 1 $70,000 2 You might wonder what to do if an investment is as desirable as an alternative in the financial markets. In principle, if there is a tie, it doesn't matter whether or not we take on the investment. In practice, we've never seen an exact tie. 60 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 54 Part II Value and Capital Budgeting I F I G U R E 3.5 Consumption Opportunities with Borrowing and Lending Consumption next year $210,000 $177,000 $175,000 Loan Land $100,000 Consumption endowment Y Slope = 1.10 Consumption this year $30,000 $100,000 $190,909.09 Figure 3.5 illustrates this situation. Notice that the $70,000 loan gives no less income today and $2,000 more next year. This example illustrates some amazing features of the financial markets. It is remarkable to consider all of the information that we did not use when arriving at the decision not to invest in the land. We did not need to know how much income the person has this year or next year. We also did not need to know whether the person preferred more income this year or next. We did not need to know any of these other facts, and more important, the person making the decision did not need to know them either. She only needed to be able to compare the investment with a relevant alternative available in the financial market. When this investment fell short of that standard--by $2,000 in the previous example--regardless of what the individual wanted to do, she knew that she should not buy the land. A Borrowing Example Let us sweeten the deal a bit. Suppose that instead of being worth $75,000 next year the land would be worth $80,000. What should our investor do now? This case is a bit more difficult. After all, even if the land seems like a good deal, this person's income this year is $100,000. Does she really want to make a $70,000 investment this year? Won't that leave only $30,000 for consumption? The answers to these questions are yes, the individual should buy the land; yes, she does want to make a $70,000 investment this year; and, most surprising of all, even though her income is $100,000, making the $70,000 investment will not leave her with $30,000 to consume this year! Now let us see how finance lets us get around the basic laws of arithmetic. The financial markets are the key to solving our problem. First, the financial markets can be used as a standard of comparison against which any investment project must be measured. Second, they can be used as a tool to actually help the individual undertake investments. These twin features of the financial markets enable us to make the right investment decision. Suppose that the person borrows the $70,000 initial investment that is needed to purchase the land. Next year she must repay this loan. Because the interest rate is 10 percent, she will owe the financial market $77,000 next year. This is depicted in Figure 3.6. Because the land will be worth $80,000 next year, she can sell it, pay off her debt of $77,000, and have $3,000 extra cash. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 61 Chapter 3 Financial Markets and Net Present Value: First Principles of Finance (Advanced) 55 I F I G U R E 3.6 Cash Flows of Borrowing to Purchase the Land Cash flows of borrowing Cash inflows Time Cash outflows $70,000 1 0 $77,000 Cash flows of investing in land Cash inflows Time Cash outflows 0 $80,000 1 $70,000 Cash flows of borrowing and investing in land Cash inflows Time 0 $3,000 1 I F I G U R E 3.7 Consumption Opportunities with Investment Opportunity and Borrowing and Lending Consumption next year $213,000 $210,000 $180,000 $177,000 Land Loan $100,000 Y Land plus borrowing Consumption this year $30,000 $100,000 $190,909.09 $102,727.27 $193,636.36 If she wishes, this person can now consume an extra $3,000 worth of goods and services next year. This possibility is illustrated in Figure 3.7. In fact, even if she wants to do all of her consuming this year, she is still better off taking the investment. All she must do is take out a loan this year and repay it from the proceeds of the land next year and profit by $3,000. Furthermore, instead of borrowing just the $70,000 that she needed to purchase the land, she could have borrowed $72,727.27. She could have used $70,000 to buy the land and consumed the remaining $2,727.27. 62 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 56 Part II Value and Capital Budgeting We will call $2,727.27 the net present value of the transaction. Notice that it is equal to $3,000 1/1.1. How did we figure out that this was the exact amount that she could borrow? It was easy: If $72,727.27 is the amount that she borrows, then, because the interest rate is 10 percent, she must repay $72,727.27 (1 0.1) $80,000 next year, and that is exactly what the land will be worth. The line through the investment position in Figure 3.7 illustrates this borrowing possibility. The amazing thing about both of these cases, one where the land is worth $75,000 next year and the other where it is worth $80,000 next year, is that we needed only to compare the investment with the financial markets to decide whether it was worth undertaking or not. This is one of the more important points in all of finance. It is true regardless of the consumption preferences of the individual. This is one of a number of separation theorems in finance. It states that the value of an investment to an individual is not dependent on consumption preferences. In our examples we showed that the person's decision to invest in land was not affected by consumption preferences. However, these preferences dictated whether she borrowed or lent. QUESTIONS CONCEPT ? Describe how the financial markets can be used to evaluate investment alternatives. What is the separation theorem? Why is it important? 3.6 ILLUSTRATING THE INVESTMENT DECISION Figure 3.2 describes the possibilities open to a person who has an income of $50,000 this year and $60,000 next year and faces a financial market in which the interest rate is 10 percent. But, at that moment, the person has no investment possibilities beyond the 10-percent borrowing and lending that is available in the financial market. Suppose that we give this person the chance to undertake an investment project that will require a $30,000 outlay of cash this year and that will return $40,000 to the investor next year. Refer to Figure 3.2 and determine how you could include this new possibility in that figure and how you could use the figure to help you decide whether to undertake the investment. Now look at Figure 3.8. In Figure 3.8 we have labeled the original point with $50,000 this year and $60,000 next year as point A. We have also added a new point B, with $20,000 available for consumption this year and $100,000 next year. The difference between point A and point B is that at point A the person is just where we started him off, and at point B the person has also decided to undertake the investment project. As a result of this decision the person at point B has $50,000 left for consumption this year, and $60,000 $40,000 $100,000 $30,000 $20,000 available next year. These are the coordinates of point B. We must use our knowledge of the individual's borrowing and lending opportunities in order to decide whether to accept or reject the investment. This is illustrated in Figure 3.9. Figure 3.9 is similar to Figure 3.8, but in it we have drawn a line through point A that shows Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 63 Chapter 3 Financial Markets and Net Present Value: First Principles of Finance (Advanced) 57 I F I G U R E 3.8 Consumption Choices with Investment but No Financial Markets Consumption next year $100,000 B $60,000 A Consumption this year $20,000 $50,000 I F I G U R E 3.9 Consumption Choices with Investment Opportunities and Financial Markets Consumption next year $122,000 $115,000 $100,000 B $67,000 $60,000 L A C Consumption this year $20,000 $50,000 $56,364 $104,545 $110,909 the possibilities open to the person if he stays at point A and does not take the investment. This line is exactly the same as the one in Figure 3.2. We have also drawn a parallel line through point B that shows the new possibilities that are available to the person if he undertakes the investment. The two lines are parallel because the slope of each is determined by the same interest rate, 10 percent. It does not matter whether the person takes the investment and goes to point B or does not and stays at point A; in the financial market, each dollar of lending is a dollar less available for consumption this year and moves him to the left by a dollar along the x-axis. Because the interest rate is 10 percent, the $1 loan repays $1.10 and it moves him up by $1.10 along the y-axis. It is easy to see from Figure 3.9 that the investment has made the person better off. The line through point B is higher than the line through point A. Thus, no matter what pattern of consumption this person wanted this year and next, he could have more in each year if he undertook the investment. 64 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 58 Part II Value and Capital Budgeting For example, suppose that our individual wanted to consume everything this year. If he did not take the investment, the point where the line through point A intersected the x-axis would give the maximum amount of consumption he could enjoy this year. This point has $104,545 available this year. To recall how we found this figure, review the analysis of Figure 3.2. But in Figure 3.9 the line that goes through point B hits the x-axis at a higher point than the line that goes through point A. Along this line the person can have the $20,000 that is left after investing $30,000, plus all that he can borrow and repay with both next year's income and the proceeds from the investment. The total amount available to consume today is therefore $50,000 $30,000 ($60,000 $20,000 ($100,000/1.1) $110,909 $40,000)/(1 0.1) The additional consumption available this year from undertaking the investment and using the financial market is the difference on the x-axis between the points where these two lines intersect: $110,909 $104,545 $6,364 This difference is an important measure of what the investment is worth to the person. It answers a variety of questions. For example, it is the answer to the question: How much money would we need to give the investor this year to make him just as well off as he is with the investment? Because the line through point B is parallel to the line through point A but has been moved over by $6,364, we know that if we were to add this amount to the investor's current income this year at point A and take away the investment, he would wind up on the line through point B and with the same possibilities. If we do this, the person will have $56,364 this year and $60,000 next year, which is the situation of the point on the line through point B that lies to the right of point A in Figure 3.9. This is point C. We could also ask a different question: How much money would we need to give the investor next year to make him just as well off as he is with the investment? This is the same as asking how much higher the line through point B is than the line through point A. In other words, what is the difference in Figure 3.9 between the point where the line through A intercepts the y-axis and the point where the line through B intercepts the y-axis? The point where the line through A intercepts the y-axis shows the maximum amount the person could consume next year if all of his current income were lent out and the proceeds of the loan were consumed along with next year's income. As we showed in our analysis of Figure 3.2, this amount is $115,000. How does this compare with what the person can have next year if he takes the investment? By taking the investment we saw that he would be at point B where he has $20,000 left this year and would have $100,000 next year. By lending the $20,000 that is left this year and adding the proceeds of this loan to the $100,000, we find the line through B intercepts the y-axis at: ($20,000 1.1) $100,000 $122,000 The difference between this amount and $115,000 is $122,000 $115,000 $7,000 which is the answer to the question of how much we would need to give the person next year to make him as well off as he is with the investment. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 65 Chapter 3 Financial Markets and Net Present Value: First Principles of Finance (Advanced) 59 I F I G U R E 3.10 Cash Flows for the Investment Project Cash inflows Time Cash outflows 0 $30,000 $40,000 1 There is a simple relationship between these two numbers. If we multiply $6,364 by 1.1 we get $7,000! Consider why this must be so. The $6,364 is the amount of extra cash we must give the person this year to substitute for having the investment. In a financial market with a 10-percent rate of interest, however, $1 this year is worth exactly the same as $1.10 next year. Thus, $6,364 this year is the same as $6,364 1.1 next year. In other words, the person does not care whether he has the investment, $6,364, this year or $6,364 1.1 next year. But we already showed that the investor is equally willing to have the investment and to have $7,000 next year. This must mean that $6,364 1.1 $7,000 You can also verify this relationship between these two variables by using Figure 3.9. Because the lines through A and B each have the same slope of 1.1, the difference of $7,000 between where they intersect on the x-axis must be in the ratio of 1.1 to 1. Now we can show you how to evaluate the investment opportunity on a stand-alone basis. Here are the relevant facts: The individual must give up $30,000 this year to get $40,000 next year. These cash flows are illustrated in Figure 3.10. The investment rule that follows from the previous analysis is the net present value (NPV) rule. Here we convert all consumption values to the present and add them up: Net present value $30,000 $30,000 $6,364 $40,000 $36,364 (1/1.1) The future amount, $40,000, is called the future value (FV). The net present value of an investment is a simple criterion for deciding whether or not to undertake an investment. NPV answers the question of how much cash an investor would need to have today as a substitute for making the investment. If the net present value is positive, the investment is worth taking on because doing so is essentially the same as receiving a cash payment equal to the net present value. If the net present value is negative, taking on the investment today is equivalent to giving up some cash today, and the investment should be rejected. We use the term net present value to emphasize that we are already including the current cost of the investment in determining its value and not simply what it will return. For example, if the interest rate is 10 percent and an investment of $30,000 today will produce a total cash return of $40,000 in one year's time, the present value of the $40,000 by itself is $40,000/1.1 $36,364 but the net present value of the investment is $36,364 minus the original investment: Net present value $36,364 $30,000 $6,364 The present value of a future cash flow is the value of that cash flow after considering the appropriate market interest rate. The net present value of an investment is the present value of the investment's future cash flows, minus the initial cost of the investment. We have just decided that our investment is a good opportunity. It has a positive net present value because it is worth more than it costs. 66 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 60 Part II Value and Capital Budgeting In general, the above can be stated in terms of the net present value rule: An investment is worth making if it has a positive NPV. If an investment's NPV is negative, it should be rejected. QUESTIONS CONCEPT ? Give the definitions of net present value, future value, and present value. What information does a person need to compute an investment's net present value? 3.7 CORPORATE INVESTMENT DECISION MAKING Up to now, everything we have done has been from the perspective of the individual investor. How do corporations and firms make investment decisions? Aren't their decisions governed by a much more complicated set of rules and principles than the simple NPV rule that we have developed for individuals? We return to questions of corporate decision making and corporate governance later in the book, but it is remarkable how well our central ideas and the NPV rule hold up even when applied to corporations. Suppose that firms are just ways in which many investors can pool their resources to make large-scale business decisions. Suppose, for example, that you own 1 percent of some firm. Now suppose that this firm is considering whether or not to undertake some investment. If that investment passes the NPV rule, that is, if it has a positive NPV, then 1 percent of that NPV belongs to you. If the firm takes on this investment, the value of the whole firm will rise by the NPV and your investment in the firm will rise by 1 percent of the NPV of the investment. Similarly, the other shareholders in the firm will profit by having the firm take on the positive NPV project because the value of their shares in the firm will also increase. This means that the shareholders in the firm will be unanimous in wanting the firm to increase its value by taking on the positive NPV project. If you follow this line of reasoning, you will also be able to see why the shareholders would oppose the firm taking on any projects with a negative NPV because this would lower the value of their shares. One difference between the firm and the individual is that the firm has no consumption endowment. In terms of our one-period consumption diagram, the firm starts at the origin. Figure 3.11 illustrates the situation of a firm with investment opportunity B. B is an investment that has a future value of $33,000 and will cost $25,000 now. If the interest rate is 10 percent, the NPV of B can be determined using the NPV rule. This is marked as point C in Figure 3.11. The cash flows of this investment are depicted in Figure 3.12. $25,000 Net present value [$33,000 (1/1.1)] $5,000 One common objection to this line of reasoning is that people differ in their tastes and that they would not necessarily agree to take on or reject investments by the NPV rule. For instance, suppose that you and we each own some shares in a company. Further suppose that we are older than you and might be anxious to spend our money. Being younger, you might be more patient than we are and more willing to wait for a good long-term investment to pay off. Because of the financial markets we all agree that the company should take on investments with positive NPVs and reject those with negative NPVs. If there were no financial markets, then, being impatient, we might want the company to do little or no investing so that we could have as much money as possible to consume now, and, being patient, you might prefer the company to make some investments. With financial markets, we are both satisfied by having the company follow the NPV rule. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 67 Chapter 3 Financial Markets and Net Present Value: First Principles of Finance (Advanced) 61 I F I G U R E 3.11 Consumption Choices, the NPV Rule, and the Corporation Consumption next year (future value) B Slope = 1.1 $33,000 Consumption this year $25,000 0 C NPV = $5,000 I F I G U R E 3.12 Corporate Investment Cash Flows Cash inflows $33,000 Time 0 1 Cash outflows $25,000 Suppose that the company takes on a positive NPV investment. Let us assume that this investment has a net payoff of $1 million next year. That means that the value of the company will increase by $1 million next year and, consequently, if you own 1 percent of the company's shares, the value of your shares will increase by 1 percent of $1 million, or $10,000, next year. Because you are patient, you might be prepared to wait for your $10,000 until next year. Being impatient, we do not want to wait, and with financial markets, we do not need to wait. We can simply borrow against the extra $10,000 we will have tomorrow and use the loan to consume more today. In fact, if there is also a market for the firm's shares, we do not even need to borrow. After the company takes on a positive NPV investment, our shares in the company increase in value today. This is because owning the shares today entitles investors to their portion of the extra $1 million the company will have next year. This means that the shares would rise in value today by the present value of $1 million. Because you want to delay your consumption, you could wait until next year and sell your shares then to have extra consumption next year. Being impatient, we might sell our shares now and use the money to consume more today. If we owned 1 percent of the company's shares, we could sell our shares for an extra amount equal to the present value of $10,000. 68 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 62 Part II Value and Capital Budgeting In reality, shareholders in big companies do not vote on every investment decision, and the managers of big companies must have rules that they follow. We have seen that all shareholders in a company will be better off--no matter what their levels of patience or impatience--if these managers follow the NPV rule. This is a marvelous result because it makes it possible for many different owners to delegate decision-making powers to the managers. They need only tell the managers to follow the NPV rule, and if the managers do so, they will be doing exactly what the stockholders want them to do. Sometimes this form of the NPV rule is stated as having the managers maximize the value of the company. As we argued, the current value of the shares of the company will increase by the NPV of any investments that the company undertakes. This means that the managers of the company can make the shareholders as well off as possible by taking on all positive NPV projects and rejecting projects with negative NPVs. Separating investment decision making from the owners is a basic requirement of the modern large firm. The separation theorem in financial markets says that all investors will want to accept or reject the same investment projects by using the NPV rule, regardless of their personal preferences. Investors can delegate the operations of the firm and require that managers use the NPV rule. Of course, much remains for us to discuss about this topic. For example, what insurance do stockholders have that managers will actually do what is best for them? We discussed this possibility in Chapter 1, and we take up this interesting topic later in the book. For now, though, we no longer will consider our perspective to be that of the lone investor. Instead, thanks to the separation theorem, we will use the NPV rule for companies as well as for investors. Our justification of the NPV rule depends on the conditions necessary to derive the separation theorem. These conditions are the ones that result in competitive financial markets. The analysis we have presented has been restricted to risk-free cash flows in one time period. However, the separation theorem also can be derived for risky cash flows that extend beyond one period. For the reader interested in studying further about the separation theorem, we include several suggested readings at the end of this chapter that build on the material we have presented. QUESTION CONCEPT ? In terms of the net present value rule, what is the essential difference between the individual and the corporation? 3.8 SUMMARY AND CONCLUSIONS Finance is a subject that builds understanding from the ground up. Whenever you come up against a new problem or issue in finance, you can always return to the basic principles of this chapter for guidance. 1. Financial markets exist because people want to adjust their consumption over time. They do this by borrowing and lending. 2. Financial markets provide the key test for investment decision making. Whether a particular investment decision should or should not be taken depends only on this test: If there is a superior alternative in the financial markets, the investment should be rejected; if not, the Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 69 Chapter 3 Financial Markets and Net Present Value: First Principles of Finance (Advanced) 63 investment is worth taking. The most important thing about this principle is that the investor need not use his preferences to decide whether the investment should be taken. Regardless of the individual's preference for consumption this year versus the next, regardless of how patient or impatient the individual is, making the proper investment decision depends only on comparing it with the alternatives in the financial markets. 3. The net present value of an investment helps us make the comparison between the investment and the financial market. If the NPV is positive, our rule tells us to undertake the investment. This illustrates the second major feature of the financial markets and investment. Not only does the NPV rule tell us which investments to accept and which to reject, the financial markets also provide us with the tools for actually acquiring the funds to make the investments. In short, we use the financial markets to decide both what to do and how to do it. 4. The NPV rule can be applied to corporations as well as to individuals. The separation theorem developed in this chapter conveys that all of the owners of the firm would agree that the firm should use the NPV rule even though each might differ in personal tastes for consumption and savings. In the next chapter we learn more about the NPV rule by using it to examine a wide array of problems in finance. KEY TERMS Equilibrium rate of interest 48 Financial intermediaries 47 Net present value rule 60 Perfectly competitive financial market Separation theorems 56 51 SUGGESTED READINGS Two books that have good discussions of the consumption and savings decisions of individuals and the beginnings of financial markets are: Fama, E. F., and M. H. Miller. The Theory of Finance. New York: Holt, Rinehart & Winston, 1971: Chapter 1. Hirshleifer, J. Investment, Interest and Capital. Upper Saddle River, N.J.: Prentice Hall, 1970: Chapter 1. The seminal work on the net present value rule is: Fisher, I. G. The Theory of Interest. New York: Augustus M. Kelly, 1965. (This is a reprint of the 1930 edition.) A rigorous treatment of the net present value rule along the lines of Irving Fisher can be found in: Hirshleifer, J. "On the Theory of Optimal Investment Decision." Journal of Political Economy 66 (August 1958). QUESTIONS AND PROBLEMS Making Consumption Choices 3.1 Currently, Jim Morris makes $100,000. Next year his income will be $120,000. Jim is a big spender and he wants to consume $150,000 this year. The equilibrium interest rate is 10 percent. What will be Jim's consumption potential next year if he consumes $150,000 this year? 3.2 Rich Pettit is a miser. His current income is $50,000; next year he will earn $40,000. He plans to consume only $20,000 this year. The current interest rate is 12 percent. What will Rich's consumption potential be next year? The Competitive Finance Market 3.3 What is the basic reason that financial markets develop? 70 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 64 Part II Value and Capital Budgeting Illustrating the Investment Decision 3.4 The following figure depicts the financial situation of Ms. J. Fawn. In period 0 her labor income and current consumption is $40; later, in period 1, her labor income and consumption will be $22. She has an opportunity to make the investment represented by point D. By borrowing and lending, she will be able to reach any point along the line FDE. a. What is the market rate of interest? (Hint: The new market interest rate line EF is parallel to AH.) b. What is the NPV of point D? c. If Ms. Fawn wishes to consume the same quantity in each period, how much should she consume in period 0? Period 1 ($) F (1 + r ) H D C B 40 A 60 E 75 22 Period 0 ($) 3.5 Harry Hernandez has $60,000 this year. He faces the investment opportunities represented by point B in the following figure. He wants to consume $20,000 this year and $67,500 next year. This pattern of consumption is represented by point F. a. What is the market interest rate? b. How much must Harry invest in financial assets and productive assets today if he follows an optimum strategy? c. What is the NPV of his investment in nonfinancial assets? Consumption next year D $90,000 $67,500 $56,250 F B (1 + r ) A $20,000 $30,000 $60,000 C Consumption this year $80,000 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) The McGraw-Hill Companies, 2002 71 Chapter 3 Financial Markets and Net Present Value: First Principles of Finance (Advanced) 65 3.6 Suppose that the person in the land-investment example in the text wants to consume $60,000 this year. a. Detail a plan of investment and borrowing or lending that would permit her to consume $60,000 if the land investment is worth $75,000 next year. b. Detail a plan of investment and borrowing or lending that would permit her to consume $60,000 if the land investment is worth $80,000 next year. c. In which of these cases should she invest in the land? d. In each of these cases, how much will she be able to consume next year? Corporate Investment Decision Making 3.7 a. Briefly explain why from the shareholders' perspective it is desirable for corporations to maximize NPV. b. What assumptions are necessary for this argument to be correct? 3.8 Consider a one-year world with perfect capital markets in which the interest rate is 10 percent. Suppose a firm has $12 million in cash. The firm invests $7 million today, and $5 million is paid to shareholders. The NPV of the firm's investment is $3 million. All shareholders are identical. a. How much cash will the firm receive next year from its investment? b. Suppose shareholders plan to spend $10 million today. (i) How can they do this? (ii) How much money will they have available to spend next year if they follow your plan? 3.9 To answer this question, refer to the following figure. C Dollars next year F Dollars this year A New issue of security B Cash on hand D E Investment The Badvest Corporation is an all-equity firm with BD in cash on hand. It has an investment opportunity at point C, and it plans to invest AD in real assets today. Thus, the firm will need to raise AB by a new issue of equity. a. What is the present value of the investment? b. What is the rate of return on the old equity? Measure this rate of return from before the investment plans are announced to afterwards. c. What is the rate of return on the new equity? 72 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 CHAPTER 4 Net Present Value EXECUTIVE SUMMARY W e now examine one of the most important concepts in all of corporate finance, the relationship between $1 today and $1 in the future. Consider the following example: A firm is contemplating investing $1 million in a project that is expected to pay out $200,000 per year for nine years. Should the firm accept the project? One might say yes at first glance, since total inflows of $1.8 million ( $200,000 9) are greater than $1 million outflow. However, the $1 million is paid out immediately, whereas the $200,000 per year will be received in the future. Also, the immediate payment is known with certainty, whereas the later inflows can only be estimated. Thus, we need to know the relationship between a dollar today and a (possibly uncertain) dollar in the future before deciding on the project. This relationship is called the time-value-of-money concept. It is important in such areas as capital budgeting, lease versus buy decisions, accounts receivable analysis, financing arrangements, mergers, and pension funding. The basics are presented in this chapter. We begin by discussing two fundamental concepts, future value and present value. Next, we treat simplifying formulas such as perpetuities and annuities. 4.1 THE ONE-PERIOD CASE E XAMPLE Don Simkowitz is trying to sell a piece of raw land in Alaska. Yesterday, he was offered $10,000 for the property. He was about ready to accept the offer when another individual offered him $11,424. However, the second offer was to be paid a year from now. Don has satisfied himself that both buyers are honest and financially solvent, so he has no fear that the offer he selects will fall through. These two offers are pictured as cash flows in Figure 4.1. Which offer should Mr. Simkowitz choose? Mike Tuttle, Don's financial advisor, points out that if Don takes the first offer, he could invest the $10,000 in the bank at an insured rate of 12 percent. At the end of one year, he would have $10,000 (0.12 $10,000) Return of Interest principal $10,000 1.12 $11,200 Because this is less than the $11,424 Don could receive from the second offer, Mr. Tuttle recommends that he take the latter. This analysis uses the concept of future value or compound value, which is the value of a sum after investing over one or more periods. The compound or future value of $10,000 is $11,200. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 73 Chapter 4 Net Present Value 67 I F I G U R E 4.1 Cash Flow for Mr. Simkowitz's Sale Alternative sale prices $10,000 $11,424 Year: 0 1 An alternative method employs the concept of present value. One can determine present value by asking the following question: How much money must Don put in the bank today so that he will have $11,424 next year? We can write this algebraically as PV 1.12 $11,424 (4.1) We want to solve for present value (PV), the amount of money that yields $11,424 if invested at 12 percent today. Solving for PV, we have PV The formula for PV can be written as Present Value of Investment: C1 PV 1 r where C1 is cash flow at date 1 and r is the appropriate interest rate. r is the rate of return that Don Simkowitz requires on his land sale. It is sometimes referred to as the discount rate. Present value analysis tells us that a payment of $11,424 to be received next year has a present value of $10,200 today. In other words, at a 12-percent interest rate, Mr. Simkowitz could not care less whether you gave him $10,200 today or $11,424 next year. If you gave him $10,200 today, he could put it in the bank and receive $11,424 next year. Because the second offer has a present value of $10,200, whereas the first offer is for only $10,000, present value analysis also indicates that Mr. Simkowitz should take the second offer. In other words, both future value analysis and present value analysis lead to the same decision. As it turns out, present value analysis and future value analysis must always lead to the same decision. As simple as this example is, it contains the basic principles that we will be working with over the next few chapters. We now use another example to develop the concept of net present value. $11,424 1.12 $10,200 E XAMPLE Louisa Dice, a financial analyst at Kaufman & Broad, a leading real estate firm, is thinking about recommending that Kaufman & Broad invest in a piece of land that costs $85,000. She is certain that next year the land will be worth $91,000, a sure $6,000 gain. Given that the guaranteed interest rate in the bank is 10 percent, should Kaufman & Broad undertake the investment in land? Ms. Dice's choice is described in Figure 4.2 with the cash flow time chart. A moment's thought should be all it takes to convince her that this is not an attractive business deal. By investing $85,000 in the land, she will have $91,000 available next year. Suppose, instead, that Kaufman & Broad puts the same 74 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 68 Part II Value and Capital Budgeting I F I G U R E 4.2 Cash Flows for Land Investment Cash inflow $91,000 Time 0 1 Cash outflow $85,000 $85,000 into the bank. At the interest rate of 10 percent, this $85,000 would grow to (1 0.10) $85,000 $93,500 next year. It would be foolish to buy the land when investing the same $85,000 in the financial market would produce an extra $2,500 (that is, $93,500 from the bank minus $91,000 from the land investment). This is a future-value calculation. Alternatively, she could calculate the present value of the sale price next year as Present value $91,000 1.10 $82,727.27 Because the present value of next year's sales price is less than this year's purchase price of $85,000, present-value analysis also indicates that she should not recommend purchasing the property. Frequently, businesspeople want to determine the exact cost or benefit of a decision. The decision to buy this year and sell next year can be evaluated as Net Present Value of Investment: $91,000 $2,273 $85,000 1.10 Cost of land Present value of today next year's sales price The formula for NPV can be written as NPV Cost PV (4.2) Equation (4.2) says that the value of the investment is $2,273, after stating all the benefits and all the costs as of date 0. We say that $2,273 is the net present value (NPV) of the investment. That is, NPV is the present value of future cash flows minus the present value of the cost of the investment. Because the net present value is negative, Louisa Dice should not recommend purchasing the land. Both the Simkowitz and the Dice examples deal with perfect certainty. That is, Don Simkowitz knows with perfect certainty that he could sell his land for $11,424 next year. Similarly, Louisa Dice knows with perfect certainty that Kaufman & Broad could receive $91,000 for selling its land. Unfortunately, businesspeople frequently do not know future cash flows. This uncertainty is treated in the next example. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 75 Chapter 4 Net Present Value 69 I F I G U R E 4.3 Cash Flows for Investment in Painting Expected cash inflow $480,000 Time 0 1 Cash outflow $400,000 E XAMPLE Professional Artworks, Inc., is a firm that speculates in modern paintings. The manager is thinking of buying an original Picasso for $400,000 with the intention of selling it at the end of one year. The manager expects that the painting will be worth $480,000 in one year. The relevant cash flows are depicted in Figure 4.3. Of course, this is only an expectation--the painting could be worth more or less than $480,000. Suppose the guaranteed interest rate granted by banks is 10 percent. Should the firm purchase the piece of art? Our first thought might be to discount at the interest rate, yielding $480,000 1.10 $436,364 Because $436,364 is greater than $400,000, it looks at first glance as if the painting should be purchased. However, 10 percent is the return one can earn on a riskless investment. Because the painting is quite risky, a higher discount rate is called for. The manager chooses a rate of 25 percent to reflect this risk. In other words, he argues that a 25-percent expected return is fair compensation for an investment as risky as this painting. The present value of the painting becomes $480,000 1.25 $384,000 Thus, the manager believes that the painting is currently overpriced at $400,000 and does not make the purchase. The preceding analysis is typical of decision making in today's corporations, though real-world examples are, of course, much more complex. Unfortunately, any example with risk poses a problem not faced by a riskless example. In an example with riskless cash flows, the appropriate interest rate can be determined by simply checking with a few banks.1 The selection of the discount rate for a risky investment is quite a difficult task. We simply don't know at this point whether the discount rate on the painting should be 11 percent, 25 percent, 52 percent, or some other percentage. 1 In Chapter 9, we discuss estimation of the riskless rate in more detail. 76 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 70 Part II Value and Capital Budgeting Because the choice of a discount rate is so difficult, we merely wanted to broach the subject here. The rest of the chapter will revert to examples under perfect certainty. We must wait until the specific material on risk and return is covered in later chapters before a riskadjusted analysis can be presented. QUESTIONS CONCEPT ? Define future value and present value. How does one use net present value when making an investment decision? 4.2 THE MULTIPERIOD CASE The previous section presented the calculation of future value and present value for one period only. We will now perform the calculations for the multiperiod case. Future Value and Compounding Suppose an individual were to make a loan of $1. At the end of the first year, the borrower would owe the lender the principal amount of $1 plus the interest on the loan at the interest rate of r. For the specific case where the interest rate is, say, 9 percent, the borrower owes the lender $1 (1 r) $1 1.09 $1.09 At the end of the year, though, the lender has two choices. She can either take the $1.09-- or, more generally, (1 r)--out of the capital market, or she can leave it in and lend it again for a second year. The process of leaving the money in the capital market and lending it for another year is called compounding. Suppose that the lender decides to compound her loan for another year. She does this by taking the proceeds from her first one-year loan, $1.09, and lending this amount for the next year. At the end of next year, then, the borrower will owe her $1 $1 (1.09) (1 r) (1.09) (1 $1 r) $1 (1.09)2 (1 $1 r)2 1 2r r2 $0.18 0.0081 $1.1881 This is the total she will receive two years from now by compounding the loan. In other words, the capital market enables the investor, by providing a ready opportunity for lending, to transform $1 today into $1.1881 at the end of two years. At the end of three years, the cash will be $1 (1.09)3 $1.2950. The most important point to notice is that the total amount that the lender receives is not just the $1 that she lent out plus two years' worth of interest on $1: 2 r 2 2 $0.09 $0.18 The lender also gets back an amount r , which is the interest in the second year on the interest that was earned in the first year. The term, 2 r, represents simple interest over the two years, and the term, r2, is referred to as the interest on interest. In our example this latter amount is exactly r2 ($0.09)2 $0.0081 When cash is invested at compound interest, each interest payment is reinvested. With simple interest, the interest is not reinvested. Benjamin Franklin's statement, "Money makes money and the money that money makes makes more money," is a colorful way of explaining compound interest. The difference between compound interest and simple interest is illustrated Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 77 Chapter 4 Net Present Value 71 I F I G U R E 4.4 Simple and Compound Interest $1.295 $1.270 $1.188 $1.180 $1.09 $1 1 year 2 years 3 years The dark-shaded area indicates the difference between compound and simple interest. The difference is substantial over a period of many years or decades. in Figure 4.4. In this example the difference does not amount to much because the loan is for $1. If the loan were for $1 million, the lender would receive $1,188,100 in two years' time. Of this amount, $8,100 is interest on interest. The lesson is that those small numbers beyond the decimal point can add up to big dollar amounts when the transactions are for big amounts. In addition, the longer-lasting the loan, the more important interest on interest becomes. The general formula for an investment over many periods can be written as Future Value of an Investment: FV C0 (1 r)T where C0 is the cash to be invested at date 0, r is the interest rate, and T is the number of periods over which the cash is invested. E XAMPLE Suh-Pyng Ku has put $500 in a savings account at the First National Bank of Kent. The account earns 7 percent, compounded annually. How much will Ms. Ku have at the end of three years? $500 1.07 1.07 1.07 $500 (1.07)3 $612.52 Figure 4.5 illustrates the growth of Ms. Ku's account. E XAMPLE Jay Ritter invested $1,000 in the stock of the SDH Company. The company pays a current dividend of $2, which is expected to grow by 20 percent per year for the next two years. What will the dividend of the SDH Company be after two years? $2 (1.20)2 $2.88 Figure 4.6 illustrates the increasing value of SDH's dividends. 78 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 72 Part II Value and Capital Budgeting I F I G U R E 4.5 Suh-Pyng Ku's Savings Account Dollars $612.52 $500 $612.52 Time 0 1 2 3 Time 0 $500 1 2 3 I F I G U R E 4.6 The Growth of the SDH Dividends Dollars $2.88 $2.40 $2.00 Cash inflows $2.40 $2.00 $2.88 Time 0 1 2 0 1 2 Time The two previous examples can be calculated in any one of three ways. The computations could be done by hand, by calculator, or with the help of a table. The appropriate table is Table A.3, which appears in the back of the text. This table presents Future values of $1 at the end of t periods. The table is used by locating the appropriate interest rate on the horizontal and the appropriate number of periods on the vertical. For example, Suh-Pyng Ku would look at the following portion of Table A.3: Interest rate Period 1 2 3 4 6% 1.0600 1.1236 1.1910 1.2625 7% 1.0700 1.1449 1.2250 1.3108 8% 1.0800 1.1664 1.2597 1.3605 She could calculate the future value of her $500 as $500 Initial investment 1.2250 Future value of $1 $612.50 In the example concerning Suh-Pyng Ku, we gave you both the initial investment and the interest rate and then asked you to calculate the future value. Alternatively, the interest rate could have been unknown, as shown in the following example. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 79 Chapter 4 Net Present Value 73 I F I G U R E 4.7 Cash Flows for Purchase of Carl Voigt's Car Cash inflow $10,000 5 0 Time Cash outflow $16,105 E XAMPLE Carl Voigt, who recently won $10,000 in the lottery, wants to buy a car in five years. Carl estimates that the car will cost $16,105 at that time. His cash flows are displayed in Figure 4.7. What interest rate must he earn to be able to afford the car? The ratio of purchase price to initial cash is $16,105 $10,000 1.6105 Thus, he must earn an interest rate that allows $1 to become $1.6105 in five years. Table A.3 tells us that an interest rate of 10 percent will allow him to purchase the car. One can express the problem algebraically as $10,000 (1 r)5 $16,105 where r is the interest rate needed to purchase the car. Because $16,105/$10,000 1.6105, we have (1 r)5 1.6105 Either the table or any sophisticated hand calculator solves2 for r. The Power of Compounding: A Digression Most people who have had any experience with compounding are impressed with its power over long periods of time. Take the stock market, for example. Ibbotson and Sinquefield have calculated what the stock market returned as a whole from 1926 through 1999.3 They find that one dollar placed in these stocks at the beginning of 1926 would have been worth $2,845.63 at the end of 1999. This is 11.35 percent compounded annually for 74 years, i.e., (1.1135)74 $2,845.63. (Note: We are rounding 11.346 to 11.35.) The example illustrates the great difference between compound and simple interest. At 11.35 percent, simple interest on $1 is 11.35 cents a year. Simple interest over 74 years is $8.40 (74 $0.1135). That is, an individual withdrawing 11.35 cents every year would have withdrawn $8.40 (74 $0.1135) over 74 years. This is quite a bit below the $2,845.63 that was obtained by reinvestment of all principal and interest. 2 Conceptually, we are taking the fifth roots of both sides of the equation. That is, r 5 1.6105 1 3 Stocks, Bonds, Bills and Inflation [SBBI]. 1999 Yearbook. Ibbotson Associates, Chicago, 2000. 80 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 74 Part II Value and Capital Budgeting The results are more impressive over even longer periods of time. A person with no experience in compounding might think that the value of $1 at the end of 148 years would be twice the value of $1 at the end of 74 years, if the yearly rate of return stayed the same. Actually the value of $1 at the end of 148 years would be the square of the value of $1 at the end of 74 years. That is, if the annual rate of return remained the same, a $1 investment in common stocks should be worth $8,097,610.1[$1 (2845.63 2845.63)]. A few years ago an archaeologist unearthed a relic stating that Julius Caesar lent the Roman equivalent of one penny to someone. Since there was no record of the penny ever being repaid, the archaeologist wondered what the interest and principal would be if a descendant of Caesar tried to collect from a descendant of the borrower in the 20th century. The archaeologist felt that a rate of 6 percent might be appropriate. To his surprise, the principal and interest due after more than 2,000 years was far greater than the entire wealth on earth. The power of compounding can explain why the parents of well-to-do families frequently bequeath wealth to their grandchildren rather than to their children. That is, they skip a generation. The parents would rather make the grandchildren very rich than make the children moderately rich. We have found that in these families the grandchildren have a more positive view of the power of compounding than do the children. E XAMPLE Some people have said that it was the best real estate deal in history. Peter Minuit, directorgeneral of New Netherlands, the Dutch West India Company's Colony in North America, in 1626 allegedly bought Manhattan Island for 60 guilders worth of trinkets from native Americans. By 1667 the Dutch were forced to exchange it for Suriname with the British (perhaps the worst real estate deal ever). This sounds cheap but did the Dutch really get the better end of the deal? It is reported that 60 guilders was worth about $24 at the prevailing exchange rate. If the native Americans had sold the trinkets at a fair market value and invested the $24 at 5 percent (tax free), it would now, 375 years later, be worth more than $2.0 billion. Today, Manhattan is undoubtedly worth more than $2 billion, and so at a 5 percent rate of return, the native Americans got the worst of the deal. However, if invested at 10 percent, the amount of money they received would be worth about $24 (1 r)T 1.1375 $72 quadrillion This is a lot of money. In fact, $72 quadrillion is more than all the real estate in the world is worth today. No one in the history of the world has ever been able to find an investment yielding 10% every year for 375 years. Present Value and Discounting We now know that an annual interest rate of 9 percent enables the investor to transform $1 today into $1.1881 two years from now. In addition, we would like to know: How much would an investor need to lend today so that she could receive $1 two years from today? Algebraically, we can write this as PV (1.09)2 $1 In the preceding equation, PV stands for present value, the amount of money we must lend today in order to receive $1 in two years' time. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 81 Chapter 4 Net Present Value 75 I F I G U R E 4.8 Compounding and Discounting Dollars $2,367.36 Compound interest Compounding at 9% $1,900 Simple interest $1,000 $1,000 $422.41 Discounting at 9% Future years 1 2 3 4 5 6 7 8 9 10 The top line shows the growth of $1,000 at compound interest with the funds invested at 9 percent: $1,000 (1.09)10 $2,367.36. Simple interest is shown on the next line. It is $1,000 [10 ($1,000 0.09)] $1,900. The bottom line shows the discounted value of $1,000 if the interest rate is 9 percent. Solving for PV in this equation, we have PV $1 1.1881 $0.84 This process of calculating the present value of a future cash flow is called discounting. It is the opposite of compounding. The difference between compounding and discounting is illustrated in Figure 4.8. To be certain that $0.84 is in fact the present value of $1 to be received in two years, we must check whether or not, if we loaned out $0.84 and rolled over the loan for two years, we would get exactly $1 back. If this were the case, the capital markets would be saying that $1 received in two years' time is equivalent to having $0.84 today. Checking the exact numbers, we get $0.84168 1.09 1.09 $1 In other words, when we have capital markets with a sure interest rate of 9 percent, we are indifferent between receiving $0.84 today or $1 in two years. We have no reason to treat these two choices differently from each other, because if we had $0.84 today and loaned it out for two years, it would return $1 to us at the end of that time. The value 0.84 [1/(1.09)2] is called the present value factor. It is the factor used to calculate the present value of a future cash flow. In the multiperiod case, the formula for PV can be written as Present Value of Investment CT PV 1 rT where CT is cash flow at date T and r is the appropriate interest rate. (4.3) E XAMPLE Bernard Dumas will receive $10,000 three years from now. Bernard can earn 8 percent on his investments, and so the appropriate discount rate is 8 percent. What is the present value of his future cash flow? 82 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 76 Part II Value and Capital Budgeting I F I G U R E 4.9 Discounting Bernard Dumas' Opportunity Dollars $10,000 $7,938 Cash inflows $10,000 Time 0 1 2 3 Time 0 1 2 3 PV $10,000 $10,000 $7,938 1 3 1.08 0.7938 Figure 4.9 illustrates the application of the present value factor to Bernard's investment. When his investments grow at an 8 percent rate of interest, Bernard Dumas is equally inclined toward receiving $7,938 now and receiving $10,000 in three years' time. After all, he could convert the $7,938 he receives today into $10,000 in three years by lending it at an interest rate of 8 percent. Bernard Dumas could have reached his present value calculation in one of three ways. The computation could have been done by hand, by calculator, or with the help of Table A.1, which appears in the back of the text. This table presents present value of $1 to be received after t periods. The table is used by locating the appropriate interest rate on the horizontal and the appropriate number of periods on the vertical. For example, Bernard Dumas would look at the following portion of Table A.1: Interest rate Period 1 2 3 4 7% 0.9346 0.8734 0.8163 0.7629 8% 0.9259 0.8573 0.7938 0.7350 9% 0.9174 0.8417 0.7722 0.7084 The appropriate present value factor is 0.7938. In the preceding example, we gave both the interest rate and the future cash flow. Alternatively, the interest rate could have been unknown. E XAMPLE A customer of the Chaffkin Corp. wants to buy a tugboat today. Rather than paying immediately, he will pay $50,000 in three years. It will cost the Chaffkin Corp. $38,610 to build the tugboat immediately. The relevant cash flows to Chaffkin Corp. are displayed in Figure 4.10. By charging what interest rate would the Chaffkin Corp. neither gain nor lose on the sale? Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 83 Chapter 4 Net Present Value 77 I F I G U R E 4.10 Cash Flows for Tugboat Cash inflows $50,000 Time 0 3 Cash outflows $38,610 The ratio of construction cost to sale price is $38,610 $50,000 0.7722 We must determine the interest rate that allows $1 to be received in three years to have a present value of $0.7722. Table A.1 tells us that 9 percent is that interest rate.4 Frequently, an investor or a business will receive more than one cash flow. The present value of the set of cash flows is simply the sum of the present values of the individual cash flows. This is illustrated in the following example. E XAMPLE Dennis Draper has won the Kentucky state lottery and will receive the following set of cash flows over the next two years: Year 1 2 Cash Flow $2,000 $5,000 Mr. Draper can currently earn 6 percent in his passbook savings account, and so, the appropriate discount rate is 6 percent. The present value of the cash flows is Year 1 2 Cash Flow $2,000 $5,000 Present Value Factor 1 1.06 1 1.06 0.943 2 Present Value $1,887 $4,450 $6,337 0.890 Total In other words, Mr. Draper is equally inclined toward receiving $6,337 today and receiving $2,000 and $5,000 over the next two years. 4 Algebraically, we are solving for r in the equation $50,000 1 r3 $38,610 or, equivalently, $1 1 r 3 $0.7722 84 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 78 Part II Value and Capital Budgeting E XAMPLE Finance.com has an opportunity to invest in a new high-speed computer that costs $50,000. The computer will generate cash flows (from cost savings) of $25,000 one year from now, $20,000 two years from now, and $15,000 three years from now. The computer will be worthless after three years, and no additional cash flows will occur. Finance.com has determined that the appropriate discount rate is 7 percent for this investment. Should Finance.com make this investment in a new high-speed computer? What is the present value of the investment? The cash flows and present value factors of the proposed computer are as follows. Cash Flows Year 0 1 2 3 $50,000 $25,000 $20,000 $15,000 Present Value Factor 1 1 1.07 1 1.07 1 1.07 1 0.9346 2 0.8734 3 0.8163 The present values of the cash flows are: Cash flows Year 0 1 2 3 Present value factor $50,000 $25,000 $20,000 $15,000 Present value 1 $50,000 0.9346 $23,365 0.8734 $17,468 0.8163 $12,244.5 Total: $ 3,077.5 Finance.com should invest in a new high-speed computer because the present value of its future cash flows is greater than its cost. The NPV is $3,077.5. The Algebraic Formula To derive an algebraic formula for net present value of a cash flow, recall that the PV of receiving a cash flow one year from now is PV C1/(1 r) r)2 and the PV of receiving a cash flow two years from now is PV C2/(1 We can write the NPV of a T-period project as NPV C0 C1 1 r 1 C2 r 2 ... CT 1 r T T C0 i 1 Ci 1 r i The initial flow, C0, is assumed to be negative because it represents an investment. The is shorthand for the sum of the series. QUESTIONS CONCEPT ? What is the difference between simple interest and compound interest? What is the formula for the net present value of a project? Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 85 Chapter 4 Net Present Value 79 4.3 COMPOUNDING PERIODS So far we have assumed that compounding and discounting occur yearly. Sometimes compounding may occur more frequently than just once a year. For example, imagine that a bank pays a 10-percent interest rate "compounded semiannually." This means that a $1,000 deposit in the bank would be worth $1,000 1.05 $1,050 after six months, and $1,050 1.05 $1,102.50 at the end of the year. The end-of-the-year wealth can be written as5 $1,000 1 0.10 2 2 $1,000 (1.05)2 $1,102.50 Of course, a $1,000 deposit would be worth $1,100 ($1,000 1.10) with yearly compounding. Note that the future value at the end of one year is greater with semiannual compounding than with yearly compounding. With yearly compounding, the original $1,000 remains the investment base for the full year. The original $1,000 is the investment base only for the first six months with semiannual compounding. The base over the second six months is $1,050. Hence, one gets interest on interest with semiannual compounding. Because $1,000 1.1025 $1,102.50, 10 percent compounded semiannually is the same as 10.25 percent compounded annually. In other words, a rational investor could not care less whether she is quoted a rate of 10 percent compounded semiannually, or a rate of 10.25 percent compounded annually. Quarterly compounding at 10 percent yields wealth at the end of one year of $1,000 1 0.10 4 4 $1,103.81 More generally, compounding an investment m times a year provides end-of-year wealth of C0 1 r m m (4.4) where C0 is one's initial investment and r is the stated annual interest rate. The stated annual interest rate is the annual interest rate without consideration of compounding. Banks and other financial institutions may use other names for the stated annual interest rate. Annual percentage rate is perhaps the most common synonym. E XAMPLE What is the end-of-year wealth if Jane Christine receives a stated annual interest rate of 24 percent compounded monthly on a $1 investment? Using (4.4), her wealth is $1 1 0.24 12 12 $1 (1.02)12 $1.2682 5 In addition to using a calculator, one can still use Table A.3 when the compounding period is less than a year. Here, one sets the interest rate at 5 percent and the number of periods at two. 86 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 80 Part II Value and Capital Budgeting The annual rate of return is 26.82 percent. This annual rate of return is either called the effective annual interest rate or the effective annual yield. Due to compounding, the effective annual interest rate is greater than the stated annual interest rate of 24 percent. Algebraically, we can rewrite the effective annual interest rate as Effective Annual Interest Rate: r m 1 1 m (4.5) Students are often bothered by the subtraction of 1 in (4.5). Note that end-of-year wealth is composed of both the interest earned over the year and the original principal. We remove the original principal by subtracting one in (4.5). E XAMPLE If the stated annual rate of interest, 8 percent, is compounded quarterly, what is the effective annual rate of interest? Using (4.5), we have 1 r m m 1 1 0.08 4 4 1 0.0824 8.24% 10%, we Referring back to our original example where C0 can generate the following table: $1,000 and r C0 $1,000 1,000 1,000 1,000 Compounding Frequency (m) Yearly (m 1) Semiannually (m 2) Quarterly (m 4) Daily (m 365) C1 $1,100.00 1,102.50 1,103.81 1,105.16 Effective Annual Interest Rate r m 1 1 m 0.10 0.1025 0.10381 0.10516 Distinction between Stated Annual Interest Rate and Effective Annual Interest Rate The distinction between the stated annual interest rate (SAIR) and the effective annual interest rate (EAIR) is frequently quite troubling to students. One can reduce the confusion by noting that the SAIR becomes meaningful only if the compounding interval is given. For example, for an SAIR of 10 percent, the future value at the end of one year with semiannual compounding is [1 (.10/2)]2 1.1025. The future value with quarterly compounding is [1 (.10/4)]4 1.1038. If the SAIR is 10 percent but no compounding interval is given, one cannot calculate future value. In other words, one does not know whether to compound semiannually, quarterly, or over some other interval. By contrast, the EAIR is meaningful without a compounding interval. For example, an EAIR of 10.25 percent means that a $1 investment will be worth $1.1025 in one year. One can think of this as an SAIR of 10 percent with semiannual compounding or an SAIR of 10.25 percent with annual compounding, or some other possibility. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 87 Chapter 4 Net Present Value 81 Compounding over Many Years Formula (4.4) applies for an investment over one year. For an investment over one or more (T) years, the formula becomes Future Value with Compounding: r mT FV C0 1 m (4.6) E XAMPLE Harry DeAngelo is investing $5,000 at a stated annual interest rate of 12 percent per year, compounded quarterly, for five years. What is his wealth at the end of five years? Using formula (4.6), his wealth is $5,000 1 0.12 4 4 5 $5,000 (1.03)20 $5,000 1.8061 $9,030.50 Continuous Compounding (Advanced) The previous discussion shows that one can compound much more frequently than once a year. One could compound semiannually, quarterly, monthly, daily, hourly, each minute, or even more often. The limiting case would be to compound every infinitesimal instant, which is commonly called continuous compounding. Surprisingly, banks and other financial institutions frequently quote continuously compounded rates, which is why we study them. Though the idea of compounding this rapidly may boggle the mind, a simple formula is involved. With continuous compounding, the value at the end of T years is expressed as C0 erT (4.7) where C0 is the initial investment, r is the stated annual interest rate, and T is the number of years over which the investment runs. The number e is a constant and is approximately equal to 2.718. It is not an unknown like C0, r, and T. E XAMPLE Linda DeFond invested $1,000 at a continuously compounded rate of 10 percent for one year. What is the value of her wealth at the end of one year? From formula (4.7) we have $1,000 e0.10 $1,000 1.1052 $1,105.20 This number can easily be read from our Table A.5. One merely sets r, the value on the horizontal dimension, to 10% and T, the value on the vertical dimension, to 1. For this problem, the relevant portion of the table is Continuously compounded rate (r) Period (T) 1 2 3 9% 1.0942 1.1972 1.3100 10% 1.1052 1.2214 1.3499 11% 1.1163 1.2461 1.3910 88 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 82 Part II Value and Capital Budgeting Note that a continuously compounded rate of 10 percent is equivalent to an annually compounded rate of 10.52 percent. In other words, Linda DeFond could not care less whether her bank quoted a continuously compounded rate of 10 percent or a 10.52-percent rate, compounded annually. E XAMPLE Linda DeFond's brother, Mark, invested $1,000 at a continuously compounded rate of 10 percent for two years. The appropriate formula here is $1,000 e0.10 2 $1,000 e0.20 $1,221.40 Using the portion of the table of continuously compounded rates reproduced above, we find the value to be 1.2214. Figure 4.11 illustrates the relationship among annual, semiannual, and continuous compounding. Semiannual compounding gives rise to both a smoother curve and a higher ending value than does annual compounding. Continuous compounding has both the smoothest curve and the highest ending value of all. E XAMPLE The Michigan state lottery is going to pay you $1,000 at the end of four years. If the annual continuously compounded rate of interest is 8 percent, what is the present value of this payment? $1,000 QUESTIONS CONCEPT 1 e0.08 4 $1,000 1 1.3771 $726.16 ? What is a stated annual interest rate? What is an effective annual interest rate? What is the relationship between the stated annual interest rate and the effective annual interest rate? Define continuous compounding. I F I G U R E 4.11 Annual, Semiannual, and Continuous Compounding Dollars Dollars Dollars 4 3 2 1 Interest earned 4 3 2 1 0 1 2 3 Years 4 5 0 1 2 3 Years 4 5 Interest earned 4 3 2 1 Interest earned 0 1 2 3 Years 4 5 Annual compounding Semiannual compounding Continuous compounding Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 89 Chapter 4 Net Present Value 83 4.4 SIMPLIFICATIONS The first part of this chapter has examined the concepts of future value and present value. Although these concepts allow one to answer a host of problems concerning the time value of money, the human effort involved can frequently be excessive. For example, consider a bank calculating the present value on a 20-year monthly mortgage. Because this mortgage has 240 (20 12) payments, a lot of time is needed to perform a conceptually simple task. Because many basic finance problems are potentially so time-consuming, we search out simplifications in this section. We provide simplifying formulas for four classes of cash flow streams: Perpetuity Growing perpetuity Annuity Growing annuity Perpetuity A perpetuity is a constant stream of cash flows without end. If you are thinking that perpetuities have no relevance to reality, it will surprise you that there is a well-known case of an unending cash flow stream: the British bonds called consols. An investor purchasing a consol is entitled to receive yearly interest from the British government forever. How can the price of a consol be determined? Consider a consol that pays a coupon of C dollars each year and will do so forever. Simply applying the PV formula gives us PV C 1 r 1 C r 2 C 1 r 3 ... where the dots at the end of the formula stand for the infinite string of terms that continues the formula. Series like the preceding one are called geometric series. It is well known that even though they have an infinite number of terms, the whole series has a finite sum because each term is only a fraction of the preceding term. Before turning to our calculus books, though, it is worth going back to our original principles to see if a bit of financial intuition can help us find the PV. The present value of the consol is the present value of all of its future coupons. In other words, it is an amount of money that, if an investor had it today, would enable him to achieve the same pattern of expenditures that the consol and its coupons would. Suppose that an investor wanted to spend exactly C dollars each year. If he had the consol, he could do this. How much money must he have today to spend the same amount? Clearly he would need exactly enough so that the interest on the money would be C dollars per year. If he had any more, he could spend more than C dollars each year. If he had any less, he would eventually run out of money spending C dollars per year. The amount that will give the investor C dollars each year, and therefore the present value of the consol, is simply PV C r (4.8) To confirm that this is the right answer, notice that if we lend the amount C/r, the interest it earns each year will be Interest C r r C 90 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 84 Part II Value and Capital Budgeting which is exactly the consol payment.6 To sum up, we have shown that for a consol Formula for Present Value of Perpetuity: C C C PV ... 1 r2 1 r3 1 r C r It is comforting to know how easily we can use a bit of financial intuition to solve this mathematical problem. E XAMPLE Consider a perpetuity paying $100 a year. If the relevant interest rate is 8 percent, what is the value of the consol? Using formula (4.8), we have PV $100 0.08 $1,250 Now suppose that interest rates fall to 6 percent. Using (4.8), the value of the perpetuity is PV $100 0.06 $1,666.67 Note that the value of the perpetuity rises with a drop in the interest rate. Conversely, the value of the perpetuity falls with a rise in the interest rate. Growing Perpetuity Imagine an apartment building where cash flows to the landlord after expenses will be $100,000 next year. These cash flows are expected to rise at 5 percent per year. If one assumes that this rise will continue indefinitely, the cash flow stream is termed a growing perpetuity. The relevant interest rate is 11 percent. Therefore, the appropriate discount rate is 11 percent and the present value of the cash flows can be represented as PV $100,000 1.11 $100,000 1.05 1.11 2 $100,000 1.05 1.11 3 2 ... $100,000 1.05 1.11 N N 1 ... 6 We can prove this by looking at the PV equation: PV C/(1 PV r) a(1 ax x C/(1 x2 ax2 x) C/r a r)2 . . .) ... ... (1) (2) r) a and 1/(1 r) x. We now have Let C/(1 Next we can multiply by x: xPV Subtracting (2) from (1) gives PV(1 Now we substitute for a and x and rearrange: PV Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 91 Chapter 4 Net Present Value 85 Algebraically, we can write the formula as PV C 1 r C 1 1 r 2 g C 1 1 r g 3 2 ... C 1 gN 1 rN 1 . . . (4.9) where C is the cash flow to be received one period hence, g is the rate of growth per period, expressed as a percentage, and r is the appropriate discount rate. Fortunately, formula (4.9) reduces to the following simplification:7 Formula for Present Value of Growing Perpetuity: C PV r g (4.10) From formula (4.10), the present value of the cash flows from the apartment building is $100,000 0.11 0.05 $1,666,667 There are three important points concerning the growing perpetuity formula: 1. The Numerator. The numerator in (4.10) is the cash flow one period hence, not at date 0. Consider the following example: E XAMPLE Rothstein Corporation is just about to pay a dividend of $3.00 per share. Investors anticipate that the annual dividend will rise by 6 percent a year forever. The applicable interest rate is 11 percent. What is the price of the stock today? The numerator in formula (4.10) is the cash flow to be received next period. Since the growth rate is 6 percent, the dividend next year is $3.18 ($3.00 1.06). The price of the stock today is $66.60 $3.00 Imminent dividend $3.18 0.11 0.06 Present value of all dividends beginning a year from now The price of $66.60 includes both the dividend to be received immediately and the present value of all dividends beginning a year from now. Formula (4.10) only makes it possible to calculate the present value of all dividends beginning a year from now. Be sure you understand this example; test questions on this subject always seem to trip up a few of our students. 7 PV is the sum of an infinite geometric series: PV a(1 x x2 . . .) where a C/(1 r) and x (1 g)/(1 r). Previously we showed that the sum of an infinite geometric series is a/(1 x). Using this result and substituting for a and x, we find PV C/(r g) Note that this geometric series converges to a finite sum only when x is less than 1. This implies that the growth rate, g, must be less than the interest rate, r. 92 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 86 Part II Value and Capital Budgeting 2. The Interest Rate and the Growth Rate. The interest rate r must be greater than the growth rate g for the growing perpetuity formula to work. Consider the case in which the growth rate approaches the interest rate in magnitude. Then the denominator in the growing perpetuity formula gets infinitesimally small and the present value grows infinitely large. The present value is in fact undefined when r is less than g. 3. The Timing Assumption. Cash generally flows into and out of real-world firms both randomly and nearly continuously. However, formula (4.10) assumes that cash flows are received and disbursed at regular and discrete points in time. In the example of the apartment, we assumed that the net cash flows of $100,000 only occurred once a year. In reality, rent checks are commonly received every month. Payments for maintenance and other expenses may occur anytime within the year. The growing perpetuity formula of (4.10) can be applied only by assuming a regular and discrete pattern of cash flow. Although this assumption is sensible because the formula saves so much time, the user should never forget that it is an assumption. This point will be mentioned again in the chapters ahead. A few words should be said about terminology. Authors of financial textbooks generally use one of two conventions to refer to time. A minority of financial writers treat cash flows as being received on exact dates, for example date 0, date 1, and so forth. Under this convention, date 0 represents the present time. However, because a year is an interval, not a specific moment in time, the great majority of authors refer to cash flows that occur at the end of a year (or alternatively, the end of a period). Under this end-of-the-year convention, the end of year 0 is the present, the end of year 1 occurs one period hence, and so on. (The beginning of year 0 has already passed and is not generally referred to.)8 The interchangeability of the two conventions can be seen from the following chart: Date 0 Now End of year 0 Now Date 1 End of year 1 Date 2 End of year 2 Date 3 End of year 3 ... ... We strongly believe that the dates convention reduces ambiguity. However, we use both conventions because you are likely to see the end-of-year convention in later courses. In fact, both conventions may appear in the same example for the sake of practice. Annuity An annuity is a level stream of regular payments that lasts for a fixed number of periods. Not surprisingly, annuities are among the most common kinds of financial instruments. The pensions that people receive when they retire are often in the form of an annuity. Leases and mortgages are also often annuities. To figure out the present value of an annuity we need to evaluate the following equation: C 1 r 1 C r 2 C 1 r 3 ... C 1 r T The present value of only receiving the coupons for T periods must be less than the present value of a consol, but how much less? To answer this we have to look at consols a bit more closely. 8 Sometimes financial writers merely speak of a cash flow in year x. Although this terminology is ambiguous, such writers generally mean the end of year x. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 93 Chapter 4 Net Present Value 87 Consider the following time chart: Now Date (or end of year) Consol 1 Consol 2 Annuity 0 1 C C 2 C C 3 C... C... T C C (T C C 1) (T 2) C... C... Consol 1 is a normal consol with its first payment at date 1. The first payment of consol 2 occurs at date T 1. The present value of having a cash flow of C at each of T dates is equal to the present value of consol 1 minus the present value of consol 2. The present value of consol 1 is given by PV C r (4.11) Consol 2 is just a consol with its first payment at date T 1. From the perpetuity formula, this consol will be worth C/r at date T.9 However, we do not want the value at date T. We want the value now; in other words, the present value at date 0. We must discount C/r back by T periods. Therefore, the present value of consol 2 is PV C 1 r 1 r T (4.12) The present value of having cash flows for T years is the present value of a consol with its first payment at date 1 minus the present value of a consol with its first payment at date T 1. Thus, the present value of an annuity is formula (4.11) minus formula (4.12). This can be written as C r This simplifies to Formula for Present Value of Annuity:10, 11 1 1 PV C r r1 rT C 1 r 1 r T (4.13) E XAMPLE Mark Young has just won the state lottery, paying $50,000 a year for 20 years. He is to receive his first payment a year from now. The state advertises this as the Million Dollar Lottery because $1,000,000 $50,000 20. If the interest rate is 8 percent, what is the true value of the lottery? 9 Students frequently think that C/r is the present value at date T 1 because the consol's first payment is at date T 1. However, the formula values the annuity as of one period prior to the first payment. 10 This can also be written as C[1 1/(1 1 r r r) T ]/r T 11 We can also provide a formula for the future value of an annuity. FV C 1 r 94 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 88 Part II Value and Capital Budgeting Formula (4.13) yields Present value of Million Dollar Lottery 1 0.08 Periodic payment $50,000 $490,905 $50,000 1 0.08 1.08 20 Annuity factor 9.8181 Rather than being overjoyed at winning, Mr. Young sues the state for misrepresentation and fraud. His legal brief states that he was promised $1 million but received only $490,905.12 The term we use to compute the value of the stream of level payments, C, for T years is called an annuity factor. The annuity factor in the current example is 9.8181. Because the annuity factor is used so often in PV calculations, we have included it in Table A.2 in the back of this book. The table gives the values of these factors for a range of interest rates, r, and maturity dates, T. The annuity factor as expressed in the brackets of (4.13) is a complex formula. For simplification, we may from time to time refer to the annuity factor as AT r (4.14) That is, expression (4.14) stands for the present value of $1 a year for T years at an interest rate of r. Our experience is that annuity formulas are not hard, but tricky, for the beginning student. We present four tricks below. Trick 1: A Delayed Annuity One of the tricks in working with annuities or perpetuities is getting the timing exactly right. This is particularly true when an annuity or perpetuity begins at a date many periods in the future. We have found that even the brightest beginning student can make errors here. Consider the following example. E XAMPLE Danielle Caravello will receive a four-year annuity of $500 per year, beginning at date 6. If the interest rate is 10 percent, what is the present value of her annuity? This situation can be graphed as: 0 1 2 3 4 5 6 $500 7 $500 8 $500 9 $500 10 12 To solve this problem on a common type HP19B II financial calculator, you should do the following: a. Press "FIN" and "TVM." b. Enter the payment 50,000 and press "PMT." c. Enter the interest rate 8 and press "I % YR." d. Enter the number of periods 20 and press "N." e. Finally, press "PV" to solve. Notice your answer is $490,907.370372. The calculator uses 11 digits for the annuity factor and the answer, whereas the example uses only 4 digits in the annuity factor and rounds the final answer to the nearest dollar. That is why the answer in the text example differs from the one using the calculator. In practice, the answer using the calculator is the best because it is more precise. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 95 Chapter 4 Net Present Value 89 The analysis involves two steps: 1. Calculate the present value of the annuity using (4.13). This is Present Value of Annuity at Date 5: 1 1 $500 $500 A4 0.10 0.10 0.10 1.10 4 $500 3.1699 $1,584.95 Note that $1,584.95 represents the present value at date 5. Students frequently think that $1,584.95 is the present value at date 6, because the annuity begins at date 6. However, our formula values the annuity as of one period prior to the first payment. This can be seen in the most typical case where the first payment occurs at date 1. The formula values the annuity as of date 0 here. 2. Discount the present value of the annuity back to date 0. That is Present Value at Date 0: $1,584.95 $984.13 1.10 5 Again, it is worthwhile mentioning that, because the annuity formula brings Danielle's annuity back to date 5, the second calculation must discount over the remaining 5 periods. The two-step procedure is graphed in Figure 4.12. Trick 2: Annuity in Advance The annuity formula of (4.13) assumes that the first annuity payment begins a full period hence. This type of annuity is frequently called an annuity in arrears. What happens if the annuity begins today, in other words, at date 0? E XAMPLE In a previous example, Mark Young received $50,000 a year for 20 years from the state lottery. In that example, he was to receive the first payment a year from the winning date. Let us now assume that the first payment occurs immediately. The total number of payments remains 20. Under this new assumption, we have a 19-date annuity with the first payment occurring at date 1--plus an extra payment at date 0. The present value is $50,000 Payment at date 0 $50,000 A19 0.08 19-year annuity $50,000 ($50,000 9.6036) $530,180 I F I G U R E 4.12 Discounting Danielle Caravello's Annuity Date Cash flow 0 1 2 3 4 5 6 $500 7 $500 8 $500 9 $500 10 $984.13 $1,584.95 Step one: Discount the four payments back to date 5 by using the annuity formula. Step two: Discount the present value at date 5 ($1,584.95) back to present value at date 0. 96 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 90 Part II Value and Capital Budgeting $530,180, the present value in this example, is greater than $490,905, the present value in the earlier lottery example. This is to be expected because the annuity of the current example begins earlier. An annuity with an immediate initial payment is called an annuity in advance. Always remember that formula (4.13), as well as Table A.2, in this book refers to an annuity in arrears. Trick 3: The Infrequent Annuity The following example treats an annuity with payments occurring less frequently than once a year. E XAMPLE Ms. Ann Chen receives an annuity of $450, payable once every two years. The annuity stretches out over 20 years. The first payment occurs at date 2, that is, two years from today. The annual interest rate is 6 percent. The trick is to determine the interest rate over a two-year period. The interest rate over two years is (1.06 1.06) 1 12.36% That is, $100 invested over two years will yield $112.36. What we want is the present value of a $450 annuity over 10 periods, with an interest rate of 12.36 percent per period. This is $450 1 0.1236 1 0.1236 1.1236 10 $450 A10 0.1236 $2,505.57 Trick 4: Equating Present Value of Two Annuities The following example equates the present value of inflows with the present value of outflows. E XAMPLE Harold and Helen Nash are saving for the college education of their newborn daughter, Susan. The Nashes estimate that college expenses will run $30,000 per year when their daughter reaches college in 18 years. The annual interest rate over the next few decades will be 14 percent. How much money must they deposit in the bank each year so that their daughter will be completely supported through four years of college? To simplify the calculations, we assume that Susan is born today. Her parents will make the first of her four annual tuition payments on her 18th birthday. They will make equal bank deposits on each of her first 17 birthdays, but no deposit at date 0. This is illustrated as Date 0 1 2 ... 17 18 19 20 21 Susan's Parents' Parents' birth 1st 2nd deposit deposit Parents' Tuition Tuition Tuition Tuition 17th and payment payment payment payment last 1 2 3 4 deposit Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 97 Chapter 4 Net Present Value 91 Mr. and Ms. Nash will be making deposits to the bank over the next 17 years. They will be withdrawing $30,000 per year over the following four years. We can be sure they will be able to withdraw fully $30,000 per year if the present value of the deposits is equal to the present value of the four $30,000 withdrawals. This calculation requires three steps. The first two determine the present value of the withdrawals. The final step determines yearly deposits that will have a present value equal to that of the withdrawals. 1. We calculate the present value of the four years at college using the annuity formula. $30,000 1 0.14 1 0.14 1.14 4 $30,000 $30,000 A4 0.14 2.9137 $87,411 We assume that Susan enters college on her 18th birthday. Given our discussion in Trick 1 $87,411 represents the present value at date 17. 2. We calculate the present value of the college education at date 0 as $87,411 1.14 17 $9,422.91 3. Assuming that Helen and Harold Nash make deposits to the bank at the end of each of the 17 years, we calculate the annual deposit that will yield a present value of all deposits of $9,422.91. This is calculated as C Because A17 0.14 6.3729, C $9,422.91 6.3729 $1,478.59 A17 0.14 $9,422.91 Thus, deposits of $1,478.59 made at the end of each of the first 17 years and invested at 14 percent will provide enough money to make tuition payments of $30,000 over the following four years. An alternative method would be to (1) calculate the present value of the tuition payments at Susan's 18th birthday and (2) calculate annual deposits such that the future value of the deposits at her 18th birthday equals the present value of the tuition payments at that date. Although this technique can also provide the right answer, we have found that it is more likely to lead to errors. Therefore, we only equate present values in our presentation. Growing Annuity Cash flows in business are very likely to grow over time, due either to real growth or to inflation. The growing perpetuity, which assumes an infinite number of cash flows, provides one formula to handle this growth. We now consider a growing annuity, which is a finite 98 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 92 Part II Value and Capital Budgeting number of growing cash flows. Because perpetuities of any kind are rare, a formula for a growing annuity would be useful indeed. The formula is13 Formula for Present Value of Growing Annuity: 1 1 1 g T PV C (4.15) r g r g 1 r where, as before, C is the payment to occur at the end of the first period, r is the interest rate, g is the rate of growth per period, expressed as a percentage, and T is the number of periods for the annuity. E XAMPLE Stuart Gabriel, a second-year MBA student, has just been offered a job at $80,000 a year. He anticipates his salary increasing by 9 percent a year until his retirement in 40 years. Given an interest rate of 20 percent, what is the present value of his lifetime salary? We simplify by assuming he will be paid his $80,000 salary exactly one year from now, and that his salary will continue to be paid in annual installments. The appropriate discount rate is 20 percent. From (4.15), the calculation is Present value of Stuart's $80,000 lifetime salary 1 0.20 0.09 0.20 1 1.09 0.09 1.20 40 $711,731 Though the growing annuity is quite useful, it is more tedious than the other simplifying formulas. Whereas most sophisticated calculators have special programs for perpetuity, growing perpetuity, and annuity, there is no special program for growing annuity. Hence, one must calculate all the terms in formula (4.15) directly. E XAMPLE In a previous example, Harold and Helen Nash planned to make 17 identical payments in order to fund the college education of their daughter, Susan. Alternatively, imagine that they planned to increase their payments at 4 percent per year. What would their first payment be? 13 This can be proved as follows. A growing annuity can be viewed as the difference between two growing perpetuities. Consider a growing perpetuity A, where the first payment of C occurs at date 1. Next, consider growing perpetuity B, where the first payment of C(1 g)T is made at date T 1. Both perpetuities grow at rate g. The growing annuity over T periods is the difference between annuity A and annuity B. This can be represented as: 2 3 g) g) C C (1 (1 (1 (1 ... g)2 . . . C g)2 . . . C T (1 (1 C r g T Date 0 1 C C C C T g)T g)T 1 1 g)T g) T T C C (1 (1 2 g)T g) 1 T C C (1 (1 T 1 3 g)T g) 2 Perpetuity A Perpetuity B Annuity C C (1 (1 ... ... T 2 1 The value of perpetuity A is The value of perpetuity B is C r The difference between the two perpetuities is given by (4.15). 1 g g 1 1 r T Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 99 Chapter 4 Net Present Value 93 The first two steps of the previous Nash family example showed that the present value of the college costs was $9,422.91. These two steps would be the same here. However, the third step must be altered. Now we must ask, How much should their first payment be so that, if payments increase by 4 percent per year, the present value of all payments will be $9,422.91? We set the growing-annuity formula equal to $9,422.91 and solve for C. C 1 r g r 1 1 g 1 g r T C 1 0.14 1 0.14 0.04 $9,422.91 1.04 0.04 1.14 17 Here, C $1,192.78. Thus, the deposit on their daughter's first birthday is $1,192.78, the deposit on the second birthday is $1,240.49 (1.04 $1,192.78), and so on. QUESTIONS CONCEPT ? What are the formulas for perpetuity, growing perpetuity, annuity, and growing annuity? What are three important points concerning the growing-perpetuity formula? What are four tricks concerning annuities? CASE STUDY: Making the Decision to Convert Lottery Prize Winnings: The Case of the Singer Asset Finance Company I n 1987, Rosalind Setchfield won more than $1.3 million in the Arizona state lottery.The winnings were to be paid in 20 yearly installments of $65,276.79. Six years later, in 1995, Mrs. Setchfield received a phone call from a salesman for the Singer Asset Finance Company of West Palm Beach, Florida.The Singer company offered to give her $140,000 immediately for one-half of the next nine lottery checks (i.e., $140,000 now for $32,638.39 9 $293,745.51 over nine years). Singer is a prize broker with many employees whose main job is to track down million-dollar-lottery prizewinners like Mrs. Setchfield. Singer knows that many people are eager to trade all or part of their promised winnings for a discounted lump sum immediately. Singer is part of a growing $700 million prize-broker business. Singer and Woodbridge Sterling Capital currently account for about 80 percent of the market for lottery prize conversions. Prize brokers like Singer resell their rights to receive future payouts (called structured payouts) to institutional investors such as SunAmerica, Inc., or the John Hancock Mutual Life Insurance Co. In the case of Mrs. Setchfield, the investor was the Enhance Financial Service Group, a New York municipal bond reinsurer. Singer had arranged to sell its stake in Mrs. Setchfield's lottery prize to Enhance for $196,000 and would make a quick $56,000 profit if she accepted the offer. Mrs. Setchfield accepted Singer's offer and the deal was made. How was Singer able to structure a deal that resulted in a $56,000 profit? The answer is that individuals and institutions have different intertemporal consumption preferences. Mrs. Setchfield's family had experienced some financial difficulties and was in need of some immediate cash. She didn't want to wait nine years for her prize winnings. On the other hand, the Enhance Group had some excess cash and was very willing to make a $196,000 investment in order to receive the rights to obtain half of Mrs. Setchfield's prize winnings, or $32,638.39 a year for nine years.The discount rate the Enhance Group applied to the future payouts was about 8.96 percent (i.e., the discount rate that equates the present value of $196,000 with Singer's right to receive their equal payments of $32,638.39). The discount rate that Mrs. Setchfield used was 18.1 percent, reflecting her aversion to deferred cash flows. Source:Vanessa Williams,"How Major Players Turn Lottery Jackpots into Guaranteed Bet," The Wall Street Journal, September 23, 1997. 100 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 94 Part II Value and Capital Budgeting 4.5 WHAT IS A FIRM WORTH? Suppose you are in the business of trying to determine the value of small companies. (You are a business appraiser.) How can you determine what a firm is worth? One way to think about the question of how much a firm is worth is to calculate the present value of its future cash flows. Let us consider the example of a firm that is expected to generate net cash flows (cash inflows minus cash outflows) of $5,000 in the first year and $2,000 for each of the next five years. The firm can be sold for $10,000 seven years from now. The owners of the firm would like to be able to make 10 percent on their investment in the firm. The value of the firm is found by multiplying the net cash flows by the appropriate present-value factor. The value of the firm is simply the sum of the present values of the individual net cash flows. The present value of the net cash flows is given next. The Present Value of the Firm End of Year 1 2 3 4 5 6 7 Net Cash Flow of the Firm $ 5,000 2,000 2,000 2,000 2,000 2,000 10,000 Present Value Factor (10%) .90909 .82645 .75131 .68301 .62092 .56447 .51315 Present value of firm Present Value of Net Cash Flows $ 4,545.45 1,652.90 1,502.62 1,366.02 1,241.84 1,128.94 5,131.58 $16,569.35 We can also use the simplifying formula for an annuity to give us $5,000 1.1 2,000 A5 0.10 1.1 10,000 1.1 7 $16,569.35 Suppose you have the opportunity to acquire the firm for $12,000. Should you acquire the firm? The answer is yes because the NPV is positive. NPV $4,569.35 PV Cost $16,569.35 $12,000 The incremental value (NPV) of acquiring the firm is $4,569.35. E XAMPLE The Trojan Pizza Company is contemplating investing $1 million in four new outlets in Los Angeles. Andrew Lo, the firm's Chief Financial Officer (CFO), has estimated that the investments will pay out cash flows of $200,000 per year for nine years and nothing thereafter. (The cash flows will occur at the end of each year and there will be no cash flow after year 9.) Mr. Lo has determined that the relevant discount rate for this investment is 15 percent. This is the rate of return that the firm can earn at comparable projects. Should the Trojan Pizza Company make the investments in the new outlets? Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 101 Chapter 4 Net Present Value 95 The decision can be evaluated as: NPV $1,000,000 $1,000,000 $1,000,000 $45,683.22 $200,000 $200,000 1.15 1.15 2 9 $200,000 A0.15 $954,316.78 ... $200,000 1.15 9 The present value of the four new outlets is only $954,316.78. The outlets are worth less than they cost. The Trojan Pizza Company should not make the investment because the NPV is $45,683.22. If the Trojan Pizza Company requires a 15 percent rate of return, the new outlets are not a good investment. 4.6 SUMMARY AND CONCLUSIONS 1. Two basic concepts, future value and present value, were introduced in the beginning of this chapter. With a 10-percent interest rate, an investor with $1 today can generate a future value of $1.10 in a year, $1.21 [$1 (1.10)2] in two years, and so on. Conversely, present-value analysis places a current value on a later cash flow. With the same 10-percent interest rate, a dollar to be received in one year has a present value of $0.909 ($1/1.10) in year 0. A dollar to be received in two years has a present value of $0.826 [$1/(1.10)2]. 2. One commonly expresses the interest rate as, say, 12 percent per year. However, one can speak of the interest rate as 3 percent per quarter. Although the stated annual interest rate remains 12 percent (3 percent 4), the effective annual interest rate is 12.55 percent [(1.03)4 1]. In other words, the compounding process increases the future value of an investment. The limiting case is continuous compounding, where funds are assumed to be reinvested every infinitesimal instant. 3. A basic quantitative technique for financial decision making is net present value analysis. The net present value formula for an investment that generates cash flows (Ci) in future periods is NPV C0 C1 1 r 1 C2 r 2 ... CN 1 r N N C0 i 1 Ci 1 r i The formula assumes that the cash flow at date 0 is the initial investment (a cash outflow). 4. Frequently, the actual calculation of present value is long and tedious. The computation of the present value of a long-term mortgage with monthly payments is a good example of this. We presented four simplifying formulas: Perpetuity: PV Growing perpetuity: PV Annuity: PV Growing annuity: PV C r C g 1 C r C 1 r g r 1 1 r 1 r g r T 1 1 g r T 5. We stressed a few practical considerations in the application of these formulas: 102 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 96 Part II Value and Capital Budgeting a. The numerator in each of the formulas, C, is the cash flow to be received one full period hence. b. Cash flows are generally irregular in practice. To avoid unwieldy problems, assumptions to create more regular cash flows are made both in this textbook and in the real world. c. A number of present value problems involve annuities (or perpetuities) beginning a few periods hence. Students should practice combining the annuity (or perpetuity) formula with the discounting formula to solve these problems. d. Annuities and perpetuities may have periods of every two or every n years, rather than once a year. The annuity and perpetuity formulas can easily handle such circumstances. e. One frequently encounters problems where the present value of one annuity must be equated with the present value of another annuity. KEY TERMS Annuity 86 Annuity factor 88 Annual percentage rate 79 Appropriate discount rate 75 Compounding 70 Compound interest 70 Compound value 66 Continuous compounding 81 Discounting 75 Effective annual interest rate 80 Effective annual yield 80 Future value 66 Growing annuity 91 Growing perpetuity 84 Net present value 68 Perpetuity 83 Present value 67 Present value factor 75 Simple interest 70 Stated annual interest rate 79 SUGGESTED READINGS To learn how to perform the mathematics of present value, we encourage you to see the handbooks that come with the Hewlett-Packard HP 19BII calculator. We also recommend: White, M. Financial Analysis with a Calculator. 3rd ed. Burr Ridge, Ill.: Irwin/McGraw-Hill, 1998. QUESTIONS AND PROBLEMS14 Annual Compounding 4.1 Compute the future value of $1,000 compounded annually for a. 10 years at 5 percent. b. 10 years at 7 percent. c. 20 years at 5 percent. d. Why is the interest earned in part c not twice the amount earned in part a? 4.2 Calculate the present value of the following cash flows discounted at 10 percent. a. $1,000 received seven years from today. b. $2,000 received one year from today. c. $500 received eight years from today. 4.3 Would you rather receive $1,000 today or $2,000 in 10 years if the discount rate is 8 percent? 14 The following conventions are used in the questions and problems for this chapter. If more frequent compounding than once a year is indicated, the problem will either state: (1) both a stated annual interest rate and a compounding period, or (2) an effective annual interest rate. If annual compounding is indicated, the problem will provide an annual interest rate. Since the stated annual interest rate and the effective annual interest rate are the same here, we use the simpler annual interest rate. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 103 Chapter 4 Net Present Value 97 4.4 The government has issued a bond that will pay $1,000 in 25 years. The bond will pay no interim coupon payments. What is the present value of the bond if the discount rate is 10 percent? 4.5 A firm has an estimated pension liability of $1.5 million due 27 years from today. If the firm can invest in a risk-free security that has a stated annual interest rate of 8 percent, how much must the firm invest today to be able to make the $1.5 million payment? 4.6 You have won the Florida state lottery. Lottery officials offer you the choice of the following alternative payouts: Alternative 1: $10,000 one year from now. Alternative 2: $20,000 five years from now. Which alternative should you choose if the discount rate is: a. 0 percent? b. 10 percent? c. 20 percent? d. What discount rate makes the two alternatives equally attractive to you? 4.7 You are selling your house. The Smiths have offered you $115,000. They will pay you immediately. The Joneses have offered you $150,000, but they cannot pay you until three years from today. The interest rate is 10 percent. Which offer should you choose? 4.8 Suppose you bought a bond that will pay $1,000 in 20 years. No intermediate coupon payments will be made. If the appropriate discount rate for the bond is 8 percent, a. what is the current price of the bond? b. what will the price be 10 years from today? c. what will the price be 15 years from today? 4.9 Suppose you deposit $1,000 in an account at the end of each of the next four years. If the account earns 12 percent, how much will be in the account at the end of seven years? 4.10 Ann Woodhouse is considering the purchase of a house. She expects that she will own the house for 10 years and then sell it for $5 million. What is the most she would be willing to pay for the house if the appropriate discount rate is 12 percent? 4.11 You have the opportunity to make an investment that costs $900,000. If you make this investment now, you will receive $120,000 one year from today, $250,000 and $800,000 two and three years from today, respectively. The appropriate discount rate for this investment is 12 percent. a. Should you make the investment? b. What is the net present value (NPV) of this opportunity? c. If the discount rate is 11 percent, should you invest? Compute the NPV to support your answer. 4.12 You have the opportunity to invest in a machine that will cost $340,000. The machine will generate cash flows of $100,000 at the end of each year and require maintenance costs of $10,000 at the beginning of each year. If the economic life of the machine is five years and the relevant discount rate is 10 percent, should you buy the machine? What if the relevant discount rate is 9 percent? 4.13 Today a firm signed a contract to sell a capital asset for $90,000. The firm will receive payment five years from today. The asset costs $60,000 to produce. a. If the appropriate discount rate is 10 percent, is the firm making a profit on this item? b. At what appropriate discount rate will the firm break even? 4.14 Your aunt owns an auto dealership. She promised to give you $3,000 in trade-in value for your car when you graduate one year from now, while your roommate offered you $3,500 for the car now. The prevailing interest rate is 12 percent. If the future value of benefit from owning the car for one year is expected to be $1,000, should you accept your aunt's offer? 104 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 98 Part II Value and Capital Budgeting Compounding Periods 4.15 What is the future value three years hence of $1,000 invested in an account with a stated annual interest rate of 8 percent, a. compounded annually? b. compounded semiannually? c. compounded monthly? d. compounded continuously? e. Why does the future value increase as the compounding period shortens? 4.16 Compute the future value of $1,000 continuously compounded for a. 5 years at a stated annual interest rate of 12 percent. b. 3 years at a stated annual interest rate of 10 percent. c. 10 years at a stated annual interest rate of 5 percent. d. 8 years at a stated annual interest rate of 7 percent. 4.17 Calculate the present value of $5,000 in 12 years at a stated annual interest rate of 10 percent, compounded quarterly. 4.18 Bank America offers a stated annual interest rate of 4.1 percent, compounded quarterly, while Bank USA offers a stated annual interest rate of 4.05 percent, compounded monthly. In which bank should you deposit your money? Perpetuities and Growing Perpetuities 4.19 The market interest rate is 15 percent. What is the price of a consol bond that pays $120 annually? 4.20 A prestigious investment bank designed a new security that pays a quarterly dividend of $10 permanently. What is the price of the security if the stated annual interest rate is 12 percent, compounded quarterly? 4.21 World Transportation, Inc., is expected to initiate its quarterly dividend of $1 five years from today and the dividend is expected to remain constant permanently. What is the price of World Transportation stock if the stated annual interest rate is 15 percent, compounded quarterly? 4.22 Assuming an interest rate of 10 percent, calculate the present value of the following streams of yearly payments: a. $1,000 per year forever, with the first payment one year from today. b. $500 per year forever, with the first payment two years from today. c. $2,420 per year forever, with the first payment three years from today. 4.23 Given an interest rate of 10 percent per year, what is the value at date t year 5) of a perpetual stream of $120 annual payments starting at date t 5 (i.e., the end of 9? 4.24 Harris, Inc., paid a $3 dividend yesterday. If the firm raises its dividend at 5 percent every year and the appropriate discount rate is 12 percent, what is the price of Harris stock? 4.25 In its most recent corporate report, Williams, Inc., apologized to its stockholders for not paying a dividend. The report states that management will pay a $1 dividend next year. That dividend will grow at 4 percent every year thereafter. If the discount rate is 10 percent, how much are you willing to pay for a share of Williams, Inc.? 4.26 Mark Weinstein has been working on an advanced technology in laser eye surgery. The technology is expected to be available to the medical industry two years from today and will generate annual income of $200,000 growing at 5 percent perpetually. What is the present value of the technology if the discount rate is 10 percent? Annuities and Growing Annuities 4.27 IDEC Pharmaceuticals is considering a drug project that costs $100,000 today and is expected to generate end-of-year annual cash flow of $50,000 forever. At what discount rate would IDEC be indifferent between accepting or rejecting the project? 4.28 Should you buy an asset that will generate income of $1,200 per year for eight years? The price of the asset is $6,200 and the annual interest rate is 10 percent. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 105 Chapter 4 Net Present Value 99 4.29 What is the present value of end-of-year cash flows of $2,000 per year, with the first cash flow received three years from today and the last one 22 years from today? Use a discount rate of 8 percent. 4.30 What is the value of a 15-year annuity that pays $500 a year? The annuity's first payment is at the end of year 6 and the annual interest rate is 12 percent for years 1 through 5 and 15 percent thereafter. 4.31 You are offered the opportunity to buy a note for $12,800. The note is certain to pay $2,000 at the end of each of the next 10 years. If you buy the note, what rate of interest will you receive? 4.32 You need $25,000 five years from now. You budget to make equal payments at the end of every year into an account that pays an annual interest rate of 7 percent. a. What are your annual payments? b. Your rich uncle died and left you $20,000. How much of it must you put into the same account as a lump sum today to meet your goal? 4.33 Nancy Ferris bought a building for $120,000. She paid 15 percent down and agreed to pay the balance in 20 equal annual installments. What are the equal installments if the annual interest rate is 10 percent? 4.34 Jack Ferguson has signed a three-year contract to work for a computer software company. He expects to receive a base salary of $5,000 a month and a bonus of $10,000 at year-end. All payments are made at the end of periods. What is the present value of the contract if the stated annual interest rate, compounded monthly, is 12 percent? 4.35 Peter Green bought a $15,000 Honda Civic with 20 percent down and financed the rest with a four-year loan at 8 percent stated annual interest rate, compounded monthly. What is his monthly payment if he starts the payment one month after the purchase? 4.36 You have recently won the super jackpot in the Illinois state lottery. On reading the fine print, you discover that you have the following two options: a. You receive $160,000 at the beginning of each year for 31 years. The income would be taxed at a rate of 28 percent. Taxes are withheld when the checks are issued. b. You receive $1,750,000 now, but you do not have access to the full amount immediately. The $1,750,000 would be taxed at 28 percent. You are able to take $446,000 of the after-tax amount now. The remaining $814,000 will be placed in a 30year annuity account that pays $101,055 on a before-tax basis at the end of each year. Using a discount rate of 10 percent, which option should you select? 4.37 On September 1, 1998, Susan Chao bought a motorcycle for $10,000. She paid $1,000 down and financed the balance with a five-year loan at a stated annual interest rate of 9.6 percent, compounded monthly. She started the monthly payment exactly one month after the purchase, i.e., October, 1998. In the middle of October, 2000, she got a new job and decided to pay off the loan. If the bank charges her 1 percent prepayment penalty based on the loan balance, how much should she pay the bank on November 1, 2000? 4.38 Assume that the cost of a college education will be $20,000 per year when your child enters college 12 years from now. You currently have $10,000 to invest. What rate of interest must your investment earn to pay the cost of a four-year college education for your child? For simplicity, assume the entire cost of the college education must be paid when your child enters college. 4.39 You are saving for the college education of your two children. They are two years apart in age; one will begin college in 15 years, the other will begin in 17 years. You estimate your children's college expenses to be $21,000 per year per child. The annual interest rate is 15 percent. How much money must you deposit in an account each year to fund your children's education? You will begin payments one year from today. You will make your last deposit when your oldest child enters college. 4.40 A well-known insurance company offers a policy known as the "Estate Creator Six Pay." Typically the policy is bought by a parent or grandparent for a child at the child's birth. 106 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 100 Part II Value and Capital Budgeting The details of the policy are as follows: The purchaser (say, the parent) makes the following six payments to the insurance company. First birthday Second birthday Third birthday $750 $750 $750 Fourth birthday Fifth birthday Sixth birthday $800 $800 $800 No more payments are made after the child's sixth birthday. When the child reaches age 65, he or she receives $250,000. If the relevant interest rate is 6 percent for the first six years and 7 percent for all subsequent years, is the policy worth buying? 4.41 Your company is considering leasing a $120,000 piece of equipment for the next 10 years. Your company can buy the equipment outright or lease it. The annual lease payments of $15,000 are due at the beginning of each year. The lease includes an option for your company to buy the equipment for $25,000 at the end of the leasing period (i.e., 10 years). Should your company accept the lease offer if the appropriate discount rate is 8 percent a year? 4.42 You are saving for your retirement. You have decided that one year from today you will deposit 2 percent of your annual salary in an account which will earn 8 percent per year. Your salary last year was $50,000, and it will increase at 4 percent per year throughout your career. How much money will you have for your retirement, which will begin in 40 years? 4.43 You must decide whether or not to purchase new capital equipment. The cost of the machine is $5,000. It will produce the following cash flows. The appropriate discount rate is 10 percent. Year 1 2 3 4 5 6 7 8 Should you purchase the equipment? 4.44 When Marilyn Monroe died, ex-husband Joe DiMaggio vowed to place fresh flowers on her grave every Sunday as long as he lived. A bunch of fresh flowers that the former baseball player thought appropriate for the star cost about $5 when she died in 1962. Based on actuarial tables, "Joltin' Joe" could expect to live for 30 years after the actress died. Assume that the stated annual interest rate, compounded weekly, is 10.4 percent. Also, assume that the rate of inflation is 3.9 percent per year, when expressed as a stated annual inflation rate, compounded weekly. Assuming that each year has exactly 52 weeks, what is the present value of this commitment? 4.45 Your younger brother has come to you for advice. He is about to enter college and has two options open to him. His first option is to study engineering. If he does this, his undergraduate degree would cost him $12,000 a year for four years. Having obtained this, he would need to gain two years of practical experience: in the first year he would earn $20,000, in the second year he would earn $25,000. He would then need to obtain his master's degree, which will cost $15,000 a year for two years. After that he will be fully qualified and can earn $40,000 per year for 25 years. His other alternative is to study accounting. If he does this, he would pay $13,000 a year for four years and then he would earn $31,000 per year for 30 years. The effort involved in the two careers is the same, so he is only interested in the earnings the jobs provide. All earnings and costs are paid at the end of the year. What advice would you give him if the market interest rate is 5 percent? A day later he comes back and says he took your advice, but in fact, the market interest rate was 6 percent. Has your brother made the right choice? Cash Flow $ 700 900 1,000 1,000 1,000 1,000 1,250 1,375 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 4. Net Present Value The McGraw-Hill Companies, 2002 107 Chapter 4 Net Present Value 101 4.46 In January 1984, Richard "Goose" Gossage signed a contract to play for the San Diego Padres that guaranteed him a minimum of $9,955,000. The guaranteed payments were $875,000 for 1984, $650,000 for 1985, $800,000 in 1986, $1 million in 1987, $1 million in 1988, and $300,000 in 1989. In addition, the contract called for $5,330,000 in deferred money payable at the rate of $240,000 per year from 1990 through 2006 and then $125,000 a year from 2007 through 2016. If the effective annual rate of interest is 9 percent and all payments are made on July 1 of each year, what would the present value of these guaranteed payments be on January 1, 1984? Assume an interest rate of 4.4 percent per six months. If he were to receive an equal annual salary at the end of each of the five years from 1984 through 1988, what would his equivalent annual salary be? Ignore taxes throughout this problem. 4.47 Ms. Adams has received a job offer from a large investment bank as an assistant to the vice president. Her base salary will be $35,000. She will receive her first annual salary payment one year from the day she begins to work. In addition, she will get an immediate $10,000 bonus for joining the company. Her salary will grow at 4 percent each year. Each year she will receive a bonus equal to 10 percent of her salary. Ms. Adams is expected to work for 25 years. What is the present value of the offer if the discount rate is 12 percent? 4.48 Justin Leonard has just arranged to purchase a $400,000 vacation home in the Bahamas with a 20% down payment. The mortgage has an 8% annual percentage rate (APR) and calls for equal monthly payments over the next 30 years. His first payment will be due one month from now. However, the mortgage has an 8-year balloon payment, meaning that the loan must be paid off then. There were no other transaction costs or finance charges. How big will Justin's balloon payment be in 8 years? 4.49 You want to lease a set of golf clubs from Pings Ltd. for $4,000. The lease contract is in the form of 24 months of equal payments at a 12% annual percentage rate (APR). Suppose payments are due in the beginning of the month and your first payment is due immediately. What will your monthly lease payment be? 4.50 A 10-year annuity pays $900 per year, with payments made at the end of each year. The first $900 will be paid 5 years from now. If the APR is 8% and interest is compounded quarterly, what is the present value of this annuity? What Is a Firm Worth? 4.51 Southern California Publishing Company is trying to decide whether or not to revise its popular textbook, Financial Psychoanalysis Made Simple. They have estimated that the revision will cost $40,000. Cash flows from increased sales will be $10,000 the first year. These cash flows will increase by 7 percent per year. The book will go out of print five years from now. Assume the initial cost is paid now and all revenues are received at the end of each year. If the company requires a 10 percent return for such an investment, should it undertake the revision? 4.52 Ernie Els wants to save money to meet two objectives. First, he would like to be able to retire 30 years from now with a retirement income of $300,000 per year for 20 years beginning at the end of the 31 years from now. Second, he would like to purchase a cabin in the mountains 10 years from now at an estimated cost of $350,000. He can afford to save only $40,000 per year for the first 10 years. He expects to earn 7 percent per year from investments. Assuming he saves the same amount each year, what must Ernie save annually from years 11 to 30 to meet his objectives? 108 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 5 CHAPTER How to Value Bonds and Stocks EXECUTIVE SUMMARY T he previous chapter discussed the mathematics of compounding, discounting, and present value. We also showed how to value a firm. We now use the mathematics of compounding and discounting to determine the present values of financial obligations of the firm, beginning with a discussion of how bonds are valued. Since the future cash flows of bonds are known, application of net-present-value techniques is fairly straightforward. The uncertainty of future cash flows makes the pricing of stocks according to NPV more difficult. 5.1 DEFINITION AND EXAMPLE OF A BOND A bond is a certificate showing that a borrower owes a specified sum. In order to repay the money, the borrower has agreed to make interest and principal payments on designated dates. For example, imagine that Kreuger Enterprises just issued 100,000 bonds for $1,000 each, where the bonds have a coupon rate of 5 percent and a maturity of two years. Interest on the bonds is to be paid yearly. This means that: 1. $100 million (100,000 $1,000) has been borrowed by the firm. 2. The firm must pay interest of $5 million (5% $100 million) at the end of one year. 3. The firm must pay both $5 million of interest and $100 million of principal at the end of two years. We now consider how to value a few different types of bonds. 5.2 HOW TO VALUE BONDS Pure Discount Bonds The pure discount bond is perhaps the simplest kind of bond. It promises a single payment, say $1, at a fixed future date. If the payment is one year from now, it is called a one-year discount bond; if it is two years from now, it is called a two-year discount bond, and so on. The date when the issuer of the bond makes the last payment is called the maturity date of the bond, or just its maturity for short. The bond is said to mature or expire on the date of its final payment. The payment at maturity ($1 in this example) is termed the bond's face value. Pure discount bonds are often called zero-coupon bonds or zeros to emphasize the fact that the holder receives no cash payments until maturity. We will use the terms zero, bullet, and discount interchangeably to refer to bonds that pay no coupons. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 109 Chapter 5 How to Value Bonds and Stocks 103 I F I G U R E 5.1 Different Types of Bonds: C, Coupon Paid Every 6 Months; F, Face Value at Year 4 (maturity for pure discount and coupon bonds) Year 1 Year 2 Year 3 Year 4 . . . Months Pure discount bonds Coupon bonds Consols 6 12 18 24 30 36 42 48 F . . . C C C C C C C C C C C C C F+C C C C C The first row of Figure 5.1 shows the pattern of cash flows from a four-year pure discount bond. Note that the face value, F, is paid when the bond expires in the 48th month. There are no payments of either interest or principal prior to this date. In the previous chapter, we indicated that one discounts a future cash flow to determine its present value. The present value of a pure discount bond can easily be determined by the techniques of the previous chapter. For short, we sometimes speak of the value of a bond instead of its present value. Consider a pure discount bond that pays a face value of F in T years, where the interest rate is r in each of the T years. (We also refer to this rate as the market interest rate.) Because the face value is the only cash flow that the bond pays, the present value of this face amount is Value of a Pure Discount Bond: F PV 1 rT The present value formula can produce some surprising results. Suppose that the interest rate is 10 percent. Consider a bond with a face value of $1 million that matures in 20 years. Applying the formula to this bond, its PV is given by PV $1 million 1.1 20 $148,644 or only about 15 percent of the face value. Level-Coupon Bonds Many bonds, however, are not of the simple, pure discount variety. Typical bonds issued by either governments or corporations offer cash payments not just at maturity, but also at regular times in between. For example, payments on U.S. government issues and American corporate bonds are made every six months until the bond matures. These payments are called the coupons of the bond. The middle row of Figure 5.1 illustrates the case of a fouryear, level-coupon bond: The coupon, C, is paid every six months and is the same throughout the life of the bond. Note that the face value of the bond, F, is paid at maturity (end of year 4). F is sometimes called the principal or the denomination. Bonds issued in the United States typically have face values of $1,000, though this can vary with the type of bond. 110 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 104 Part II Value and Capital Budgeting As we mentioned before, the value of a bond is simply the present value of its cash flows. Therefore, the value of a level-coupon bond is merely the present value of its stream of coupon payments plus the present value of its repayment of principal. Because a levelcoupon bond is just an annuity of C each period, together with a payment at maturity of $1,000, the value of a level-coupon bond is C 1 Value of a Level-Coupon Bond: C C ... 2 r 1 r 1 rT $1,000 1 rT PV where C is the coupon and the face value, F, is $1,000. The value of the bond can be rewritten as Value of a Level-Coupon Bond: $1,000 PV C AT r 1 rT As mentioned in the previous chapter, AT is the present value of an annuity of $1 per period r for T periods at an interest rate per period of r. E XAMPLE Suppose it is November 2000 and we are considering a government bond. We see in The Wall Street Journal some 13s of November 2004. This is jargon that means the annual coupon rate is 13 percent.1 The face value is $1,000, implying that the yearly coupon is $130 (13% $1,000). Interest is paid each May and November, implying that the coupon every six months is $65 ($130/2). The face value will be paid out in November 2004, four years from now. By this we mean that the purchaser obtains claims to the following cash flows: 5/01 $65 11/01 $65 5/02 $65 11/02 $65 5/03 $65 11/03 $65 5/04 $65 $65 11/04 $1,000 If the stated annual interest rate in the market is 10 percent per year, what is the present value of the bond? Our work on compounding in the previous chapter showed that the interest rate over any six-month interval is one half of the stated annual interest rate. In the current example, this semiannual rate is 5 percent (10%/2). Since the coupon payment in each six-month period is $65, and there are eight of these six-month periods from November 2000 to November 2004, the present value of the bond is PV $65 $65 $65 ... 1.05 1.05 2 1.05 8 $65 A8 $1,000/(1.05)8 0.05 ($65 6.463) ($1,000 0.677) $420.095 $677 $1,097.095 $1,000 1.05 8 Traders will generally quote the bond as 109.7095,2 indicating that it is selling at 109.7095 percent of the face value of $1,000. 1 The coupon rate is specific to the bond. The coupon rate indicates what cash flow should appear in the numerator of the NPV equation. The coupon rate does not appear in the denominator of the NPV equation. 2 Bond prices are actually quoted in 32nds of a dollar, so a quote this precise would not be given. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 111 Chapter 5 How to Value Bonds and Stocks 105 At this point, it is worthwhile to relate the above example of bond-pricing to the discussion of compounding in the previous chapter. At that time we distinguished between the stated annual interest rate and the effective annual interest rate. In particular, we pointed out that the effective annual interest rate is (1 r/m)m 1 where r is the stated annual interest rate and m is the number of compounding intervals. Since r 10% and m 2 (because the bond makes semiannual payments), the effective annual interest rate is [1 (0.10/2)]2 1 (1.05)2 1 10.25% In other words, because the bond is paying interest twice a year, the bondholder earns a 10.25-percent return when compounding is considered.3 One final note concerning level-coupon bonds: Although the preceding example concerns government bonds, corporate bonds are identical in form. For example, DuPont Corporation has an 81/2-percent bond maturing in 2006. This means that DuPont will make semiannual payments of $42.50 (81/2%/2 $1,000) between now and 2006 for each face value of $1,000. Consols Not all bonds have a final maturity date. As we mentioned in the previous chapter, consols are bonds that never stop paying a coupon, have no final maturity date, and therefore never mature. Thus, a consol is a perpetuity. In the 18th century the Bank of England issued such bonds, called "English consols." These were bonds that the Bank of England guaranteed would pay the holder a cash flow forever! Through wars and depressions, the Bank of England continued to honor this commitment, and you can still buy such bonds in London today. The U.S. government also once sold consols to raise money to build the Panama Canal. Even though these U.S. bonds were supposed to last forever and to pay their coupons forever, don't go looking for any. There is a special clause in the bond contract that gives the government the right to buy them back from the holders, and that is what the government has done. Clauses like that are call provisions, and we study them later. An important example of a consol, though, is called preferred stock. Preferred stock is stock that is issued by corporations and that provides the holder a fixed dividend in perpetuity. If there were never any question that the firm would actually pay the dividend on the preferred stock, such stock would in fact be a consol. These instruments can be valued by the perpetuity formula of the previous chapter. For example, if the marketwide interest rate is 10 percent, a consol with a yearly interest payment of $50 is valued at $50 0.10 QUESTIONS CONCEPT $500 ? Define pure discount bonds, level-coupon bonds, and consols. Contrast the stated interest rate and the effective annual interest rate for bonds paying semiannual interest. 3 For an excellent discussion of how to value semiannual payments, see J. T. Lindley, B. P. Helms, and M. Haddad, "A Measurement of the Errors in Intra-Period Compounding and Bond Valuation," The Financial Review 22 (February 1987). We benefited from several conversations with the authors of this article. 112 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 106 Part II Value and Capital Budgeting 5.3 BOND CONCEPTS We complete our discussion on bonds by considering two concepts concerning them. First, we examine the relationship between interest rates and bond prices. Second, we define the concept of yield to maturity. Interest Rates and Bond Prices The above discussion on level-coupon bonds allows us to relate bond prices to interest rates. Consider the following example. E XAMPLE The interest rate is 10 percent. A two-year bond with a 10-percent coupon pays interest of $100 ($1,000 10%). For simplicity, we assume that the interest is paid annually. The bond is priced at its face value of $1,000: $1,000 $100 1.10 $1,000 $100 1.10 2 If the interest rate unexpectedly rises to 12 percent, the bond sells at $966.20 $100 1.12 $1,000 $100 1.12 2 Because $966.20 is below $1,000, the bond is said to sell at a discount. This is a sensible result. Now that the interest rate is 12 percent, a newly issued bond with a 12-percent coupon rate will sell at $1,000. This newly issued bond will have coupon payments of $120 (0.12 $1,000). Because our bond has interest payments of only $100, investors will pay less than $1,000 for it. If interest rates fell to 8 percent, the bond would sell at $1,035.67 $100 1.08 $1,000 $100 1.08 2 Because $1,035.67 is above $1,000, the bond is said to sell at a premium. Thus, we find that bond prices fall with a rise in interest rates and rise with a fall in interest rates. Furthermore, the general principle is that a level-coupon bond sells in the following ways. 1. At the face value of $1,000 if the coupon rate is equal to the marketwide interest rate. 2. At a discount if the coupon rate is below the marketwide interest rate. 3. At a premium if the coupon rate is above the marketwide interest rate. Yield to Maturity Let's now consider the previous example in reverse. If our bond is selling at $1,035.67, what return is a bondholder receiving? This can be answered by considering the following equation: $1,035.67 $100 1 y $1,000 $100 1 y2 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 113 Chapter 5 How to Value Bonds and Stocks 107 THE PRESENT VALUE FORMULAS FOR BONDS Pure Discount Bonds PV Level-Coupon Bonds PV C 1 r r 1 1 F r T F 1 r T 1 r T C AT r F 1 r T where F is typically $1,000 for a level-coupon bond. Consols PV C r The unknown, y, is the discount rate that equates the price of the bond with the discounted value of the coupons and face value. Our earlier work implies that y 8%. Thus, traders state that the bond is yielding an 8-percent return. Bond traders also state that the bond has a yield to maturity of 8 percent. The yield to maturity is frequently called the bond's yield for short. So we would say the bond with its 10-percent coupon is priced to yield 8 percent at $1,035.67. Bond Market Reporting Almost all corporate bonds are traded by institutional investors and are traded on the over-the-counter market (OTC for short). There is a corporate bond market associated with the New York Stock Exchange. This bond market is mostly a retail market for individual investors for smaller trades. It represents a very small fraction of total corporate bond trading. Table 5.1 reproduces some bond data that can be found in The Wall Street Journal on any particular day. At the bottom of the list you will find AT&T and an entry AT&T 81/8 /22. This entry represents AT&T bonds that mature in the year 2022 and have a coupon rate of 81/8. The coupon rate means 81/8 percent of the par value (or face value) of $1,000. Therefore, the annual coupon for AT&T bonds is $81.25. Under the heading "Close," you will find the last price for the AT&T bonds at the close of this particular day. The price is quoted as a percentage of the par value. So the last price for the AT&T bonds on this particular day was 100 percent of $1,000 or $1,000.00. This bond is trading at a price less than its par value, and so it is trading at a "discount." The last column is "Net Chg." AT&T bonds traded up from the day before by 3/8 of 1 percent. The AT&T bonds have a current yield of 8.1 percent. The current yield is simply the current coupon divided by the current price, or 81.25 divided by 1,000, equal to 8.1 percent (rounded to one decimal place). You should know from our discussion of bond yields that the current yield is not the same thing as the bonds' yield to maturity. The yield to maturity is not usually reported on a daily basis by the financial press. The "Vol" column is the daily volume of 97. This is the number of bonds that were traded on the New York Stock Exchange on this particular day. 114 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 108 Part II Value and Capital Budgeting I TA B L E 5.1 Bond Market Reporting Bonds AMF 107/8 06 AMR 9s16 ATT 51/8 01 ATT 71/8 02 ATT 61/2 02 ATT 63/4 04 ATT 55/8 04 ATT 71/2 06 ATT 73/4 07 ATT 6s09 ATT 81/8 22 Cur Yld. 25.3 8.8 5.2 7.1 6.6 6.9 6.0 7.4 7.6 6.7 8.1 Vol. 10 25 30 55 50 52 138 60 83 40 97 Close 43 102 981/2 1001/8 99 973/4 943/8 1003/4 1011/2 89 100 Net Chg. ... 3 /8 5 /16 1 /8 7 /8 3 /8 ... 1 /2 1 /2 5 /8 3 /8 QUESTIONS CONCEPT ? What is the relationship between interest rates and bond prices? How does one calculate the yield to maturity on a bond? 5.4 THE PRESENT VALUE OF COMMON STOCKS Dividends versus Capital Gains Our goal in this section is to value common stocks. We learned in the previous chapter that an asset's value is determined by the present value of its future cash flows. A stock provides two kinds of cash flows. First, most stocks pay dividends on a regular basis. Second, the stockholder receives the sale price when she sells the stock. Thus, in order to value common stocks, we need to answer an interesting question: Is the value of a stock equal to 1. The discounted present value of the sum of next period's dividend plus next period's stock price, or 2. The discounted present value of all future dividends? This is the kind of question that students would love to see on a multiple-choice exam, because both (1) and (2) are right. To see that (1) and (2) are the same, let's start with an individual who will buy the stock and hold it for one year. In other words, she has a one-year holding period. In addition, she is willing to pay P0 for the stock today. That is, she calculates P0 Div1 1 r P1 1 r (5.1) Div1 is the dividend paid at year's end and P1 is the price at year's end. P0 is the PV of the common-stock investment. The term in the denominator, r, is the discount rate of the stock. It will be equal to the interest rate in the case where the stock is riskless. It is likely to be greater than the interest rate in the case where the stock is risky. That seems easy enough, but where does P1 come from? P1 is not pulled out of thin air. Rather, there must be a buyer at the end of year 1 who is willing to purchase the stock for P1. This buyer determines price by Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 115 Chapter 5 How to Value Bonds and Stocks 109 P2 1 r (5.2) P1 Div2 1 r Substituting the value of P1 from (5.2) into equation (5.1) yields P0 1 Div2 P2 Div1 1 r 1 r Div1 Div2 P2 1 r 1 r2 1 r 2 (5.3) We can ask a similar question for formula (5.3): Where does P2 come from? An investor at the end of year 2 is willing to pay P2 because of the dividend and stock price at year 3. This process can be repeated ad nauseam.4 At the end, we are left with P0 Div1 1 r Div2 1 r 2 Div3 1 r 3 ... t 1 Divt 1 r t (5.4) Thus the value of a firm's common stock to the investor is equal to the present value of all of the expected future dividends. This is a very useful result. A common objection to applying present value analysis to stocks is that investors are too shortsighted to care about the long-run stream of dividends. These critics argue that an investor will generally not look past his or her time horizon. Thus, prices in a market dominated by short-term investors will reflect only near-term dividends. However, our discussion shows that a long-run dividend-discount model holds even when investors have short-term time horizons. Although an investor may want to cash out early, she must find another investor who is willing to buy. The price this second investor pays is dependent on dividends after his date of purchase. Valuation of Different Types of Stocks The above discussion shows that the value of the firm is the present value of its future dividends. How do we apply this idea in practice? Equation (5.4) represents a very general model and is applicable regardless of whether the level of expected dividends is growing, fluctuating, or constant. The general model can be simplified if the firm's dividends are expected to follow some basic patterns: (1) zero growth, (2) constant growth, and (3) differential growth. These cases are illustrated in Figure 5.2. Case 1 (Zero Growth) The value of a stock with a constant dividend is given by P0 Div1 1 r Div2 1 r 2 ... Div r Here it is assumed that Div1 Div2 . . . tuity formula of the previous chapter. Div. This is just an application of the perpe- Case 2 (Constant Growth) Dividends grow at rate g, as follows: End of Year Dividend 1 Div 2 Div(1 g) 3 Div(1 g)2 4 Div(1 g)3 ... Note that Div is the dividend at the end of the first period. 4 This procedure reminds us of the physicist lecturing on the origins of the universe. He was approached by an elderly gentleman in the audience who disagreed with the lecture. The attendee said that the universe rests on the back of a huge turtle. When the physicist asked what the turtle rested on, the gentleman said another turtle. Anticipating the physicist's objections, the attendee said, "Don't tire yourself out, young fellow. It's turtles all the way down." 116 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 110 Part II Value and Capital Budgeting I F I G U R E 5.2 Zero-Growth, Constant-Growth, and DifferentialGrowth Patterns Dividends per share Low growth g2 Differential growth g1 g2 Constant growth High growth g1 Zero growth g=0 Years 1 2 3 4 5 Div r Div r g T 6 7 8 9 10 Dividend-growth models Zero growth: P0 Constant growth: P0 Differential growth: P0 t Div 1 g1 1 rt 1 t DivT 1 r g2 1 rT E XAMPLE Hampshire Products will pay a dividend of $4 per share a year from now. Financial analysts believe that dividends will rise at 6 percent per year for the foreseeable future. What is the dividend per share at the end of each of the first five years? End of Year Dividend 1 $4.00 $4 2 (1.06) $4.24 $4 3 (1.06)2 $4.4944 $4 4 (1.06)3 $4.7641 $4 5 (1.06)4 $5.0499 The value of a common stock with dividends growing at a constant rate is P0 Div 1 r Div r g Div 1 g 1 r2 Div 1 g 1 r3 2 Div 1 g 1 r4 3 ... where g is the growth rate. Div is the dividend on the stock at the end of the first period. This is the formula for the present value of a growing perpetuity, which we derived in the previous chapter. E XAMPLE Suppose an investor is considering the purchase of a share of the Utah Mining Company. The stock will pay a $3 dividend a year from today. This dividend is expected to grow at 10 percent per year (g 10%) for the foreseeable future. The Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 117 Chapter 5 How to Value Bonds and Stocks 111 investor thinks that the required return (r) on this stock is 15 percent, given her assessment of Utah Mining's risk. (We also refer to r as the discount rate of the stock.) What is the value of a share of Utah Mining Company's stock? Using the constant growth formula of case 2, we assess the value to be $60: $60 $3 0.15 0.10 P0 is quite dependent on the value of g. If g had been estimated to be 121/2 percent, the value of the share would have been $120 0.15 $3 0.125 The stock price doubles (from $60 to $120) when g only increases 25 percent (from 10 percent to 12.5 percent). Because of P0's dependency on g, one must maintain a healthy sense of skepticism when using this constant growth of dividends model. Furthermore, note that P0 is equal to infinity when the growth rate, g, equals the discount rate, r. Because stock prices do not grow infinitely, an estimate of g greater than r implies an error in estimation. More will be said of this point later. Case 3 (Differential Growth) In this case, an algebraic formula would be too unwieldy. Instead, we present examples. E XAMPLE Consider the stock of Elixir Drug Company, which has a new back-rub ointment and is enjoying rapid growth. The dividend for a share of stock a year from today will be $1.15. During the next four years, the dividend will grow at 15 percent per year (g1 15%). After that, growth (g2) will be equal to 10 percent per year. Can you calculate the present value of the stock if the required return (r) is 15 percent? Figure 5.3 displays the growth in the dividends. We need to apply a two-step process to discount these dividends. We first calculate the net present value of the dividends growing at 15 percent per annum. That is, we first calculate the present value of the dividends at the end of each of the first five years. Second, we calculate the present value of the dividends beginning at the end of year 6. Calculate Present Value of First Five Dividends The present value of dividend payments in years 1 through 5 is as follows: Future Year 1 2 3 4 5 Years 15 Growth Rate (g1) Expected Dividend Present Value $1 1 1 1 1 $5 0.15 $1.15 0.15 1.3225 0.15 1.5209 0.15 1.7490 0.15 2.0114 The present value of dividends The growing-annuity formula of the previous chapter could normally be used in this step. However, note that dividends grow at 15 percent, which is also the discount rate. Since g r, the growing-annuity formula cannot be used in this example. 118 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 112 Part II Value and Capital Budgeting I F I G U R E 5.3 Growth in Dividends for Elixir Drug Company Dividends 10% growth rate 15% growth rate $2.9449 $2.6772 $2.4338 $2.0114 $2.2125 $1.7490 $1.5209 $1.3225 $1.15 End of year 1 2 3 4 5 6 7 8 9 10 Calculate Present Value of Dividends Beginning at End of Year 6 This is the procedure for deferred perpetuities and deferred annuities that we mentioned in the previous chapter. The dividends beginning at the end of year 6 are End of Year Dividend 6 7 2 8 Div5 (1 g2) 2.0114 (1.10)3 $2.6772 3 9 Div5 (1 g2)4 2.0114 (1.10)4 $2.9449 Div5 (1 g2) Div5 (1 g2) $2.0114 1.10 2.0114 (1.10)2 $2.2125 $2.4338 As stated in the previous chapter, the growing-perpetuity formula calculates present value as of one year prior to the first payment. Because the payment begins at the end of year 6, the present value formula calculates present value as of the end of year 5. The price at the end of year 5 is given by P5 Div6 r g2 $44.25 $2.2125 0.15 0.10 The present value of P5 at the end of year 0 is P5 1 r 5 $44.25 1.15 5 $22 $5). The present value of all dividends as of the end of year 0 is $27 ($22 5.5 ESTIMATES OF PARAMETERS IN THE DIVIDENDDISCOUNT MODEL The value of the firm is a function of its growth rate, g, and its discount rate, r. How does one estimate these variables? Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 119 Chapter 5 How to Value Bonds and Stocks 113 Where Does g Come From? The previous discussion on stocks assumed that dividends grow at the rate g. We now want to estimate this rate of growth. Consider a business whose earnings next year are expected to be the same as earnings this year unless a net investment is made. This situation is likely to occur, because net investment is equal to gross, or total, investment less depreciation. A net investment of zero occurs when total investment equals depreciation. If total investment is equal to depreciation, the firm's physical plant is maintained, consistent with no growth in earnings. Net investment will be positive only if some earnings are not paid out as dividends, that is, only if some earnings are retained.5 This leads to the following equation: Earnings next year Earnings this year Retained Return on earnings retained this year earnings Increase in earnings (5.5) The increase in earnings is a function of both the retained earnings and the return on the retained earnings. We now divide both sides of (5.5) by earnings this year, yielding Earnings next year Earnings this year Earnings this year Earnings this year Retained earnings this year Earnings this year Return on retained earnings (5.6) The left-hand side of (5.6) is simply one plus the growth rate in earnings, which we write as 1 g.6 The ratio of retained earnings to earnings is called the retention ratio. Thus, we can write 1 g 1 Retention ratio Return on retained earnings (5.7) It is difficult for a financial analyst to determine the return to be expected on currently retained earnings, because the details on forthcoming projects are not generally public information. However, it is frequently assumed that the projects selected in the current year have an anticipated return equal to returns from projects in other years. Here, we can estimate the anticipated return on current retained earnings by the historical return on equity, or ROE. After all, ROE is simply the return on the firm's entire equity, which is the return on the cumulation of all the firm's past projects.7 From (5.7), we have a simple way to estimate growth: g Formula for Firm's Growth Rate: Retention ratio Return on retained earnings (5.8) 5 We ignore the possibility of the issuance of stocks or bonds in order to raise capital. These possibilities are considered in later chapters. 6 Previously g referred to growth in dividends. However, the growth in earnings is equal to the growth rate in dividends in this context, because as we will presently see, the ratio of dividends to earnings is held constant. 7 Students frequently wonder whether return on equity (ROE) or return on assets (ROA) should be used here. ROA and ROE are identical in our model because debt financing is ignored. However, most real-world firms have debt. Because debt is treated in later chapters, we are not yet able to treat this issue in depth now. Suffice it to say that ROE is the appropriate rate, because both ROE for the firm as a whole and the return to equityholders from a future project are calculated after interest has been deducted. 120 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 114 Part II Value and Capital Budgeting E XAMPLE Pagemaster Enterprises just reported earnings of $2 million. It plans to retain 40 percent of its earnings. The historical return on equity (ROE) has been 0.16, a figure that is expected to continue into the future. How much will earnings grow over the coming year? We first perform the calculation without reference to equation (5.8). Then we use (5.8) as a check. Calculation without Reference to Equation (5.8) The firm will retain $800,000 (40% $2 million). Assuming that historical ROE is an appropriate estimate for future returns, the anticipated increase in earnings is $800,000 The percentage growth in earnings is Change in earnings Total earnings $128,000 $2 million 0.064 1.064). 0.16 $128,000 This implies that earnings in one year will be $2,128,000 ($2,000,000 Check Using Equation (5.8) We use g g 0.4 0.16 Retention ratio 0.064 ROE. We have Where Does r Come From? In this section, we want to estimate r, the rate used to discount the cash flows of a particular stock. There are two methods developed by academics. We present one method below but must defer the second until we give it extensive treatment in later chapters. The first method begins with the concept that the value of a growing perpetuity is P0 Solving for r, we have r Div P0 g (5.9) r Div g As stated earlier, Div refers to the dividend to be received one year hence. Thus, the discount rate can be broken into two parts. The ratio, Div/P0, places the dividend return on a percentage basis, frequently called the dividend yield. The second term, g, is the growth rate of dividends. Because information on both dividends and stock price is publicly available, the first term on the right-hand side of equation (5.9) can be easily calculated. The second term on the right-hand side, g, can be estimated from (5.8). E XAMPLE Pagemaster Enterprises, the company examined in the previous example, has 1,000,000 shares of stock outstanding. The stock is selling at $10. What is the required return on the stock? Because the retention ratio is 40 percent, the payout ratio is 60 percent (1 Retention ratio). The payout ratio is the ratio of dividends/earnings. Because earnings a year from now will be $2,128,000 ($2,000,000 1.064), dividends will be $1,276,800 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 121 Chapter 5 How to Value Bonds and Stocks 115 (0.60 $2,128,000). Dividends per share will be $1.28 ($1,276,800/1,000,000). Given our previous result that g 0.064, we calculate r from (5.9) as follows: $1.28 0.192 0.064 $10.00 A Healthy Sense of Skepticism It is important to emphasize that our approach merely estimates g; our approach does not determine g precisely. We mentioned earlier that our estimate of g is based on a number of assumptions. For example, we assume that the return on reinvestment of future retained earnings is equal to the firm's past ROE. We assume that the future retention ratio is equal to the past retention ratio. Our estimate for g will be off if these assumptions prove to be wrong. Unfortunately, the determination of r is highly dependent on g. For example, if g is estimated to be 0, r equals 12.8 percent ($1.28/$10.00). If g is estimated to be 12 percent, r equals 24.8 percent ($1.28/$10.00 12%). Thus, one should view estimates of r with a healthy sense of skepticism. Because of the preceding, some financial economists generally argue that the estimation error for r or a single security is too large to be practical. Therefore, they suggest calculating the average r for an entire industry. This r would then be used to discount the dividends of a particular stock in the same industry. One should be particularly skeptical of two polar cases when estimating r for individual securities. First, consider a firm currently paying no dividend. The stock price will be above zero because investors believe that the firm may initiate a dividend at some point or the firm may be acquired at some point. However, when a firm goes from no dividends to a positive number of dividends, the implied growth rate is infinite. Thus, equation (5.9) must be used with extreme caution here, if at all--a point we emphasize later in this chapter. Second, we mentioned earlier that the value of the firm is infinite when g is equal to r. Because prices for stocks do not grow infinitely, an analyst whose estimate of g for a particular firm is equal to or above r must have made a mistake. Most likely, the analyst's high estimate for g is correct for the next few years. However, firms simply cannot maintain an abnormally high growth rate forever. The analyst's error was to use a short-run estimate of g in a model requiring a perpetual growth rate. 5.6 GROWTH OPPORTUNITIES We previously spoke of the growth rate of dividends. We now want to address the related concept of growth opportunities. Imagine a company with a level stream of earnings per share in perpetuity. The company pays all of these earnings out to stockholders as dividends. Hence, EPS Div where EPS is earnings per share and Div is dividends per share. A company of this type is frequently called a cash cow. From the perpetuity formula of the previous chapter, the value of a share of stock is: Value of a Share of Stock when Firm Acts as a Cash Cow: EPS Div r r where r is the discount rate on the firm's stock. 122 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 116 Part II Value and Capital Budgeting This policy of paying out all earnings as dividends may not be the optimal one. Many firms have growth opportunities, that is, opportunities to invest in profitable projects. Because these projects can represent a significant fraction of the firm's value, it would be foolish to forgo them in order to pay out all earnings as dividends. Although firms frequently think in terms of a set of growth opportunities, let's focus on only one opportunity, that is, the opportunity to invest in a single project. Suppose the firm retains the entire dividend at date 1 in order to invest in a particular capital budgeting project. The net present value per share of the project as of date 0 is NPVGO, which stands for the net present value (per share) of the growth opportunity. What is the price of a share of stock at date 0 if the firm decides to take on the project at date 1? Because the per share value of the project is added to the original stock price, the stock price must now be: Stock Price after Firm Commits to New Project: EPS NPVGO r (5.10) Thus, equation (5.10) indicates that the price of a share of stock can be viewed as the sum of two different items. The first term (EPS/r) is the value of the firm if it rested on its laurels, that is, if it simply distributed all earnings to the stockholders. The second term is the additional value if the firm retains earnings in order to fund new projects. E XAMPLE Sarro Shipping, Inc., expects to earn $1 million per year in perpetuity if it undertakes no new investment opportunities. There are 100,000 shares of stock outstanding, so earnings per share equal $10 ($1,000,000/100,000). The firm will have an opportunity at date 1 to spend $1,000,000 in a new marketing campaign. The new campaign will increase earnings in every subsequent period by $210,000 (or $2.10 per share). This is a 21-percent return per year on the project. The firm's discount rate is 10 percent. What is the value per share before and after deciding to accept the marketing campaign? The value of a share of Sarro Shipping before the campaign is Value of a Share of Sarro when Firm Acts as a Cash Cow: EPS $10 $100 r 0.1 The value of the marketing campaign as of date 1 is: Value of Marketing Campaign at Date 1: $210,000 $1,000,000 $1,100,000 0.1 (5.11) Because the investment is made at date 1 and the first cash inflow occurs at date 2, equation (5.11) represents the value of the marketing campaign as of date 1. We determine the value at date 0 by discounting back one period as follows: Value of Marketing Campaign at Date 0: $1,100,000 $1,000,000 1.1 Thus, NPVGO per share is $10 ($1,000,000/100,000). The price per share is EPS/r NPVGO $100 $10 $110 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 123 Chapter 5 How to Value Bonds and Stocks 117 The calculation can also be made on a straight net-present-value basis. Because all the earnings at date 1 are spent on the marketing effort, no dividends are paid to stockholders at that date. Dividends in all subsequent periods are $1,210,000 ($1,000,000 $210,000). In this case, $1,000,000 is the annual dividend when Sarro is a cash cow. The additional contribution to the dividend from the marketing effort is $210,000. Dividends per share are $12.10 ($1,210,000/100,000). Because these dividends start at date 2, the price per share at date 1 is $121 ($12.10/0.1). The price per share at date 0 is $110 ($121/1.1). Note that value is created in this example because the project earned a 21-percent rate of return when the discount rate was only 10 percent. No value would have been created had the project earned a 10-percent rate of return. The NPVGO would have been zero, and value would have been negative had the project earned a percentage return below 10 percent. The NPVGO would be negative in that case. Two conditions must be met in order to increase value. 1. Earnings must be retained so that projects can be funded.8 2. The projects must have positive net present value. Surprisingly, a number of companies seem to invest in projects known to have negative net present values. For example, Jensen has pointed out that, in the late 1970s, oil companies and tobacco companies were flush with cash.9 Due to declining markets in both industries, high dividends and low investment would have been the rational action. Unfortunately, a number of companies in both industries reinvested heavily in what were widely perceived to be negative-NPVGO projects. A study by McConnell and Muscarella documents this perception.10 They find that, during the 1970s, the stock prices of oil companies generally decreased on the days that announcements of increases in exploration and development were made. Given that NPV analysis (such as that presented in the previous chapter) is common knowledge in business, why would managers choose projects with negative NPVs? One conjecture is that some managers enjoy controlling a large company. Because paying dividends in lieu of reinvesting earnings reduces the size of the firm, some managers find it emotionally difficult to pay high dividends. Growth in Earnings and Dividends versus Growth Opportunities As mentioned earlier, a firm's value increases when it invests in growth opportunities with positive NPVGOs. A firm's value falls when it selects opportunities with negative NPVGOs. However, dividends grow whether projects with positive NPVs or negative NPVs are selected. This surprising result can be explained by the following example. E XAMPLE Lane Supermarkets, a new firm, will earn $100,000 a year in perpetuity if it pays out all its earnings as dividends. However, the firm plans to invest 20 percent of its earnings in projects that earn 10 percent per year. The discount rate is 18 percent. An earlier formula tells us that the growth rate of dividends is g Retention ratio Return on retained earnings 0.2 0.10 2% 8 9 Later in the text we speak of issuing stock or debt in order to fund projects. M. C. Jensen, "Agency Costs of Free Cash Flows, Corporate Finance and Takeovers," American Economic Review (May 1986). 10 J. J. McConnell and C. J. Muscarella, "Corporate Capital Expenditure Decisions and the Market Value of the Firm," Journal of Financial Economics 14 (1985). 124 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 118 Part II Value and Capital Budgeting For example, in this first year of the new policy, dividends are $80,000 [(1 0.2) $100,000]. Dividends next year are $81,600 ($80,000 1.02). Dividends the following year are $83,232 [$80,000 (1.02)2] and so on. Because dividends represent a fixed percentage of earnings, earnings must grow at 2 percent a year as well. However, note that the policy reduces value because the rate of return on the projects of 10 percent is less than the discount rate of 18 percent. That is, the firm would have had a higher value at date 0 if it had a policy of paying all its earnings out as dividends. Thus, a policy of investing in projects with negative NPVs rather than paying out earnings as dividends will lead to growth in dividends and earnings, but will reduce value. Dividends or Earnings: Which to Discount? As mentioned earlier, this chapter applied the growing-perpetuity formula to the valuation of stocks. In our application, we discounted dividends, not earnings. This is sensible since investors select a stock for what they can get out of it. They only get two things out of a stock: dividends and the ultimate sales price, which is determined by what future investors expect to receive in dividends. The calculated stock price would be too high were earnings to be discounted instead of dividends. As we saw in our estimation of a firm's growth rate, only a portion of earnings goes to the stockholders as dividends. The remainder is retained to generate future dividends. In our model, retained earnings are equal to the firm's investment. To discount earnings instead of dividends would be to ignore the investment that a firm must make today in order to generate future returns. The No-Dividend Firm Students frequently ask the following questions: If the dividend-discount model is correct, why aren't no-dividend stocks selling at zero? This is a good question and gets at the goals of the firm. A firm with many growth opportunities is faced with a dilemma. The firm can pay out dividends now, or it can forgo dividends now so that it can make investments that will generate even greater dividends in the future.11 This is often a painful choice, because a strategy of dividend deferment may be optimal yet unpopular among certain stockholders. Many firms choose to pay no dividends--and these firms sell at positive prices.12 Rational shareholders believe that they will either receive dividends at some point or they will receive something just as good. That is, the firm will be acquired in a merger, with the stockholders receiving either cash or shares of stock at that time. Of course, the actual application of the dividend-discount model is difficult for firms of this type. Clearly, the model for constant growth of dividends does not apply. Though the differential growth model can work in theory, the difficulties of estimating the date of first dividend, the growth rate of dividends after that date, and the ultimate merger price make application of the model quite difficult in reality. Empirical evidence suggests that firms with high growth rates are likely to pay lower dividends, a result consistent with the above analysis. For example, consider McDonald's Corporation. The company started in the 1950s and grew rapidly for many years. It paid its first dividend in 1975, though it was a billion-dollar company (in both sales and market 11 A third alternative is to issue stock so that the firm has enough cash both to pay dividends and to invest. This possibility is explored in a later chapter. 12 For example, most Internet firms, such as Amazon.com, Earthlink, Inc., and Ebay, Inc., pay no dividends. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 125 Chapter 5 How to Value Bonds and Stocks 119 value of stockholder's equity) prior to that date. Why did it wait so long to pay a dividend? It waited because it had so many positive growth opportunities, that is, additional locations for new hamburger outlets, to take advantage of. Utilities are an interesting contrast because, as a group, they have few growth opportunities. Because of this, they pay out a large fraction of their earnings in dividends. For example, Consolited Edison, Sempra Energy, and Kansas City Power and Light have had payout ratios of over 70 percent in many recent years. 5.7 THE DIVIDEND-GROWTH MODEL AND THE NPVGO MODEL (ADVANCED) This chapter has revealed that the price of a share of stock is the sum of its price as a cash cow plus the per-share value of its growth opportunities. The Sarro Shipping example illustrated this formula using only one growth opportunity. We also used the growing-perpetuity formula to price a stock with a steady growth in dividends. When the formula is applied to stocks, it is typically called the dividend-growth model. A steady growth in dividends results from a continual investment in growth opportunities, not just investment in a single opportunity. Therefore, it is worthwhile to compare the dividend-growth model with the NPVGO model when growth occurs through continual investing. E XAMPLE Cumberland Book Publishers has EPS of $10 at the end of the first year, a dividend-payout ratio of 40 percent, a discount rate of 16 percent, and a return on its retained earnings of 20 percent. Because the firm retains some of its earnings each year, it is selecting growth opportunities each year. This is different from Sarro Shipping, which had a growth opportunity in only one year. We wish to calculate the price per share using both the dividend-growth model and the NPVGO model. The Dividend-Growth Model The dividends at date 1 are 0.40 $10 $4 per share. The retention ratio is 0.60 (1 implying a growth rate in dividends of 0.12 (0.60 0.20). From the dividend-growth model, the price of a share of stock is r Div g $4 0.16 0.12 $100 0.40), The NPVGO Model Using the NPVGO model, it is more difficult to value a firm with growth opportunities each year (like Cumberland) than a firm with growth opportunities in only one year (like Sarro). In order to value according to the NPVGO model, we need to calculate on a pershare basis (1) the net present value of a single growth opportunity, (2) the net present value of all growth opportunities, and (3) the stock price if the firm acts as a cash cow, that is, the value of the firm without these growth opportunities. The value of the firm is the sum of (2) (3). 126 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 120 Part II Value and Capital Budgeting 1. Value per Share of a Single Growth Opportunity Out of the earnings per share of $10 at date 1, the firm retains $6 (0.6 $10) at that date. The firm earns $1.20 ($6 0.20) per year in perpetuity on that $6 investment. The NPV from the investment is Per-Share NPV Generated from Investment at Date 1: $1.20 $6 $1.50 0.16 (5.12) That is, the firm invests $6 in order to reap $1.20 per year on the investment. The earnings are discounted at 0.16, implying a value per share from the project of $1.50. Because the investment occurs at date 1 and the first cash flow occurs at date 2, $1.50 is the value of the investment at date 1. In other words, the NPV from the date 1 investment has not yet been brought back to date 0. 2. Value per Share of All Opportunities As pointed out earlier, the growth rate of earnings and dividends is 12 percent. Because retained earnings are a fixed percentage of total earnings, retained earnings must also grow at 12 percent a year. That is, retained earnings at date 2 are $6.72 ($6 1.12), retained earnings at date 3 are $7.5264 [$6 (1.12)2], and so on. Let's analyze the retained earnings at date 2 in more detail. Because projects will always earn 20 percent per year, the firm earns $1.344 ($6.72 0.20) in each future year on the $6.72 investment at date 2. The NPV from the investment is NPV per Share Generated from Investment at Date 2: $1.344 $6.72 $1.68 0.16 (5.13) $1.68 is the NPV as of date 2 of the investment made at date 2. The NPV from the date 2 investment has not yet been brought back to date 0. Now consider the retained earnings at date 3 in more detail. The firm earns $1.5053 ($7.5264 0.20) per year on the investment of $7.5264 at date 3. The NPV from the investment is NPV per Share Generated from Investment at Date 3: $1.5053 $7.5264 $1.882 0.16 (5.14) From equations (5.12), (5.13), and (5.14), the NPV per share of all of the growth opportunities, discounted back to date 0, is $1.50 1.16 $1.68 1.16 2 $1.882 1.16 3 ... (5.15) Because it has an infinite number of terms, this expression looks quite difficult to compute. However, there is an easy simplification. Note that retained earnings are growing at 12 percent per year. Because all projects earn the same rate of return per year, the NPVs in (5.12), (5.13), and (5.14) are also growing at 12 percent per year. Hence, we can write equation (5.15) as $1.50 1.16 $1.50 1.12 1.16 2 $1.50 1.12 2 +... 1.16 3 This is a growth perpetuity whose value is NPVGO $ 1.50 0.16 0.12 $37.50 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 127 Chapter 5 How to Value Bonds and Stocks 121 Because the first NPV of $1.50 occurs at date 1, the NPVGO is $37.50 as of date 0. In other words, the firm's policy of investing in new projects from retained earnings has an NPV of $37.50. 3. Value per Share if Firm Is a Cash Cow We now assume that the firm pays out all of its earnings as dividends. The dividends would be $10 per year in this case. Since there would be no growth, the value per share would be evaluated by the perpetuity formula: Div r $10 0.16 $62.50 Summation Formula (5.10) states that value per share is the value of a cash cow plus the value of the growth opportunities. This is $100 $62.50 $37.50 Hence, value is the same whether calculated by a discounted-dividend approach or a growth-opportunities approach. The share prices from the two approaches must be equal, because the approaches are different yet equivalent methods of applying concepts of present value. 5.8 PRICE-EARNINGS RATIO We argued earlier that one should not discount earnings in order to determine price per share. Nevertheless, financial analysts frequently relate earnings and price per share, as made evident by their heavy reliance on the price-earnings (or P/E) ratio. Our previous discussion stated that Price per share Dividing by EPS yields Price per share EPS 1 r NPVGO EPS EPS r NPVGO The left-hand side is the formula for the price-earnings ratio. The equation shows that the P/E ratio is related to the net present value of growth opportunities. As an example, consider two firms, each having just reported earnings per share of $1. However, one firm has many valuable growth opportunities while the other firm has no growth opportunities at all. The firm with growth opportunities should sell at a higher price, because an investor is buying both current income of $1 and growth opportunities. Suppose that the firm with growth opportunities sells for $16 and the other firm sells for $8. The $1 earnings per share number appears in the denominator of the P/E ratio for both firms. Thus, the P/E ratio is 16 for the firm with growth opportunities, but only 8 for the firm without the opportunities. This explanation seems to hold fairly well in the real world. Electronic and other hightech stocks generally sell at very high P/E ratios (or multiples, as they are often called) because they are perceived to have high growth rates. In fact, some technology stocks sell at high prices even though the companies have never earned a profit. The P/E ratios of these companies are infinite. Conversely, railroads, utilities, and steel companies sell at lower multiples because of the prospects of lower growth. 128 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 122 Part II Value and Capital Budgeting I TA B L E 5.2 International P/E Ratios Country Composite United States Japan Germany Britain France Canada Sweden Italy 1994 24 101 35 18 29 45 52 29 1997 21 44 31 18 25 25 17 22 2000 30 38 31 20 27 21 20 28 Source: Abstracted from "The Global 1000," Business Week, July 11, 1994, July 7, 1997, and Forbes, July 24, 2000. Of course, the market is merely pricing perceptions of the future, not the future itself. We will argue later in the text that the stock market generally has realistic perceptions of a firm's prospects. However, this is not always true. In the late 1960s, many electronics firms were selling at multiples of 200 times earnings. The high perceived growth rates did not materialize, causing great declines in stock prices during the early 1970s. In earlier decades, fortunes were made in stocks like IBM and Xerox because the high growth rates were not anticipated by investors. One of the most puzzling phenomena to American investors has been the high P/E ratios in the Japanese stock market. The average P/E ratio for the Tokyo Stock Exchange has varied between 40 and 100 in recent years, while the average American stock had a multiple of around 25 during this time. Our formula indicates that Japanese companies have been perceived to have great growth opportunities. However, American commentators have frequently suggested that investors in the Japanese markets have been overestimating these growth prospects.13 This enigma (at least to American investors) can only be resolved with the passage of time. Some selected country average P/E ratios appear in Table 5.2. You can see Japan's P/E ratio has trended down. There are two additional factors explaining the P/E ratio. The first is the discount rate, r. The above formula shows that the P/E ratio is negatively related to the firm's discount rate. We have already suggested that the discount rate is positively related to the stock's risk or variability. Thus, the P/E ratio is negatively related to the stock's risk. To see that this is a sensible result, consider two firms, A and B, behaving as cash cows. The stock market expects both firms to have annual earnings of $1 per share forever. However, the earnings of firm A are known with certainty while the earnings of firm B are quite variable. A rational stockholder is likely to pay more for a share of firm A because of the absence of risk. If a share of firm A sells at a higher price and both firms have the same EPS, the P/E ratio of firm A must be higher. The second additional factor concerns the firm's choice of accounting methods. Under current accounting rules, companies are given a fair amount of leeway. For example, consider inventory accounting where either FIFO or LIFO may be used. In an inflationary environment, FIFO (first infirst out) accounting understates the true cost of inventory and hence inflates reported earnings. Inventory is valued according to more recent costs under LIFO (last infirst out), implying that reported earnings are lower here than they would be under 13 It has been suggested that Japanese companies use more conservative accounting practices, thereby creating higher P/E ratios. This point, which will shortly be examined for firms in general, appears to explain only a small part of Japan's high multiples. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 129 Chapter 5 How to Value Bonds and Stocks 123 FIFO. Thus, LIFO inventory accounting is a more conservative method than FIFO. Similar accounting leeway exists for construction costs (completed-contracts versus percentageof-completion methods) and depreciation (accelerated depreciation versus straight-line depreciation). As an example, consider two identical firms, C and D. Firm C uses LIFO and reports earnings of $2 per share. Firm D uses the less conservative accounting assumptions of FIFO and reports earnings of $3 per share. The market knows that both firms are identical and prices both at $18 per share. This price-earnings ratio is 9 ($18/$2) for firm C and 6 ($18/$3) for firm D. Thus, the firm with the more conservative principles has the higher P/E ratio. This last example depends on the assumption that the market sees through differences in accounting treatments. A significant portion of the academic community believes that the market sees through virtually all accounting differences. These academics are adherents of the hypothesis of efficient capital markets, a theory that we explore in great detail later in the text. Though many financial people might be more moderate in their beliefs regarding this issue, the consensus view is certainly that many of the accounting differences are seen through. Thus, the proposition that firms with conservative accountants have high P/E ratios is widely accepted. This discussion argued that the P/E ratio is a function of three different factors. A company's ratio or multiple is likely to be high if (1) it has many growth opportunities, (2) it has low risk, and (3) it is accounted for in a conservative manner. While each of the three factors is important, it is our opinion that the first factor is much more so. Thus, our discussion of growth is quite relevant in understanding price-earnings multiples. QUESTION CONCEPT ? What are the three factors determining a firm's P/E ratio? 5.9 STOCK MARKET REPORTING The Wall Street Journal, the New York Times, or your own local newspaper provides useful information on a large number of stocks in several stock exchanges. Table 5.3 reproduces what has been reported on a particular day for several stocks listed on the New York Stock Exchange. In Table 5.3, you can easily find the line for General Electric (i.e., "GenElec"). Reading left to right, the first two numbers are the high and low share prices over the last 52 weeks. For example, the highest price that General Electric traded for at the end of any particular day over the last 52 weeks was $6050. This is read as 60 and the decimal .50. The stock symbol for General Electric is GE. Its annual dividend is $0.55. Most dividend-paying companies such as General Electric pay dividends on a quarterly basis. So the annual dividend is actually the last quarterly dividend of .138 multiplied by 4 (i.e., .138 4 $0.55). Some firms like GenenTech do not pay dividends. The Div column for GenenTech is blank. The "Yld" column stands for dividend yield. General Electric's dividend yield is the current annual dividend, $0.55, divided by the current closing daily price, which is $5663 (you can find the closing price for this particular day in the next to last column). Note that $0.55/5663 1.0 percent. The next column is labeled PE, which is the symbol for the priceearnings ratio. The price-earnings ratio is the closing price divided by the current earnings per share (based upon the latest quarterly earnings per share multiplied by 4). General Electric's price-earnings ratio is 51. If we were financial analysts or investment bankers, we would say General Electric "sells for 51 times earnings." The next column is the volume of 130 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 124 Part II Value and Capital Budgeting I TA B L E 5.3 Stock Market Reporting of NYSE-Listed Securities 52 Weeks Hi 5375 2225 84 245 1544 6494 6050 4394 9463 Lo 1906 956 43 6688 250 3625 3821 2938 5694 Stock Gap Inc GartnerGp Gateway Genentech GenDatacm GenDynam GenElec GenMills GenMotor Sym GPS IT GTW DNA GDC GD GE GIS GM Div .09 Yld % .5 ... ... ... ... 1.6 1.0 2.9 3.4 PE Vol 100s Hi 2050 1094 4740 159 425 6481 5769 3794 6113 Lo 19 1031 4215 147 4 6344 5531 3731 5838 Close 1925 1094 4462 149 406 6456 5663 3769 5863 Net Chg 175 ... 129 431 025 1 144 013 106 1.04 .55 1.10 2.00 15 65172 22 2331 31 23354 dd 21468 dd 456 17 23318 51 183051 18 5054 7 22653 shares traded on this particular day (in hundreds). For General Electric, 18,305,100 shares traded. This was a heavy trading day for General Electric. The last columns are the High, the Low, and the Last (Close) share prices on this day. The "Net Chg" tells us that the General Electric closing price of $5663 was lower than its closing price on the previous day by 144. In other words, the price of General Electric dropped from $5807 to $5663, in one day. From Table 5.3: QUESTIONS CONCEPT ? What is the closing price of Gateways? What is the PE of Gateways? What is the annual dividend of General Motors? 5.10 SUMMARY AND CONCLUSIONS In this chapter we use general present-value formulas from the previous chapter to price bonds and stock. 1. Pure discount bonds and perpetuities can be viewed as the polar cases of bonds. The value of a pure discount bond (also called a zero-coupon bond, or simply a zero) is PV F 1 r T The value of a perpetuity (also called a consol) is PV C r Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 131 Chapter 5 How to Value Bonds and Stocks 125 2. Level-payment bonds can be viewed as an intermediate case. The coupon payments form an annuity and the principal repayment is a lump sum. The value of this type of bond is simply the sum of the values of its two parts. 3. The yield to maturity on a bond is that single rate that discounts the payments on the bond to its purchase price. 4. A stock can be valued by discounting its dividends. We mention three types of situations: a. The case of zero growth of dividends. b. The case of constant growth of dividends. c. The case of differential growth. 5. An estimate of the growth rate of a stock is needed for formulas (4b) or (4c) above. A useful estimate of the growth rate is g Retention ratio Return on retained earnings 6. It is worthwhile to view a share of stock as the sum of its worth, if the company behaves like a cash cow (the company does no investing), and the value per share of its growth opportunities. We write the value of a share as EPS r NPVGO We show that, in theory, share price must be the same whether the dividend-growth model or the above formula is used. 7. From accounting, we know that earnings are divided into two parts: dividends and retained earnings. Most firms continually retain earnings in order to create future dividends. One should not discount earnings to obtain price per share since part of earnings must be reinvested. Only dividends reach the stockholders and only they should be discounted to obtain share price. 8. We suggest that a firm's price-earnings ratio is a function of three factors: a. The per-share amount of the firm's valuable growth opportunities. b. The risk of the stock. c. The type of accounting method used by the firm. KEY TERMS Coupons 103 Discount 106 Face value 102 Maturity date 102 Payout ratio 114 Premium 106 Pure discount bond 102 Retention ratio 113 Return on equity 113 Yield to maturity 107 SUGGESTED READINGS The best place to look for additional information is in investment textbooks. A good one is: Bodie, Z., A. Kane, and A. Marcus. Investments. 5th ed. Burr Ridge, Ill.: Irwin/McGraw-Hill, 2002. QUESTIONS AND PROBLEMS How to Value Bonds 5.1 What is the present value of a 10-year, pure discount bond that pays $1,000 at maturity and is priced to yield the following rates? a. 5 percent 132 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 126 Part II Value and Capital Budgeting b. 10 percent c. 15 percent 5.2 Microhard has issued a bond with the following characteristics: Principal: $1,000 Term to maturity: 20 years Coupon rate: 8 percent Semiannual payments Calculate the price of the Microhard bond if the stated annual interest rate is: a. 8 percent b. 10 percent c. 6 percent 5.3 Consider a bond with a face value of $1,000. The coupon is paid semiannually and the market interest rate (effective annual interest rate) is 12 percent. How much would you pay for the bond if a. the coupon rate is 8 percent and the remaining time to maturity is 20 years? b. the coupon rate is 10 percent and the remaining time to maturity is 15 years? 5.4 Pettit Trucking has issued an 8-percent, 20-year bond that pays interest semiannually. If the market prices the bond to yield an effective annual rate of 10 percent, what is the price of the bond? 5.5 A bond is sold at $923.14 (below its par value of $1,000). The bond has 15 years to maturity and investors require a 10-percent yield on the bond. What is the coupon rate for the bond if the coupon is paid semiannually? 5.6 You have just purchased a newly issued $1,000 five-year Vanguard Company bond at par. This five-year bond pays $60 in interest semiannually. You are also considering the purchase of another Vanguard Company bond that returns $30 in semiannual interest payments and has six years remaining before it matures. This bond has a face value of $1,000. a. What is effective annual return on the five-year bond? b. Assume that the rate you calculated in part (a) is the correct rate for the bond with six years remaining before it matures. What should you be willing to pay for that bond? c. How will your answer to part (b) change if the five-year bond pays $40 in semiannual interest? Bond Concepts 5.7 Consider two bonds, bond A and bond B, with equal rates of 10 percent and the same face values of $1,000. The coupons are paid annually for both bonds. Bond A has 20 years to maturity while bond B has 10 years to maturity. a. What are the prices of the two bonds if the relevant market interest rate is 10 percent? b. If the market interest rate increases to 12 percent, what will be the prices of the two bonds? c. If the market interest rate decreases to 8 percent, what will be the prices of the two bonds? 5.8 a. If the market interest rate (the required rate of return that investors demand) unexpectedly increases, what effect would you expect this increase to have on the prices of long-term bonds? Why? b. What would be the effect of the rise in the interest rate on the general level of stock prices? Why? 5.9 Consider a bond that pays an $80 coupon annually and has a face value of $1,000. Calculate the yield to maturity if the bond has a. 20 years remaining to maturity and it is sold at $1,200. b. 10 years remaining to maturity and it is sold at $950. 5.10 The Sue Fleming Corporation has two different bonds currently outstanding. Bond A has a face value of $40,000 and matures in 20 years. The bond makes no payments for the first six years and then pays $2,000 semiannually for the subsequent eight years, and finally pays $2,500 semiannually for the last six years. Bond B also has a face value of $40,000 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 133 Chapter 5 How to Value Bonds and Stocks 127 and a maturity of 20 years; it makes no coupon payments over the life of the bond. If the required rate of return is 12 percent compounded semiannually, what is the current price of Bond A? of Bond B? The Present Value of Common Stocks 5.11 Use the following February 11, 2000, WSJ quotation for AT&T Corp. Which of the following statements is false? a. The closing price of the bond with the shortest time to maturity was $1,000. b. The annual coupon for the bond maturing in year 2016 is $90.00. c. The price on the day before this quotation (i.e., February 9) for the ATT bond maturing in year 2022 was $1.075 per bond contract. d. The current yield on the ATT bond maturing in year 2002 was 7.125% e. The ATT bond maturing in year 2002 has a yield to maturity less than 7.125%. Bonds ATT 9s 16 ATT 5 1/8 01 ATT 7 1/8 02 ATT 8 1/8 22 Cur Yld ? ? ? ? Vol 10 5 193 39 Close 117 100 104 1/8 107 3/8 Net Chg 1/4 3/4 1/4 1/8 5.12 Following are selected quotations for New York Exchange Bonds from the Wall Street Journal. Which of the following statements about Wilson's bond is false? a. The bond maturing in year 2000 has a yield to maturity greater than 63/8%. b. The closing price of the bond with the shortest time to maturity on the day before this quotation was $1,003.25. c. This annual coupon for the bond maturing in year 2013 is $75.00. d. The current yield on the Wilson's bond with the longest time to maturity was 7.29%. e. None of the above. Quotations as of 4 P.M. Eastern Time Friday, April 23, 1999 Bonds WILSON 6 3/8 99 WILSON 6 3/8 00 WILSON 7 1/4 02 WILSON 7 1/2 13 Current Yield ? ? ? ? Vol 76 9 39 225 Close 100 3/8 98 103 5/8 102 7/8 Net 1/8 1/2 1/8 1/8 5.13 A common stock pays a current dividend of $2. The dividend is expected to grow at an 8-percent annual rate for the next three years; then it will grow at 4 percent in perpetuity. The appropriate discount rate is 12 percent. What is the price of this stock? 5.14 Use the following February 12, 1998, WSJ quotation for Merck & Co. to answer the next question. 52 Weeks Hi 120. Yld Vol Hi 115.9 Lo 114.5 Close 115 Net Chg 1.25 Lo Stock Sym Div % PE 100s 80.19 Merck MRK 1.80 ? 30 195111 Which of the following statements is false? a. The dividend yield was about 1.6%. b. The 52 weeks' trading range was $39.81. c. The closing price per share on February 10, 1998, was $113.75. d. The closing price per share on February 11, 1998, was $115. e. The earnings per share were about $3.83. 134 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 128 Part II Value and Capital Budgeting 5.15 Use the following stock quote. 52 Weeks Hi 126.25 Yld Vol 100s 20925 Hi 98.4 Lo 97.8 Close 98.13 Net Chg .13 Lo Stock Sym Div % PE 72.50 Citigroup CCI 1.30 1.32 16 The expected growth rate in Citigroup's dividends is 7% a year. Suppose you use the discounted dividend model to price Citigroup's shares. The constant growth dividend model would suggest that the required return on the Citigroup's stock is what? 5.16 You own $100,000 worth of Smart Money stock. At the end of the first year you receive a dividend of $2 per share; at the end of year 2 you receive a $4 dividend. At the end of year 3 you sell the stock for $50 per share. Only ordinary (dividend) income is taxed at the rate of 28 percent. Taxes are paid at the time dividends are received. The required rate of return is 15 percent. How many shares of stock do you own? 5.17 Consider the stock of Davidson Company that will pay an annual dividend of $2 in the coming year. The dividend is expected to grow at a constant rate of 5 percent permanently. The market requires a 12-percent return on the company. a. What is the current price of a share of the stock? b. What will the stock price be 10 years from today? 5.18 Easy Type, Inc., is one of a myriad of companies selling word processor programs. Their newest program will cost $5 million to develop. First-year net cash flows will be $2 million. As a result of competition, profits will fall by 2 percent each year thereafter. All cash inflows will occur at year-end. If the market discount rate is 14 percent, what is the value of this new program? 5.19 Whizzkids, Inc., is experiencing a period of rapid growth. Earnings and dividends per share are expected to grow at a rate of 18 percent during the next two years, 15 percent in the third year, and at a constant rate of 6 percent thereafter. Whizzkids' last dividend, which has just been paid, was $1.15. If the required rate of return on the stock is 12 percent, what is the price of a share of the stock today? 5.20 Allen, Inc., is expected to pay an equal amount of dividends at the end of the first two years. Thereafter, the dividend will grow at a constant rate of 4 percent indefinitely. The stock is currently traded at $30. What is the expected dividend per share for the next year if the required rate of return is 12 percent? 5.21 Calamity Mining Company's reserves of ore are being depleted, and its costs of recovering a declining quantity of ore are rising each year. As a result, the company's earnings are declining at the rate of 10 percent per year. If the dividend per share that is about to be paid is $5 and the required rate of return is 14 percent, what is the value of the firm's stock? 5.22 The Highest Potential, Inc., will pay a quarterly dividend per share of $1 at the end of each of the next 12 quarters. Subsequently, the dividend will grow at a quarterly rate of 0.5 percent indefinitely. The appropriate rate of return on the stock is 10 percent. What is the current stock price? Estimates of Parameters in the Dividend-Discount Model 5.23 The newspaper reported last week that Bradley Enterprises earned $20 million. The report also stated that the firm's return on equity remains on its historical trend of 14 percent. Bradley retains 60 percent of its earnings. What is the firm's growth rate of earnings? What will next year's earnings be? 5.24 Von Neumann Enterprises has just reported earnings of $10 million, and it plans to retain 75 percent of its earnings. The company has 1.25 million shares of common stock outstanding. The stock is selling at $30. The historical return on equity (ROE) of 12 percent is expected to continue in the future. What is the required rate of return on the stock? Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 135 Chapter 5 How to Value Bonds and Stocks 129 Growth Opportunities 5.25 Rite Bite Enterprises sells toothpicks. Gross revenues last year were $3 million, and total costs were $1.5 million. Rite Bite has 1 million shares of common stock outstanding. Gross revenues and costs are expected to grow at 5 percent per year. Rite Bite pays no income taxes, and all earnings are paid out as dividends. a. If the appropriate discount rate is 15 percent and all cash flows are received at year's end, what is the price per share of Rite Bite stock? b. The president of Rite Bite decided to begin a program to produce toothbrushes. The project requires an immediate outlay of $15 million. In one year, another outlay of $5 million will be needed. The year after that, net cash inflows will be $6 million. This profit level will be maintained in perpetuity. What effect will undertaking this project have on the price per share of the stock? 5.26 California Electronics, Inc., expects to earn $100 million per year in perpetuity if it does not undertake any new projects. The firm has an opportunity that requires an investment of $15 million today and $5 million in one year. The new investment will begin to generate additional annual earnings of $10 million two years from today in perpetuity. The firm has 20 million shares of common stock outstanding, and the required rate of return on the stock is 15 percent. a. What is the price of a share of the stock if the firm does not undertake the new project? b. What is the value of the growth opportunities resulting from the new project? c. What is the price of a share of the stock if the firm undertakes the new project? 5.27 Suppose Smithfield Foods, Inc., has just paid a dividend of $1.40 per share. Sales and profits for Smithfield Foods are expected to grow at a rate of 5% per year. Its dividend is expected to grow by the same rate. If the required return is 10%, what is the value of a share of Smithfield Foods? 5.28 In order to buy back its own shares, Pennzoil Co. has decided to suspend its dividends for the next two years. It will resume its annual cash dividend of $2.00 a share 3 years from now. This level of dividends will be maintained for one more year. Thereafter, Pennzoil is expected to increase its cash dividend payments by an annual growth rate of 6% per year forever. The required rate of return on Pennzoil's stock is 16%. According to the discounted dividend model, what should Pennzoil's current share price be? 5.29 Four years ago, Ultramar Diamond Inc. paid a dividend of $0.80 per share. This year Ultramar paid a dividend of $1.66 per share. It is expected that the company will pay dividends growing at the same rate for the next 5 years. Thereafter, the growth rate will level at 8% per year. The required return on this stock is 18%. According to the discounted dividend model, what would Ultramar's cash dividend be in 7 years? a. $2.86 b. $3.06 c. $3.68 d. $4.30 e. $4.82 5.30 The Webster Co. has just paid a dividend of $5.25 per share. The company will increase its dividend by 15 percent next year and will then reduce its dividend growth by 3 percent each year until it reaches the industry average of 5 percent growth, after which the company will keep a constant growth, forever. The required rate of return for the Webster Co. is 14 percent. What will a share of stock sell for? Price-Earnings Ratio 5.31 Consider Pacific Energy Company and U.S. Bluechips, Inc., both of which reported recent earnings of $800,000 and have 500,000 shares of common stock outstanding. Assume both firms have the same required rate of return of 15 percent a year. a. Pacific Energy Company has a new project that will generate cash flows of $100,000 each year in perpetuity. Calculate the P/E ratio of the company. 136 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 130 Part II Value and Capital Budgeting b. U.S. Bluechips has a new project that will increase earnings by $200,000 in the coming year. The increased earnings will grow at 10 percent a year in perpetuity. Calculate the P/E ratio of the firm. 5.32 (Challenge Question) Lewin Skis Inc. (today) expects to earn $4.00 per share for each of the future operating periods (beginning at time 1) if the firm makes no new investments (and returns the earnings as dividends to the shareholders). However, Clint Williams, President and CEO, has discovered an opportunity to retain (and invest) 25% of the earnings beginning three years from today (starting at time 3). This opportunity to invest will continue (for each period) indefinitely. He expects to earn 40% (per year) on this new equity investment (ROE of 40), the return beginning one year after each investment is made. The firm's equity discount rate is 14% throughout. a. What is the price per share (now at time 0) of Lewin Skis Inc. stock without making the new investment? b. If the new investment is expected to be made, per the preceding information, what would the value of the stock (per share) be now (at time 0)? c. What is the expected capital gain yield for the second period, assuming the proposed investment is made? What is the expected capital gain yield for the second period if the proposed investment is not made? d. What is the expected dividend yield for the second period if the new investment is made? What is the expected dividend yield for the second period if the new investment is not made? Appendix 5A THE TERM STRUCTURE OF INTEREST RATES, SPOT RATES, AND YIELD TO MATURITY In the main body of this chapter, we have assumed that the interest rate is constant over all future periods. In reality, interest rates vary through time. This occurs primarily because inflation rates are expected to differ through time. To illustrate, we consider two zero-coupon bonds. Bond A is a one-year bond and bond B is a two-year bond. Both have face values of $1,000. The one-year interest rate, r1, is 8 percent. The two-year interest rate, r2, is 10 percent. These two rates of interest are examples of spot rates. Perhaps this inequality in interest rates occurs because inflation is expected to be higher over the second year than over the first year. The two bonds are depicted in the following time chart. 0 Bond A Bond B Year 1 8% 1 $1,000 10% $1,000 Year 2 2 We can easily calculate the present value for bond A and bond B as PVA PVB $925.93 $826.45 $1,000 1.08 $1,000 1.10 2 Of course, if PVA and PVB were observable and the spot rates were not, we could determine the spot rates using the PV formula, because PVA $925.93 $1,000 r1 1 r1 8% Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 137 Chapter 5 How to Value Bonds and Stocks 131 and PVB $826.45 $1,000 r2 1 r2 2 10% Now we can see how the prices of more complicated bonds are determined. Try to do the next example. It illustrates the difference between spot rates and yields to maturity. E XAMPLE Given the spot rates, r1 equals 8 percent and r2 equals 10 percent, what should a 5-percent coupon, two-year bond cost? The cash flows C1 and C2 are illustrated in the following time chart. 0 Year 1 8% 1 $50 10% $1,050 Year 2 2 The bond can be viewed as a portfolio of zero-coupon bonds with one- and twoyear maturities. Therefore, PV 1 $50 0.08 1 $1,050 0.10 2 $914.06 (A.1) We now want to calculate a single rate for the bond. We do this by solving for y in the following equation: $914.06 $50 1 y $1,050 1 y2 (A.2) In (A.2), y equals 9.95 percent. As mentioned in the chapter, we call y the yield to maturity on the bond. Solving for y for a multiyear bond is generally done by means of trial and error.14 While this can take much time with paper and pencil, it is virtually instantaneous on a hand-held calculator. It is worthwhile to contrast equation (A.1) and equation (A.2). In (A.1), we use the marketwide spot rates to determine the price of the bond. Once we get the bond price, we use (A.2) to calculate its yield to maturity. Because equation (A.1) employs two spot rates whereas only one appears in (A.2), we can think of yield to maturity as some sort of average of the two spot rates.15 Using the above spot rates, the yield to maturity of a two-year coupon bond whose coupon rate is 12 percent and PV equals $1,036.73 can be determined by $1,036.73 $120 1 r $1,120 r 1 r2 9.89% As these calculations show, two bonds with the same maturity will usually have different yields to maturity if the coupons differ. 14 The quadratic formula may be used to solve for y for a two-year bond. However, formulas generally do not apply for longer-term bonds. 15 Yield to maturity is not a simple average of r1 and r2. Rather, financial economists speak of it as a timeweighted average of r1 and r2. 138 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 132 Part II Value and Capital Budgeting I F I G U R E 5A.1 The Term Structure of Interest Rates Spot interest rates (%) 14 12 10 8 6 4 2 Time (years) 1 2 3 4 5 6 7 r1 r2 r3 Graphing the Term Structure The term structure describes the relationship of spot rates with different maturities. Figure 5A.1 graphs a particular term structure. In Figure 5A.1 the spot rates are increasing with longer maturities, that is, r3 r2 r1. Graphing the term structure is easy if we can observe spot rates. Unfortunately, this can be done only if there are enough zero-coupon government bonds. A given term structure, such as that in Figure 5A.1, exists for only a moment in time, say, 10:00 A.M., July 30, 1990. Interest rates are likely to change in the next minute, so that a different (though quite similar) term structure would exist at 10:01 A.M. QUESTION CONCEPT ? What is the difference between a spot interest rate and the yield to maturity? Explanations of the Term Structure Figure 5A.1 showed one of many possible relationships between the spot rate and maturity. We now want to explore the relationship in more detail. We begin by defining a new term, the forward rate. Next, we relate this forward rate to future interest rates. Finally, we consider alternative theories of the term structure. Definition of Forward Rate Earlier in this appendix, we developed a two-year example where the spot rate over the first year is 8 percent and the spot rate over the two years is 10 percent. Here, an individual investing $1 in a two-year zero-coupon bond would have $1 (1.10)2 in two years. In order to pursue our discussion, it is worthwhile to rewrite16 $1 16 (1.10)2 $1 1.08 1.1204 (A.3) 12.04 percent is equal to 1.10 2 1.08 1 when rounding is performed after four digits. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 139 Chapter 5 How to Value Bonds and Stocks 133 I F I G U R E 5A.2 Breakdown of a Two-Year Spot Rate into a One-Year Spot Rate and Forward Rate over the Second Year Date 0 Year 1 Date 1 Year 2 Date 2 $1 10% $1 (1.10)2 = $1.21 With a two-year spot rate of 10 percent, investor in two-year bond receives $1.21 at date 2. This is the same return as if investor received the spot rate of 8 percent over the first year and 12.04-percent return over the second year. $1 ------ 8% -------- $1.08 ----12.04% ----$1 1.08 1.1204 $1.21 Because both the one-year spot rate and the two-year spot rate are known at date 0, the forward rate over the second year can be calculated at date 0. Equation (A.3) tells us something important about the relationship between one- and twoyear rates. When an individual invests in a two-year zero-coupon bond yielding 10 percent, his wealth at the end of two years is the same as if he received an 8-percent return over the first year and a 12.04-percent return over the second year. This hypothetical rate over the second year, 12.04 percent, is called the forward rate. Thus, we can think of an investor with a two-year zero-coupon bond as getting the one-year spot rate of 8 percent and locking in 12.04 percent over the second year. This relationship is presented in Figure 5A.2. More generally, if we are given spot rates, r1 and r2, we can always determine the forward rate, f2, such that: (1 We solve for f2, yielding: f2 1 1 r2 2 r1 1 (A.5) r2)2 (1 r1) (1 f2) (A.4) E XAMPLE If the one-year spot rate is 7 percent and the two-year spot rate is 12 percent, what is f2? We plug in equation (A.5), yielding f2 1.12 2 1.07 1 17.23% Consider an individual investing in a two-year zero-coupon bond yielding 12 percent. We say it is as if he receives 7 percent over the first year and simultaneously locks in 17.23 percent over the second year. Note that both the one-year spot rate and the two-year spot rate are known at date 0. Because the forward rate is calculated from the one-year and two-year spot rates, it can be calculated at date 0 as well. Forward rates can be calculated over later years as well. The general formula is fn 1 1 rn rn 1 1 n n 1 1 (A.6) is where fn is the forward rate over the nth year, rn is the n-year spot rate, and rn the spot rate for n 1 years. 140 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 134 Part II Value and Capital Budgeting E XAMPLE Assume the following set of rates: Year 1 2 3 4 Spot Rate 5% 6 7 6 What are the forward rates over each of the four years? The forward rate over the first year is, by definition, equal to the one-year spot rate. Thus, we do not generally speak of the forward rate over the first year. The forward rates over the later years are f2 f3 f4 1.06 2 1.05 1.07 3 1.06 2 1.06 4 1.07 3 1 1 1 7.01% 9.03% 3.06% An individual investing $1 in the two-year zero-coupon bond receives $1.1236 [$1 (1.06)2] at date 2. He can be viewed as receiving the one-year spot rate of 5 percent over the first year and receiving the forward rate of 7.01 percent over the second year. An individual investing $1 in a three-year zerocoupon bond receives $1.2250 [$1 (1.07)3] at date 3. She can be viewed as receiving the two-year spot rate of 6 percent over the first two years and receiving the forward rate of 9.03 percent over the third year. An individual investing $1 in a four-year zero-coupon bond receives $1.2625 [$1 (1.06)4] at date 4. He can be viewed as receiving the three-year spot rate of 7 percent over the first three years and receiving the forward rate of 3.06 percent over the fourth year. Note that all of the four spot rates in this problem are known at date 0. Because the forward rates are calculated from the spot rates, they can be determined at date 0 as well. The material in this appendix is likely to be difficult for a student exposed to term structure for the first time. It helps to state what the student should know at this point. Given equations (A.5) and (A.6), a student should be able to calculate a set of forward rates given a set of spot rates. This can simply be viewed as a mechanical computation. In addition to the calculations, a student should understand the intuition of Figure 5A.2. We now turn to the relationship between the forward rate and the expected spot rates in the future. Estimating the Price of a Bond at a Future Date In the example from the body of this chapter, we considered zero-coupon bonds paying $1,000 at maturity and selling at a discount prior to maturity. We now wish to change the example slightly. Now, each bond Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 141 Chapter 5 How to Value Bonds and Stocks 135 initially sells at par so that payment at maturity is above $1,000.17 Keeping the spot rates at 8 percent and 10 percent, we have Date 0 Bond A $1,000 Initial purchase price $1,000 Initial purchase price Date 1 $1,080 Payment at maturity 10% $1,210 Payment at maturity ? Date 2 Year 1 8% Year 2 Bond B One-year spot rate from date 1 to date 2 is unknown as of date 0. The payments at maturity are $1,080 and $1,210 for the one- and two-year zero-coupon bonds, respectively. The initial purchase price of $1,000 for each bond is determined as $1,000 $1,000 $1,080 1.08 $1,210 1.10 2 We refer to the one-year bond as bond A and the two-year bond as bond B. There will be a different one-year spot rate when date 1 arrives. This will be the spot rate from date 1 to date 2. We can also call it the spot rate over year 2. This spot rate is not known as of date 0. For example, should the rate of inflation rise between date 0 and date 1, the spot rate over year 2 would likely be high. Should the rate of inflation fall between date 0 and date 1, the spot rate over year 2 would likely be low. Now that we have determined the price of each bond at date 0, we want to determine what the price of each bond will be at date 1. The price of the one-year bond (bond A) must be $1,080 at date 1, because the payment at maturity is made then. The hard part is determining what the price of the two-year bond (bond B) will be at that time. Suppose we find that, on date 1, the one-year spot rate from date 1 to date 2 is 6 percent. We state that this is the one-year spot rate over year 2. This means that I can invest $1,000 at date 1 and receive $1,060 ($1,000 1.06) at date 2. Because one year has already passed for bond B, the bond has only one year left. Because bond B pays $1,210 at date 2, its value at date 1 is $1,141.51 $1,210 1.06 (A.7) Note that no one knew ahead of time the price that bond B would sell for on date 1, because no one knew that the one-year spot rate over year 2 would be 6 percent. 17 This change in assumptions simplifies our presentation but does not alter any of our conclusions. 142 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 136 Part II Value and Capital Budgeting I TA B L E 5A.1 Price of Bond B at Date 1 as a Function of Spot Rate over Year 2 Spot Rate over Year 2 6% 7% 14% Price of Bond B at Date 1 $1,141.51 $1,130.84 $1,061.40 $1,210 1.06 $1,210 1.07 $1,210 1.14 Suppose the one-year spot rate beginning at date 1 turned out not to be 6 percent, but to be 7 percent instead. This means that I can invest $1,000 at date 1 and receive $1,070 ($1,000 1.07) at date 2. In this case, the value of bond B at date 1 would be $1,130.84 $1,210 1.07 (A.8) Finally, suppose that the one-year spot rate at date 1 turned out to be neither 6 percent nor 7 percent, but 14 percent instead. This means that I can invest $1,000 at date 1 and receive $1,140 ($1,000 1.14) at date 2. In this case, the value of bond B at date 1 would be $1,061.40 $1,210 1.14 The above possible bond prices are represented in Table 5A.1. The price that bond B will sell for on date 1 is not known before date 1 since the one-year spot rate prevailing over year 2 is not known until date 1. It is important to reemphasize that, although the forward rate is known at date 0, the one-year spot rate beginning at date 1 is unknown ahead of time. Thus, the price of bond B at date 1 is unknown ahead of time. Prior to date 1, we can speak only of the amount that bond B is expected to sell for on date 1. We write this as18 The Amount that Bond B Is Expected to Sell for on Date 1: $1,210 1 Spot rate expected over year 2 (A.9) It is worthwhile making two points now. First, because each individual is different, the expected value of bond B differs across individuals. Later we will speak of a consensus expected value across investors. Second, equation (A.9) represents one's forecast of the price that the bond will be selling for on date 1. The forecast is made ahead of time, that is, on date 0. 18 Technically, equation (A.9) is only an approximation due to Jensen's inequality. That is, expected values of 1 $1,210 Spot rate 1 $1,210 Spot rate expected over year 2 However, we ignore this very minor issue in the rest of the analysis. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 143 Chapter 5 How to Value Bonds and Stocks 137 The Relationship between Forward Rate over Second Year and Spot Rate Expected over Second Year Given a forecast of bond B's price, an investor can choose one of two strategies at date 0: I. Buy a one-year bond. Proceeds at date 1 would be $1,080 $1,000 1.08 (A.10) II. Buy a two-year bond but sell at date 1. Expected proceeds would be 1 $1,000 1.10 2 Spot rate expected over year 2 (A.11) Given our discussion of forward rates, we can rewrite (A.11) as 1 $1,000 1.08 1.1204 Spot rate expected over year 2 (A.12) (Remember that 12.04 percent was the forward rate over year 2; i.e., f2 12.04%.) Under what condition will the return from strategy I equal the expected return from strategy II? In other words, under what condition will formula (A.10) equal formula (A.12)? The two strategies will yield the same expected return only when 12.04% Spot rate expected over year 2 (A.13) In other words, if the forward rate equals the expected spot rate, one would expect to earn the same return over the first year whether one 1. invested in a one-year bond, or 2. invested in a two-year bond but sold after one year. The Expectations Hypothesis Equation (A.13) seems fairly reasonable. That is, it is reasonable that investors would set interest rates in such a way that the forward rate would equal the spot rate expected by the marketplace a year from now.19 For example, imagine that individuals in the marketplace do not concern themselves with risk. If the forward rate, f2, is less than the spot rate expected over year 2, individuals desiring to invest for one year would always buy a one-year bond. That is, our work above shows that an individual investing in a two-year bond but planning to sell at the end of one year would expect to earn less than if he simply bought a one-year bond. Equation (A.13) was stated for the specific case where the forward rate was 12.04 percent. We can generalize this to: f2 Expectations Hypothesis: Spot rate expected over year 2 (A.14) Equation (A.14) says that the forward rate over the second year is set to the spot rate that people expect to prevail over the second year. This is called the expectations hypothesis. It states that investors will set interest rates such that the forward rate over the second year is equal to the one-year spot rate expected over the second year. 19 Of course, each individual will have different expectations, so (A.13) cannot hold for all individuals. However, financial economists generally speak of a consensus expectation. This is the expectation of the market as a whole. 144 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 138 Part II Value and Capital Budgeting Liquidity-Preference Hypothesis At this point, many students think that equation (A.14) must hold. However, note that we developed (A.14) by assuming that investors were risk-neutral. Suppose, alternatively, that investors are adverse to risk. Which strategy would appear more risky for an individual who wants to invest for one year? I. Invest in a one-year bond. II. Invest in a two-year bond but sell at the end of one year. Strategy (I) has no risk because the investor knows that the rate of return must be r1. Conversely, strategy (II) has much risk; the final return is dependent on what happens to interest rates. Because strategy (II) has more risk than strategy (I), no risk-averse investor will choose strategy (II) if both strategies have the same expected return. Risk-averse investors can have no preference for one strategy over the other only when the expected return on strategy (II) is above the return on strategy (I). Because the two strategies have the same expected return when f2 equals the spot rate expected over year 2, strategy (II) can only have a higher rate of return when Liquidity-Preference Hypothesis: f2 Spot rate expected over year 2 (A.15) That is, in order to induce investors to hold the riskier two-year bonds, the market sets the forward rate over the second year to be above the spot rate expected over the second year. Equation (A.15) is called the liquidity-preference hypothesis. We developed the entire discussion by assuming that individuals are planning to invest over one year. We pointed out that for these types of individuals, a two-year bond has extra risk because it must be sold prematurely. What about those individuals who want to invest for two years? (We call these people investors with a two-year time horizon.) They could choose one of the following strategies: III. Buy a two-year zero-coupon bond. IV. Buy a one-year bond. When the bond matures, immediately buy another one-year bond. Strategy (III) has no risk for an investor with a two-year time horizon, because the proceeds to be received at date 2 are known as of date 0. However, strategy (IV) has risk since the spot rate over year 2 is unknown at date 0. It can be shown that risk-averse investors will prefer neither strategy (III) nor strategy (IV) over the other when f2 Spot rate expected over year 2 (A.16) Note that the assumption of risk aversion gives contrary predictions. Relationship (A.15) holds for a market dominated by investors with a one-year time horizon. Relationship (A.16) holds for a market dominated by investors with a two-year time horizon. Financial economists have generally argued that the time horizon of the typical investor is generally much shorter than the maturity of typical bonds in the marketplace. Thus, economists view (A.15) as the best depiction of equilibrium in the bond market with riskaverse investors. However, do we have a market of risk-neutral or risk-averse investors? In other words, can the expectations hypothesis of equation (A.14) or the liquidity-preference hypothesis of equation (A.15) be expected to hold? As we will learn later in this book, economists view investors as being risk-averse for the most part. Yet economists are never satisfied with a casual examination of a theory's assumptions. To them, empirical evidence of a theory's predictions must be the final arbiter. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 5. How to Value Bonds and Stocks The McGraw-Hill Companies, 2002 145 Chapter 5 How to Value Bonds and Stocks 139 There has been a great deal of empirical evidence on the term structure of interest rates. Unfortunately (perhaps fortunately for some students), we will not be able to present the evidence in any detail. Suffice it to say that, in our opinion, the evidence supports the liquiditypreference hypothesis over the expectations hypothesis. One simple result might give students the flavor of this research. Consider an individual choosing between one of the following two strategies: I. Invest in a 1-year bond. II. Invest in a 20-year bond but sell at the end of 1 year. (Strategy (II) is identical to strategy (II), except that a 20-year bond is substituted for a 2-year bond.) The expectations hypothesis states that the expected returns on both strategies are identical. The liquidity-preference hypothesis states that the expected return on strategy (II) should be above the expected return on strategy (I). Though no one knows what returns are actually expected over a particular time period, actual returns from the past may allow us to infer expectations. The results from January 1926 to December 1999 are illuminating. The average yearly return on strategy (I) is 3.8 percent and 5.5 percent on strategy (II) over this time period.20, 21 This evidence is generally considered to be consistent with the liquidity-preference hypothesis and inconsistent with the expectations hypothesis. QUESTIONS CONCEPT ? Define the forward rate. What is the relationship between the one-year spot rate, the two-year spot rate, and the forward rate over the second year? What is the expectations hypothesis? What is the liquidity-preference hypothesis? QUESTIONS AND PROBLEMS A.1 The appropriate discount rate for cash flows received one year from today is 10 percent. The appropriate annual discount rate for cash flows received two years from today is 11 percent. a. What is the price of a two-year bond that pays an annual coupon of 6 percent? b. What is the yield to maturity of this bond? A.2 The one-year spot rate equals 10 percent and the two-year spot rate equals 8 percent. What should a 5-percent coupon two-year bond cost? A.3 If the one-year spot rate is 9 percent and the two-year spot rate is 10 percent, what is the forward rate? A.4 Assume the following spot rates: Maturity 1 2 3 Spot Rates (%) 5 7 10 What are the forward rates over each of the three years? 20 Taken from Stocks, Bonds, Bills and Inflation 2000 Yearbook (Chicago: Ibbotson Associates, Inc.). Ibbotson Associates annually updates work by Roger G. Ibbotson and Rex A. Sinquefield. 21 It is important to note that strategy (II) does not involve buying a 20-year bond and holding it to maturity. Rather, it consists of buying a 20-year bond and selling it 1 year later, that is, when it has become a 19-year bond. This round-trip transaction occurs 74 times in the 74-year sample from January 1926 to December 1999. 146 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 6 CHAPTER Some Alternative Investment Rules EXECUTIVE SUMMARY C hapter 4 examined the relationship between $1 today and $1 in the future. For example, a corporate project generating a set of cash flows can be valued by discounting these flows, an approach called the net-present-value (NPV) approach. While we believe that the NPV approach is the best one for evaluating capital budgeting projects, our treatment would be incomplete if we ignored alternative methods. This chapter examines these alternative methods. We first consider the NPV approach as a benchmark. Next we examine three alternatives--payback, accounting rates of return, and internal rate of return. 6.1 WHY USE NET PRESENT VALUE? Before examining competitors of the NPV approach, we should ask: Why consider using NPV in the first place? Answering this question will put the rest of this chapter in a proper perspective. There are actually a number of arguments justifying the use of NPV, and you may have already seen the detailed one of Chapter 3. We now present one of the simplest justifications through an example. E XAMPLE The Alpha Corporation is considering investing in a riskless project costing $100. The project pays $107 at date 1 and has no other cash flows. The managers of the firm might contemplate one of two strategies: 1. Use $100 of corporate cash to invest in the project. The $107 will be paid as a dividend in one period. 2. Forgo the project and pay the $100 of corporate cash as a dividend today. If strategy 2 is employed, the stockholder might deposit the dividend in the bank for one period. Because the project is riskless and lasts for one period, the stockholder would prefer strategy 1 if the bank interest rate was below 7 percent. In other words, the stockholder would prefer strategy 1 if strategy 2 produced less than $107 by the end of the year. The comparison can easily be handled by NPV analysis. If the interest rate is 6 percent, the NPV of the project is $0.94 $100 $107 1.06 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 147 Chapter 6 Some Alternative Investment Rules 141 Because the NPV is positive, the project should be accepted. Of course, a bank interest rate above 7 percent would cause the project's NPV to be negative, implying that the project should be rejected. Thus, our basic point is: Accepting positive NPV projects benefits the stockholders. Although we used the simplest possible example, the results could easily be applied to more plausible situations. If the project lasted for many periods, we would calculate the NPV of the project by discounting all the cash flows. If the project were risky, we could determine the expected return on a stock whose risk is comparable to that of the project. This expected return would serve as the discount rate. Having shown that NPV is a sensible approach, how can we tell whether alternative approaches are as good as NPV? The key to NPV is its three attributes: 1. NPV Uses Cash Flows Cash flows from a project can be used for other corporate purposes (e.g., dividend payments, other capital-budgeting projects, or payments of corporate interest). By contrast, earnings are an artificial construct. While earnings are useful to accountants, they should not be used in capital budgeting because they do not represent cash. 2. NPV Uses All the Cash Flows of the Project Other approaches ignore cash flows beyond a particular date; beware of these approaches. 3. NPV Discounts the Cash Flows Properly Other approaches may ignore the time value of money when handling cash flows. Beware of these approaches as well. 6.2 THE PAYBACK PERIOD RULE Defining the Rule One of the most popular alternatives to NPV is the payback period rule. Here is how the payback period rule works. Consider a project with an initial investment of $50,000. Cash flows are $30,000, $20,000, and $10,000 in the first three years, respectively. These flows are illustrated in Figure 6.1. A useful way of writing down investments like the preceding is with the notation: ( $50,000, $30,000, $20,000, $10,000) The minus sign in front of the $50,000 reminds us that this is a cash outflow for the investor, and the commas between the different numbers indicate that they are received--or if they are cash outflows, that they are paid out--at different times. In this example we are assuming that the cash flows occur one year apart, with the first one occurring the moment we decide to take on the investment. I F I G U R E 6.1 Cash Flows of an Investment Project $30,000 Cash inflow $20,000 $10,000 Time 0 1 2 3 Cash outflow $50,000 148 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 142 Part II Value and Capital Budgeting The firm receives cash flows of $30,000 and $20,000 in the first two years, which add up to the $50,000 original investment. This means that the firm has recovered its investment within two years. In this case two years is the payback period of the investment. The payback period rule for making investment decisions is simple. A particular cutoff time, say two years, is selected. All investment projects that have payback periods of two years or less are accepted and all of those that pay off in more than two years--if at all--are rejected. Problems with the Payback Method There are at least three problems with the payback method. To illustrate the first two problems, we consider the three projects in Table 6.1. All three projects have the same threeyear payback period, so they should all be equally attractive--right? Actually, they are not equally attractive, as can be seen by a comparison of different pairs of projects. Problem 1: Timing of Cash Flows within the Payback Period Let us compare project A with project B. In years 1 through 3, the cash flows of project A rise from $20 to $50 while the cash flows of project B fall from $50 to $20. Because the large cash flow of $50 comes earlier with project B, its net present value must be higher. Nevertheless, we saw above that the payback periods of the two projects are identical. Thus, a problem with the payback period is that it does not consider the timing of the cash flows within the payback period. This shows that the payback method is inferior to NPV because, as we pointed out earlier, the NPV approach discounts the cash flows properly. Problem 2: Payments after the Payback Period Now consider projects B and C, which have identical cash flows within the payback period. However, project C is clearly preferred because it has the cash flow of $60,000 in the fourth year. Thus, another problem with the payback method is that it ignores all cash flows occurring after the payback period. This flaw is not present with the NPV approach because, as we pointed out earlier, the NPV approach uses all the cash flows of the project. The payback method forces managers to have an artificially short-term orientation, which may lead to decisions not in the shareholders' best interests. Problem 3: Arbitrary Standard for Payback Period We do not need to refer to Table 6.1 when considering a third problem with the payback approach. When a firm uses the NPV approach, it can go to the capital market to get the discount rate. There is no comparable guide for choosing the payback period, so the choice is arbitrary to some extent. I TA B L E 6.1 Expected Cash Flows for Projects A through C ($) Year 0 1 2 3 4 Payback period (years) A 100 20 30 50 60 3 B 100 50 30 20 60 3 C 100 50 30 20 60,000 3 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 149 Chapter 6 Some Alternative Investment Rules 143 Managerial Perspective The payback rule is often used by large and sophisticated companies when making relatively small decisions. The decision to build a small warehouse, for example, or to pay for a tune-up for a truck is the sort of decision that is often made by lower-level management. Typically a manager might reason that a tune-up would cost, say, $200, and if it saved $120 each year in reduced fuel costs, it would pay for itself in less than two years. On such a basis the decision would be made. Although the treasurer of the company might not have made the decision in the same way, the company endorses such decision making. Why would upper management condone or even encourage such retrograde activity in its employees? One answer would be that it is easy to make decisions using the payback rule. Multiply the tune-up decision into 50 such decisions a month, and the appeal of this simple rule becomes clearer. Perhaps most important though, the payback rule also has some desirable features for managerial control. Just as important as the investment decision itself is the company's ability to evaluate the manager's decision-making ability. Under the NPV rule, a long time may pass before one decides whether or not a decision was correct. With the payback rule we know in two years whether the manager's assessment of the cash flows was correct. It has also been suggested that firms with very good investment opportunities but no available cash may justifiably use the payback method. For example, the payback method could be used by small, privately held firms with good growth prospects but limited access to the capital markets. Quick cash recovery may enhance the reinvestment possibilities for such firms. Notwithstanding all of the preceding rationale, it is not surprising to discover that as the decision grows in importance, which is to say when firms look at bigger projects, the NPV becomes the order of the day. When questions of controlling and evaluating the manager become less important than making the right investment decision, the payback period is used less frequently. For the big-ticket decisions, such as whether or not to buy a machine, build a factory, or acquire a company, the payback rule is seldom used. Summary of the Payback Period Rule To summarize, the payback period is not the same as the NPV rule and is therefore conceptually wrong. With its arbitrary cutoff date and its blindness to cash flows after that date, it can lead to some flagrantly foolish decisions if it is used too literally. Nevertheless, because it is so simple, companies often use it as a screen for making the myriad of minor investment decisions they continually face. Although this means that you should be wary of trying to change rules like the payback period when you encounter them in companies, you should probably be careful not to fall into the sloppy financial thinking they represent. After this course you would do your company a disservice if you ever used the payback period instead of the NPV when you had a choice. QUESTIONS CONCEPT ? List the problems of the payback period rule. What are some advantages? 6.3 THE DISCOUNTED PAYBACK PERIOD RULE Aware of the pitfalls of the payback approach, some decision makers use a variant called the discounted payback period rule. Under this approach, we first discount the cash flows. Then we ask how long it takes for the discounted cash flows to equal the initial investment. 150 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 144 Part II Value and Capital Budgeting For example, suppose that the discount rate is 10 percent and the cash flows on a project are given by ( $100, $50, $50, $20) This investment has a payback period of two years, because the investment is paid back in that time. To compute the project's discounted payback period, we first discount each of the cash flows at the 10-percent rate. In discounted terms, then, the cash flows look like [ $100, $50/1.1, $50/(1.1)2, $20/(1.1)3] ( $100, $45.45, $41.32, $15.03) The discounted payback period of the original investment is simply the payback period for these discounted cash flows. The payback period for the discounted cash flows is slightly less than three years since the discounted cash flows over the three years are $101.80 ($45.45 $41.32 $15.03). As long as the cash flows are positive, the discounted payback period will never be smaller than the payback period, because discounting will lower the cash flows. At first glance the discounted payback may seem like an attractive alternative, but on closer inspection we see that it has some of the same major flaws as the payback. Like payback, discounted payback first requires us to make a somewhat magical choice of an arbitrary cutoff period, and then it ignores all of the cash flows after that date. If we have already gone to the trouble of discounting the cash flows, any small appeal to simplicity or to managerial control that payback may have, has been lost. We might just as well add up the discounted cash flows and use the NPV to make the decision. Although discounted payback looks a bit like the NPV, it is just a poor compromise between the payback method and the NPV. 6.4 THE AVERAGE ACCOUNTING RETURN Defining the Rule Another attractive and fatally flawed approach to making financial decisions is the average accounting return. The average accounting return is the average project earnings after taxes and depreciation, divided by the average book value of the investment during its life. In spite of its flaws, the average accounting return method is worth examining because it is used frequently in the real world. E XAMPLE Consider a company that is evaluating whether or not to buy a store in a newly built mall. The purchase price is $500,000. We will assume that the store has an estimated life of five years and will need to be completely scrapped or rebuilt at the end of that time. The projected yearly sales and expense figures are shown in Table 6.2. It is worth looking carefully at this table. In fact, the first step in any project assessment is a careful look at the projected cash flows. When the store starts up, it is estimated that first-year sales will be $433,333 and that, after expenses, the before-tax cash flow will be $233,333. After the first year, sales are expected to rise and expenses are expected to fall, resulting in a before-tax cash flow of $300,000. After that, competition from other stores and the loss in novelty will drop before-tax cash flow to $166,667, $100,000, and $33,333, respectively, in the next three years. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 151 Chapter 6 Some Alternative Investment Rules 145 I TA B L E 6.2 Projected Yearly Revenue and Costs for Average Accounting Return Year 1 Revenue Expenses Before-tax cash flow Depreciation Earnings before taxes Taxes (Tc 0.25)* Net income Average net income Average investment AAR $50,000 $250,000 $433,333 200,000 ________ 233,333 100,000 ________ 133,333 33,333 ________ $100,000 $100,000 $500,000 2 20% $16,667 occurs if the rest of the firm is profitable. Here, Year 2 $450,000 150,000 ________ 300,000 100,000 ________ 200,000 50,000 ________ $150,000 150,000 5 0 $250,000 Year 3 $266,667 100,000 ________ 166,667 100,000 ________ 66,667 16,667 ________ $ 50,000 50,000 0 Year 4 $200,000 100,000 ________ 100,000 100,000 ________ 0 0 ________ $ 0 $50,000 Year 5 $133,333 100,000 ________ 33,333 100,000 ________ 66,667 16,667 ________ $ 50,000 50,000 *Corporate tax rate Tc. The tax rebate in year 5 of the loss in the project reduces taxes of entire firm. To compute the average accounting return (AAR) on the project, we divide the average net income by the average amount invested. This can be done in three steps. Step One: Determining Average Net Income The net income in any year is the net cash flow minus depreciation and taxes. Depreciation is not a cash outflow.1 Rather, it is a charge reflecting the fact that the investment in the store becomes less valuable every year. We assume the project has a useful life of five years, at which time it will be worthless. Because the initial investment is $500,000 and because it will be worthless in five years, we will assume that it loses value at the rate of $100,000 each year. This steady loss in value of $100,000 is called straight-line depreciation. We subtract both depreciation and taxes from before-tax cash flow to derive the net income, as shown in Table 6.2. The net income over the five years is $100,000 in the first year, $150,000 in year 2, $50,000 in year 3, zero in year 4, and $50,000 in the last year. The average net income over the life of the project is therefore Average Net Income: [$100,000 $150,000 $50,000 $0 ( $50,000)]/5 $50,000 Step Two: Determining Average Investment We stated earlier that, due to depreciation, the investment in the store becomes less valuable every year. Because depreciation is $100,000 per year, the value at the end of year zero is $500,000, the value at the end of year 1 is $400,000 and so on. What is the average value of the investment over the life of the investment? The mechanical calculation is Average Investment: ($500,000 1 $400,000 $300,000 $200,000 $100,000 $0)/6 $250,000 (6.1) Depreciation will be treated in more detail in the next chapter. 152 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 146 Part II Value and Capital Budgeting We divide by 6 and not 5, because $500,000 is what the investment is worth at the beginning of the five years and $0 is what it is worth at the beginning of the sixth year. In other words, there are six terms in the parenthesis of equation (6.1). Step Three: Determining AAR The average return is simply AAR $50,000 $250,000 20% If the firm had a targeted accounting rate of return greater than 20 percent, the project would be rejected, and if its targeted return were less than 20 percent, it would be accepted. Analyzing the Average Accounting Return Method By now you should be able to see what is wrong with the AAR method of making investment decisions. The most important flaw in the AAR method is that it does not use the right raw materials. It uses the net income figures and the book value of the investment (from the accountant's books) to figure out whether to take the investment. Conversely, the NPV rule uses cash flows. Second, AAR takes no account of timing. In the previous example, the AAR would have been the same if the $100,000 net income in the first year had occurred in the last year. However, delaying an inflow for five years would have made the investment less attractive under the NPV rule as well as by the common sense of the time value of money. That is, the NPV approach discounts properly. Third, just as the payback period requires an arbitrary choice of a cutoff date, the AAR method offers no guidance on what the right targeted rate of return should be. It could be the discount rate in the market. But then again, because the AAR method is not the same as the present value method, it is not obvious that this would be the right choice. Like the payback method, the AAR (and variations of it) is frequently used as a "backup" to discounted cash flow methods. Perhaps this is so because it is easy to calculate and uses accounting numbers readily available from the firm's accounting system. QUESTIONS CONCEPT ? What are the three steps in calculating AAR? What are some flaws with the AAR approach? 6.5 THE INTERNAL RATE OF RETURN Now we come to the most important alternative to the NPV approach, the internal rate of return, universally known as the IRR. The IRR is about as close as you can get to the NPV without actually being the NPV. The basic rationale behind the IRR is that it tries to find a single number that summarizes the merits of a project. That number does not depend on the interest rate that prevails in the capital market. That is why it is called the internal rate of return; the number is internal or intrinsic to the project and does not depend on anything except the cash flows of the project. For example, consider the simple project ( $100, $110) in Figure 6.2. For a given rate, the net present value of this project can be described as NPV $100 $110 1 r (6.2) Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 153 Chapter 6 Some Alternative Investment Rules 147 I F I G U R E 6.2 Cash Flows for a Simple Project $110 Cash inflow Time 0 1 Cash outflow $100 where r is the discount rate. What must the discount rate be to make the NPV of the project equal to zero? We begin by using an arbitrary discount rate of 0.08, which yields $1.85 $100 $110 1.08 (6.3) Since the NPV in equation (6.3) is positive, we now try a higher discount rate, say, 0.12. This yields $1.79 $100 $110 1.12 (6.4) Since the NPV in equation (6.4) is negative, we lower the discount rate to, say, 0.10. This yields 0 $100 $110 1.10 (6.5) This trial-and-error procedure tells us that the NPV of the project is zero when r equals 10 percent.2 Thus, we say that 10 percent is the project's internal rate of return (IRR). In general, the IRR is the rate that causes the NPV of the project to be zero. The implication of this exercise is very simple. The firm should be equally willing to accept or reject the project if the discount rate is 10 percent. The firm should accept the project if the discount rate is below 10 percent. The firm should reject the project if the discount rate is above 10 percent. The general investment rule is clear: Accept the project if IRR is greater than the discount rate. Reject the project if IRR is less than the discount rate. We refer to this as the basic IRR rule. Now we can try the more complicated example in Figure 6.3. As we did in equations (6.3) to (6.5), we use trial and error to calculate the internal rate of return. We try 20 percent and 30 percent, yielding Discount Rate 20% 30 NPV $10.65 18.39 2 Of course, we could have directly solved for r in equation (6.2) after setting NPV equal to zero. However, with a long series of cash flows, one cannot generally directly solve for r. Instead, one is forced to use a trial-anderror method similar to that in (6.3), (6.4), and (6.5). 154 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 148 Part II Value and Capital Budgeting I F I G U R E 6.3 Cash Flows for a More Complex Project Cash inflow $100 $100 $100 Time 0 1 2 3 Cash outflow $200 I F I G U R E 6.4 Net Present Value (NPV) and Discount Rates for a More Complex Project NPV $100 $10.65 $0 10 $18.39 20 IRR 23.37 30 40 Discount rate (%) The NPV is positive for discount rates below the IRR and negative for discount rates above the IRR. After much more trial and error, we find that the NPV of the project is zero when the discount rate is 23.37 percent. Thus, the IRR is 23.37 percent. With a 20-percent discount rate the NPV is positive and we would accept it. However, if the discount rate were 30 percent, we would reject it. Algebraically, IRR is the unknown in the following equation:3 0 $200 1 $100 IRR 1 $100 IRR 2 1 $100 IRR 3 Figure 6.4 illustrates what it means to find the IRR for a project. The figure plots the NPV as a function of the discount rate. The curve crosses the horizontal axis at the IRR of 23.37 percent because this is where the NPV equals zero. 3 One can derive the IRR directly for a problem with an initial outflow and either one or two subsequent inflows. In the case of two subsequent inflows, the quadratic formula is needed. In general, however, only trial and error will work for an outflow and three or more subsequent inflows. Hand calculators calculate IRR by trial and error, though at lightning speed. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 155 Chapter 6 Some Alternative Investment Rules 149 It should also be clear that the NPV is positive for discount rates below the IRR and negative for discount rates above the IRR. This means that if we accept projects like this one when the discount rate is less than the IRR, we will be accepting positive NPV projects. Thus, the IRR rule will coincide exactly with the NPV rule. If this were all there were to it, the IRR rule would always coincide with the NPV rule. This would be a wonderful discovery because it would mean that just by computing the IRR for a project we would be able to tell where it ranks among all of the projects we are considering. For example, if the IRR rule really works, a project with an IRR of 20 percent will always be at least as good as one with an IRR of 15 percent. But the world of finance is not so kind. Unfortunately, the IRR rule and the NPV rule are the same only for examples like the ones above. Several problems with the IRR approach occur in more complicated situations. QUESTION CONCEPT ? How does one calculate the IRR of a project? 6.6 PROBLEMS WITH THE IRR APPROACH Definition of Independent and Mutually Exclusive Projects An independent project is one whose acceptance or rejection is independent of the acceptance or rejection of other projects. For example, imagine that McDonald's is considering putting a hamburger outlet on a remote island. Acceptance or rejection of this unit is likely to be unrelated to the acceptance or rejection of any other restaurant in their system. The remoteness of the outlet in question insures that it will not pull sales away from other outlets. Now consider the other extreme, mutually exclusive investments. What does it mean for two projects, A and B, to be mutually exclusive? You can accept A or you can accept B or you can reject both of them, but you cannot accept both of them. For example, A might be a decision to build an apartment house on a corner lot that you own, and B might be a decision to build a movie theater on the same lot. We now present two general problems with the IRR approach that affect both independent and mutually exclusive projects. Next, we deal with two problems affecting mutually exclusive projects only. Two General Problems Affecting Both Independent and Mutually Exclusive Projects We begin our discussion with project A, which has the following cash flows: ( $100, $130) The IRR for project A is 30 percent. Table 6.3 provides other relevant information on the project. The relationship between NPV and the discount rate is shown for this project in Figure 6.5. As you can see, the NPV declines as the discount rate rises. Problem 1: Investing or Financing? Now consider project B, with cash flows of ($100, $130) 156 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 150 Part II Value and Capital Budgeting I TA B L E 6.3 The Internal Rate of Return and Net Present Value Project A _______________ Dates: Cash flows IRR NPV @ 10% Accept if market rate Financing or investing 0 $100 1 $130 30% $18.2 30% Investing 2 Project B _______________ 0 $100 1 $130 30% $18.2 30% Financing 2 Project C _________________ 0 $100 10% 10% 1 $230 and 0 but Mixture 2 $132 20% 20% These cash flows are exactly the reverse of the flows for project A. In project B, the firm receives funds first and then pays out funds later. While unusual, projects of this type do exist. For example, consider a corporation conducting a seminar where the participants pay in advance. Because large expenses are frequently incurred at the seminar date, cash inflows precede cash outflows. Consider our trial-and-error method to calculate IRR: $4 $0 $3.70 $100 $100 $100 $130 1.25 $130 1.30 $130 1.35 As with project A, the internal rate of return is 30 percent. However, notice that the net present value is negative when the discount rate is below 30 percent. Conversely, the net present value is positive when the discount rate is above 30 percent. The decision rule is exactly the opposite of our previous result. For this type of a project, the rule is Accept the project when IRR is less than the discount rate. Reject the project when IRR is greater than the discount rate. This unusual decision rule follows from the graph of project B in Figure 6.5. The curve is upward sloping, implying that NPV is positively related to the discount rate. The graph makes intuitive sense. Suppose that the firm wants to obtain $100 immediately. It can either (1) conduct project B or (2) borrow $100 from a bank. Thus, the project is actually a substitute for borrowing. In fact, because the IRR is 30 percent, taking on project B is tantamount to borrowing at 30 percent. If the firm can borrow from a bank at, say, only 25 percent, it should reject the project. However, if a firm can only borrow from a bank at, say, 35 percent, it should accept the project. Thus, project B will be accepted if and only if the discount rate is above the IRR.4 This should be contrasted with project A. If the firm has $100 of cash to invest, it can either (1) conduct project A or (2) lend $100 to the bank. The project is actually a substitute for lending. In fact, because the IRR is 30 percent, taking on project A is tantamount to lending at 30 percent. The firm should accept project A if the lending rate is below 30 percent. Conversely, the firm should reject project A if the lending rate is above 30 percent. 4 This paragraph implicitly assumes that the cash flows of the project are risk-free. In this way, we can treat the borrowing rate as the discount rate for a firm needing $100. With risky cash flows, another discount rate would be chosen. However, the intuition behind the decision to accept when IRR is less than the discount rate would still apply. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 157 Chapter 6 Some Alternative Investment Rules 151 I F I G U R E 6.5 Net Present Value and Discount Rates for Projects A, B, and C Project A NPV $30 NPV Project B NPV Project C 0 30 Discount rate (%) 30 Discount rate (%) $2 10 20 Approaches 100 when r Discount rate (%) $30 $100 Project A has a cash outflow at date 0 followed by a cash inflow at date 1. Its NPV is negatively related to the discount rate. Project B has a cash inflow at date 0 followed by a cash outflow at date 1. Its NPV is positively related to the discount rate. Project C has two changes of sign in its cash flows. It has an outflow at date 0, an inflow at date 1, and an outflow at date 2. Projects with more than one change of sign can have multiple rates of return. Because the firm initially pays out money with project A but initially receives money with project B, we refer to project A as an investing-type project and project B as a financing-type project. Investing-type projects are the norm. Because the IRR rule is reversed for a financingtype project, we view this type of project as a problem--unless it is understood properly. Problem 2: Multiple Rates of Return Suppose the cash flows from a project are ( $100, $230, $132) Because this project has a negative cash flow, a positive cash flow, and another negative cash flow, we say that the project's cash flows exhibit two changes of signs, or "flip-flops." While this pattern of cash flows might look a bit strange at first, many projects require outflows of cash after receiving some inflows. An example would be a strip-mining project. The first stage in such a project is the initial investment in excavating the mine. Profits from operating the mine are received in the second stage. The third stage involves a further investment to reclaim the land and satisfy the requirements of environmental-protection legislation. Cash flows are negative at this stage. Projects financed by lease arrangements also produce negative cash flows followed by positive ones. We study leasing carefully in a later chapter, but for now we will give you a hint. Using leases for financing can sometimes bring substantial tax advantages. These advantages are often sufficient to make an otherwise bad investment have positive cash flows following an initial outlay. But after a while the tax advantages decline or run out. The cash flows turn negative when this occurs. It is easy to verify that this project has not one but two IRRs, 10 percent and 20 percent.5 In a case like this, the IRR does not make any sense. What IRR are we to use, 10 percent or 20 percent? Because there is no good reason to use one over the other, IRR simply cannot be used here. 5 The calculations are $100 0 $100 $230 $132 1.1 1.1 2 $209.09 $109.09 $230 $132 1.2 1.2 2 $191.67 $91.67 and $100 0 Thus, we have multiple rates of return. $100 158 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 152 Part II Value and Capital Budgeting Of course, we should not feel too worried about multiple rates of return. After all, we can always fall back on NPV. Figure 6.5 plots the NPV for this project C as a function of the different discount rates. As it shows, the NPV is zero at both 10 percent and 20 percent. Furthermore, the NPV is positive for discount rates between 10 percent and 20 percent and negative outside of this range. This example generates multiple internal rates of return because both an inflow and an outflow occur after the initial investment. In general, these flip-flops or changes in sign produce multiple IRRs. In theory, a cash flow stream with M changes in sign can have up to M positive internal rates of return.6 As we pointed out, projects whose cash flows change sign repeatedly can occur in the real world. Are We Ever Safe from the Multiple-IRR Problem? If the first cash flow for a project is negative--because it is the initial investment--and if all of the remaining flows are positive, there can be only a single, unique IRR, no matter how many periods the project lasts. This is easy to understand by using the concept of the time value of money. For example, it is easy to verify that project A in Table 6.3 has an IRR of 30 percent, because using a 30percent discount rate gives NPV 0 How do we know that this is the only IRR? Suppose that we were to try a discount rate greater than 30 percent. In computing the NPV, changing the discount rate does not change the value of the initial cash flow of $100 because that cash flow is not discounted. But raising the discount rate can only lower the present value of the future cash flows. In other words, because the NPV is zero at 30 percent, any increase in the rate will push the NPV into the negative range. Similarly, if we try a discount rate of less than 30 percent, the overall NPV of the project will be positive. Though this example has only one positive flow, the above reasoning still implies a single, unique IRR if there are many inflows (but no outflows) after the initial investment. If the initial cash flow is positive--and if all of the remaining flows are negative--there can only be a single, unique IRR. This result follows from reasoning similar to that above. Both these cases have only one change of sign or flip-flop in the cash flows. Thus, we are safe from multiple IRRs whenever there is only one sign change in the cash flows. Those of you who are steeped in algebra might have recognized that finding the IRR is like finding the root of a polynomial equation. For a project with cash flows of (C0, . . . , Cr), the formula for computing the IRR requires us to find the interest rate, r, that makes NPV C0 C1 1 x then the formula for the IRR becomes NPV C0 C1x C2x2 ... CTxT 0 Finding the IRR, then, is the same as finding the roots of this polynomial equation. If a particular value x* is a root of the equation, then, because x it follows that there is an associated IRR: r* (1/x*) 1 From the theory of polynomials, it is well known that an nth-order polynomial has n roots. Each such root that is positive and less than 1 can have a sensible IRR associated with it. Applying Descartes's rules of signs gives the result that a stream of n cash flows can have up to M positive IRRs, where M is the number of changes of sign for the cash flows. 1/(1 r) r 1/(1 ... r) CT 1 r T 6 $100 $130/(1.3) 0 If we let the symbol x stand for the discount factor, Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 159 Chapter 6 Some Alternative Investment Rules 153 General Rules The following chart summarizes our rules:7 Flows First cash flow is negative and all remaining cash flows are positive. First cash flow is positive and all remaining cash flows are negative. Some cash flows after first are positive and some cash flows after first are negative. Number of IRRs 1 IRR Criterion Accept if IRR Reject if IRR Accept if IRR Reject if IRR No valid IRR r r r r NPV Criterion Accept if NPV Reject if NPV Accept if NPV Reject if NPV Accept if NPV Reject if NPV 0 0 0 0 0 0 1 May be more than 1 Note that the NPV criterion is the same for each of the three cases. In other words, NPV analysis is always appropriate. Conversely, the IRR can be used only in certain cases. When it comes to NPV, the preacher's words, "You just can't lose with the stuff I use," clearly apply. Problems Specific to Mutually Exclusive Projects As mentioned earlier, two or more projects are mutually exclusive if the firm can, at most, accept only one of them. We now present two problems dealing with the application of the IRR approach to mutually exclusive projects. These two problems are quite similar, though logically distinct. The Scale Problem A professor we know motivates class discussions on this topic with the statement: "Students, I am prepared to let one of you choose between two mutually exclusive `business' propositions. Opportunity 1--You give me $1 now and I'll give you $1.50 back at the end of the class period. Opportunity 2--You give me $10 and I'll give you $11 back at the end of the class period. You can only choose one of the two opportunities. And you cannot choose either opportunity more than once. I'll pick the first volunteer." Which would you choose? The correct answer is opportunity 2.8 To see this, look at the following chart: Cash Flow at Beginning of Class Opportunity 1 Opportunity 2 $1 10 Cash Flow at End of Class (90 minutes later) $1.50 11.00 NPV9 $0.50 1.00 IRR 50% 10 As we have stressed earlier in the text, one should choose the opportunity with the highest NPV. This is opportunity 2 in the example. Or, as one of the professor's students explained it: "I'm bigger than the professor, so I know I'll get my money back. And I have $10 in my pocket right now so I can choose either opportunity. At the end of the class, 7 8 IRR stands for internal rate of return, NPV stands for net present value, and r stands for discount rate. The professor uses real money here. Though many students have done poorly on the professor's exams over the years, no student ever chose opportunity 1. The professor claims that his students are "money players." 9 We assume a zero rate of interest because his class lasted only 90 minutes. It just seemed like a lot longer. 160 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 154 Part II Value and Capital Budgeting I'll be able to play two rounds of my favorite electronic game with opportunity 2 and still have my original investment, safe and sound.10 The profit on opportunity 1 buys only one round." We believe that this business proposition illustrates a defect with the internal rate of return criterion. The basic IRR rule says take opportunity 1, because the IRR is 50 percent. The IRR is only 10 percent for opportunity 2. Where does IRR go wrong? The problem with IRR is that it ignores issues of scale. While opportunity 1 has a greater IRR, the investment is much smaller. In other words, the high percentage return on opportunity 1 is more than offset by the ability to earn at least a decent return11 on a much bigger investment under opportunity 2. Since IRR seems to be misguided here, can we adjust or correct it? We illustrate how in the next example. E XAMPLE Stanley Jaffe and Sherry Lansing have just purchased the rights to Corporate Finance: The Motion Picture. They will produce this major motion picture on either a small budget or a big budget. The estimated cash flows are Cash Flow at Date 0 Small budget Large budget $10 million 25 million Cash Flow at Date 1 $40 million 65 million NPV @ 25% $22 million 27 million IRR 300% 160 Because of high risk, a 25-percent discount rate is considered appropriate. Sherry wants to adopt the large budget because the NPV is higher. Stanley wants to adopt the small budget because the IRR is higher. Who is right? For the reasons espoused in the classroom example above, NPV is correct. Hence, Sherry is right. However, Stanley is very stubborn where IRR is concerned. How can Sherry justify the large budget to Stanley using the IRR approach? This is where incremental IRR comes in. She calculates the incremental cash flows from choosing the large budget instead of the small budget as Cash Flow at Date 0 (in $ millions) Incremental cash flows from choosing large budget instead of small budget 25 ( 10) 15 Cash Flow at Date 1 (in $ millions) 65 40 25 This chart shows that the incremental cash flows are lion at date 1. Sherry calculates incremental IRR as $15 million at date 0 and $25 mil- Formula for Calculating the Incremental IRR: 0 $15 million $25 million 1 IRR 10 11 At press time for this text, electronic games cost $0.50 apiece. A 10-percent return is more than decent over a 90-minute interval! Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 161 Chapter 6 Some Alternative Investment Rules 155 IRR equals 66.67 percent in this equation. Sherry says that the incremental IRR is 66.67 percent. Incremental IRR is the IRR on the incremental investment from choosing the large project instead of the small project. In addition, we can calculate the NPV of the incremental cash flows: NPV of Incremental Cash Flows: $15 million $25 million 1.25 $5 million We know the small-budget picture would be acceptable as an independent project since its NPV is positive. We want to know whether it is beneficial to invest an additional $15 million in order to make the large-budget picture instead of the small-budget picture. In other words, is it beneficial to invest an additional $15 million in order to receive an additional $25 million next year? First, the above calculations show the NPV on the incremental investment to be positive. Second, the incremental IRR of 66.67 percent is higher than the discount rate of 25 percent. For both reasons, the incremental investment can be justified. The second reason is what Stanley needed to hear to be convinced. Hence, the large-budget movie should be made. In review, we can handle this example (or any mutually exclusive example) in one of three ways: 1. Compare the NPVs of the two choices. The NPV of the large-budget picture is greater than the NPV of the small-budget picture, that is, $27 million is greater than $22 million. 2. Compare the incremental NPV from making the large-budget picture instead of the small-budget picture. Because the incremental NPV equals $5 million, we choose the large-budget picture. 3. Compare the incremental IRR to the discount rate. Because the incremental IRR is 66.67 percent and the discount rate is 25 percent, we take the large-budget picture. All three approaches always give the same decision. However, we must not compare the IRRs of the two pictures. If we did we would make the wrong choice, that is, we would accept the small-budget picture. One final note here. Students often ask which project should be subtracted from the other in calculating incremental flows. Notice that we are subtracting the smaller project's cash flows from the bigger project's cash flows. This leaves an outflow at date 0. We then use the basic IRR rule on the incremental flows.12 The Timing Problem Next we illustrate another, but very similar, problem with using the IRR approach to evaluate mutually exclusive projects. E XAMPLE Suppose that the Kaufold Corporation has two alternative uses for a warehouse. It can store toxic waste containers (investment A) or electronic equipment (investment B). The cash flows are as follows: NPV Year: Investment A Investment B 12 0 1 2 3 @0% @10% @15% IRR $10,000 $10,000 $1,000 $ 1,000 $2,000 $669 10,000 1,000 1,000 12,000 4,000 751 $ 109 16.04% 484 12.94 Alternatively, we could have subtracted the larger project's cash flows from the smaller project's cash flows. This would have left an inflow at date 0, making it necessary to use the IRR rule for financing situations. This would work but we find it more confusing. 162 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 156 Part II Value and Capital Budgeting We find that the NPV of investment B is higher with low discount rates, and the NPV of investment A is higher with high discount rates. This is not surprising if you look closely at the cash flow patterns. The cash flows of A occur early, whereas the cash flows of B occur later. If we assume a high discount rate, we favor investment A because we are implicitly assuming that the early cash flow (for example, $10,000 in year 1) can be reinvested at that rate. Because most of investment B's cash flows occur in year 3, B's value is relatively high with low discount rates. The patterns of cash flow for both projects appear in Figure 6.6. Project A has an NPV of $2,000 at a discount rate of zero. This is calculated by simply adding up the cash flows without discounting them. Project B has an NPV of $4,000 at the zero rate. However, the NPV of project B declines more rapidly as the discount rate increases than does the NPV of project A. As we mentioned above, this occurs because the cash flows of B occur later. Both projects have the same NPV at a discount rate of 10.55 percent. The IRR for a project is the rate at which the NPV equals zero. Because the NPV of B declines more rapidly, B actually has a lower IRR. As with the movie example presented above, we can select the better project with one of three different methods: 1. Compare NPVs of the Two Projects. Figure 6.6 aids our decision. If the discount rate is below 10.55 percent, one should choose project B because B has a higher NPV. If the rate is above 10.55 percent, one should choose project A because A has a higher NPV. 2. Compare Incremental IRR to Discount Rate. The above method employed NPV. Another way of determining that B is a better project is to subtract the cash flows of A from the cash flows of B and then to calculate the IRR. This is the incremental IRR approach we spoke of earlier. The incremental cash flows are NPV of Incremental Cash Flows Year: B A 0 0 1 $9,000 2 0 3 $11,000 Incremental IRR 10.55% @0% $2,000 @10% $83 @15% $593 This chart shows that the incremental IRR is 10.55 percent. In other words, the NPV on the incremental investment is zero when the discount rate is 10.55 percent. Thus, if the relevant discount rate is below 10.55 percent, project B is preferred to project A. If the relevant discount rate is above 10.55 percent, project A is preferred to project B.13 3. Calculate NPV on Incremental Cash Flows. Finally, one could calculate the NPV on the incremental cash flows. The chart that appears with the previous method displays these NPVs. We find that the incremental NPV is positive when the discount rate is either 0 percent or 10 percent. The incremental NPV is negative if the discount rate is 15 percent. If the NPV is positive on the incremental flows, one should choose B. If the NPV is negative, one should choose A. 13 In this example, we first showed that the NPVs of the two projects are equal when the discount rate is 10.55 percent. We next showed that the incremental IRR is also 10.55 percent. This is not a coincidence; this equality must always hold. The incremental IRR is the rate that causes the incremental cash flows to have zero NPV. The incremental cash flows have zero NPV when the two projects have the same NPV. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 163 Chapter 6 Some Alternative Investment Rules 157 I F I G U R E 6.6 Net Present Value and the Internal Rate of Return for Mutually Exclusive Projects Net present value ($) $4,000 NPVB > NPVA 2,000 NPVA > NPVB 0 484 10.55 12.94 16.04 Discount rate (%) Project A Project B In summary, the same decision is reached whether one (a) compares the NPVs of the two projects, (b) compares the incremental IRR to the relevant discount rate, or (c) examines the NPV of the incremental cash flows. However, as mentioned earlier, one should not compare the IRR of project A with the IRR of project B. We suggested earlier that one should subtract the cash flows of the smaller project from the cash flows of the bigger project. What do we do here since the two projects have the same initial investment? Our suggestion in this case is to perform the subtraction so that the first nonzero cash flow is negative. In the Kaufold Corporation example, we achieved this by subtracting A from B. In this way, we can still use the basic IRR rule for evaluating cash flows. The preceding examples illustrate problems with the IRR approach in evaluating mutually exclusive projects. Both the professor-student example and the motion-picture example illustrate the problem that arises when mutually exclusive projects have different initial investments. The Kaufold Corp. example illustrates the problem that arises when mutually exclusive projects have different cash flow timing. When working with mutually exclusive projects, it is not necessary to determine whether it is the scale problem or the timing problem that exists. Very likely both occur in any real-world situation. Instead, the practitioner should simply use either an incremental IRR or an NPV approach. Redeeming Qualities of the IRR The IRR probably survives because it fills a need that the NPV does not. People seem to want a rule that summarizes the information about a project in a single rate of return. This single rate provides people with a simple way of discussing projects. For example, one manager in a firm might say to another, "Remodeling the north wing has a 20-percent IRR." To their credit, however, companies that employ the IRR approach seem to understand its deficiencies. For example, companies frequently restrict managerial projections of cash flows to be negative at the beginning and strictly positive later. Perhaps, then, the ability of the IRR approach to capture a complex investment project in a single number and the ease of communicating that number explain the survival of the IRR. 164 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 158 Part II Value and Capital Budgeting A Test To test your knowledge, consider the following two statements: 1. You must know the discount rate to compute the NPV of a project but you compute the IRR without referring to the discount rate. 2. Hence, the IRR rule is easier to apply than the NPV rule because you don't use the discount rate when applying IRR. The first statement is true. The discount rate is needed to compute NPV. The IRR is computed by solving for the rate where the NPV is zero. No mention is made of the discount rate in the mere computation. However, the second statement is false. In order to apply IRR, you must compare the internal rate of return with the discount rate. Thus, the discount rate is needed for making a decision under either the NPV or IRR approach. QUESTIONS CONCEPT ? What is the difference between independent projects and mutually exclusive projects? What are two problems with the IRR approach that apply to both independent and mutually exclusive projects? What are two additional problems applying only to mutually exclusive projects? 6.7 THE PROFITABILITY INDEX Another method that is used to evaluate projects is called the profitability index. It is the ratio of the present value of the future expected cash flows after initial investment divided by the amount of the initial investment. The profitability index can be represented as Profitability index (PI) PV of cash flows subsequent to initial investment Initial investment E XAMPLE Hiram Finnegan, Inc., applies a 12-percent discount rate to two investment opportunities. Cash Flows ($000,000) Project 1 2 C0 20 10 C1 70 15 C2 10 40 PV @12% of Cash Flows Subsequent to Initial Investment ($000,000) 70.5 45.3 Profitability Index 3.53 4.53 NPV @ 12% ($000,000) 50.5 35.3 For example, the profitability index is calculated for project 1 as follows. The present value of the cash flows after the initial investment are $70.5 $70 1.12 $10 1.12 2 (6.6) Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 165 Chapter 6 Some Alternative Investment Rules 159 The profitability index is calculated by dividing the result of equation (6.6) by the initial investment of $20. This yields 3.53 We consider three possibilities: 1. Independent Projects. We first assume that we have two independent projects. According to the NPV criterion, both projects should be accepted since NPV is positive in each case. The NPV is positive whenever the profitability index (PI) is greater than one. Thus, the PI decision rule is Accept an independent project if PI Reject if PI 1. 1. $70.5 $20 2. Mutually Exclusive Projects. Let us assume that you can now only accept one project. NPV analysis says accept project 1 because this project has the bigger NPV. Because project 2 has the higher PI, the profitability index leads to the wrong selection. The problem with the profitability index for mutually exclusive projects is the same as the scale problem with the IRR that we mentioned earlier. Project 2 is smaller than project 1. Because the PI is a ratio, this index misses the fact that project 1 has a larger investment than project 2 has. Thus, like IRR, PI ignores differences of scale for mutually exclusive projects. However, like IRR, the flaw with the PI approach can be corrected using incremental analysis. We write the incremental cash flows after subtracting project 2 from project 1 as follows: Cash Flows ($000,000) Project 1 2 C0 10 C1 55 C2 30 PV @12% of Cash Flows Subsequent to Initial Investment ($000,000) 25.2 Profitability Index 2.52 NPV @ 12% ($000,000) 15.2 Because the profitability index on the incremental cash flows is greater than 1.0, we should choose the bigger project, that is, project 1. This is the same decision we get with the NPV approach. 3. Capital Rationing. The two cases above implicitly assumed that the firm could always attract enough capital to make any profitable investments. Now we consider the case when a firm does not have enough capital to fund all positive NPV projects. This is the case of capital rationing. Imagine that the firm has a third project, as well as the first two. Project 3 has the following cash flows: Cash Flows ($000,000) Project 3 C0 10 C1 5 C2 60 PV @12% of Cash Flows Subsequent to Initial Investment ($000,000) 43.4 Profitability Index 4.34 NPV @ 12% ($000,000) 33.4 Further, imagine that (a) the projects of Hiram Finnegan, Inc., are independent, but (b) the firm has only $20 million to invest. Because project 1 has an initial investment of $20 million, the firm cannot select both this project and another one. Conversely, because 166 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 160 Part II Value and Capital Budgeting projects 2 and 3 have initial investments of $10 million each, both these projects can be chosen. In other words, the cash constraint forces the firm to choose either project 1 or projects 2 and 3. What should the firm do? Individually, projects 2 and 3 have lower NPVs than project 1 has. However, when the NPVs of projects 2 and 3 are added together, they are higher than the NPV of project 1. Thus, common sense dictates that projects 2 and 3 shall be accepted. What does our conclusion have to say about the NPV rule or the PI rule? In the case of limited funds, we cannot rank projects according to their NPVs. Instead, we should rank them according to the ratio of present value to initial investment. This is the PI rule. Both project 2 and project 3 have higher PI ratios than does project 1. Thus, they should be ranked ahead of project 1 when capital is rationed. The usefulness of the profitability index under capital rationing can be explained in military terms. The Pentagon speaks highly of a weapon with a lot of "bang for the buck." In capital budgeting, the profitability index measures the bang (the dollar return) for the buck invested. Hence, it is useful for capital rationing. It should be noted that the profitability index does not work if funds are also limited beyond the initial time period. For example, if heavy cash outflows elsewhere in the firm were to occur at date 1, project 3 might need to be rejected. In other words, the profitability index cannot handle capital rationing over multiple time periods. QUESTIONS CONCEPT ? How does one calculate a project's profitability index? How is the profitability index applied to independent projects, mutually exclusive projects, and situations of capital rationing? 6.8 THE PRACTICE OF CAPITAL BUDGETING Not all firms use capital budgeting procedures based on discounted cash flows. Some firms use the payback method, and others use the accounting-rate-of-return method. Most studies find that the most frequently used capital budgeting technique for large corporations is either the internal rate of return (IRR) or the net present value (NPV) or a combination of both.14 Table 6.4 summarizes the results of a survey of large U.S. multinational firms and shows that over 80 percent of the responding firms use either NPV or IRR. Payback is rarely used as a primary method but it is the most frequently used secondary method.15 A recent survey of capital budgeting techniques used by a very large sample of U.S. and Canadian firms is summarized in Table 6.5. Graham and Harvey find about 75 percent of all firms use the NPV and IRR in capital budgeting. They report large-dividend-paying firms with high leverage are more likely to use the NPV and IRR than small firms with low debt ratios that pay no dividends.16 Graham and Harvey find that the payback period is used by more than one-half of all firms. The payback criterion is more frequently used by small firms and by CEOs without an MBA. 14 This conclusion is consistent with the results of L.Schall and G. Sundem, "Capital Budgeting Methods and Risk: A Further Analysis," Financial Management (Spring 1980). However, they report a tendency for firms to use less sophisticated capital budgeting methods in highly uncertain environments. 15 This result is similar to that of L. Schall, G. Sundem, and W. R. Gerjsbeek, Jr., "Survey and Analysis of Capital Budgeting Methods," Journal of Finance (March 1978). They found that 86 percent of their respondents used discounted cash flow, but only 16 percent used it exclusively. 16 John R. Graham and Campbell R. Harvey, "The Theory and Practice of Corporate Finance: Evidence from the Field," Journal of Financial Economics (forthcoming). Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 167 Chapter 6 Some Alternative Investment Rules 161 I N T HEIR O WN W ORDS "Kitchen Confidential": Adventures in the Culinary Underbelly by Anthony Bourdain (Bloomsbury Press, 2000) T o want to own a restaurant can be a strange and terrible affliction. What causes such a destructive urge in so many otherwise sensible people? Why would anyone who has worked hard, saved money, often been successful in other fields, want to pump their hardearned cash down a hole that statistically, at least, will almost surely prove dry? Why venture into an industry with enormous fixed expenses (rent, electricity, gas, water, linen, maintenance, insurance, license fees, trash removal, etc.), with a notoriously transient and unstable workforce and highly perishable inventory of assets? The chances of ever seeing a return on your investment are about one in five. What insidious spongi-form bacteria so riddles the brains of men and women that they stand there on the tracks, watching the lights of the oncoming locomotive, knowing full well it will eventually run them over? After all these years in the business, I still don't know. I TA B L E 6.4 Percentage of Large Multinational Responding Firms Using Different Types of Capital Budgeting Methods* Primary Technique Average accounting return (AAR) Payback period (PP) Internal rate of return (IRR) Net present value (NPV) Other 10.7% 5.0 65.3 16.5 2.5 _____ 100 % Secondary Technique 14.6% 37.6 14.6 30.0 3.2 _____ 100 % *The number of responding firms is 121. Source: M. T. Stanley and S. B. Block, "A Survey of Multinational Capital Budgeting," The Finance Review (March 1984), pp. 3651. I TA B L E 6.5 Percent of CFOs Who Always or Almost Always Use a Given Technique % Always or Almost Always Internal rate of return (IRR) Net present value (NPV) Payback period Discounted payback period Accounting rate of return Profitability index 75.6% 74.9 56.7 29.5 30.3 11.9 Source: John R. Graham and Campbell R. Harvey, "The Theory and Practice of Corporate Finance: Evidence from the Field," Journal of Financial Economics (forthcoming). Based on a survey of 392 CFOs. 168 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 162 Part II Value and Capital Budgeting Noncash flow factors may occasionally play a role in capital budgeting decisions. The easy answer, of course, is ego. The classic example is the retired dentist who was always told he threw a great dinner party. "You should open a restaurant," his friends tell him. And our dentist believes them. He wants to get in the business--not to make money, no really, but to swan about the dining room signing dinner checks, like Rick in Casablanca. (See our In Their Own Words box.) The use of quantitative techniques in capital budgeting varies with the industry. As one would imagine, firms that are better able to precisely estimate cash flows are more likely to use NPV. For example, estimation of cash flow in certain aspects of the oil business is quite feasible. Because of this, energy-related firms were among the first to use NPV analysis. Conversely, the cash flows in the motion-picture business are very hard to project. The grosses of the great hits like Rocky, Star Wars, ET, and Fatal Attraction were far, far greater than anyone imagined. The big failures like Heaven's Gate and Howard the Duck were unexpected as well. Because of this, NPV analysis is frowned upon in the movie business. How does Hollywood perform capital budgeting? The information that a studio uses to accept or reject a movie idea comes from the pitch. An independent movie producer schedules an extremely brief meeting with a studio to pitch his or her idea for a movie. Consider the following four paragraphs of quotes concerning the pitch from the thoroughly delightful book Reel Power.17 "They [studio executives] don't want to know too much," says Ron Simpson. "They want to know concept . . . . They want to know what the three-liner is, because they want it to suggest the ad campaign. They want a title . . . . They don't want to hear any esoterica. And if the meeting lasts more than five minutes, they're probably not going to do the project." "A guy comes in and says this is my idea: `Jaws on a spaceship,' " says writer Clay Frohman (Under Fire). "And they say, `Brilliant, fantastic.' Becomes Alien. That is Jaws on a spaceship, ultimately . . . . And that's it. That's all they want to hear. Their attitude is `Don't confuse us with the details of the story.' " ". . . Some high-concept stories are more appealing to the studios than others. The ideas liked best are sufficiently original that the audience will not feel it has already seen the movie, yet similar enough to past hits to reassure executives wary of anything too far-out. Thus, the frequently used shorthand: It's Flashdance in the country (Footloose) or High Noon in outer space (Outland)." ". . . One gambit not to use during a pitch," says executive Barbara Boyle, "is to talk about big box-office grosses your story is sure to make. Executives know as well as anyone that it's impossible to predict how much money a movie will make, and declarations to the contrary are considered pure malarkey." 17 Mark Litwak, Reel Power: The Struggle for Influence and Success in the New Hollywood (New York: William Morrow and Company, Inc., 1986), pp. 73, 74, and 77. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 169 Chapter 6 Some Alternative Investment Rules 163 6.9 SUMMARY AND CONCLUSIONS 1. In this chapter we cover different investment decision rules. We evaluate the most popular alternatives to the NPV: the payback period, the accounting rate of return, the internal rate of return, and the profitability index. In doing so, we learn more about the NPV. 2. While we find that the alternatives have some redeeming qualities, when all is said and done, they are not the NPV rule; for those of us in finance, that makes them decidedly second-rate. 3. Of the competitors to NPV, IRR must be ranked above either payback or accounting rate of return. In fact, IRR always reaches the same decision as NPV in the normal case where the initial outflows of an independent investment project are only followed by a series of inflows. 4. We classified the flaws of IRR into two types. First, we considered the general case applying to both independent and mutually exclusive projects. There appeared to be two problems here: a. Some projects have cash inflows followed by one or more outflows. The IRR rule is inverted here: One should accept when the IRR is below the discount rate. b. Some projects have a number of changes of sign in their cash flows. Here, there are likely to be multiple internal rates of return. The practitioner must use NPV here. Clearly, (b) is a bigger problem than (a). A new IRR criterion is called for with (a). No IRR criterion at all will work under (b). 5. Next, we considered the specific problems with the NPV for mutually exclusive projects. We showed that, either due to differences in size or in timing, the project with the highest IRR need not have the highest NPV. Hence, the IRR rule should not be applied. (Of course, NPV can still be applied.) However, we then calculated incremental cash flows. For ease of calculation, we suggested subtracting the cash flows of the smaller project from the cash flows of the larger project. In that way, the incremental initial cash flow is negative. One can correctly pick the better of two mutually exclusive projects in three other ways: a. Choose the project with the highest NPV. b. If the incremental IRR is greater than the discount rate, choose the bigger project. c. If the incremental NPV is positive, choose the bigger project. 6. We describe capital rationing as a case where funds are limited to a fixed dollar amount. With capital rationing the profitability index is a useful method of adjusting the NPV. KEY TERMS Average accounting return 144 Basic IRR rule 147 Capital rationing 159 Discounted payback period rule 143 Incremental IRR 155 Independent project 149 Internal rate of return 147 Mutually exclusive investments Payback period rule 141 Profitability index 158 149 170 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 164 Part II Value and Capital Budgeting SUGGESTED READINGS For a discussion of what capital budgeting techniques are used by large firms, see: Schall, L., and G. Sundem. "Capital Budgeting Methods and Risk: A Further Analysis." Financial Management (Spring 1980). Marc Ross presents an in-depth look at the capital budgeting procedures of 12 firms in the process industry: Ross, Marc. "Capital Budgeting Practices of Twelve Large Manufacturers." Financial Management (Winter 1986). QUESTIONS AND PROBLEMS The Payback Period Rule 6.1 Fuji Software, Inc., has the following projects. Year 0 1 2 3 Project A $7,500 4,000 3,500 1,500 Project B $5,000 2,500 1,200 3,000 a. Suppose Fuji's cutoff payback period is two years. Which of these two projects should be chosen? b. Suppose Fuji uses the NPV rule to rank these two projects. If the appropriate discount rate is 15 percent, which project should be chosen? 6.2 Suppose Peach Paving Company invests $1 million today on a new construction project. The project will generate annual cash flows of $150,000 in perpetuity. The appropriate annual discount rate for the project is 10 percent. a. What is the payback period for the project? If the Peach Paving Company desires to have a 10-year payback period, should the project be adopted? b. What is the discounted payback period for the project? c. What is the NPV of the project? The Average Accounting Return 6.3 The annual, end-of-year, book-investment accounts for the machine whose purchase your firm is considering are shown below. Purchase Date Gross investment Less: accumulated depreciation Net investment $16,000 0 _______ $16,000 Year 1 $16,000 4,000 _______ $12,000 Year 2 $16,000 8,000 _______ $ 8,000 Year 3 $16,000 12,000 _______ $ 4,000 Year 4 $16,000 16,000 ______ $ 0 If your firm purchases this machine, you can expect it to generate, on average, $4,500 per year in additional net income. a. What is the average accounting return for this machine? b. What three flaws are inherent in this decision rule? 6.4 Western Printing Co. has an opportunity to purchase a $2 million new printing machine. It has an economic life of five years and will be worthless after that time. This new investment is expected to generate an annual net income of $100,000 one year from today and the income stream will grow at 7 percent per year subsequently. The company adopts a straight- Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 171 Chapter 6 Some Alternative Investment Rules 165 line depreciation method (i.e., equal amounts of depreciation in each year). What is the average accounting return of the investment? Supposing Western Printing's AAR cutoff is 20 percent, should the machine be purchased? 6.5 Nokia Group has invested $8,000 in a high-tech project. This cost is depreciated on an accelerated basis that yields $4,000, $2,500, $1,500 of depreciation, respectively, during its three-year economic life. The project is expected to produce income before tax of $2,000 each year during its economic life. If the tax rate is 25%, what is the project's average accounting return (AAR)? a. 44.44% b. 50.23% c. 66.67% d. 70.00% e. 82.21% The Internal Rate of Return 6.6 Compute the internal rate of return on projects with the following cash flows. Cash Flows ($) Year 0 1 2 Project A 3,000 2,500 1,000 Project B 6,000 5,000 2,000 6.7 CPC, Inc., has a project with the following cash flows. Year 0 1 2 3 Cash Flows ($) 8,000 4,000 3,000 2,000 a. Compute the internal rate of return on the project. b. Suppose the appropriate discount rate is 8 percent. Should the project be adopted by CPC? 6.8 Compute the internal rate of return for the cash flows of the following two projects. Cash Flows ($) Time 0 1 2 3 A 2,000 2,000 8,000 8,000 B 1,500 500 1,000 1,500 6.9 Suppose you are offered $5,000 today and obligated to make scheduled payments as follows: Year 0 1 2 3 4 Cash Flows ($) 5,000 2,500 2,000 1,000 1,000 a. What is the IRRs of this offer? b. If the appropriate discount rate is 10 percent, should you accept this offer? c. If the appropriate discount rate is 20 percent, should you accept this offer? 172 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 166 Part II Value and Capital Budgeting d. What is the corresponding NPV of the project if the appropriate discount rates are 10 percent and 20 percent, respectively? Are the choices under the NPV rule consistent with those of the IRR rule? 6.10 As the Chief Financial Officer of the Orient Express, you are offered the following two mutually exclusive projects. Year 0 1 2 Project A $5,000 3,500 3,500 Project B $100,000 65,000 65,000 a. What are the IRRs of these two projects? b. If you are told only the IRRs of the projects, which would you choose? c. What did you ignore when you made your choice in part (b)? d. How can the problem be remedied? e. Compute the incremental IRR for the projects. f. Based on your answer to part (e), which project should you choose? g. Suppose you have determined that the appropriate discount rate for these projects is 15 percent. According to the NPV rule, which of these two projects should be adopted? 6.11 Consider two streams of cash flows, A and B. Cash flow A consists of $5,000 starting three years from today and growing at 4 percent in perpetuity. Cash flow B consists of $6,000 starting two years from today and continuing in perpetuity. Assume the appropriate discount rate is 12 percent. a. What is the present value of each stream? b. What is the IRR of a project C, which is a combination of projects A and B; that is, C A B? c. If it is assumed that the discount rate is always positive, what is the rule related to IRR for assessing project C that would correspond to the NPV rule? 6.12 Project A involves an investment of $1 million, and project B involves an investment of $2 million. Both projects have a unique internal rate of return of 20 percent. Is the following statement true or false? Explain your answer. For any discount rate between 0 percent and 20 percent, inclusive, project B has an NPV twice as great as that of project A. The Profitability Index 6.13 Suppose the following two mutually exclusive investment opportunities are available to the DeAngelo Firm. The appropriate discount rate is 10 percent. Year 0 1 2 3 Project Alpha $500 300 700 600 Project Beta $2,000 300 1,800 1,700 a. What is the NPV of project alpha and project beta? b. Which project would you recommend for the DeAngelo Firm? 6.14 The firm for which you work must choose between the following two mutually exclusive projects. The appropriate discount rate for the projects is 10 percent. Profitability Index 1.32 1.57 C0 A B $1,000 500 C1 $1,000 500 C2 $500 400 NPV $322 285 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 173 Chapter 6 Some Alternative Investment Rules 167 The firm chose to undertake A. At a luncheon for shareholders, the manager of a pension fund that owns a substantial amount of the firm's stock asks you why the firm chose project A instead of project B when B is more profitable. How would you justify your firm's action? Are there any circumstances under which the pension fund manager's argument could be correct? 6.15 The treasurer of Davids, Inc., has projected the cash flows of projects A, B, and C as follows. Suppose the relevant discount rate is 12 percent a year. Year 0 1 2 Project A $100,000 70,000 70,000 Project B $200,000 130,000 130,000 Project C $100,000 75,000 60,000 a. Compute the profitability indices for each of the three projects. b. Compute the NPVs for each of the three projects. c. Suppose these three projects are independent. Which projects should Davids accept based on the profitability index rule? d. Suppose these three projects are mutually exclusive. Which project should Davids accept based on the profitability index rule? e. Suppose Davids' budget for these projects is $300,000. The projects are not divisible. Which projects should Davids accept? 6.16 Bill plans to open a self-serve grooming center in a storefront. The grooming equipment will cost $160,000. Bill expects the after-tax cash inflows to be $40,000 annually for seven years, after which he plans to scrap the equipment and retire to the beaches of Jamaica. Assume the required return is 15%. What is the project's PI? Should it be accepted? Comparison of Investment Rules 6.17 Define each of the following investment rules. In your definition state the criteria for accepting or rejecting an investment under each rule. a. Payback period b. Average accounting return c. Internal rate of return d. Profitability index e. Net present value 6.18 Consider the following cash flows of two mutually exclusive projects for Chinese Daily News. Year 0 1 2 3 New Sunday Early Edition $1,200 600 550 450 New Saturday Late Edition $2,100 1,000 900 800 a. Based on the payback period rule, which project should be chosen? b. Suppose there is no corporate tax and the cash flows above are income before the depreciation. The firm uses a straight-line depreciation method (i.e., equal amounts of depreciation in each year). What is the average accounting return for each of these two projects? c. Which project has a greater IRR? d. Based on the incremental IRR rule, which project should be chosen? 174 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 6. Some Alternative Investment Rules The McGraw-Hill Companies, 2002 168 Part II Value and Capital Budgeting 6.19 Consider the following cash flows on two mutually exclusive projects that require an annual return of 15 percent. Working in the financial planning department for the Bahamas Recreation Corp., you are trying to compare different investment criteria to arrive at a sensible choice of these two projects. Deepwater Fishing $600,000 270,000 350,000 300,000 New Submarine Ride $1,800,000 1,000,000 700,000 900,000 Year 0 1 2 3 a. Based on the discounted payback period rule, which project should be chosen? b. If your decision rule is to accept the project with a greater IRR, which project should you choose? c. Since you are fully aware of the IRR rule's scale problem, you calculate the incremental IRR for the cash flows. Based on your computation, which project should you choose? d. To be prudent, you compute the NPV for both projects. Which project should you choose? Is it consistent with the incremental IRR rule? 6.20 The Utah Mining Corporation is set to open a gold mine near Provo, Utah. According to the treasurer, Steven Sample, "This is a golden opportunity." The mine will cost $600,000 to open. It will generate a cash inflow of $100,000 during the first year and the cash flows are projected to grow at 8 percent per year for 10 years. After 10 years the mine will be abandoned. Abandonment costs will be $50,000. a. What is the IRR for the gold mine? b. The Utah Mining Corporation requires a 10 percent return on such undertakings. Should the mine be opened? Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 175 7 CHAPTER Net Present Value and Capital Budgeting EXECUTIVE SUMMARY I n late 1990, the Boeing Company announced its intention to build the Boeing 777, a commercial airplane that would be able to carry up to 390 passengers and fly 7,600 miles. This was expected to be an enormous undertaking. Analysts believed the up-front investment and research and development expenditures necessary to manufacture the Boeing 777 would be as much as $8 billion. Delivery of the first planes was expected to take place in 1995 and to continue for at least 35 years. Was the Boeing 777 a good project for Boeing? In 1990, was the NPV for the Boeing 777 positive? This chapter attempts to show you how Boeing and other firms should go about trying to answer these important questions. The Boeing 777 is an example of capital budgeting decision making at the Boeing Company. Previous chapters discussed the basics of capital budgeting and the net present value approach. We now want to move beyond these basics into the real-world application of these techniques. We want to show you how to use discounted cash flow (DCF) analysis and net present value (NPV) in capital budgeting decision making. In this chapter, we show how to identify the relevant cash flows of a project, including initial investment outlays, requirements for working capital, and operating cash flows. We look at the effects of depreciation and taxes. We examine the impact of inflation on interest rates and on a project's discount rate, and we show why inflation must be handled consistently in NPV analysis. 7.1 INCREMENTAL CASH FLOWS Cash Flows--Not Accounting Income You may not have thought about it, but there is a big difference between corporate finance courses and financial accounting courses. Techniques in corporate finance generally use cash flows, whereas financial accounting generally stresses income or earnings numbers. Certainly, our text has followed this tradition since our net present value techniques discounted cash flows, not earnings. When considering a single project, we discounted the cash flows that the firm receives from the project. When valuing the firm as a whole, we discounted dividends--not earnings--because dividends are the cash flows that an investor receives. There are many differences between earnings and cash flows. In fact, much of a standard financial accounting course delineates these differences. Because we have no desire to duplicate such course material, we merely discuss one example of the differences. Consider a firm buying a building for $100,000 today. The entire $100,000 is an immediate cash outflow. However, assuming straight-line depreciation over 20 years, only $5,000 ($100,000/20) is considered an accounting expense in the current year. Current earnings are thereby reduced only by $5,000. The remaining $95,000 is expensed over the following 19 years. 176 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 170 Part II Value and Capital Budgeting Because the seller of the property demands immediate payment, the cost at date 0 of the project to the firm is $100,000. Thus, the full $100,000 figure should be viewed as an immediate outflow for capital budgeting purposes. This is not merely our opinion but the unanimous verdict of both academics and practitioners. In addition, it is not enough to use cash flows. In calculating the NPV of a project, only cash flows that are incremental to the project should be used. These cash flows are the changes in the firm's cash flows that occur as a direct consequence of accepting the project. That is, we are interested in the difference between the cash flows of the firm with the project and the cash flows of the firm without the project. The use of incremental cash flows sounds easy enough, but pitfalls abound in the real world. In this section we describe how to avoid some of the pitfalls of determining incremental cash flows. Sunk Costs A sunk cost is a cost that has already occurred. Because sunk costs are in the past, they cannot be changed by the decision to accept or reject the project. Just as we "let bygones be bygones," we should ignore such costs. Sunk costs are not incremental cash outflows. E XAMPLE The General Milk Company is currently evaluating the NPV of establishing a line of chocolate milk. As part of the evaluation the company had paid a consulting firm $100,000 to perform a test-marketing analysis. This expenditure was made last year. Is this cost relevant for the capital budgeting decision now confronting the management of General Milk Company? The answer is no. The $100,000 is not recoverable, so the $100,000 expenditure is a sunk cost, or spilled milk. Of course, the decision to spend $100,000 for a marketing analysis was a capital budgeting decision itself and was perfectly relevant before it was sunk. Our point is that once the company incurred the expense, the cost became irrelevant for any future decision. Opportunity Costs Your firm may have an asset that it is considering selling, leasing, or employing elsewhere in the business. If the asset is used in a new project, potential revenues from alternative uses are lost. These lost revenues can meaningfully be viewed as costs. They are called opportunity costs because, by taking the project, the firm forgoes other opportunities for using the assets. E XAMPLE Suppose the Weinstein Trading Company has an empty warehouse in Philadelphia that can be used to store a new line of electronic pinball machines. The company hopes to market the machines to affluent northeastern consumers. Should the cost of the warehouse and land be included in the costs associated with introducing a new line of electronic pinball machines? The answer is yes. The use of a warehouse is not free; it has an opportunity cost. The cost is the cash that could be raised by the company if the decision to market the electronic pinball machines were rejected and the warehouse and land were put to some other use (or sold). If so, the NPV of the alternative uses becomes an opportunity cost of the decision to sell electronic pinball machines. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 177 Chapter 7 Net Present Value and Capital Budgeting 171 Side Effects Another difficulty in determining incremental cash flows comes from the side effects of the proposed project on other parts of the firm. The most important side effect is erosion. Erosion is the cash flow transferred to a new project from customers and sales of other products of the firm. E XAMPLE Suppose the Innovative Motors Corporation (IMC) is determining the NPV of a new convertible sports car. Some of the customers who would purchase the car are owners of IMC's compact sedan. Are all sales and profits from the new convertible sports car incremental? The answer is no because some of the cash flow represents transfers from other elements of IMC's product line. This is erosion, which must be included in the NPV calculation. Without taking erosion into account, IMC might erroneously calculate the NPV of the sports car to be, say, $100 million. If IMC's managers recognized that half the customers are transfers from the sedan and that lost sedan sales have an NPV of $150 million, they would see that the true NPV is $50 million ($100 million $150 million). QUESTIONS CONCEPT ? What are the three difficulties in determining incremental cash flows? Define sunk costs, opportunity costs, and side effects. 7.2 THE BALDWIN COMPANY: AN EXAMPLE We next consider the example of a proposed investment in machinery and related items. Our example involves the Baldwin Company and colored bowling balls. The Baldwin Company, originally established in 1965 to make footballs, is now a leading producer of tennis balls, baseballs, footballs, and golf balls. In 1973 the company introduced "High Flite," its first line of high-performance golf balls. The Baldwin management has sought opportunities in whatever businesses seem to have some potential for cash flow. In 1999 W. C. Meadows, vice president of the Baldwin Company, identified another segment of the sports ball market that looked promising and that he felt was not adequately served by larger manufacturers. That market was for brightly colored bowling balls, and he believed a large number of bowlers valued appearance and style above performance. He also believed that it would be difficult for competitors to take advantage of the opportunity because of Baldwin's cost advantages and because of its ability to use its highly developed marketing skills. As a result, in late 2000 the Baldwin Company decided to evaluate the marketing potential of brightly colored bowling balls. Baldwin sent a questionnaire to consumers in three markets: Philadelphia, Los Angeles, and New Haven. The results of the three questionnaires were much better than expected and supported the conclusion that the brightly colored bowling ball could achieve a 10- to 15-percent share of the market. Of course, some people at Baldwin complained about the cost of the test marketing, which was $250,000. However, Meadows argued that it was a sunk cost and should not be included in project evaluation. 178 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 172 Part II Value and Capital Budgeting In any case, the Baldwin Company is now considering investing in a machine to produce bowling balls. The bowling balls would be produced in a building owned by the firm and located near Los Angeles. This building, which is vacant, and the land can be sold to net $150,000 after taxes. The adjusted basis of this property, the original purchase price of the property less depreciation, is zero.1 Working with his staff, Meadows is preparing an analysis of the proposed new product. He summarizes his assumptions as follows: The cost of the bowling ball machine is $100,000. The machine has an estimated market value at the end of five years of $30,000. Production by year during the five-year life of the machine is expected to be as follows: 5,000 units, 8,000 units, 12,000 units, 10,000 units, and 6,000 units. The price of bowling balls in the first year will be $20. The bowling ball market is highly competitive, so Meadows believes that the price of bowling balls will increase at only 2 percent per year, as compared to the anticipated general inflation rate of 5 percent. Conversely, the plastic used to produce bowling balls is rapidly becoming more expensive. Because of this, production cash outflows are expected to grow at 10 percent per year. First-year production costs will be $10 per unit. Meadows has determined, based upon Baldwin's taxable income, that the appropriate incremental corporate tax rate in the bowling ball project is 34 percent. Net working capital is defined as the difference between current assets and current liabilities. Baldwin finds that it must maintain an investment in working capital. Like any manufacturing firm, it will purchase raw materials before production and sale, giving rise to an investment in inventory. It will maintain cash as a buffer against unforeseen expenditures. Its credit sales will generate accounts receivable. Management believes that the investment in the different items of working capital totals $10,000 in year 0, rises somewhat in the early years of the project, and falls to $0 by the project's end. In other words, the investment in working capital is completely recovered by the end of the project's life. Projections based on these assumptions and Meadows's analysis appear in Tables 7.1 through 7.4. In these tables all cash flows are assumed to occur at the end of the year. Because of the large amount of data in these tables, it is important to see how the tables are related. Table 7.1 shows the basic data for both investment and income. Supplementary schedules on operations and depreciation, as presented in Tables 7.2 and 7.3, help explain where the numbers in Table 7.1 come from. Our goal is to obtain projections of cash flow. The data in Table 7.1 are all that are needed to calculate the relevant cash flows, as shown in Table 7.4. An Analysis of the Project Investments The investment outlays required for the project are summarized in the top segment of Table 7.1. They consist of three parts: 1. The Bowling Ball Machine. The purchase requires a cash outflow of $100,000 at year 0. The firm realizes a cash inflow when the machine is sold in year 5. These cash flows are shown in line 1 of Table 7.1. As indicated in the footnote to the table, taxes are incurred when the asset is sold. 2. The Opportunity Cost of Not Selling the Warehouse. If Baldwin accepts the bowlingball project, it will use a warehouse and land that could otherwise be sold. The estimated sales price of the warehouse and land is therefore included as an opportunity cost, as 1 We use the term adjusted basis rather than book value because we are concerned with the firm's tax books, not its accounting books. This point is treated later in the chapter in the section entitled "Which Set of Books?" The current market value of the building and land is $227,272.73. We will assume the corporate tax rate is 34 percent, the basis is zero, and the after-tax net is $227,272.73 (1 0.34) $150,000. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 179 Chapter 7 Net Present Value and Capital Budgeting 173 I TA B L E 7.1 The Worksheet for Cash Flows of the Baldwin Company (in $ thousands) (All cash flows occur at the end of the year.) Year 0 Investments: (1) Bowling ball machine (2) Accumulated depreciation (3) Adjusted basis of machine after depreciation (end-of-year) (4) Opportunity cost (warehouse) (5) Net working capital (end-of-year) (6) Change in net working capital (7) Total cash flow of investment [(1) (4) (6)] Income: (8) Sales revenues (9) Operating costs (10) Depreciation (11) Income before taxes [(8) (9) (10)] (12) Tax at 34 percent (13) Net income $100.00 $20.00 80.00 150.00 10.00 10.00 260.00 $52.00 48.00 $71.20 28.80 $82.72 17.28 Year 1 Year 2 Year 3 Year 4 Year 5 $21.76* 94.24 5.76 150.00 0 21.22 192.98 10.00 16.32 6.32 6.32 24.97 8.65 8.65 21.22 3.75 3.75 $100.00 50.00 20.00 30.00 10.20 19.80 $163.20 88.00 32.00 43.20 14.69 28.51 $249.72 145.20 19.20 85.32 29.01 56.31 $212.20 133.10 11.52 67.58 22.98 44.60 $129.90 87.84 11.52 30.54 10.38 20.16 *We assume that the ending market value of the capital investment at year 5 is $30 (in thousands). Capital gain is the difference between ending market value and adjusted basis of the machine. The adjusted basis is the original purchase price of the machine less depreciation. The capital gain is $24.24 ($30 $5.76). We will assume the incremental corporate tax rate for Baldwin on this project is 34 percent. Capital gains are now taxed at the ordinary income rate, so the capital gains tax here is $8.24 [0.34 ($30 $5.76)]. The after-tax capital gain is $30 [0.34 ($30 $5.76)] $21.76. I TA B L E 7.2 Operating Revenues and Costs of the Baldwin Company (1) Year 1 2 3 4 5 (2) Production 5,000 8,000 12,000 10,000 6,000 (3) Price $20.00 20.40 20.81 21.22 21.65 (4) Sales Revenues $100,000 163,200 249,720 212,200 129,900 (5) Cost per Unit $10.00 11.00 12.10 13.31 14.64 (6) Operating Costs $ 50,000 88,000 145,200 133,100 87,840 Prices rise at 2% a year. Unit costs rise at 10% a year. presented in line 4. Opportunity costs are treated as cash flows for purposes of capital budgeting. However, the expenditures of $250,000 for test marketing are not included. The tests occurred in the past and should be viewed as a sunk cost. 3. The Investment in Working Capital. Required working capital appears in line 5. Working capital rises over the early years of the project as expansion occurs. However, all working capital is assumed to be recovered at the end, a common assumption in capital 180 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 174 Part II Value and Capital Budgeting I TA B L E 7.3 Depreciation for the Baldwin Company Recovery Period Class Year 1 2 3 4 5 6 7 8 Total 3 Years $ 33,340 44,440 14,810 7,410 5 Years $ 20,000 32,000 19,200 11,520 11,520 5,760 7 Years $ 14,280 24,490 17,490 12,500 8,920 8,920 8,920 4,480 $100,000 $100,000 $100,000 These schedules are based on the IRS publication Depreciation. Details on depreciation are presented in the appendix. Three-year depreciation actually carries over four years because the IRS assumes you purchase in midyear. I TA B L E 7.4 Incremental Cash Flows for the Baldwin Company (in $ thousands) Year 0 (1) (2) (3) (4) Sales revenue [line 8, Table 7.1] Operating costs [line 9, Table 7.1] Taxes [line 12, Table 7.1] Cash flow from operations [(1) (2) (3)] (5) Total cash flow of investment [line 7, Table 7.1] (6) Total cash flow of project [(4) (5)] NPV @ 4% 123.641 10% 51.588 15% 5.472 20% 31.351 Year 1 $100.00 50.00 10.20 39.80 $260.00 260.00 39.80 Year 2 $163.20 88.00 14.69 60.51 6.32 54.19 Year 3 $249.72 145.20 29.01 75.51 8.65 66.86 Year 4 $212.20 133.10 22.98 56.12 3.75 59.87 Year 5 $129.90 87.84 10.38 31.68 192.98 224.66 budgeting. In other words, all inventory is sold by the end, the cash balance maintained as a buffer is liquidated, and all accounts receivable are collected. Increases in working capital in the early years must be funded by cash generated elsewhere in the firm. Hence, these increases are viewed as cash outflows. Conversely, decreases in working capital in the later years are viewed as cash inflows. All of these cash flows are presented in line 6. A more complete discussion of working capital is provided later in this section. The total cash flow from the above three investments is shown in line 7. Income and Taxes Next, the determination of income is presented in the bottom segment of Table 7.1. While we are ultimately interested in cash flow--not income--we need the income calculation in order to determine taxes. Lines 8 and 9 of Table 7.1 show sales revenues and operating costs, respectively. The projections in these lines are based on the sales rev- Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 181 Chapter 7 Net Present Value and Capital Budgeting 175 enues and operating costs computed in columns 4 and 6 of Table 7.2. The estimates of revenues and costs follow from assumptions made by the corporate planning staff at Baldwin. In other words, the estimates critically depend on the fact that product prices are projected to increase at 2 percent per year and costs are projected to increase at 10 percent per year. Depreciation of the $100,000 capital investment is based on the amount allowed by the 1986 Tax Reform Act.2 Depreciation schedules under the act for three-year, five-year, and seven-year recovery periods are presented in Table 7.3. The IRS ruled that Baldwin is to depreciate its capital investment over five years, so the middle column of the table applies to this case. Depreciation from this middle column is reproduced in line 10 of Table 7.1. Income before taxes is calculated in line 11 of Table 7.1. Taxes are provided in line 12 of this table, and net income is calculated in line 13. Cash Flow Cash flow is finally determined in Table 7.4. We begin by reproducing lines 8, 9, and 12 in Table 7.1 as lines 1, 2, and 3 in Table 7.4. Cash flow from operations, which is sales minus both operating costs and taxes, is provided in line 4 of Table 7.4. Total investment cash flow, taken from line 7 of Table 7.1, appears as line 5 of Table 7.4. Cash flow from operations plus total cash flow of the investment equals total cash flow of the project, which is displayed as line 6 of Table 7.4. The bottom of the table presents the NPV of these cash flows for different discount rates. Net Present Value It is possible to calculate the NPV of the Baldwin bowling ball project from these cash flows. As can be seen at the bottom of Table 7.4, the NPV is $51,588 if 10 percent is the appropriate discount rate and $31,351 if 20 percent is the appropriate discount rate. If the discount rate is 15.67 percent, the project will have a zero NPV. In other words, the project's internal rate of return is 15.67 percent. If the discount rate of the Baldwin bowling ball project is above 15.67 percent, it should not be accepted because its NPV would be negative. Which Set of Books? It should be noted that the firm's management generally keeps two sets of books, one for the IRS (called the tax books) and another for its annual report (called the stockholders' books). The tax books follow the rules of the IRS. The stockholders' books follow the rules of the Financial Accounting Standards Board (FASB), the governing body in accounting. The two sets of rules differ widely in certain areas. For example, income on municipal bonds is ignored for tax purposes while being treated as income by the FASB. The differences almost always benefit the firm, because the rules permit income on the stockholders' books to be higher than income on the tax books. That is, management can look profitable to the stockholders without needing to pay taxes on all of the reported profit. In fact, there are plenty of large companies that consistently report positive earnings to the stockholders while reporting losses to the IRS. We present a synopsis of the IRS rules on depreciation in the appendix. The rules on depreciation for the stockholders' books differ, as they do in many other accounting areas. Which of the two sets of rules on depreciation do we want in order to create the previous tables for Baldwin? Clearly, we are interested in the IRS rules. Our purpose is to determine net cash flow, and tax payments are a cash outflow. The FASB regulations determine the calculation of accounting income, not cash flow. 2 Depreciation rules are discussed in detail in the appendix to this chapter. 182 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 176 Part II Value and Capital Budgeting A Note on Net Working Capital The investment in net working capital is an important part of any capital budgeting analysis. While we explicitly considered net working capital in lines 5 and 6 of Table 7.1, students may be wondering where the numbers in these lines came from. An investment in net working capital arises whenever (1) raw materials and other inventory are purchased prior to the sale of finished goods, (2) cash is kept in the project as a buffer against unexpected expenditures, and (3) credit sales are made, generating accounts receivable rather than cash. (The investment in net working capital is offset to the extent that purchases are made on credit, that is, when an accounts payable is created.) This investment in net working capital represents a cash outflow, because cash generated elsewhere in the firm is tied up in the project. To see how the investment in net working capital is built from its component parts, we focus on year 1. We see in Table 7.1 that Baldwin's managers predict sales in year 1 to be $100,000 and operating costs to be $50,000. If both the sales and costs were cash transactions, the firm would receive $50,000 ($100,000 $50,000). However, the managers: 1. Forecast that $9,000 of the sales will be on credit, implying that cash receipts in year 1 will be only $91,000 ($100,000 $9,000). The accounts receivable of $9,000 will be collected in year 2. 2. Believe that they can defer payment on $3,000 of the $50,000 of costs, implying that cash disbursements will be only $47,000 ($50,000 $3,000). Of course, Baldwin will pay off the $3,000 of accounts payable in year 2. 3. Decide that inventory of $2,500 should be left on hand at year 1 to avoid stockouts (that is, running out of inventory) and other contingencies. 4. Decide that cash of $1,500 should be earmarked for the project at year 1 to avoid running out of cash. Thus, net working capital in year 1 is $9,000 Accounts receivable $3,000 Accounts payable $2,500 Inventory $1,500 Cash $10,000 Net working capital Because $10,000 of cash generated elsewhere in the firm must be used to offset this requirement for net working capital, Baldwin's managers correctly view the investment in net working capital as a cash outflow of the project. As the project grows over time, needs for net working capital increase. Changes in net working capital from year to year represent further cash flows, as indicated by the negative numbers for the first few years of line 6 of Table 7.1. However, in the declining years of the project, net working capital is reduced--ultimately to zero. That is, accounts receivable are finally collected, the project's cash buffer is returned to the rest of the corporation, and all remaining inventory is sold off. This frees up cash in the later years, as indicated by positive numbers in years 4 and 5 on line 6. Typically, corporate worksheets (such as Table 7.1) treat net working capital as a whole. The individual components of working capital (receivables, inventory, etc.) do not generally appear in the worksheets. However, the reader should remember that the working capital numbers in the worksheets are not pulled out of thin air. Rather, they result from a meticulous forecast of the components, just as we illustrated for year 1. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 183 Chapter 7 Net Present Value and Capital Budgeting 177 Interest Expense It may have bothered you that interest expense was ignored in the Baldwin example. After all, many projects are at least partially financed with debt, particularly a bowling ball machine that is likely to increase the debt capacity of the firm. As it turns out, our approach of assuming no debt financing is rather standard in the real world. Firms typically calculate a project's cash flows under the assumption that the project is financed only with equity. Any adjustments for debt financing are reflected in the discount rate, not the cash flows. The treatment of debt in capital budgeting will be covered in depth later in the text. Suffice it to say at this time that the full ramifications of debt financing are well beyond our current discussion. QUESTIONS CONCEPT ? What are the items leading to cash flow in any year? Why did we determine income when NPV analysis discounts cash flows, not income? Why is working capital viewed as a cash outflow? E XAMPLE In late 1990, when the Boeing Company announced its intention to build a new passenger airplane called the Boeing 777, it anticipated it could sell several thousand planes over a 35-year period. Table 7.5 describes one set of possible (and hypothetical) cash flows of the Boeing 777. Although Boeing incurred several hundred million dollars of research and development prior to 1991, we ignore these costs because they are sunk costs. Notice also that we have subtracted depreciation from sales revenue for tax purposes but added it back for total cash flow. It is possible to calculate the NPV of the Boeing 777 from these cash flows. If the discount rate is 10 percent, the NPV is positive whereas if the appropriate discount rate is 30 percent, the NPV is negative. The break-even discount rate is 19 percent. (Recall we also call the break-even discount rate the IRR.) In May 2000, Boeing had delivered 282 777s--somewhat less than the deliveries hypothesized in Table 7.5. 7.3 INFLATION AND CAPITAL BUDGETING Inflation is an important fact of economic life, and it must be considered in capital budgeting. We begin our examination of inflation by considering the relationship between interest rates and inflation. Interest Rates and Inflation Suppose that the one-year interest rate that the bank pays is 10 percent. This means that an individual who deposits $1,000 at date 0 will get $1,100 ($1,000 1.10) in one year. While 10 percent may seem like a handsome return, one can only put it in perspective after examining the rate of inflation. Suppose that the rate of inflation is 6 percent over the year and it affects all goods equally. For example, a restaurant that charges $1.00 for a hamburger at date 0 charges $1.06 for the same hamburger at the end of the year. You can use your $1,000 to buy 1,000 184 I TA B L E 7.5 Incremental Cash Flows: Boeing 777 178 Operating Costs Depreciation Taxes Investment Income before Taxes Change in NWC Capital Expenditure Depreciation Total Add-back Cash Flow Year Number of Planes Delivered Sales Revenue Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition $ II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 $ 181.06 1,722.00 (17.12) (343.62) 50.90 90.54 (102.33) 42.01 246.57 (212.42) 431.41 376.22 (136.82) (388.81) 603.60 118.95 74.43 (484.45) (253.12) 173.60 59.75 61.54 63.38 65.29 67.24 69.26 71.34 73.48 75.68 $ 77.95 14 145 140 111 107 102 92 92 105 89 111 130 118 94 123 125 125 98 84 89 89 89 89 89 89 89 89 89 89 89 $ 1,847.55 19,418.96 19,244.23 15,737.95 16,257.35 15,333.42 14,289.29 14,717.97 17,233.97 15,066.42 19,468.56 23,307.53 21,911.40 17,944.00 24,103.23 25,316.97 26,076.48 21,133.07 18,550.25 20,321.64 20,931.29 21,559.23 22,206.00 22,872.18 23,558.35 24,265.10 24,993.05 25,742.85 26,515.13 $27,310.58 865.00 1,340.00 1,240.00 840.00 1,976.69 17,865.45 16,550.04 13,377.26 13,656.17 12,726.74 11,860.11 12,068.74 14,131.85 12,354.47 17,911.07 20,510.63 18,843.81 15,252.40 22,174.98 22,278.94 22,425.77 17,963.10 15,582.21 16,866.97 17,372.97 17,894.16 18,430.98 18,983.92 19,553.43 20,140.03 20,744.23 21,366.56 22,007.56 $22,667.78 $ 40.00 96.00 116.40 124.76 112.28 101.06 90.95 82.72 77.75 75.63 75.00 75.00 99.46 121.48 116.83 112.65 100.20 129.20 96.99 76.84 65.81 61.68 57.96 54.61 52.83 52.83 52.83 52.83 47.52 35.28 28.36 28.36 28.36 $ 16.05 $ (905.00) (1,436.00) (1,356.40) (964.76) (241.42) 1,452.45 2,603.24 2,277.97 2,523.43 2,531.05 2,354.18 2,574.23 3,002.66 2,590.47 1,440.66 2,684.25 2,967.39 2,562.40 1,831.26 2,961.19 3,584.90 3,108.29 2,910.08 3,400.06 3,505.49 3,612.24 3,722.19 3,835.43 3,957.40 4,089.79 4,220.46 4,347.93 4,479.21 $ 4,626.75 $ (307.70) (488.24) (461.18) (328.02) (82.08) 493.83 885.10 774.51 857.97 860.56 800.42 875.24 1,020.90 880.76 489.82 912.65 1,008.91 871.22 622.63 1,006.80 1,218.87 1,056.82 989.43 1,156.02 1,191.87 1,228.16 1,265.54 1,304.05 1,345.52 1,390.53 1,434.96 1,478.30 1,522.93 $1,573.10 $400.00 600.00 300.00 200.00 1.85 19.42 19.42 15.74 16.26 15.33 14.29 14.72 244.64 244.64 19.47 23.31 21.91 567.22 24.10 25.32 26.08 21.13 18.55 20.32 20.93 21.56 22.21 22.87 23.56 24.27 24.99 25.74 26.52 $ 27.31 $ 400.00 600.00 300.00 200.00 182.91 1,741.42 2.30 (327.88) 67.16 105.87 (88.04) 56.73 491.21 32.22 450.88 399.53 (114.91) 178.41 627.70 144.27 100.51 (463.32) (234.57) 193.92 80.68 83.10 85.59 88.16 90.80 93.53 96.33 99.22 102.20 $ 105.26 $ 40.00 96.00 116.40 124.76 112.28 101.06 90.95 82.72 77.75 75.63 75.00 75.00 99.46 121.48 116.83 112.65 100.20 129.20 96.99 76.84 65.81 61.68 57.96 54.61 52.83 52.83 52.83 52.83 47.52 35.28 28.36 28.36 28.36 $ 16.05 $ (957.30) (1,451.76) (1,078.82) (711.98) (229.97) 681.74 1,806.79 1,914.06 1,676.05 1,640.25 1,716.80 1,717.26 1,590.01 1,798.97 616.79 1,484.73 2,173.59 1,641.97 677.92 1,886.96 2,331.33 2,576.47 2,213.18 2,104.73 2,285.77 2,353.81 2,423.89 2,496.05 2,568.60 2,641.01 2,717.53 2,798.77 2,882.44 $ 2,964.45 The McGraw-Hill Companies, 2002 Notes: Tax rate is 34 percent of taxable income. Total cash flow can be determined by adding across the rows. Recall that total cash flow is equal to Sales revenue Source: Robert Brumer, Case Studies in Finance (Burr Ridge, Ill.: Times Mirror/Irwin, 1997). Operating costs Taxes Investment. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 185 Chapter 7 Net Present Value and Capital Budgeting 179 I F I G U R E 7.1 Calculation of Real Rate of Interest Date 0 Individual invests $1,000 in bank (Because hamburgers sell for $1 at date 0, $1,000 would have purchased 1,000 hamburgers.) 10% Interest rate 3.8% Inflation rate has been 6% over year Date 1 Individual receives $1,100 from bank Because each hamburger sells for $1.06 at date 1, 1,038 (= $1,100/$1.06) hamburgers can be purchased. Hamburger is used as illustrative good. 1,038 hamburgers can be purchased on date 1 instead of 1,000 hamburgers at date 0. Real interest rate 1,038/1,000 1 3.8%. hamburgers at date 0. Alternatively, if you put all of your money in the bank, you can buy 1,038 ($1,100/$1.06) hamburgers at date 1. Thus, you are only able to increase your hamburger consumption by 3.8 percent by lending to the bank. Since the prices of all goods rise at this 6-percent rate, lending lets you increase your consumption of any single good or any combination of goods by only 3.8 percent. Thus, 3.8 percent is what you are really earning through your savings account, after adjusting for inflation. Economists refer to the 3.8-percent number as the real interest rate. Economists refer to the 10-percent rate as the nominal interest rate or simply the interest rate. This discussion is illustrated in Figure 7.1. We have used an example with a specific nominal interest rate and a specific inflation rate. In general, the formula between real and nominal cash flows can be written as 1 Nominal interest rate (1 Real interest rate) (1 Inflation rate) Rearranging terms, we have Real interest rate 1 Nominal interest rate 1 Inflation rate 1 (7.1) The formula indicates that the real interest rate in our example is 3.8 percent (1.10/1.06 1). The above formula determines the real interest rate precisely. The following formula is an approximation: Real interest rate Nominal interest rate Inflation rate (7.2) The symbol indicates that the equation is approximately true. This latter formula calculates the real rate in our example as: 4% 10% 6% The student should be aware that, while equation (7.2) may seem more intuitive than equation (7.1), (7.2) is only an approximation. This approximation is reasonably accurate for low rates of interest and inflation. In our example, the difference between the approximate calculation and the exact one is only .2 percent (4 percent 3.8 percent). Unfortunately, the approximation becomes poor when rates are higher. 186 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 180 Part II Value and Capital Budgeting E XAMPLE The little-known monarchy of Gerberovia recently had a nominal interest rate of 300 percent and an inflation rate of 280 percent. According to equation (7.2), the real interest rate is: 300% 280% 20% (Approximate formula) However, according to equation (7.1), this rate is: 1 1 300% 280% 1 5.26% (Exact formula) The recent real and nominal interest rates for the United States are illustrated in Figure 7.2. The figure suggests that the nominal rate of interest exhibits more variability from year to year than does the real rate, a finding that seems to hold over most time periods. Cash Flow and Inflation The above analysis defines two types of interest rates, nominal rates and real rates, and relates them through equation (7.1). Capital budgeting requires data on cash flows as well as on interest rates. Like interest rates, cash flows can be expressed in either nominal or real terms. A cash flow is expressed in nominal terms if the actual dollars to be received (or paid out) are given. A cash flow is expressed in real terms if the current or date 0 purchasing power of the cash flow is given. Like most definitions, these definitions are best explained by examples. I F I G U R E 7.2 Nominal and Real Interest Rates and Inflation for the United States 20 U.S. Treasury bills and rate Inflation (CPI) U.S real risk-free return 15 10 Percentage 5 0 5 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 2000 10 Year (1950 2000) Nominal interest rates are based on three-month Treasury bills (or equivalent). The measure of inflation used is the Consumer Price Index. Real rates are calculated according to equation (7.1). Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 187 Chapter 7 Net Present Value and Capital Budgeting 181 E XAMPLE Burrows Publishing has just purchased the rights to the next book of famed romantic novelist Barbara Musk. Still unwritten, the book should be available to the public in four years. Currently, romantic novels sell for $10.00 in softcover. The publishers believe that inflation will be 6 percent a year over the next four years. Since romantic novels are so popular, the publishers anticipate that the prices of romantic novels will rise about 2 percent per year more than the inflation rate over the next four years. Not wanting to overprice, Burrows Publishing plans to sell the novel at $13.60 [(1.08)4 $10.00] four years from now. The firm anticipates selling 100,000 copies. The expected cash flow in the fourth year of $1.36 million ($13.60 100,000) is a nominal cash flow. That is because the firm expects to receive $1.36 million at that time. In other words, a nominal cash flow reflects the actual dollars to be received in the future. We determine the purchasing power of $1.36 million in four years as $1.08 million $1.36 million 1.06 4 The figure $1.08 million is a real cash flow since it is expressed in terms of date 0 purchasing power. Extending our hamburger example, the $1.36 million to be received in four years will only buy 1.08 million hamburgers because the price of a hamburger will rise from $1 to $1.26 [$1 (1.06)4] over the period. E XAMPLE EOBII Publishers, a competitor of Burrows, recently bought a printing press for $2,000,000 to be depreciated by the straight-line method over five years. This implies yearly depreciation of $400,000 ($2,000,000/5). Is this $400,000 figure a real or nominal quantity? Depreciation is a nominal quantity because $400,000 is the actual tax deduction over each of the next four years. Depreciation becomes a real quantity if it is adjusted for purchasing power. Hence, $316,837 ($400,000/(1.06)4) is depreciation in the fourth year, expressed as a real quantity. Discounting: Nominal or Real? Our previous discussion showed that interest rates can be expressed in either nominal or real terms. Similarly, cash flows can be expressed in either nominal or real terms. Given these choices, how should one express interest rates and cash flows when performing capital budgeting? Financial practitioners correctly stress the need to maintain consistency between cash flows and discount rates. That is, Nominal cash flows must be discounted at the nominal rate. Real cash flows must be discounted at the real rate. 188 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 182 Part II Value and Capital Budgeting E XAMPLE Shields Electric forecasts the following nominal cash flows on a particular project: Date: Cash flow 0 $1,000 1 $600 2 $650 The nominal interest rate is 14 percent, and the inflation rate is forecast to be 5 percent. What is the value of the project? Using Nominal Quantities The NPV can be calculated as $26.47 The project should be accepted. Using Real Quantities The real cash flows are Date: Cash flow 0 $1,000 1 $571.43 $600 1.05 2 $589.57 $650 1.05 2 $1,000 $600 1.14 $650 1.14 2 The real interest rate is 8.57143 percent (1.14/1.05 The NPV can be calculated as $26.47 $1,000 $571.43 1.0857143 1). $589.57 1.0857143 2 The NPV is the same when cash flows are expressed in real quantities. It must always be the case that the NPV is the same under the two different approaches. Because both approaches always yield the same result, which one should be used? Students will be happy to hear the following rule: Use the approach that is simpler. Since the Shields Electric case begins with nominal cash flows, nominal quantities produce a simpler calculation here. E XAMPLE Altshuler, Inc., used the following data for a capital budgeting project: Year 0 1 $1,900 950 605 2 $2,000 1,000 605 Capital expenditure $1,210 Revenues (in real terms) Cash expenses (in real terms) Depreciation (straight line) The president, David Altshuler, estimates inflation to be 10 percent per year over the next two years. In addition, he believes that the cash flows of the project should be discounted at the nominal rate of 15.5 percent. His firm's tax rate is 40 percent. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 189 Chapter 7 Net Present Value and Capital Budgeting 183 Mr. Altshuler forecasts all cash flows in nominal terms. Thus, he generates the following spreadsheet: Year Capital expenditure Revenues Expenses Depreciation ________________ Taxable income Taxes (40%) ________________ Income after taxes Depreciation ________________ Cash flow 0 $1,210 $2,090 ( 1,045 ( 605 _____ ( 440 176 _____ 264 605 _____ $ 869 1,900 1.10) $2,420 ( 950 1.10) 1,210 ( 1.210/2) 605 _____ 605 242 _____ 363 605 _____ $ 968 2,000 1,000 (1.10)2) (1.10)2) 1 2 NPV $1,210 $869 1.155 $968 1.155 2 $268 Mr. Altshuler's sidekick, Stuart Weiss, prefers working in real terms. He first calculates the real rate to be 5 percent ( 1.155/1.10 1). Next, he generates the following spreadsheet in real quantities: Year Capital expenditure Revenues Expenses Depreciation ________________ Taxable income Taxes (40%) ________________ Income after taxes Depreciation ________________ Cash flow 0 $1,210 $1,900 950 550 _____ ( 400 160 _____ 240 550 _____ $ 790 $2,000 1,000 500 ______ ( 500 200 ______ 300 500 ______ $ 800 1 2 605/1.1) 605/1.1)2) NPV $1,210 $790 1.05 $800 1.05 2 $268 In explaining his calculations to Mr. Altshuler, Mr. Weiss points out: 1. Since the capital expenditure occurs at date 0 (today), its nominal value and its real value are equal. 2. Since yearly depreciation of $605 is a nominal quantity, one converts it to a real quantity by discounting at the inflation rate of 10 percent. 3. It is no coincidence that both Mr. Altshuler and Mr. Weiss arrive at the same NPV number. Both methods must always give the same NPV. QUESTIONS CONCEPT ? What is the difference between the nominal and the real interest rate? What is the difference between nominal and real cash flows? 190 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 184 Part II Value and Capital Budgeting 7.4 INVESTMENTS OF UNEQUAL LIVES: THE EQUIVALENT ANNUAL COST METHOD Suppose a firm must choose between two machines of unequal lives. Both machines can do the same job, but they have different operating costs and will last for different time periods. A simple application of the NPV rule suggests that we should take the machine whose costs have the lower present value. This could lead to the wrong decision, though, because the lower-cost machine may need to be replaced before the other one. If we are choosing between two mutually exclusive projects that have different lives, the projects must be evaluated on an equal-life basis. In other words, we must devise a method that takes into account all future replacement decisions. We first discuss the classic replacement-chain problem. Next, a more difficult replacement decision is examined. Replacement Chain E XAMPLE Downtown Athletic Club must choose between two mechanical tennis ball throwers. Machine A costs less than machine B but will not last as long. The cash outflows from the two machines are: Date Machine A B 0 $500 600 1 $120 100 2 $120 100 3 $120 100 4 $100 Machine A costs $500 and lasts three years. There will be maintenance expenses of $120 to be paid at the end of each of the three years. Machine B costs $600 and lasts four years. There will be maintenance expenses of $100 to be paid at the end of each of the four years. We place all costs in real terms, an assumption greatly simplifying the analysis. Revenues per year are assumed to be the same, regardless of machine, so they are ignored in the analysis. Note that all numbers in the above chart are outflows. To get a handle on the decision, we take the present value of the costs of each of the two machines: Machine A: $798.42 Machine B: $916.99 $500 $600 $120 1.1 $100 1.1 $120 1.1 2 $100 1.1 2 $120 1.1 3 $100 1.1 3 (7.3) $100 1.1 4 Machine B has a higher present value of outflows. A naive approach would be to select machine A because of the lower outflows. However, machine B has a longer life so perhaps its cost per year is actually lower. How might one properly adjust for the difference in useful life when comparing the two machines? We present two methods. 1. Matching Cycles. Suppose that we run the example for 12 years. Machine A would have four complete cycles in this case and machine B would have three, so a comparison would be appropriate. Consider machine A's second cycle. The replacement of machine A Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 191 Chapter 7 Net Present Value and Capital Budgeting 185 occurs at date 3. Thus, another $500 must be paid at date 3 with the yearly maintenance cost of $120 payable at dates 4, 5, and 6. Another cycle begins at date 6 and a final cycle begins at date 9. Our present value analysis of (7.3) tells us that the payments in the first cycle are equivalent to a payment of $798.42 at date 0. Similarly, the payments from the second cycle are equivalent to a payment of $798.42 at date 3. Carrying this out for all four cycles, the present value of all costs from machine A over 12 years is Present Value of Costs of Machine A over 12 Years: $798.42 $798.42 $798.42 $2,188 $798.42 1.10 3 1.10 6 1.10 9 (7.4) Now consider machine B's second cycle. The replacement of machine B occurs at date 4. Thus, another $600 must be paid at this time, with yearly maintenance costs of $100 payable at dates 5, 6, 7, and 8. A third cycle completes the 12 years. Following our calculations for machine A, the present value of all costs from machine B over 12 years is Present Value of Costs of Machine B over 12 Years: $916.99 $916.99 $1,971 $916.99 1.10 4 1.10 8 Because both machines have complete cycles over the 12 years, a comparison of 12-year costs is appropriate. The present value of machine B's costs is lower than the present value of machine A's costs over the 12 years, implying that machine B should be chosen. While the above approach is straightforward, it has one drawback: Sometimes the number of cycles is high, demanding an excessive amount of calculating time. For example, if machine C lasts for seven years and machine D lasts for 11 years, these two machines must be compared over a period of 77 (7 11) years. And if machines C, D, and E are compared, where machine E has a four-year cycle, a complete set of cycles occurs over 308 (7 11 4) years. Therefore, we offer the following alternative approach. 2. Equivalent Annual Cost. Equation (7.3) showed that payments of ($500, $120, $120, $120) are equivalent to a single payment of $798.42 at date 0. We now wish to equate the single payment of $798.42 at date 0 with a three-year annuity. Using techniques of previous chapters, we have $798.42 C A3 0.10 A3 is an annuity of $1 a year for three years, discounted at 10 percent. C is the 0.10 unknown--the annuity payment per year that causes the present value of all payments to equal $798.42. Because A3 equals 2.4869, C equals $321.05 ($798.42/2.4869). Thus, a 0.10 payment stream of ($500, $120, $120, $120) is equivalent to annuity payments of $321.05 made at the end of each year for three years. Of course, this calculation assumes only one cycle of machine A. Use of machine A over many cycles is equivalent to annual payments of $321.05 for an indefinite period into the future. We refer to $321.05 as the equivalent annual cost of machine A. Now let us turn to machine B. We calculate its equivalent annual cost from $916.99 C A4 0.10 Because A4 equals 3.1699, C equals $916.99/3.1699, or $289.28. 0.10 The following chart facilitates a comparison of machine A with machine B. Date Machine A Machine B 0 1 $321.05 289.28 2 $321.05 289.28 3 $321.05 289.28 4 $321.05 289.28 5 ... $321.05 . . . 289.28 . . . 192 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 186 Part II Value and Capital Budgeting Repeated cycles of machine A give rise to yearly payments of $321.05 for an indefinite period into the future. Repeated cycles of machine B give rise to yearly payments of $289.28 for an indefinite period into the future. Clearly, machine B is preferred to machine A. So far, we have presented two approaches: matching cycles and equivalent annual costs. Machine B was preferred under both methods. The two approaches are simply different ways of presenting the same information so that, for problems of this type, the same machine must be preferred under both approaches. In other words, use whichever method is easier for you since the decision will always be the same. Assumptions in Replacement Chains Strictly speaking, the two approaches make sense only if the time horizon is a multiple of 12 years. However, if the time horizon is long, but not known precisely, these approaches should still be satisfactory in practice. The problem comes in if the time horizon is short. Suppose that the Downtown Athletic Club knows that a new machine will come on the market at date 5. The machine will be incredibly cheap and virtually maintenance-free, implying that it will replace either machine A or machine B immediately. Furthermore, its cheapness implies no salvage value for either A or B. The relevant cash flows for A and B are Date Machine A Machine B 0 $500 600 1 $120 100 2 $120 100 3 $120 $500 100 4 $120 100 600 5 $120 100 Note the double cost of machine A at date 3. This occurs because machine A must be replaced at that time. However, maintenance costs still continue, because machine A remains in service until the day of its replacement. Similarly, there is a double cost of machine B at date 4. Present values are Present Value of Costs of Machine A: $1,331 $500 $120 1.10 $120 1.10 2 $620 1.10 3 $120 1.10 4 $120 1.10 5 Present Value of Costs of Machine B: $1,389 $600 $100 1.10 $100 1.10 2 $100 1.10 3 $700 1.10 4 $100 1.10 5 Thus, machine B is more costly. Why is machine B more costly here when it is less costly under strict replacement-chain assumptions? Machine B is hurt more than machine A by the termination at date 5 because B's second cycle ends at date 8 while A's second cycle ends at date 6.3 One final remark: Our analysis of replacement chains applies only if one anticipates replacement. The analysis would be different if no replacement were possible. This would occur if the only company that manufactured tennis ball throwers just went out of business and no new producers are expected to enter the field. In this case, machine B would generate revenues in the fourth year whereas machine A would not. In that case, simple net present value analysis for mutually exclusive projects including both revenues and costs would be appropriate. 3 This reminds us of the famous New Yorker joke where two businessmen-types are conversing in heaven. One turns to the other and says, "The thing that gets me is that I still had 40,000 miles left on my radial tires." Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 193 Chapter 7 Net Present Value and Capital Budgeting 187 The General Decision to Replace (Advanced) The previous analysis concerned the choice between machine A and machine B, both of which were new acquisitions. More typically, firms must decide when to replace an existing machine with a new one. The analysis is actually quite straightforward. First, one calculates the equivalent annual cost (EAC) for the new equipment. Second, one calculates the yearly cost for the old equipment. This cost likely rises over time because the machine's maintenance expense should increase with age. Replacement should occur right before the cost of the old equipment exceeds the EAC on the new equipment. As with much else in finance, an example clarifies this criterion better than further explanation. E XAMPLE Consider the situation of BIKE. BIKE is contemplating whether to replace an existing machine or to spend money overhauling it. BIKE currently pays no taxes. The replacement machine costs $9,000 now and requires maintenance of $1,000 at the end of every year for eight years. At the end of eight years it would have a salvage value of $2,000 and would be sold. The existing machine requires increasing amounts of maintenance each year, and its salvage value falls each year, as shown: Year Present 1 2 3 4 Maintenance $ 0 1,000 2,000 3,000 4,000 Salvage $4,000 2,500 1,500 1,000 0 The existing machine can be sold for $4,000 now. If it is sold in one year, the resale price will be $2,500, and $1,000 must be spent on maintenance during the year to keep it running. For ease of calculation, we assume that this maintenance fee is paid at the end of the year. The machine will last for four more years before it falls apart. If BIKE faces an opportunity cost of capital of 15 percent, when should it replace the machine? Equivalent Annual Cost of New Machine The present value of the cost of the new replacement machine is as follows: PVcosts $9,000 $1,000 A8 0.15 $2,000 1.15 8 4.4873 $2,000 $9,000 $1,000 $12,833 0.3269 Notice that the $2,000 salvage value is an inflow. It is treated as a negative number in the above equation because it offsets the cost of the machine. The EAC of a new replacement machine equals PV 8-year annuity factor at 15% PV A8 0.15 $12,833 4.4873 $2,860 Cost of Old Machine If the new machine is purchased immediately, the existing machine can be sold for $4,000 today. Thus, a cost of keeping the existing machine for one more year is that BIKE must forgo receiving the $4,000 today. This $4,000 is an 194 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 188 Part II Value and Capital Budgeting opportunity cost. The total cost of keeping the existing machine one more year includes the following: 1. The opportunity cost of not selling it now ($4,000). 2. Additional maintenance ($1,000). 3. Salvage value ($2,500). Thus, the PV of the costs of keeping the machine one more year and selling it equals $4,000 $1,000 1.15 $2,500 1.15 $2,696 While we normally express cash flows in terms of present value, the analysis to come is made easier if we express the cash flow in terms of its future value one year from now. This future value is $2,696 1.15 $3,100 In other words, the equivalent cost of keeping the machine for one year is $3,100 at the end of the year. Making the Comparison If we replace the machine immediately, we can view our annual expense as $2,860, beginning at the end of the year. This annual expense occurs forever, if we replace the new machine every eight years. This cash flow stream can be written as Year 1 Expenses from replacing machine immediately $2,860 Year 2 $2,860 Year 3 $2,860 Year 4 $2,860 ... ... If we replace the old machine in one year, our expense from using the old machine for that final year can be viewed as $3,100, payable at the end of the year. After replacement, we can view our annual expense as $2,860, beginning at the end of two years. This annual expense occurs forever, if we replace the new machine every eight years. This cash flow stream can be written as Year 1 Expenses from using old machine for one year and then replacing it $3,100 Year 2 $2,860 Year 3 $2,860 Year 4 $2,860 ... ... BIKE should replace the old machine immediately in order to minimize the expense at year 1. One caveat is in order. Perhaps the old machine's maintenance is high in the first year but drops after that. A decision to replace immediately might be premature in that case. Therefore, we need to check the cost of the old machine in future years. The cost of keeping the existing machine a second year is PV of costs at time 1 $2,500 $2,000 1.15 $1,500 1.15 $2,935 which has future value of $3,375 ($2,935 1.15). The costs of keeping the existing machine for years 3 and 4 are also greater than the EAC of buying a new machine. Thus, BIKE's decision to replace the old machine immediately still is valid. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 195 Chapter 7 QUESTIONS CONCEPT Net Present Value and Capital Budgeting 189 ? What is the equivalent annual cost method of capital budgeting? Can you list the assumptions that we must make to use EAC? 7.5 SUMMARY AND CONCLUSIONS This chapter discusses a number of practical applications of capital budgeting. 1. Capital budgeting must be placed on an incremental basis. This means that sunk costs must be ignored, while both opportunity costs and side effects must be considered. 2. In the Baldwin case, we computed NPV using the following two steps: a. Calculate the net cash flow from all sources for each period. b. Calculate the NPV using the cash flows calculated above. 3. Inflation must be handled consistently. One approach is to express both cash flows and the discount rate in nominal terms. The other approach is to express both cash flow and the discount rate in real terms. Because either approach yields the same NPV calculation, the simpler method should be used. The simpler method will generally depend on the type of capital budgeting problem. 4. When a firm must choose between two machines of unequal lives, the firm can apply either the matching cycle approach or the equivalent annual cost approach. Since both approaches are different ways of presenting the same information, the same machine must be preferred under both approaches. KEY TERMS Erosion 171 Net working capital 172 Nominal cash flow 181 Nominal interest rate 179 Opportunity cost 170 Real cash flow 181 Real interest rate 179 Sunk cost 170 SUGGESTED READING An excellent in-depth examination of the capital budgeting decision is contained in: Copeland, T., T. Koller, and J. Murrin. Valuation: Measuring and Managing the Value of Companies, 2nd ed. The McKinsey Company, 1994. QUESTIONS AND PROBLEMS NPV and Capital Budgeting 7.1 Which of the following cash flows should be treated as incremental cash flows when computing the NPV of an investment? a. The reduction in the sales of the company's other products. b. The expenditure on plant and equipment. 196 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 190 Part II Value and Capital Budgeting c. The cost of research and development undertaken in connection with the product during the past three years. d. The annual depreciation expense. e. Dividend payments. f. The resale value of plant and equipment at the end of the project's life. g. Salary and medical costs for production employees on leave. 7.2 Your company currently produces and sells steel-shaft golf clubs. The Board of Directors wants you to look at introducing a new line of titanium bubble woods with graphite shaft. Which of the following costs are not relevant? I. Land you already own that will be used for the project and has a market value of $700,000. II. $300,000 drop in sales of steel-shaft clubs if titanium woods with graphite shaft are introduced. III. $200,000 spent on Research and Development last year on graphite shafts. a. I only b. II only c. III only d. I and III only e. II and III only 7.3 The Best Manufacturing Company is considering a new investment. Financial projections for the investment are tabulated below. (Cash flows are in $ thousands and the corporate tax rate is 34 percent.) Year 0 Sales revenue Operating costs Investment Depreciation Net working capital (end of year) Year 1 7,000 2,000 10,000 200 2,500 250 2,500 300 2,500 200 2,500 0 Year 2 7,000 2,000 Year 3 7,000 2,000 Year 4 7,000 2,000 a. Compute the incremental net income of the investment. b. Compute the incremental cash flows of the investment. c. Suppose the appropriate discount rate is 12 percent. What is the NPV of the project? 7.4 According to the February 7, 1983, issue of The Sporting News, the Kansas City Royals' designated hitter, Hal McRae, signed a three-year contract in January 1983 with the following provisions: $400,000 signing bonus. $250,000 salary per year for three years. 10 years of deferred payments of $125,000 per year (these payments begin in year 4). Several bonus provisions that total as much as $75,000 per year for the three years of the contract. Assume that McRae has a 60-percent probability of receiving the bonuses each year, and that he signed the contract on January 1, 1983. (Hint: Use the expected bonuses as incremental cash flows.) Assume an effective annual interest rate of 12.36 percent, and ignore taxes. McRae's salary and bonus are paid at the end of the year. What was the present value of this contract in January when McRae signed it? 7.5 Benson Enterprises, Inc., is evaluating alternative uses for a three-story manufacturing and warehousing building that it has purchased for $225,000. The company could continue to rent the building to the present occupants for $12,000 per year. The present occupants have indicated an interest in staying in the building for at least another 15 years. Alternatively, the company could modify the existing structure to use for its own manufacturing and warehousing needs. Benson's production engineer feels the building could be adapted to Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 197 Chapter 7 Net Present Value and Capital Budgeting 191 handle one of two new product lines. The cost and revenue data for the two product alternatives follow. Product A Initial cash outlay for building modifications Initial cash outlay for equipment Annual pretax cash revenues (generated for 15 years) Annual pretax cash expenditures (generated for 15 years) $ 36,000 144,000 105,000 60,000 Product B $ 54,000 162,000 127,500 75,000 The building will be used for only 15 years for either product A or product B. After 15 years, the building will be too small for efficient production of either product line. At that time, Benson plans to rent the building to firms similar to the current occupants. To rent the building again, Benson will need to restore the building to its present layout. The estimated cash cost of restoring the building if product A has been undertaken is $3,750; if product B has been produced, the cash cost will be $28,125. These cash costs can be deducted for tax purposes in the year the expenditures occur. Benson will depreciate the original building shell (purchased for $225,000) over a 30year life to zero, regardless of which alternative it chooses. The building modifications and equipment purchases for either product are estimated to have a 15-year life; also, they can and will be depreciated on a straight-line basis. The firm's tax rate is 34 percent, and its required rate of return on such investments is 12 percent. For simplicity, assume all cash flows for a given year occur at the end of the year. The initial outlays for modifications and equipment will occur at t 0, and the restoration outlays will occur at the end of year 15. Also, Benson has other profitable ongoing operations that are sufficient to cover any losses. Which use of the building would you recommend to management? 7.6 Samsung International has rice fields in California that are expected to produce average annual profits of $800,000 in real terms forever. Samsung has no depreciable assets and is an all-equity firm with 200,000 shares outstanding. The appropriate discount rate for its stock is 12 percent. Samsung has an investment opportunity with a gross present value of $1 million. The investment requires a $400,000 outlay now. Samsung has no other investment opportunities. Assume that all cash flows are received at the end of each year. What is the price per share of Samsung? 7.7 Dickinson Brothers, Inc., is considering investing in a machine to produce computer keyboards. The price of the machine will be $400,000 and its economic life five years. The machine will be fully depreciated by the straight-line method. The machine will produce 10,000 units of keyboards each year. The price of the keyboard will be $40 in the first year, and it will increase at 5 percent per year. The production cost per unit of the keyboard will be $20 in the first year, and it will increase at 10 percent per year. The corporate tax rate for the company is 34 percent. If the appropriate discount rate is 15 percent, what is the NPV of the investment? 7.8 Scott Investors, Inc., is considering the purchase of a $500,000 computer that has an economic life of five years. The computer will be depreciated based on the system enacted by the Tax Reform Act of 1986. (See Table 7.3 for the depreciation schedules.) The market value of the computer will be $100,000 in five years. The use of the computer will save five office employees whose annual salaries are $120,000. It also contributes to lower net working capital by $100,000 when they buy the computer. The net working capital will be recovered at the end of the period. The corporate tax rate is 34 percent. Is it worthwhile to buy the computer if the appropriate discount rate is 12 percent? 7.9 The Gap is considering buying an on-line cash register software from IBM so that it can effectively deal with its retail sales. The software package costs $750,000 and will be depreciated down to zero using the straight-line method over its five-year economic life. The marketing department predicts that sales will be $600,000 per year for the next three years, after which the market will cease to exist. Cost of goods sold and 198 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 192 Part II Value and Capital Budgeting operating expenses are predicted to be 25 percent of sales. After three years the software can be sold for $40,000. The Gap also needs to add net working capital of $25,000 immediately. This additional net working capital will be recovered in full at the end of the project life. The corporate tax rate for Gap is 35 percent and the required rate of return on it is 17 percent. What is the NPV of the new software? 7.10 Etonic Inc. is considering an investment of $250,000 in an asset with an economic life of five years. The firm estimates that the nominal annual cash revenues and expenses will be $200,000 and $50,000, respectively. Both revenues and expenses are expected to grow at 3 percent per year as that of the expected annual inflation. Etonic will use straight-line method to depreciate its asset to zero over the economic life. The salvage value of the asset is estimated to be $30,000 in nominal terms at the end of five years. The one-time NWC investment of $10,000 is required immediately. Further, the nominal discount rate for all cash flows is 15 percent. All corporate cash flows are subject to a 35 percent tax rate. All cash flows, except the initial investment and the NWC, occur at the end of the year. What is the project's total nominal cash flow from assets in year 5? 7.11 Commercial Real Estate, Inc., is considering the purchase of a $4 million building to lease. The economic life of the building will be 20 years. Assume that the building will be fully depreciated by the straight-line method and its market value in 20 years will be zero. The company expects that annual lease payments will increase at 3 percent per year. The appropriate discount rate for cash flows of lease payments is 13 percent, while the discount rate for depreciation is 9 percent. The corporate tax rate is 34 percent. What is the least Commercial Real Estate should ask for the first-year lease? Assume that the annual lease payment starts right after the signature of the lease contract. 7.12 Royal Dutch Petroleum is considering going into a new project, which is typical for the firm. A capital tool required for the project costs $2 million. The marketing department predicts that sales will be $1.2 million per year for the next four years, after which the market will cease to exist. The tool, a five-year class capital tool, will be depreciated down to zero using the straight-line method. Cost of goods sold and operating expenses are predicted to be 25 percent of sales. After four years the tool can be sold for $150,000. Royal Dutch also needs to add net working capital of $100,000 immediately. This additional capital will be received in full at the end of the project life. The tax rate for Royal Dutch is 35 percent. The required rate of return on Royal Dutch is 16.55 percent. Capital Budgeting with Inflation 7.13 Consider the following cash flows on two mutually exclusive projects. Year 0 1 2 3 Project A $40,000 20,000 15,000 15,000 Project B $50,000 10,000 20,000 40,000 Cash flows of project A are expressed in real terms while those of project B are expressed in nominal terms. The appropriate nominal discount rate is 15 percent, and the inflation is 4 percent. Which project should you choose? 7.14 Sanders Enterprises, Inc., has been considering the purchase of a new manufacturing facility for $120,000. The facility is to be depreciated on a seven-year basis. It is expected to have no value after seven years. Operating revenues from the facility are expected to be $50,000 in the first year. The revenues are expected to increase at the inflation rate of 5 percent. Production costs in the first year are $20,000, and they are expected to increase at 7 percent per year. The real discount rate for risky cash flows is 14 percent, while the nominal riskless interest rate is 10 percent. The corporate tax rate is 34 percent. Should the company accept the suggestion? Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 199 Chapter 7 Net Present Value and Capital Budgeting 193 7.15 Phillips Industries runs a small manufacturing operation. For this year, it expects to have real net cash flows of $120,000. Phillips is an ongoing operation, but it expects competitive pressures to erode its (inflation-adjusted) net cash flows at 6 percent per year. The appropriate real discount rate for Phillips is 11 percent. All net cash flows are received at year-end. What is the present value of the net cash flows from Phillips's operations? 7.16 Harry Gultekin, a small restaurant owner/manager, is contemplating the purchase of a larger restaurant from its owner who is retiring. Gultekin would finance the purchase by selling his existing small restaurant, taking a second mortgage on his house, selling the stocks and bonds that he owns, and, if necessary, taking out a bank loan. Because Gultekin would have almost all of his wealth in the restaurant, he wants a careful analysis of how much he should be willing to pay for the business. The present owner of the larger restaurant has supplied the following information about the restaurant from the past five years. Year 5 4 3 2 Last Gross Revenue $875,000 883,000 828,000 931,000 998,000 Profit $ 62,000 28,000 4,400 96,000 103,000 As with many small businesses, the larger restaurant is structured as a Subchapter S corporation. This structure gives the owner the advantage of limited liability, but the pretax profits flow directly through to the owner, without any corporate tax deducted. The preceding figures have not been adjusted for changes in the price level. There is general agreement that the average profits for the past five years are representative of what can be expected in the future, after adjusting for inflation. Gultekin is of the opinion that he could earn at least $3,000 in current dollars per month as a hired manager. Gultekin feels he should subtract this amount from profits when analyzing the venture. Furthermore, he is aware of statistics showing that for restaurants of this size, approximately 6 percent of owners go out of business each year. Gultekin has done some preliminary work to value the business. His analysis is as follows: Year 5 4 3 2 Last Profits $ 62,000 28,000 4,400 96,000 103,000 Price-Level Factor 1.28 1.18 1.09 1.04 1.00 Profits (current dollars) $ 79,400 33,000 4,800 99,800 103,000 Imputed Managerial Wage $36,000 36,000 36,000 36,000 36,000 Net Profits $ 43,400 3,000 31,200 63,800 67,000 The average profits for the past five years, expressed in current dollars, are $28,000. Using this average profit figure, Gultekin produced the following figures. These figures are in current dollars. Expected Profits if Business Continues $28,000 28,000 28,000 28,000 . . . Probability of Cont.* 1.000 0.940 0.884 0.831 . . . RiskAdjusted Profits $28,000 26,300 24,700 23,300 . . . Real Discount Factor 2% 0.980 0.961 0.942 0.924 . . . Present Value $27,400 25,300 23,300 21,500 . . . Year Next 2 3 4 . . . *Probability of the business continuing. The probability of failing in any year is 6 percent. That probability compounds over the years. 200 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 194 Part II Value and Capital Budgeting Based on these calculations, Gultekin has calculated that the value of the restaurant is $350,000. a. Assume that there is indeed a 6 percent per year probability of going out of business. Do you agree with Gultekin's assessment of the restaurant? In your answer, consider his treatment of inflation, his deduction of the managerial wage of $3,000 per month, and the manner in which he assessed risk. b. What present value would you place on the revenue stream; in other words, how much would you advise Gultekin that he should be willing to pay for the restaurant? 7.17 The Biological Insect Control Corporation (BICC) has hired you as a consultant to evaluate the NPV of their proposed toad ranch. BICC plans to breed toads and sell them as ecologically desirable insect-control mechanisms. They anticipate that the business will continue in perpetuity. Following negligible start-up costs, BICC will incur the following nominal cash flows at the end of the year. Revenues Labor costs Other costs $150,000 80,000 40,000 The company will lease machinery from a firm for $20,000 per year. (The lease payment starts at the end of year 1.) The payments of the lease are fixed in nominal terms. Sales will increase at 5 percent per year in real terms. Labor costs will increase at 3 percent per year in real terms. Other costs will decrease at 1 percent per year in real terms. The rate of inflation is expected to be 6 percent per year. The real rate of discount for revenues and costs is 10 percent. The lease payments are risk-free; therefore, they must be discounted at the risk-free rate. The real risk-free rate is 7 percent. There are no taxes. All cash flows occur at year-end. What is the NPV of BICC's proposed toad ranch today? 7.18 Sony International has an investment opportunity to produce a new stereo color TV. The required investment on January 1 of this year is $32 million. The firm will depreciate the investment to zero using the straight-line method. The firm is in the 34-percent tax bracket. The price of the product on January 1 will be $400 per unit. That price will stay constant in real terms. Labor costs will be $15 per hour on January 1. They will increase at 2 percent per year in real terms. Energy costs will be $5 per physical unit on January 1; they will increase at 3 percent per year in real terms. The inflation rate is 5 percent. Revenues are received and costs are paid at year-end. Year 1 Physical production, in units Labor input, in hours Energy input, physical units 100,000 2,000,000 200,000 Year 2 200,000 2,000,000 200,000 Year 3 200,000 2,000,000 200,000 Year 4 150,000 2,000,000 200,000 The riskless nominal discount rate is 4 percent. The real discount rate for costs and revenues is 8 percent. Calculate the NPV of this project. 7.19 Sparkling Water, Inc., sells 2 million bottles of drinking water each year. Each bottle sells at $2.5 in real terms and costs per bottle are $0.7 in real terms. Sales income and costs occur at year-end. Sales income is expected to rise at a real rate of 7 percent annually, while real costs are expected to rise at 5 percent annually. The relevant, real discount rate is 10 percent. The corporate tax rate is 34 percent. What is Sparkling worth today? 7.20 International Buckeyes is building a factory that can make 1 million buckeyes a year for five years. The factory costs $6 million. In year 1, each buckeye will sell for $3.15 in nominal terms. The price will rise 5 percent each year in real terms. During the first year variable costs will be $0.2625 per buckeye in nominal terms and will rise by 2 percent each year in real terms. International Buckeyes will depreciate the value of the factory to zero over the five years by use of the straight-line method. International Buckeyes expects to be able to sell the factory for $638,140.78 at the end of year 5 (or $500,000 in real terms). The Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 201 Chapter 7 Net Present Value and Capital Budgeting 195 nominal discount rate for risky cash flows is 20 percent. The nominal discount rate for riskless cash flows is 11 percent. The rate of inflation is 5 percent. Cash flows, except the initial investment, occur at the end of the year. The corporate tax rate is 34 percent; capital gains are also taxed at 34 percent. What is the net present value of this project? 7.21 Majestic Mining Company (MMC) is negotiating for the purchase of a new piece of equipment for their current operations. MMC wants to know the maximum price that it should be willing to pay for the equipment. That is, how high must the price be for the equipment to have an NPV of zero? You are given the following facts: a. The new equipment would replace existing equipment that has a current market value of $20,000. b. The new equipment would not affect revenues, but before-tax operating costs would be reduced by $10,000 per year for eight years. These savings in cost would occur at year-end. c. The old equipment is now five years old. It is expected to last for another eight years, and it is expected to have no resale value at the end of those eight years. It was purchased for $40,000 and is being depreciated to zero on a straight-line basis over 10 years. d. The new equipment will be depreciated to zero using straight-line depreciation over five years. MMC expects to be able to sell the equipment for $5,000 at the end of eight years. The proceeds from this sale would be subject to taxes at the ordinary corporate income tax rate of 34 percent. e. MMC has profitable ongoing operations. f. The appropriate discount rate is 8 percent. 7.22 After extensive medical and marketing research, Pill, Inc., believes it can penetrate the pain reliever market. It can follow one of two strategies. The first is to manufacture a medication aimed at relieving headache pain. The second strategy is to make a pill designed to relieve headache and arthritis pain. Both products would be introduced at a price of $4 per package in real terms. The broader remedy would probably sell 10 million packages a year. This is twice the sales rate for the headache-only medication. Cash costs of production in the first year are expected to be $1.50 per package in real terms for the headache-only brand. Production costs are expected to be $1.70 in real terms for the more general pill. All prices and costs are expected to rise at the general inflation rate of 5 percent. Either strategy would require further investment in plant. The headache-only pill could be produced using equipment that would cost $10.2 million, last three years, and have no resale value. The machinery required to produce the broader remedy would cost $12 million and last three years. At this time the firm would be able to sell it for $1 million (in real terms). The production machinery would need to be replaced every three years, at constant real costs. Suppose that for both projects the firm will use straight-line depreciation. The firm faces a corporate tax rate of 34 percent. The firm believes the appropriate real discount rate is 13 percent. Capital gains are taxed at the ordinary corporate tax rate of 34 percent. Which pain reliever should the firm produce? 7.23 A machine that lasts four years has the following net cash outflows. $12,000 is the cost of purchasing the machine, and $6,000 is the annual year-end operating cost. At the end of four years, the machine is sold for $2,000; thus, the cash flow at year 4, C4, is only $4,000. C0 $12,000 C1 $6,000 C2 $6,000 C3 $6,000 C4 $4,000 The cost of capital is 6 percent. What is the present value of the costs of operating a series of such machines in perpetuity? 7.24 A machine costs $60,000 and requires $5,000 maintenance for each year of its three-year life. After three years, this machine will be replaced. Assume a tax rate of 34 percent and a discount rate of 14 percent. If the machine is depreciated with a three-year straight-line without a salvage value, what is the equivalent annual cost (EAC)? 202 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 196 Part II Value and Capital Budgeting 7.25 United Healthcare, Inc. needs a new admitting system, which costs $60,000 and requires $2,000 in maintenance for each year of its five-year life. The system will be depreciated straight-line down to zero without salvage value at the end of five years. Assume a tax rate of 35 percent and an annual discount rate of 18 percent. What is the equivalent annual cost of this admitting system? 7.26 Aviara Golf Academy is evaluating different golf practice equipment. The "easy as pie" equipment costs $45,000, has a three-year life, and costs $5,000 per year to operate. The relevant discount rate is 12 percent. Assume that the straight-line depreciation down to zero is used. Furthermore, it has a salvage value of $10,000. The relevant tax rate is 34 percent. What is the EAC of this equipment? Replacement with Unequal Lives 7.27 Office Automation, Inc., is obliged to choose between two copiers, XX40 or RH45. XX40 costs less than RH45, but its economic life is shorter. The costs and maintenance expenses of these two copiers are given as follows. These cash flows are expressed in real terms. Copier XX40 RH45 Year 0 $700 900 Year 1 $100 110 Year 2 $100 110 Year 3 $100 110 Year 4 $110 Year 5 $110 The inflation rate is 5 percent and the nominal discount rate is 14 percent. Assume that revenues are the same regardless of the copier, and that whichever copier the company chooses, it will buy the model forever. Which copier should the company choose? Ignore taxes and depreciation. 7.28 Fiber Glasses must choose between two kinds of facilities. Facility I costs $2.1 million and its economic life is seven years. The maintenance costs for facility I are $60,000 per year. Facility II costs $2.8 million and it lasts 10 years. The annual maintenance costs for facility II are $100,000 per year. Both facilities are fully depreciated by the straight-line method. The facilities will have no values after their economic lives. The corporate tax rate is 34 percent. Revenues from the facilities are the same. The company is assumed to earn a sufficient amount of revenues to generate tax shields from depreciation. If the appropriate discount rate is 10 percent, which facility should Fiber Glasses choose? 7.29 Pilot Plus Pens is considering when to replace its old machine. The replacement costs $3 million now and requires maintenance costs of $500,000 at the end of each year during the economic life of five years. At the end of five years the new machine would have a salvage value of $500,000. It will be fully depreciated by the straight-line method. The corporate tax rate is 34 percent and the appropriate discount rate is 12 percent. Maintenance cost, salvage value, depreciation, and book value of the existing machine are given as follows. Book Value (end of year) $1,000,000 800,000 600,000 400,000 200,000 Year 0 1 2 3 4 Maintenance $ 400,000 1,500,000 1,500,000 2,000,000 2,000,000 Salvage $2,000,000 1,200,000 800,000 600,000 400,000 Depreciation $200,000 200,000 200,000 200,000 200,000 The company is assumed to earn a sufficient amount of revenues to generate tax shields from depreciation. When should the company replace the machine? 7.30 Gold Star Industries is in need of computers. They have narrowed the choices to the SAL 5000 and the DET 1000. They would need 10 SALs. Each SAL costs $3,750 and requires $500 of maintenance each year. At the end of the computer's eight-year life Gold Star expects to be able to sell each one for $500. On the other hand, Gold Star could buy eight DETs. DETs cost $5,250 each and each machine requires $700 of maintenance every year. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 203 Chapter 7 Net Present Value and Capital Budgeting 197 They last for six years and have a resale value of $600 for each one. Whichever model Gold Star chooses, it will buy that model forever. Ignore tax effects, and assume that maintenance costs occur at year-end. Which model should they buy if the appropriate discount rate is 11 percent? 7.31 BYO University is faced with the decision of which word processor to purchase for its typing pool. It can buy 10 Bang word processors which cost $8,000 each and have estimated annual, year-end maintenance costs of $2,000 per machine. The Bang word processors will be replaced at the end of year 4 and have no value at that time. Alternatively, BYO could buy 11 IOU word processors to accomplish the same work. The IOU word processors would need to be replaced after three years. They cost only $5,000 each, but annual, year-end maintenance costs will be $2,500 per machine. A reasonable forecast is that each IOU word processor will have a resale value of $500 at the end of three years. The university's opportunity cost of funds for this type of investment is 14 percent. Because the university is a nonprofit institution, it does not pay taxes. It is anticipated that whichever manufacturer is chosen now will be the supplier of future machines. Would you recommend purchasing 10 Bang word processors or 11 IOU machines? 7.32 Station WJXT is considering the replacement of its old, fully depreciated sound mixer. Two new models are available. Mixer X has a cost of $400,000, a five-year expected life, and after-tax cash flow savings of $120,000 per year. Mixer Y has a cost of $600,000, an eight-year life, and after-tax cash flow savings of $130,000 per year. No new technological developments are expected. The cost of capital is 11 percent. Should WJXT replace the old mixer with X or Y? 7.33 Kaul Construction must choose between two pieces of equipment. Tamper A costs $600,000 and it will last five years. This tamper will require $110,000 of maintenance each year. Tamper B costs $750,000, but it will last seven years. Maintenance costs for Tamper B are $90,000 per year. Kaul incurs all maintenance costs at the end of the year. The appropriate discount rate for Kaul Construction is 12 percent. a. Which machine should Kaul purchase? b. What assumptions are you making in your analysis for part (a)? 7.34 Philben Pharmaceutics must decide when to replace its autoclave. Philben's current autoclave will require increasing amounts of maintenance each year. The resale value of the equipment falls every year. The following table presents this data. Year Today 1 2 3 4 5 Maintenance Costs $ 0 200 275 325 450 500 Resale Value $900 850 775 700 600 500 Philben can purchase a new autoclave for $3,000. The new equipment will have an economic life of six years. At the end of each of those years, the equipment will require $20 of maintenance. Philben expects to be able to sell the machine for $1,200 at the end of six years. Assume that Philben will pay no taxes. The appropriate discount rate for this decision is 10 percent. When should Philben replace its current machine? 7.35 (Challenge) A firm considers an investment of $28,000,000 (purchase price) in new equipment to replace old equipment that has a book value of $12,000,000 (market value of $20,000,000). If the firm replaces the old equipment with the new equipment, it expects to save $17,500,000 in pretax cash flow (net savings) savings the first year and an additional 12 percent (more than the previous year) per year for each of the following three years (total of four years). The old equipment has a four-year remaining life, being written off on a straight-line depreciation basis with no expected salvage value. The new equipment will 204 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 198 Part II Value and Capital Budgeting be depreciated under the MACRS system (which uses a double-declining balance approach, the half-year convention in year 1, and the option to switch to straight-line when it is beneficial) using a three-year life. In addition, it is assumed that replacement of the old equipment with the new equipment would require an increase in working capital of $5,000,000, which would not be recovered until the end of the four-year investment. If the relevant tax rates is 40 percent, find: a. The net investment (time 0 cash flow). b. The after-tax cash flow for each period. c. The internal rate of return, the net present value, and the profitability index. CASE STUDY: Goodweek Tires, Inc. A fter extensive research and development, Goodweek Tires, Inc., has recently developed a new tire, the SuperTread, and must decide whether to make the investment necessary to produce and market the SuperTread.The tire would be ideal for drivers doing a large amount of wet weather and off-road driving in addition to its normal freeway usage.The research and development costs so far total about $10 million. The SuperTread would be put on the market beginning this year and Goodweek expects it to stay on the market for a total of four years.Test marketing costing $5 million shows that there is a significant market for a SuperTread-type tire. As a financial analyst at Goodweek Tires, you are asked by your CFO, Mr.Adam Smith, to evaluate the SuperTread project and provide a recommendation on whether to go ahead with the investment.You are informed that all previous investments in the SuperTread are sunk costs and only future cash flows should be considered. Except for the initial investment which will occur immediately, assume all cash flows will occur at year-end. Goodweek must initially invest $120 million in production equipment to make the SuperTread. The equipment is expected to have a seven-year useful life.This equipment can be sold for $51,428,571 at the end of four years. Goodweek intends to sell the SuperTread to two distinct markets: 1. The Original Equipment Manufacturer (OEM) Market The OEM market consists primarily of the large automobile companies (e.g., General Motors) who buy tires for new cars. In the OEM market, the SuperTread is expected to sell for $36 per tire.The variable cost to produce each tire is $18. 2. The Replacement Market The replacement market consists of all tires purchased after the automobile has left the factory.This market allows higher margins and Goodweek expects to sell the SuperTread for $59 per tire there.Variable costs are the same as in the OEM market. Goodweek Tires intends to raise prices at 1 percent above the inflation rate.Variable costs will also increase 1 percent above the inflation rate. In addition, the SuperTread project will incur $25 million in marketing and general administration costs the first year (this figure is expected to increase at the inflation rate in the subsequent years). Goodweek's corporate tax rate is 40 percent.Annual inflation is expected to remain constant at 3.25 percent.The company uses a 15.9 percent discount rate to evaluate new product decisions. The tire market Automotive industry analysts expect automobile manufacturers to produce 2 million new cars this year and production to grow at 2.5 percent per year thereafter. Each new car needs four tires (the spare tires are undersized and are in a different category). Goodweek Tires expects the SuperTread to capture 11 percent of the OEM market. Industry analysts estimate that the replacement tire market size will be 14 million tires this year and that it will grow at 2 percent annually. Goodweek expects the SuperTread to capture an 8 percent market share. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 7. Net Present Value and Capital Budgeting The McGraw-Hill Companies, 2002 205 Chapter 7 Net Present Value and Capital Budgeting 199 You decide to use the MACRS depreciation schedule (seven-year property class).You also decide to consider net working capital (NWC) requirements in this scenario. The immediate initial working capital requirement is $11 million, and thereafter the net working capital requirements will be 15 percent of sales.What will be the NPV, payback period, discounted payback period, AAR, IRR, and PI on this project? Appendix 7A DEPRECIATION The Baldwin case made some assumptions about depreciation. Where did these assumptions come from? Assets are currently depreciated for tax purposes according to the provisions of the 1986 Tax Reform Act. There are seven classes of depreciable property. The three-year class includes certain specialized short-lived property. Tractor units and racehorses over two years old are among the very few items fitting into this class. The five-year class includes (a) cars and trucks; (b) computers and peripheral equipment, as well as calculators, copiers, and typewriters; and (c) specific items used for research purposes. The seven-year class includes office furniture, equipment, books, and single-purpose agricultural structures. It is also a catch-all category, because any asset not designated to be in another class is included here. The 10-year class includes vessels, barges, tugs, and similar equipment related to water transportation. The 15-year class encompasses a variety of specialized items. Included are equipment of telephone distribution plants and similar equipment used for voice and data communications, and sewage treatment plants. The 20-year class includes farm buildings, sewer pipe, and other very long-lived equipment. Real property that is depreciable is separated into two classes: residential and nonresidential. The cost of residential property is recovered over 271/2 years and nonresidential property over 311/2 years. Items in the three-, five-, and seven-year classes are depreciated using the 200-percent declining-balance method, with a switch to straight-line depreciation at a point specified in the Tax Reform Act. Items in the 15- and 20-year classes are depreciated using the 150-percent declining-balance method, with a switch to straight-line depreciation at a specified point. All real estate is depreciated on a straight-line basis. All calculations of depreciation include a half-year convention, which treats all property as if it were placed in service at midyear. To be consistent, the IRS allows half a year of depreciation for the year in which property is disposed of or retired. The effect of this is to spread the deductions for property over one year more than the name of its class, for example, six tax years for five-year property. 206 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 8 CHAPTER Strategy and Analysis in Using Net Present Value EXECUTIVE SUMMARY T he previous chapter discussed how to identify the incremental cash flows involved in capital budgeting decisions. In this chapter we look more closely at what it is about a project that produces a positive net present value (NPV). The process of asking about the sources of positive NPV in capital budgeting is often referred to as corporate strategy analysis. We talk about corporate strategy analysis in the first part of the chapter. Next, we consider several analytical tools that help managers deal with the effects of uncertainty on incremental cash flows. The concepts of decision trees, scenario analysis, and break-even analysis are discussed. 8.1 CORPORATE STRATEGY AND POSITIVE NPV The intuition behind discounted cash flow analysis is that a project must generate a higher rate of return than the one that can be earned in the capital markets. Only if this is true will a project's NPV be positive. A significant part of corporate strategy analysis is seeking investment opportunities that can produce positive NPV. Simple "number crunching" in a discounted cash flow analysis can sometimes erroneously lead to a positive NPV calculation. In calculating discounted cash flows, it is always useful to ask: What is it about this project that produces a positive NPV? or Where does the positive NPV in capital budgeting come from? In other words, we must be able to point to the specific sources of positive increments to present value in doing discounted cash flow analysis. In general, it is sensible to assume that positive NPV projects are hard to find and that most project proposals are "guilty until proven innocent." Here are some ways that firms create positive NPV: 1. Be the first to introduce a new product. 2. Further develop a core competency to produce goods or services at lower cost than competitors. 3. Create a barrier that makes it difficult for other firms to compete effectively. 4. Introduce variations on existing products to take advantage of unsatisfied demand. 5. Create product differentiation by aggressive advertising and marketing networks. 6. Use innovation in organizational processes to do all of the above. This is undoubtedly a partial list of potential sources of positive NPV. However, it is important to keep in mind the fact that positive NPV projects are probably not common. Our basic economic intuition should tell us that it will be harder to find positive NPV projects in a competitive industry than a noncompetitive industry. Now we ask another question: How can someone find out whether a firm is obtaining positive NPV from its operating and investment activities? First we talk about how share Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 207 Chapter 8 Strategy and Analysis in Using Net Present Value 201 HOW TO CREATE POSITIVE NPV Type of Action Introduce new product Develop core technology Examples Apple Corp. introduction of the first personal computer in 1976 Honda's mastery of small-motor technology to efficiently produce automobiles, motorcycles, and lawn mowers Qualcomm patents on proprietary technology in CDMA wireless communication Chrysler's introduction of the minivan Coca-Cola's use of advertising: "It's the real thing" Motorola's use of "Japanese management practice," including "just in time" inventory procurement, consensus decision making, and performance-based incentive systems Yahoo! Inc.'s use of banner advertisements on the web and the digital distribution of new services Create barrier to entry Introduce variations on existing products Create product differentiation Utilize organizational innovation Exploit new technology prices are related to long-term and short-term decision making. Next we explain how managers can find clues in share price behavior on whether they are making good decisions. Corporate Strategy and the Stock Market There should be a connection between the stock market and capital budgeting. If a firm invests in a project that is worth more than its cost, the project will produce positive NPV, and the firm's stock price should go up. However, the popular financial press frequently suggests that the best way for a firm to increase its share price is to report high short-term earnings (even if by doing so it "cooks the books"). As a consequence, it is often said that U.S. firms tend to reduce capital expenditures and research and development in order to increase short-term profits and stock prices.1 Moreover, it is claimed that U.S. firms that have valid long-term goals and undertake long-term capital budgeting at the expense of short-term profits are hurt by shortsighted stock market reactions. Sometimes institutional investors are blamed for this state of affairs. By contrast, Japanese firms are said to have a long-term perspective and make the necessary investments in research and development to provide a competitive edge against U.S. firms. Of course, these claims rest, in part, on the assumption that the U.S. stock market systematically overvalues short-term earnings and undervalues long-term earnings. The available evidence suggests the contrary. McConnell and Muscarella looked closely at the effect of corporate investment on the market value of equity.2 They found that, for most industrial See Judith H. Dobrznyski, "More than Ever, It's Management for the Short Term," Business Week (November 24, 1986), p. 92. In this article Andrew Sigler, CEO of Champion International, is quoted as saying that U.S. managers are under great pressure to avoid long-term investments and to produce short-term earnings. 2 1 John J. McConnell and Chris J. Muscarella, "Corporate Capital Expenditure Decisions and the Market Value of the Firm," Journal of Financial Economics (September 1985), pp. 399422. 208 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 202 Part II Value and Capital Budgeting firms, announcements of increases in planned capital spending were associated with significant increases in the market value of the common stock and that announcements of decreases in capital spending had the opposite effect. The McConnell and Muscarella research suggests that the stock market does pay close attention to corporate capital spending and it reacts positively to firms making long-term investments. In another highly regarded study, Woolridge studied the stock market reaction to the strategic capital spending programs of several hundred U.S. firms.3 He looked at firms announcing joint ventures, research and development spending, new-product strategies, and capital spending for expansion and modernization. He found a strong positive stock reaction to these types of announcements. This finding provides significant support for the notion that the stock market encourages managers to make long-term strategic investment decisions in order to maximize shareholders' value. It strongly opposes the viewpoint that markets and managers are myopic. CASE STUDY: How Firms Can Learn about NPV from the Stock Market: The AT&T Decision to Acquire NCR and to Change Its CEO asic economic common sense tells us that the market value of a firm's outstanding shares reflects the stock market's assessment of future cash flows from the firm's investing activities. Therefore, it is not surprising that the stock market usually reacts positively to the proposed capital budgeting programs of U.S. firms. However, this is not always the case. Sometimes the stock market provides negative clues to a new project's NPV. Consider AT&T's repeated attempts to penetrate the computer-manufacturing industry. On December 6, 1990, AT&T made a $90 per share or $6.12 billion cash offer for all of NCR Corporation's common stock. From December 4, 1990, to December 11, 1990, AT&T's stock dropped from $303/8 per share to $291/2, representing a loss of about $1 billion to the shareholders of AT&T. Five months later, when these firms finally agreed to a deal, AT&T's stock dropped again. Why did AT&T buy NCR, a large computer manufacturer? Why did the stock market reaction suggest that the acquisition was a negative NPV investment for AT&T? AT&T was apparently convinced that the telecommunications and computer industries were becoming one industry. AT&T's basic idea was that telephone switches are big computers and success in computers means success in telephones. The message from the stock market is that AT&T could be wrong. That is, making computers is basically a manufacturing business and telephone communications is basically a service business. The core competency4 of making computers (efficient manufacturing) is different from that of providing telecommunications for business (service support and software). Of course, even if AT&T had acquired NCR for the "right" reasons, it is possible that it paid too much. The negative stock market reaction suggests that AT&T shareholders believed that NCR was worth less than its cost to AT&T. On September 20, 1995, when AT&T announced its intention to spin off NCR (as well as Lucent), its stock price increased by about 11 percent. On the other hand, when it was announced, on November 5, 1992, that AT&T was negotiating the purchase of one-third of McCaw Cellular Communications with the option to obtain voting control, B J. Randall Woolridge, "Competitive Decline: Is a Myopic Stock Market to Blame?" Journal of Applied Corporate Finance (Spring 1988), pp. 2636. Another interesting study has been conducted by Su Han Chan, John Martin, and John Kensinger, "Corporate Research and Development Expenditures and Share Value," Journal of Financial Economics 26 (1990), pp. 25576. They report that the share-price responses to announcements of increased research and development are significantly positive, even when the firm's earnings were decreasing. 4 3 Gregg Jarrell, ("For a Higher Share Price, Focus Your Business," The Wall Street Journal, September 13, 1991) reports that an increase in "focus" by a firm is typically associated with increases in its share price. Those companies that reduced their number of business lines from 1979 to 1988 had better stock market performance than other firms. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 209 Chapter 8 Strategy and Analysis in Using Net Present Value 203 AT&T's stock price jumped from $426/8 to $443/8, representing a gain in market value close to $2 billion. Two years later, the Federal Communications Commission approved the acquisition of all of McCaw by AT&T, and AT&T's stock price was holding at over $55 per share. The positive stock market reaction suggests that the shareholders of AT&T believe that AT&T's acquisition of McCaw is a positive NPV decision. AT&T could use McCaw's cellular telephone network to bypass local telephone companies for completing long distance telephone calls, eliminating the access fees normally paid to them. Perhaps because of AT&T's spotty acquisition record, its stock price rose 13.5 percent when on October 17, 1997, it was learned that Robert Allen would step down and Michael Armstrong would become the new CEO. On June 24, 1998, when it was disclosed that AT&T appeared close to a deal to acquire TCI for $30 billion, AT&T's stock jumped 4 percent.The market believed that by buying TCI, which owned a large portfolio of cable lines, AT&T might be able to bypass the local phone monopolies of the "baby bells." TCI would offer AT&T a detour around the "last mile" and ultimately be part of AT&T's broadband strategy. AT&T's market share of long-distance business continues to fall and there have been reports of pressure by the credit rating agencies for it to reduce its $62 billion of debt and $3 billion of interest costs. AT&T's stock price fell by more than 60 percent during the year 2000, a year that included AT&T's announced breakup into three companies: wireless, broadband, and business services. The stock market appeared to be very skeptical of AT&T's ability to carry out its long term strategy. At the end of the year, it was reported that AT&T was expected to reduce its dividend by about 60 percent from its current level. This would be the first time in the company's more than 100-year history that it had cut its dividend. Upon the report of a dividend cut, AT&T's stock price increased. Overall, the evidence suggests that firms can use the stock market to help potentially shortsighted managers make positive net present value decisions. Unfortunately only a few firms use the market as effectively as they could to help them make capital budgeting decisions. QUESTIONS CONCEPT ? What are the ways a firm can create positive NPV projects? How can managers use the market to help them screen out negative NPV projects? 8.2 DECISION TREES We have considered potential sources of value in NPV analysis. Moreover, we pointed out that there is a connection between the stock market and a firm's capital budgeting decisions. A savvy CEO can learn from the stock market. Now our interest is in coming up with estimates of NPV for a proposed project. A fundamental problem in NPV analysis is dealing with uncertain future outcomes. Furthermore, there is usually a sequence of decisions in NPV project analysis. This section introduces the device of decision trees for identifying the sequential decisions in NPV analysis. Imagine you are the treasurer of the Solar Electronics Corporation (SEC), and the engineering group has recently developed the technology for solar-powered jet engines. The jet engine is to be used with 150-passenger commercial airplanes. The marketing staff has proposed that SEC develop some prototypes and conduct test marketing of the engine. A corporate planning group, including representatives from production, marketing, and engineering, has recommended that the firm go ahead with the test and development phase. They estimate that this preliminary phase will take a year and will cost $100 million. Furthermore, the group believes there is a 75-percent chance that the reproduction and marketing tests will prove successful. Based on its experience in the industry, the company has a fairly accurate idea of how much the development and testing expenditures will cost. Sales of jet engines, however, are subject to (1) uncertainty about the demand for air travel in the future, (2) uncertainty about 210 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 204 Part II Value and Capital Budgeting I TA B L E 8.1 Cash Flow Forecasts for Solar Electronics Corporation's Jet Engine Base Case (millions)* Investment Revenues Variable costs Fixed costs Depreciation Pretax profit Tax (Tc 0.34) Net profit Cash flow Initial investment costs Year 1 Year 2 $6,000 (3,000) (1,791) (300) _____ 909 (309) _____ _____ $ 600 $ 900 $1,500 *Assumptions: (1) Investment is depreciated in years 2 through 6 using the straight-line method; (2) tax rate is 34 percent; (3) the company receives no tax benefits on initial development costs. future oil prices, (3) uncertainty about SEC's market share for engines for 150-passenger planes, and (4) uncertainty about the demand for 150-passenger planes relative to other sizes. Future oil prices will have a substantial impact on when airlines replace their existing fleets of Boeing 727 jets, because the 727s are much less fuel efficient compared with the new jets that will be produced over the next five years. If the initial marketing tests are successful, SEC can acquire some land, build several new plants, and go ahead with full-scale production. This investment phase will cost $1,500 million. Production will occur over the next five years. The preliminary cash flow projection appears in Table 8.1. Should SEC decide to go ahead with investment and production on the jet engine, the NPV at a discount rate of 15 percent (in millions) is NPV $1,500 $1,500 $1,517 Note that the NPV is calculated as of date 1, the date at which the investment of $1,500 million is made. Later we bring this number back to date 0. If the initial marketing tests are unsuccessful, SEC's $1,500 million investment has an NPV of $3,611 million. (You will see how to calculate this number in the section.) This figure is also calculated as of date 1. Figure 8.1 displays the problem concerning the jet engine as a decision tree. If SEC decides to conduct test marketing, there is a 75-percent probability that the test marketing will be successful. If the tests are successful, the firm faces a second decision: whether to invest $1,500 million in a project that yields $1,517 million NPV or to stop. If the tests are unsuccessful, the firm faces a different decision: whether to invest $1,500 million in a project that yields $3,611 million NPV or to stop. $900 t t 1 1.15 5 $900 A0.15 5 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 211 Chapter 8 Strategy and Analysis in Using Net Present Value 205 I F I G U R E 8.1 Decision Tree ($ millions) for SEC Now Test and development $100 1 year Initial investment $1,500 2 years Production NPV = $1,517 Invest Success Test Do not invest NPV = 0 Do not invest Failure Invest NPV = $3,611 Do not test Open circles represent decision points; closed circles represent receipt of information. As can be seen from Figure 8.1, SEC has the following two decisions to make: 1. Whether to test and develop the solar-powered jet engine. 2. Whether to invest for full-scale production following the results of the test. One makes decisions in reverse order with decision trees. Thus, we analyze the secondstage investment of $1,500 million first. If the tests are successful, it is obvious that SEC should invest, because $1,517 million is greater than zero. Just as obviously, if the tests are unsuccessful, SEC should not invest. Now we move back to the first stage, where the decision boils down to a simple question: Should SEC invest $100 million now to obtain a 75-percent chance of $1,517 million one year later? The expected payoff evaluated at date 1 (in millions) is Expected payoff Probability of success (0.75 $1,138 Payoff if successful $1,517) Probability of failure (0.25 Payoff if failure $0) The NPV of testing computed at date 0 (in millions) is NPV $100 $890 Thus, the firm should test the market for solar-powered jet engines. Warning 1 We have used a discount rate of 15 percent for both the testing and the investment decisions. Perhaps a higher discount rate should have been used for the initial testmarketing decision, which is likely to be riskier than the investment decision. Warning 2 It was assumed that after making the initial investment to produce solar engines and then being confronted with a low demand, SEC could lose money. This worstcase scenario leads to an NPV of $3,611 million. This is an unlikely eventuality. Instead, $1,138 1.15 212 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 206 Part II Value and Capital Budgeting it is more plausible to assume that SEC would try to sell its initial investment--patents, land, buildings, machinery, and prototypes--for $1,000 million. For example, faced with low demand, suppose SEC could scrap the initial investment. In this case, it would lose $500 million of the original investment. This is much better than if it produced the solarpowered jet engines and generated a negative NPV of $3,611 million. It is hard for decision trees to capture all of the managerial options in changing environments. QUESTIONS CONCEPT ? What is a decision tree? What are two potential problems in using decision trees? 8.3 SENSITIVITY ANALYSIS, SCENARIO ANALYSIS, AND BREAK-EVEN ANALYSIS One thrust of this book is that NPV analysis is a superior capital budgeting technique. In fact, because the NPV approach uses cash flows rather than profits, uses all the cash flows, and discounts the cash flows properly, it is hard to find any theoretical fault with it. However, in our conversations with practical businesspeople, we hear the phrase "a false sense of security" frequently. These people point out that the documentation for capital budgeting proposals is often quite impressive. Cash flows are projected down to the last thousand dollars (or even the last dollar) for each year (or even each month). Opportunity costs and side effects are handled quite properly. Sunk costs are ignored--also quite properly. When a high net present value appears at the bottom, one's temptation is to say yes immediately. Nevertheless, the projected cash flow often goes unmet in practice, and the firm ends up with a money loser. Sensitivity Analysis and Scenario Analysis How can the firm get the net-present-value technique to live up to its potential? One approach is sensitivity analysis (a.k.a. what-if analysis and bop analysis5). This approach examines how sensitive a particular NPV calculation is to changes in underlying assumptions. We illustrate the technique with Solar Electronics' solar-powered jet engine from the previous section. As pointed out earlier, the cash flow forecasts for this project appear in Table 8.1. We begin by considering the assumptions underlying revenues, costs, and aftertax cash flows shown in the table. Revenues Sales projections for the proposed jet engine have been estimated by the marketing department as Number of jet engines sold 3,000 Sales revenues $6,000 million 5 Market Share 0.30 Number of jet engines sold 3,000 Size of jet engine market 10,000 Price per engine $2 million Bop stands for best, optimistic, pessimistic. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 213 Chapter 8 Strategy and Analysis in Using Net Present Value 207 Thus, it turns out that the revenue estimates depend on three assumptions. 1. Market share. 2. Size of jet engine market. 3. Price per engine. Costs Financial analysts frequently divide costs into two types: variable costs and fixed costs. Variable costs change as the output changes, and they are zero when production is zero. Costs of direct labor and raw materials are usually variable. It is common to assume that variable costs are proportional to production. A typical variable cost is one that is constant per unit of output. For example, if direct labor is variable and one unit of final output requires $10 of direct labor, then 100 units of final output should require $1,000 of direct labor. Fixed costs are not dependent on the amount of goods or services produced during the period. Fixed costs are usually measured as costs per unit of time, such as rent per month or salaries per year. Naturally, fixed costs are not fixed forever. They are only fixed over a predetermined time period. Variable costs per unit produced have been estimated by the engineering department at $1 million. Fixed costs are $1,791 million per year. The cost breakdowns are Variable cost $3,000 million Total cost before taxes $4,791 million Variable cost per unit $1 million Variable cost $3,000 million Number of jet engines sold 3,000 Fixed cost $1,791 million The above estimates for market size, market share, price, variable cost, and fixed cost, as well as the estimate of initial investment, are presented in the middle column of Table 8.2. These figures represent the firm's expectations or best estimates of the different parameters. For purposes of comparison, the firm's analysts prepared both optimistic and pessimistic forecasts for the different variables. These are also provided in the table. Standard sensitivity analysis calls for an NPV calculation for all three possibilities of a single variable, along with the expected forecast for all other variables. This procedure is illustrated in Table 8.3. For example, consider the NPV calculation of $8,154 million provided in the upper right-hand corner of this table. This occurs when the optimistic forecast of 20,000 units per year is used for market size. However, the expected forecasts from Table 8.2 are employed for all other variables when the $8,154 million figure is generated. Note that I TA B L E 8.2 Different Estimates for Solar Electronics' Solar Plane Variable Market size (per year) Market share Price Variable cost (per plane) Fixed cost (per year) Investment Pessimistic 5,000 20% $1.9 million $1.2 million $1,891 million $1,900 million Expected or Best 10,000 30% $2 million $1 million $1,791 million $1,500 million Optimistic 20,000 50% $2.2 million $0.8 million $1,741 million $1,000 million 214 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 208 Part II Value and Capital Budgeting I TA B L E 8.3 NPV Calculations as of Date 1 (in $ millions) for the Solar Plane Using Sensitivity Analysis Expected or Best $1,517 1,517 1,517 1,517 1,517 1,517 Pessimistic Market size Market share Price Variable cost Fixed cost Investment $1,802* 696* 853 189 1,295 1,208 Optimistic $8,154 5,942 2,844 2,844 1,628 1,903 Under sensitivity analysis, one input is varied while all other inputs are assumed to meet their expectation. For example, an NPV of $1,802 occurs when the pessimistic forecast of 5,000 is used for market size. However, the expected forecasts from Table 8.2 are used for all other variables when $1,802 is generated. *We assume that the other divisions of the firm are profitable, implying that a loss on this project can offset income elsewhere in the firm. The firm reports a loss to the IRS in these two cases. Thus, the loss on the project generates a tax rebate to the firm. the same number of $1,517 million appears in each row of the middle column of Table 8.3. This occurs because the expected forecast is used for the variable that was singled out, as well as for all other variables. A table such as Table 8.3 can be used for a number of purposes. First, taken as a whole, the table can indicate whether NPV analysis should be trusted. In other words, it reduces the false sense of security we spoke of earlier. Suppose that NPV is positive when the expected forecast for each variable is used. However, further suppose that every number in the pessimistic column is wildly negative and every number in the optimistic column is wildly positive. Even a single error in this forecast greatly alters the estimate, making one leery of the net present value approach. A conservative manager might well scrap the entire NPV analysis in this case. Fortunately, this does not seem to be the case in Table 8.3, because all but two of the numbers are positive. Managers viewing the table will likely consider NPV analysis to be useful for the solar-powered jet engine. Second, sensitivity analysis shows where more information is needed. For example, error in the investment appears to be relatively unimportant because even under the pessimistic scenario, the NPV of $1,208 million is still highly positive. By contrast, the pessimistic forecast for market share leads to a negative NPV of $696 million, and a pessimistic forecast for market size leads to a substantially negative NPV of $1,802 million. Because the effect of incorrect estimates on revenues is so much greater than the effect of incorrect estimates on costs, more information on the factors determining revenues might be needed. Unfortunately, sensitivity analysis suffers from some drawbacks. For example, sensitivity analysis may unwittingly increase the false sense of security among managers. Suppose all pessimistic forecasts yield positive NPVs. A manager might feel that there is no way the project can lose money. Of course, the forecasters may simply have an optimistic view of a pessimistic forecast. To combat this, some companies do not treat optimistic and pessimistic forecasts subjectively. Rather, their pessimistic forecasts are al- Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 215 Chapter 8 Strategy and Analysis in Using Net Present Value 209 I TA B L E 8.4 Cash Flow Forecast (in $ millions) under the Scenario of a Plane Crash* Year 1 Revenues Variable costs Fixed costs Depreciation Pretax profit Tax (Tc 0.34) Net profit Cash flow Initial investment cost *Assumptions are Market size Market share 7,000 (70 percent of expectation) 20% (2/3 of expectation) Years 26 $2,800 1,400 1,791 300 691 235 456 156 $1,500 Forecasts for all other variables are the expected forecasts as given in Table 8.2. Tax loss offsets income elsewhere in firm. ways, say, 20 percent less than expected. Unfortunately, the cure in this case may be worse than the disease, because a deviation of a fixed percentage ignores the fact that some variables are easier to forecast than others. In addition, sensitivity analysis treats each variable in isolation when, in reality, the different variables are likely to be related. For example, if ineffective management allows costs to get out of control, it is likely that variable costs, fixed costs, and investment will all rise above expectation at the same time. If the market is not receptive to a solar plane, both market share and price should decline together. Managers frequently perform scenario analysis, a variant of sensitivity analysis, to minimize this problem. Simply put, this approach examines a number of different likely scenarios, where each scenario involves a confluence of factors. As a simple example, consider the effect of a few airline crashes. These crashes are likely to reduce flying in total, thereby limiting the demand for any new engines. Furthermore, even if the crashes did not involve solar-powered aircraft, the public could become more averse to any innovative and controversial technologies. Hence, SEC's market share might fall as well. Perhaps the cash flow calculations would look like those in Table 8.4 under the scenario of a plane crash. Given the calculations in the table, the NPV (in millions) would be $2,023 $1,500 $156 A5 0.15 A series of scenarios like this might illuminate issues concerning the project better than a standard application of sensitivity analysis would. Break-Even Analysis Our discussion of sensitivity analysis and scenario analysis suggests that there are many ways to examine variability in forecasts. We now present another approach, break-even analysis. As its name implies, this approach determines the sales needed to break even. The approach is a useful complement to sensitivity analysis, because it also sheds light on the severity of incorrect forecasts. We calculate the break-even point in terms of both accounting profit and present value. 216 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 210 Part II Value and Capital Budgeting Accounting Profit Net profit under four different sales forecasts is Unit Sales 0 1,000 3,000 10,000 Net Profit (in $ millions) $1,380 720 600 5,220 A more complete presentation of costs and revenues appears in Table 8.5. We plot the revenues, costs, and profits under the different assumptions about sales in Figure 8.2. The revenue and cost curves cross at 2,091 jet engines. This is the break-even point, in other words, the point where the project generates no profits or losses. As long as sales are above 2,091 jet engines, the project will make a profit. This break-even point can be calculated very easily. Because the sales price is $2 million per engine and the variable cost is $1 million per engine,6 the after-tax difference per engine is (Sales price Variable cost) (1 Tc) ($2 million $1 million) (1 0.34) $0.66 million where Tc is the corporate tax rate of 34 percent. This after-tax difference is called the contribution margin because it is the amount that each additional engine contributes to aftertax profit. Fixed costs are $1,791 million and depreciation is $300 million, implying that the after-tax sum of these costs is (Fixed costs Depreciation) (1 Tc) ($1,791 million $300 million) (1 0.34) $1,380 million I TA B L E 8.5 Revenues and Costs of Project under Different Sales Assumptions (in $ millions, except unit sales) Year 1 Initial Investment $1,500 1,500 1,500 1,500 Annual Unit Sales 0 1,000 3,000 10,000 Variable Costs $ 0 1,000 3,000 10,000 Years 26 Fixed Costs $1,791 1,791 1,791 1,791 DepreciTaxes* ation (Tc 0.34) $300 300 300 300 $ 711 371 309 2,689 Net Profits $1,380 720 600 5,220 Operating Cash Flows $1,080 420 900 5,520 NPV (evaluated date 1) $ 5,120 2,908 1,517 17,004 Revenues $ 0 2,000 6,000 20,000 *Loss is incurred in the first two rows. For tax purposes, this loss offsets income elsewhere in the firm. 6 Though the previous section considered both optimistic and pessimistic forecasts for sales price and variable cost, break-even analysis only works with the expected or best estimates of these variables. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 217 Chapter 8 Strategy and Analysis in Using Net Present Value 211 I F I G U R E 8.2 Break-Even Point Using Accounting Numbers $ millions Total revenues Total costs Variable costs $4,182 Fixed costs 2,091 $2,091 (including depreciation) Output (in terms of sales units) That is, the firm incurs costs of $1,380 million, regardless of the number of sales. Because each engine contributes $0.66 million, sales must reach the following level to offset the above costs: Accounting Profit Break-Even Point: Fixed costs Sales price Depreciation Variable costs 1 1 Tc Tc $1,380 million $0.66 million 2,091 Thus, 2,091 engines is the break-even point required for an accounting profit. Present Value As we stated many times in the text, we are more interested in present value than we are in net profits. Therefore, we must calculate the present value of the cash flows. Given a discount rate of 15 percent, we have Unit Sales 0 1,000 3,000 10,000 NPV ($ millions) 5,120 2,908 1,517 17,004 These NPV calculations are reproduced in the last column of Table 8.5. We can see that the NPV is negative if SEC produces 1,000 jet engines and positive if it produces 3,000 jet engines. Obviously, the zero NPV point occurs between 1,000 and 3,000 jet engines. The present value break-even point can be calculated very easily. The firm originally invested $1,500 million. This initial investment can be expressed as a five-year equivalent annual cost (EAC), determined by dividing the initial investment by the appropriate fiveyear annuity factor: EAC Initial investment 5-year annuity factor at 15% Initial investment A5 0.15 $1,500 million 3.3522 $447.5 million Note that the EAC of $447.5 million is greater than the yearly depreciation of $300 million. This must occur since the calculation of EAC implicitly assumes that the $1,500 million investment could have been invested at 15 percent. 218 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 212 Part II Value and Capital Budgeting After-tax costs, regardless of output, can be viewed as $1,528 million $447.5 million EAC $1,791 million Fixed costs 0.66 (1 Tc) $300 million Depreciation 0.34 Tc That is, in addition to the initial investment's equivalent annual cost of $447.5 million, the firm pays fixed costs each year and receives a depreciation tax shield each year. The depreciation tax shield is written as a negative number because it offsets the costs in the equation. Because each plane contributes $0.66 million to after-tax profit, it will take the following sales to offset the above costs: Present Value Break-Even Point: EAC Depreciation Fixed costs 1 Tc Sales price Variable costs 1 Tc Tc $1,528 million $0.66 million 2,315 Thus, 2,315 planes is the break-even point from the perspective of present value. Why is the accounting break-even point different from the financial break-even point? When we use accounting profit as the basis for the break-even calculation, we subtract depreciation. Depreciation for the solar-jet-engines project is $300 million. If 2,091 solar jet engines are sold, SEC will generate sufficient revenues to cover the $300 million depreciation expense plus other costs. Unfortunately, at this level of sales SEC will not cover the economic opportunity costs of the $1,500 million laid out for the investment. If we take into account that the $1,500 million could have been invested at 15 percent, the true annual cost of the investment is $447.5 million and not $300 million. Depreciation understates the true costs of recovering the initial investment. Thus, companies that break even on an accounting basis are really losing money. They are losing the opportunity cost of the initial investment. QUESTIONS CONCEPT ? What is a sensitivity analysis? Why is it important to perform a sensitivity analysis? What is a break-even analysis? Describe how sensitivity analysis interacts with break-even analysis. 8.4 OPTIONS The analysis we have presented so far is static. In fact, standard NPV analysis is somewhat static. Because corporations make decisions in a dynamic environment, they have options that should be considered in project valuation. The Option to Expand One of the most important options is the option to expand when economic prospects are good. The option to expand has value. Expansion pays off if demand is high. Recall the Solar Electronics Corporation (SEC) in Section 8.2. SEC's expenditure on the test-marketing program buys an option to produce new jet engines. This turned out to be a very valuable option. SEC had the option to produce new jet engines depending on the results of the test marketing. There are many real-world examples. In 1977 Saab was the first car maker to introduce turbo-charged automobile engines in its gasoline model. Sales of the Saab 900 almost doubled after the introduction. In response to this high demand, Saab has increased its capac- Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 219 Chapter 8 Strategy and Analysis in Using Net Present Value 213 ity and entered into joint ventures with other car makers to increase production. Now many automobile manufacturers use turbo chargers. The Option to Abandon The option to close a facility also has value. The SEC would not have been obligated to produce jet engines if the test-marketing results had been negative. Instead, SEC had the option to abandon the jet engine project if the results had been bad. Take the case of General Motors (GM). On December 19, 1991, GM announced plans to close 21 factories and cut 74,000 jobs by the end of 1995. It said that it also intended to sell non-auto assets. Faced with low demand for its automobiles, GM decided to scrap the investment it had made in automobile manufacturing capacity, and it will likely lose much of its original investment in the 21 factories. However, this outcome is much better than would have occurred if GM continued to operate these factories in a declining auto market. On the day the factory closing was announced, GM's stock was marginally down by $0.125 (from $27.875 to $27.75). The stock market reaction was a signal that GM had waited too long to close its factories and that the declining demand GM was encountering was greater than expected. However, the market was relieved that GM had finally abandoned money-losing factories. There is a special graveyard for abandoned products in the market for handheld computers. In October 1991, Momenta International Corporation introduced one of the very first handheld computers, a five-pound pen-based computer. Ten months later the company went bankrupt. Eo, a company backed by AT&T, demonstrated a new personal communicator in November 1992. The project was terminated in 1994. In January 1994, Motorola began shipping its Envoy, a wireless communicator. The computer was discontinued two years later. The point of our examples of failed handheld computer products is that a firm will frequently exercise its option of abandoning a project rather than keeping a money-losing product on the market in hopes that economic conditions will improve. Discounted Cash Flows and Options Conventional NPV analysis discounts a project's cash flows estimated for a certain project life. The decision is whether to accept the project or reject it. In practice, managers can expand or contract the scope of a project at various moments over its life. In theory, all such managerial options should be included in the project's value. The market value of the project (M) will be the sum of the NPV of the project without options to expand or contract and the value of the managerial options (Opt): M NPV Opt E XAMPLE Imagine two ways of producing Frisbees. Method A uses a conventional machine that has an active secondary market. Method B uses highly specialized machine tools for which there is no secondary market. Method B has no salvage value, but is more efficient. Method A has a salvage value, but is inefficient. If production of Frisbees goes on until the machines used in methods A and B are used up, the NPV of B will be greater than that of A. However, if there is some possibility that production of Frisbees will be stopped before the end of the useful life of the Frisbee-making machines, method A may well be better. Method A's higher value in the secondary market increases its NPV relative to B's. There is a valuable embedded option to abandoning Method A. 220 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 214 Part II Value and Capital Budgeting An Example Suppose we are analyzing a new product that will sell an expected 10 units a year in perpetuity at $10 net cash flow. In other words, we expect that cash flows will be $100 per year. At the end of the first year we will learn more about the economic viability of the new product. Specifically, we will know if the project will be a success or a failure. If the product is a success, unit sales will be revised to 20 and if the product is a failure, unit sales will be 0. Success and failure are equally likely. The discount rate is 10 percent and the initial investment outlay is $1,050. The dismantled equipment originally purchased for the project can be sold for scrap in one year for $500. A standard discount cash flow analysis of the new product is very straightforward. The expected cash flows are $100 per year and the discount rate is 10 percent. The NPV of the product is: $100/.10 $1,050 $50 So we shouldn't launch the new product. Correct? No! In one year we can sell out for $500 and we can learn more about the success or failure of our new product. If it is a success, we can continue to sell the product. But if it is a failure, we can abandon the product. The option to abandon in one year is valuable. In one year if the cash flows are revised to $0, the PV of the project will be $0 and we will abandon the product for $500. The NPV will be $500. On the other hand, if we learn that we can sell 20 of the products, the PV of future cash flows will be $200/.10 $2,000. The PV exceeds the abandonment value of $500. So we will continue to sell the product. To sum up, we now have a new product that costs $1,050 today. In one year we expect a cash flow of $100. After one year the new product will be worth either $500 (if we abandon the product) or $2,000 (if we continue to sell the product). These outcomes are equally likely so we expect the project to be worth $500 $2,000/2 $1,250. The bottom line is that in one year we expect to have $100 in cash plus a project worth $1,250. At a 10-percent discount the project is worth $1,227.27 so the NPV is $1,227.27 $1,050 $177.27. We should launch the new product! Notice the NPV of our new product has increased from $50 to $177.27 or, by $227.27. How did this happen? The original analysis implicitly assumed we would launch the new product even though it was a failure. Actually, when we took a closer look, we saw that we were $500 better off if we abandoned the product. There was a 50-percent probability of this happening. So the expected cash flow from abandonment is $250. The PV of this amount is $250/1.1 $227.27. The value of the option to abandon after one year is $227.27. Robichek and Van Horne and Dye and Long were among the first to recognize the abandonment value in project analysis.7 More recently, Myers and Majd constructed a model of abandonment based on an American put option with varying dividend yields and an uncertain exercise price.8 They present a numerical procedure for calculating abandonment value in problems similar to that of the Frisbee-making machine. 7 A. Robichek and J. Van Horne, "Abandonment Value and Capital Budgeting," Journal of Finance (December 1967); and E. Dye and H. Long, "Abandonment Value and Capital Budgeting: Comment," Journal of Finance (March 1969). 8 S. C. Myers and S. Majd, "Calculating Abandonment Value Using Option Pricing Theory." Unpublished manuscript (June 1985). Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 221 Chapter 8 Strategy and Analysis in Using Net Present Value 215 Brennan and Schwartz use a gold mine to illustrate the value of managerial operations.9 They show that the value of a gold mine will depend on management's ability to shut it down if the price of gold falls below a certain point, and the ability to reopen it subsequently if conditions are right. They show that valuation approaches that ignore these managerial options are likely to substantially underestimate the value of the project. There are both qualitative and quantitative approaches to adjusting for option value in capital budgeting decisions. Most firms use qualitative approaches, such as subjective judgment. However, quantitative approaches are gaining acceptance. We talk about the quantitative approaches in Chapters 21 and 22. 8.5 SUMMARY AND CONCLUSIONS This chapter discusses a number of practical applications of capital budgeting. 1. In Chapter 7, we observed how the net present value rule in capital budgeting is used. In Chapter 8, we ask about the sources of positive net present value and we explain what managers can do to create positive net present value. 2. Though NPV is the best capital budgeting approach conceptually, it has been criticized in practice for providing managers with a false sense of security. Sensitivity analysis shows NPV under varying assumptions, giving managers a better feel for the project's risks. Unfortunately, sensitivity analysis modifies only one variable at a time, while many variables are likely to vary together in the real world. Scenario analysis considers the joint movement of the different factors under different scenarios (e.g., war breaking out or oil prices skyrocketing). Finally, managers want to know how bad forecasts must be before a project loses money. Break-even analysis calculates the sales figure at which the project breaks even. Though break-even analysis is frequently performed on an accounting profit basis, we suggest that a net present value basis is more appropriate. 3. We talk about hidden options in doing discounted cash flow analysis of capital budgeting. We discuss the option to expand and the option to abandon. KEY TERMS Break-even analysis 209 Contribution margin 210 Decision trees 203 Fixed costs 207 Scenario analysis 209 Sensitivity analysis 206 Variable costs 207 9 M. J. Brennan and E. S. Schwartz, "A New Approach to Evaluating Natural Resource Investments," Midland Corporate Finance Journal 3 (Spring 1985). 222 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 216 Part II Value and Capital Budgeting SUGGESTED READING The classic article on break-even analysis is: Reinhart, U. E. "Breakeven Analysis for Lockheed's Tristar: An Application of Financial Theory." Journal of Finance (September 1977). QUESTIONS AND PROBLEMS Decision Trees 8.1 Sony Electronics, Inc., has developed a new type of VCR. If the firm directly goes to the market with the product, there is only a 50 percent chance of success. On the other hand, if the firm conducts test marketing of the VCR, it will take a year and will cost $2 million. Through the test marketing, however, the firm is able to improve the product and increase the probability of success to 75 percent. If the new product proves successful, the present value (at the time when the firm starts selling it) of the payoff is $20 million, while if it turns out to be a failure, the present value of the payoff is $5 million. Should the firm conduct test marketing or go directly to the market? The appropriate discount rate is 15 percent. 8.2 The marketing manager for a growing consumer products firm is considering launching a new product. To determine consumers' interest in such a product, the manager can conduct a focus group that will cost $120,000 and has a 70 percent chance of correctly predicting the success of the product, or hire a consulting firm that will research the market at a cost of $400,000. The consulting firm boasts a correct assessment record of 90 percent. Of course going directly to the market with no prior testing will be the correct move 50 percent of the time. If the firm launches the product, and it is a success, the payoff will be $1.2 million. Which action will result in the highest expected payoff for the firm? 8.3 Tandem Bicycles is noticing a decline in sales due to the increase of lower-priced import products from the Far East. The CFO is considering a number of strategies to maintain its market share. The options she sees are the following: Price the products more aggressively, resulting in a $1.3 million decline in cash flows. The likelihood that Tandem will lose no cash flows to the imports is 55 percent; there is a 45 percent probability that they will lose only $550,000 in cash flows to the imports. Hire a lobbyist to convince the regulators that there should be important tariffs placed upon overseas manufacturers of bicycles. This will cost Tandem $800,000 and will have a 75 percent success rate, that is, no loss in cash flows to the importers. If the lobbyists do not succeed, Tandem Bicycles will lose $2 million in cash flows. As the assistant to the CFO, which strategy would you recommend to your boss? Accounting Break-Even Analysis 8.4 Samuelson Inc. has invested in a facility to produce calculators. The price of the machine is $600,000 and its economic life is five years. The machine is fully depreciated by the straight-line method and will produce 20,000 units of calculators in the first year. The variable production cost per unit of the calculator is $15, while fixed costs are $900,000. The corporate tax rate for the company is 30 percent. What should the sales price per unit of the calculator be for the firm to have a zero profit? 8.5 What is the minimum number of units that a distributor of big-screen TVs must sell in a given period to break even? Sales price Variable costs Fixed costs Depreciation Tax rate $1,500 $1,100 $120,000 $20,000 35% Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 223 Chapter 8 Strategy and Analysis in Using Net Present Value 217 8.6 You are considering investing in a fledgling company that cultivates abalone for sale to local restaurants. The proprietor says he'll return all profits to you after covering operating costs and his salary. How many abalone must be harvested and sold in the first year of operations for you to get any payback? (Assume no depreciation.) Price per adult abalone Variable costs Fixed costs Salaries Tax rate $2.00 $0.72 $300,000 $40,000 35% How much profit will be returned to you if he sells 300,000 abalone? Present Value Break-Even Analysis 8.7 Using the information in the problem above, what is the present value break-even point if the discount rate is 15 percent, initial investment is $140,000, and the life of the project is seven years? Assume a straight-line depreciation method with a zero salvage value. 8.8 Kids & Toys Inc. has purchased a $200,000 machine to produce toy cars. The machine will be fully depreciated by the straight-line method for its economic life of five years and will be worthless after its life. The firm expects that the sales price of the toy is $25 while its variable cost is $5. The firm should also pay $350,000 as fixed costs each year. The corporate tax rate for the company is 25 percent, and the appropriate discount rate is 12 percent. What is the present value break-even point? 8.9 The Cornchopper Company is considering the purchase of a new harvester. The company is currently involved in deliberations with the manufacturer and the parties have not come to settlement regarding the final purchase price. The management of Cornchopper has hired you to determine the break-even purchase price of the harvester. This price is that which will make the NPV of the project zero. Base your analysis on the following facts: The new harvester is not expected to affect revenues, but operating expenses will be reduced by $10,000 per year for 10 years. The old harvester is now 5 years old, with 10 years of its scheduled life remaining. It was purchased for $45,000. It has been depreciated on a straight-line basis. The old harvester has a current market value of $20,000. The new harvester will be depreciated on a straight-line basis over its 10-year life. The corporate tax rate is 34 percent. The firm's required rate of return is 15 percent. All cash flows occur at year-end. However, the initial investment, the proceeds from selling the old harvester, and any tax effects will occur immediately. Capital gains and losses are taxed at the corporate rate of 34 percent when they are realized. The expected market value of both harvesters at the end of their economic lives is zero. Scenario Analysis 8.10 Ms. Thompson, as the CFO of a clock maker, is considering an investment of a $420,000 machine that has a seven-year life and no salvage value. The machine is depreciated by a straight-line method with a zero salvage over the seven years. The appropriate discount rate for cash flows of the project is 13 percent, and the corporate tax rate of the company is 35 percent. Calculate the NPV of the project in the following scenario. What is your conclusion about the project? Pessimistic Unit sales Price Variable costs Fixed costs 23,000 $ 38 $ 21 $320,000 Expected 25,000 $ 40 $ 20 $300,000 Optimistic 27,000 $ 42 $ 19 $280,000 224 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition II. Value and Capital Budgeting 8. Strategy and Analysis in Using Net Present Value The McGraw-Hill Companies, 2002 218 Part II Value and Capital Budgeting 8.11 You are the financial analyst for a manufacturer of tennis rackets that has identified a graphite-like material that it is considering using in its rackets. Given the following information about the results of launching a new racket, will you undertake the project? (Assumptions: Tax rate 40%, Effective discount rate 13%, Depreciation $300,000 per year, and production will occur over the next five years only.) Pessimistic Market size Market share Price Variable costs Fixed costs Investment 110,000 22% $ 115 $ 72 $ 850,000 $1,500,000 Expected 120,000 25% $ 120 $ 70 $ 800,000 $1,500,000 Optimistic 130,000 27% $ 125 $ 68 $ 750,000 $1,500,000 8.12 What would happen to the analysis done above if your competitor introduces a graphite composite that is even lighter than your product? What factors would this likely affect? Do an NPV analysis assuming market size increases (due to more awareness of graphite-based rackets) to the level predicted by the optimistic scenario but your market share decreases to the pessimistic level (due to competitive forces). What does this tell you about the relative importance of market size versus market share? The Option to Abandon 8.13 You have been hired as a financial analyst to do a feasibility study of a new video game for Passivision. Marketing research suggests Passivision can sell 12,000 units per year at $62.50 net cash flow per unit for the next 10 years. Total annual operating cash flow is forecasted to be $62.50 12,000 $750,000. The relevant discount rate is 10 percent. The required initial investment is $10 million. a. What is the base case NPV? b. After one year, the video game project can be abandoned for $200,000. After one year, expected cash flows will be revised upward to $1.5 million or to $0 with equal probability. What is the option value of abandonment? What is the revised NPV? 8.14 Allied Products is thinking about a new product launch. The vice president of marketing suggests that Allied Products can sell 2 million units per year at $100 net cash flow per unit for the next 10 years. Allied Products uses a 20-percent discount rate for new product launches and the required initial investment is $100 million. a. What is the base case NPV? b. After the first year, the project can be dismantled and sold for scrap for $50 million. If expected cash flows can be revised based on the first year's experience, when would it make sense to abandon the project? (Hint: At what level of expected cash flows does it make sense to abandon the project?) Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk Introduction The McGraw-Hill Companies, 2002 225 PART III Risk 9 10 11 12 Capital Market Theory: An Overview 220 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 242 An Alternative View of Risk and Return: The Arbitrage Pricing Theory 285 Risk, Cost of Capital, and Capital Budgeting 307 T part of the book examines the relationship between expected return and risk for portfolios and individual assets. When capital markets are in equilibrium, they determine a trade-off between expected return and risk. The returns that shareholders can expect to obtain in the capital markets are the ones they will require from firms when the firms evaluate risky investment projects. The shareholders' required return is the firm's cost of equity capital. Chapter 9 examines the modern history of the U.S. capital markets. A central fact emerges: The return on risky assets has been higher on average than the return on riskfree assets. This fact supports the perspective for our examination of risk and return. In Chapter 9 we introduce several key intuitions of modern finance and show how they can be useful in determining a firm's cost of capital. Chapters 10 and 11 contain more advanced discussions of risk and expected return. The chapters are self-contained and build on the material in Chapter 9. Chapter 10 shows what determines the relationship between return and risk for portfolios. The model of risk and expected return used in the chapter is called the capitalasset-pricing model (CAPM). Chapter 11 examines risk and return from another perspective: the arbitrage pricing theory (APT). This approach yields insights that one cannot get from the CAPM. The key concept is that the total risk of individual stocks can be divided into two parts: systematic and unsystematic. The fundamental principle of diversification is that, for highly diversified portfolios, unsystematic risk disappears; only systematic risk survives. The section on risk finishes with a discussion in Chapter 12 on estimating a firm's cost of equity capital and some of the problems that are encountered in doing so. HIS 226 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 9 CHAPTER Capital Market Theory: An Overview EXECUTIVE SUMMARY W e learned in Chapter 4 that riskless cash flows should be discounted at the riskless rate of interest. Because most capital-budgeting projects involve risky flows, a different discount rate must be used. The next four chapters are devoted to determining the discount rate for risky projects. Past experience indicates that students find the upcoming material among the most difficult in the entire textbook. Because of this, we always teach the material by presenting the results and conclusions first. By seeing where we are going ahead of time, it is easier to absorb the material when we get there. A synopsis of the four chapters follows: 1. Because our ultimate goal is to discount risky cash flows, we must first find a way to measure risk. In the current chapter we measure the variability of an asset by the variance or standard deviation of its returns. If an individual holds only one asset, its variance or standard deviation would be the appropriate measure of risk. 2. While Chapter 9 considers one type of asset in isolation, Chapter 10 examines a portfolio of many assets. In this case, we are interested in the contribution of the security to the risk of the entire portfolio. Because much of an individual security's variance is dispersed in a large diversified portfolio, neither the security's variance nor its standard deviation can be viewed as the security's contribution to the risk of a large portfolio. Rather, this contribution is best measured by the security's beta ( ). As an example, consider a stock whose returns are high when the returns on a large, diversified portfolio are low--and vice versa. This stock has a negative beta. In other words, it acts as a hedge, implying that the stock actually tends to reduce the risk of the portfolio. However, the stock could have a high variance, implying high risk for an investor holding only this security. 3. Investors will only hold a risky security if its expected return is high enough to compensate for its risk. Given the above, the expected return on a security should be positively related to the security's beta. In fact, the relationship between risk and expected return can be expressed more precisely by the following equation: Expected return on a security Risk-free rate Beta Expected return on market portfolio Risk-free rate Because the term in parentheses on the right-hand side is positive, this equation says that the expected return on a security is a positive function of its beta. This equation is frequently referred to as the capital-asset-pricing model (CAPM). 4. We derive the relationship between risk and return in a different manner in Chapter 11. However, many of the conclusions are quite similar. This chapter is based on the arbitrage pricing theory (APT). 5. The theoretical ideas in Chapters 9, 10, and 11 are intellectually challenging. Fortunately, Chapter 12, which applies the above theory to the selection of discount rates, is much simpler. In a world where (a) a project has the same risk as the firm, and (b) the firm has no Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 227 Chapter 9 Capital Market Theory: An Overview 221 debt, the expected return on the stock should serve as the project's discount rate. This expected return is taken from the capital-asset-pricing model, as presented above. Because we have a long road ahead of us, the maxim that any journey begins with a single step applies here. We start with the perhaps mundane calculation of a security's return. 9.1 RETURNS Dollar Returns Suppose the Video Concept Company has several thousand shares of stock outstanding and you are a shareholder. Further suppose that you purchased some of the shares of stock in the company at the beginning of the year; it is now year-end and you want to figure out how well you have done on your investment. The return you get on an investment in stocks, like that in bonds or any other investment, comes in two forms. First, over the year most companies pay dividends to shareholders. As the owner of stock in the Video Concept Company, you are a part owner of the company. If the company is profitable, it generally will distribute some of its profits to the shareholders. Therefore, as the owner of shares of stock, you will receive some cash, called a dividend, during the year.1 This cash is the income component of your return. In addition to the dividends, the other part of your return is the capital gain--or, if it is negative, the capital loss (negative capital gain)--on the investment. For example, suppose we are considering the cash flows of the investment in Figure 9.1 and you purchased 100 shares of stock at the beginning of the year at a price of $37 per share. Your total investment, then, would be C0 $37 100 $3,700 Suppose that over the year the stock paid a dividend of $1.85 per share. During the year, then, you would have received income of Div $1.85 100 $185 Suppose, lastly, that at the end of the year the market price of the stock is $40.33 per share. Because the stock increased in price, you have a capital gain of Gain ($40.33 $37) 100 $333 I F I G U R E 9.1 Dollar Returns $4,218 Inflows $185 TOTAL Dividends Ending market value 1 $4,033 Time 0 Initial investment Outflows $3,700 1 In fact, companies often continue to pay dividends even when they have lost money during the year. 228 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 222 Part III Risk The capital gain, like the dividend, is part of the return that shareholders require to maintain their investment in the Video Concept Company. Of course, if the price of Video Concept stock had dropped in value to, say, $34.78, you would have recorded a capital loss of Loss ($34.78 $37) 100 $222 The total dollar return on your investment is the sum of the dividend income and the capital gain or loss on the investment: Total dollar return Dividend income Capital gain (or loss) (From now on we will refer to capital losses as negative capital gains and not distinguish them.) In our first example, then, the total dollar return is given by Total dollar return $185 $333 $518 Notice that if you sold the stock at the end of the year, your total amount of cash would be the initial investment plus the total dollar return. In the preceding example, then, you would have Total cash if stock is sold Initial investment $3,700 $518 $4,218 Total dollar return As a check, notice that this is the same as the proceeds from the sale of stock plus the dividends: Proceeds from stock sale Dividends $40.33 100 $185 $4,033 $185 $4,218 Suppose, however, that you hold your Video Concept stock and don't sell it at year-end. Should you still consider the capital gain as part of your return? Does this violate our previous present value rule that only cash matters? The answer to the first question is a strong yes, and the answer to the second question is an equally strong no. The capital gain is every bit as much a part of your return as is the dividend, and you should certainly count it as part of your total return. That you have decided to hold onto the stock and not sell or realize the gain or the loss in no way changes the fact that, if you want to, you could get the cash value of the stock.2 Percentage Returns It is more convenient to summarize the information about returns in percentage terms than in dollars, because the percentages apply to any amount invested. The question we want to answer is: How much return do we get for each dollar invested? To find this out, let t stand for the year we are looking at, let Pt be the price of the stock at the beginning of the year, and let Divt 1 be the dividend paid on the stock during the year. Consider the cash flows in Figure 9.2. 2 After all, you could always sell the stock at year-end and immediately buy it back. As we previously computed, the total dollar return on the investment would be $518 before you bought the stock back. The total amount of cash you would have at year-end would be this $518 plus your initial investment of $3,700. You would not lose this return when you bought back 100 shares of stock. In fact, you would be in exactly the same position as if you had not sold the stock (assuming, of course, that there are no tax consequences and no brokerage commissions from selling the stock). Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 229 Chapter 9 Capital Market Theory: An Overview 223 I F I G U R E 9.2 Percentage Returns $42.18 Inflows $1.85 TOTAL Dividends Ending market value t 1 $40.33 Time t Outflows $37 Dividends paid Change in market at end of period value over period Percentage return Beginning market value Dividends paid Market value at end of period at end of period Beginning market value 1 Percentage return In our example, the price at the beginning of the year was $37 per share and the dividend paid during the year on each share was $1.85. Hence the percentage of income return,3 sometimes called the dividend yield, is Dividend yield Pt Divt 1/Pt $1.85/$37 0.05 5% Capital gain is the change in the price of the stock divided by the initial price. Letting 1 be the price of the stock at year-end, the capital gain can be computed Capital gain (Pt 1 Pt)/Pt $3.33/$37 0.09 9% ($40.33 $37)/$37 Combining these two results, we find that the total return on the investment in Video Concept stock over the year, which we will label Rt 1, was Rt 1 Divt 1 Pt 1 Pt Pt Pt 5% 9% $14% From now on we will refer to returns in percentage terms. E XAMPLE Suppose a stock begins the year with a price of $25 per share and ends with a price of $35 per share. During the year it paid a $2 dividend per share. What are its dividend yield, its capital gain, and its total return for the year? We can imagine the cash flows in Figure 9.3. 3 We will use 0.05 and 5 percent interchangeably. Keep in mind that, although (0.05)2 0.0025, (52)% Thus, it is important to keep track of parentheses so that decimal points land where they belong. 25%. 230 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 224 Part III Risk I F I G U R E 9.3 Cash Flow--An Investment Example $37 Cash inflows $2 TOTAL Dividends (Div1) Ending price per share (P1) 1 $35 Time 0 Cash outflows $25 (P0) R1 Div1 P0 $2 $25 8% P1 P0 $12 $25 48% P0 $35 $25 $25 40% Thus, the stock's dividend yield, its capital gain yield, and its total return are 8 percent, 40 percent, and 48 percent, respectively. Suppose you had $5,000 invested. The total dollar return you would have received on an investment in the stock is $5,000 0.48 $2,400. If you know the total dollar return on the stock, you do not need to know how many shares you would have had to purchase to figure out how much money you would have made on the $5,000 investment. You just use the total dollar return.4 QUESTIONS CONCEPT ? What are the two parts of total return? Why are unrealized capital gains or losses included in the calculation of returns? What is the difference between a dollar return and a percentage return? 4 Consider the stock in the previous example. We have ignored the question of when during the year you receive the dividend. Does it make a difference? To explore this question, suppose first that the dividend is paid at the very beginning of the year, and you receive it the moment after you have purchased the stock. Suppose, too, that interest rates are 10 percent, and that immediately after receiving the dividend you loan it out. What will be your total return, including the loan proceeds, at the end of the year? Alternatively, instead of loaning out the dividend you could have reinvested it and purchased more of the stock. If that is what you do with the dividend, what will your total return be? (Warning: This does not go on forever, and when you buy more stock with the cash from the dividend on your first purchase, you are too late to get yet another dividend on the new stock.) Finally, suppose the dividend is paid at year-end. What answer would you get for the total return? As you can see, by ignoring the question of when the dividend is paid when we calculate the return, we are implicitly assuming that it is received at the end of the year and cannot be reinvested during the year. The right way to figure out the return on a stock is to determine exactly when the dividend is received and to include the return that comes from reinvesting the dividend in the stock. This gives a pure stock return without confounding the issue by requiring knowledge of the interest rate during the year. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 231 Chapter 9 Capital Market Theory: An Overview 225 9.2 HOLDING-PERIOD RETURNS A famous set of studies dealing with rates of return on common stocks, bonds, and Treasury bills was conducted by Roger Ibbotson and Rex Sinquefield.5 They present year-byyear historical rates of return for the following five important types of financial instruments in the United States: 1. Large-Company Common Stocks. The common-stock portfolio is based on the Standard & Poor's (S&P) composite index. At present, the S&P composite includes 500 of the largest (in terms of market value) stocks in the United States. 2. Small-Company Common Stocks. This is a portfolio composed of the bottom fifth of stocks traded on the New York Stock Exchange in which stocks are ranked by market value (i.e., the price of the stock multiplied by the number of shares outstanding). 3. Long-Term Corporate Bonds. This is a portfolio of high-quality corporate bonds with a 20-year maturity. 4. Long-Term U.S. Government Bonds. This is a portfolio of U.S. government bonds with a maturity of 20 years. 5. U.S. Treasury Bills. This is a portfolio of Treasury bills of three-month maturity. None of the returns are adjusted for taxes or transactions costs. In addition to the yearby-year returns on financial instruments, the year-to-year change in the consumer price index is computed. This is a basic measure of inflation. Year-by-year real returns can be calculated by subtracting annual inflation. Before looking closely at the different portfolio returns, we graphically present the returns and risks available from U.S. capital markets in the 74-year period from 1926 to 1999. Figure 9.4 shows the growth of $1 invested at the beginning of 1926. Notice that the vertical axis is logarithmic, so that equal distances measure the same number of percentage changes. The figure shows that if $1 were invested in common stocks and all dividends were reinvested, the dollar would have grown to $2,845.63 by the end of 1999. The biggest growth was in the small-stock portfolio. If $1 were invested in small stocks in 1926, the investment would have grown to $6,640.79. However, when you look carefully at Figure 9.4, you can see great variability in the returns on small stocks, especially in the earlier part of the period. A dollar in long-term government bonds was very stable as compared with a dollar in common stocks. Figures 9.5 to 9.8 plot each year-toyear percentage return as a vertical bar drawn from the horizontal axis for common stocks, for small-company stocks, for long-term bonds and Treasury bills, and for inflation, respectively. Figure 9.4 gives the growth of a dollar investment in the stock market from 1926 through 1999. In other words, it shows what the worth of the investment would have been if the dollar had been left in the stock market and if each year the dividends from the previous year had been reinvested in more stock. If Rt is the return in year t (expressed in decimals), the value you would have at the end of year T is the product of 1 plus the return in each of the years: (1 R1) (1 R2) ... (1 Rt) ... (1 RT) 5 The most recent update of this work is Stocks, Bonds, Bills and Inflation: 2000 YearbookTM (Chicago: Ibbotson Associates). All rights reserved. 232 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 226 Part III Risk I F I G U R E 9.4 A $1 Investment in Different Types of Portfolios, 19261999 (Year-end 1925 Index $10,000 $6,640.79 $2,845.63 $1.00) $1,000 Small-company stocks $100 Large-company stocks $40.22 $15.64 $9.39 Inflation Treasury bills $10 Long-term government bonds $1 $0 1965 1975 1985 1999 Year-End Redrawn from Stocks, Bonds, Bills and Inflation: 2000 Yearbook,TM annual updates work by Roger G. Ibbotson and Rex A. Sinquefield (Chicago: Ibbotson Associates). All rights reserved. 1925 1935 1945 1955 I F I G U R E 9.5 Year-by-Year Total Returns on Common Stocks Total annual returns in percent 60 50 40 30 20 10 0 10 20 30 40 50 1925 1935 1945 1955 Year Redrawn from Stocks, Bonds, Bills and Inflation: 2000 Yearbook,TM annual updates work by Roger G. Ibbotson and Rex A. Sinquefield (Chicago: Ibbotson Associates). All rights reserved. 1965 1975 1985 1999 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 233 Chapter 9 Capital Market Theory: An Overview 227 I F I G U R E 9.6 Year-by-Year Total Returns on Small-Company Stocks Total annual returns in percent 160 140 120 100 80 60 40 20 0 20 40 1965 1975 1985 1999 Year Redrawn from Stocks, Bonds, Bills and Inflation: 2000 Yearbook,TM annual updates work by Roger G. Ibbotson and Rex A. Sinquefield (Chicago: Ibbotson Associates). All rights reserved. 60 1925 1935 1945 1955 For example, if the returns were 11 percent, 5 percent, and 9 percent in a three-year period, an investment of $1 at the beginning of the period would be worth (1 R1) (1 R2) (1 R3) ($1 0.11) ($1 0.05) $1.11 $0.95 $1.09 $1.15 ($1 0.09) at the end of the three years. Notice that 0.15 or 15 percent is the total return and that it includes the return from reinvesting the first-year dividends in the stock market for two more years and reinvesting the second-year dividends for the final year. The 15 percent is called a three-year holding-period return. Table 9.1 gives the annual returns each year from 1926 to 1999. From this table you can determine holding-period returns for any combination of years. QUESTIONS CONCEPT ? What is the largest one-period return in the 74-year history of common stocks we have displayed, and when did it occur? What is the smallest return, and when did it occur? In how many years did the common-stock return exceed 30 percent, and in how many years was it below 20 percent? For common stocks, what is the longest period of time without a single losing year? What is the longest streak of losing years? What is the longest period of time such that if you had invested at the beginning of the period, you would still not have had a positive return on your common-stock investment by the end? 234 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 228 Part III Risk I F I G U R E 9.7 Year-by-Year Total Returns on Bonds and Bills Long-term government bonds Total annual returns in percent 50 40 30 20 10 0 10 1925 1935 1945 1955 1965 Year 1975 1985 1999 Treasury bills Total annual returns in percent 16 14 12 10 8 6 4 2 0 2 1925 1935 1945 1955 1965 Year 1975 1985 1999 Redrawn from Stocks, Bonds, Bills and Inflation: 2000 Yearbook,TM annual updates work by Roger G. Ibbotson and Rex A. Sinquefield (Chicago: Ibbotson Associates). All rights reserved. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 235 Chapter 9 Capital Market Theory: An Overview 229 I F I G U R E 9.8 Year-by-Year Inflation Total annual returns in percent 20 15 10 5 0 5 10 15 1965 1975 1985 1999 Year Redrawn from Stocks, Bonds, Bills and Inflation: 2000 Yearbook,TM annual updates work by Roger G. Ibbotson and Rex A. Sinquefield (Chicago: Ibbotson Associates). All rights reserved. 1925 1935 1945 1955 I TA B L E 9.1 Year-by-Year Total Returns, 19261999 Large-Company Stocks 13.70% 35.80% 45.14% 8.88% 25.22% 43.75% 8.38% 53.11% 2.41% 46.94% 32.35% 35.68% 32.29% 1.54% 10.54% 12.14% 20.98% 25.52% 19.46% 36.35% 8.48% 4.96% Long-Term Government Bonds 6.40% 4.51% 0.18% 5.66% 4.16% 0.41% 5.61% 5.92% 5.95% 3.22% 1.73% 4.63% 4.74% 2.26% 4.25% 1.56% 1.82% 2.00% 2.28% 5.23% 0.54% 0.93% Long-Term Corporate Bonds 7.00% 6.54% 3.42% 4.33% 6.34% 2.45% 12.23% 5.24% 9.75% 6.89% 6.22% 2.50% 4.36% 4.28% 4.49% 1.78% 3.14% 3.35% 3.12% 3.51% 2.52% 0.46% U.S. Treasury Bills 4.40% 4.21% 4.87% 6.05% 3.72% 2.63% 2.95% 1.66% 1.04% 0.29% 0.15% 0.44% 0.07% 0.00% 0.00% 0.07% 0.36% 0.36% 0.36% 0.36% 0.43% 0.57% Year 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942 1943 1944 1945 1946 1947 Inflation 1.10% 2.33% 1.14% 0.63% 6.45% 9.23% 10.29% 0.68% 1.63% 2.94% 1.43% 2.81% 2.74% 0.00% 0.77% 9.90% 9.01% 2.97% 2.26% 2.31% 18.09% 8.83% (continued) 236 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 I TA B L E 9.1 Year-by-Year Total Returns, 19261999, continued Large-Company Stocks 4.95% 17.74% 30.04% 23.88% 18.44% 1.11% 52.44% 31.65% 6.90% 10.53% 43.73% 12.02% 0.45% 26.90% 8.79% 22.72% 16.43% 12.37% 10.10% 24.04% 11.03% 8.47% 4.00% 14.35% 19.00% 14.85% 26.58% 37.42% 23.76% 7.38% 6.54% 18.59% 32.61% 4.97% 21.67% 22.57% 6.19% 31.85% 18.68% 5.22% 16.58% 31.75% 3.13% 30.53% 7.62% 10.07% 1.27% 37.80% 22.74% 33.43% 28.13% 21.03% Long-Term Government Bonds 2.62% 4.53% 0.92% 0.14% 2.42% 2.32% 3.07% 0.69% 1.61% 6.75% 1.61% 1.89% 11.04% 2.24% 6.03% 1.42% 3.89% 1.05% 4.81% 2.36% 1.66% 4.82% 18.15% 11.39% 2.51% 3.50% 3.82% 5.63% 15.20% 0.55% 0.99% 0.50% 0.63% 2.62% 43.98% 2.03% 15.96% 30.34% 22.86% 3.24% 6.86% 18.64% 7.26% 18.52% 8.52% 13.45% 7.31% 24.86% 1.63% 10.89% 13.44% 7.12% Long-Term Corporate Bonds 3.72% 4.32% 1.91% 0.24% 3.45% 2.05% 4.65% 1.07% 1.78% 4.48% 0.85% 0.15% 6.71% 3.69% 6.20% 3.17% 3.97% 2.10% 0.26% 1.17% 4.17% 2.46% 11.18% 9.70% 8.32% 2.99% 0.22% 11.04% 14.57% 5.50% 1.84% 1.55% 4.99% 8.98% 34.90% 7.30% 17.10% 29.37% 21.26% 1.82% 13.78% 15.30% 8.60% 15.63% 10.88% 14.68% 2.42% 22.03% 3.87% 11.11% 11.44% 2.30% U.S. Treasury Bills 0.99% 1.12% 1.25% 1.51% 1.76% 1.93% 0.98% 1.68% 2.66% 3.34% 1.79% 3.35% 3.13% 2.32% 2.80% 3.20% 3.56% 4.02% 4.90% 4.49% 5.42% 6.81% 6.68% 4.51% 4.04% 6.98% 8.09% 6.04% 5.16% 5.26% 7.23% 10.32% 12.04% 15.21% 11.28% 8.89% 10.04% 7.70% 6.18% 5.87% 6.73% 8.48% 7.85% 5.71% 3.57% 3.08% 4.15% 5.64% 5.12% 5.22% 5.06% 4.85% Year 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Inflation 2.98% 2.08% 5.99% 5.94% 0.81% 0.74% 0.73% 0.34% 3.01% 2.92% 1.76% 1.67% 1.40% 0.66% 1.31% 1.65% 0.98% 1.95% 3.43% 3.05% 4.70% 6.20% 5.56% 3.28% 3.40% 8.72% 16.20% 3.40% 4.84% 6.71% 9.02% 13.30% 12.51% 8.92% 3.85% 3.78% 3.96% 3.79% 1.10% 4.44% 4.42% 4.65% 6.10% 3.06% 2.89% 2.75% 2.68% 2.53% 3.32% 1.70% 1.61% 2.69% 230 Global Financial Data (www.globalfindata.com) copyright 2000. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 237 Chapter 9 Capital Market Theory: An Overview 231 I F I G U R E 9.9 Histogram of Returns on Common Stocks, 19261999 1988 1997 1990 1986 1999 1995 1981 1994 1979 1998 1991 1977 1969 1962 1953 1946 1973 1966 1974 1957 1931 1937 1930 1941 80 70 60 50 40 30 20 1940 1939 1934 1932 1929 1993 1992 1987 1984 1978 1970 1960 1956 1948 1947 0 1972 1971 1968 1965 1964 1959 1952 1949 1944 1926 1996 1983 1982 1976 1967 1963 1961 1951 1943 1942 20 1989 1985 1980 1975 1955 1950 1945 1938 1958 1936 1935 1954 1927 1928 1933 40 50 60 70 80 90 Large-Company Stocks 10 10 30 1999 1997 1993 1992 1998 1987 1984 1966 1960 1974 1970 1962 1937 1973 1990 1957 1929 1931 1930 1969 1946 80 70 60 50 40 30 20 1953 1948 1941 1940 1932 0 1994 1986 1972 1956 1996 1952 1951 1947 1939 1926 1989 1981 1971 1959 1949 1988 1985 1982 1995 1978 1983 1977 1980 1964 1963 1955 1934 1927 1968 1961 1950 1938 1928 Small-Company Stocks 1991 1979 1965 1976 1958 1967 1942 1975 1954 1935 1944 1936 1945 1943 50 60 70 80 90 1933 140 150 10 10 20 30 40 Redrawn from Stocks, Bonds, Bills and Inflation: 2000 Yearbook,TM annual updates work by Roger G. Ibbotson and Rex A. Sinquefield (Chicago: Ibbotson Associates). All rights reserved. 9.3 RETURN STATISTICS The history of capital-market returns is too complicated to be handled in its undigested form. To use the history we must first find some manageable ways of describing it, dramatically condensing the detailed data into a few simple statements. This is where two important numbers summarizing the history come in. The first and most natural number is some single measure that best describes the past annual returns on the stock market. In other words, what is our best estimate of the return that an investor could have realized in a particular year over the 1926-to-1999 period? This is the average return. Figure 9.9 plots the histogram of the yearly stock market returns given in Table 9.1. This plot is the frequency distribution of the numbers. The height of the graph gives the number of sample observations in the range on the horizontal axis. Given a frequency distribution like that in Figure 9.9, we can calculate the average or mean of the distribution. To compute the arithmetic average of the distribution, we add up all of the values and divide by the total (T) number (74 in our case because we have 74 years 238 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 232 Part III Risk of data). The bar over the R is used to represent the mean, and the formula is the ordinary formula for the average: Mean R R1 ... T RT The arithmetic mean of the 74 annual returns from 1926 to 1999 is 13.3 percent. E XAMPLE The returns on common stock from 1926 to 1929 are 0.1370, 0.3580, 0.4514, and 0.0888, respectively. (These numbers are taken from Table 9.1.) The average, or mean, return over these four years is R 0.1370 0.3580 4 0.4514 0.0888 0.2144 9.4 AVERAGE STOCK RETURNS AND RISK-FREE RETURNS Now that we have computed the average return on the stock market, it seems sensible to compare it with the returns on other securities. The most obvious comparison is with the low-variability returns in the government-bond market. These are free of most of the volatility we see in the stock market. The government borrows money by issuing bonds, which the investing public holds. As we discussed in an earlier chapter, these bonds come in many forms, and the ones we will look at here are called Treasury bills, or T-bills. Once a week the government sells some bills at an auction. A typical bill is a pure discount bond that will mature in a year or less. Because the government can raise taxes to pay for the debt it incurs--a trick that many of us would like to be able to perform--this debt is virtually free of the risk of default. Thus we will call this the risk-free return over a short time (one year or less).6 An interesting comparison, then, is between the virtually risk-free return on T-bills and the very risky return on common stocks. This difference between risky returns and risk-free returns is often called the excess return on the risky asset. It is called excess because it is the additional return resulting from the riskiness of common stocks and is interpreted as a risk premium. Table 9.2 shows the average stock return, bond return, T-bill return, and inflation rate for the period from 1926 through 1999. From this we can derive excess returns. The average excess return from common stocks for the entire period was 9.5 percent (13.3% 3.8%). One of the most significant observations of stock market data is this long-run excess of the stock return over the risk-free return. An investor for this period was rewarded for investment in the stock market with an extra or excess return over what would have been achieved by simply investing in T-bills. Why was there such a reward? Does it mean that it never pays to invest in T-bills and that someone who invested in them instead of in the stock market needs a course in finance? A complete answer to these questions lies at the heart of modern finance, and Chapter 10 is devoted entirely to this. However, part of the answer can be found in the variability of the 6 A Treasury bill with a 90-day maturity is risk-free only during that particular time period. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 239 Chapter 9 Capital Market Theory: An Overview 233 TA B L E 9.2 Total Annual Returns, 19261999 Arithmetic mean Risk premium (relative to U.S. Treasury bills) Standard deviation Series Distribution Large-company stocks 13.3% 9.5% 20.1% * Small-company stocks 17.6 13.8 33.6 Long-term corporate bonds 5.9 2.1 8.7 Long-term government bonds 5.5 1.7 9.3 Intermediate-term government bonds 5.4 1.6 5.8 U.S. Treasury bills 3.8 3.2 Inflation 3.2 4.5 90% 0% 90% *The 1933 small-company stock total return was 142.9 percent. Modified from Stocks, Bonds, Bills and Inflation: 2000 Yearbook,TM annual updates work by Roger G. Ibbotson and Rex. A. Sinquefield (Chicago: Ibbotson Associates). All rights reserved. various types of investments. We see in Table 9.1 many years when an investment in T-bills achieved higher returns than an investment in common stocks. Also, we note that the returns from an investment in common stocks are frequently negative whereas an investment in T-bills never produces a negative return. So, we now turn our attention to measuring the variability of returns and an introductory discussion of risk. Now we look more closely at Table 9.2. We see that the standard deviation of T-bills is substantially less than that of common stocks. This suggests that the risk of T-bills is less than that of common stocks. Because the answer turns on the riskiness of investments in common stock, we now turn our attention to measuring this risk. QUESTIONS CONCEPT ? What is the major observation about capital markets that we will seek to explain? What does the observation tell us about investors for the period from 1926 through 1999? 240 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 234 Part III Risk 9.5 RISK STATISTICS The second number that we use to characterize the distribution of returns is a measure of the risk in returns. There is no universally agreed-upon definition of risk. One way to think about the risk of returns on common stock is in terms of how spread out the frequency distribution in Figure 9.9 is.7 The spread, or dispersion, of a distribution is a measure of how much a particular return can deviate from the mean return. If the distribution is very spread out, the returns that will occur are very uncertain. By contrast, a distribution whose returns are all within a few percentage points of each other is tight, and the returns are less uncertain. The measures of risk we will discuss are variance and standard deviation. Variance The variance and its square root, the standard deviation, are the most common measures of variability or dispersion. We will use Var and 2 to denote the variance and SD and to represent the standard deviation. is, of course, the Greek letter sigma. E XAMPLE The returns on common stocks from 1926 to 1929 are (in decimals) 0.1370, 0.3580, 0.4514, and 0.0888, respectively. The variance of this sample is computed as Var 0.0582 SD 1 R R2 R2 R 2 T 1 1 1 /3[(0.1370 0.2144)2 (0.3580 (0.4514 0.2144)2 ( 0.0888 0.0582 0.2413 R3 R 2 R4 R 2 0.2144)2 0.2144)2] (i.e., 24.13%) This formula tells us just what to do: Take the T individual returns (R1, R2, . . .) and subtract the average return R, square the result, and add them up. Finally, this total must be divided by the number of returns less one (T 1). The standard deviation is always just the square root of the variance. Using the actual stock returns in Table 9.1 for the 74-year period from 1926 through 1999 in the above formula, the resulting standard deviation of stock returns is 20.1 percent. The standard deviation is the standard statistical measure of the spread of a sample, and it will be the measure we use most of the time. Its interpretation is facilitated by a discussion of the normal distribution. Normal Distribution and Its Implications for Standard Deviation A large enough sample drawn from a normal distribution looks like the bell-shaped curve drawn in Figure 9.10. As you can see, this distribution is symmetric about its mean, not skewed, and it has a much cleaner shape than the actual distribution of yearly returns drawn 7 Several condensed frequency distributions are also in the extreme right column of Table 9.2. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 241 Chapter 9 Capital Market Theory: An Overview 235 I F I G U R E 9.10 The Normal Distribution Probability 68.26% Return on 0 1 2 3 stocks 47.0% 26.9% 13.3% 33.4% 53.5% 73.6% In the case of a normal distribution, there is a 68.26-percent probability that a return will be within one standard deviation of the mean. In this example, there is a 68.26-percent probability that a yearly return will be between 6.8 percent and 33.4 percent. There is a 95.44-percent probability that a return will be within two standard deviations of the mean. In this example, there is a 95.44-percent probability that a yearly return will be between 26.9 percent and 53.5 percent. Finally, there is a 99.74-percent probability that a return will be within three standard deviations of the mean. In this example, there is a 99.74-percent probability that a yearly return will be between 47.0 percent and 73.6 percent. 3 2 1 6.8% 95.44% 99.74% in Figure 9.9.8 Of course, if we had been able to observe stock market returns for 1,000 years, we might have filled in a lot of the jumps and jerks in Figure 9.9 and had a smoother curve. In classical statistics the normal distribution plays a central role, and the standard deviation is the usual way to represent the spread of a normal distribution. For the normal distribution, the probability of having a return that is above or below the mean by a certain amount depends only on the standard deviation. For example, the probability of having a return that is within one standard deviation of the mean of the distribution is approximately 0.68 or 2/3, and the probability of having a return that is within two standard deviations of the mean is approximately 0.95. The 20.1-percent standard deviation we found for stock returns from 1926 through 1999 can now be interpreted in the following way: If stock returns are roughly normally distributed, the probability that a yearly return will fall within 20.1 percent of the mean of 13.3 percent will be approximately 2/3. That is, about 2/3 of the yearly returns will be between 6.8 percent and 33.4 percent. (Note that 6.8% 13.3% 20.1% and 33.4% 13.3% 20.1%.) The probability that the return in any year will fall within two standard deviations is about 0.95. That is, about 95 percent of yearly returns will be between 26.9 percent and 53.5 percent. The distribution in Figure 9.10 is a theoretical distribution, sometimes called the population distribution or true distribution. There is no assurance that the actual distribution of observations in a given sample will produce a histogram that looks exactly like the theoretical distribution. We can see how messy the actual frequency function of historical observations Some people define risk as the possibility of obtaining a return below the average. Some measures of risk, such as semivariance, use only the negative deviations from the average return. However, for symmetric distributions, such as the normal distribution, this method of measuring downside risk is equivalent to measuring risk with deviations from the mean on both sides. 8 242 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 236 Part III Risk is by observing Figure 9.9. If we were to keep on generating observations for a long enough period of time, however, the aberrations in the sample would disappear, and the actual historical distribution would start to look like the underlying theoretical distribution. This points out that sampling error exists in any individual sample. In other words, the distribution of the sample only approximates the true distribution: we always measure the truth with some error. For example, we do not know what the true expected return was for common stocks in the 74-year history. However, we are sure that our 13.3 percent realized return is very close to it. QUESTIONS CONCEPT ? What is the definition of sample estimates of variance and standard deviation? How does the normal distribution help us interpret standard deviation? 9.6 SUMMARY AND CONCLUSIONS 1. This chapter presents returns for a number of different asset classes. The general conclusion is that stocks have outperformed bonds over most of the 20th century, though stocks have also exhibited more risk. 2. The statistical measures in this chapter are necessary building blocks for the material of the next three chapters. In particular, standard deviation and variance measure the variability of the return on an individual security and on portfolios of securities. In the next chapter, we will argue that standard deviation and variance are appropriate measures of the risk of an individual security if an investor's portfolio is composed of that security only. KEY TERMS Average (mean) 231 Capital gain 223 Frequency distribution 231 Holding-period return 227 Normal distribution 234 Risk premium 232 Standard deviation 234 Variance 234 SUGGESTED READINGS An important record of the performance of financial instruments in the U.S. capital markets can be found in: Ibbotson, Roger G., and Rex A. Sinquefield. Stocks, Bonds, Bills and Inflation: 2000 Yearbook.TM Chicago: Ibbotson Associates. What is the equity risk premium? This is the question addressed by: Cornell, Bradford. The Equity Risk Premium: The Long Term Future of the Stock Market. New York: John Wiley, 1999 and Shiller, Robert S. Irrational Exuberance. Princeton, N.J.: Princeton University Press, 2000. For a look at market risk premiums worldwide, see: Jorion, P., and W. N. Goetzmann, "Global Stock Markets in the Twentieth Century." Journal of Finance 54 (1999). Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 243 Chapter 9 Capital Market Theory: An Overview 237 QUESTIONS AND PROBLEMS Returns 9.1 Last year, you bought 500 shares of Twedt El Dee stock at $37 per share. You have received total dividends of $1,000 during the year. Currently, Twedt El Dee stock sells for $38. a. How much did you earn in capital gains? b. What was your total dollar return? c. What was your percentage return? d. Must you sell the Twedt El Dee stock to include the capital gains in your return? Explain. 9.2 Mr. Alexander Bell invested $10,400 in 200 shares of First Industries stock a year ago and has received total dividends of $600 during the period. He sold the stock today at $54.25. a. What was his total dollar return? b. What was his capital gain? c. What was his percentage return? d. What was the stock's dividend yield? 9.3 Suppose a stock had an initial price of $42 per share. During the year, the stock paid a dividend of $2.40 per share. At the end of the year, the price is $31 per share. What is the percentage return on this stock? 9.4 Lydian Stock currently sells for $52 per share. You intend to buy the stock today and hold it for two years. During those two years, you expect to receive dividends at the year-ends that total $5.50 per share. Finally, you expect to sell the Lydian stock for $54.75 per share. What is your expected holding-period return on Lydian stock? 9.5 Use the information from Ibbotson and Sinquefield provided in the text to compute the nominal and real annual returns from 1926 to 1997 for each of the following items. a. Common stock b. Long-term corporate bonds c. Long-term government bonds d. U.S. Treasury bills 9.6 Suppose the current interest rate on U.S. Treasury bills is 6.2 percent. Ibbotson and Sinquefield found the average return on Treasury bills from 1926 through 1997 to be 3.8 percent. The average return on common stock during the same period was 13.0 percent. Given this information, what is the current expected return on common stocks? 9.7 Two stocks, Koke and Pepsee, had the same prices two years ago. During the last two years, Koke's stock price had first increased by 10 percent and then dropped by 10 percent, while Pepsee's stock price had first dropped by 10 percent and then increased by 10 percent. Do these two stocks have the same prices today? Explain. 9.8 S&P 500 index returns of common stocks for the period 19811985 are as follows. Calculate the five-year holding-period return. 1981 S&P 500 index return (%) 4.91 1982 21.41 1983 22.51 1984 6.27 1985 32.16 9.9 The Wall Street Journal announced yesterday that the current rate for one-year Treasury bills is 4.36 percent, while an Ibbotson and Sinquefield study shows that the average return on Treasury bills for the period 19261997 is 3.8 percent. During the same period the average return on long-term corporate bonds is 6.1 percent. What is the risk premium of the long-term corporate bonds? What is the expected return on the market of long-term corporate bonds? 244 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 238 Part III Risk Average Returns, Expected Returns, and Variance 9.10 During the past seven years, the returns on a portfolio of long-term corporate bonds were the following: Year 7 6 5 4 3 2 Last Long-Term Corporate Bonds 2.6% 1.0 43.8 4.7 16.4 30.1 19.9 a. Calculate the average return for long-term corporate bonds over this period. b. Calculate the variance and the standard deviation of the returns for long-term corporate bonds during this period. 9.11 The following are the returns during the past seven years on a market portfolio of common stocks and on Treasury bills. Common Stocks 32.4% 4.9 21.4 22.5 6.3 32.2 18.5 Treasury Bills 11.2% 14.7 10.5 8.8 9.9 7.7 6.2 Year 7 6 5 4 3 2 Last The realized risk premium is the return on the common stocks less the return on the Treasury bills. a. Calculate the realized risk premium of common stocks over T-bills in each year. b. Calculate the average risk premium of common stocks over T-bills during the period. c. Is it possible that this observed risk premium can be negative? Explain. 9.12 The probability that the economy will experience moderate growth next year is 0.6. The probability of a recession is 0.2, and the probability of a rapid expansion is also 0.2. If the economy falls into a recession, you can expect to receive a return on your portfolio of 5 percent. With moderate growth your return will be 8 percent. If there is a rapid expansion, your portfolio will return 15 percent. a. What is your expected return? b. What is the standard deviation of that return? 9.13 The probability that the economy will experience moderate growth next year is 0.4. The probability of a recession is 0.3, and the probability of a rapid expansion is also 0.3. If the economy falls into a recession, you can expect to receive a return on your portfolio of 2 percent. With moderate growth your return will be 5 percent. If there is a rapid expansion, your portfolio will return 10 percent. a. What is your expected return? b. What is the standard deviation of that return? 9.14 The returns on the market and on Trebli stock are shown below for the five possible states of the economy that might prevail next year. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 245 Chapter 9 Capital Market Theory: An Overview Market Return 0.23 0.18 0.15 0.09 0.03 Trebli Return 0.12 0.09 0.05 0.01 0.02 239 Economic Condition Rapid expansion Moderate expansion No growth Moderate contraction Serious contraction Probability 0.12 0.40 0.25 0.15 0.08 a. What is the expected return on the market? b. What is the expected return on Trebli stock? 9.15 Four equally likely states of the economy may prevail next year. Below are the returns on the stocks of P and Q companies under each of the possible states. State 1 2 3 4 P Stock 0.04 0.06 0.09 0.04 Q Stock 0.05 0.07 0.10 0.14 a. What is the expected return on each stock? b. What is the variance of the returns of each stock? 9.16 The returns on the small-company stocks and on the S&P composite index of common stocks from 1935 through 1939 are tabulated below. Year 1935 1936 1937 1938 1939 Small-Company Stocks 47.7% 33.9 35.0 31.0 0.5 Market Index of Common Stocks 40.2% 64.8 58.0 32.8 0.4 a. Calculate the average return for the small-company stocks and the market index of common stocks. b. Calculate the variance and standard deviation of returns for the small-company stocks and the market index of common stocks. 9.17 The following data are the returns for 1980 through 1986 on five types of capital-market instruments: common stocks, small-capitalization stocks, long-term corporate bonds, longterm U.S. government bonds, and U.S. Treasury bills. Long-Term Corporate Bonds 0.0262 0.0096 0.4379 0.0470 0.1639 0.3090 0.1985 Long-Term Government Bonds 0.0395 0.0185 0.4035 0.0068 0.1543 0.3097 0.2444 U.S. Treasury Bills 0.1124 0.1471 0.1054 0.0880 0.0985 0.0772 0.0616 Year 1980 1981 1982 1983 1984 1985 1986 Common Stock 0.3242 0.0491 0.2141 0.2251 0.0627 0.3216 0.1847 Small Stocks 0.3988 0.1388 0.2801 0.3967 0.0667 0.2466 0.0685 Calculate the average return and variance for each type of security. 246 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 240 Part III Risk Return and Risk Statistics 9.18 Ibbotson and Sinquefield have reported the returns on small-company stocks and U.S. Treasury bills for the period 19861991 as follows. Small-Company Stocks 6.85% 9.30 22.87 10.18 21.56 44.63 U.S. Treasury Bills 6.16% 5.47 6.35 8.37 7.81 5.60 Year 1986 1987 1988 1989 1990 1991 a. Calculate the average returns on small-company stocks and U.S. Treasury bills. b. Calculate the variances and standard deviations of the returns on small-company stocks and U.S. Treasury bills. c. Compare the returns and risks of these two types of securities. 9.19 Suppose International Trading Company's stock returns follow a normal distribution with a mean of 17.5 percent and a standard deviation of 8.5 percent. What is the range of returns in which about 95 percent of International Trading's stock returns are located? 9.20 The returns on the market of common stocks and on Treasury bills are contingent on the economy as follows. Economic Condition Recession Normal Boom Probability 0.25 0.50 0.25 Market Return 8.2% 12.3 25.8 Treasury Bills 3.5% 3.5 3.5 a. Calculate the expected returns on the market and Treasury bills. b. Calculate the expected risk premium. Appendix 9A THE HISTORICAL MARKET RISK PREMIUM: THE VERY LONG RUN The data in Chapter 9 indicate that the returns on common stock have historically been much higher than the returns on short-term government securities. This phenomenon has bothered economists, since it is difficult to justify why large numbers of rational investors purchase the lower yielding bills and bonds. In 1985 Mehra and Prescott published a very influential paper that showed that the historical returns for common stocks are far too high when compared to the rates of return on short-term government securities.9 They point out that the difference in returns (frequently called the market risk premium for equity) implies a very high degree of risk aversion on the part of investors. Since the publication of the Mehra and Prescott research, financial economists have tried to explain the so-called equity risk premium puzzle. The high historical equity risk premium is especially intriguing compared to the very low historical rate of return on Treasury securities. This seems to imply behavior that has not actually hap9 Rajnish Mehra and Edward C. Prescott, "The Equity Premium: A Puzzle," Journal of Monetary Economics 15 (1985), pp. 14561. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 9. Capital Market Theory: An Overview The McGraw-Hill Companies, 2002 247 Chapter 9 Capital Market Theory: An Overview 241 I TA B L E 9A.1 18021870 Common Stock Treasury bills Risk premium 6.8 5.4 1.4 18711925 8.5 4.1 4.4 19261999 13.3 3.8 9.5 Overall 18021999 9.7 4.4 5.3 pened. For example, if people have been very risk-averse and historical borrowing rates have been low, it suggests that persons should have been willing to borrow in periods of economic uncertainty and downturn to avoid the possibility of a reduced standard of living. However, we do not observe increased borrowing during recessions. The equity risk premium puzzle of Mehra and Prescott has been generally viewed as an unexplained paradox. However, recently, Jeremy Seigel has shown that the historical risk premium may be substantially lower than previously realized (see Table 9A.1). He shows that, while the risk premium averaged 9.5 percent from 1926 to 1999, it averaged only 1.4 percent from 1802 to 1870, and 4.4 percent from 1871 to 1925.10 It is puzzling that the trend has been rising over the last 200 years. It has been especially high since 1926. However, the key point is that historically the risk premium has been lower than in more recent times and we should be somewhat cautious about assumptions we make concerning the current risk premium. 10 Jeremy J. Seigel, Stocks for the Long Run, 2nd ed. (New York City: McGraw-Hill, 1998). 248 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 10 CHAPTER Return and Risk: The Capital-Asset-Pricing Model (CAPM) EXECUTIVE SUMMARY T he previous chapter achieved two purposes. First, we acquainted you with the history of U.S. capital markets. Second, we presented statistics such as expected return, variance, and standard deviation. Our ultimate goal in the next three chapters is to determine the appropriate discount rate for capital budgeting projects. Because the discount rate on a project is a function of its risk, the discussion in the previous chapter on standard deviation is a necessary first step. However, we shall see that standard deviation is not the final word on risk. Our next step is to investigate the relationship between the risk and the return of individual securities when these securities are part of a large portfolio. This task is taken up in Chapter 10. The actual treatment of the appropriate discount rate for capital budgeting is reserved for Chapter 12. The crux of the current chapter can be summarized as follows: An individual who holds one security should use expected return as the measure of the security's return. Standard deviation or variance is the proper measure of the security's risk. An individual who holds a diversified portfolio cares about the contribution of each security to the expected return and the risk of the portfolio. It turns out that a security's expected return is the appropriate measure of the security's contribution to the expected return on the portfolio. However, neither the security's variance nor the security's standard deviation is an appropriate measure of a security's contribution to the risk of a portfolio. The contribution of a security to the risk of a portfolio is best measured by beta. 10.1 INDIVIDUAL SECURITIES In the first part of Chapter 10 we will examine the characteristics of individual securities. In particular, we will discuss: 1. Expected Return. This is the return that an individual expects a stock to earn over the next period. Of course, because this is only an expectation, the actual return may be either higher or lower. An individual's expectation may simply be the average return per period a security has earned in the past. Alternatively, it may be based on a detailed analysis of a firm's prospects, on some computer-based model, or on special (or inside) information. 2. Variance and Standard Deviation. There are many ways to assess the volatility of a security's return. One of the most common is variance, which is a measure of the squared deviations of a security's return from its expected return. Standard deviation is the square root of the variance. 3. Covariance and Correlation. Returns on individual securities are related to one another. Covariance is a statistic measuring the interrelationship between two securities. Alternatively, Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 249 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 243 this relationship can be restated in terms of the correlation between the two securities. Covariance and correlation are building blocks to an understanding of the beta coefficient. 10.2 EXPECTED RETURN, VARIANCE, AND COVARIANCE Expected Return and Variance Suppose financial analysts believe that there are four equally likely states of the economy: depression, recession, normal, and boom times. The returns on the Supertech Company are expected to follow the economy closely, while the returns on the Slowpoke Company are not. The return predictions are as follows: Supertech Returns RAt Depression Recession Normal Boom 20% 10 30 50 Slowpoke Returns RBt 5% 20 12 9 Variance can be calculated in four steps. An additional step is needed to calculate standard deviation. (The calculations are presented in Table 10.1.) The steps are: 1. Calculate the expected return: Supertech: 0.20 0.10 4 Slowpoke: 0.05 0.20 4 0.12 0.09 0.055 5.5% RB 0.30 0.50 0.175 17.5% RA 2. For each company, calculate the deviation of each possible return from the company's expected return given previously. This is presented in the third column of Table 10.1. 3. The deviations we have calculated are indications of the dispersion of returns. However, because some are positive and some are negative, it is difficult to work with them in this form. For example, if we were to simply add up all the deviations for a single company, we would get zero as the sum. To make the deviations more meaningful, we multiply each one by itself. Now all the numbers are positive, implying that their sum must be positive as well. The squared deviations are presented in the last column of Table 10.1. 4. For each company, calculate the average squared deviation, which is the variance:1 Supertech: 0.140625 0.005625 4 1 0.015625 0.105625 0.066875 In this example, the four states give rise to four possible outcomes for each stock. Had we used past data, the outcomes would have actually occurred. In that case, statisticians argue that the correct divisor is N 1, where N is the number of observations. Thus the denominator would be 3 ( (4 1)) in the case of past data, not 4. Note that the example in Section 9.5 involved past data and we used a divisor of N 1. While this difference causes grief to both students and textbook writers, it is a minor point in practice. In the real world, samples are generally so large that using N or N 1 in the denominator has virtually no effect on the calculation of variance. 250 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 244 Part III Risk I TA B L E 10.1 Calculating Variance and Standard Deviation (1) State of Economy (2) Rate of Return Supertech* RAt 0.20 0.10 0.30 0.50 Slowpoke RBt 0.05 0.20 0.12 0.09 (3) Deviation from Expected Return (Expected return 0.175) RAt RA 0.375 ( 0.20 0.175) 0.075 0.125 0.325 (Expected return 0.055) RBt RB 0.005 ( 0.05 0.055) 0.145 0.175 0.035 (4) Squared Value of Deviation RAt RA 2 0.140625 [ ( 0.375)2] 0.005625 0.015625 0.105625 ___________ 0.267500 RBt RB 2 0.000025 [ ( 0.005)2] 0.021025 0.030625 0.001225 ___________ 0.052900 Depression Recession Normal Boom Depression Recession Normal Boom * RA Var RA SD(RA) RB Var RB SD(RB) 0.20 2 A A 0.10 4 0.30 0.50 0.175 17.5% 0.05 2 B B 0.2675 0.066875 4 0.066875 0.2586 0.20 0.12 0.09 4 0.0529 0.013225 4 0.013225 0.1150 25.86% 0.055 5.5% 11.50% Slowpoke: 0.000025 0.021025 4 0.030625 0.001225 0.013225 Thus, the variance of Supertech is 0.066875, and the variance of Slowpoke is 0.013225. 5. Calculate standard deviation by taking the square root of the variance: Supertech: 0.066875 = 0.2586 = 25.86% Slowpoke: 0.013225 = 0.1150 = 11.50% Algebraically, the formula for variance can be expressed as Var(R) Expected value of R R 2 where R is the security's expected return and R is the actual return. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 251 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 245 A look at the four-step calculation for variance makes it clear why it is a measure of the spread of the sample of returns. For each observation, one squares the difference between the actual return and the expected return. One then takes an average of these squared differences. Squaring the differences makes them all positive. If we used the differences between each return and the expected return and then averaged these differences, we would get zero because the returns that were above the mean would cancel the ones below. However, because the variance is still expressed in squared terms, it is difficult to interpret. Standard deviation has a much simpler interpretation, which was provided in Section 9.5. Standard deviation is simply the square root of the variance. The general formula for the standard deviation is SD(R) Var R Covariance and Correlation Variance and standard deviation measure the variability of individual stocks. We now wish to measure the relationship between the return on one stock and the return on another. Enter covariance and correlation. Covariance and correlation measure how two random variables are related. We explain these terms by extending the Supertech and Slowpoke example presented earlier in this chapter. E XAMPLE We have already determined the expected returns and standard deviations for both Supertech and Slowpoke. (The expected returns are 0.175 and 0.055 for Supertech and Slowpoke, respectively. The standard deviations are 0.2586 and 0.1150, respectively.) In addition, we calculated the deviation of each possible return from the expected return for each firm. Using these data, covariance can be calculated in two steps. An extra step is needed to calculate correlation. 1. For each state of the economy, multiply Supertech's deviation from its expected return and Slowpoke's deviation from its expected return together. For example, Supertech's rate of return in a depression is 0.20, which is 0.375 ( 0.20 0.175) from its expected return. Slowpoke's rate of return in a depression is 0.05, which is 0.005 (0.05 0.055) from its expected return. Multiplying the two deviations together yields 0.001875 [( 0.375) ( 0.005)]. The actual calculations are given in the last column of Table 10.2.This procedure can be written algebraically as RAt RA RBt RB (10.1) where RAt and RBt are the returns on Supertech and Slowpoke in state t. RA and RB are the expected returns on the two securities. 2. Calculate the average value of the four states in the last column. This average is the covariance. That is,2 AB Cov RA, RB 0.0195 4 0.004875 2 As with variance, we divided by N (4 in this example) because the four states give rise to four possible outcomes. However, had we used past data, the correct divisor would be N 1 (3 in this example). 252 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 246 Part III Risk I TA B L E 10.2 Calculating Covariance and Correlation State of Economy Rate of Return of Supertech RAt Deviation from Expected Return RAt RA (Expected return 0.175) 0.375 ( 0.20 0.175) 0.075 0.125 0.325 Rate of Return of Slowpoke RBt Deviation from Expected Return RBt RB (Expected return 0.055) 0.005 ( 0.05 0.055) 0.145 0.175 0.035 RAt Product of Deviations RA RBt RB Depression Recession Normal Boom 0.20 0.10 0.30 0.50 ____ 0.70 0.05 0.20 0.12 0.09 ____ 0.22 ( 0.001875 0.375 0.005) 0.010875 ( 0.075 0.145) 0.021875 ( 0.125 0.175) 0.011375 ( 0.325 0.035) ________________ 0.0195 AB Cov RA, RB Corr RA, RB AB 0.0195 0.004875 4 Cov RA, RB 0.004875 SD RA SD RB 0.2586 0.1150 0.1639 Note that we represent the covariance between Supertech and Slowpoke as either Cov(RA, RB) or AB. Equation (10.1) illustrates the intuition of covariance. Suppose Supertech's return is generally above its average when Slowpoke's return is above its average, and Supertech's return is generally below its average when Slowpoke's return is below its average. This is indicative of a positive dependency or a positive relationship between the two returns. Note that the term in equation (10.1) will be positive in any state where both returns are above their averages. In addition, (10.1) will still be positive in any state where both terms are below their averages. Thus, a positive relationship between the two returns will give rise to a positive value for covariance. Conversely, suppose Supertech's return is generally above its average when Slowpoke's return is below its average, and Supertech's return is generally below its average when Slowpoke's return is above its average. This is indicative of a negative dependency or a negative relationship between the two returns. Note that the term in equation (10.1) will be negative in any state where one return is above its average and the other return is below its average. Thus, a negative relationship between the two returns will give rise to a negative value for covariance. Finally, suppose there is no relation between the two returns. In this case, knowing whether the return on Supertech is above or below its expected return tells us nothing about the return on Slowpoke. In the covariance formula, then, there will be no tendency for the deviations to be positive or negative together. On average, they will tend to offset each other and cancel out, making the covariance zero. Of course, even if the two returns are unrelated to each other, the covariance formula will not equal zero exactly in any actual history. This is due to sampling error; randomness alone will make the calculation positive or negative. But for a historical sample that is long enough, if the two returns are not related to each other, we should expect the covariance to come close to zero. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 253 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 247 The covariance formula seems to capture what we are looking for. If the two returns are positively related to each other, they will have a positive covariance, and if they are negatively related to each other, the covariance will be negative. Last, and very important, if they are unrelated, the covariance should be zero. The formula for covariance can be written algebraically as AB Cov RA, RB Expected value of RA RA RB RB where RA and RB are the expected returns for the two securities, and RA and RB are the actual returns. The ordering of the two variables is unimportant. That is, the covariance of A with B is equal to the covariance of B with A. This can be stated more formally as Cov(RA, RB) Cov(RB, RA) or AB BA. The covariance we calculated is 0.004875. A negative number like this implies that the return on one stock is likely to be above its average when the return on the other stock is below its average, and vice versa. However, the size of the number is difficult to interpret. Like the variance figure, the covariance is in squared deviation units. Until we can put it in perspective, we don't know what to make of it. We solve the problem by computing the correlation: 3. To calculate the correlation, divide the covariance by the standard deviations of both of the two securities. For our example, we have: AB Corr RA, RB Cov RA, RB A B 0.004875 0.2586 0.1150 0.1639 (10.2) where A and B are the standard deviations of Supertech and Slowpoke, respectively. Note that we represent the correlation between Supertech and Slowpoke either as Corr(RA, RB) or AB. As with covariance, the ordering of the two variables is unimportant. That is, the correlation of A with B is equal to the correlation of B with A. More formally, Corr(RA, RB) Corr(RB, RA) or AB BA. Because the standard deviation is always positive, the sign of the correlation between two variables must be the same as that of the covariance between the two variables. If the correlation is positive, we say that the variables are positively correlated; if it is negative, we say that they are negatively correlated; and if it is zero, we say that they are uncorrelated. Furthermore, it can be proved that the correlation is always between 1 and 1. This is due to the standardizing procedure of dividing by the two standard deviations. We can compare the correlation between different pairs of securities. For example, it turns out that the correlation between General Motors and Ford is much higher than the correlation between General Motors and IBM. Hence, we can state that the first pair of securities is more interrelated than the second pair. Figure 10.1 shows the three benchmark cases for two assets, A and B. The figure shows two assets with return correlations of 1, 1, and 0. This implies perfect positive correlation, perfect negative correlation, and no correlation, respectively. The graphs in the figure plot the separate returns on the two securities through time. 10.3 THE RETURN AND RISK FOR PORTFOLIOS Suppose that an investor has estimates of the expected returns and standard deviations on individual securities and the correlations between securities. How then does the investor choose the best combination or portfolio of securities to hold? Obviously, the investor would like a portfolio with a high expected return and a low standard deviation of return. It is therefore worthwhile to consider: 254 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 248 Part III Risk I F I G U R E 10.1 Examples of Different Correlation Coefficients--the Graphs in the Figure Plot the Separate Returns on the Two Securities through Time Perfect positive correlation Corr(RA, RB) = 1 Returns Returns B 0 A B Time Both the return on security A and the return on security B are higher than average at the same time. Both the return on security A and the return on security B are lower than average at the same time. 0 A Time Security A has a higher-than-average return when security B has a lower-than-average return, and vice versa. Perfect negative correlation Corr(RA, RB) = 1 Zero correlation Corr(RA, RB) = 0 Returns 0 A B Time The return on security A is completely unrelated to the return on security B. 1. The relationship between the expected return on individual securities and the expected return on a portfolio made up of these securities. 2. The relationship between the standard deviations of individual securities, the correlations between these securities, and the standard deviation of a portfolio made up of these securities. The Example of Supertech and Slowpoke In order to analyze the above two relationships, we will use the same example of Supertech and Slowpoke that was presented previously. The relevant calculations are as follows. The Expected Return on a Portfolio The formula for expected return on a portfolio is very simple: The expected return on a portfolio is simply a weighted average of the expected returns on the individual securities. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 255 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 249 RELEVANT DATA FROM EXAMPLE OF SUPERTECH AND SLOWPOKE Item Expected return on Supertech Expected return on Slowpoke Variance of Supertech Variance of Slowpoke Standard deviation of Supertech Standard deviation of Slowpoke Covariance between Supertech and Slowpoke Correlation between Supertech and Slowpoke Symbol RSuper RSlow 2 2 Super Slow Super Slow Super, Slow Super, Slow Value 0.175 17.5% 0.055 5.5% 0.066875 0.013225 0.2586 25.86% 0.1150 11.50% 0.004875 0.1639 E XAMPLE Consider Supertech and Slowpoke. From the preceding box, we find that the expected returns on these two securities are 17.5 percent and 5.5 percent, respectively. The expected return on a portfolio of these two securities alone can be written as Expected return on portfolio XSuper 17.5% XSlow 5.5% RP where XSuper is the percentage of the portfolio in Supertech and XSlow is the percentage of the portfolio in Slowpoke. If the investor with $100 invests $60 in Supertech and $40 in Slowpoke, the expected return on the portfolio can be written as Expected return on portfolio Algebraically, we can write Expected return on portfolio XARA XBRB RP (10.3) 0.6 17.5% 0.4 5.5% 12.7% where XA and XB are the proportions of the total portfolio in the assets A and B, respectively. (Because our investor can only invest in two securities, XA XB must equal 1 or 100 percent.) RA and RB are the expected returns on the two securities. Now consider two stocks, each with an expected return of 10 percent. The expected return on a portfolio composed of these two stocks must be 10 percent, regardless of the proportions of the two stocks held. This result may seem obvious at this point, but it will become important later. The result implies that you do not reduce or dissipate your expected return by investing in a number of securities. Rather, the expected return on your portfolio is simply a weighted average of the expected returns on the individual assets in the portfolio. Variance and Standard Deviation of a Portfolio The Variance The formula for the variance of a portfolio composed of two securities, A and B, is The Variance of the Portfolio: Var portfolio X2 A 2 A 2XAXB A, B X2 B 2 B 256 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 250 Part III Risk Note that there are three terms on the right-hand side of the equation. The first term involves 2 the variance of A A , the second term involves the covariance between the two securities 2 ( A,B), and the third term involves the variance of B B . (As stated earlier in this chapter, A,B B,A. That is, the ordering of the variables is not relevant when expressing the covariance between two securities.) The formula indicates an important point. The variance of a portfolio depends on both the variances of the individual securities and the covariance between the two securities. The variance of a security measures the variability of an individual security's return. Covariance measures the relationship between the two securities. For given variances of the individual securities, a positive relationship or covariance between the two securities increases the variance of the entire portfolio. A negative relationship or covariance between the two securities decreases the variance of the entire portfolio. This important result seems to square with common sense. If one of your securities tends to go up when the other goes down, or vice versa, your two securities are offsetting each other. You are achieving what we call a hedge in finance, and the risk of your entire portfolio will be low. However, if both your securities rise and fall together, you are not hedging at all. Hence, the risk of your entire portfolio will be higher. The variance formula for our two securities, Super and Slow, is Var portfolio 2 X Super 2 Super 2XSuperXSlow Super, Slow 2 XSlow 2 Slow (10.4) Given our earlier assumption that an individual with $100 invests $60 in Supertech and $40 in Slowpoke, XSuper 0.6 and XSlow 0.4. Using this assumption and the relevant data from the box above, the variance of the portfolio is 0.023851 0.36 0.066875 2 [0.6 0.4 ( 0.004875)] 0.16 0.013225 (10.4) The Matrix Approach Alternatively, equation (10.4) can be expressed in the following matrix format: Supertech Supertech 2 2 X Super Super 0.024075 0.36 0.066875 Slowpoke XSuperXSlow Super, Slow 0.00117 0.6 0.4 ( 0.004875) 2 2 X Slow Slow 0.002116 0.16 0.013225 Slowpoke XSuperXSlow Super, Slow 0.00117 0.6 0.4 ( 0.004875) There are four boxes in the matrix. We can add the terms in the boxes to obtain equation (10.4), the variance of a portfolio composed of the two securities. The term in the upper left-hand corner involves the variance of Supertech. The term in the lower right-hand corner involves the variance of Slowpoke. The other two boxes contain the term involving the covariance. These two boxes are identical, indicating why the covariance term is multiplied by 2 in equation (10.4). At this point, students often find the box approach to be more confusing than equation (10.4). However, the box approach is easily generalized to more than two securities, a task we perform later in this chapter. Standard Deviation of a Portfolio Given (10.4), we can now determine the standard deviation of the portfolio's return. This is P SD(portfolio) Var portfolio 0.1544 15.44% 0.023851 (10.5) Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 257 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 251 The interpretation of the standard deviation of the portfolio is the same as the interpretation of the standard deviation of an individual security. The expected return on our portfolio is 12.7 percent. A return of 2.74 percent (12.7% 15.44%) is one standard deviation below the mean and a return of 28.14 percent (12.7% 15.44%) is one standard deviation above the mean. If the return on the portfolio is normally distributed, a return between 2.74 percent and 28.14 percent occurs about 68 percent of the time.3 The Diversification Effect It is instructive to compare the standard deviation of the portfolio with the standard deviation of the individual securities. The weighted average of the standard deviations of the individual securities is Weighted average of standard deviations 0.2012 XSuper Super XSlow 0.6 0.2586 0.4 Slow (10.6) 0.115 One of the most important results in this chapter concerns the difference between equations (10.5) and (10.6). In our example, the standard deviation of the portfolio is less than a weighted average of the standard deviations of the individual securities. We pointed out earlier that the expected return on the portfolio is a weighted average of the expected returns on the individual securities. Thus, we get a different type of result for the standard deviation of a portfolio than we do for the expected return on a portfolio. It is generally argued that our result for the standard deviation of a portfolio is due to diversification. For example, Supertech and Slowpoke are slightly negatively correlated ( 0.1639). Supertech's return is likely to be a little below average if Slowpoke's return is above average. Similarly, Supertech's return is likely to be a little above average if Slowpoke's return is below average. Thus, the standard deviation of a portfolio composed of the two securities is less than a weighted average of the standard deviations of the two securities. The above example has negative correlation. Clearly, there will be less benefit from diversification if the two securities exhibit positive correlation. How high must the positive correlation be before all diversification benefits vanish? To answer this question, let us rewrite (10.4) in terms of correlation rather than covariance. The covariance can be rewritten as4 Super, Slow Super, Slow Super Slow (10.7) The formula states that the covariance between any two securities is simply the correlation between the two securities multiplied by the standard deviations of each. In other words, covariance incorporates both (1) the correlation between the two assets and (2) the variability of each of the two securities as measured by standard deviation. From our calculations earlier in this chapter we know that the correlation between the two securities is 0.1639. Given the variances used in equation (10.4), the standard deviations are 0.2586 and 0.115 for Supertech and Slowpoke, respectively. Thus, the variance of a portfolio can be expressed as Variance of the portfolio's return 2 X Super 0.023851 0.36 2XSuperXSlow Super, Slow Super Slow X 2 Slow 0.066875 2 0.6 0.4 ( 0.1639) 0.2586 0.115 0.16 2 Super 2 Slow (10.8) 0.013225 3 There are only four equally probable returns for Supertech and Slowpoke, so neither security possesses a normal distribution. Thus, probabilities would be slightly different in our example. 4 As with covariance, the ordering of the two securities is not relevant when expressing the correlation between the two securities. That is, Super,Slow Slow,Super. 258 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 252 Part III Risk The middle term on the right-hand side is now written in terms of correlation, , not covariance. Suppose Super, Slow 1, the highest possible value for correlation. Assume all the other parameters in the example are the same. The variance of the portfolio is Variance of the portfolio's return 0.040466 0.36 0.066875 2 (0.6 0.4 1 0.2586 0.115) 0.16 0.013225 The standard deviation is Standard variation of portfolio's return 0.040466 0.2012 20.12% (10.9) Note that equations (10.9) and (10.6) are equal. That is, the standard deviation of a portfolio's return is equal to the weighted average of the standard deviations of the individual returns when 1. Inspection of (10.8) indicates that the variance and hence the standard deviation of the portfolio must fall as the correlation drops below 1. This leads to: As long as 1, the standard deviation of a portfolio of two securities is less than the weighted average of the standard deviations of the individual securities. In other words, the diversification effect applies as long as there is less than perfect correlation (as long as 1). Thus, our Supertech-Slowpoke example is a case of overkill. We illustrated diversification by an example with negative correlation. We could have illustrated diversification by an example with positive correlation--as long as it was not perfect positive correlation. An Extension to Many Assets The preceding insight can be extended to the case of many assets. That is, as long as correlations between pairs of securities are less than 1, the standard deviation of a portfolio of many assets is less than the weighted average of the standard deviations of the individual securities. Now consider Table 10.3, which shows the standard deviation of the Standard & Poor's 500 Index and the standard deviations of some of the individual securities listed in the index over a recent 10-year period. Note that all of the individual securities in the table have higher standard deviations than that of the index. In general, the standard deviations of most of the individual securities in an index will be above the standard deviation of the index itself, though a few of the securities could have lower standard deviations than that of the index. QUESTIONS CONCEPT ? What are the formulas for the expected return, variance, and standard deviation of a portfolio of two assets? What is the diversification effect? What are the highest and lowest possible values for the correlation coefficient? 10.4 THE EFFICIENT SET FOR TWO ASSETS Our results on expected returns and standard deviations are graphed in Figure 10.2. In the figure, there is a dot labeled Slowpoke and a dot labeled Supertech. Each dot represents both the expected return and the standard deviation for an individual security. As can be seen, Supertech has both a higher expected return and a higher standard deviation. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 259 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 253 I TA B L E 10.3 Standard Deviations for Standard & Poor's 500 Index and for Selected Stocks in the Index Standard Deviation 13.33% 28.60 31.39 41.05 29.54 32.18 32.38 29.76 32.23 59.21 Asset S&P 500 Index Bell Atlantic Ford Motor Co. Walt Disney Co. General Electric IBM McDonald's Corp. Sears, Roebuck & Co. Toys "R" Us Inc. Amazon.com As long as the correlations between pairs of securities are less than 1, the standard deviation of an index is less than the weighted average of the standard deviations of the individual securities within the index. I F I G U R E 10.2 Expected Returns and Standard Deviations for Supertech, Slowpoke, and a Portfolio Composed of 60 Percent in Supertech and 40 Percent in Slowpoke Expected return (%) Supertech 17.5 12.7 5.5 Slowpoke Standard deviation (%) 11.50 15.44 25.86 The box or "" in the graph represents a portfolio with 60 percent invested in Supertech and 40 percent invested in Slowpoke. You will recall that we have previously calculated both the expected return and the standard deviation for this portfolio. The choice of 60 percent in Supertech and 40 percent in Slowpoke is just one of an infinite number of portfolios that can be created. The set of portfolios is sketched by the curved line in Figure 10.3. 260 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 254 Part III Risk I F I G U R E 10.3 Set of Portfolios Composed of Holdings in Supertech and Slowpoke (correlation between the two securities is 0.1639) Expected return on portfolio (%) XSupertech = 60% XSlowpoke = 40% Supertech 17.5 3 2 MV 1 5.5 Slowpoke Standard deviation of portfolio's return (%) 1 11.50 25.86 Portfolio 1 is composed of 90 percent Slowpoke and 10 percent Supertech ( 0.1639). Portfolio 2 is composed of 50 percent Slowpoke and 50 percent Supertech ( 0.1639). Portfolio 3 is composed of 10 percent Slowpoke and 90 percent Supertech ( 0.1639). Portfolio 1' is composed of 90 percent Slowpoke and 10 percent Supertech ( 1). Point MV denotes the mimimum variance portfolio. This is the portfolio with the lowest possible variance. By definition, the same portfolio must also have the lowest possible standard deviation. Consider portfolio 1. This is a portfolio composed of 90 percent Slowpoke and 10 percent Supertech. Because it is weighted so heavily toward Slowpoke, it appears close to the Slowpoke point on the graph. Portfolio 2 is higher on the curve because it is composed of 50 percent Slowpoke and 50 percent Supertech. Portfolio 3 is close to the Supertech point on the graph because it is composed of 90 percent Supertech and 10 percent Slowpoke. There are a few important points concerning this graph. 1. We argued that the diversification effect occurs whenever the correlation between the two securities is below 1. The correlation between Supertech and Slowpoke is 0.1639. The diversification effect can be illustrated by comparison with the straight line between the Supertech point and the Slowpoke point. The straight line represents points that would have been generated had the correlation coefficient between the two securities been 1. The diversification effect is illustrated in the figure since the curved line is always to the left of the straight line. Consider point 1. This represents a portfolio composed of 90 percent in Slowpoke and 10 percent in Supertech if the correlation between the two were exactly 1. We argue that there is no diversification effect if 1. However, the diversification effect applies to the curved line, because point 1 has the same expected return as point 1 but has a lower standard deviation. (Points 2 and 3 are omitted to reduce the clutter of Figure 10.3.) Though the straight line and the curved line are both represented in Figure 10.3, they do not simultaneously exist in the same world. Either 0.1639 and the curve exists or 1 and the straight line exists. In other words, though an investor can choose between different points on the curve if 0.1639, she cannot choose between points on the curve and points on the straight line. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 261 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 255 2. The point MV represents the minimum variance portfolio. This is the portfolio with the lowest possible variance. By definition, this portfolio must also have the lowest possible standard deviation. (The term minimum variance portfolio is standard in the literature, and we will use that term. Perhaps minimum standard deviation would actually be better, because standard deviation, not variance, is measured on the horizontal axis of Figure 10.3.) 3. An individual contemplating an investment in a portfolio of Slowpoke and Supertech faces an opportunity set or feasible set represented by the curved line in Figure 10.3. That is, he can achieve any point on the curve by selecting the appropriate mix between the two securities. He cannot achieve any point above the curve because he cannot increase the return on the individual securities, decrease the standard deviations of the securities, or decrease the correlation between the two securities. Neither can he achieve points below the curve because he cannot lower the returns on the individual securities, increase the standard deviations of the securities, or increase the correlation. (Of course, he would not want to achieve points below the curve, even if he were able to do so.) Were he relatively tolerant of risk, he might choose portfolio 3. (In fact, he could even choose the end point by investing all his money in Supertech.) An investor with less tolerance for risk might choose portfolio 2. An investor wanting as little risk as possible would choose MV, the portfolio with minimum variance or minimum standard deviation. 4. Note that the curve is backward bending between the Slowpoke point and MV. This indicates that, for a portion of the feasible set, standard deviation actually decreases as one increases expected return. Students frequently ask, "How can an increase in the proportion of the risky security, Supertech, lead to a reduction in the risk of the portfolio?" This surprising finding is due to the diversification effect. The returns on the two securities are negatively correlated with each other. One security tends to go up when the other goes down and vice versa. Thus, an addition of a small amount of Supertech acts as a hedge to a portfolio composed only of Slowpoke. The risk of the portfolio is reduced, implying backward bending. Actually, backward bending always occurs if 0. It may or may not occur when 0. Of course, the curve bends backward only for a portion of its length. As one continues to increase the percentage of Supertech in the portfolio, the high standard deviation of this security eventually causes the standard deviation of the entire portfolio to rise. 5. No investor would want to hold a portfolio with an expected return below that of the minimum variance portfolio. For example, no investor would choose portfolio 1. This portfolio has less expected return but more standard deviation than the minimum variance portfolio has. We say that portfolios such as portfolio 1 are dominated by the minimum variance portfolio. Though the entire curve from Slowpoke to Supertech is called the feasible set, investors only consider the curve from MV to Supertech. Hence, the curve from MV to Supertech is called the efficient set or the efficient frontier. Figure 10.3 represents the opportunity set where 0.1639. It is worthwhile to examine Figure 10.4, which shows different curves for different correlations. As can be seen, the lower the correlation, the more bend there is in the curve. This indicates that the diversification effect rises as declines. The greatest bend occurs in the limiting case where 1. This is perfect negative correlation. While this extreme case where 1 seems to fascinate students, it has little practical importance. Most pairs of securities exhibit positive correlation. Strong negative correlation, let alone perfect negative correlation, are unlikely occurrences indeed.5 5 A major exception occurs with derivative securities. For example, the correlation between a stock and a put on the stock is generally strongly negative. Puts will be treated later in the text. 262 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 256 Part III Risk I F I G U R E 10.4 Opportunity Sets Composed of Holdings in Supertech and Slowpoke Expected return on portfolio =1 = 0.1639 =0 = 0.5 =1 Standard deviation of portfolio's return Each curve represents a different correlation. The lower the correlation, the more bend in the curve. Note that there is only one correlation between a pair of securities. We stated earlier that the correlation between Slowpoke and Supertech is 0.1639. Thus, the curve in Figure 10.4 representing this correlation is the correct one, and the other curves should be viewed as merely hypothetical. The graphs we examined are not mere intellectual curiosities. Rather, efficient sets can easily be calculated in the real world. As mentioned earlier, data on returns, standard deviations, and correlations are generally taken from past observations, though subjective notions can be used to determine the values of these parameters as well. Once the parameters have been determined, any one of a whole host of software packages can be purchased to generate an efficient set. However, the choice of the preferred portfolio within the efficient set is up to you. As with other important decisions like what job to choose, what house or car to buy, and how much time to allocate to this course, there is no computer program to choose the preferred portfolio. An efficient set can be generated where the two individual assets are portfolios themselves. For example, the two assets in Figure 10.5 are a diversified portfolio of American stocks and a diversified portfolio of foreign stocks. Expected returns, standard deviations, and the correlation coefficient were calculated over the recent past. No subjectivity entered the analysis. The U.S. stock portfolio with a standard deviation of about 0.173 is less risky than the foreign stock portfolio, which has a standard deviation of about 0.222. However, combining a small percentage of the foreign stock portfolio with the U.S. portfolio actually reduces risk, as can be seen by the backward-bending nature of the curve. In other words, the diversification benefits from combining two different portfolios more than offset the introduction of a riskier set of stocks into one's holdings. The minimum variance portfolio occurs with about 80 percent of one's funds in American stocks and about 20 percent in foreign stocks. Addition of foreign securities beyond this point increases the risk of one's entire portfolio. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 263 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 257 I F I G U R E 10.5 Return/Risk Trade-off for World Stocks: Portfolio of U.S. and Foreign Stocks Total return on portfolio (%) 0.2 0.19 Minimum 0.18 variance 0.17 portfolio 0.16 0.15 0.14 0.13 0.12 0.11 0.1 0.09 0.08 0.07 0.06 0.15 0.17 0.19 0.21 60% 70% 80% U.S., 20% Foreign 90% 100% U.S. Risk (standard deviation of 0.23 portfolio's return) (%) 30% 40% 50% 0 % U.S., 100% Foreign 10% 20% U.S., 80% Foreign The backward-bending curve in Figure 10.5 is important information that has not bypassed American money managers. In recent years, pension-fund and mutual-fund managers in the United States have sought out investment opportunities overseas. Another point worth pondering concerns the potential pitfalls of using only past data to estimate future returns. The stock markets of many foreign countries have had phenomenal growth in the past 25 years. Thus, a graph like Figure 10.5 makes a large investment in these foreign markets seem attractive. However, because abnormally high returns cannot be sustained forever, some subjectivity must be used when forecasting future expected returns. QUESTION CONCEPT ? What is the relationship between the shape of the efficient set for two assets and the correlation between the two assets? 10.5 THE EFFICIENT SET FOR MANY SECURITIES The previous discussion concerned two securities. We found that a simple curve sketched out all the possible portfolios. Because investors generally hold more than two securities, we should look at the same graph when more than two securities are held. The shaded area in Figure 10.6 represents the opportunity set or feasible set when many securities are considered. The shaded area represents all the possible combinations of expected return and standard deviation for a portfolio. For example, in a universe of 100 securities, point 1 might represent a portfolio of, say, 40 securities. Point 2 might represent a portfolio of 80 securities. Point 3 might represent a different set of 80 securities, or the same 80 securities held in different proportions, or something else. Obviously, the combinations are virtually endless. However, note 264 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 258 Part III Risk I F I G U R E 10.6 The Feasible Set of Portfolios Constructed from Many Securities Expected return on portfolio X 2 R W MV 1 3 Standard deviation of portfolio's return that all possible combinations fit into a confined region. No security or combination of securities can fall outside of the shaded region. That is, no one can choose a portfolio with an expected return above that given by the shaded region. Furthermore, no one can choose a portfolio with a standard deviation below that given in the shady area. Perhaps more surprisingly, no one can choose an expected return below that given in the curve. In other words, the capital markets actually prevent a self-destructive person from taking on a guaranteed loss.6 So far, Figure 10.6 is different from the earlier graphs. When only two securities are involved, all the combinations lie on a single curve. Conversely, with many securities the combinations cover an entire area. However, notice that an individual will want to be somewhere on the upper edge between MV and X. The upper edge, which we indicate in Figure 10.6 by a thick curve, is called the efficient set. Any point below the efficient set would receive less expected return and the same standard deviation as a point on the efficient set. For example, consider R on the efficient set and W directly below it. If W contains the risk you desire, you should choose R instead in order to receive a higher expected return. In the final analysis, Figure 10.6 is quite similar to Figure 10.3. The efficient set in Figure 10.3 runs from MV to Supertech. It contains various combinations of the securities Supertech and Slowpoke. The efficient set in Figure 10.6 runs from MV to X. It contains various combinations of many securities. The fact that a whole shaded area appears in Figure 10.6 but not in Figure 10.3 is just not an important difference; no investor would choose any point below the efficient set in Figure 10.6 anyway. We mentioned before that an efficient set for two securities can be traced out easily in the real world. The task becomes more difficult when additional securities are included because the number of observations grows. For example, using subjective analysis to estimate expected returns and standard deviations for, say, 100 or 500 securities may very well become overwhelming, and the difficulties with correlations may be greater still. There are almost 5,000 correlations between pairs of securities from a universe of 100 securities. 6 Of course, someone dead set on parting with his money can do so. For example, he can trade frequently without purpose, so that commissions more than offset the positive expected returns on the portfolio. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 265 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 259 I TA B L E 10.4 Matrix Used to Calculate the Variance of a Portfolio Stock 1 2 3 . . . N XNX1Cov(RN,R1) XNX2Cov(RN,R2) XNX3Cov(RN,R3) 2 XN 2 N 1 2 X1 2 1 2 X1X2Cov(R1,R2) 2 X2 2 2 3 X1X3Cov(R1,R3) X2X3Cov(R2,R3) 2 X3 2 3 ... N X1XNCov(R1,RN) X2XNCov(R2,RN) X3XNCov(R3,RN) X2X1Cov(R2,R1) X3X1Cov(R3,R1) X3X2Cov(R3,R2) The variance of the portfolio is the sum of the terms in all the boxes. i is the standard deviation of stock i. Cov(Ri, Rj) is the covariance between stock i and stock j. Terms involving the standard deviation of a single security appear on the diagonal. Terms involving covariance between two securities appear off the diagonal. Though much of the mathematics of efficient-set computation had been derived in the 1950s,7 the high cost of computer time restricted application of the principles. In recent years, the cost has been drastically reduced. A number of software packages allow the calculation of an efficient set for portfolios of moderate size. By all accounts these packages sell quite briskly, so that our discussion above would appear to be important in practice. Variance and Standard Deviation in a Portfolio of Many Assets We earlier calculated the formulas for variance and standard deviation in the two-asset case. Because we considered a portfolio of many assets in Figure 10.6, it is worthwhile to calculate the formulas for variance and standard deviation in the many-asset case. The formula for the variance of a portfolio of many assets can be viewed as an extension of the formula for the variance of two assets. To develop the formula, we employ the same type of matrix that we used in the twoasset case. This matrix is displayed in Table 10.4. Assuming that there are N assets, we write the numbers 1 through N on the horizontal axis and 1 through N on the vertical axis. This creates a matrix of N N N2 boxes. The variance of the portfolio is the sum of the terms in all the boxes. Consider, for example, the box in the second row and the third column. The term in the box is X2X3 Cov(R2, R3). X2 and X3 are the percentages of the entire portfolio that are invested in the second asset and the third asset, respectively. For example, if an individual with a portfolio of $1,000 invests $100 in the second asset, X2 10% ($100/$1,000). Cov(R3, R2) is the covariance between the returns on the third asset and the returns on the second asset. Next, note the box in the third row and the second column. The term in this box is X3X2 Cov(R3, R2). Because Cov(R3, R2) Cov(R2, R3), both boxes have the same value. The second security and the third security make up one pair of stocks. In fact, every pair of stocks appears twice in the table, once in the lower left-hand side and once in the upper right-hand side. 7 The classic treatise is Harry Markowitz, Portfolio Selection (New York: John Wiley & Sons, 1959). Markowitz won the Nobel Prize in economics in 1990 for his work on modern portfolio theory. 266 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 260 Part III Risk I TA B L E 10.5 Number of Variance and Covariance Terms as a Function of the Number of Stocks in the Portfolio Number of Variance Terms (number of terms on diagonal) 1 2 3 10 100 . . . N Number of Covariance Terms (number of terms off diagonal) 0 2 6 90 9,900 . . . N2 N Number of Stocks in Portfolio 1 2 3 10 100 . . . N Total Number of Terms 1 4 9 100 10,000 . . . N2 In a large portfolio, the number of terms involving covariance between two securities is much greater than the number of terms involving variance of a single security. Now consider boxes on the diagonal. For example, the term in the first box on the di2 2 2 agonal is X 1 1 . Here, 1 is the variance of the return on the first security. Thus, the diagonal terms in the matrix contain the variances of the different stocks. The off-diagonal terms contain the covariances. Table 10.5 relates the numbers of diagonal and off-diagonal elements to the size of the matrix. The number of diagonal terms (number of variance terms) is always the same as the number of stocks in the portfolio. The number of off-diagonal terms (number of covariance terms) rises much faster than the number of diagonal terms. For example, a portfolio of 100 stocks has 9,900 covariance terms. Since the variance of a portfolio's returns is the sum of all the boxes, we have: The variance of the return on a portfolio with many securities is more dependent on the covariances between the individual securities than on the variances of the individual securities. QUESTIONS CONCEPT ? What is the formula for the variance of a portfolio for many assets? How can the formula be expressed in terms of a box or matrix? 10.6 DIVERSIFICATION: AN EXAMPLE The preceding point can be illustrated by altering the matrix in Table 10.4 slightly. Suppose that we make the following three assumptions: 1. All securities possess the same variance, which we write as var. In other words, 2 var for every security. i 2. All covariances in Table 10.4 are the same. We represent this uniform covariance as cov. In other words, Cov Ri, Rj cov for every pair of securities. It can easily be shown that var cov. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 267 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 261 I TA B L E 10.6 Matrix Used to Calculate the Variance of a Portfolio When (a) All Securities Possess the Same Variance, Which We Represent as var; (b) All Pairs of Securities Possess the Same Covariance, Which We Represent as cov; (c) All Securities Are Held in the Same Proportion, Which Is 1/N Stock 1 2 3 . . . N 1/N2 cov 1/N2 cov 1/N2 cov 1/N2 var 1 1/N2 var 1/N2 cov 1/N cov 2 2 1/N2 cov 1/N2 var 1/N cov 2 3 1/N2 cov 1/N2 cov 1/N var 2 ... N 1/N2 cov 1/N2 cov 1/N2 cov 3. All securities are equally weighted in the portfolio. Because there are N assets, the weight of each asset in the portfolio is 1/N. In other words, Xi 1/N for each security i. Table 10.6 is the matrix of variances and covariances under these three simplifying assumptions. Note that all of the diagonal terms are identical. Similarly, all of the offdiagonal terms are identical. As with Table 10.4, the variance of the portfolio is the sum of the terms in the boxes in Table 10.6. We know that there are N diagonal terms involving variance. Similarly, there are N (N 1) off-diagonal terms involving covariance. Summing across all the boxes in Table 10.6 we can express the variances of the portfolio as Variance of portfolio N 1 var N2 NN 1 1 cov (10.10) N2 Each off-diagonal term Number of Each Number of diagonal diagonal off-diagonal terms term terms 1 N2 N var cov N N2 1 1 var 1 cov N N Equation (10.10) expresses the variance of our special portfolio as a weighted sum of the average security variance and the average covariance.8 8 Equation (10.10) is actually a weighted average of the variance and covariance terms because the weights, 1/N and 1 1/N, sum to 1. 268 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 262 Part III Risk Now, let's increase the number of securities in the portfolio without limit. The variance of the portfolio becomes Variance of portfolio (when N ) cov (10.11) This occurs because (1) the weight on the variance term, 1/N, goes to 0 as N goes to infinity, and (2) the weight on the covariance term, 1 1/N, goes to 1 as N goes to infinity. Formula (10.11) provides an interesting and important result. In our special portfolio, the variances of the individual securities completely vanish as the number of securities becomes large. However, the covariance terms remain. In fact, the variance of the portfolio becomes the average covariance, cov. One often hears that one should diversify. In other words, you should not put all your eggs in one basket. The effect of diversification on the risk of a portfolio can be illustrated in this example. The variances of the individual securities are diversified away, but the covariance terms cannot be diversified away. The fact that part, but not all, of one's risk can be diversified away should be explored. Consider Mr. Smith, who brings $1,000 to the roulette table at a casino. It would be very risky if he put all his money on one spin of the wheel. For example, imagine that he put the full $1,000 on red at the table. If the wheel showed red, he would get $2,000, but if the wheel showed black, he would lose everything. Suppose, instead, he divided his money over 1,000 different spins by betting $1 at a time on red. Probability theory tells us that he could count on winning about 50 percent of the time. This means that he could count on pretty nearly getting all his original $1,000 back.9 In other words, risk is essentially eliminated with 1,000 different spins. Now, let's contrast this with our stock market example, which we illustrate in Figure 10.7. The variance of the portfolio with only one security is, of course, var because the variance of a portfolio with one security is the variance of the security. The variance of the portfolio drops as more securities are added, which is evidence of the diversification effect. However, unlike Mr. Smith's roulette example, the portfolio's variance can never drop to zero. Rather it reaches a floor of cov, which is the covariance of each pair of securities.10 Because the variance of the portfolio asymptotically approaches cov, each additional security continues to reduce risk. Thus, if there were neither commissions nor other transactions costs, it could be argued that one can never achieve too much diversification. However, there is a cost to diversification in the real world. Commissions per dollar invested fall as one makes larger purchases in a single stock. Unfortunately, one must buy fewer shares of each security when buying more and more different securities. Comparing the costs and benefits of diversification, Meir Statman argues that a portfolio of about 30 stocks is needed to achieve optimal diversification.11 We mentioned earlier that var must be greater than cov. Thus, the variance of a security's return can be broken down in the following way: Total risk of individual security var Portfolio risk cov Unsystematic or diversifiable risk var cov Total risk, which is var in our example, is the risk that one bears by holding onto one security only. Portfolio risk is the risk that one still bears after achieving full diversification, 9 This example ignores the casino's cut. 10 Though it is harder to show, this risk reduction effect also applies to the general case where variances and covariances are not equal. 11 Meir Statman, "How Many Stocks Make a Diversified Portfolio?" Journal of Financial and Quantitative Analysis (September 1987). Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 269 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 263 I F I G U R E 10.7 Relationship between the Variance of a Portfolio's Return and the Number of Securities in the Portfolio* Variance of portfolio's return Diversifiable risk, unique risk, or unsystematic risk var cov Portfolio risk, market risk, or systematic risk 1 2 3 4 Number of securities *This graph assumes a. All securities have constant variance, var. b. All securities have constant covariance, cov. c. All securities are equally weighted in portfolio. The variance of a portfolio drops as more securities are added to the portfolio. However, it does not drop to zero. Rather, cov serves as the floor. which is cov in our example. Portfolio risk is often called systematic or market risk as well. Diversifiable, unique, or unsystematic risk is that risk that can be diversified away in a large portfolio, which must be var cov by definition. To an individual who selects a diversified portfolio, the total risk of an individual security is not important. When considering adding a security to a diversified portfolio, the individual cares about only that portion of the risk of a security that cannot be diversified away. This risk can alternatively be viewed as the contribution of a security to the risk of an entire portfolio. We will talk later about the case where securities make different contributions to the risk of the entire portfolio. Risk and the Sensible Investor Having gone to all this trouble to show that unsystematic risk disappears in a well-diversified portfolio, how do we know that investors even want such portfolios? Suppose they like risk and don't want it to disappear? We must admit that, theoretically at least, this is possible, but we will argue that it does not describe what we think of as the typical investor. Our typical investor is risk averse. Risk-averse behavior can be defined in many ways, but we prefer the following example: A fair gamble is one with zero expected return; a risk-averse investor would prefer to avoid fair gambles. Why do investors choose well-diversified portfolios? Our answer is that they are risk averse, and risk-averse people avoid unnecessary risk, such as the unsystematic risk on a stock. If you do not think this is much of an answer, consider whether you would take on such a risk. For example, suppose you had worked all summer and had saved $5,000, which 270 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 264 Part III Risk you intended to use for your college expenses. Now, suppose someone came up to you and offered to flip a coin for the money: heads, you would double your money, and tails, you would lose it all. Would you take such a bet? Perhaps you would, but most people would not. Leaving aside any moral question that might surround gambling and recognizing that some people would take such a bet, it's our view that the average investor would not. To induce the typical risk-averse investor to take a fair gamble, you must sweeten the pot. For example, you might need to raise the odds of winning from 5050 to 7030 or higher. The risk-averse investor can be induced to take fair gambles only if they are sweetened so that they become unfair to the investor's advantage. QUESTIONS CONCEPT ? What are the two components of the total risk of a security? Why doesn't diversification eliminate all risk? 10.7 RISKLESS BORROWING AND LENDING Figure 10.6 assumes that all the securities on the efficient set are risky. Alternatively, an investor could combine a risky investment with an investment in a riskless or risk-free security, such as an investment in United States Treasury bills. This is illustrated in the following example. E XAMPLE Ms. Bagwell is considering investing in the common stock of Merville Enterprises. In addition, Ms. Bagwell will either borrow or lend at the risk-free rate. The relevant parameters are Common Stock of Merville Expected return Standard deviation 14% 0.20 Risk-Free Asset 10% 0 Suppose Ms. Bagwell chooses to invest a total of $1,000, $350 of which is to be invested in Merville Enterprises and $650 placed in the risk-free asset. The expected return on her total investment is simply a weighted average of the two returns: Expected return on portfolio composed of one riskless and one risky asset 0.114 (0.35 0.14) (0.65 0.10) (10.12) Because the expected return on the portfolio is a weighted average of the expected return on the risky asset (Merville Enterprises) and the risk-free return, the calculation is analogous to the way we treated two risky assets. In other words, equation (10.3) applies here. Using equation (10.4), the formula for the variance of the portfolio can be written as 2 X Merville 2 Merville 2XMervilleXRisk-free Merville, Risk-free 2 X Risk-free 2 Risk-free Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 271 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 265 I F I G U R E 10.8 Relationship between Expected Return and Risk for a Portfolio of One Risky Asset and One Riskless Asset Expected return on portfolio (%) 120% in Merville Enterprises 20% in risk-free assets (borrowing at risk-free rate) Merville Enterprises 14 Borrowing to invest in Merville when the borrowing rate is greater than the lending rate Standard deviation of portfolio's return (%) 10=RF 35% in Merville Enterprises 65% in risk-free assets 20 However, by definition, the risk-free asset has no variability. Thus, both 2 Merville, Risk-free and Risk-free are equal to zero, reducing the above expression to Variance of portfolio composed of one riskless and one risky asset 2 X2 Merville Merville (10.13) 0.35 2 0.20 2 0.0049 The standard deviation of the portfolio is Standard deviation of portfolio composed of one riskless and one risky asset XMerville Merville 0.35 (10.14) 0.20 0.07 The relationship between risk and expected return for one risky and one riskless asset can be seen in Figure 10.8. Ms. Bagwell's split of 3565 percent between the two assets is represented on a straight line between the risk-free rate and a pure investment in Merville Enterprises. Note that, unlike the case of two risky assets, the opportunity set is straight, not curved. Suppose that, alternatively, Ms. Bagwell borrows $200 at the risk-free rate. Combining this with her original sum of $1,000, she invests a total of $1,200 in Merville. Her expected return would be Expected return on portfolio formed by borrowing to invest in risky asset 14.8% 1.20 0.14 ( 0.2 0.10) Here, she invests 120 percent of her original investment of $1,000 by borrowing 20 percent of her original investment. Note that the return of 14.8 percent is greater than the 14-percent expected return on Merville Enterprises. This occurs because she is borrowing at 10 percent to invest in a security with an expected return greater than 10 percent. 272 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 266 Part III Risk The standard deviation is Standard deviation of portfolio formed by borrowing to invest in risky asset 0.24 1.20 0.2 The standard deviation of 0.24 is greater than 0.20, the standard deviation of the Merville investment, because borrowing increases the variability of the investment. This investment also appears in Figure 10.8. So far, we have assumed that Ms. Bagwell is able to borrow at the same rate at which she can lend.12 Now let us consider the case where the borrowing rate is above the lending rate. The dotted line in Figure 10.8 illustrates the opportunity set for borrowing opportunities in this case. The dotted line is below the solid line because a higher borrowing rate lowers the expected return on the investment. The Optimal Portfolio The previous section concerned a portfolio formed between one riskless asset and one risky asset. In reality, an investor is likely to combine an investment in the riskless asset with a portfolio of risky assets. This is illustrated in Figure 10.9. Consider point Q, representing a portfolio of securities. Point Q is in the interior of the feasible set of risky securities. Let us assume the point represents a portfolio of 30 percent in AT&T, 45 percent in General Motors (GM), and 25 percent in IBM. Individuals com- I F I G U R E 10.9 Relationship between Expected Return and Standard Deviation for an Investment in a Combination of Risky Securities and the Riskless Asset Expected return on portfolio 5 A Line (capital market line) II Y 4 2 Risk-free rate ( RF ) 1 X Q 3 Line I 35% in risk-free asset 40% in risk-free asset 140% in stocks 65% in stocks represented by Q represented by Q 70% in risk-free asset 30% in stocks represented by Q Standard deviation of portfolio's return Portfolio Q is composed of 30 percent AT&T, 45 percent GM, 25 percent IBM. Surprisingly, this appears to be a decent approximation because a large number of investors are able to borrow from a stockbroker (called going on margin) when purchasing stocks. The borrowing rate here is very near the riskless rate of interest, particularly for large investors. More will be said about this in a later chapter. 12 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 273 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 267 bining investments in Q with investments in the riskless asset would achieve points along the straight line from RF to Q. We refer to this as line I. For example, point 1 on the line represents a portfolio of 70 percent in the riskless asset and 30 percent in stocks represented by Q. An investor with $100 choosing point 1 as his portfolio would put $70 in the risk-free asset and $30 in Q. This can be restated as $70 in the riskless asset, $9 (0.3 $30) in AT&T, $13.50 (0.45 $30) in GM, and $7.50 (0.25 $30) in IBM. Point 2 also represents a portfolio of the risk-free asset and Q, with more (65%) being invested in Q. Point 3 is obtained by borrowing to invest in Q. For example, an investor with $100 of his own would borrow $40 from the bank or broker in order to invest $140 in Q. This can be stated as borrowing $40 and contributing $100 of one's money in order to invest $42 (0.3 $140) in AT&T, $63 (0.45 $140) in GM, and $35 (0.25 $140) in IBM. The above investments can be summarized as: Point Q AT&T GM IBM Risk-free Total investment $ 30 45 25 0 ____ $100 Point 1 (lending $70) 9 13.50 7.50 70.00 _______ $100 $ Point 3 (borrowing $40) $ 42 63 35 40 ____ $100 Though any investor can obtain any point on line I, no point on the line is optimal. To see this, consider line II, a line running from RF through A. Point A represents a portfolio of risky securities. Line II represents portfolios formed by combinations of the risk-free asset and the securities in A. Points between RF and A are portfolios in which some money is invested in the riskless asset and the rest is placed in A. Points past A are achieved by borrowing at the riskless rate to buy more of A than one could with one's original funds alone. As drawn, line II is tangent to the efficient set of risky securities. Whatever point an individual can obtain on line I, he can obtain a point with the same standard deviation and a higher expected return on line II. In fact, because line II is tangent to the efficient set of risky assets, it provides the investor with the best possible opportunities. In other words, line II can be viewed as the efficient set of all assets, both risky and riskless. An investor with a fair degree of risk aversion might choose a point between RF and A, perhaps point 4. An individual with less risk aversion might choose a point closer to A or even beyond A. For example, point 5 corresponds to an individual borrowing money to increase his investment in A. The graph illustrates an important point. With riskless borrowing and lending, the portfolio of risky assets held by any investor would always be point A. Regardless of the investor's tolerance for risk, he would never choose any other point on the efficient set of risky assets (represented by curve XAY) nor any point in the interior of the feasible region. Rather, he would combine the securities of A with the riskless assets if he had high aversion to risk. He would borrow the riskless asset to invest more funds in A had he low aversion to risk. This result establishes what financial economists call the separation principle. That is, the investor's investment decision consists of two separate steps: 1. After estimating (a) the expected returns and variances of individual securities, and (b) the covariances between pairs of securities, the investor calculates the efficient set of risky assets, represented by curve XAY in Figure 10.9. He then determines point A, the tangency between the risk-free rate and the efficient set of risky assets (curve XAY). Point A represents the portfolio of risky assets that the investor will hold. This point is determined solely from his estimates of returns, variances, and covariances. No personal characteristics, such as degree of risk aversion, are needed in this step. 274 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 268 Part III Risk 2. The investor must now determine how he will combine point A, his portfolio of risky assets, with the riskless asset. He might invest some of his funds in the riskless asset and some in portfolio A. He would end up at a point on the line between RF and A in this case. Alternatively, he might borrow at the risk-free rate and contribute some of his own funds as well, investing the sum in portfolio A. He would end up at a point on line II beyond A. His position in the riskless asset, that is, his choice of where on the line he wants to be, is determined by his internal characteristics, such as his ability to tolerate risk. QUESTIONS CONCEPT ? What is the formula for the standard deviation of a portfolio composed of one riskless and one risky asset? How does one determine the optimal portfolio among the efficient set of risky assets? 10.8 MARKET EQUILIBRIUM Definition of the Market-Equilibrium Portfolio The above analysis concerns one investor. His estimates of the expected returns and variances for individual securities and the covariances between pairs of securities are his and his alone. Other investors would obviously have different estimates of the above variables. However, the estimates might not vary much because all investors would be forming expectations from the same data on past price movements and other publicly available information. Financial economists often imagine a world where all investors possess the same estimates on expected returns, variances, and covariances. Though this can never be literally true, it can be thought of as a useful simplifying assumption in a world where investors have access to similar sources of information. This assumption is called homogeneous expectations.13 If all investors had homogeneous expectations, Figure 10.9 would be the same for all individuals. That is, all investors would sketch out the same efficient set of risky assets because they would be working with the same inputs. This efficient set of risky assets is represented by the curve XAY. Because the same risk-free rate would apply to everyone, all investors would view point A as the portfolio of risky assets to be held. This point A takes on great importance because all investors would purchase the risky securities that it represents. Those investors with a high degree of risk aversion might combine A with an investment in the riskless asset, achieving point 4, for example. Others with low aversion to risk might borrow to achieve, say, point 5. Because this is a very important conclusion, we restate it: In a world with homogeneous expectations, all investors would hold the portfolio of risky assets represented by point A. If all investors choose the same portfolio of risky assets, it is possible to determine what that portfolio is. Common sense tells us that it is a market-value-weighted portfolio of all existing securities. It is the market portfolio. In practice, financial economists use a broad-based index such as the Standard & Poor's (S&P) 500 as a proxy for the market portfolio. Of course all investors do not hold the same portfolio in practice. However, we know that a large number of investors hold di13 The assumption of homogeneous expectations states that all investors have the same beliefs concerning returns, variances, and covariances. It does not say that all investors have the same aversion to risk. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 275 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 269 versified portfolios, particularly when mutual funds or pension funds are included. A broadbased index is a good proxy for the highly diversified portfolios of many investors. Definition of Risk When Investors Hold the Market Portfolio The previous section states that many investors hold diversified portfolios similar to broadbased indices. This result allows us to be more precise about the risk of a security in the context of a diversified portfolio. Researchers have shown that the best measure of the risk of a security in a large portfolio is the beta of the security. We illustrate beta by an example. E XAMPLE Consider the following possible returns on both the stock of Jelco, Inc., and on the market: Type of Economy Bull Bull Bear Bear Return on Market (percent) 15 15 5 5 Return on Jelco, Inc. (percent) 25 15 5 15 State I II III IV Though the return on the market has only two possible outcomes (15% and 5%), the return on Jelco has four possible outcomes. It is helpful to consider the expected return on a security for a given return on the market. Assuming each state is equally likely, we have Type of Economy Bull Bear Return on Market (percent) 15% 5% 20% 10% Expected Return on Jelco, Inc. (percent) 25% 5% 1 1 /2 /2 15% 1/2 ( 15%) 1/2 Jelco, Inc., responds to market movements because its expected return is greater in bullish states than in bearish states. We now calculate exactly how responsive the security is to market movements. The market's return in a bullish economy is 20 percent [15% ( 5%)] greater than the market's return in a bearish economy. However, the expected return on Jelco in a bullish economy is 30 percent [20% ( 10%)] greater than its expected return in a bearish state. Thus, Jelco, Inc., has a responsiveness coefficient of 1.5 (30%/20%). This relationship appears in Figure 10.10. The returns for both Jelco and the market in each state are plotted as four points. In addition, we plot the expected return on the security for each of the two possible returns on the market. These two points, each of which we designate by an X, are joined by a line called the characteristic line of the security. The slope of the line is 1.5, the number calculated in the previous paragraph. This responsiveness coefficient of 1.5 is the beta of Jelco. The interpretation of beta from Figure 10.10 is intuitive. The graph tells us that the returns of Jelco are magnified 1.5 times over those of the market. When the market does well, Jelco's stock is expected to do even better. When the market does poorly, Jelco's stock is expected to do even worse. Now imagine an individual with 276 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 270 Part III Risk I F I G U R E 10.10 Performance of Jelco, Inc., and the Market Portfolio Return on security (%) 25 20 I Characteristic line X (15%, 20%)* II 10 Slope = = 1.5 Return on market (%) 15 III 5 5 10 15 25 (5%, 10%) X IV 20 The two points marked X represent the expected return on Jelco for each possible outcome of the market portfolio. The expected return on Jelco is positively related to the return on the market. Because the slope is 1.5, we say that Jelco's beta is 1.5. Beta measures the responsiveness of the security's return to movement in the market. *(20%, 15%) refers to the point where the return on the security is 20 percent and the return on the market is 15 percent. a portfolio near that of the market who is considering the addition of Jelco to his portfolio. Because of Jelco's magnification factor of 1.5, he will view this stock as contributing much to the risk of the portfolio. (We will show shortly that the beta of the average security in the market is 1.) Jelco contributes more to the risk of a large, diversified portfolio than does an average security because Jelco is more responsive to movements in the market. Further insight can be gleaned by examining securities with negative betas. One should view these securities as either hedges or insurance policies. The security is expected to do well when the market does poorly and vice versa. Because of this, adding a negative-beta security to a large, diversified portfolio actually reduces the risk of the portfolio.14 Table 10.7 presents empirical estimates of betas for individual securities. As can be seen, some securities are more responsive to the market than others. For example, Oracle has a beta of 1.63. This means that, for every 1 percent movement in the market,15 Oracle is expected to move 1.63 percent in the same direction. Conversely, Green Mountain Power has a beta of only 0.26. This means that, for every 1 percent movement in the market, Green Mountain is expected to move 0.26 percent in the same direction. We can summarize our discussion of beta by saying: Beta measures the responsiveness of a security to movements in the market portfolio. 14 15 Unfortunately, empirical evidence shows that virtually no stocks have negative betas. In Table 10.7, we use the Standard & Poor's 500 Index as the proxy for the market portfolio. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 277 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 271 I TA B L E 10.7 Estimates of Beta for Selected Individual Stocks Stock High-beta stocks Oracle, Inc. Inprise Corporation Citicorp Average-beta stocks Du Pont Kimberly-Clark Corp. Ford Motor Co. Low-beta stocks Green Mountain Power Homestake Mining Bell Atlantic Beta 1.63 1.58 2.29 1.08 0.80 0.96 0.26 0.22 0.37 The beta is defined as Cov(Ri, RM)/ Var(RM), where Cov(Ri, RM) is the covariance of the return on an individual stock, Ri, and the return on the market, RM. Var(RM) is the variance of the return on the market, RM. The Formula for Beta Our discussion so far has stressed the intuition behind beta. The actual definition of beta is i Cov Ri, RM 2 RM (10.15) where Cov(Ri, RM) is the covariance between the return on asset i and the return on the market portfolio and 2(RM) is the variance of the market. One useful property is that the average beta across all securities, when weighted by the proportion of each security's market value to that of the market portfolio, is 1. That is, N Xi i 1 i 1 (10.16) where Xi is the proportion of security i's market value to that of the entire market and N is the number of securities in the market. Equation (10.16) is intuitive, once you think about it. If you weight all securities by their market values, the resulting portfolio is the market. By definition, the beta of the market portfolio is 1. That is, for every 1 percent movement in the market, the market must move 1 percent--by definition. A Test We have put these questions on past corporate finance examinations: 1. What sort of investor rationally views the variance (or standard deviation) of an individual security's return as the security's proper measure of risk? 2. What sort of investor rationally views the beta of a security as the security's proper measure of risk? A good answer might be something like the following: A rational, risk-averse investor views the variance (or standard deviation) of her portfolio's return as the proper measure of the risk of her portfolio. If for some reason or another the 278 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 272 Part III Risk investor can hold only one security, the variance of that security's return becomes the variance of the portfolio's return. Hence, the variance of the security's return is the security's proper measure of risk. If an individual holds a diversified portfolio, she still views the variance (or standard deviation) of her portfolio's return as the proper measure of the risk of her portfolio. However, she is no longer interested in the variance of each individual security's return. Rather, she is interested in the contribution of an individual security to the variance of the portfolio. Under the assumption of homogeneous expectations, all individuals hold the market portfolio. Thus, we measure risk as the contribution of an individual security to the variance of the market portfolio. This contribution, when standardized properly, is the beta of the security. While very few investors hold the market portfolio exactly, many hold reasonably diversified portfolios. These portfolios are close enough to the market portfolio so that the beta of a security is likely to be a reasonable measure of its risk. QUESTIONS CONCEPT ? If all investors have homogeneous expectations, what portfolio of risky assets do they hold? What is the formula for beta? Why is beta the appropriate measure of risk for a single security in a large portfolio? 10.9 RELATIONSHIP BETWEEN RISK AND EXPECTED RETURN (CAPM) It is commonplace to argue that the expected return on an asset should be positively related to its risk. That is, individuals will hold a risky asset only if its expected return compensates for its risk. In this section, we first estimate the expected return on the stock market as a whole. Next, we estimate expected returns on individual securities. Expected Return on Market Financial economists frequently argue that the expected return on the market can be represented as: RM RF Risk premium In words, the expected return on the market is the sum of the risk-free rate plus some compensation for the risk inherent in the market portfolio. Note that the equation refers to the expected return on the market, not the actual return in a particular month or year. Because stocks have risk, the actual return on the market over a particular period can, of course, be below RF, or can even be negative. Since investors want compensation for risk, the risk premium is presumably positive. But exactly how positive is it? It is generally argued that the best estimate for the risk premium in the future is the average risk premium in the past. As reported in Chapter 9, Ibbotson and Sinquefield found that the expected return on common stocks was 13.3 percent over 19261999. The average risk-free rate over the same time interval was 3.8 percent. Thus, the average difference between the two was 9.5 percent (13.3% 3.8%). Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 279 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 273 I F I G U R E 10.11 Relationship between Expected Return on an Individual Security and Beta of the Security Expected return on security (%) Security market line (SML) M RM T S RF 0 0.8 1 Beta of security The Security Market Line (SML) is the graphical depiction of the capital-asset-pricing model (CAPM). The expected return on a stock with a beta of 0 is equal to the risk-free rate. The expected return on a stock with a beta of 1 is equal to the expected return on the market. Financial economists find this to be a useful estimate of the difference to occur in the future. We will use it frequently in this text.16 For example, if the risk-free rate, generally estimated by the yield on a one-year Treasury bill, is 4 percent, the expected return on the market is 13.5% 4% 9.5% Expected Return on Individual Security Now that we have estimated the expected return on the market as a whole, what is the expected return on an individual security? We have argued that the beta of a security is the appropriate measure of risk in a large, diversified portfolio. Since most investors are diversified, the expected return on a security should be positively related to its beta. This is illustrated in Figure 10.11. Actually, financial economists can be more precise about the relationship between expected return and beta. They posit that, under plausible conditions, the relationship between expected return and beta can be represented by the following equation.17 Capital-Asset-Pricing Model: R Expected return on a security 16 RF Riskfree rate Beta of the security RM RF (10.17) Difference between expected return on market and risk-free rate This is not the only way to estimate the market-risk premium. In fact, there are several useful ways to estimate the market-risk premium. For example, refer to Table 9.2 and note the average return on common stocks (13.3%) and long-term government bonds (5.5%). One could argue that the long-term government bond return is the best measure of the long-term historical risk-free rate. If so, a good estimate of the historical market risk premium would be 13.3% 5.5% 8.8%. With this empirical version of the CAPM, one would use the current long-term government bond return to estimate the current risk-free rate. 17 This relationship was first proposed independently by John Lintner and William F. Sharpe. 280 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 274 Part III Risk This formula, which is called the capital-asset-pricing model (or CAPM for short), implies that the expected return on a security is linearly related to its beta. Since the average return on the market has been higher than the average risk-free rate over long periods of time, RM RF is presumably positive. Thus, the formula implies that the expected return on a security is positively related to its beta. The formula can be illustrated by assuming a few special cases: Assume that 0. Here R RF, that is, the expected return on the security is equal to the risk-free rate. Because a security with zero beta has no relevant risk, its expected return should equal the risk-free rate. Assume that 1. Equation (10.17) reduces to R RM. That is, the expected return on the security is equal to the expected return on the market. This makes sense since the beta of the market portfolio is also 1. Formula (10.17) can be represented graphically by the upward-sloping line in Figure 10.11. Note that the line begins at RF and rises to RM when beta is 1. This line is frequently called the security market line (SML). As with any line, the SML has both a slope and an intercept. RF, the risk-free rate, is the intercept. Because the beta of a security is the horizontal axis, RM RF is the slope. The line will be upward-sloping as long as the expected return on the market is greater than the risk-free rate. Because the market portfolio is a risky asset, theory suggests that its expected return is above the risk-free rate. In addition, the empirical evidence of the previous chapter showed that the average return per year on the market portfolio over the past 74 years was 9.5 percent above the risk-free rate. E XAMPLE The stock of Aardvark Enterprises has a beta of 1.5 and that of Zebra Enterprises has a beta of 0.7. The risk-free rate is 7 percent, and the difference between the expected return on the market and the risk-free rate is 9.5 percent. The expected returns on the two securities are: Expected Return for Aardvark: 21.25% 7% 1.5 9.5% (10.18) Expected Return for Zebra: 13.65% 7% 0.7 9.5% Three additional points concerning the CAPM should be mentioned: 1. Linearity. The intuition behind an upwardly sloping curve is clear. Because beta is the appropriate measure of risk, high-beta securities should have an expected return above that of low-beta securities. However, both Figure 10.11 and equation (10.17) show something more than an upwardly sloping curve; the relationship between expected return and beta corresponds to a straight line. It is easy to show that the line of Figure 10.11 is straight. To see this, consider security S with, say, a beta of 0.8. This security is represented by a point below the security market line in the figure. Any investor could duplicate the beta of security S by buying a portfolio with 20 percent in the risk-free asset and 80 percent in a security with a beta of 1. However, the homemade portfolio would itself lie on the SML. In other words, the portfolio dominates security S because the portfolio has a higher expected return and the same beta. Now consider security T with, say, a beta greater than 1. This security is also below the SML in Figure 10.11. Any investor could duplicate the beta of security T by borrowing to Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 281 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 275 invest in a security with a beta of 1. This portfolio must also lie on the SML, thereby dominating security T. Because no one would hold either S or T, their stock prices would drop. This price adjustment would raise the expected returns on the two securities. The price adjustment would continue until the two securities lay on the security market line. The preceding example considered two overpriced stocks and a straight SML. Securities lying above the SML are underpriced. Their prices must rise until their expected returns lie on the line. If the SML is itself curved, many stocks would be mispriced. In equilibrium, all securities would be held only when prices changed so that the SML became straight. In other words, linearity would be achieved. 2. Portfolios as well as securities. Our discussion of the CAPM considered individual securities. Does the relationship in Figure 10.11 and equation (10.17) hold for portfolios as well? Yes. To see this, consider a portfolio formed by investing equally in our two securities, Aardvark and Zebra. The expected return on the portfolio is Expected Return on Portfolio: 17.45% 0.5 21.25% 0.5 13.65% (10.19) The beta of the portfolio is simply a weighted average of the betas of the two securities. Thus we have Beta of Portfolio: 1.1 0.5 1.5 0.5 0.7 Under the CAPM, the expected return on the portfolio is 17.45% 7% 1.1 9.5% (10.20) Because the expected return in (10.19) is the same as the expected return in (10.20), the example shows that the CAPM holds for portfolios as well as for individual securities. 3. A potential confusion. Students often confuse the SML in Figure 10.11 with line II in Figure 10.9. Actually, the lines are quite different. Line II traces the efficient set of portfolios formed from both risky assets and the riskless asset. Each point on the line represents an entire portfolio. Point A is a portfolio composed entirely of risky assets. Every other point on the line represents a portfolio of the securities in A combined with the riskless asset. The axes on Figure 10.9 are the expected return on a portfolio and the standard deviation of a portfolio. Individual securities do not lie along line II. The SML in Figure 10.11 relates expected return to beta. Figure 10.11 differs from Figure 10.9 in at least two ways. First, beta appears in the horizontal axis of Figure 10.11, but standard deviation appears in the horizontal axis of Figure 10.9. Second, the SML in Figure 10.11 holds both for all individual securities and for all possible portfolios, whereas line II in Figure 10.9 holds only for efficient portfolios. We stated earlier that, under homogeneous expectations, point A in Figure 10.9 becomes the market portfolio. In this situation, line II is referred to as the capital market line (CML). QUESTIONS CONCEPT ? Why is the SML a straight line? What is the capital-asset-pricing model? What are the differences between the capital market line and the security market line? 282 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 276 Part III Risk 10.10 SUMMARY AND CONCLUSIONS This chapter sets forth the fundamentals of modern portfolio theory. Our basic points are these: 1. This chapter shows us how to calculate the expected return and variance for individual securities, and the covariance and correlation for pairs of securities. Given these statistics, the expected return and variance for a portfolio of two securities A and B can be written as Expected return on portfolio XARA 2 2 2XAXB AB Var portfolio XA A XBRB 2 2 XB B 2. In our notation, X stands for the proportion of a security in one's portfolio. By varying X, one can trace out the efficient set of portfolios. We graphed the efficient set for the two-asset case as a curve, pointing out that the degree of curvature or bend in the graph reflects the diversification effect: The lower the correlation between the two securities, the greater the bend. The same general shape of the efficient set holds in a world of many assets. 3. Just as the formula for variance in the two-asset case is computed from a 2 2 matrix, the variance formula is computed from an N N matrix in the N-asset case. We show that, with a large number of assets, there are many more covariance terms than variance terms in the matrix. In fact, the variance terms are effectively diversified away in a large portfolio but the covariance terms are not. Thus, a diversified portfolio can only eliminate some, but not all, of the risk of the individual securities. 4. The efficient set of risky assets can be combined with riskless borrowing and lending. In this case, a rational investor will always choose to hold the portfolio of risky securities represented by point A in Figure 10.9. Then he can either borrow or lend at the riskless rate to achieve any desired point on line II in the figure. 5. The contribution of a security to the risk of a large, well-diversified portfolio is proportional to the covariance of the security's return with the market's return. This contribution, when standardized, is called the beta. The beta of a security can also be interpreted as the responsiveness of a security's return to that of the market. 6. The CAPM states that R RF RM RF In other words, the expected return on a security is positively (and linearly) related to the security's beta. KEY TERMS Beta 269 Capital-asset-pricing model 274 Capital market line 275 Characteristic line 269 Correlation 245 Covariance 245 Diversifiable (unique) (unsystematic) risk 263 Efficient set (efficient frontier) 255 Homogeneous expectations 268 Market portfolio 268 Opportunity (feasible) set 255 Portfolio 247 Risk averse 263 Security market line 274 Separation principle 267 Systematic (market) risk 263 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 283 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 277 SUGGESTED READINGS The capital-asset-pricing model was originally published in these two classic articles: Lintner, J. "Security Prices, Risk and Maximal Gains from Diversification." Journal of Finance (December 1965). Sharpe, W. F. "Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk." Journal of Finance (September 1964). (William F. Sharpe won the Nobel Prize in Economics in 1990 for his development of CAPM.) The seminal influence of Harry Markowitz is described in: Markowitz, H. "Travels along the Efficient Frontier." Dow Jones Asset Management (May/June 1997). QUESTIONS AND PROBLEMS Expected Return, Variance, and Covariance 10.1 Ms. Sharp thinks that the distribution of rates of return on Q-mart stock is as follows. State of Economy Depression Recession Normal Boom Probability of State Occurring 0.10 0.20 0.50 0.20 Q-mart Stock Return (%) 4.5% 4.4 12.0 20.7 a. What is the expected return for the stock? b. What is the standard deviation of returns for the stock? 10.2 Suppose you have invested only in two stocks, A and B. You expect that returns on the stocks depend on the following three states of economy, which are equally likely to happen. State of Economy Bear Normal Bull Return on Stock A (%) 6.3% 10.5 15.6 Return on Stock B (%) 3.7% 6.4 25.3 a. Calculate the expected return of each stock. b. Calculate the standard deviation of returns of each stock. c. Calculate the covariance and correlation between the two stocks. 10.3 Mr. Henry can invest in Highbull stock or Slowbear stock. His projection of the returns on these two stocks is as follows: State of Economy Recession Normal Boom Probability of State Occurring 0.25 0.60 0.15 Return on Return on Highbull Stock (%) Slowbear Stock (%) 2.0% 9.2 15.4 5.0% 6.2 7.4 a. Calculate the expected return of each stock. b. Calculate the standard deviation of return of each stock. c. Calculate the covariance and correlation between the two stocks. 284 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 278 Part III Risk Portfolios 10.4 A portfolio consists of 120 shares of Atlas stock, which sells for $50 per share, and 150 shares of Babcock stock, which sells for $20 per share. What are the weights of the two stocks in this portfolio? 10.5 Security F has an expected return of 12 percent and a standard deviation of 9 percent per year. Security G has an expected return of 18 percent and a standard deviation of 25 percent per year. a. What is the expected return on a portfolio composed of 30 percent of security F and 70 percent of security G? b. If the correlation coefficient between the returns of F and G is 0.2, what is the standard deviation of the portfolio? 10.6 Suppose the expected returns and standard deviations of stocks A and B are RA 0.15, RB 0.25, A 0.1, and B 0.2, respectively. a. Calculate the expected return and standard deviation of a portfolio that is composed of 40 percent A and 60 percent B when the correlation coefficient between the stocks is 0.5. b. Calculate the standard deviation of a portfolio that is composed of 40 percent A and 60 percent B when the correlation coefficient between the stocks is 0.5. c. How does the correlation coefficient affect the standard deviation of the portfolio? 10.7 Suppose Janet Smith holds 100 shares of Macrosoft stock and 300 shares of Intelligence stock. Macrosoft stock is currently sold at $80 per share, while Intelligence stock is sold at $40. The expected return of Macrosoft stock is 15 percent, while that of Intelligence stock is 20 percent. The standard deviation of Macrosoft is 8 percent, while that of Intelligence is 20 percent. The correlation coefficient between the stocks is 0.38. a. Calculate the expected return and standard deviation of her portfolio. b. Today she sold 200 shares of Intelligence stock to pay the tuition. Calculate the expected return and standard deviation of her new portfolio. 10.8 Consider the possible rates of return that you might obtain over the next year. You can invest in stock U or stock V. State of Economy Recession Normal Boom Probability of State Occurring 0.2 0.5 0.3 Stock U Return if State Occurs (%) 7% 7 7 Stock V Return if State Occurs (%) 5% 10 25 a. Determine the expected return, variance, and the standard deviation for stock U and stock V. b. Determine the covariance and correlation between the returns of stock U and stock V. c. Determine the expected return and standard deviation of an equally weighted portfolio of stock U and stock V. 10.9 Suppose there are only two stocks in the world: stock A and stock B. The expected returns of these two stocks are 10 percent and 20 percent, while the standard deviations of the stocks are 5 percent and 15 percent, respectively. The correlation coefficient of the two stocks is zero. a. Calculate the expected return and standard deviation of a portfolio that is composed of 30 percent A and 70 percent B. b. Calculate the expected return and standard deviation of a portfolio that is composed of 90 percent A and 10 percent B. c. Suppose you are risk averse. Would you hold 100 percent stock A? How about 100 percent stock B? 10.10 If a portfolio has a positive weight for each asset, can the expected return on the portfolio be greater than the return on the asset in the portfolio that has the highest return? Can the Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 285 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 279 expected return on the portfolio be less that the return on the asset in the portfolio with the lowest return? Explain. 10.11 Miss Maple is considering two securities, A and B, and the relevant information is given below: State of Economy Bear Bull Return on Security A (%) 3.0% 15.0 Return on Security B (%) 6.5% 6.5 Probability 0.4 0.6 a. Calculate the expected returns and standard deviations of the two securities. b. Suppose Miss Maple invested $2,500 in security A and $3,500 in security B. Calculate the expected return and standard deviation of her portfolio. c. Suppose Miss Maple borrowed from her friend 40 shares of security B, which is currently sold at $50, and sold all shares of the security. (She promised her friend to pay back in a year with the same number of shares of security B.) Then she bought security A with the proceeds obtained in the sales of security B shares and the cash of $6,000 she owned. Calculate the expected return and standard deviation of the portfolio. 10.12 A broker has advised you not to invest in oil industry stocks because, in her opinion, they are far too risky. She has shown you evidence of how wildly the prices of oil stocks have fluctuated in the recent past. She demonstrated that the standard deviation of oil stocks is very high relative to most stocks. Do you think the broker's advice is sound for a riskaverse investor like you? Why or why not? 10.13 There are three securities in the market. The following chart shows their possible payoffs. Probability of Outcome 0.10 0.40 0.40 0.10 Return on Security 1 0.25 0.20 0.15 0.10 Return on Security 2 0.25 0.15 0.20 0.10 Return on Security 3 0.10 0.15 0.20 0.25 State 1 2 3 4 a. What are the expected return and standard deviation of each security? b. What are the covariances and correlations between the pairs of securities? c. What are the expected return and standard deviation of a portfolio with half of its funds invested in security 1 and half in security 2? d. What are the expected return and standard deviation of a portfolio with half of its funds invested in security 1 and half in security 3? e. What are the expected return and standard deviation of a portfolio with half of its funds invested in security 2 and half in security 3? f. What do your answers in parts (a), (c), (d), and (e) imply about diversification? 10.14 Suppose that there are two stocks, A and B. Suppose that their returns are independent. Stock A has a 40-percent chance of having a return of 15 percent and 60-percent chance of a return of 10 percent. Stock B has a one-half chance of a 35-percent return and a onehalf chance of a 5-percent return. a. Write the list of all of the possible outcomes and their probabilities. b. What is the expected return on a portfolio with 50 percent invested in stock A and 50 percent invested in stock B? 10.15 Assume there are N securities in the market. The expected return of every security is 10 percent. All securities also have the same variance of 0.0144. The covariance between any pair of securities is 0.0064. 286 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 280 Part III Risk a. What are the expected return and variance of an equally weighted portfolio containing all N securities? Note: The weight of each security in the portfolio is 1/N. b. What will happen to the variance as N gets larger? c. What security characteristics are most important in the determination of the variance of a well-diversified portfolio? 10.16 Is the following statement true or false? Explain. The most important characteristic in determining the variance of a well-diversified portfolio is the variance of the individual stocks. 10.17 Briefly explain why the covariance of a security with the rest of a portfolio is a more appropriate measure of risk than the security's variance. 10.18 Comment on the following quotation from a leading investment analyst. Stocks that move perfectly with the market have a beta of 1. Betas get higher as volatility goes up and lower as it goes down. Thus, Southern Co., a utility whose shares have traded close to $12 for most of the past three years, has a low beta. At the other extreme, there's Texas Instruments, which has been as high as $150 and as low as its current $75. 10.19 Assume that there are two stocks with the following characteristics. The covariance between the returns on the stocks is 0.001. Expected Return A B 0.05 0.10 Standard Deviation 0.1 0.2 a. What is the expected return on the minimum variance portfolio? (Hint: Find the portfolio weights XA and XB such that the portfolio variance is minimized. Remember that the sum of the weights must equal 1.) b. If Cov(RA, RB) 0.02, what are the minimum variance weights? c. What is the portfolio variance when Cov(RA, RB) 0.02? 10.20 Assume a world with homogeneous expectations (i.e., everybody agrees on expected returns and standard deviations). In this world the market portfolio has an expected return of 12 percent and a standard deviation of 10 percent. The risk-free asset has an expected return of 5 percent. a. What should the expected return of the portfolio be if it has a standard deviation of 7 percent? b. What should the standard deviation of the portfolio be if it has an expected return of 20 percent? 10.21 Consider the following information on the returns on the market and Fuji stock. Expected Return on Market (%) 2.5% 16.3 Expected Return on Fuji (%) 3.4% 12.8 Type of Economy Bear Bull a. Calculate the beta of Fuji. What is the responsiveness of Fuji's return to movements of the market? b. Suppose the estimate of expected return on the market is 4.0 percent when the type of economy is Bear. Using your answer in part (a), what should the expected return on Fuji be in this case? 10.22 William Shakespeare's character Polonius in Hamlet says, "Neither a borrower nor a lender be." Under the assumptions of the CAPM, what would be the composition of Polonius's portfolio? Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 287 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 281 10.23 Securities A, B, and C have the following characteristics. Security A B C E(R)% 10% 14 20 Beta 0.7 1.2 1.8 a. What is the expected return on a portfolio with equal weights? b. What is the beta of a portfolio with equal weights? c. Are the three securities priced in equilibrium? The CAPM 10.24 The Alpha firm makes pneumatic equipment. Its beta is 1.2. The market risk premium is 8.5 percent, and the current risk-free rate is 6 percent. What is the expected return for the Alpha firm? 10.25 Suppose the beta for the Ross Corporation is 0.80. The risk-free rate is 6 percent, and the market risk premium is 8.5 percent. What is the expected return for the Ross Corporation? 10.26 The risk-free rate is 8 percent. The beta for the Jordan Company is 1.5, and the expected return of the market is 15 percent. What is the expected return for the Jordan Company? 10.27 Suppose the market risk premium is 7.5 percent and the risk-free rate is 3.7 percent. The expected return of TriStar Textiles is 14.2 percent. What is the beta for TriStar Textiles? 10.28 Consider the following two stocks: Beta Murck Pharmaceutical 1.4 Pizer Drug Corp. 0.7 Expected Return 25% 14% Assume the CAPM holds. Based upon the CAPM, what is the return on the market? What is the risk-free rate? 10.29 Suppose you observe the following situation: Return if a State Occurs State of Economy Bust Normal Boom Probability of State .25 .50 .25 Stock A .10 .10 .20 Stock B .30 .05 .40 a. Calculate the expected return of each stock. b. Assuming the CAPM is true and stock A's beta is greater than stock B's beta by .25, what is the risk premium? 10.30 a. Draw the security market line for the case where the market-risk premium is 5 percent and the risk-free rate is 7 percent. b. Suppose that an asset has a beta of 1 and an expected return of 4 percent. Plot it on the graph you drew in part (a). Is the security properly priced? If not, explain what will happen in this market. c. Suppose that an asset has a beta of 3 and an expected return of 20 percent. Plot it on the graph you drew in part (a). Is the security properly priced? If not, explain what will happen in this market. 10.31 A stock has a beta of 1.8. A security analyst who specializes in studying this stock expects its return to be 18 percent. Suppose the risk-free rate is 5 percent and the market- 288 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 282 Part III Risk risk premium is 8 percent. Is the analyst pessimistic or optimistic about this stock relative to the market's expectations? 10.32 Suppose the expected return on the market is 13.8 percent and the risk-free rate is 6.4 percent. Solomon Inc. stock has a beta of 1.2. a. What is the expected return on the Solomon stock? b. If the risk-free rate decreases to 3.5 percent, what is the expected return on the Solomon stock? 10.33 The expected return on a portfolio that combines the risk-free asset and the asset at the point of tangency to the efficient set is 25 percent. The expected return was calculated under the following assumptions: The risk-free rate is 5 percent. The expected return on the market portfolio of risky assets is 20 percent. The standard deviation of the efficient portfolio is 4 percent. In this environment, what expected rate of return would a security earn if it had a 0.5 correlation with the market and a standard deviation of 2 percent? 10.34 Suppose the current risk-free rate is 7.6 percent. Potpourri Inc. stock has a beta of 1.7 and an expected return of 16.7 percent. (Assume the CAPM is true.) a. What is the risk premium on the market? b. Magnolia Industries stock has a beta of 0.8. What is the expected return on the Magnolia stock? c. Suppose you have invested $10,000 in both Potpourri and Magnolia, and the beta of the portfolio is 1.07. How much did you invest in each stock? What is the expected return on the portfolio? 10.35 Suppose the risk-free rate is 6.3 percent and the market portfolio has an expected rate of return of 14.8 percent. The market portfolio has a variance of 0.0121. Portfolio Z has a correlation coefficient with the market of 0.45 and a variance of 0.0169. According to the CAPM, what is the expected rate of return on portfolio Z? 10.36 The following data have been developed for the Durham Company. Variance of market returns Covariance of the returns on Durham and the market 0.04326 0.0635 Suppose the market risk premium is 9.4 percent and the expected return on Treasury bills is 4.9 percent. a. Write the equation of the security market line. b. What is the required return of Durham Company? 10.37 Johnson Paint stock has an expected return of 19 percent with a beta of 1.7, while Williamson Tire stock has an expected return of 14 percent with a beta of 1.2. Assume the CAPM is true. What is the expected return on the market? What is the risk-free rate? 10.38 Is the following statement true or false? Explain. A risky security cannot have an expected return that is less than the risk-free rate because no risk-averse investor would be willing to hold this asset in equilibrium. 10.39 Suppose you have invested $30,000 in the following four stocks. Security Stock A Stock B Stock C Stock D Amount Invested $ 5,000 10,000 8,000 7,000 Beta 0.75 1.10 1.36 1.88 The risk-free rate is 4 percent and the expected return on the market portfolio is 15 percent. Based on the CAPM, what is the expected return on the above portfolio? Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 289 Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 283 10.40 You have been provided the following data on the securities of three firms and the market: Security Firm A Firm B Firm C The market The risk-free asset Ri i iM i Ri 0.13 0.16 0.25 0.15 0.05 i iM i 0.12 (ii) 0.24 0.10 (vi) (i) 0.40 0.75 (iv) (vii) 0.90 1.10 (iii) (v) (viii) Average return of security i. Standard deviation of the return of i. Correlation coefficient of return on asset i with the market portfolio. Beta coefficient of security i. Assume the CAPM holds true. a. Fill in the missing values in the table. b. Provide an evaluation of the investment performance of the three firms. c. What is your investment recommendation? Why? 10.41 There are two stocks in the market, stock A and stock B. The price of stock A today is $50. The price of stock A next year will be $40 if the economy is in a recession, $55 if the economy is normal, and $60 if the economy is expanding. The attendant probabilities of recession, normal times, and expansion are 0.1, 0.8, and 0.1, respectively. Stock A pays no dividend. Assume the CAPM is true. Other information about the market includes: SD(RM) SD(RB) RB Corr(RA,RM) Corr(RB,RM) Corr(RA,RB) Standard deviation of the market portfolio 0.10 Standard deviation of stock B's return 0.12 Expected return on stock B 0.09 The correlation of stock A and the market 0.8 The correlation of stock B and the market 0.2 The correlation of stock A and stock B 0.6 a. If you are a typical, risk-averse investor, which stock would you prefer? Why? b. What are the expected return and standard deviation of a portfolio consisting of 70 percent of stock A and 30 percent of stock B? c. What is the beta of the portfolio in part (b)? Appendix 10A IS BETA DEAD? The capital-asset-pricing model represents one of the most important advances in financial economics. It is clearly useful for investment purposes, since it shows how the expected return on an asset is related to its beta. In addition, we will show in Chapter 12 that it is useful in corporate finance, since the discount rate on a project is a function of the project's beta. However, one must never forget that, as with any other model, the CAPM is not revealed truth but, rather, a construct to be empirically tested. 290 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 10. Return and Risk: The Capital-Asset-Pricing Model The McGraw-Hill Companies, 2002 284 Part III Risk The first empirical tests of the CAPM occurred over 20 years ago and were quite supportive. Using data from the 1930s to the 1960s, researchers showed that the average return on a portfolio of stocks was positively related to the beta of the portfolio,18 a finding consistent with the CAPM. Though some evidence in these studies was less consistent with the CAPM,19 financial economists were quick to embrace the CAPM following these empirical papers. While a large body of empirical work developed in the following decades, often with varying results, the CAPM was not seriously called into question until the 1990s. Two papers by Fama and French20 (yes, the same Fama whose joint paper in 1973 with James MacBeth supported the CAPM) present evidence inconsistent with the model. Their work has received a great deal of attention, both in academic circles and in the popular press, with newspaper articles displaying headlines such as "Beta Is Dead!" These papers make two related points. First, they conclude that the relationship between average return and beta is weak over the period from 1941 to 1990 and virtually nonexistent from 1963 to 1990. Second, they argue that the average return on a security is negatively related to both the firm's price-to-earnings (P/E) ratio and the firm's market value-to-book value (M/B) ratio. These contentions, if confirmed by other research, would be quite damaging to the CAPM. After all, the CAPM states that the expected returns on stocks should be related only to beta, and not to other factors such as P/E and M/B. However, a number of researchers have criticized the Fama-French papers. While we avoid an in-depth discussion of the fine points of the debate, we mention a few issues. First, although Fama and French cannot reject the hypothesis that average returns are unrelated to beta, one can also not reject the hypothesis that average returns are related to beta exactly as specified by the CAPM. In other words, while 50 years of data seem like a lot, they may simply not be enough to test the CAPM properly. Second, the result with P/E and M/B may be due to a statistical fallacy called a hindsight bias.21 Third, P/E and M/B are merely two of an infinite number of possible factors. Thus, the relationship between average return and both P/E and M/B may be spurious, being nothing more than the result of data mining. Fourth, average returns are positively related to beta over the period from 1927 to the present. There appears to be no compelling reason for emphasizing a shorter period than this one. Fifth, average returns are actually positively related to beta over shorter periods when annual data, rather than monthly data, are used to estimate beta.22 There appears to be no compelling reason for preferring either monthly data over annual data or vice versa. Thus, we believe that, while the results of Fama and French are quite intriguing, they cannot be viewed as the final word. 18 Perhaps the two most well-known papers were Fischer Black, Michael C. Jensen, and Myron S. Scholes, "The Capital Asset Pricing Model: Some Empirical Tests," in M. Jensen, ed., Studies in the Theory of Capital Markets (New York: Praeger, 1972), and Eugene F. Fama and James MacBeth, "Risk, Return and Equilibrium: Some Empirical Tests," Journal of Political Economy 8 (1973), pp. 60736. 19 For example, the studies suggest that the average return on a zero-beta portfolio is above the risk-free rate, a finding inconsistent with the CAPM. 20 Eugene F. Fama and Kenneth R. French, "The Cross-Section of Expected Stock Returns," Journal of Finance 47 (1992), pp. 42766, and E. F. Fama and K. R. French, "Common Risk Factors in the Returns on Stocks and Bonds," Journal of Financial Economics 17 (1993), pp. 356. 21 For example, see William J. Breen and Robert A. Koraczyk, "On Selection Biases in Book-to-Market Based Tests of Asset Pricing Models," unpublished paper. Northwestern University, November 1993; and S. P. Kothari, Jay Shanken, and Richard G. Sloan, "Another Look at the Cross-Section of Expected Stock Returns," Journal of Finance (March 1995). 22 Points 4 and 5 are addressed in the Kothari, Shanken, and Sloan paper. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 291 11 CHAPTER An Alternative View of Risk and Return: The Arbitrage Pricing Theory EXECUTIVE SUMMARY T he previous two chapters mentioned the obvious fact that returns on securities are variable. This variability is measured by variance and by standard deviation. Next, we mentioned the somewhat less obvious fact that the returns on securities are interdependent. We measured the degree of interdependence between a pair of securities by covariance and by correlation. This interdependence led to a number of interesting results. First, we showed that diversification in stocks can eliminate some, but not all, risk. By contrast, we showed that diversification in a casino can eliminate all risk. Second, the interdependence of returns led to the capital-asset-pricing model (CAPM). This model posits a positive (and linear) relationship between the beta of a security and its expected return. The CAPM was developed in the early 1960s.1 An alternative to the CAPM, called the arbitrage pricing theory (APT), has been developed more recently.2 For our purposes, the differences between the two models stem from the APT's treatment of interrelationship among the returns on securities.3 The APT assumes that returns on securities are generated by a number of industrywide and marketwide factors. Correlation between a pair of securities occurs when these two securities are affected by the same factor or factors. By contrast, though the CAPM allows correlation among securities, it does not specify the underlying factors causing the correlation. Both the APT and the CAPM imply a positive relationship between expected return and risk. In our (perhaps biased) opinion, the APT allows this relationship to be developed in a particularly intuitive manner. In addition, the APT views risk more generally than just the standardized covariance or beta of a security with the market portfolio. Therefore, we offer this approach as an alternative to the CAPM. 1 In particular, see Jack Treynor, "Toward a Theory of the Market Value of Risky Assets," unpublished manuscript (1961); William F. Sharpe, "Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk," Journal of Finance (September 1964); and John Lintner, "The Valuation of Risky Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets," Review of Economics and Statistics (February 1965). 2 3 See Stephen A. Ross, "The Arbitrage Theory of Capital Asset Pricing," Journal of Economic Theory (December 1976). This is by no means the only difference in the assumptions of the two models. For example, the CAPM usually assumes either that the returns on assets are normally distributed or that investors have quadratic utility functions. The APT does not require either assumption. While this and other differences are quite important in research, they are not relevant to the material presented in our text. 292 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 286 Part III Risk 11.1 FACTOR MODELS: ANNOUNCEMENTS, SURPRISES, AND EXPECTED RETURNS We learned in the previous chapter how to construct portfolios and how to evaluate their returns. We now step back and examine the returns on individual securities more closely. By doing this we will find that the portfolios inherit and alter the properties of the securities they comprise. To be concrete, let us consider the return on the stock of a company called Flyers. What will determine this stock's return in, say, the coming month? The return on any stock traded in a financial market consists of two parts. First, the normal or expected return from the stock is the part of the return that shareholders in the market predict or expect. It depends on all of the information shareholders have that bears on the stock, and it uses all of our understanding of what will influence the stock in the next month. The second part is the uncertain or risky return on the stock. This is the portion that comes from information that will be revealed within the month. The list of such information is endless, but here are some examples: News about Flyers' research. Government figures released on the gross national product (GNP). Results of the latest arms-control talks. Discovery that a rival's product has been tampered with. News that Flyers' sales figures are higher than expected. A sudden drop in interest rates. The unexpected retirement of Flyers' founder and president. A way to write the return on Flyers' stock in the coming month, then, is R R U where R is the actual total return in the month, R is the expected part of the return, and U stands for the unexpected part of the return. Some care must be exercised in studying the effect of these or other news items on the return. For example, the government might give us GNP or unemployment figures for this month, but how much of that is new information for shareholders? Surely at the beginning of the month shareholders will have some idea or forecast of what the monthly GNP will be. To the extent to which the shareholders had forecast the government's announcement, that forecast should be factored into the expected part of the return as of the beginning of the month, R. On the other hand, insofar as the announcement by the government is a surprise and to the extent to which it influences the return on the stock, it will be part of U, the unanticipated part of the return. As an example, suppose shareholders in the market had forecast that the GNP increase this month would be 0.5 percent. If GNP influences our company's stock, this forecast will be part of the information shareholders use to form the expectation, R, of the monthly return. If the actual announcement this month is exactly 0.5 percent, the same as the forecast, then the shareholders learned nothing new, and the announcement is not news. It is like hearing a rumor about a friend when you knew it all along. Another way of saying this is that shareholders had already discounted the announcement. This use of the word discount is different from that in computing present value, but the spirit is similar. When we discount a dollar in the future, we say that it is worth less to us because of the time value of money. When we discount an announcement or a news item in the future, we mean that it has less impact on the market because the market already knew much of it. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 293 Chapter 11 An Alternative View of Risk and Return: The Arbitrage Pricing Theory 287 On the other hand, suppose the government announced that the actual GNP increase during the year was 1.5 percent. Now shareholders have learned something--that the increase is one percentage point higher than they had forecast. This difference between the actual result and the forecast, one percentage point in this example, is sometimes called the innovation or surprise. Any announcement can be broken into two parts, the anticipated or expected part and the surprise or innovation: Announcement Expected part Surprise The expected part of any announcement is part of the information the market uses to form the expectation, R, of the return on the stock. The surprise is the news that influences the unanticipated return on the stock, U. To give another example, if shareholders knew in January that the president of a firm was going to resign, the official announcement in February will be fully expected and will be discounted by the market. Because the announcement was expected before February, its influence on the stock will have taken place before February. The announcement itself in February will contain no surprise and the stock's price should not change at all at the announcement in February. When we speak of news, then, we refer to the surprise part of any announcement and not the portion that the market has expected and therefore has already discounted. QUESTIONS CONCEPT ? What are the two basic parts of a return? Under what conditions will some news have no effect on common stock prices? 11.2 RISK: SYSTEMATIC AND UNSYSTEMATIC The unanticipated part of the return--that portion resulting from surprises--is the true risk of any investment. After all, if we got what we had expected, there would be no risk and no uncertainty. There are important differences, though, among various sources of risk. Look at our previous list of news stories. Some of these stories are directed specifically at Flyers, and some are more general. Which of the news items are of specific importance to Flyers? Announcements about interest rates or GNP are clearly important for nearly all companies, whereas the news about Flyers' president, its research, its sales, or the affairs of a rival company are of specific interest to Flyers. We will divide these two types of announcements and the resulting risk, then, into two components: a systematic portion, called systematic risk, and the remainder, which we call specific or unsystematic risk. The following definitions describe the difference: A systematic risk is any risk that affects a large number of assets, each to a greater or lesser degree. An unsystematic risk is a risk that specifically affects a single asset or a small group of assets.4 Uncertainty about general economic conditions, such as GNP, interest rates, or inflation, is an example of systematic risk. These conditions affect nearly all stocks to some degree. 4 In the previous chapter, we briefly mentioned that unsystematic risk is risk that can be diversified away in a large portfolio. This result will also follow from the present analysis. 294 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 288 Part III Risk An unanticipated or surprise increase in inflation affects wages and the costs of the supplies that companies buy, the value of the assets that companies own, and the prices at which companies sell their products. These forces to which all companies are susceptible are the essence of systematic risk. In contrast, the announcement of a small oil strike by a company may very well affect that company alone or a few other companies. Certainly, it is unlikely to have an effect on the world oil market. To stress that such information is unsystematic and affects only some specific companies, we sometimes call it an idiosyncratic risk. The distinction between a systematic risk and an unsystematic risk is never as exact as we make it out to be. Even the most narrow and peculiar bit of news about a company ripples through the economy. It reminds us of the tale of the war that was lost because one horse lost a shoe; even a minor event may have an impact on the world. But this degree of hair-splitting should not trouble us much. To paraphrase a Supreme Court Justice's comment when speaking of pornography, we may not be able to define a systematic risk and an unsystematic risk exactly, but we know them when we see them. This permits us to break down the risk of Flyers' stock into its two components: the systematic and the unsystematic. As is traditional, we will use the Greek epsilon, , to represent the unsystematic risk and write R R R U m where we have used the letter m to stand for the systematic risk. Sometimes systematic risk is referred to as market risk. This emphasizes the fact that m influences all assets in the market to some extent. The important point about the way we have broken the total risk, U, into its two components, m and , is that , because it is specific to the company, is unrelated to the specific risk of most other companies. For example, the unsystematic risk on Flyers' stock, F, is unrelated to the unsystematic risk of Xerox's stock, X. The risk that Flyers' stock will go up or down because of a discovery by its research team--or its failure to discover something-- probably is unrelated to any of the specific uncertainties that affect Xerox stock. Using the terms of the previous chapter, this means that the unsystematic risk of Flyers' stock and Xerox's stock are unrelated to each other, or uncorrelated. In the symbols of statistics, Corr( F, QUESTIONS CONCEPT X) 0 ? Describe the difference between systematic risk and unsystematic risk. Why is unsystematic risk sometimes referred to as idiosyncratic risk? 11.3 SYSTEMATIC RISK AND BETAS The fact that the unsystematic parts of the returns on two companies are unrelated to each other does not mean that the systematic portions are unrelated. On the contrary, because both companies are influenced by the same systematic risks, individual companies' systematic risks and therefore their total returns will be related. For example, a surprise about inflation will influence almost all companies to some extent. How sensitive is Flyers' stock return to unanticipated changes in inflation? If Flyers' stock tends to go up on news that inflation is exceeding expectations, we would say that it is positively related to inflation. If the stock goes down when inflation exceeds expectations and up when inflation falls short of expectations, it is negatively related. In the unusual case where a stock's return is uncorrelated with inflation surprises, inflation has no effect on it. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 295 Chapter 11 An Alternative View of Risk and Return: The Arbitrage Pricing Theory 289 We capture the influence of a systematic risk like inflation on a stock by using the beta coefficient. The beta coefficient, , tells us the response of the stock's return to a systematic risk. In the previous chapter, beta measured the responsiveness of a security's return to a specific risk factor, the return on the market portfolio. We used this type of responsiveness to develop the capital-asset-pricing model. Because we now consider many types of systematic risks, our current work can be viewed as a generalization of our work in the previous chapter. If a company's stock is positively related to the risk of inflation, that stock has a positive inflation beta. If it is negatively related to inflation, its inflation beta is negative, and if it is uncorrelated with inflation, its inflation beta is zero. It's not hard to imagine some stocks with positive inflation betas and other stocks with negative inflation betas. The stock of a company owning gold mines will probably have a positive inflation beta because an unanticipated rise in inflation is usually associated with an increase in gold prices. On the other hand, an automobile company facing stiff foreign competition might find that an increase in inflation means that the wages it pays are higher, but that it cannot raise its prices to cover the increase. This profit squeeze, as the company's expenses rise faster than its revenues, would give its stock a negative inflation beta. Some companies that have few assets and that act as brokers--buying items in competitive markets and reselling them in other markets--might be relatively unaffected by inflation, because their costs and their revenues would rise and fall together. Their stock would have an inflation beta of zero. Some structure is useful at this point. Suppose we have identified three systematic risks on which we want to focus. We may believe that these three are sufficient to describe the systematic risks that influence stock returns. Three likely candidates are inflation, GNP, and interest rates. Thus, every stock will have a beta associated with each of these systematic risks: an inflation beta, a GNP beta, and an interest-rate beta. We can write the return on the stock, then, in the following form: R R R R U m IFI GNPFGNP rFr where we have used the symbol I to denote the stock's inflation beta, GNP for its GNP beta, and r to stand for its interest-rate beta. In the equation, F stands for a surprise, whether it be in inflation, GNP, or interest rates. Let us go through an example to see how the surprises and the expected return add up to produce the total return, R, on a given stock. To make it more familiar, suppose that the return is over a horizon of a year and not just a month. Suppose that at the beginning of the year, inflation is forecast to be 5 percent for the year, GNP is forecast to increase by 2 percent, and interest rates are expected not to change. Suppose the stock we are looking at has the following betas: I GNP r 2 1 1.8 The magnitude of the beta describes how great an impact a systematic risk has on a stock's returns. A beta of 1 indicates that the stock's return rises and falls one for one with the systematic factor. This means, in our example, that because the stock has a GNP beta of 1, it experiences a 1-percent increase in return for every 1-percent surprise increase in GNP. If its GNP beta were 2, it would fall by 2 percent when there was an unanticipated increase of 1 percent in GNP, and it would rise by 2 percent if GNP experienced a surprise 1-percent decline. Finally, let us suppose that during the year the following occurs: Inflation rises by 7 percent, GNP rises by only 1 percent, and interest rates fall by 2 percent. Last, suppose we learn some good news about the company, perhaps that it is succeeding quickly with 296 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 290 Part III Risk some new business strategy, and that this unanticipated development contributes 5 percent to its return. In other words, 5% Let us assemble all of this information to find what return the stock had during the year. First, we must determine what news or surprises took place in the systematic factors. From our information we know that Expected inflation Expected GNP change and Expected change in interest rates 0% 5% 2% This means that the market had discounted these changes, and the surprises will be the difference between what actually takes place and these expectations: FI Surprise in inflation Actual inflation Expected inflation 7% 5% 2% Similarly, FGNP Surprise in GNP Actual GNP Expected GNP 1% 2% 1% and Fr Surprise in change in interest rates Actual change Expected change 2% 0% 2% The total effect of the systematic risks on the stock return, then, is m Systematic risk portion of return IFI GNPFGNP rFr [2 2%] [1 ( 1%)] [( 1.8) 6.6% ( 2%)] Combining this with the unsystematic risk portion, the total risky portion of the return on the stock is m 6.6% 5% 11.6% Last, if the expected return on the stock for the year was, say, 4 percent, the total return from all three components will be R R m 4% 6.6% 15.6% 5% The model we have been looking at is called a factor model, and the systematic sources of risk, designated F, are called the factors. To be perfectly formal, a k-factor model is a model where each stock's return is generated by Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 297 Chapter 11 An Alternative View of Risk and Return: The Arbitrage Pricing Theory 291 R R 1F1 2F2 ... kFk where is specific to a particular stock and uncorrelated with the term for other stocks. In our preceding example we had a three-factor model. We used inflation, GNP, and the change in interest rates as examples of systematic sources of risk, or factors. Researchers have not settled on what is the correct set of factors. Like so many other questions, this might be one of those matters that is never laid to rest. In practice, researchers frequently use a one-factor model for returns. They do not use all of the sorts of economic factors we used previously as examples; instead, they use an index of stock market returns--like the S&P 500, or even a more broadly based index with more stocks in it--as the single factor. Using the single-factor model we can write returns as R R RS&P500 RS&P500 Where there is only one factor (the returns on the S&P 500portfolio index), we do not need to put a subscript on the beta. In this form (with minor modifications) the factor model is called a market model. This term is employed because the index that is used for the factor is an index of returns on the whole (stock) market. The market model is written as R R RM 5 RM is called the beta coefficient. where RM is the return on the market portfolio. The single QUESTIONS CONCEPT ? What is an inflation beta? A GNP beta? An interest-rate beta? What is the difference between a k-factor model and the market model? Define the beta coefficient. 11.4 PORTFOLIOS AND FACTOR MODELS Now let us see what happens to portfolios of stocks when each of the stocks follows a onefactor model. For purposes of discussion, we will take the coming one-month period and examine returns. We could have used a day or a year or any other time period. If the period represents the time between decisions, however, we would rather it be short than long, and a month is a reasonable time frame to use. We will create portfolios from a list of N stocks, and we will use a one-factor model to capture the systematic risk. The ith stock in the list will therefore have returns Ri Ri iF i (11.1) where we have subscripted the variables to indicate that they relate to the ith stock. Notice that the factor F is not subscripted. The factor that represents systematic risk could be a surprise in GNP, or we could use the market model and let the difference between the S&P 500 return and what we expect that return to be, RS&P500 RS&P500, be the factor. In either case, the factor applies to all of the stocks. 5 Alternatively, the market model could be written as R RM RM. Here alpha ( ) is an intercept term equal R 298 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 292 Part III Risk I F I G U R E 11.1 The One-Factor Model The excess return (%) on stock i: Ri Ri i = 1.5 i = 1.0 20 15 10 5 The return (%) on the factor, F i = 0.5 20 15 10 5 5 10 15 20 5 10 15 20 Each line represents a different security, where each security has a different beta. The i is subscripted because it represents the unique way the factor influences the ith stock. To recapitulate our discussion of factor models, if i is zero, the returns on the ith stock are Ri Ri i In words, the ith stock's returns are unaffected by the factor, F, if i is zero. If i is positive, positive changes in the factor raise the ith stock's returns, and declines lower them. Conversely, if i is negative, its returns and the factor move in opposite directions. Figure 11.1 illustrates the relationship between a stock's excess returns, Ri Ri, and the factor F for different betas, where i 0. The lines in Figure 11.1 plot equation (11.1) on the assumption that there has been no unsystematic risk. That is, i 0. Because we are assuming positive betas, the lines slope upward, indicating that the return on the stock rises with F. Notice that if the factor is zero (F 0), the line passes through zero on the y-axis. Now let us see what happens when we create stock portfolios where each stock follows a one-factor model. Let Xi be the proportion of security i in the portfolio. That is, if an individual with a portfolio of $100 wants $20 in General Motors, we say XGM 20%. Because the Xs represent the proportions of wealth we are investing in each of the stocks, we know that they must add up to 100 percent or 1. That is, X1 X2 X3 ... XN 1 We know that the portfolio return is the weighted average of the returns on the individual assets in the portfolio. Algebraically, this can be written as: RP X1R1 X2R2 X3R3 ... XNRN (11.2) Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 299 Chapter 11 An Alternative View of Risk and Return: The Arbitrage Pricing Theory 293 We saw from equation (11.1) that each asset, in turn, is determined by both the factor F and the unsystematic risk of i. Thus, by substituting equation (11.1) for each Ri in equation (11.2), we have RP X1 R1 1F 1 (Return on stock 1) X3 R3 3F (Return on stock 3) 3 X2 R2 2F 2 (Return on stock 2) ... XN RN NF N (Return on stock N) (11.3) Equation (11.3) shows us that the return on a portfolio is determined by three sets of parameters: 1. The expected return on each individual security, Ri. 2. The beta of each security multiplied by the factor F. 3. The unsystematic risk of each individual security, i. We express equation (11.3) in terms of these three sets of parameters as Weighted Average of Expected Returns: RP X1R1 X2R2 X3R3 ... XNRN (11.4) (Weighted Average of Betas)F: (X1 1 X2 2 X3 3 ... XN N)F Weighted Average of Unsystematic Risks: X1 1 X2 2 X3 3 ... XN N This rather imposing equation is actually straightforward. The first row is the weighted average of each security's expected return. The items in the parentheses of the second row represent the weighted average of each security's beta. This weighted average is, in turn, multiplied by the factor F. The third row represents a weighted average of the unsystematic risks of the individual securities. Where does uncertainty appear in equation (11.4)? There is no uncertainty in the first row because only the expected value of each security's return appears there. Uncertainty in the second row is reflected by only one item, F. That is, while we know that the expected value of F is zero, we do not know what its value will be over a particular time period. Uncertainty in the third row is reflected by each unsystematic risk, i. Portfolios and Diversification In the previous sections of this chapter, we expressed the return on a single security in terms of our factor model. Portfolios were treated next. Because investors generally hold diversified portfolios, we now want to know what equation (11.4) looks like in a large or diversified portfolio.6 As it turns out, something unusual occurs to equation (11.4); the third row actually disappears in a large portfolio. To see this, consider a gambler who divides $1,000 by betting on red over many spins of the roulette wheel. For example, he may participate in 1,000 spins, betting $1 at a time. Though we do not know ahead of time whether a particular spin will yield red or black, we can be confident that red will win about 50 percent of the time. Ignoring the house take, the investor can be expected to end up with just about his original $1,000. 6 Technically, we can think of a large portfolio as one where an investor keeps increasing the number of securities without limit. In practice, effective diversification would occur if at least a few dozen securities were held. 300 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 294 Part III Risk Though we are concerned with stocks, not roulette wheels, the same principle applies. Each security has its own unsystematic risk, where the surprise for one stock is unrelated to the surprise of another stock. By investing a small amount in each security, the weighted average of the unsystematic risks will be very close to zero in a large portfolio.7 Although the third row completely vanishes in a large portfolio, nothing unusual occurs in either row 1 or row 2. Row 1 remains a weighted average of the expected returns on the individual securities as securities are added to the portfolio. Because there is no uncertainty at all in the first row, there is no way for diversification to cause this row to vanish. The terms inside the parentheses of the second row remain a weighted average of the betas. They do not vanish, either, when securities are added. Because the factor F is unaffected when securities are added to the portfolios, the second row does not vanish. Why does the third row vanish while the second row does not, though both rows reflect uncertainty? The key is that there are many unsystematic risks in row 3. Because these risks are independent of each other, the effect of diversification becomes stronger as we add more assets to the portfolio. The resulting portfolio becomes less and less risky, and the return becomes more certain. However, the systematic risk, F, affects all securities because it is outside the parentheses in row 2. Since one cannot avoid this factor by investing in many securities, diversification does not occur in this row. E XAMPLE The preceding material can be further explained by the following example. We keep our one-factor model here but make three specific assumptions: 1. All securities have the same expected return of 10 percent. This assumption implies that the first row of equation (11.4) must also equal 10 percent because this row is a weighted average of the expected returns of the individual securities. 2. All securities have a beta of 1. The sum of the terms inside the parentheses in the second row of (11.4) must equal 1 because these terms are a weighted average of the individual betas. Since the terms inside the parentheses are multiplied by F, the value of the second row is 1 F F. 3. In this example, we focus on the behavior of one individual, Walter V. Bagehot. Mr. Bagehot decides to hold an equally weighted portfolio. That is, the proportion of each security in his portfolio is 1/N. We can express the return on Mr. Bagehot's portfolio as Return on Walter V. Bagehot's Portfolio: RP 10% F 1 N 1 From row 1 of (11.4) From row 2 of (11.4) 1 N 2 1 N 3 ... 1 N N (11.4) From row 3 of (11.4) 7 More precisely, we say that the weighted average of the unsystematic risk approaches zero as the number of equally weighted securities in a portfolio approaches infinity. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 301 Chapter 11 An Alternative View of Risk and Return: The Arbitrage Pricing Theory 295 I F I G U R E 11.2 Diversification and the Portfolio Risk for an Equally Weighted Portfolio Total risk, 2 P Unsystematic risk Systematic risk N, number of securities in portfolio Total risk decreases as the number of securities in the portfolio rises. This drop occurs only in the unsystematicrisk component. Systematic risk is unaffected by diversification. We mentioned before that, as N increases without limit, row 3 of (11.4) becomes equal to zero.8 Thus, the return to Walter Bagehot's portfolio when the number of securities is very large is RP 10% F (11.4) The key to diversification is exhibited in (11.4). The unsystematic risk of row 3 vanishes, while the systematic risk of row 2 remains. This is illustrated in Figure 11.2. Systematic risk, captured by variation in the factor F, is not reduced through diversification. Conversely, unsystematic risk diminishes as securities are added, vanishing as the number of securities becomes infinite. Our result is analogous to the diversification example of the previous chapter. In that chapter, we said that undiversifiable or systematic risk arises from positive covariances between securities. In this chapter, we say that systematic risk arises from a common factor F. Because a common factor causes positive covariances, the arguments of the two chapters are parallel. QUESTIONS CONCEPT ? How can the return on a portfolio be expressed in terms of a factor model? What risk is diversified away in a large portfolio? 11.5 BETAS AND EXPECTED RETURNS The Linear Relationship We have argued many times that the expected return on a security compensates for its risk. In the previous chapter we showed that market beta (the standardized covariance of the security's returns with those of the market) was the appropriate measure of risk under the assumptions 8 Our presentation on this point has been nonrigorous. The student interested in more rigor should note that the variance of row 3 is 1 N2 where 2 2 1 N2 2 1 N2 2 ... 1 N2 2 e /N , 2 1 N N2 2 is the variance of each . This can be rewritten as which tends to 0 as N goes to infinity. 302 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 296 Part III Risk I F I G U R E 11.3 A Graph of Beta and Expected Return for Individual Stocks under the One-Factor Model Expected returns (%) Ri Security market line L 35 P 22.5 RF =10 B C A Beta: 1 2 i of homogeneous expectations and riskless borrowing and lending. The capital-asset-pricing model, which posited these assumptions, implied that the expected return on a security was positively (and linearly) related to its beta. We will find a similar relationship between risk and return in the one-factor model of this chapter. We begin by noting that the relevant risk in large and well-diversified portfolios is all systematic because unsystematic risk is diversified away. An implication is that, when a well-diversified shareholder considers changing her holdings of a particular stock, she can ignore the security's unsystematic risk. Notice that we are not claiming that stocks, like portfolios, have no unsystematic risk. Nor are we saying that the unsystematic risk of a stock will not affect its returns. Stocks do have unsystematic risk, and their actual returns do depend on the unsystematic risk. Because this risk washes out in a well-diversified portfolio, however, shareholders can ignore this unsystematic risk when they consider whether or not to add a stock to their portfolio. Therefore, if shareholders are ignoring the unsystematic risk, only the systematic risk of a stock can be related to its expected return. This relationship is illustrated in the security market line of Figure 11.3. Points P, C, A, and L all lie on the line emanating from the risk-free rate of 10 percent. The points representing each of these four assets can be created by combinations of the risk-free rate and any of the other three assets. For example, since A has a beta of 2.0 and P has a beta of 1.0, a portfolio of 50 percent in asset A and 50 percent in the riskless rate has the same beta as asset P. The risk-free rate is 10 percent and the expected return on security A is 35 percent, implying that the combination's return of 22.5 percent [(10% 35%)/2] is identical to security P's expected return. Because security P has both the same beta and the same expected return as a combination of the riskless asset and security A, an individual is equally inclined to add a small amount of security P and to add a small amount of this combination to her portfolio. However, the unsystematic risk of security P need not be equal to the unsystematic risk of the combination of security A and the risk-free rate because unsystematic risk is diversified away in a large portfolio. Of course, the potential combinations of points on the security market line are endless. One can duplicate P by combinations of the risk-free rate and either C or L (or both of them). One can duplicate C (or A or L) by borrowing at the risk-free rate to invest in P. The infinite number of points on the security market line that are not labeled can be used as well. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 303 Chapter 11 An Alternative View of Risk and Return: The Arbitrage Pricing Theory 297 Now consider security B. Because its expected return is below the line, no investor would hold it. Instead, the investor would prefer security P, a combination of security A and the riskless asset, or some other combination. Thus, security B's price is too high. Its price will fall in a competitive market, forcing its expected return back up to the line in equilibrium. The preceding discussion allows us to provide an equation for the security market line of Figure 11.3. We know that a line can be described algebraically from two points. It is perhaps easiest to focus on the risk-free rate and asset P, since the risk-free rate has a beta of 0 and P has a beta of 1. Because we know that the return on any zero-beta asset is RF and the expected return on asset P is RP, it can easily be shown that R RF RP RF (11.5) In equation (11.5), R can be thought of as the expected return on any security or portfolio lying on the security market line. is the beta of that security or portfolio. The Market Portfolio and the Single Factor In the CAPM, the beta of a security measures the security's responsiveness to movements in the market portfolio. In the one-factor model of the APT, the beta of a security measures its responsiveness to the factor. We now relate the market portfolio to the single factor. A large, diversified portfolio has no unsystematic risk because the unsystematic risks of the individual securities are diversified away. Assuming enough securities so that the market portfolio is fully diversified and assuming that no security has a disproportionate market share, this portfolio is fully diversified and contains no unsystematic risk.9 In other words, the market portfolio is perfectly correlated with the single factor, implying that the market portfolio is really a scaled-up or scaled-down version of the factor. After scaling properly, we can treat the market portfolio as the factor itself. The market portfolio, like every security or portfolio, lies on the security market line. When the market portfolio is the factor, the beta of the market portfolio is 1 by definition. This is shown in Figure 11.4. (We deleted the securities and the specific expected returns from Figure 11.3 for clarity: the two graphs are otherwise identical.) With the market portfolio as the factor, equation (11.5) becomes R RF RM RF where RM is the expected return on the market. This equation shows that the expected return on any asset, R, is linearly related to the security's beta. The equation is identical to that of the CAPM, which we developed in the previous chapter. QUESTION CONCEPT ? What is the relationship between the one-factor model and the CAPM? 9 This assumption is plausible in the real world. For example, even the market value of General Electric is only 3 percent to 4 percent of the market value of the S&P 500 Index. 304 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 298 Part III Risk I F I G U R E 11.4 A Graph of Beta and Expected Return for Individual Stocks under the One-Factor Model Expected returns (%) Security market line RM RF Beta 1 The factor is scaled so that it is identical to the market portfolio. The beta of the market portfolio is 1. 11.6 THE CAPITAL-ASSET-PRICING MODEL AND THE ARBITRAGE PRICING THEORY The CAPM and the APT are alternative models of risk and return. It is worthwhile to consider the differences between the two models, both in terms of pedagogy and in terms of application. Differences in Pedagogy We feel that the CAPM has at least one strong advantage from the student's point of view. The derivation of the CAPM necessarily brings the reader through a discussion of efficient sets. This treatment--beginning with the case of two risky assets, moving to the case of many risky assets, and finishing when a riskless asset is added to the many risky ones--is of great intuitive value. This sort of presentation is not as easily accomplished with the APT. However, the APT has an offsetting advantage. The model adds factors until the unsystematic risk of any security is uncorrelated with the unsystematic risk of every other security. Under this formulation, it is easily shown that (1) unsystematic risk steadily falls (and ultimately vanishes) as the number of securities in the portfolio increases but (2) the systematic risks do not decrease. This result was also shown in the CAPM, though the intuition was cloudier because the unsystematic risks could be correlated across securities. Differences in Application One advantage of the APT is that it can handle multiple factors while the CAPM ignores them. Although the bulk of our presentation in this chapter focused on the one-factor model, a multifactor model is probably more reflective of reality. That is, one must abstract from many marketwide and industrywide factors before the unsystematic risk of one security becomes uncorrelated with the unsystematic risks of other securities. Under this multifactor version of the APT, the relationship between risk and return can be expressed as: R RF R1 RF 1 R2 RF 2 R3 RF 3 ... RK RF K (11.6) In this equation, 1 stands for the security's beta with respect to the first factor, 2 stands for the security's beta with respect to the second factor, and so on. For example, if the first factor is GNP, 1 is the security's GNP beta. The term R1 is the expected return on Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 305 Chapter 11 An Alternative View of Risk and Return: The Arbitrage Pricing Theory 299 a security (or portfolio) whose beta with respect to the first factor is 1 and whose beta with respect to all other factors is zero. Because the market compensates for risk, (R1 RF ) will be positive in the normal case.10 (An analogous interpretation can be given to R2, R3, and so on.) The equation states that the security's expected return is related to the security's factor betas. The intuition in equation (11.6) is straightforward. Each factor represents risk that cannot be diversified away. The higher a security's beta with regard to a particular factor is, the higher is the risk that the security bears. In a rational world, the expected return on the security should compensate for this risk. The above equation states that the expected return is a summation of the risk-free rate plus the compensation for each type of risk that the security bears. As an example, consider a study where the factors were monthly growth in industrial production (IP), change in expected inflation ( EI), unanticipated inflation (UI), unanticipated change in the risk premium between risky bonds and default-free bonds (URP), and unanticipated change in the difference between the return on long-term government bonds and the return on short-term government bonds (UBR).11 Using the period 19581984, the empirical results of the study indicated that the expected monthly return on any stock, RS, can be described as RS URP 0.0041 0.0136 IP 0.0001 EI 0.0006 UI 0.0072 URP 0.0052 UBR Suppose a particular stock had the following betas: IP 1.1, EI 2, UI 0.1, UBR 1.6. The expected monthly return on that security would be 0.0041 0.0136 1.1 0.0001 0.0006 2 3 0.0072 0.1 0.0052 1.6 3, RS 0.0095 Assuming that a firm is unlevered and that one of the firm's projects has risk equivalent to that of the firm, this value of 0.0095 (i.e., .95%) can be used as the monthly discount rate for the project. (Because annual data are often supplied for capital budgeting purposes, the annual rate of 0.120 [(1.0095)12 1] might be used instead.) Because many factors appear on the right-hand side of equation (11.5), the APT formulation has the potential to measure expected returns more accurately than does the CAPM. However, as we mentioned earlier, one cannot easily determine which are the appropriate factors. The factors in the above study were included for reasons of both common sense and convenience. They were not derived from theory. By contrast, the use of the market index in the CAPM formulation is implied by the theory of the previous chapter. We suggested in earlier chapters that the S&P 500 Index mirrors stock market movements quite well. Using the Ibbotson-Sinquefield results showing that the yearly return on the S&P 500 Index was, on average, 9.2 percent greater than the risk-free rate, the last chapter easily calculated expected returns on different securities from the CAPM.12 10 11 Actually, (Ri RF) could be negative in the case where factor i is perceived as a hedge of some sort. N. Chen, R. Roll, and S. Ross, "Economic Forces and the Stock Market," Journal of Business (July 1986). 12 Though many researchers assume that surrogates for the market portfolio are easily found, Richard Roll, "A Critique of the Asset Pricing Theory's Tests," Journal of Financial Economics (March 1977), argues that the absence of a universally acceptable proxy for the market portfolio seriously impairs application of the theory. After all, the market must include real estate, racehorses, and other assets that are not in the stock market. 306 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 300 Part III Risk 11.7 EMPIRICAL APPROACHES TO ASSET PRICING Empirical Models The CAPM and the APT by no means exhaust the models and techniques used in practice to measure the expected return on risky assets. Both the CAPM and the APT are risk-based models. They each measure the risk of a security by its beta(s) on some systematic factor(s), and they each argue that the expected excess return must be proportional to the beta(s). While we have seen that this is intuitively appealing and has a strong basis in theory, there are alternative approaches. Most of these alternatives can be lumped under the broad heading of parametric or empirical models. The word empirical refers to the fact that these approaches are based less on some theory of how financial markets work and more on simply looking for regularities and relations in the history of market data. In these approaches the researcher specifies some parameters or attributes associated with the securities in question and then examines the data directly for a relation between these attributes and expected returns. For example, an extensive amount of research has been done on whether the expected return on a firm is related to its size. Is it true that small firms have higher average returns than large firms? Researchers have also examined a variety of accounting measures such as the ratio of the price of a stock to the accounting earnings, the P/E ratio, and the closely related ratio of the market value of the stock to the book value of the company, the M/B ratio. Here it might be argued that companies with low P/E's or low M/B's are "undervalued" and can be expected to have higher returns in the future. To use the empirical approach to determine the expected return, we would estimate the following equation: Ri RF kP/E P/E i kM/B M/B i ksize size P where Ri is the expected return of firm i, and where the k's are coefficients that we estimate from stock market data. Notice that this is the same form as equation (11.6) with the firm's attributes in place of betas and with the k's in place of the excess factor portfolio returns. When tested with data, these parametric approaches seem to do quite well. In fact, when comparisons are made between using parameters and using betas to predict stock returns, the parameters, such as P/E and M/B, seem to work better. There are a variety of possible explanations for these results, and the issues have certainly not been settled. Critics of the empirical approach are skeptical of what they call data mining. The particular parameters that researchers work with are often chosen because they have been shown to be related to returns. For instance, suppose that you were asked to explain the change in SAT test scores over the past 40 years in some particular state. Suppose that to do this you searched through all of the data series you could find. After much searching, you might discover, for example, that the change in the scores was directly related to the jackrabbit population in Arizona. We know that any such relation is purely accidental but if you search long enough and have enough choices, you will find something even if it is not really there. It's a bit like staring at clouds. After a while you will see clouds that look like anything you want, clowns, bears, or whatever, but all you are really doing is data mining. Needless to say, the researchers on these matters defend their work by arguing that they have not mined the data and have been very careful to avoid such traps by not snooping at the data to see what will work. Of course, as a matter of pure theory, since anyone in the market can easily look up the P/E ratio of a firm, one would certainly not expect to find that firms with low P/E's did better than firms with high P/E's simply because they were undervalued. In an efficient market, such public measures of undervaluation would be quickly exploited and would not expect to last. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 307 Chapter 11 An Alternative View of Risk and Return: The Arbitrage Pricing Theory 301 Perhaps a better explanation for the success of empirical approaches lies in a synthesis of the risk-based approaches and the empirical methods. In an efficient market, risk and return are related, hence perhaps the parameters or attributes which appear to be related to returns are also better measures of risk. For example, if we were to find that low P/E firms outperformed high P/E firms and that this was true even for firms that had the same beta(s), then we have at least two possible explanations. First, we could simply discard the riskbased theories as incorrect. Furthermore, we could argue that markets are inefficient and that buying low P/E stocks provides us with an opportunity to make higher than predicted returns. Second, we could argue that both views of the world are correct and that the P/E is really just a better way to measure systematic risk, i.e., beta(s), than directly estimating beta from the data. Style Portfolios In addition to their use as a platform for estimating expected returns, stock attributes are also widely used as a way of characterizing money management styles. For example, a portfolio that has a P/E ratio much in excess of the market average might be characterized as a high P/E or a growth stock portfolio. Similarly, a portfolio made up of stocks with an average P/E less than that for a market index might be characterized as a low P/E or a value portfolio. To evaluate how well a portfolio manager is doing, often their performance is compared with the performance of some basic indexes. For example, the portfolio returns of a manager who purchases large U.S. stocks might be compared to the performance of the S&P 500 Index. In such a case the S&P 500 is said to be the benchmark against which their performance is measured. Similarly, an international manager might be compared against some common index of international stocks. In choosing an appropriate benchmark, care should be taken to identify a benchmark that contains only those types of stocks that the manager targets as representative of his or her style and that are also available to be purchased. A manager who was told not to purchase any stocks in the S&P 500 Index would not consider it legitimate to be compared against the S&P 500. Increasingly, too, managers are compared not only against an index, but also against a peer group of similar managers. The performance of a fund that advertises itself as a growth fund might be measured against the performance of a large sample of similar funds. For instance, the performance over some period commonly is assigned to quartiles. The top 25 percent of the funds are said to be in the first quartile, the next 25 percent in the second quartile, the next 25 percent in the third quartile, and the worst performing 25 percent of the funds in the last quartile. If the fund we are examining happens to have a performance that falls in the second quartile, then we speak of it as a second quartile manager. Similarly, we call a fund that purchases low M/B stocks a value fund and would measure its performance against a sample of similar value funds. These approaches to measuring performance are relatively new, and they are part of an active and exciting effort to refine our ability to identify and use investment skills. QUESTIONS CONCEPT ? Empirical models are sometimes called factor models. What is the difference between a factor as we have used it previously in this chapter and an attribute as we use it in this section? What is data mining and why might it overstate the relation between some stock attribute and returns? What is wrong with measuring the performance of a U.S. growth stock manager against a benchmark composed of English stocks? 308 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 302 Part III Risk 11.8 SUMMARY AND CONCLUSIONS The previous chapter developed the capital-asset-pricing model (CAPM). As an alternative, this chapter develops the arbitrage pricing theory (APT). 1. The APT assumes that stock returns are generated according to factor models. For example, we might describe a stock's return as R R IFI GNPFGNP rFr where I, GNP, and r stand for inflation, gross national product, and the interest rate, respectively. The three factors FI, FGNP, and Fr represent systematic risk because these factors affect many securities. The term is considered unsystematic risk because it is unique to each individual security. 2. For convenience, we frequently describe a security's return according to a one-factor model: R R F 3. As securities are added to a portfolio, the unsystematic risks of the individual securities offset each other. A fully diversified portfolio has no unsystematic risk but still has systematic risk. This result indicates that diversification can eliminate some, but not all, of the risk of individual securities. 4. Because of this, the expected return on a stock is positively related to its systematic risk. In a one-factor model, the systematic risk of a security is simply the beta of the CAPM. Thus, the implications of the CAPM and the one-factor APT are identical. However, each security has many risks in a multifactor model. The expected return on a security is positively related to the beta of the security with each factor. 5. Empirical or parametric models that capture the relations between returns and stock attributes such as P/E or M/B ratios can be estimated directly from the data without any appeal to theory. These ratios are also used to measure the style of a portfolio manager and to construct benchmarks and samples against which they are measured. KEY TERMS Benchmark 301 Beta coefficient 289 Empirical model 300 Factor model 290 Growth stock portfolios Market model 291 Value portfolios 301 301 SUGGESTED READINGS Complete treatments of the APT can be found in both of the following articles: Ross, S. A. "Return, Risk and Arbitrage." In Friend and Bicksler, eds., Risk and Return in Finance. New York: Heath Lexington, 1974. Ross, S. A. "The Arbitrage Theory of Asset Pricing." Journal of Economic Theory (December 1976). Two less technical discussions of APT are: Bower, D. H.; R. S. Bower; and D. Logue. "A Primer on Arbitrage Pricing Theory." Midland Corporate Finance Journal (Fall 1984). Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 309 Chapter 11 An Alternative View of Risk and Return: The Arbitrage Pricing Theory 303 Roll, R., and S. Ross. "The Arbitrage Pricing Theory Approach to Strategic Portfolio Planning." Financial Analysts Journal (May/June 1984). The following article describes the idea of style portfolios: Roll, R. "Style Return Differentials: Illusions, Risk Premia, or Investment Opportunities." In Fabozzi (ed.), Handbook of Equity Style Management. New Hope, PA: Frank Fabozzi Associates, 1995. QUESTIONS AND PROBLEMS Factor Models and Risk 11.1 You own stock in the Lewis-Striden Drug Company. Suppose you had expected the following events to occur last month. a. The government would announce that real GNP would have grown 1.2 percent during the previous quarter. The returns of Lewis-Striden are positively related to real GNP. b. The government would announce that inflation over the previous quarter was 3.7 percent. The returns of Lewis-Striden are negatively related to inflation. c. Interest rates would rise 2.5 percentage points. The returns of Lewis-Striden are negatively related to interest rates. d. The president of the firm would announce his retirement. The retirement would be effective six months from the announcement day. The president is well liked: in general he is considered an asset to the firm. e. Research data would conclusively prove the efficacy of an experimental drug. Completion of the efficacy testing means the drug will be on the market soon. Suppose the following events actually occurred. a. The government announced that real GNP grew 2. 3 percent during the previous quarter. b. The government announced that inflation over the previous quarter was 3.7 percent. c. Interest rates rose 2.1 percentage points. d. The president of the firm died suddenly of a heart attack. e. Research results in the efficacy testing were not as strong as expected. The drug must be tested another six months and the efficacy results must be resubmitted to the FDA. f. Lab researchers had a breakthrough with another drug. g. A competitor announced that it will begin distribution and sale of a medicine that will compete directly with one of Lewis-Striden's top-selling products. i. Discuss how each of the actual occurrences affects the returns on your LewisStriden stock. ii. Which events represent systematic risk? iii. Which events represent unsystematic risk? 11.2 Suppose a three-factor model is appropriate to describe the returns of a stock. Information about those three factors is presented in the following chart. Suppose this is the only information you have concerning the factors. Beta of Factor 0.0042 1.40 0.67 Expected Value $4,416 3.1% 9.5% Actual Value $4,480 4.3% 11.8% Factor GNP Inflation Interest rate a. What is the systematic risk of the stock return? b. Suppose unexpected bad news about the firm was announced that dampens the returns by 2.6 percentage points. What is the unsystematic risk of the stock return? c. Suppose the expected return of the stock is 9.5 percent. What is the total return on this stock? 310 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 304 Part III Risk 11.3 Suppose a factor model is appropriate to describe the returns on a stock. Information about those factors is presented in the following chart. Beta of Factor 2.04 1.90 Expected Value (%) 3.5% 14.0 10.0 Actual Value (%) 4.8% 15.2 Factor Growth in GNP Interest rates Stock return a. What is the systematic risk of the stock return? b. The firm announced that its market share had unexpectedly increased from 23 percent to 27 percent. Investors know from their past experience that the stock return will increase by 0.36 percent per an increase of 1 percent in its market share. What is the unsystematic risk of the stock? c. What is the total return on this stock? 11.4 The following three stocks are available in the market. Expected Return (%) Stock A Stock B Stock C Market 10.5% 13.0 15.7 14.2 Beta 1.20 0.98 1.37 1.00 Assume the market model is valid. a. Write the market-model equation for each stock. b. What is the return on a portfolio that is 30-percent stock A, 45-percent stock B, and 25percent stock C? c. Suppose the return on the market is 15 percent and there are no unsystematic surprises in the returns. i. What is the return on each stock? ii. What is the return on the portfolio? 11.5 You are forming an equally weighted portfolio of stocks. There are many stocks that all have the same beta of 0.84 for factor 1 and the same beta of 1.69 for factor 2. All stocks also have the same expected return of 11 percent. Assume a two-factor model describes the returns on each of these stocks. a. Write the equation of the returns on your portfolio if you place only five stocks in it. b. Write the equation of the returns on your portfolio if you place in it a very large number of stocks that all have the same expected returns and the same betas. The APT 11.6 There are two stock markets, each driven by the same common force F with an expected value of zero and standard deviation of 10 percent. There are a large number of securities in each market; thus, you can invest in as many stocks as you wish. Due to restrictions, however, you can invest in only one of the two markets. The expected return on every security in both markets is 10 percent. The returns for each security i in the first market are generated by the relationship R1i 0.10 1.5F 1i where 1i is the term that measures the surprises in the returns of stock i in market 1. These surprises are normally distributed; their mean is zero. The returns for security j in the second market are generated by the relationship R2j where 2j 0.10 0.5F 2j is the term that measures the surprises in the returns of stock j in market 2. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 311 Chapter 11 An Alternative View of Risk and Return: The Arbitrage Pricing Theory 305 These surprises are normally distributed; their mean is zero. The standard deviation of 1i and 2j for any two stocks, i and j, is 20 percent. a. If the correlation between the surprises in the returns of any two stocks in the first market is zero, and if the correlation between the surprises in the returns of any two stocks in the second market is zero, in which market would a risk-averse person prefer to invest? (Note: The correlation between 1i and 1j for any i and j is zero, and the correlation between 2i and 2j for any i and j is zero.) b. If the correlation between 1i and 1j in the first market is 0.9 and the correlation between 2i and 2j in the second market is zero, in which market would a risk-averse person prefer to invest? c. If the correlation between 1i and 1j in the first market is zero and the correlation between 2i and 2j in the second market is 0.5, in which market would a risk-averse person prefer to invest? d. In general, what is the relationship between the correlations of the disturbances in the two markets that would make a risk-averse person equally willing to invest in either of the two markets? 11.7 Assume that the following market model adequately describes the return-generating behavior of risky assets. Rit where Rit and RMt The return on a portfolio containing all risky assets in some proportion, at time t The return for the ith asset at time t i iRMt it RMt and it are statistically independent. Suppose the following data are true. Asset A B C Var(RMt) i E(Ri) 8.41% 12.06 13.95 Var( i) 1.00% 1.44 2.25 0.7 1.2 1.5 1.21% a. Calculate the standard deviation of returns for each asset. b. Assume short selling is allowed. i. Calculate the variance of return of three portfolios containing an infinite number of asset types A, B, or C, respectively. ii. Assume: RF 3.3% and RM 10.6%. Which asset will not be held by rational investors? iii. What equilibrium state will emerge such that no arbitrage opportunities exist? Why? 11.8 Assume that the returns of individual securities are generated by the following two-factor model: Rit E(Rit) i1F1t i2F2t Rit is the return for security i at time t. F1t and F2t are market factors with zero expectation and zero covariance. In addition, assume that there is a capital market for four securities, where each one has the following characteristics: Security 1 2 3 4 1 2 E(Rit) 20% 20 10 10 1.0 0.5 1.0 1.5 1.5 2.0 0.5 0.75 312 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory The McGraw-Hill Companies, 2002 306 Part III Risk The capital market for these four assets is perfect in the sense that there are no transactions costs and short sales can take place. a. Construct a portfolio containing (long or short) securities 1 and 2, with a return that does not depend on the market factor, F1t, in any way. (Hint: Such a portfolio will have 0.) Compute the expected return and 2 coefficient for this portfolio. 1 b. Following the procedure in (a), construct a portfolio containing securities 3 and 4 with a return that does not depend on the market factor, F1t. Compute the expected return and 2 coefficient for this portfolio. c. Consider a risk-free asset with expected return equal to 5 percent, 1 0, and 2 0. Describe a possible arbitrage opportunity in such detail that an investor could implement it. d. What effect would the existence of these kinds of arbitrage opportunities have on the capital markets for these securities in the short and long run? Graph your analysis. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 313 12 CHAPTER Risk, Cost of Capital, and Capital Budgeting EXECUTIVE SUMMARY O ur text has devoted a number of chapters to net present value (NPV) analysis. We pointed out that a dollar to be received in the future is worth less than a dollar received today for two reasons. First, there is the simple time-value-of-money argument in a riskless world. If you have a dollar today, you can invest it in the bank and receive more than a dollar by some future date. Second, a risky dollar is worth less than a riskless dollar. Consider a firm expecting a $1 cash flow. If actuality exceeds expectations (revenues are especially high or expenses are especially low), perhaps $1.10 or $1.20 will be received. If actuality falls short of expectations, perhaps only $0.80 or $0.90 will be received. This risk is unattractive to the typical firm. Our work on NPV allowed us to value riskless cash flows precisely. That is, we discounted by the riskless interest rate. However, because most real-world cash flows in the future are risky, business demands a procedure for discounting risky cash flows. This chapter applies the concept of net present value to risky cash flows. Let us review what previous work in the text has to say about NPV. In earlier chapters we learned that the basic NPV formula for an investment that generates cash flows (Ct) in future periods is T NPV C0 t 1 Ct 1 r t For risky projects, expected incremental cash flows Ct are placed in the numerator, and the NPV formula becomes T NPV C0 t 1 Ct 1 r t In this chapter, we will learn that the discount rate used to determine the NPV of a risky project can be computed from the CAPM (or APT). For example, if an all-equity firm is seeking to value a risky project, such as renovating a warehouse, the firm will determine the required return, rS, on the project by using the SML. We call rS the firm's cost of equity capital. When firms finance with both debt and equity, the discount rate to use is the project's overall cost of capital. The overall cost of capital is a weighted average of the cost of debt and the cost of equity. 12.1 THE COST OF EQUITY CAPITAL Whenever a firm has extra cash, it can take one of two actions. On the one hand, it can pay out the cash immediately as a dividend. On the other hand, the firm can invest extra cash in a project, paying out the future cash flows of the project as dividends. Which procedure would the stockholders prefer? If a stockholder can reinvest the dividend in a financial asset (a stock or bond) with the same risk as that of the project, the stockholders would desire the 314 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 308 Part III Risk I F I G U R E 12.1 Choices of a Firm with Extra Cash Corporation receives cash. It can either Invest cash in project Stockholders want the firm to invest in a project only if the expected return on the project is at least as great as that of a financial asset of comparable risk. Pay dividend Shareholder invests dividend in financial asset alternative with the highest expected return. In other words, the project should be undertaken only if its expected return is greater than that of a financial asset of comparable risk. This is illustrated in Figure 12.1. This discussion implies a very simple capital-budgeting rule: The discount rate of a project should be the expected return on a financial asset of comparable risk. From the firm's perspective, the expected return is the cost of equity capital. Under the CAPM, the expected return on the stock is R RF (RM RF) (12.1) where RF is the risk-free rate and RM RF is the difference between the expected return on the market portfolio and the riskless rate. This difference is often called the expected excess market return.1 We now have the tools to estimate a firm's cost of equity capital. To do this, we need to know three things: The risk-free rate, RF The market-risk premium, RM The company beta, i RF E XAMPLE Suppose the stock of the Quatram Company, a publisher of college textbooks, has a beta ( ) of 1.3. The firm is 100-percent equity financed; that is, it has no debt. Quatram is considering a number of capital-budgeting projects that will double its size. Because these new projects are similar to the firm's existing ones, the average beta on the new projects is assumed to be equal to Quatram's existing beta. The risk-free rate is 7 percent. What is the appropriate discount rate for these new projects, assuming a market-risk premium of 9.5 percent? We estimate the cost of equity rS for Quatram as rS 7% (9.5% 1.3) 7% 12.35% 19.35% 1 Of course, we can use the k-factor APT model (Chapter 11) and estimate several beta coefficients. However, for our purposes it is sufficient to estimate a single beta. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 315 Chapter 12 Risk, Cost of Capital, and Capital Budgeting 309 Two key assumptions were made in this example: (1) The beta risk of the new projects is the same as the risk of the firm, and (2) The firm is all-equity financed. Given these assumptions, it follows that the cash flows of the new projects should be discounted at the 19.35-percent rate. E XAMPLE Suppose Alpha Air Freight is an all-equity firm with a beta of 1.21. Further suppose the market-risk premium is 9.5 percent, and the risk-free rate is 5 percent. We can determine the expected return on the common stock of Alpha Air Freight by using the SML of equation (12.1). We find that the expected return is 5% (1.21 9.5%) 16.495% Because this is the return that shareholders can expect in the financial markets on a stock with a of 1.21, it is the return they expect on Alpha Air Freight's stock. Further suppose Alpha is evaluating the following non-mutually exclusive projects: Project's Expected Cash Flows Next Year $140 120 110 Project's Internal Rate of Return 40% 20 10 Project's NPV When Cash Flows Are Discounted at 16.495% $20.2 3.0 5.6 Project A B C Project's Beta ( ) 1.21 1.21 1.21 Accept or Reject Accept Accept Reject Each project initially costs $100. All projects are assumed to have the same risk as the firm as a whole. Because the cost of equity capital is 16.495 percent, projects in an all-equity firm are discounted at this rate. Projects A and B have positive NPVs, and C has a negative NPV. Thus, only A and B will be accepted.2 This is illustrated in Figure 12.2. 2 In addition to the SML, the dividend-valuation model presented earlier in the text can be used to represent the firm's cost of equity capital. Using this model, the present value (P) of the firm's expected dividend payments can be expressed as P Div1 1 rS 1 Div2 rS 2 ... 1 DivN rS N ... (a) where rS is the required return of shareholders and the firm's cost of equity capital. If the dividends are expected to grow at a constant rate, g, equation (a) reduces to P Equation (b) can be reformulated as rS Div1 P g (c) Div1 rS g (b) We can use equation (c) to estimate rS. Div1/P is the dividend yield expected over the next year. An estimate of the cost of equity capital is determined from an estimate of Div1/P and g. The dividend-valuation model is generally considered both less theoretically sound and more difficult to apply practically than the SML. In addition, J. R. Graham and C. R. Harvey, "The Theory and Practice of Corporate Finance: Evidence from the Field," unpublished paper, Duke University (April, 2000) present evidence that only about 15 percent of real-world companies use the dividend-valuation model, a far smaller percentage than use the SML approach. Hence, examples in this chapter calculate cost of equity capital using the SML approach. 316 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 310 Part III Risk I F I G U R E 12.2 Using the Security-Market Line to Estimate the RiskAdjusted Discount Rate for Risky Projects Project's internal rate of return (%) 40 Accept region 20 16.3 B A (NPV = $20.2) SML (NPV = $3.0) Reject region 10 5 Firm's risk (beta) 1.21 The diagonal line represents the relationship between the cost of equity capital and the firm's beta. An all-equity firm should accept a project whose internal rate of return is greater than the cost of equity capital, and should reject a project whose internal rate of return is less than the cost of equity capital. (The above graph assumes that all projects are as risky as the firm.) C (NPV = $5.6) 12.2 ESTIMATION OF BETA In the previous section we assumed that the beta of the company was known. Of course, beta must be estimated in the real world. We pointed out earlier that the beta of a security is the standardized covariance of a security's return with the return on the market portfolio. The formula for security i, first given in Chapter 10, is Beta of security i Cov Ri, RM Var RM i, M 2 M In words, the beta is the covariance of a security with the market, divided by the variance of the market. Because we calculated both covariance and variance in earlier chapters, calculating beta involves no new material. E XAMPLE (A DVANCED ) Suppose we sample the returns on the stock of the General Tool Company and the returns on the S&P 500 Index for four years. They are tabulated as follows: General Tool Company RG 10% 3 20 15 S&P 500 Index RM 40% 30 10 20 Year 1 2 3 4 We can calculate beta in six steps. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 317 Chapter 12 Risk, Cost of Capital, and Capital Budgeting 311 TA B L E 12.1 Calculating Beta (1) (2) Rate of Return on General Tool (RG) 0.10 0.03 0.20 0.15 ____ 0.07 (3) General Tool's Deviation from Average Return* (RG RG) 0.17 ( 0.10 0.07) 0.04 0.13 0.08 Avg (4) Rate of Return on Market Portfolio 0.40 0.30 0.10 0.20 ____ 0.10 (5) Market Portfolio's Deviation from Average Return (RM RM) 0.30 0.20 0.20 0.30 (6) Deviation of General Tool Multiplied by Deviation of Market Portfolio (7) Squared Deviation of Market Portfolio Year 1 2 3 4 Avg 0.051 0.090 [( 0.17) ( 0.30)] [( 0.30) ( 0.30)] 0.008 0.040 0.026 0.040 0.024 0.090 _____ _____ Sum: 0.109 Sum: 0.260 Beta of General Tool: 0.419 0.109 . 0.260 *Average return for General Tool is 0.07. Average return for market is 0.10. 1. Calculate average return on each asset: Average Return on General Tool: 0.10 0.03 4 0.20 0.15 0.07 7% Average Return on Market Portfolio: 0.40 0.30 4 0.10 0.20 0.10 10% 2. For each asset, calculate the deviation of each return from the asset's average return determined above. This is presented in columns 3 and 5 of Table 12.1. 3. Multiply the deviation of General Tool's return by the deviation of the market's return. This is presented in column 6. This procedure is analogous to our calculation of covariance in an earlier chapter. The procedure will be used in the numerator of the beta calculation. 4. Calculate the squared deviation of the market's return. This is presented in column 7. This procedure is analogous to our calculation of variance in Chapter 9. This procedure will be used in the denominator of the beta calculation. 5. Take the sum of column 6 and the sum of column 7. They are Sum of Deviation of General Tool Multiplied by Deviation of Market Portfolio: 0.051 0.008 0.026 0.024 0.109 Sum of Squared Deviation of Market Portfolio: 0.090 0.040 0.040 0.090 0.260 318 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 312 Part III Risk MEASURING COMPANY BETAS The basic method of measuring company betas is to estimate: Cov Rit, RMt Var RMt using t 1, 2, . . . , T observations Problems 1. Betas may vary over time. 2. The sample size may be inadequate. 3. Betas are influenced by changing financial leverage and business risk. Solutions 1. Problems 1 and 2 (above) can be moderated by more sophisticated statistical techniques. 2. Problem 3 can be lessened by adjusting for changes in business and financial risk. 3. Look at average beta estimates of several comparable firms in the industry. 6. The beta is the sum of column 6 divided by the sum of column 7. This is Beta of General Tool: 0.109 0.419 0.260 Real-World Betas The General Tool Company discussed in the previous example is fictional. It is instructive to see how betas are determined for actual real-world companies. Figure 12.3 plots monthly returns for four large firms against monthly returns on the Standard & Poor's (S&P) 500 Index. As mentioned in Chapter 10, each firm has its own characteristic line. The slope of the characteristic line is beta, as estimated using the technique of Table 12.1. This technique is called regression. Though we have not shown it in the table, one can also determine the intercept (commonly called alpha) of the characteristic line by regression. Since a line can be created from its intercept and slope, the regression allows one to estimate the characteristic line of a firm. We use five years of monthly data for each plot. While this choice is arbitrary, it is in line with calculations performed in the real world. Practitioners know that the accuracy of the beta coefficient is suspect when too few observations are used. Conversely, since firms may change their industry over time, observations from the distant past are out-of-date. We stated in Chapter 10 that the average beta across all stocks in an index is 1. Of course, this need not be true for a subset of the index. For example, of the four securities in our figure, three have betas above 1 and one has a beta below 1. Since beta is a measure of the risk of a single security for someone holding a large, diversified portfolio, our results indicate that Coca-Cola has relatively low risk and Philip Morris has relatively high risk. A more detailed discussion of the determinants of beta is presented in Section 12.3. Stability of Beta We stated above that the beta of a firm is likely to change if the firm changes its industry. It is also interesting to ask the reverse question: Does the beta of a firm stay the same if its industry stays the same? Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 319 Chapter 12 Risk, Cost of Capital, and Capital Budgeting 313 I F I G U R E 12.3 Plots of Five Years of Monthly Returns on Four Individual Securities against Five Years of Monthly Returns on the Standard & Poor's (S&P) 500 Index Coca-Cola versus S&P 500--Beta 0.88 Coca-Cola 20.0% 15.0% 10.0% 5.0% 0.0% 5.0% 10.0% 4.0% 0.0% 4.0% 8.0% 12.0% 6.0% 10.0% 6.0% 2.0% 2.0% Procter & Gamble versus S&P 500--Beta 1.01 Procter & Gamble 20.0% Characteristic line 15.0% 10.0% 5.0% 0.0% 5.0% 10.0% 15.0% 4.0% 0.0% 4.0% 8.0% 12.0% 6.0% 2.0% 2.0% 6.0% 10.0% S&P 500 S&P 500 Characteristic line Philip Morris versus S&P 500--Beta 1.69 Philip Morris Characteristic 20.0% line 15.0% 10.0% 5.0% S&P 500 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 4.0% 0.0% 4.0% 8.0% 12.0% 6.0% 10.0% 6.0% 2.0% 2.0% Sears, Roebuck versus S&P 500--Beta 1.29 Sears, Roebuck 25.0% Characteristic 20.0% line 15.0% 10.0% 5.0% 0.0% S&P 500 5.0% 10.0% 15.0% 20.0% 4.0% 0.0% 4.0% 8.0% 12.0% 6.0% 10.0% 6.0% 2.0% 2.0% Take the case of General Electric, a large, diversified firm that for the most part has stayed in the same industries for many decades. Figure 12.4 plots the returns on General Electric and the returns on the S&P 500 for four successive five-year periods. As can be seen from the figure, GE's beta has increased slightly from the first to the third subperiod while falling in the last subperiod. However, this movement in beta is probably nothing more than random variation.3 Thus, for practical purposes, GE's beta has been approximately constant over the two decades covered in the figure. While GE is just one company, most analysts argue that betas are generally stable for firms remaining in the same industry. However, this is not to say that, as long as a firm stays in the same industry, its beta will never change. Changes in product line, changes in technology, or changes in the market may affect a firm's beta. For example, the deregulation of the airline industry has increased the betas of airline firms. Furthermore, as we will show in a later section, an increase in the leverage of a firm (i.e., the amount of debt in its capital structure) will increase the firm's beta. Using an Industry Beta Our approach of estimating the beta of a company from its own past data may seem commonsensical to you. However, it is frequently argued that one can better estimate a firm's beta by involving the whole industry. Consider Table 12.2, which shows the betas of some 3 More precisely, one can say that the beta coefficients over the four periods are not statistically different from each other. 320 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 314 Part III Risk I F I G U R E 12.4 Plots of Monthly Returns on General Electric and on the Standard & Poor's 500 Index for Four Five-Year Periods 19781983 General Electric versus S&P 500--Beta 0.97 General Electric 19831988 General Electric versus S&P 500--Beta 1.12 General Electric 20% 15% 10% 5% 0% 5% 10% 15% 15% 20% 15% 10% 5% S&P 500 0% 5% 10% 15% S&P 500 10% 5% 0% 5% 10% 15% 15% 10% 5% 0% 5% 10% 15% 20% 15% 10% 5% 0% 5% 10% 15% 15% 19881993 General Electric versus S&P 500--Beta 1.15 General Electric 20% 15% 10% 5% S&P 500 0% 5% 10% 15% 10% 5% 0% 5% 10% 15% 15% 19931998 General Electric versus S&P 500--Beta 0.92 General Electric S&P 500 10% 5% 0% 5% 10% 15% I TA B L E 12.2 Betas for Firms in the Software Industry Company Adobe Systems Inc. BMC Software Inc. Cadence Design Cerner Corp. Citrix Systems Inc. Comshare Inc. Informix Corp. Int. Lottery & Totalizator Sys. Inc. Microsoft Corp. Oracle Corp. Symantec Corp. Veritas Software Equally weighted portfolio Beta 1.51 0.96 0.98 1.87 1.29 1.22 2.09 3.34 1.11 1.63 1.82 1.94 1.65 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 321 Chapter 12 Risk, Cost of Capital, and Capital Budgeting 315 of the more prominent firms in the software industry. The average beta across all of the firms in the table is 1.65. Imagine a financial executive at Oracle Corp. trying to estimate the firm's beta. Because beta-estimation is subject to large random variation in this volatile industry, the executive may be uncomfortable with the estimate of 1.63. However, the error in beta-estimation on a single stock is much higher than the error for a portfolio of securities. Thus, the executive of Oracle may use the industry beta of 1.65 as the estimate of its own firm's beta. (As it turns out, the choice is unimportant here, since the industry beta is so close to that of the firm.) By contrast, consider Cadence Design. Assuming a risk-free rate of 6 percent and a risk-premium of 9.5 percent, Cadence might estimate its cost of equity capital as: 6% 0.98 9.5% 15.31% However, if Cadence believed that the industry beta contained less estimation error, it could estimate its cost of equity capital as: 6% 1.65 9.5% 21.67% The difference is substantial here, perhaps presenting a difficult choice for a financial executive at Cadence. While there is no formula for selecting the right beta, there is a very simple guideline. If one believes that the operations of the firm are similar to the operations of the rest of the industry, one should use the industry beta simply to reduce estimation error.4 However, if an executive believes that the operations of the firm are fundamentally different from those in the rest of the industry, the firm's beta should be used. QUESTIONS CONCEPT ? What is the disadvantage of using too few observations when estimating beta? What is the disadvantage of using too many observations when estimating beta? What is the disadvantage of using the industry beta as the estimate of the beta of an individual firm? 12.3 DETERMINANTS OF BETA The regression analysis approach in the previous section doesn't tell us where beta comes from. The beta of a stock does not come out of thin air. Rather, it is determined by the characteristics of the firm. We consider three factors: the cyclical nature of revenues, operating leverage, and financial leverage. Cyclicality of Revenues The revenues of some firms are quite cyclical. That is, these firms do well in the expansion phase of the business cycle and do poorly in the contraction phase. Empirical evidence suggests high-tech firms, retailers, and automotive firms fluctuate with the business cycle. Firms in industries such as utilities, railroads, food, and airlines are less dependent upon the cycle. Because beta is the standardized covariability of a stock's return with the market's return, it is not surprising that highly cyclical stocks have high betas. For example, Sears's beta, as shown in Figure 12.3, is high because its sales are dependent on the market cycle. 4 As we will see later, an adjustment must be made when the debt level in the industry is different from that of the firm. However, we ignore this adjustment here, since firms in the software industry generally have little debt. 322 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 316 Part III Risk It is worthwhile to point out that cyclicality is not the same as variability. For example, a movie-making firm has highly variable revenues because hits and flops are not easily predicted. However, because the revenues of a studio are more dependent on the quality of its releases than upon the phase of the business cycle, motion-picture companies are not particularly cyclical. In other words, stocks with high standard deviations need not have high betas, a point we have stressed before. Operating Leverage We distinguished fixed costs from variable costs earlier in the text. At that time, we mentioned that fixed costs do not change as quantity changes. Conversely, variable costs increase as the quantity of output rises. This difference between variable and fixed costs allows us to define operating leverage. E XAMPLE Consider a firm that can choose either technology A or technology B when making a particular product. The relevant differences between the two technologies are displayed below: Technology A Fixed cost: $1,000/year Variable cost: $8/unit Price: $10/unit Contribution margin: $2 ($10 Technology B Fixed cost: $2,000/year Variable cost: $6/unit Price: $10/unit Contribution margin: $4 ($10 $8) $6) Technology A has lower fixed costs and higher variable costs than does technology B. Perhaps technology A involves less mechanization than does B. Or, the equipment in A may be leased whereas the equipment in B must be purchased. Alternatively, perhaps technology A involves few employees but many subcontractors, whereas B involves only highly skilled employees who must be retained in bad times. Because technology B has both lower variable costs and higher fixed costs, we say that it has higher operating leverage.5 Figure 12.5 graphs the costs under both technologies. The slope of each totalcost line represents variable costs under a single technology. The slope of A's line is steeper, indicating greater variable costs. Because the two technologies are used to produce the same products, a unit price of $10 applies for both cases. We mentioned in an earlier chapter that contribution margin is the difference between price and variable cost. It measures the incremental profit from one additional unit. Because the contribution margin in B is greater, its technology is riskier. An unexpected sale increases profit by $2 under A but increases profit by $4 under B. Similarly, an unexpected sale cancellation reduces profit by $2 under A but reduces profit by $4 under B. This is 5 The actual definition of operating leverage is Change in EBIT EBIT Sales Change in sales where EBIT is the earnings before interest and taxes. That is, operating leverage measures the percentage change in EBIT for a given percentage change in sales or revenues. It can be shown that operating leverage increases as fixed costs rise and as variable costs fall. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 323 Chapter 12 Risk, Cost of Capital, and Capital Budgeting 317 I F I G U R E 12.5 Illustration of Two Different Technologies Technology A $ Total costs $ Technology B Total costs Fixed costs Fixed costs Volume Volume Technology A has higher variable costs and lower fixed costs than does technology B. Technology B has higher operating leverage. I F I G U R E 12.6 Illustration of the Effect of a Change in Volume on the Change in Earnings before Interest and Taxes (EBIT) Technology A EBIT Technology B EBIT Volume Volume Technology B has lower variable costs than A, implying a higher contribution margin. The profits of the firm are more responsive to changes in volume under technology B than under A. illustrated in Figure 12.6. This figure shows the change in earnings before interest and taxes for a given change in volume. The slope of the right-hand graph is greater, indicating that technology B is riskier. The cyclicality of a firm's revenues is a determinant of the firm's beta. Operating leverage magnifies the effect of cyclicality on beta. As mentioned earlier, business risk is generally defined as the risk of the firm without financial leverage. Business risk depends both on the responsiveness of the firm's revenues to the business cycle and on the firm's operating leverage. Although the preceding discussion concerns firms, it applies to projects as well. If one cannot estimate a project's beta in another way, one can examine the project's revenues and operating leverage. Those projects whose revenues appear strongly cyclical and whose operating leverage appears high are likely to have high betas. Conversely, weak cyclicality and low operating leverage implies low betas. As mentioned earlier, this approach is unfortunately qualitative in nature. Because start-up projects have little data, quantitative estimates of beta generally are not feasible. 324 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 318 Part III Risk Financial Leverage and Beta As suggested by their names, operating leverage and financial leverage are analogous concepts. Operating leverage refers to the firm's fixed costs of production. Financial leverage is the extent to which a firm relies on debt and a levered firm is a firm with some debt in its capital structure. Because a levered firm must make interest payments regardless of the firm's sales, financial leverage refers to the firm's fixed costs of finance. Consider our discussion in Section 10.8 concerning the beta of Jelco, Inc. In that example, we estimated beta from the returns on Jelco stock. Similarly, we estimated General Tool's beta in Section 12.1 from stock returns. Furthermore, the betas in Figures 12.3 and 12.4 from real-world firms were estimated from returns on stock. Thus, in each case, we estimated the firm's stock or equity beta. The beta of the assets of a levered firm is different from the beta of its equity. As the name suggests, the asset beta is the beta of the assets of the firm. The asset beta could also be thought of as the beta of the common stock had the firm been financed only with equity. Imagine an individual who owns all the firm's debt and all its equity. In other words, this individual owns the entire firm. What is the beta of her portfolio of the firm's debt and equity? As with any portfolio, the beta of this portfolio is a weighted average of the betas of the individual items in the portfolio. Hence, we have Asset Debt Debt Equity Debt Equity Debt Equity Equity (12.2) where Equity is the beta of the stock of the levered firm. Notice that the beta of debt is multiplied by debt/(debt equity), the percentage of debt in the capital structure. Similarly, the beta of equity is multiplied by the percentage of equity in the capital structure. Because the portfolio contains both the debt of the firm and the equity of the firm, the beta of the portfolio is the asset beta. As we said above, the asset beta can also be viewed as the beta of the common stock had the firm been all equity. The beta of debt is very low in practice. If we make the commonplace assumption that the beta of debt is zero, we have Asset Equity Debt Equity Equity (12.3) Asset Because equity/(debt equity) must be below 1 for a levered firm, it follows that Equity. Rearranging this equation, we have Equity Asset 1 Debt Equity The equity beta will always be greater than the asset beta with financial leverage.6 E XAMPLE Consider a tree-growing company, Rapid Cedars, Inc., which is currently all equity and has a beta of 0.8. The firm has decided to move to a capital structure of one part debt to two parts equity. Because the firm is staying in the same industry, 6 It can be shown that the relationship between a firm's asset beta and its equity beta with corporate taxes is Equity Asset 1 1 TC Debt Equity See Chapter 17 for more details. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 325 Chapter 12 Risk, Cost of Capital, and Capital Budgeting 319 its asset beta should remain at 0.8. However, assuming a zero beta for its debt, its equity beta would become Equity Asset 1 1 2 Debt Equity 1.2 0.8 1 If the firm had one part debt to one part equity in its capital structure, its equity beta would be 1.6 0.8 (1 1) However, as long as it stayed in the same industry, its asset beta would remain at 0.8. The effect of leverage, then, is to increase the equity beta. QUESTIONS CONCEPT ? What are determinants of equity betas? What is the difference between an asset beta and an equity beta? 12.4 EXTENSIONS OF THE BASIC MODEL The Firm versus the Project: Vive la Diffrence We now assume that the risk of a project differs from that of the firm, while going back to the all-equity assumption. We began the chapter by pointing out that each project should be paired with a financial asset of comparable risk. If a project's beta differs from that of the firm, the project should be discounted at the rate commensurate with its own beta. This is a very important point because firms frequently speak of a corporate discount rate. (Hurdle rate, cutoff rate, benchmark, and cost of capital are frequently used synonymously.) Unless all projects in the corporation are of the same risk, choosing the same discount rate for all projects is incorrect. E XAMPLE D. D. Ronnelley Co., a publishing firm, may accept a project in computer software. Noting that computer software companies have high betas, the publishing firm views the software venture as more risky than the rest of its business. It should discount the project at a rate commensurate with the risk of software companies. For example, it might use the average beta of a portfolio of publicly traded software firms. Instead, if all projects in D. D. Ronnelley Co. were discounted at the same rate, a bias would result. The firm would accept too many high-risk projects (software ventures) and reject too many low-risk projects (books and magazines). This point is illustrated in Figure 12.7. The D. D. Ronnelley example assumes that the proposed project has identical risk to that of the software industry, allowing the industry beta to be used. However, the beta of a new project may be greater than the beta of existing firms in the same industry because the very newness of the project likely increases its responsiveness to economy wide movements. For 326 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 320 Part III Risk I F I G U R E 12.7 Relationship between the Firm's Cost of Capital and the Security Market Line Discount rate for project Software venture (SML) Firm's overall cost of capital RF Beta of project Use of a firm's cost of capital in calculations may lead to incorrect capital-budgeting decisions. Projects with high risk, such as the software venture for D. D. Ronnelley Co., should be discounted at a high rate. By using the firm's cost of equity, the firm is likely to accept too many high-risk projects. Projects with low risk should be discounted at a low rate. By using the firm's cost of capital, the firm is likely to reject too many low-risk projects. example, a start-up computer venture may fail in a recession while IBM, Compaq, or Hewlett-Packard will still be around. Conversely, in an economywide expansion, the venture may grow much faster than the old-line computer firms. Fortunately, a slight adjustment is all that is needed here. The new venture should be assigned a somewhat higher beta than that of the industry to reflect added risk. The adjustment is necessarily ad hoc, so no formula can be given. Our experience indicates that this approach is widespread in practice today. However, a problem does arise for the rare project constituting its own industry. For example, consider the firms providing consumer shopping by television. Today, one can obtain a reasonable estimate for the beta of this industry, since a few of the firms have publicly traded stock. However, when the ventures began in the 1980s, any beta estimate was suspect. At that time, no one knew whether shopping by TV belonged in the television industry, the retail industry, or in an entirely new industry. What beta should be used in the rare case when an industrywide beta is not appropriate? One approach, which considers the determinants of the project's beta, was treated earlier in this chapter. Unfortunately, that approach is only qualitative in nature. The Cost of Capital with Debt Section 12.1 showed how to choose the discount rate when a project is all-equity financed. In this section, we discuss an adjustment when the project is financed with both debt and equity. Suppose a firm uses both debt and equity to finance its investments. If the firm pays rB for its debt financing and rS for its equity, what is the overall or average cost of its capital? The cost of equity is rS, as discussed in earlier sections. The cost of debt is the firm's bor- Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 327 Chapter 12 Risk, Cost of Capital, and Capital Budgeting 321 rowing rate, rB. If a firm uses both debt and equity, the cost of capital is a weighted average of each. This works out to be S S B rS B S B rB The weights in the formula are, respectively, the proportion of total value represented by the equity S S B and the proportion of total value represented by debt B S B This is only natural. If the firm had issued no debt and was therefore an all-equity firm, its average cost of capital would equal its cost of equity, rS. At the other extreme, if the firm had issued so much debt that its equity was valueless, it would be an all-debt firm, and its average cost of capital would be its cost of debt, rB. Of course, interest is tax deductible at the corporate level, a point to be treated in more detail in Chapter 15. The after-tax cost of debt is Cost of debt (after corporate tax) where TC is the corporation's tax rate. Assembling these results, we get the average cost of capital (after tax) for the firm: Average cost of capital S S B rS B S B rB (1 TC) (12.4) rB (1 TC) Because the average cost of capital is a weighting of its cost of equity and its cost of debt, it is usually referred to as the weighted average cost of capital, rWACC, and from now on we will use this term. E XAMPLE Consider a firm whose debt has a market value of $40 million and whose stock has a market value of $60 million (3 million outstanding shares of stock, each selling for $20 per share). The firm pays a 15-percent rate of interest on its new debt and has a beta of 1.41. The corporate tax rate is 34 percent. (Assume that the SML holds, that the risk premium on the market is 9.5 percent, and that the current Treasury bill rate is 11 percent.) What is this firm's rWACC? To compute the rWACC using equation (12.4), we must know (1) the after-tax cost of debt, rB (1 TC), (2) the cost of equity, rS, and (3) the proportions of debt and equity used by the firm. These three values are computed below. 1. The pretax cost of debt is 15 percent, implying an after-tax cost of 9.9 percent [15% (1 0.34)]. 2. The cost of equity capital is computed by using the SML: rS RF [RM RF] 11% 1.41 9.5% 24.40% 328 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 322 Part III Risk 3. The proportions of debt and equity are computed from the market values of debt and equity. Because the market value of the firm is $100 million ($40 million $60 million), the proportions of debt and equity are 40 and 60 percent, respectively. (1 The cost of equity, rS, is 24.40 percent, and the after-tax cost of debt, rB TC), is 9.9 percent. B is $40 million and S is $60 million. Therefore, rWACC B B 40 100 S rB 9.9% (1 TC) 60 100 S B S rS 18.60% 24.40% This procedure is presented in chart form next: (1) Financing Components Debt Equity (2) Market Values $ 40,000,000 60,000,000 ___________ $100,000,000 (3) Weight 0.40 0.60 1.00 (4) Cost of Capital (after corporate tax) 15% (1 11% 1.41 0.34) 9.5% (5) Weighted Cost of Capital 3.96% 14.64 _____ 18.60% 9.9% 24.40% The weights we used in the previous example were market-value weights. Market-value weights are more appropriate than book-value weights because the market values of the securities are closer to the actual dollars that would be received from their sale. Actually it is usually useful to think in terms of "target" market weights. These are the market weights expected to prevail over the life of the firm or project. E XAMPLE Suppose that a firm has both a current and a target debt-equity ratio of 0.6, a cost of debt of 15.15 percent, and a cost of equity of 20 percent. The corporate tax rate is 34 percent. Our first step calls for transforming the debt-to-equity (B/S) ratio to a debt-tovalue ratio. A B/S ratio of 0.6 implies 6 parts debt for 10 parts equity. Since value is 6 equal to the sum of the debt plus the equity, the debt-to-value ratio is 0.375. 6 10 10 Similarly, the equity-to-value ratio is 0.625. The rWACC will then be 6 10 rWACC S B rS rB (1 TC) S B S B .625 20% .375 15.15% (.66) 16.25% Suppose the firm is considering taking on a warehouse renovation costing $50 million that is expected to yield cost savings of $12 million a year for six Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 329 Chapter 12 Risk, Cost of Capital, and Capital Budgeting 323 years. Using the NPV equation and discounting the six years of expected cash flows from the renovation at the rWACC, we have7 NPV $50 1 $12 rWACC A.6625 1 3.66) ... 1 $12 rWACC 6 $50 $12 $50 (12 $6.07 Should the firm take on the warehouse renovation? The project has a negative NPV using the firm's rWACC. This means that the financial markets offer superior projects in the same risk class (namely, the firm's risk class). The answer is clear: The firm should reject the project. 12.5 ESTIMATING INTERNATIONAL PAPER'S COST OF CAPITAL In the previous section, we calculated the cost of capital in two examples. Now, we will do the same thing for a real-world company. Table 12.3 lists nine large and well-known firms in the paper and pulp mills industry. We will calculate the cost of capital for one of them, International Paper (IP). From the previous section, we know that there are two steps in the calculation of the cost of capital. First, we estimate the cost of equity and cost of debt. Second, we determine the weighted average cost of capital by weighting these two costs appropriately. I TA B L E 12.3 Betas for Firms in the Pulp and Paper Mills Industry Company Abitibi-Price Inc. American Israeli Paper Mills, Ltd. Boise Cascade Corp. Glatfelter, P. H., Co. International Paper Co. Kimberly-Clark Corp. Mead Corp. Union Camp Corp. Westvaco Corp. Equally weighted portfolio Beta 0.74 0.41 0.97 0.57 0.83 0.90 1.14 0.85 0.97 0.82 7 This discussion of WACC has been implicitly based on perpetual cash flows. However, an important paper by J. Miles and R. Ezzel, "The Weighted Average Cost of Capital, Perfect Capital Markets and Project Life: A Clarification," Journal of Financial and Quantitative Analysis (September 1980), shows that the WACC is appropriate even when cash flows are not perpetual. 330 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 324 Part III Risk Cost of Equity and Debt We will tackle the cost of equity first. We need a beta estimate to determine International Paper's cost of equity and Table 12.3 shows the betas of the nine firms in the industry. The table tells us that IP's beta is 0.83 and the industry's average beta is 0.82. Which number should we use? We argued earlier in the chapter that there is less measurement error with the industry beta. Therefore, we will work with 0.82, though IP's beta is so close to the average of the industry that either number would have been fine. As discussed in Chapter 9, 9.5 percent is our best estimate of the market's risk premium. If the risk-free rate is 6 percent, our best estimate of International Paper's cost of equity capital is: [RM RF] RF 6% 0.82 9.5% 13.79% The yield on the company's debt is about 8 percent, which we will use as the (pretax) cost of debt capital, rB. Determining rWACC Now that we have estimates of both rS, the cost of equity, and rB, the cost of debt, we are ready to determine the weighted average cost of capital. However, we still need the percentages of debt and equity in IP's capital structure and the tax rate. We find that the ratio of debt-to-value is 32 percent and the ratio of equity-to-value is 68 percent. The tax rate is 37 percent.8 These inputs allow us to calculate the weighted average cost of capital: rWACC S rS S B 0.68 13.79% 10.99% B rB 1 Tc S B 0.32 8% (1 .37) Thus, 10.99 percent is International Paper's cost of capital. It should be used to discount any project where one believes that the project's risk is equal to the risk of the firm as a whole, and the project has the same leverage as the firm as a whole. 12.6 REDUCING THE COST OF CAPITAL Chapters 912 develop the idea that both the expected return on a stock and the cost of capital of the firm are positively related to risk. Recently, a number of academics have argued that expected return and cost of capital are negatively related to liquidity as well.9 In addition, these scholars make the interesting point that, although it is quite difficult to lower the risk of a firm, it is much easier to increase the liquidity of the firm's stock. Therefore, they suggest that a firm can actually lower its cost of capital through liquidity enhancement. We develop this idea next. 8 9 These numbers were taken from Value Line Investment Survey. The tax rate includes both federal and local taxes. For example, see Y. Amihud and H. Mendelson, "The Liquidity Route to a Lower Cost of Capital," Journal of Applied Corporate Finance (Winter 2000) and M. J. Brennan and C. Tamarowski, "Investor Relations, Liquidity, and Stock Prices," Journal of Applied Corporate Finance (Winter 2000). Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 331 Chapter 12 Risk, Cost of Capital, and Capital Budgeting 325 What Is Liquidity? Anyone who owns his or her own home probably thinks of liquidity in terms of the time it takes to buy or sell the home. For example, condominiums in large metropolitan areas are generally quite liquid. Particularly in good times, a condominium may sell within days of being placed on the market. By contrast, single-family homes in suburban areas may take weeks or months to sell. Special properties such as multimillion dollar mansions may take longer still. The concept of liquidity is similar, but not identical, in stocks. Here, we speak of the cost of buying and selling instead. That is, those stocks that are expensive to trade are considered less liquid than those that trade cheaply. What do we mean by the cost to trade? We generally think of three costs here: brokerage fees, the bid-ask spread, and market-impact costs. Brokerage fees are the easiest to understand, because you must pay a broker to execute a trade. More difficult is the bid-ask spread. Consider the New York Stock Exchange (NYSE), where all trades on a particular stock must go through the stock's specialist, who is physically on the floor of the exchange. If you want to trade 100 shares of XYZ Co., your broker must get the quote from XYZ's specialist. Suppose the specialist provides a quote of 1001001/8. This means that you can buy from the specialist at $1001/8 per share and sell to the specialist at $100 per share. Note that the specialist makes money here, since she buys from you at $100 and sells to you (or to someone else) at $1001/8. The gain to the specialist is a cost to you, because you are losing 1/8 dollar per share over a round-trip transaction (over a purchase and a subsequent sale). Finally, we have market-impact costs. Suppose that a trader wants to sell 10,000 shares instead of just 100 shares. Here, the specialist has to take on extra risk when buying. First, she has to pay out $100,000 (10,000 $100), cash which may not be easily available to her. Second, the trader may be selling this large amount because she has special information that the stock will fall imminently. The specialist bears the risk of losing a lot of money on that trade. Consequently, to compensate for these risks, the specialist may not buy at $100/share but at a lower price. Similarly, the specialist may be willing to sell a large block of stock only at a price above $1001/8. The price drop associated with a large sale and the price rise associated with a large purchase are the market-impact costs. Liquidity, Expected Returns, and the Cost of Capital The cost of trading a nonliquid stock reduces the total return that an investor receives. That is, if one buys a stock for $100 and sells it later for $105, the gain before trading costs is $5. If one must pay a dollar of commission when buying and another dollar when selling, the gain after trading costs is only $3. Both the bid-ask spread and market-impact costs would reduce this gain still further. As we will see later, trading costs vary across securities. In the last four chapters, we have stressed that investors demand a high expected return as compensation when investing in high risk, e.g., high-beta, stocks. Because the expected return to the investor is the cost of capital to the firm, the cost of capital is positively related to beta. Now, we are saying the same thing for trading costs. Investors demand a high expected return when investing in stocks with high trading costs, i.e., low liquidity. And, this high expected return implies a high cost of capital to the firm. This idea is illustrated in Figure 12.8. Liquidity and Adverse Selection Liquidity varies across stocks, because the factors determining liquidity vary across stocks. Although there are a number of factors, we focus on just one, adverse selection. As mentioned before, the specialist will lose money on a trade if the trader has information that the 332 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 326 Part III Risk I F I G U R E 12.8 Liquidity and the Cost of Capital Cost of capital Liquidity An increase in liquidity, i.e., a reduction in trading costs, lowers a firm's cost of capital. specialist does not have. If you have special information that the stock is worth $110 in the preceding example, you will want to buy shares at $1001/8. The specialist is obligated to sell to you at this price, which is considerably below the true price of $110. Conversely, if you know that the stock is worth only $90 and you currently own 100 shares, you will be happy to sell these shares to the specialist at $100. Again, the specialist loses, since he pays $100/share for a stock worth only $90. In either of these cases, we say that the specialist has been picked off, or has been subject to adverse selection. The specialist must protect himself in some way here. Of course, he can not forbid informed individuals from trading, because he does not know ahead of time who these investors are. His next best alternative is to widen the bid-ask spread, thereby increasing the costs of trading to all traders--both informed and uninformed. That is, if the spread is widened to, say 997/81001/4, each trader pays a round-trip cost of $3/8 per share. The key here is that the spread should be positively related to the ratio of informed to uninformed traders. That is, informed traders will pick off the specialist and uninformed traders will not. Thus, informed traders in a stock raise the required return on equity, thereby increasing the cost of capital. What the Corporation Can Do The corporation has an incentive to lower trading costs because--given the preceding discussion--a lower cost of capital should result. Amihud and Mendelson identify two general strategies for corporations. First, they argue that firms should try to bring in more uninformed investors. Stock splits may be a useful tool here. Imagine that a company has 1 million shares outstanding with a price per share of $100. Because investors generally buy in round lots of 100 shares, these investors would need $10,000 ($100 100 shares) for a purchase. A number of small investors might be "priced out" of the stock, although large investors would not be. Thus, the ratio of large investors to small investors would be high. Because large investors are generally more likely than small investors to be informed, the ratio of informed investors to uninformed investors will likely be high. A 2:1 stock split would give two shares of stock for every one that the investor previously held. Because every investor would still hold the same proportional interest in the firm, each investor would be no better off than before. Thus, it is likely that the Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 333 Chapter 12 Risk, Cost of Capital, and Capital Budgeting 327 price per share will fall to $50 from $100. Here, an individual with 100 shares worth $10,000 ($100 100 shares) finds herself still worth $10,000 ( $50 200 shares) after the split. However, a round lot becomes more affordable, thereby bringing more small and uninformed investors into the firm. Consequently, the adverse selection costs are reduced, allowing the specialist to lower the bid-ask spread. In turn, it is hoped that the expected return on the stock, and the cost of equity capital, will fall as well. If this happens, the stock might actually trade at a price slightly above $50. This idea is a new one and empirical evidence is not yet in. Amihud and Mendelson themselves point out the possibility that this strategy might backfire, because brokerage commissions are often higher on lower-priced securities. We must await confirmation of this intriguing suggestion. Companies can also attract small investors by facilitating stock purchases through the Internet. Direct stock purchase plans and dividend reinvestment programs handled online allow small investors the opportunity to buy securities cheaply. In addition, Amihud and Mendelson state, "And when these plans are administered over the Internet using web sites like Stockpower.com, moneypaper.com and Netstockdirect.com, the process is fast and efficient for both the company and the investor."10 Secondly, companies can disclose more information. This narrows the gap between uninformed and informed investors, thereby lowering the cost of capital. Suggestions include providing greater financial data on corporate segments and more management forecasts. An interesting study by Coller and Yohn11 concludes that the bid-ask spread is reduced after the release of these forecasts. This section would not be complete without a discussion of security analysts. These analysts are employed by brokerage houses to follow the companies in individual industries. For example, an analyst for a particular brokerage house might follow all the firms in, say, the auto industry. This analyst distributes reports and other information to the clients of the brokerage house. Virtually all brokerage houses have analysts following the major industries. Again, through dissemination of the information, these analysts narrow the gap between the informed and the uninformed investors, thereby tending to reduce the bid-ask spread. Although all major industries are covered, the smaller firms in these industries are often ignored, implying a higher bid-ask spread and a higher cost of capital for these firms. Analysts frequently state that they avoid following companies that release little information, pointing out that these companies are more trouble than they are worth. Thus, it behooves companies that are not followed to release as much information as possible to security analysts in the hopes of attracting their interest. Friendliness toward security analysts would be very helpful as well. The argument here is not to get the analysts to make buy recommendations. Rather, it is simply to interest the analysts in following the company, thereby reducing the information asymmetry between informed and uninformed investors. QUESTIONS CONCEPT ? 10 11 What is liquidity? What is the relation between liquidity and expected returns? What is adverse selection? What can a corporation do to lower its cost of capital? Ibid., p. 19. M. Coller and T. Yohn, "Management Forecasts and Information Asymmetry: An Examination of Bid-Ask Spreads," Journal of Accounting Research (Fall 1997). 334 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 328 Part III Risk 12.7 SUMMARY AND CONCLUSIONS Earlier chapters on capital budgeting assumed that projects generate riskless cash flows. The appropriate discount rate in that case is the riskless interest rate. Of course, most cash flows from real-world capital-budgeting projects are risky. This chapter discusses the discount rate when cash flows are risky. 1. A firm with excess cash can either pay a dividend or make a capital expenditure. Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capital-budgeting project should be at least as great as the expected return on a financial asset of comparable risk. 2. The expected return on any asset is dependent upon its beta. Thus, we showed how to estimate the beta of a stock. The appropriate procedure employs regression analysis on historical returns. 3. We considered the case of a project whose beta risk was equal to that of the firm. If the firm is unlevered, the discount rate on the project is equal to RF (RM RF) 4. 5. 6. 7. 8. where RM is the expected return on the market portfolio and RF is the risk-free rate. In words, the discount rate on the project is equal to the CAPM's estimate of the expected return on the security. If the project's beta differs from that of the firm, the discount rate should be based on the project's beta. The project's beta can generally be estimated by determining the average beta of the project's industry. The beta of a company is a function of a number of factors. Perhaps the three most important are Cyclicality of revenues Operating leverage Financial leverage Sometimes one cannot use the average beta of the project's industry as an estimate of the beta of the project. For example, a new project may not fall neatly into any existing industry. In this case, one can estimate the project's beta by considering the project's cyclicality of revenues and its operating leverage. This approach is qualitative in nature. If a firm uses debt, the discount rate to use is the rWACC. In order to calculate rWACC, the cost of equity and the cost of debt applicable to a project must be estimated. If the project is similar to the firm, the cost of equity can be estimated using the SML for the firm's equity. Conceptually, a dividend-growth model could be used as well, though it is likely to be far less accurate in practice. A number of academics have argued that expected returns are negatively related to liquidity, where high liquidity is equivalent to low costs of trading. These scholars have further suggested that firms can reduce their cost of capital by lowering these trading costs. Practical suggestions include stock splits, more complete dissemination of information, and more effective assistance to security analysts. KEY TERMS Asset beta 318 Cost of equity 307 Equity beta 318 Operating leverage 316 Weighted average cost of capital (rWACC) 321 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 335 Chapter 12 Risk, Cost of Capital, and Capital Budgeting 329 SUGGESTED READINGS The following article contains a superb discussion of some of the subtleties of using WACC for project evaluation: Miles, J., and R. Ezzel. "The Weighted Average Cost of Capital, Perfect Capital Markets and Project Life: A Clarification." Journal of Financial and Quantitative Analysis 15 (September 1980). The following article provides a comprehensive survey of capital budgeting in practice, including the determination of the cost of capital: Graham, J. R., and C. R. Harvey, "The Theory and Practice of Corporate Finance: Evidence from the Field," unpublished paper, Duke University (April, 2000). Estimates of the cost of capital under both the capital asset pricing model and the arbitrage pricing theory are contained in: Fama, E. F., and K. R. French, "Industry Cost of Capital," Journal of Financial Economics (February 1997). One of the best "how-to" guides is: Copeland, T.; T. Koller; and J. Murrin. Valuation: Measuring and Managing the Value of Companies. 2nd ed. New York: John Wiley & Sons, 1995. QUESTIONS AND PROBLEMS Beta and the Cost of Equity 12.1 Furniture Depot, Inc., is an all-equity firm with a beta of 0.95. The market-risk premium is 9 percent and the risk-free rate is 5 percent. The company must decide whether or not to undertake the project that requires an immediate investment of $1.2 million and will generate annual after-tax cash flows of $340,000 at year-end for five years. If the project has the same risk as the firm as a whole, should Furniture Depot undertake the project? 12.2 The returns for the past five years on Douglas stock and the New York Stock Exchange Composite Index (NYSE) are listed below: Douglas 0.05 0.05 0.08 0.15 0.10 NYSE 0.12 0.01 0.06 0.10 0.05 a. What are the average returns on Douglas stock and on the market? b. Compute the beta of Douglas stock. 12.3 Mitsubishi Inc. is a levered firm with a debt-to-equity ratio of 0.25. The beta of common stock is 1.15, while the beta of debt is 0.3. The market-risk premium is 10 percent and the risk-free rate is 6 percent. The corporate tax rate is 35 percent. The SML holds for the company. a. If a new project of the company has the same risk as the common stock of the firm, what is the cost of equity on the project? b. If a new project of the company has the same risk as the overall firm, what is the weighted average cost of capital on the project? 12.4 The correlation between the returns on Ceramics Craftsman, Inc., and the returns on the S&P 500 is 0.675. The variance of the returns on Ceramics Craftsman, Inc., is 0.004225, 336 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 330 Part III Risk and the variance of the returns on the S&P 500 is 0.001467. What is the beta of Ceramics Craftsman stock? 12.5 The returns from the past 13 quarters on Mercantile Bank Corporation and the market are listed below. Mercantile 0.009 0.051 0.001 0.045 0.085 0.000 0.080 0.020 0.125 0.110 0.100 0.040 Market 0.023 0.058 0.020 0.050 0.071 0.012 0.075 0.050 0.120 0.049 0.030 0.028 a. What is the beta of Mercantile Bank Corporation stock? b. Is Mercantile's beta higher or lower than the beta of the average stock? 12.6 The following table lists possible rates of return on two risky assets, M and J. The table also lists their joint probabilities, that is, the probabilities that they will occur simultaneously. RM 0.16 0.16 0.16 0.18 0.18 0.18 0.20 0.20 0.20 0.20 RJ 0.16 0.18 0.22 0.18 0.20 0.22 0.18 0.20 0.22 0.24 Prob(RM, RJ) 0.10 0.06 0.04 0.12 0.36 0.12 0.02 0.04 0.04 0.10 a. List the possible values for RM and the probabilities that correspond to those values. b. Compute the following items for RM. i. Expected value ii. Variance iii. Standard deviation c. List the possible values for RJ and the probabilities that correspond to those values. d. Compute the following items for RJ. i. Expected value ii. Variance iii. Standard deviation e. Calculate the covariance and correlation coefficient of RM and RJ. f. Assume M is the market portfolio. Calculate the beta coefficient for security J. 12.7 If you use the stock beta and the security market line to compute the discount rate for a project, what assumptions are you implicitly making? Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 337 Chapter 12 Risk, Cost of Capital, and Capital Budgeting 331 12.8 Pacific Cosmetics is evaluating a project to produce a perfume line. Pacific currently produces no body-scent products. Pacific Cosmetics is an all-equity firm. a. Should Pacific Cosmetics use its stock beta to evaluate the project? b. How should Pacific Cosmetics compute the beta to evaluate the project? 12.9 The following table lists possible rates of return on Compton Technology's stock and debt, and on the market portfolio. The corporate tax rate is 35 percent. The corresponding probabilities are also listed. Return on Equity (%) 3% 8 20 15 Return on Debt (%) 8% 8 10 10 Return on the Market (%) 5% 10 15 20 State 1 2 3 4 Probability 0.1 0.3 0.4 0.2 a. What is the beta of Compton Technology debt? b. What is the beta of Compton Technology stock? c. If the debt-to-equity ratio of Compton Technology is 0.5, what is the asset beta of Compton Technology? 12.10 Is the discount rate for the projects of a levered firm higher or lower than the cost of equity computed using the security market line? Why? (Consider only projects that have similar risk to that of the firm.) 12.11 What factors determine the beta of a stock? Define and describe each. Weighted Average Cost of Capital 12.12 The equity beta for Adobe Online Company is 1.29. Adobe Online has a debt-to-equity ratio of 1.0. The expected return on the market is 13 percent. The risk-free rate is 7 percent. The cost of debt capital is 7 percent. The corporate tax rate is 35 percent. a. What is Adobe Online's cost of equity? b. What is Adobe Online's weighted average cost of capital? 12.13 Calculate the weighted average cost of capital for the Luxury Porcelain Company. The book value of Luxury's outstanding debt is $60 million. Currently, the debt is trading at 120 percent of book value and is priced to yield 12 percent. The 5 million outstanding shares of Luxury stock are selling for $20 per share. The required return on Luxury stock is 18 percent. The tax rate is 25 percent. 12.14 First Data Co. has 20 million shares of common stock outstanding that are currently being sold for $25 per share. The firm's debt is publicly traded at 95 percent of its face value of $180 million. The cost of debt is 10 percent and the cost of equity is 20 percent. What is the weighted average cost of capital for the firm? Assume the corporate tax rate is 40 percent. 12.15 Calgary Industries, Inc., is considering a new project that costs $25 million. The project will generate after-tax (year-end) cash flows of $7 million for five years. The firm has a debt-to-equity ratio of 0.75. The cost of equity is 15 percent and the cost of debt is 9 percent. The corporate tax rate is 35 percent. It appears that the project has the same risk as that of the overall firm. Should Calgary take on the project? 12.16 Suppose Garageband.com has a 28 percent cost of equity capital and a 10 percent beforetax cost of debt capital. The firm's debt-to-equity ratio is 1.0. Garageband is interested in investing in a telecomm project that will cost $1,000,000 and will provide $600,000 pretax annual earnings for 5 years. Given the project is an extension of its core business, the project risk is similar to the overall risk of the firm. What is the net present value of this project if Garageband's tax rate is 35%? 338 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 332 Part III Risk MINICASE: ALLIEDPRODUCTS AlliedProducts, Inc., has recently won approval from the Federal Aviation Administration (FAA) for its Enhanced Ground Proximity Warning System (GPWS). This system is designed to give airplane pilots additional warning of approaching ground danger and thus help prevent crashes. AlliedProducts has spent $10 million in research and development the past four years developing GPWS. The GPWS will be put on the market beginning this year and AlliedProducts expects it to stay on the market for a total of five years. As a financial analyst specializing in the aerospace industry for USC Pension & Investment, Inc., you are asked by your managing partner, Mr. Adam Smith, to evaluate the potential of this new GPWS project. Initially, AlliedProducts will need to acquire $42 million in production equipment to make the GPWS. The equipment is expected to have a seven-year useful life. This equipment can be sold for $12 million at the end of five years. AlliedProducts intends to sell two different versions of the GPWS: 1. New GPWS--intended for installation in new aircraft. The selling price is $70,000 per system and the variable cost of production is $50,000 per system. (Assume cash flows occur at year-end.) 2. Upgrade GPWS--intended for installation on existing aircraft with an older version ground proximity radar in place. The selling price of the Upgrade system is $35,000 per system and the variable cost to produce it is $22,000 per system. AlliedProducts intends to raise prices at the same rate as inflation. Variable costs will also increase with inflation. In addition, the GPWS project will also incur $3 million in marketing and general administration costs the first year (expected to increase at the same rate as inflation). AlliedProducts' corporate tax rate is 40 percent. Assume that the equity beta listed in Value Line Investment Survey (the latest edition) is the best estimate of AlliedProducts' beta. A five-year U.S. Treasury Bond has a rate of 6.20 percent and the S&P 500 recent years' historical average excess return (i.e., the market return less the Treasury bond rate) is 8.3 percent. Annual inflation is expected to remain constant at 3 percent. Further, suppose AlliedProducts' cost of debt is 6.2 percent and (although somewhat unrealistic) its debt-toequity ratio is 50 percent and will remain at 50 percent for at least five years. Commercial Aircraft Market The state of the economy has a major impact on the airplane manufacturing industry. Airline industry analysts have the following production expectations, depending on the annual state of the economy for the next five years: I TA B L E 12.4 State of Economy Strong growth Moderate growth Mild recession Severe recession Probability of State .15 .45 .30 .10 New Aircraft (year 1) 350 250 150 50 Annual Growth .15 .10 .06 .03 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 339 Chapter 12 Risk, Cost of Capital, and Capital Budgeting 333 While probabilities of each state of the economy will not change during the next five years, airplane production for each category will increase, as shown in Table 12.4, each year after year 1. The FAA requires that these planes have new ground proximity warning systems, of which there are a number of manufacturers besides AlliedProducts. AlliedProducts estimates that there are approximately 12,500 existing aircraft that comprise the market for its GPWS Upgrade package. Due to FAA regulations, all existing aircraft will be required to get an upgraded ground proximity warning system within the next five years, again, not necessarily from AlliedProducts. AlliedProducts believes the upgrades of the existing aircraft fleet will be spread evenly over the five years (the time value of money would suggest manufacturers defer purchasing upgrades until the fifth year; however, consumer demand for the additional safety will induce earlier upgrades). AlliedProducts uses the MACRS depreciation schedule (seven-year property class). The immediate initial working capital requirement is $2 million and thereafter the net working capital requirements will be 5 percent of sales. AlliedProducts has a number of competitors both in the new GPWS and upgrade GPWS markets but expects to dominate the market with a 45 percent share. Assignment: First, use the CAPM to determine the appropriate discount rate for this product. Then, use computer spreadsheets such as Excel or Lotus 1-2-3 to analyze the project. Will the GPWS project improve the wealth of AlliedProducts' shareholders, such as your firm--USC Pension & Investment, Inc.? Economic Value Added and the Measurement of Financial Performance Chapter 12 shows how to calculate the appropriate discount rate for capital budgeting and other valuation problems. We now consider the measurement of financial performance. We introduce the concept of economic value added, which uses the same discount rate developed for capital budgeting. We begin with a simple example. Many years ago, Henry Bodenheimer started Bodie's Blimps, one of the largest highspeed blimp manufacturers. Because growth was so rapid, Henry put most of his effort into capital budgeting. His approach to capital budgeting paralleled that of Chapter 12. He forecasted cash flows for various projects and discounted them at the cost of capital appropriate to the beta of the blimp business. However, these projects have grown rapidly, in some cases becoming whole divisions. He now needs to evaluate the performance of these divisions in order to reward his division managers. How does he perform the appropriate analysis? Henry is aware that capital budgeting and performance measurement are essentially mirror images of each other. Capital budgeting is forward-looking by nature because one must estimate future cash flows to value a project. By contrast, performance measurement is backward-looking. As Henry stated to a group of his executives, "Capital budgeting is like looking through the windshield while driving a car. You need to know what lies further down the road to calculate a net present value. Performance measurement is like looking into the rearview mirror. You find out where you have been." 340 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 334 Part III Risk Henry first measured the performance of his various divisions by return on assets (ROA), an approach, which we treated in the appendix to Chapter 2. For example, if a division had earnings after tax of $1,000 and had assets of $10,000, the ROA would be12 $1,000 $10,000 10%. He calculated the ROA ratio for each of his divisions, paying a bonus to each of his division managers based on the size of that division's ROA. However, while ROA was generally effective in motivating his managers, there were a number of situations where it appeared that ROA was counterproductive. For example, Henry always believed that Sharon Smith, head of the supersonic division, was his best manager. The ROA of Smith's division was generally in the high double digits, but the best estimate of the weighted average cost of capital for the division was only 20%. Furthermore, the division had been growing rapidly. However, as soon as Henry paid bonuses based on ROA, the division stopped growing. At that time, Smith's division had after tax earnings of $2,000,000 on an asset base of $2,000,000, for an ROA of 100% ($2 million/$2 million). Henry found out why the growth stopped when he suggested a project to Smith that would earn $1,000,000 per year on an investment of $2,000,000. This was clearly an attractive project with an ROA of 50% ($1 million/$2 million). He thought that Smith would jump at the chance to place his project into her division, because the ROA of the project was much higher than the cost of capital of 20%. However, Smith did everything she could to kill the project. And, as Henry later figured out, Smith was rational to do so. Smith must have realized that if the project were accepted, the division's ROA would become $2,000,000 $2,000,000 $1,000,000 $2,000,000 75% Thus, the ROA of Smith's division would fall from 100% to 75% if the project were accepted, with Smith's bonus falling in tandem. Henry was later exposed to the economic-value-added (EVA) approach,13 which seems to obviate this particular problem. The formula for EVA is [ROA Weighted average cost of capital] Total capital Without the new project, the EVA of Smith's division would be: [100% 20%] $2,000,000 $1,600,000 This is an annual number. That is, the division would bring in $1.6 million above and beyond the cost of capital to the firm each year. With the new project included, the EVA jumps to [75% 20%] $4,000,000 $2,200,000 If Sharon Smith knew that her bonus was based on EVA, she would now have an incentive to accept, not reject, the project. Although ROA appears in the EVA formula, EVA differs substantially from ROA. The big difference is that ROA is a percentage number and 12 13 Earnings after tax is EBIT (1 Tc) where EBIT is earnings before interest and taxes and Tc is the tax rate. Stern Stewart & Company have a copyright on the terms economic value added and EVA. Details on the Stern Steward & Company EVA can be found in J. M. Stern, G. B. Stewart, and D. A. Chew, "The EVA Financial Management System," Journal of Applied Corporate Finance (Summer 1999). Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 341 Chapter 12 Risk, Cost of Capital, and Capital Budgeting 335 EVA is a dollar value. In the preceding example, EVA increased when the new project was added even though the ROA actually decreased. In this situation, EVA correctly incorporates the fact that a high return on a large division may be better than a very high return on a smaller division. The situation here is quite similar to the scale problem in capital budgeting that we discussed in Section 6.6. Further understanding of EVA can be achieved by rewriting the EVA formula. Because ROA total capital is equal to earnings after tax, we can write the EVA formula as: Earnings after tax Weighted average cost of capital Total capital Thus, EVA can simply be viewed as earnings after capital costs. Although accountants subtract many costs (including depreciation) to get the earnings number shown in financial reports, they do not subtract out capital costs. One can see the logic of accountants, because the cost of capital is very subjective. By contrast, costs such as COGS (cost of goods sold), SGA (sales, general and administration), and even depreciation can be measured more objectively. However, even if the cost of capital is difficult to estimate, it is hard to justify ignoring it completely. After all, this textbook argues that the cost of capital is a necessary input to capital budgeting. Shouldn't it also be a necessary input to performance measurement? This example argues that EVA can increase investment for those firms that are currently underinvesting. However, there are many firms in the reverse situation; the managers are so focused on increasing earnings that they take on projects for which the profits do not justify the capital outlays. These managers either are unaware of capital costs or, knowing these costs, choose to ignore them. Because the cost of capital is right in the middle of the EVA formula, managers will not easily ignore these costs when evaluated on an EVA system. One other advantage of EVA is that it is so stark; the number is either positive or it is negative. Plenty of divisions have negative EVAs for a number of years. Because these divisions are destroying more value than they are creating, a strong point can be made for liquidating these divisions. Although managers are generally emotionally opposed to this type of action, EVA analysis makes liquidation harder to ignore. The preceding discussion puts EVA in a very positive light. However, one can certainly find much to criticize with EVA as well. We now focus on two well-known problems with EVA. First, the preceding example uses EVA for performance measurement, where we believe it properly belongs. To us, EVA seems a clear improvement over ROA and other financial ratios. However, EVA has little to offer for capital budgeting because EVA focuses only on current earnings. By contrast, net-present-value analysis uses projections of all future cash flows, where the cash flows will generally differ from year to year. Thus, as far as capital budgeting is concerned, NPV analysis has a richness that EVA does not have. Although supporters may argue that EVA correctly incorporates the weighted average cost of capital, one must remember that the discount rate in NPV analysis is the same weighted average cost of capital. That is, both approaches take the cost of equity capital based on beta and combine it with the cost of debt to get an estimate of this weighted average. A second problem with EVA is that it may increase the shortsightedness of managers. Under EVA, a manager will be well rewarded today if earnings are high today. Future losses may not harm the manager, because there is a good chance that she will be promoted or have left the firm by then. Thus, the manager has an incentive to run a division with more regard for short-term than long-term value. By raising prices or cutting quality, the manager may increase current profits (and, therefore, current EVA). However, to the extent that customer satisfaction is reduced, future profits (and therefore future EVA) are likely to fall. However, one should not be too harsh with EVA here, because the same problem occurs with ROA. A manager who raises prices or cuts quality will increase current ROA at the expense of future ROA. The problem, then, is not EVA per se but with the use of accounting numbers in 342 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition III. Risk 12. Risk, Cost of Capital, and Capital Budgeting The McGraw-Hill Companies, 2002 336 Part III Risk general. Because stockholders want the discounted present value of all cash flows to be maximized, managers with bonuses based on some function of current profits or current cash flows are likely to behave in a shortsighted way. E XAMPLE Assume the following figures for the International Trade Corporation EBIT Tc rWACC Total capital contributed $2.5 billion .4 11% Total debt Equity $10 billion $10 billion $20 billion Now we can calculate International Trade's EVA: EVA EBIT (1 Tc) rWACC Total capital ($2.5 billion .6) (.11 $20 billion) $1.5 billion $2.2 billion $700 million Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy Introduction The McGraw-Hill Companies, 2002 343 PART IV Capital Structure and Dividend Policy 13 14 15 16 17 18 Corporate-Financing Decisions and Efficient Capital Markets Long-Term Financing: An Introduction 371 Capital Structure: Basic Concepts 390 Capital Structure: Limits to the Use of Debt 422 Valuation and Capital Budgeting for the Levered Firm 468 Dividend Policy: Why Does It Matter? 495 339 P II discussed the capital budgeting decisions of the firm. We argued that the objective of the firm should be to create value from its capital budgeting decisions. To do this the firm must find investments with a positive net present value. In Part IV we concentrate on financing decisions. As with capital budgeting decisions, the firm seeks to create value with its financing decisions. To do this the firm must find positive NPV financing arrangements. However, financial markets do not provide as many opportunities for positive NPV transactions as do nonfinancial markets. We show that the sources of NPV in financing are taxes, bankruptcy costs, and agency costs. Chapter 13 introduces the concept of efficient markets, where current market prices reflect available information. We describe several forms of efficiency: the weak form, the semistrong form, and the strong form. The chapter offers a number of important lessons for the corporate financial manager in understanding the logic behind efficient financial markets. In Chapter 14 we describe the basic types of long-term financing: common stock, preferred stock, and bonds. We then briefly analyze the major trends and patterns of long-term financing. We consider the firm's overall capital-structure decision in Chapters 15 and 16. In general, a firm can choose any capital structure it desires: common stocks, bonds, preferred stocks, and so on. How should a firm choose its capital structure? Changing the capital structure of the firm changes the way the firm pays out its cash flows. Firms that borrow pay lower taxes than firms that do not. Because of corporate taxes, the value of a firm that borrows may be higher than the value of one that does not. However, with costly bankruptcy, a firm that borrows may have lower value. The combined effects of taxes and bankruptcy costs can produce an optimal capital structure. ART 344 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy Introduction The McGraw-Hill Companies, 2002 338 Part IV Capital Structure and Dividend Policy Chapter 17 discusses capital budgeting for firms with some debt in their capital structures. It extends some of the material of Chapter 12. This chapter presents three alternative valuation methods: the weighted-average-cost-of-capital approach, the flows-to-equity approach, and the adjusted-present-value approach. We discuss dividend policy in Chapter 18. It seems surprising that much empirical evidence and logic suggest that dividend policy does not matter. There are some good reasons for firms to pay low levels of dividends: lower taxes and costs of issuing new equity. However, there are also some good reasons to pay high levels of dividends: to reduce agency costs and to satisfy low-tax, high-income clienteles. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 345 CHAPTER Corporate-Financing Decisions and Efficient Capital Markets EXECUTIVE SUMMARY 13 T he section on value concentrated on the firm's capital budgeting decisions--the left-hand side of the balance sheet of the firm. This chapter begins our analysis of corporate-financing decisions--the right-hand side of the balance sheet. We take the firm's capital budgeting decision as fixed in this section of the text. The point of this chapter is to introduce the concept of efficient capital markets and its implications for corporate finance. Efficient capital markets are those in which current market prices reflect available information. This means that current market prices reflect the underlying present value of securities, and there is no way to make unusual or excess profits by using the available information. This concept has profound implications for financial managers, because market efficiency eliminates many value-enhancing strategies of firms. In particular, we show that in an efficient market 1. Financial managers cannot time issues of bonds and stocks. 2. The issuance of additional stock should not depress the stock's market price. 3. Stock and bond prices should not be affected by a firm's choice of accounting method. Ultimately, whether or not capital markets are efficient is an empirical question. We will describe several of the important studies that have been carried out to examine efficient markets. 13.1 CAN FINANCING DECISIONS CREATE VALUE? Earlier parts of the book show how to evaluate projects according to the net present value criterion. The real world is a competitive one where projects with positive net present value are not always easy to come by. However, through hard work or through good fortune, a firm can identify winning projects. For example, to create value from capital budgeting decisions, the firm is likely to 1. 2. 3. 4. Locate an unsatisfied demand for a particular product or service. Create a barrier to make it more difficult for other firms to compete. Produce products or services at lower cost than the competition. Be the first to develop a new product. The next five chapters concern financing decisions. Typical financing decisions include how much debt and equity to sell, what types of debt and equity to sell, and when to sell debt and equity. Just as the net present value criterion was used to evaluate capital budgeting projects, we now want to use the same criterion to evaluate financing decisions. Though the procedure for evaluating financing decisions is identical to the procedure for evaluating projects, the results are different. It turns out that the typical firm has many more capital-expenditure opportunities with positive net present values than financing 346 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 340 Part IV Capital Structure and Dividend Policy opportunities with positive net present values. In fact, we later show that some plausible financial models imply that no valuable financial opportunities exist at all. Though this dearth of profitable financing opportunities will be examined in detail later, a few remarks are in order now. We maintain that there are basically three ways to create valuable financing opportunities: 1. Fool Investors. Assume that a firm can raise capital either by issuing stock or by issuing a more complex security, say, a combination of stock and warrants. Suppose that, in truth, 100 shares of stock are worth the same as 50 units of our complex security. If investors have a misguided, overly optimistic view of the complex security, perhaps the 50 units can be sold for more than the 100 shares of stock can be. Clearly this complex security provides a valuable financing opportunity because the firm is getting more than fair value for it. Financial managers try to package securities to receive the greatest value. A cynic might view this as attempting to fool investors. However, empirical evidence suggests that investors cannot easily be fooled. Thus, one must be skeptical that value can easily be created here. The theory of efficient capital markets expresses this idea. In its extreme form, it says that all securities are appropriately priced at all times, implying that the market as a whole is very shrewd indeed. Thus, corporate managers should not attempt to create value by fooling investors. Instead, managers must create value in other ways. 2. Reduce Costs or Increase Subsidies. We show later in the book that certain forms of financing have greater tax advantages than other forms. Clearly, a firm packaging securities to minimize taxes can increase firm value. In addition, any financing technique involves other costs. For example, investment bankers, lawyers, and accountants must be paid. A firm packaging securities to minimize these costs can also increase its value. Finally, any financing vehicle that provides subsidies is valuable. This last possibility is illustrated below. E XAMPLE Suppose Vermont Electronics Company is thinking about relocating its plant to Mexico where labor costs are lower. In the hope that it can stay in Vermont, the company has submitted an application to the State of Vermont to issue $2 million in five-year, tax-exempt industrial bonds. The coupon rate on industrial revenue bonds in Vermont is currently 5 percent. This is an attractive rate because the normal cost of debt capital for Vermont Electronics Company is 10 percent. What is the NPV of this potential financing transaction? If the application is accepted and the industrial revenue bonds are issued by the Vermont Electronics Company, the NPV (ignoring corporate taxes) is NPV $2,000,000 $2,000,000 $379,079 $100,000 1.1 $1,620,921 $100,000 1.1 2 $100,000 1.1 3 $100,000 1.1 4 $2,100,000 1.1 5 This transaction has a positive NPV. The Vermont Electronics Company obtains subsidized financing where the amount of the subsidy is $379,079. 3. Create a New Security. There has been a surge in financial innovation in recent years. For example, in a speech on financial innovation, Nobel laureate Merton Miller asked the rhetorical question, "Can any twenty-year period in recorded history have witnessed even a tenth as much new development? Where corporations once issued only straight debt and straight common stock, they now issue zero-coupon bonds, adjustable-rate notes, floating- Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 347 Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets 341 rate notes, putable bonds, credit-enhanced debt securities, receivable-backed securities, adjusted-rate preferred stock, convertible adjustable preferred stock, auction-rate preferred stock, single-point adjustable-rate stock, convertible exchangeable preferred stock, adjustable-rate convertible debt, zero-coupon convertible debt, debt with mandatory common-stock-purchase contracts--to name just a few!"1 And, financial innovation has occurred even more rapidly in the years following Miller's speech. Though the advantage of each instrument is different, one general theme is that these new securities cannot easily be duplicated by combinations of existing securities. Thus, a previously unsatisfied clientele may pay extra for a specialized security catering to its needs. For example, putable bonds let the purchaser sell the bond at a fixed price back to the firm. This innovation creates a price floor, allowing the investor to reduce his or her downside risk. Perhaps risk-averse investors or investors with little knowledge of the bond market would find this feature particularly attractive. Corporations gain from developing unique securities by issuing these securities at high prices. However, we believe that the value captured by the innovator is small in the long run because the innovator usually cannot patent or copyright his idea. Soon many firms are issuing securities of the same kind, forcing prices down as a result.2 This brief introduction sets the stage for the next five chapters of the book. The rest of this chapter examines the efficient-capital-markets hypothesis. We show that if capital markets are efficient, corporate managers cannot create value by fooling investors. This is quite important, because managers must create value in other, perhaps more difficult, ways. The following four chapters concern the costs and subsidies of various forms of financing. A discussion of new financing instruments is postponed until later chapters of the text. QUESTION CONCEPT ? List three ways financing decisions can create value. 13.2 A DESCRIPTION OF EFFICIENT CAPITAL MARKETS An efficient capital market is one in which stock prices fully reflect available information. To illustrate how an efficient market works, suppose the F-stop Camera Corporation (FCC) is attempting to develop a camera that will double the speed of the auto-focusing system now available. FCC believes this research has positive NPV. 1 M. Miller, "Financial Innovation: The Last Twenty Years and the Next," Journal of Financial and Quantitative Analysis (December 1986). However, Peter Tufano, "Securities Innovations: A Historical and Functional Perspective," Journal of Applied Corporate Finance (Winter 1995), shows that many securities commonly believed to have been invented in the 1970s and 1980s can be traced as far back as the 1830s. Most financial innovations originally come from investment banks and are then sold to firms. Peter Tufano, "Financial Innovation and First-Mover Advantages," Journal of Financial Economics 25 (1990), pp. 21340, looked at 58 financial innovations (including original-issue deep-discount bonds) to examine how well investment banks are compensated for developing new financial products. He finds investment banks underwrite significantly more public offerings of the products they create. His study does not directly address the question of whether investment banks or corporations obtain most of the benefits of new financial products. However, it is clear that investment banks benefit substantially from creating new products. Raj Varma and Donald Chambers, "The Role of Financial Innovation in Raising Capital," Journal of Financial Economics 26 (1990), pp. 28998, look at how firms have benefited from issuing original-issue deepdiscount bonds after TEFRA. They report no gains. 2 348 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 342 Part IV Capital Structure and Dividend Policy Now consider a share of stock in FCC. What determines the willingness of investors to hold shares of FCC at a particular price? One important factor is the probability that FCC will be the company to develop the new auto-focusing system first. In an efficient market we would expect the price of the shares of FCC to increase if this probability increases. Suppose a well-known engineer is hired by FCC to help develop the new autofocusing system. In an efficient market, what will happen to FCC's share price when this is announced? If the well-known scientist is paid a salary that fully reflects his or her contribution to the firm, the price of the stock will not necessarily change. Suppose, instead, that hiring the scientist is a positive NPV transaction. In this case, the price of shares in FCC will increase because the firm can pay the scientist a salary below his or her true value to the company. When will the increase in the price of FCC's shares take place? Assume that the hiring announcement is made in a press release on Wednesday morning. In an efficient market, the price of shares in FCC will immediately adjust to this new information. Investors should not be able to buy the stock on Wednesday afternoon and make a profit on Thursday. This would imply that it took the stock market a day to realize the implication of the FCC press release. The efficient-market hypothesis predicts that the price of shares of FCC stock on Wednesday afternoon will already reflect the information contained in the Wednesday morning press release. The efficient-market hypothesis (EMH) has implications for investors and for firms. Because information is reflected in prices immediately, investors should only expect to obtain a normal rate of return. Awareness of information when it is released does an investor no good. The price adjusts before the investor has time to trade on it. Firms should expect to receive the fair value for securities that they sell. Fair means that the price they receive for the securities they issue is the present value. Thus, valuable financing opportunities that arise from fooling investors are unavailable in efficient capital markets. Some people spend their entire careers trying to pick stocks that will outperform the average. For any given stock, they can learn not only what has happened in the past to the stock price and dividends, but also what the company earnings have been, how much debt it owes, what taxes it pays, what businesses it is in, what market share it has for its products, how well it is doing in each of its businesses, what new investments it has planned, how sensitive it is to the economy, and so on. If you want to learn about a given company and its stock, an enormous amount of information is available to you. The preceding list only scratches the surface. Not only is there a lot to know about any given company, there is also a powerful motive for doing so, the profit motive. If you know more about a company than other investors in the marketplace, you can profit from that knowledge by investing in the company's stock if you have good news or selling it if you have bad news. There are other ways to use your information. If you could convince investors that you have reliable information about the fortunes of the companies, you might start a newsletter and sell investors that information. You could even charge a varying rate depending on how fresh the information is. You could sell the monthly standard report for a subscription price of $100 per year, but for an extra $300 a subscriber could get special interim once-a-week reports. For $5,000 per year you could offer to telephone the customer as soon as you had a new idea or a new piece of information. This may sound a bit farfetched, but it is what many sellers of market information actually do. The logical consequence of all of this information being available, studied, sold, and used in an effort to make profits from stock market trading is that the market becomes efficient. A market is efficient with respect to information if there is no way to make unusual Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 349 Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets 343 or excess profits by using that information. When a market is efficient with respect to information, we say that prices incorporate the information. Without knowing anything special about a stock, an investor in an efficient market expects to earn an equilibrium required return from an investment, and a company expects to pay an equilibrium cost of capital.3 E XAMPLE Suppose IBM announces it has invented a microprocessor that will make its computer 30 times faster than existing computers. The price of a share of IBM should increase immediately to a new equilibrium level. Figure 13.1 presents several possible adjustments in stock prices. The solid line represents the path taken by the stock in an efficient market. In this case the price adjusts immediately to the new information so that further changes take place in the price of the stock. The dotted line depicts a delayed reaction. Here it takes the market 30 days to fully absorb the information. Finally, the broken line illustrates an overreaction and subsequent correction back to the true price. The broken line and the dotted line show the paths that the stock price might take in an inefficient market. If the price of the stock takes several days to adjust, trading profits would be available to investors who bought at the date of the announcement and sold once the price settled back to the equilibrium.4 QUESTION CONCEPT ? Can you define an efficient market? 13.3 THE DIFFERENT TYPES OF EFFICIENCY In our previous discussion, we assumed that the market responds immediately to all available information. In actuality, certain information may affect stock prices more quickly than other information. To handle differential response rates, researchers separate information into different types. The most common classification system speaks of three types: information on past prices, publicly available information, and all information. The effect of these three information sets on prices is examined next. The Weak Form Imagine a trading strategy that recommends buying a stock when it has gone up three days in a row and recommends selling a stock when it has gone down three days in a row. This strategy uses information based only on past prices. It does not use any other information, 3 4 In Chapter 10 we analyzed how the required return on a risky asset is determined. Now you should understand the following short story. A student was walking down the hall with his finance professor when they both saw a $20 bill on the ground. As the student bent down to pick it up, the professor shook his head slowly and, with a look of disappointment on his face, said patiently to the student, "Don't bother. If it was really there, someone else would have already picked it up." The moral of the story reflects the logic of the efficient-market hypothesis: If you think you have found a pattern in stock prices or a simple device for picking winners, you probably have not. If there were such a simple way to make money, someone else would have found it before. Furthermore, if people tried to exploit the information, their efforts would become self-defeating and the pattern would disappear. 350 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 344 Part IV Capital Structure and Dividend Policy I F I G U R E 13.1 Reaction of Stock Price to New Information in Efficient and Inefficient Markets Stock price Overreaction and reversion Delayed response Efficient-market response to new information 30 20 10 0 + 10 + 20 + 30 Days before ( ) and after ( + ) announcement Public announcement day Efficient-market response: The price instantaneously adjusts to and fully reflects new information; there is no tendency for subsequent increases and decreases. Delayed response: The price adjusts slowly to the new information; 30 days elapse before the price completely reflects the new information. Overreaction: The price overadjusts to the new information; there is a bubble in the price sequence. such as earnings, forecasts, merger announcements, or money-supply figures. A capital market is said to be weakly efficient or to satisfy weak-form efficiency if it fully incorporates the information in past stock prices. Thus, the above strategy would not be able to generate profits if weak-form efficiency holds. Often weak-form efficiency is represented mathematically as Pt Pt 1 Expected return Random errort (13.1) Equation (13.1) states that the price today is equal to the sum of the last observed price plus the expected return on the stock plus a random component occurring over the interval. The last observed price could have occurred yesterday, last week, or last month, depending on one's sampling interval. The expected return is a function of a security's risk and would be based on the models of risk and return in previous chapters. The random component is due to new information on the stock. It could be either positive or negative and has an expectation of zero. The random component in any one period is unrelated to the random component in any past period. Hence, this component is not predictable from past prices. If stock prices follow equation (13.1), they are said to follow a random walk.5 5 For purposes of this text, the random walk can be considered synonymous with weak-form efficiency. Technically, the random walk is a slightly more restrictive hypothesis because it assumes that stock returns are identically distributed through time. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 351 Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets 345 I F I G U R E 13.2 Investor Behavior Tends to Eliminate Cyclical Patterns Stock price Sell Sell Sell Buy Buy Buy Time If a stock's price has followed a cyclical pattern, the pattern will be quickly eliminated in an efficient market. A random pattern will emerge as investors buy at the trough and sell at the peak of a cycle. Weak-form efficiency is about the weakest type of efficiency that we would expect a financial market to display because historical price information is the easiest kind of information about a stock to acquire. If it were possible to make extraordinary profits simply by finding the patterns in the stock price movements, everyone would do it, and any profits would disappear in the scramble. The effect of competition can be seen in Figure 13.2. Suppose the price of a stock displayed a cyclical pattern, as indicated by the wavy curve. Shrewd investors would buy at the low points, forcing those prices up. Conversely, they would sell at the high points, forcing prices down. Via competition, the cyclical regularities would be eliminated, leaving only random fluctuations. By denying that future market movements can be predicted from past movements, we are denying the profitability of a host of techniques falling under the heading of technical analysis. The term technical analysis refers to attempts to predict the future from the patterns of past price movements. Furthermore, we are denigrating the work of all of their followers, who are called technical analysts. To provide some flavor to technical analysis, consider two commonly used approaches. First, many technical analysts believe that stock prices are likely to follow a head-andshoulders pattern. This is presented in the left-hand side of Figure 13.3. An analyst at point A, anticipating a head-and-shoulders pattern, might very well buy the stock and hopefully hold it for a short-term gain. An analyst at point B, anticipating the completion of the pattern, would sell the stock. Second, other analysts believe that stocks making three tops are likely to fall in price. This triple-tops pattern is presented in the right-hand side of Figure 13.3. An analyst who, at point C, discovers that the pattern has occurred, might sell the stock. At this point, one might wonder why anyone would restrict his or her information to the set of past prices. Surprisingly, many technical analysts do just that, saying that all relevant information on a security's future price movement is contained in the security's past movement. Other information is considered distracting. John Magee,6 one of the most renowned of technical analysts, took this approach to an extreme. He reportedly worked on his stock market charts in an office with boarded-up windows. To him, weather was superfluous information that could only impede his task of stock selection. 6 His book (John Magee and Robert Davis Edwards, Technical Analysis of Stock Trends, 7th ed., New York: AMACON, 1997) is considered by many to be the bible of technical analysis. 352 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 346 Part IV Capital Structure and Dividend Policy I F I G U R E 13.3 Two Widely Believed Technical Patterns Head and shoulders Stock price B Stock price C Triple tops A Time Time Technical analysts frequently claim that the price of a stock is likely to follow a head-andshoulders pattern or a triple-tops pattern. According to a technical analyst, if a head-andshoulders pattern can be identified early enough, an investor might like to buy at point A and sell at point B. A triple-tops pattern occurs when three highs are followed by a precipitous drop. If a triple-tops pattern can be identified early enough, an investor might like to sell at point C. The Semistrong and Strong Forms If weak-form efficiency is controversial, even more contentious are the two stronger types of efficiency, semistrong-form efficiency and strong-form efficiency. A market is semistrong-form efficient if prices reflect (incorporate) all publicly available information, including information such as published accounting statements for the firm as well as historical price information. A market is strong-form efficient if prices reflect all information, public or private. The information set of past prices is a subset of the information set of publicly available information, which in turn is a subset of all information. This is shown in Figure 13.4. Thus, strong-form efficiency implies semistrong-form efficiency, and semistrong-form efficiency implies weak-form efficiency. The distinction between semistrong-form efficiency and weak-form efficiency is that semistrong-form efficiency requires not only that the market be efficient with respect to historical price information, but that all of the information available to the public be reflected in price. To illustrate the different forms of efficiency, imagine an investor who always sold a particular stock after its price had risen. A market that was only weak-form efficient and not semistrong-form efficient would still prevent such a strategy from generating positive profits. According to weak-form efficiency, a recent price rise does not imply that the stock is overvalued. Now consider a firm reporting increased earnings. An individual might consider investing in the stock after hearing of the news release giving this information. However, if the market is semistrong efficient, the price should rise immediately upon the news release. Thus, the investor would end up paying the higher price, eliminating all chance for profit. At the furthest end of the spectrum is strong-form efficiency, which incorporates the other two types of efficiency. This form says that anything that is pertinent to the value of the stock and that is known to at least one investor is, in fact, fully incorporated into the stock value. A strict believer in strong-form efficiency would deny that an insider who knew whether a company mining operation had struck gold could profit from that information. Such a devotee of the strong-form efficient-market hypothesis might argue that as soon as the insider tried to trade on his or her information, the market would recognize what was Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 353 Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets 347 I F I G U R E 13.4 Relationship among Three Different Information Sets All information relevant to a stock Information set of publicly available information Information set of past prices The information set of past prices is a subset of the information set of publicly available information, which in turn is a subset of all information. If today's price reflects only information on past prices, the market is weak-form efficient. If today's price reflects all publicly available information, the market is semistrong-form efficient. If today's price reflects all information, both public and private, the market is strong-form efficient. Semistrong-form efficiency implies weak-form efficiency and strong-form efficiency implies semistrong-form efficiency. happening, and the price would shoot up before he or she could buy any of the stock. Alternatively, sometimes believers in strong-form efficiency take the view that there are no such things as secrets and that as soon as the gold is discovered, the secret gets out. Are the hypotheses of semistrong-form efficiency and strong-form efficiency good descriptions of how markets work? Expert opinion is divided here. The evidence in support of semistrong-form efficiency is, of course, more compelling than that in support of strongform efficiency, and for many purposes it seems reasonable to assume that the market is semistrong-form efficient. The extreme of strong-form efficiency seems more difficult to accept. Before we look at the evidence on market efficiency, we will summarize our thinking on the versions of the efficient-market hypothesis in terms of basic economic arguments. One reason to expect that markets are weak-form efficient is that it is so cheap and easy to find patterns in stock prices. Anyone who can program a computer and knows a little bit of statistics can search for such patterns. It stands to reason that if there were such patterns, people would find and exploit them, in the process causing them to disappear. Semistrong-form efficiency, though, uses much more sophisticated information and reasoning than weak-form efficiency. An investor must be skilled at economics and statistics, and steeped in the idiosyncrasies of individual industries and companies. Furthermore, to acquire and use such skills requires talent, ability, and time. In the jargon of the economist, such an effort is costly and the ability to be successful at it is probably in scarce supply. As for strong-form efficiency, this is just farther down the road than semistrong-form efficiency. It is difficult to believe that the market is so efficient that someone with true and valuable inside information cannot prosper by using it. It is also difficult to find direct evidence concerning strong-form efficiency. What we have tends to be unfavorable to this hypothesis of market efficiency. 354 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 348 Part IV Capital Structure and Dividend Policy Some Common Misconceptions about the Efficient-Market Hypothesis No idea in finance has attracted as much attention as that of efficient markets, and not all of the attention has been flattering. To a certain extent this is because much of the criticism has been based on a misunderstanding of what the hypothesis does and does not say. We illustrate three misconceptions below. The Efficacy of Dart Throwing When the notion of market efficiency was first publicized and debated in the popular financial press, it was often characterized by the following quote: ". . . throwing darts at the financial page will produce a portfolio that can be expected to do as well as any managed by professional security analysts."7, 8 This is almost, but not quite, true. All the efficient-market hypothesis really says is that, on average, the manager will not be able to achieve an abnormal or excess return. The excess return is defined with respect to some benchmark expected return that comes from the security market line of Chapter 10 (SML). The investor must still decide how risky a portfolio he or she wants and what expected return it will normally have. A random dart thrower might wind up with all of the darts sticking into one or two high-risk stocks that deal in genetic engineering. Would you really want all of your stock investments in two such stocks? (Beware, though--a professional portfolio manager could do the same.) The failure to understand this has often led to a confusion about market efficiency. For example, sometimes it is wrongly argued that market efficiency means that it does not matter what you do because the efficiency of the market will protect the unwary. However, someone once remarked, "The efficient market protects the sheep from the wolves, but nothing can protect the sheep from themselves." What efficiency does say is that the price that a firm will obtain when it sells a share of its stock is a fair price in the sense that it reflects the value of that stock given the information that is available about it. Shareholders need not worry that they are paying too much for a stock with a low dividend or some other characteristic, because the market has already incorporated it into the price. However, investors still have to worry about such things as their level of risk exposure and their degree of diversification. Price Fluctuations Much of the public is skeptical of efficiency because stock prices fluctuate from day to day. However, daily price movement is in no way inconsistent with efficiency; a stock in an efficient market adjusts to new information by changing price. A great deal of new information comes into the stock market each day. In fact, the absence of daily price movements in a changing world might suggest an inefficiency. Stockholder Disinterest Many laypersons are skeptical that the market price can be efficient if only a fraction of the outstanding shares changes hands on any given day. However, the number of traders in a stock on a given day is generally far less than the number of people following the stock. This is true because an individual will trade only when his appraisal of the value of the stock differs enough from the market price to justify incurring brokerage commissions and other transaction costs. Furthermore, even if the number of traders following a stock is small relative to the number of outstanding shareholders, the 7 8 B. G. Malkiel, A Random Walk Down Wall Street, 7th ed. (New York: Norton, 1999). Older articles often referred to the benchmark of "dart-throwing monkeys." As government involvement in the securities industry grew, the benchmark was oftentimes restated as "dart-throwing congressmen." Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 355 Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets 349 stock can be expected to be efficiently priced as long as a number of interested traders use the publicly available information. That is, the stock price can reflect the available information even if many stockholders never follow the stock and are not considering trading in the near future, and even if some stockholders trade with little or no information. Thus, the empirical findings suggesting that the stock market is predominantly efficient need not be surprising. QUESTIONS CONCEPT ? Can you describe the three forms of the efficient-market hypothesis? What kinds of things could make markets inefficient? Does market efficiency mean you can throw darts at The Wall Street Journal listing of New York Stock Exchange stocks to pick a portfolio? What does it mean to say the price you pay for a stock is fair? 13.4 THE EVIDENCE The record on the efficient-market hypothesis is extensive, and in large measure it is reassuring to advocates of the efficiency of markets. The studies done by academicians fall into broad categories. First, there is evidence as to whether changes of stock prices are random. Second are event studies. Third is the record of professionally managed investment firms. The Weak Form The random-walk hypothesis, as expressed in equation (13.1), implies that a stock's price movement in the past is unrelated to its price movement in the future. The work of Chapter 10 allows us to test this implication. In that chapter, we discussed the concept of correlation between the returns on two different stocks. For example, the correlation between the return on General Motors and the return on Ford is likely to be high because both stocks are in the same industry. Conversely, the correlation between the return on General Motors and the return on the stock of, say, a European fast-food chain is likely to be low. Financial economists frequently speak of serial correlation, which involves only one security. This is the correlation between the current return on a security and the return on the same security over a later period. A positive coefficient of serial correlation for a particular stock indicates a tendency toward continuation. That is, a higher-than-average return today is likely to be followed by higher-than-average returns in the future. Similarly, a lower-thanaverage return today is likely to be followed by lower-than-average returns in the future. A negative coefficient of serial correlation for a particular stock indicates a tendency toward reversal. A higher-than-average return today is likely to be followed by lower-thanaverage returns in the future. Similarly, a lower-than-average return today is likely to be followed by higher-than-average returns in the future. Both significantly positive and significantly negative serial-correlation coefficients are indications of market inefficiencies; in either case, returns today can be used to predict future returns. Serial correlation coefficients for stock returns near zero would be consistent with the random-walk hypothesis. Thus, a current stock return that is higher than average is as likely to be followed by lower-than-average returns as by higher-than-average returns. Similarly, a current stock return that is lower than average is as likely to be followed by higher-thanaverage returns as by lower-than-average returns. Table 13.1 shows the serial correlation for daily stock-price changes for 8 large U.S. companies. These coefficients indicate whether or not there are relationships between yesterday's return and today's return. As can be seen, the correlation coefficients are predominantly 356 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 350 Part IV Capital Structure and Dividend Policy I TA B L E 13.1 Serial Correlation Coefficients for 8 Large U.S. Companies Company Boeing Co. Bristol-Myers Squibb Co. Coca-Cola Co. IBM Corporation Philip Morris Companies Inc. Procter & Gamble Co. Sears, Roebuck & Co. Texaco Inc. Serial Correlation Coefficient 0.038 0.064 0.041 0.004 0.075 0.030 0.046 0.005 Boeing's coefficient of 0.038 is slightly positive, implying that a positive return today makes a positive return tomorrow slightly more likely. IBM's coefficient is negative, implying that a negative return today makes a positive return tomorrow slightly more likely. However, the coefficients are so small relative to estimation error and transaction costs that the results are generally considered to be consistent with efficient capital markets. positive, implying that a higher-than-average return today makes a higher-than-average return tomorrow slightly more likely. Conversely, IBM's coefficient is slightly negative, implying that a lower-than-average return today makes a higher-than-average return tomorrow slightly more likely. However, because correlation coefficients can, in principle, vary between 1 and 1, the reported coefficients are quite small. In fact, the coefficients are so small relative to both estimation errors and to transactions costs that the results are generally considered to be consistent with weak-form efficiency. The weak form of the efficient-market hypothesis has been tested in many other ways as well. Our view of the literature is that the evidence, taken as a whole, is strongly consistent with weak-form efficiency. This finding raises an interesting thought: If price changes are truly random, why do so many believe that prices follow patterns? The work of both psychologists and statisticians suggests that most people simply do not know what randomness looks like. For example, consider Figure 13.5. The top graph was generated by a computer using random numbers and equation (13.1). Because of this it must follow a random walk. Yet, we have found that people examining the chart generally see patterns. Different people will see different patterns and will forecast different future price movements. However, in our experience, viewers are all quite confident of the patterns they see. Next, consider the bottom graph, which tracks actual movements in Sears, Roebuck's stock price. This graph may look quite nonrandom to some, suggesting weak-form inefficiency. However, it also bears a close visual resemblance to the simulated series above, and statistical tests indicate that it indeed behaves like a purely random series. Thus, in our opinion, people claiming to see patterns in stock-price data are probably seeing optical illusions. The Semistrong Form The semistrong form of the efficient-market hypothesis implies that prices should reflect all publicly available information. We present two types of tests of this form. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 357 Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets 351 I F I G U R E 13.5 Simulated and Actual Stock-Price Movements A. Simulated price movements 103.0 102.0 Relative price 101.0 100.0 99.0 98.0 97.0 B. Actual price movements for the stock of Sears, Roebuck 103.0 102.0 101.0 100.0 99.0 98.0 97.0 96.0 95.0 94.0 Time Relative price Time Event Studies The abnormal return (AR) on a given stock for a particular day can be calculated by subtracting the market's return on the same day (Rm)--as measured by a broadbased index such as the S&P composite index--from the actual return (R) on the stock for that day.9 We write this algebraically as: AR R Rm A way to think of the tests of the semistrong form is to examine the following system of relationships: Information released at time t 1 ARt Information released at time t ARt Information released at time t 1 ARt 1 1 The arrows indicate that the return in any time period is related only to the information released during that period. According to the efficient-market hypothesis, a stock's abnormal return at time t, ARt, should reflect the release of information at the same time, t. Any information released before then, though, should have no effect on abnormal returns in this period, because all of its influence should have been felt before. In other words, an efficient market would already have incorporated previous information into prices. Because a stock's return today cannot depend on what the market does not yet know, the information that will be known only in the future cannot influence the stock's return either. Hence the arrows point in the direction that is shown, with information in any one time period affecting only that period's abnormal return. Event studies are statistical studies that examine whether the arrows are as shown or whether the release of information influences returns on other days. 9 The abnormal return can also be measured by using the market model. In this case the abnormal return is AR R Rm 358 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 352 Part IV Capital Structure and Dividend Policy I F I G U R E 13.6 Cumulative Abnormal Returns for Companies Announcing Dividend Omissions 0.146 0 0.108 0.072 0.032 0.244 0.483 Cumulative abnormal returns (%) 1 2 3 3.619 4 4.563 5 5.012 5.183 5.411 7 6 5 4 4.898 4.747 4.685 4.490 3 2 1 0 1 2 3 Days relative to announcement of dividend omission 4 5 6 7 Cumulative abnormal returns (CARs) fall on both the day before the announcement and the day of the announcement of dividend omissions. CARs have very little movement after the announcement date. This pattern is consistent with market efficiency. From Exhibit 2 in S. H. Szewczyk, George P. Tsetsekos, and Zaher Zantout, "Do Dividend Omissions Signal Future Earnings or Past Earnings?" Journal of Investing (Spring 1997). As an example, consider the study by Szewczyk, Tsetsekos, and Zantout10 on dividend omissions. Figure 13.6 shows the plot of cumulative abnormal returns (CARs) for a sample of companies announcing dividend omissions. Since dividend omissions are generally considered to be bad events, we would expect that abnormal returns would be negative around the time of the announcements. They are, as evidenced by a drop in the CAR on both the day before the announcement (day 1) and the day of the announcement (day 0).11 However, note that there is virtually no movement in the CARs in the days following the announcement. This implies that the bad news is fully incorporated into the stock price by the announcement day, a result consistent with market efficiency. 10 Samuel H. Szewczyk, George P. Tsetsekos, and Zaher Z. Zantout, "Do Dividend Omissions Signal Future Earnings or Past Earnings?" Journal of Investing (Spring 1997). 11 An astute reader may wonder why the abnormal return is negative on day 1, as well as on day 0. To see why, first note that the announcement date is generally taken in academic studies to be the publication date of the story in The Wall Street Journal (WSJ). Then consider a company announcing a dividend omission via a press release at noon on Tuesday. The stock should fall on Tuesday. The announcement will be reported in the WSJ on Wednesday, because the Tuesday edition of the WSJ has already been printed. For this firm, the stock price falls on the day before the announcement in the WSJ. Alternatively, imagine another firm announcing a dividend omission via a press release on Tuesday at 8 P.M. Since the stock market is closed at that late hour, the stock price will fall on Wednesday. Because the WSJ will report the announcement on Wednesday, the stock price falls on the day of the announcement in the WSJ. Since firms may either make announcements during trading hours or after trading hours, stocks should fall on both day 1 and day 0 relative to publication in the WSJ. Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 359 Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets 353 Over the years this type of methodology has been applied to a large number of events. Announcements of dividends, earnings, mergers, capital expenditures, and new issues of stock are a few examples of the vast literature in the area.12 Although there are exceptions, the event-study tests generally support the view that the market is semistrong-form (and therefore also weak-form) efficient. In fact, the tests even tend to support the view that the market is gifted with a certain amount of foresight. By this we mean that news tends to leak out and be reflected in stock prices even before the official release of the information. Tests of market efficiency can be found in the oddest places. The price of frozen orange juice depends to a large extent on the weather in Orlando, Florida, where many of the oranges that are frozen for juice are grown. One researcher found that he could actually use frozenorange-juice prices to improve the U.S. Weather Bureau's forecast of the temperature for the following night.13 Clearly the market knows something that the weather forecasters do not. Another group of researchers found that, as expected, stock prices generally fall on the date when the sudden death of a chief executive is announced.14 However, the stock price generally rises for the sudden death of a company's founder if he was still heading up the firm prior to his death. The implication is that many of these individuals have outlived their usefulness to their firms. The Record of Mutual Funds If the market is efficient in the semistrong form, then no matter what publicly available information mutual-fund managers rely on to pick stocks, their average returns should be the same as those of the average investor in the market as a whole. We can test efficiency, then, by comparing the performance of these professionals with that of a market index. Consider Figure 13.7, which presents the performance of various types of mutual funds relative to the stock market as a whole. The far left of the figure shows that the universe of all funds covered in the study underperforms the market by 2.13 percent per year, after an appropriate adjustment for risk.15 Thus, rather than outperforming the market, the evidence shows underperformance. This underperformance holds for a number of types of funds as well. Returns in this study are net of fees, expenses, and commissions, so fund returns would be higher if these costs were added back. However, the study shows no evidence that funds, as a whole, are beating the market. Perhaps nothing rankles successful stock market investors more than to have some professor tell them that they are not necessarily smart, just lucky. However, while Figure 13.7 represents only one study, there have been many papers on mutual funds. The overwhelming evidence here is that mutual funds, on average, do not beat broad-based indices. This does not mean that no individual investor can beat the market average or that he or she lacks a special insight, only that proof seems difficult to find. By and large, mutual-fund managers rely on publicly available information. Thus the finding that they do not outperform the market indices is consistent with semistrong-form 12 In academic finance nothing is ever completely resolved, and some event studies suggest that stock market prices respond to information too slowly for the market to be efficient. For example, Eli Bartov, Suresh Radhakrishnan, and Itzhak Krinsky, "Investor Sophistication and Patterns in Stock Returns after Earnings Announcements," The Accounting Review 75 (January 2000). 13 These findings are reported in R. Roll, "Orange Juice and Weather," American Economic Review (December 1984). 14 W. B. Johnson, R. P. Magee, N. J. Nagarajan, and H. A. Newman, "An Analysis of the Stock Price Reaction to Sudden Executive Deaths: Implications for the Managerial Labor Market," Journal of Accounting and Economics (April 1985). 15 This finding is similar to those reported by R. Wermers, "Mutual Fund Performance: An Empirical Decomposition into Stock-Picking, Talent, Style, Transactions Costs, and Expenses," Journal of Finance (August 2000). 360 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 354 Part IV Capital Structure and Dividend Policy I F I G U R E 13.7 Annual Return Performance* of Different Types of U.S. Mutual Funds Relative to a Broad-Based Market Index (19631998) 0.39% 2.13% 2.17% 0.51% 2.29% 1.06% 5.41% 8.45% All Funds Small-company growth funds Other aggressive growth funds Growth funds Income funds Growth and income funds Maximum capital gains funds Sector funds On average, mutual funds do not appear to be outperforming the market. Taken from Table 2 of Lubos Pastor and Robert F. Stambaugh, "Mutual Fund Performance and Seemingly Unrelated Assets," unpublished paper, Graduate School of Business, University of Chicago (February, 2001), forthcoming Journal of Financial Economics. *Performance is relative to the market-model. and weak-form efficiency. This does not imply that mutual funds are bad investments for individuals. Though these funds fail to achieve better returns than some indices of the market, they do permit the investor to buy a portfolio that has a large number of stocks in it (the phrase "a well-diversified portfolio" is often used). They might also be very good at providing a variety of services such as keeping custody and records of all the stocks. Some Contrary Views Although the bulk of the evidence supports the view that markets are efficient, we would not be fair if we did not note the existence of contrary results. We begin with three areas of academic research. 1. Size. In 1981, two important papers presented evidence that, in the United States, the returns on stocks with small market capitalizations16 were greater than the returns on stocks with large market capitalizations over most of the 20th century.17 The studies have since been replicated over different time periods and in different countries. For example, Figure 13.8 shows average returns over the period from 1963 to 1995 for five portfolios of U.S. stocks ranked on size. As can be seen, the average return on small stocks is quite a bit higher than the average return on large stocks. Although much of the differential performance is merely compensation for the extra risk of small stocks, researchers have generally argued that not all of it can be explained by risk differences. In addition, Donald Keim18 presented evidence that most of the 5 percent per year difference in performance occurs in the month of January. 2. Temporal Anomalies. After Keim's surprising results in January, researchers examined returns over various time intervals. For example, studies indicate that average stock returns in January are higher than in other months for both large and small capitalization securities. 16 17 Market capitalization is the price per share of stock multiplied by the number of shares outstanding. See R. W. Banz, "The Relationship between Return and Market Value of Common Stocks," Journal of Financial Economics (March 1981), and M. R. Reinganum, "Misspecification of Capital Asset Pricing: Empirical Anomalies Based on Earnings Yields and Market Values," Journal of Financial Economics (March 1981). 18 D. B. Keim, "Size-Related Anomalies and Stock Return Seasonality: Further Empirical Evidence," Journal of Financial Economics (June 1983). Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 361 Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets 355 I F I G U R E 13.8 Annual Stock Returns on Portfolios Sorted by Size (Market Capitalization) 18.90% 16.25% 15.31% 13.71% 11.91% Portfolio Small 2 3 4 Large Historically, the average return on small stocks has been above the average return on large stocks. Source: Tim Loughran, "Book-to-Market across Firm Size, Exchange and Seasonality," Journal of Financial and Quantitative Analysis 32 (1997). Average stock returns are significantly higher over the first half of the month than they are over the second half of the month.19 Returns are particularly high on the day before a holdiay.20 Across days of the week, stock returns are highest on Wednesdays and Fridays and are lowest on Mondays.21 In fact, researchers generally conclude that the average return on Monday is negative. This finding is inconsistent with market efficiency since rational investors should never be willing to lose money on average--and to take risk to boot. Consider Figure 13.9, which shows average returns for Monday and for the other days of the week for five different countries. For each country, average daily returns on Monday are negative while they are positive for the rest of the week. The evidence on temporal anomalies is quite convincing, with results being replicated in other time periods and in other countries. However, the implications are few because the return differences generally do not exceed transaction costs. For example, an individual who bought a stock every Tuesday morning and sold the stock every Friday evening in order to avoid the negative Monday return would have a lower return after commissions than an individual who bought the same stock and held it for months or years without trading. 3. Value versus Growth. A number of papers have argued that stocks with high bookvalue-to-stock-price ratios and/or high earnings-to-price ratios (generally called value stocks) R. A. Ariel, "A Monthly Effect on Stock Returns," Journal of Financial Economics, (1987). R. A. Ariel, "High Stock Returns before Holidays: Existence and Evidence on Possible Causes," Journal of Finance, (December 1990). 21 One of the original articles to observce "day of the week" anomalies is M. R. Gibbons and P. Hess, "Day of the Week Effects and Asset Returns," Journal of Business (1981). 20 19 362 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 356 Part IV Capital Structure and Dividend Policy I F I G U R E 13.9 Average Daily Returns (in percent) for Monday and for Rest of the Week for Stock Market Indices in Selected Countries 0.1269 0.0721 0.0546 0.0762 0.0404 Mon. Rest of Week Mon. Rest of Week Mon. Rest of Week Mon. Rest of Week Mon. Rest of Week 0.0500 0.0621 .0972 0.1157 0.1592 United States Japan United Kingdom France Returns on Monday are lower than the returns on the other days of the week. Germany Source: Adapted from Table 3 of Wilson Tong, "International Evidence on Weekend Anomalies," unpublished paper, Hong Kong University of Science and Engineering (1999). outperform stocks with low ratios (growth stocks). For example, Fama and French22 find that, for twelve of thirteen major international stock markets, the average return on stocks with high book-value-to-stock-price ratios is above the average return on stocks with low book-valueto-stock-price ratios. Figure 13.10 shows these returns for the world's five largest stock markets. Value stocks have outperformed growth stocks in each of these five markets. Because the return difference is so large and because the above ratios can be obtained so easily for individual stocks, the results may constitute strong evidence against market efficiency. However, a number of current papers suggest that the unusual returns are due to biases in the commercial databases or to differences in risk, not to a true inefficiency.23 Since the debate revolves around arcane statistical issues, we will not pursue the issue further. However, it is safe to say that no conclusion is warranted at this time. As with so many other topics in finance and economics, further research is needed. In addition, the stock market crash of October 19, 1987, is extremely puzzling. The market dropped between 20 percent and 25 percent on a Monday following a weekend during which little surprising news was released. A drop of this magnitude for no apparent reason is not consistent with market efficiency. Because the crash of 1929 is still an enigma, it 22 Taken from Table III of Eugene F. Fama and Kenneth R. French, "Value versus Growth: The International Evidence," Journal of Finance 53 (December, 1998). For example, see S. P. Kothari, J. Shanken, and R. G. Sloan, "Another Look at the Cross Section of Expected Stock Returns," Journal of Finance (March 1995), and E. F. Fama and K. R. French, "Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance 51 (March 1996). 23 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 363 Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets 357 I F I G U R E 13.10 Annual Dollar Returns* (in percent) on Low Bookto-Price Firms and High Book-to-Price Firms in Selected Countries Value Value 16.91 Value 14.55 Growth 13.25 Growth Growth 7.75 9.46 Growth 7.06 Growth 10.01 Value 12.77 17.87 Value 17.10 United States Japan United Kingdom France Germany High book-to-price stocks (frequently called value stocks) outperform low book-to-price (growth) stocks in different countries. Source: Eugene F. Fama and Kenneth R. French, "Value versus Growth: The International Evidence," Journal of Finance (December 1998). *Dollar returns are expressed as the excess over the return on U.S. Treasury bills. is doubtful that the more recent debacle will be explained anytime soon. The recent comments of an eminent historian are apt here: When asked what, in his opinion, the effect of the French Revolution of 1789 was, he replied that it was too early to tell. Perhaps the two stock market crashes are evidence consistent with the bubble theory of speculative markets. That is, security prices sometimes move wildly above their true values. Eventually prices fall back to their original level, causing great losses for investors. The tulip craze of the 17th century in Holland and the South Sea Bubble in England the following century are perhaps the two best-known bubbles. In the first episode, tulips rose to unheard-of prices. For example: A single bulb of the Harlaem species was exchanged for twelve acres of building ground. . . . Another variety fetched 4,600 florins, a new carriage and two gray horses, plus nine complete sets of harnesses. A bulb of the Viceroy species commanded the sum of all the following items in exchange: seventeen bushels of wheat, thirty-four bushels of rye, four fat oxen, eight fat swine, twelve fat sheep, two hogshead of wine, four tons of beer, two tons of butter, 1,000 pounds of cheese, a complete bed, a suit of clothes, and a silver drinking cup thrown in for good measure.24 It seems speculative fervor hit England a century later. Fantastic schemes of all types were paraded before a public eager to invest. Most of them provided good evidence for the dictums: "A sucker is born every minute" and "A fool and his money are soon parted." 24 B. G. Malkiel, A Random Walk Down Wall Street, college ed. (New York: Norton, 1975), pp. 3132. 364 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 WERE THE JAPANESE STOCK PRICES TOO HIGH? T his is the question investors have been asking about the Japanese stock market. As can be seen from the chart below, an investment of one yen, placed in a diversified portfolio of Japanese stocks on the last day of 1969, would have grown to about 18 yen by 1988. By contrast, the tables in Chapter 9 can be used to show that a $1 investment in American stocks would have only risen to under $7 over the same time period. During this time period, the average price-earnings ratio for Japanese stocks was much higher than that for American stocks. For example, the Japanese P/E ratio was 54.3 in 1988, while the United States P/E ratio was 12.9 at the same time.* However, as can be seen from the chart below, Japanese stocks took quite a fall after 1988. By the end of 1993, the 18:1 ratio had dropped to 9:1. It has stayed at about 9:1 over the ensuing years. By contrast, the U.S. ratio had risen from 7:1 to over 22. Not surprisingly, the P/E ratios had moved closer together. By the middle of 1997, the Japanese P/E ratio was approximately 44, while the American P/E ratio was about 21. This pattern has persisted into the year 2001. Worth of an Investment of One Yen Made at the End of 1969 in Japanese Stocks 18 17 16 15 14 13 12 11 Wealth in yen 10 9 8 7 6 5 4 3 2 1 0 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Date Data for this chart supplied by Yasushi Hamao. Reinvestment of dividends is assumed. *Actually, this disparity is partly due to differences in accounting treatments for the two countries. Kenneth R. French and James M. Poterba ("Were Japanese Stock Prices Too High?" Journal of Financial Economics 29 (October 1991), pp. 33764) estimate that in 1988 the price-earnings ratio of Japanese firms would have been 32.1 instead of 54.3 had U.S. accounting practices been adopted. Is this a bubble? 358 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 365 Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets 359 According to Malkiel, The prize, however, must surely go to the unknown soul who started "A Company for carrying on an undertaking of great advantage, but nobody to know what it is." The prospectus promises unheard-of rewards. At nine o'clock in the morning, when the subscription books opened, crowds of people from all walks of life practically beat down the doors in an effort to subscribe. Within five hours a thousand investors handed over their money for shares in the company. Not being greedy himself, the promoter promptly closed up shop and set off for the Continent. He was never heard from again.25 The Strong Form Even the strongest adherents to the efficient-market hypothesis would not be surprised to find that markets are inefficient in the strong form. After all, if an individual has information that no one else has, it is likely that he can profit from it. One group of studies of strong-form efficiency investigates insider trading. Insiders in firms have access to information that is not generally available. But if the strong form of the efficient-market hypothesis holds, they should not be able to profit by trading on their information. A government agency, the Securities and Exchange Commission, requires insiders in companies to reveal any trading they might do in their own company's stock. By examining the record of such trades, we can see whether they made abnormal returns. A number of studies support the view that these trades were abnormally profitable. Thus, strong-form efficiency does not seem to be substantiated by the evidence.26 13.5 IMPLICATIONS FOR CORPORATE FINANCE Accounting and Efficient Markets The accounting profession provides firms with a significant amount of leeway in their reporting practices. For example, companies may choose between the last-infirst-out (LIFO) or first-infirst-out (FIFO) method in valuing inventories. They may choose either the percentage-of-completion or the completed-contract method for construction projects. They may depreciate physical assets by either accelerated or straight-line depreciation. Accountants have frequently been accused of misusing this leeway in the hopes of boosting earnings and stock prices. For example, U.S. Steel (now USX Corporation) switched from straight-line to accelerated depreciation after World War II, because their high reported profits at the time attracted much governmental scrutiny. They switched back to straight-line depreciation in the 1960s after years of low reported earnings. However, accounting choice should not affect stock price if two conditions hold. First, enough information must be provided in the annual report so that financial analysts can construct earnings under the alternative accounting methods. This appears to be the case for many, though not necessarily all, accounting choices. For example, most skilled analysts can create pro forma financial statements under a LIFO assumption if they are provided with actual statements prepared under FIFO. Second, the market must be efficient in the semistrong form. In other words, the market must appropriately use all of this accounting information in determining the market price. Of course, the issue of whether accounting choice affects stock price is ultimately an empirical matter. A number of academic papers have addressed this issue. Kaplan and Roll 25 26 B. G. Malkiel, A Random Walk Down Wall Street. H. N. Seyhun, Investor Intelligence from Insider Trading, MIT Press: Cambridge, Mass., 1998. 366 Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition IV. Capital Structure and Dividend Policy 13. Corporate-Financing Decisions and Efficient Capital Markets The McGraw-Hill Companies, 2002 360 Part IV Capital Structure and Dividend Policy found that the switch from accelerated to straight-line depreciation generally did not significantly affect stock prices.27 Kaplan and Roll also looked at changes from the deferral method of accounting for the investment tax credit to the flow-through method.28 They found that a switch would increase accounting earnings but had no effect on stock prices. Several other accounting procedures have been studied. Hong, Kaplan, and Mandelker found no evidence that the stock market was affected by the artificially higher earnings reported using the pooling method, compared to the purchase method, for reporting mergers and acquisitions.29 Biddle and Lindahl found that firms switching to the LIFO method of costing inventory experienced an increase in stock price.30 This is to be expected in inflationary environments because LIFO inventory costing can reduce taxes, compared to FIFO inventory costing. They found that the larger the tax decrease resulting from the use of LIFO, the greater was the increase in stock price. In summary, the above empirical evidence suggests that accounting changes do not fool the market. However, a recent study reaches different conclusions.31 Sloane points out that a firm's earnings can be broken up into the following two components: Earnings Cash flow Accruals This relationship implies that a firm with no cash