introduction to corporate finance (1565 slides, 24 chapters presentation)

INTRODUCTION TOINTRODUCTION TO

CORPORATE FINANCECORPORATE FINANCECORPORATE FINANCECORPORATE FINANCELaurence Booth Laurence Booth •• W. Sean ClearyW. Sean Cleary

ContentsContents

•• CHAPTER 1: CHAPTER 1: An Introduction to FinanceAn Introduction to Finance 0303•• CHAPTER 2: CHAPTER 2: Business (Corporate) FinanceBusiness (Corporate) Finance 3838•• CHAPTER 3: CHAPTER 3: Financial StatementsFinancial Statements 8080•• CHAPTER 4: CHAPTER 4: Financial Statement Analysis and Forecas tingFinancial Statement Analysis and Forecasting 136136•• CHAPTER 5: Time Value of Money CHAPTER 5: Time Value of Money 221221•• CHAPTER 6: Bond Valuation and Interest RatesCHAPTER 6: Bond Valuation and Interest Rates 281281•• CHAPTER 7: Equity ValuationCHAPTER 7: Equity Valuation 353353•• CHAPTER 8: Risk, Return, and Portfolio TheoryCHAPTER 8: Risk, Return, and Portfolio Theory 410410•• CHAPTER 9: The Capital Asset Pricing Model (CAPMCHAPTER 9: The Capital Asset Pricing Model (CAPM ) 504) 504•• CHAPTER 10: Market EfficiencyCHAPTER 10: Market Efficiency 618618

www.bookfiesta4u.com Contents

•• CHAPTER 10: Market EfficiencyCHAPTER 10: Market Efficiency 618618•• CHAPTER 11: Forwards, Futures, and Swaps CHAPTER 11: Forwards, Futures, and Swaps 663663•• CHAPTER 12: Options CHAPTER 12: Options 717717•• CHAPTER 13: Capital Budgeting, Risk Considerations and Other Special Issues CHAPTER 13: Capital Budgeting, Risk Considerations and Other Special Issues 781781•• CHAPTER 14: Cash Flow Estimation and Capital Budge ting DecisionsCHAPTER 14: Cash Flow Estimation and Capital Budge ting Decisions 867867•• CHAPTER 15: Mergers and Acquisitions CHAPTER 15: Mergers and Acquisitions 937937•• CHAPTER 16: Leasing CHAPTER 16: Leasing 992992•• CHAPTER 17: Investment Banking and Securities Laws CHAPTER 17: Investment Banking and Securities Laws 10151015•• CHAPTER 18: Debt Instruments CHAPTER 18: Debt Instruments 10421042•• CHAPTER 19: Equity and Hybrid Instruments CHAPTER 19: Equity and Hybrid Instruments 10881088•• CHAPTER 20: Cost of CapitalCHAPTER 20: Cost of Capital 11531153•• CHAPTER 21: Capital Structure Decisions CHAPTER 21: Capital Structure Decisions 12881288•• CHAPTER 22: Dividend Policy CHAPTER 22: Dividend Policy 13831383•• CHAPTER 23: Working Capital Management: General Is sues CHAPTER 23: Working Capital Management: General Is sues 14571457•• CHAPTER 24: Working Capital Management: Current As sets and Current Liabilities CHAPTER 24: Working Capital Management: Current As sets and Current Liabilities 15311531

CHAPTER 1 - An Introduction to Finance1 - 2

CHAPTER 1CHAPTER 1An Introduction to FinanceAn Introduction to FinanceAn Introduction to FinanceAn Introduction to Finance

Lecture AgendaLecture Agenda

•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• Finance DefinedFinance Defined•• Real versus Financial AssetsReal versus Financial Assets

www.bookfiesta4u.com ContentsCHAPTER 1 - An Introduction to Finance

1 - 4

•• Real versus Financial AssetsReal versus Financial Assets•• The Financial SystemThe Financial System•• Financial Instruments and MarketsFinancial Instruments and Markets•• The Global Financial CommunityThe Global Financial Community•• Summary and ConclusionsSummary and Conclusions

–– Concept Review QuestionsConcept Review Questions

Learning ObjectivesLearning Objectives

1.1. What finance is and what is involved in the study of finance.What finance is and what is involved in the study of finance.2.2. How financial securities can be used to provide financing for How financial securities can be used to provide financing for

borrowers and simultaneously to provide investment borrowers and simultaneously to provide investment opportunities for lenders.opportunities for lenders.

3.3. How financial systems work in general.How financial systems work in general.


1 - 5

3.3. How financial systems work in general.How financial systems work in general.4.4. The channels of intermediation and the role played by The channels of intermediation and the role played by

market and financial intermediaries within this system.market and financial intermediaries within this system.5.5. The basic types of financial instruments that are available The basic types of financial instruments that are available

and how they are traded.and how they are traded.6.6. The importance of the global financial system.The importance of the global financial system.

Key TermsKey Terms

•• Bourse de MontréalBourse de Montréal•• brokersbrokers•• Canadian Trading and Quotation System Inc. (CNQ)Canadian Trading and Quotation System Inc. (CNQ)•• capital market securitiescapital market securities•• common sharecommon share•• corporate financecorporate finance•• Crown corporationsCrown corporations


1 - 6

•• Crown corporationsCrown corporations•• dealer or overdealer or over--thethe--counter (OTC) marketscounter (OTC) markets•• debt instrumentsdebt instruments•• equity instrumentsequity instruments•• exchanges or auction marketsexchanges or auction markets•• financefinance•• financial assetsfinancial assets•• financial intermediariesfinancial intermediaries•• fourth marketfourth market•• intermediationintermediation•• investmentsinvestments

Key TermsKey Terms

•• market capitalizationmarket capitalization•• market intermediarymarket intermediary•• marketable financial assetsmarketable financial assets•• money market securitiesmoney market securities•• New York Stock Exchange (NYSE)New York Stock Exchange (NYSE)•• nonnon--marketable financial assetsmarketable financial assets•• Ontario Securities CommissionOntario Securities Commission


1 - 7

•• Ontario Securities CommissionOntario Securities Commission•• preferred sharespreferred shares•• primary marketsprimary markets•• real assetsreal assets•• secondary marketssecondary markets•• third marketthird market•• Toronto Stock Exchange (TSX)Toronto Stock Exchange (TSX)•• TSX Group Inc.TSX Group Inc.•• TSX MarketsTSX Markets•• TSX Venture ExchangeTSX Venture Exchange•• Winnipeg Commodity ExchangeWinnipeg Commodity Exchange

What Is Finance?What Is Finance?

•• Finance is the study of how and under what Finance is the study of how and under what terms savings (money) are allocated between terms savings (money) are allocated between lenders and borrowers.lenders and borrowers.–– Finance is distinct from economics in that it Finance is distinct from economics in that it

addresses not only how resources are allocated but addresses not only how resources are allocated but


1 - 8

addresses not only how resources are allocated but addresses not only how resources are allocated but also under also under what termswhat terms and through and through what channelswhat channels

•• Financial contracts or Financial contracts or securitiessecurities occur whenever occur whenever funds are transferred from issuer to buyer.funds are transferred from issuer to buyer.

The Study of FinanceThe Study of Finance

•• The study of finance requires a basic The study of finance requires a basic understanding of:understanding of:–– SecuritiesSecurities–– Corporate lawCorporate law


1 - 9

–– Corporate lawCorporate law–– Financial institutions and marketsFinancial institutions and markets

Real Versus Financial AssetsReal Versus Financial Assets

•• Real assets are tangible things owned by Real assets are tangible things owned by persons and businessespersons and businesses–– Residential structures and propertyResidential structures and property–– Major appliances and automobilesMajor appliances and automobiles–– Office towers, factories, minesOffice towers, factories, mines


1 - 10

–– Office towers, factories, minesOffice towers, factories, mines–– Machinery and equipmentMachinery and equipment

•• Financial assets are what one individual has lent Financial assets are what one individual has lent to anotherto another–– Consumer creditConsumer credit–– LoansLoans–– Mortgages Mortgages

Assets and Liabilities of Households, Assets and Liabilities of Households, 20052005

Assets $ Billion Liabilities $ BillionHouses 1,086 Consumer credit 260Consumer Durables 435 Loans 131Land 827 Mortgages 588Real Assets 2,348 Total Liabilities 979

Table 1-2 Assets and Liabilities of Households, 20 05


1 - 11

Real Assets 2,348 Total Liabilities 979Deposits 683Debt 114Pensions and insurance 1,200Shares 1,254Foreign and other 72Financial Assets 3323Total Assets 5,671

Source: Statistics Canada. National Balance Sheet Accounts, Quarterly Estimates, Fourth Quarter 2005. Ottawa: M inister o f Industry, 2006 (Catalogue No. 13-214-XIE).

The Financial System The Financial System OverviewOverview

•• The household is the primary provider of funds to The household is the primary provider of funds to businesses and government.businesses and government.

•• Households must accumulate financial resources throughout their Households must accumulate financial resources throughout their working life times to have enough savings (pension) to live on in working life times to have enough savings (pension) to live on in their retirement yearstheir retirement years

•• Financial intermediaries transform the nature of the Financial intermediaries transform the nature of the


1 - 12

•• Financial intermediaries transform the nature of the Financial intermediaries transform the nature of the securities they issue and invest insecurities they issue and invest in

•• Banks, trust companies, credit unions, insurance firms, mutual Banks, trust companies, credit unions, insurance firms, mutual fundsfunds

•• Market intermediaries simply help make markets workMarket intermediaries simply help make markets work•• Investment dealersInvestment dealers•• BrokersBrokers

The Financial System The Financial System

FIGURE 1-2


1 - 13

The Financial SystemThe Financial SystemChannels of IntermediationChannels of Intermediation

•• Funds can be channeled from saver to borrower Funds can be channeled from saver to borrower in three ways:in three ways:–– Direct intermediation (direct transfer from saver to Direct intermediation (direct transfer from saver to

borrower borrower –– a nona non--market transaction)market transaction)


1 - 14

borrower borrower –– a nona non--market transaction)market transaction)–– Direct intermediation (a marketDirect intermediation (a market--based transaction based transaction

usually through a market intermediary such as a usually through a market intermediary such as a broker)broker)

–– Indirect claims through a financial intermediary Indirect claims through a financial intermediary (where the financial intermediary such as a bank (where the financial intermediary such as a bank offers depositoffers deposit--taking services and ultimately lends taking services and ultimately lends those deposits out as mortgages or loans)those deposits out as mortgages or loans)

Channels of IntermediationChannels of Intermediation

FIGURE 1-3


1 - 15

The Financial SystemThe Financial SystemFinancial IntermediariesFinancial Intermediaries

•• Banks and other depositBanks and other deposit--taking institutionstaking institutions•• Insurance companiesInsurance companies•• Pension FundsPension Funds


1 - 16

•• Pension FundsPension Funds•• Mutual FundsMutual Funds

Financial IntermediariesFinancial IntermediariesCanadian Chartered BanksCanadian Chartered Banks

•• Banks take deposits from numerous depositors from across CanadaBanks take deposits from numerous depositors from across Canada•• The deposits are ‘pooled’ in the BankThe deposits are ‘pooled’ in the Bank•• The bank takes these pooled funds and lends them out to households and The bank takes these pooled funds and lends them out to households and

businesses in the form of mortgages and loansbusinesses in the form of mortgages and loans•• The bank transforms the original nature of the savers (depositors) money:The bank transforms the original nature of the savers (depositors) money:

–– Deposits are usually small in amount…face little or no risk, and depositors Deposits are usually small in amount…face little or no risk, and depositors expect to withdraw the amount at any timeexpect to withdraw the amount at any time


1 - 17

expect to withdraw the amount at any timeexpect to withdraw the amount at any time–– Loans and mortgages on the other hand usually have the following Loans and mortgages on the other hand usually have the following

characteristics:characteristics:•• Large sumsLarge sums•• Borrowed for long periods of timeBorrowed for long periods of time•• Borrowed for risky purposes.Borrowed for risky purposes.

•• Banks can perform this transformation function because they become Banks can perform this transformation function because they become experts at risk assessment, financial contracting (pricing the risk) and experts at risk assessment, financial contracting (pricing the risk) and monitoring the activities of borrowers.monitoring the activities of borrowers.

Financial IntermediariesFinancial IntermediariesCanadian Chartered BanksCanadian Chartered Banks

BankRevenue

($ million)Assets

($ million)Profits

($ million)Royal Bank of Canada 29,403 469,521 3,387Canadian Imperial Bank of Commerce

Table 1-3 Chartered Banks: Financial Statistics, 2 005


1 - 18

Canadian Imperial Bank of Commerce (CIBC) 18,677 280,370 -32Bank of Nova Scotia 18,332 314,025 3,209TD Canada Trust 18,665 365,210 2,229Bank of Montreal 15,138 297,532 2,400National Bank 5,320 107,598 855

Source: BM O Investo rLine website: www.bmo investo rline.com, October 31, 2006.

Financial IntermediariesFinancial IntermediariesInsurance CompaniesInsurance Companies

–– Insurers sell policies and collect premiums from customers Insurers sell policies and collect premiums from customers based on the pricing of those policies given the probability of a based on the pricing of those policies given the probability of a claim and the size the policy and administrative fees. claim and the size the policy and administrative fees.

–– They invest the premiums so that the accumulated value in the They invest the premiums so that the accumulated value in the future will grow to meet the anticipated claims of the future will grow to meet the anticipated claims of the


1 - 19

future will grow to meet the anticipated claims of the future will grow to meet the anticipated claims of the policyholders.policyholders.

–– In this way, unsupportable risks (such as the death of wage In this way, unsupportable risks (such as the death of wage earner or the burning down of a business) are shared among a earner or the burning down of a business) are shared among a large number of policyholders through the insurance company.large number of policyholders through the insurance company.

–– Insurance allows households, business and government to Insurance allows households, business and government to engage in risky activities without having to bear the entire risk of engage in risky activities without having to bear the entire risk of loss themselves.loss themselves.

Financial IntermediariesFinancial IntermediariesInsurance CompaniesInsurance Companies

InsurerRevenue

($ million)Assets

($ million)Profits

($ million)Manulife Financial 32,187 322,171 3,294

Table 1-4 Insurance Companies: Financial Statistic s, 2005


1 - 20

Manulife Financial 32,187 322,171 3,294Sun Life Financial 21,871 171,850 1,867Great-West Lifeco 23,883 102,161 1,775ING Canada 4,446 9,926 782

Source: Data from BM O Investo rLine website: www.bmo investorline.com, October 31, 2006.

Financial IntermediariesFinancial IntermediariesPension Plan AssetsPension Plan Assets

–– Individuals and employers make payments over the Individuals and employers make payments over the entire working life of a person with those funds entire working life of a person with those funds invested to grow over time.invested to grow over time.

–– Ultimately, the accumulated value in the pension can Ultimately, the accumulated value in the pension can be used by the person in retirement.be used by the person in retirement.

–– Pension plans accumulate considerable sums of Pension plans accumulate considerable sums of


1 - 21

–– Pension plans accumulate considerable sums of Pension plans accumulate considerable sums of money, and their managers invest those funds with money, and their managers invest those funds with longlong--term investment time horizons in diversified term investment time horizons in diversified portfolios of investments. These investments are a portfolios of investments. These investments are a major source of capital, fuelling investment in major source of capital, fuelling investment in research and development, capital equipment, research and development, capital equipment, resource exploration and ultimately contributing in a resource exploration and ultimately contributing in a substantial way to growth in the economy.substantial way to growth in the economy.

Financial IntermediariesFinancial IntermediariesPension Plan AssetsPension Plan Assets

Pension Plan ManagersNet Assets ($ billion)

Table 1-5 Pension Plan Assets, 2005


1 - 22

Pension Plan Managers ($ billion)Caisse de depot et placement du Quebec 216.1Canada Pension Plan (CPP) 98.0Ontario Teachers (Teachers) 96.1Ontario Municipal Employees (OMERS) 41.6

* The Caisse manages the investments o f several pension plans.

Financial IntermediariesFinancial IntermediariesCanadian Mutual Fund AssetsCanadian Mutual Fund Assets

•• Mutual funds give small investors access to diversified, Mutual funds give small investors access to diversified, professionallyprofessionally--managed portfolios of securities.managed portfolios of securities.

•• Small investors often do not have the funds necessary to Small investors often do not have the funds necessary to invest directly into marketinvest directly into market--traded stocks and bonds.traded stocks and bonds.

•• This is called denomination intermediation because the This is called denomination intermediation because the mutual fund makes investments available in smaller, mutual fund makes investments available in smaller,


1 - 23

mutual fund makes investments available in smaller, mutual fund makes investments available in smaller, more affordable amounts of money.more affordable amounts of money.

•• Canadian indirect investment in the markets through Canadian indirect investment in the markets through managed products such as mutual funds and segregated managed products such as mutual funds and segregated funds has grown exponentially. funds has grown exponentially.

(see Figure 1(see Figure 1--4 on the next slide)4 on the next slide)

Financial IntermediariesFinancial IntermediariesCanadian Mutual Fund AssetsCanadian Mutual Fund Assets

FIGURE 1-4


1 - 24

The Financial SystemThe Financial SystemThe Major BorrowersThe Major Borrowers

•• Public DebtPublic Debt–– GovernmentsGovernments

•• FederalFederal•• ProvincialProvincial•• MunicipalMunicipal


1 - 25

•• MunicipalMunicipal•• Crown CorporationsCrown Corporations

•• Private DebtPrivate Debt–– HouseholdsHouseholds–– NonNon--financial Corporationsfinancial Corporations

The Financial SystemThe Financial SystemLargest NonLargest Non--financial Companiesfinancial Companies

Non-financial CompaniesRevenue

($ million)Assets

($ million)General Motors of Canada Ltd. 34,991 n/aLoblaw Companies Ltd. 27,812 13,761Magna International Inc. 22,873 12,321

Table 1-6 Non-Financial Canadian Companies: Financ ial Statistics, 2005


1 - 26

Magna International Inc. 22,873 12,321Imperial Oil Ltd. 26,936 15,582Alcan Inc.* 20,408 26,638BCE Inc. 19,150 40,630Bombardier Inc.* 14,882 17,483Petro-Canada 17,673 20,655Onex Corp. 17,626 14,845EnCana Corp.* 14,322 34,148

Source: Data from "The Top 1000 in 2005." Globe and M ail Repo rt on Business website: www.theglobeandmail.com.

*Company reports in U.S. do llars.

Financial InstrumentsFinancial Instruments

•• There are two major categories of financial There are two major categories of financial securities:securities:

1.1. Debt InstrumentsDebt Instruments–– Commercial paperCommercial paper–– Bankers’ acceptancesBankers’ acceptances


1 - 27

–– Bankers’ acceptancesBankers’ acceptances–– Treasury billsTreasury bills–– Mortgage loansMortgage loans–– BondsBonds–– DebenturesDebentures

2.2. Equity InstrumentsEquity Instruments–– Common stockCommon stock–– Preferred stockPreferred stock

Financial Instruments Financial Instruments NonNon--marketablemarketable

•• Characteristics of nonCharacteristics of non--marketable securitiesmarketable securities–– Cannot be traded between or among investorsCannot be traded between or among investors–– May be redeemable (a reverse transaction May be redeemable (a reverse transaction

between the borrower and the lender)between the borrower and the lender)


1 - 28

–– Examples:Examples:•• Savings accountsSavings accounts•• Term DepositsTerm Deposits•• Guaranteed Investment CertificatesGuaranteed Investment Certificates•• Canada Savings BondsCanada Savings Bonds

Financial Instruments Financial Instruments MarketableMarketable

•• Characteristics of Marketable securitiesCharacteristics of Marketable securities–– Can be traded between or among investors after their original Can be traded between or among investors after their original

issue in public markets and before they mature or expireissue in public markets and before they mature or expire

•• Market CapitalizationMarket Capitalization

www.bookfiesta4u.com ContentsCHAPTER 1 - An Introduction to Finance 1 - 29

•• Market CapitalizationMarket Capitalization–– Is an important term in financeIs an important term in finance–– It is the total market value of a company It is the total market value of a company –– It is found by multiplying the number of shares outstanding by It is found by multiplying the number of shares outstanding by

the market price per share.the market price per share.

shareper Price shares ofNumber tion CapitalizaMarket ×=

Financial Instruments Financial Instruments MarketableMarketable

Markets can be categorized by the time to maturity:Markets can be categorized by the time to maturity:•• Money Market SecuritiesMoney Market Securities (for short(for short--term debt securities that are term debt securities that are

pure discount notes)pure discount notes)–– Bankers’ acceptancesBankers’ acceptances–– Commercial PaperCommercial Paper–– Treasury BillsTreasury Bills


1 - 30

–– Treasury BillsTreasury Bills

•• Capital Market SecuritiesCapital Market Securities (for long(for long--term debt or equity term debt or equity securities with maturities greater than 1 year)securities with maturities greater than 1 year)–– BondsBonds–– DebenturesDebentures–– Common StockCommon Stock–– Preferred StockPreferred Stock

Financial MarketsFinancial Markets

•• Primary MarketPrimary Market–– Markets that involve the issue of new securities by the Markets that involve the issue of new securities by the

borrower in return for cash from investors (Capital borrower in return for cash from investors (Capital formation occurs)formation occurs)

•• Secondary MarketSecondary Market


1 - 31

•• Secondary MarketSecondary Market–– Markets that involve buyers and sellers of existing Markets that involve buyers and sellers of existing

securities. Funds flow from buyer to seller. Seller securities. Funds flow from buyer to seller. Seller becomes the new owner of the security. (No capital becomes the new owner of the security. (No capital formation occurs)formation occurs)

Financial Markets Financial Markets Types of Secondary MarketsTypes of Secondary Markets

•• Exchanges or Auction MarketsExchanges or Auction Markets•• Secondary markets that involve a bidding process that takes Secondary markets that involve a bidding process that takes

place in specific locationplace in specific location•• For example TSX, NYSEFor example TSX, NYSE


1 - 32

•• Dealer or OverDealer or Over--thethe--counter (OTC) Marketscounter (OTC) Markets•• Secondary markets that do not have a physical location and Secondary markets that do not have a physical location and

consist of a network of dealers who trade directly with one consist of a network of dealers who trade directly with one another.another.

•• For example the bond marketFor example the bond market

Financial Markets Financial Markets Other MarketsOther Markets

•• Third MarketThird Market•• Trading of securities that are listed on organized exchanges Trading of securities that are listed on organized exchanges

in the Overin the Over--thethe--counter marketcounter market

•• Fourth MarketFourth Market


1 - 33

•• Fourth MarketFourth Market•• Trading of securities directly between investors (usually Trading of securities directly between investors (usually

between two large institutions) without the involvement of between two large institutions) without the involvement of brokers or dealers.brokers or dealers.

•• Operates through the use of privately owned automated Operates through the use of privately owned automated systems such as systems such as InstinetInstinet

The Global Financial CommunityThe Global Financial Community

•• Represents an important source of funds for Represents an important source of funds for borrowersborrowers

•• Provides investors with important alternatives as Provides investors with important alternatives as


1 - 34

•• Provides investors with important alternatives as Provides investors with important alternatives as they seek to build wealth through diversified they seek to build wealth through diversified portfoliosportfolios

The Global Financial CommunityThe Global Financial Community

Total Assets($ million) 1,016,031

Canadian direct investments abroad 465,058Canadian portfolio investments 284,604Portfolio foreign bonds 82,374Portfolio foreign stocks 189,175Other portfolio investments 13,055Other Canadian investments 266,369Loans 48,325

Table 1-7 Canada's International Investments, 2005


1 - 35

AllowancesDeposits 120,694Official international reserves 38,030Other assets 59,319Total Liabilities 1,184,534Foreign direct investments in Canada 415,561Foreign portfolio investments 508,398Portfolio Canadian bonds 380,017Portfolio Canadian stocks 107,598Portfolio Canadian money market instruments 20,783Other foreign investments 260,575Loans 36,107Deposits 201,639Other liabilities 22,829Canada's Net International Investment Position -168, 503

Source: Statistics Canada.

SummarySummary

•• In this chapter you have learned about:In this chapter you have learned about:–– Financial systems in general, and the Canadian Financial systems in general, and the Canadian

financial system in particularfinancial system in particular–– Major participants in the Canadian financial system, Major participants in the Canadian financial system,


1 - 36

–– Major participants in the Canadian financial system, Major participants in the Canadian financial system, including the different types of financial securities and including the different types of financial securities and financial marketsfinancial markets


CORPORATE FINANCECORPORATE FINANCELaurence Booth Laurence Booth •• W. Sean ClearyW. Sean Cleary

Chapter 2 Chapter 2 –– Business (Corporate) Business (Corporate) FinanceFinance

CHAPTER 2CHAPTER 2Business (Corporate) Business (Corporate) Business (Corporate) Business (Corporate)

FinanceFinance


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• Types of Business OrganizationsTypes of Business Organizations•• Goals of the CorporationGoals of the Corporation•• Role of Management and Agency IssuesRole of Management and Agency Issues

www.bookfiesta4u.com ContentsCHAPTER 2 – Business (Corporate) Finance

2 - 39

•• Role of Management and Agency IssuesRole of Management and Agency Issues•• Corporate FinanceCorporate Finance•• Finance Careers Finance Careers •• Organization of the Finance FunctionOrganization of the Finance Function•• Sample ProblemsSample Problems


1.1. The advantages of disadvantages of four different ways to The advantages of disadvantages of four different ways to organize a businessorganize a business

2.2. Some of the pressures exerted on corporations by various Some of the pressures exerted on corporations by various stakeholdersstakeholders

3.3. What the ultimate objective of a firm is and why this is a logical What the ultimate objective of a firm is and why this is a logical objectiveobjective


2 - 40

objectiveobjective4.4. Why agency costs arise and how they can reduce shareholder Why agency costs arise and how they can reduce shareholder

wealthwealth5.5. The main types of decisions made by corporations regarding the The main types of decisions made by corporations regarding the

financial management of their real and financial assets, as well as financial management of their real and financial assets, as well as the associated corporate financing decisionsthe associated corporate financing decisions

6.6. Some of the major types of finance jobs available with financial Some of the major types of finance jobs available with financial and nonand non--financial companiesfinancial companies

Important Chapter TermsImportant Chapter Terms

•• Account managersAccount managers•• Agency costsAgency costs•• Agency problemsAgency problems•• Agency relationshipsAgency relationships•• AnalystsAnalysts•• AssociatesAssociates•• Banking associatesBanking associates

•• Financial managementFinancial management•• Fixed income or equity tradersFixed income or equity traders•• Income and royalty trustsIncome and royalty trusts•• Limited liabilityLimited liability•• ManagersManagers•• PartnershipPartnership•• Portfolio managersPortfolio managers•• Private bankersPrivate bankers


2 - 41

•• Banking associatesBanking associates•• Capital budgetingCapital budgeting•• Chief financial officerChief financial officer•• ControllerController•• Corporate financeCorporate finance•• Corporate finance associatesCorporate finance associates•• Corporate financingCorporate financing•• CorporationsCorporations•• Financial and investment analystsFinancial and investment analysts

•• Private bankersPrivate bankers•• Retail brokersRetail brokers•• Sales and trading peopleSales and trading people•• Security analystsSecurity analysts•• Senior viceSenior vice--president of financepresident of finance•• Sole proprietorshipSole proprietorship•• TreasurerTreasurer•• TrustTrust•• Unlimited liabilityUnlimited liability

Types of Business OrganizationsTypes of Business Organizations

•• Sole proprietorshipsSole proprietorships•• PartnershipsPartnerships•• TrustsTrusts


2 - 42

•• TrustsTrusts•• CorporationsCorporations

Types of Business OrganizationsTypes of Business OrganizationsSole Proprietorships Sole Proprietorships -- CharacteristicsCharacteristics

Nature of the BusinessNature of the Business–– A business owned and operated by one personA business owned and operated by one person–– Legally inseparable from the person who owns and operates the Legally inseparable from the person who owns and operates the

businessbusiness–– Report income (gross and net) on personal income tax returnReport income (gross and net) on personal income tax return–– Net business income is taxed at the person’s marginal tax rateNet business income is taxed at the person’s marginal tax rate

FinancingFinancing


2 - 43

FinancingFinancing–– Limited to the resources of the individual owning and operating the Limited to the resources of the individual owning and operating the

business and their personal capacity to borrowbusiness and their personal capacity to borrowFormalityFormality

–– Business records must be maintained for reporting to Canada Revenue Business records must be maintained for reporting to Canada Revenue Agency like any other businessAgency like any other business

–– Owners may wish to register the business with the ProvinceOwners may wish to register the business with the Province–– If employing persons, the owner must obtain a employer number, If employing persons, the owner must obtain a employer number,

deduct and remit income taxes as well as make employer contributions deduct and remit income taxes as well as make employer contributions to CPP and Employment Insurance.to CPP and Employment Insurance.

Types of Business OrganizationsTypes of Business OrganizationsSole ProprietorshipsSole Proprietorships

AdvantagesAdvantages

•• Easy to startEasy to start•• Little formality Little formality –– but must but must

maintain business records maintain business records

DisadvantagesDisadvantages

•• Unlimited legal liabilityUnlimited legal liability•• Net income taxed at Net income taxed at

personal marginal tax ratepersonal marginal tax rate


2 - 44

maintain business records maintain business records like any other businesslike any other business

personal marginal tax ratepersonal marginal tax rate•• Financing is limited to the Financing is limited to the

resources of the single resources of the single ownerowner

Types of Business OrganizationsTypes of Business OrganizationsPartnership CharacteristicsPartnership Characteristics

Nature of the BusinessNature of the Business–– Involves two or more partnersInvolves two or more partners–– Must have at least one general partner who holds unlimited legal Must have at least one general partner who holds unlimited legal

liability for the activities of the business liability for the activities of the business FinancingFinancing

–– A function of the combined resources of the partnersA function of the combined resources of the partners


2 - 45

–– A function of the combined resources of the partnersA function of the combined resources of the partners–– Can attract additional resources through limited partner Can attract additional resources through limited partner

contributionscontributionsFormalityFormality

–– Must be registered under provincial partnership legislationMust be registered under provincial partnership legislation–– Should be formalized through a partnership agreementShould be formalized through a partnership agreement outlining outlining

partner responsibilities, how partners enter and cash out of the partner responsibilities, how partners enter and cash out of the business, and division of net business incomebusiness, and division of net business income

Types of Business OrganizationsTypes of Business OrganizationsLimited Liability Partnerships (LLP)Limited Liability Partnerships (LLP)

•• New form of organization for professional firmsNew form of organization for professional firms•• Partners have limited legal liability Partners have limited legal liability •• Partner’s income included as ordinary income Partner’s income included as ordinary income


2 - 46

•• Partner’s income included as ordinary income Partner’s income included as ordinary income and filed using an individual tax return.and filed using an individual tax return.

•• This form of business organization is used by This form of business organization is used by Canadian legal and accounting firmsCanadian legal and accounting firms

Types of Business OrganizationsTypes of Business OrganizationsExamples of LLPs in CanadaExamples of LLPs in Canada

Law Firms Employees Lawyers PartnersMcCarthy Tetrault LLP 1,250 712 379Gowling Lafleur Henderson LLP 1,181 698 353Borden Ladner Gervais LLP 1,290 679 395Fasken Martineau DuMoulin LLP 936 583 348

Table 2-1 Canadian Law and Accounting Firms, 2004


2 - 47

Fasken Martineau DuMoulin LLP 936 583 348

Accounting Firms

Sales ($ million)

Partners Professional Staff

Deloitte & Touche LLP 1,024 512 4,603KPMG LLP 729 433 3,163PricewaterhouseCoopers LLP 698 430 2,640Ernst & Young LLP 556 266 2,081Grant Thornton LLP 315 349 2,166

Source: Financial Post , FP500, 2004.

Types of Business OrganizationsTypes of Business OrganizationsLimited and General PartnershipsLimited and General Partnerships

Used for tax purposesUsed for tax purposes–– Limited partners are often able to use unused nonLimited partners are often able to use unused non--cash cash

deductions such as ‘depreciation’ and/or business losses to deductions such as ‘depreciation’ and/or business losses to offset personal tax liabilities.offset personal tax liabilities.

General PartnerGeneral Partner


2 - 48

General PartnerGeneral Partner–– There must be one general partner (responsible for operating the There must be one general partner (responsible for operating the

business)business)–– Unlimited legal liabilityUnlimited legal liability–– Often the general partner is a corporationOften the general partner is a corporation

Limited PartnersLimited Partners–– Passive investorsPassive investors–– Contribute money only to the business, and share in the profits Contribute money only to the business, and share in the profits

Types of Business OrganizationsTypes of Business OrganizationsGeneral PartnershipsGeneral Partnerships


•• Harnesses the combined talents Harnesses the combined talents and energies of all the partnersand energies of all the partners

•• Potentially taps the greater Potentially taps the greater combined financial resources of combined financial resources of the partnersthe partners

•• Spreads liability across the Spreads liability across the


•• Income is taxed at the individual’s Income is taxed at the individual’s marginal tax ratemarginal tax rate

•• Governed by provincial Governed by provincial partnership legislation partnership legislation –– so some so some formality does exist formality does exist –– and and probably should exist through a probably should exist through a


2 - 49

•• Spreads liability across the Spreads liability across the partners (jointly and severally)partners (jointly and severally)

probably should exist through a probably should exist through a formal partnership agreementformal partnership agreement

•• Unlimited legal liabilityUnlimited legal liability•• Under law, nonUnder law, non--partnership partnership

business arrangements can be business arrangements can be deemed a partnership under the deemed a partnership under the lawlaw

•• It can be legally challenging to It can be legally challenging to disassociate ones’ self from disassociate ones’ self from and/or dissolve a partnership and/or dissolve a partnership arrangementarrangement

Types of Business OrganizationsTypes of Business OrganizationsTrust CharacteristicsTrust Characteristics

Nature of the BusinessNature of the Business–– Trusts are used to separate Trusts are used to separate ownershipownership from from controlcontrol–– Controlled by a trustee in accordance with the trust documents for the Controlled by a trustee in accordance with the trust documents for the

benefit of the named beneficiary(ies)benefit of the named beneficiary(ies)–– Income that passes through the trust without any taxes payable at the Income that passes through the trust without any taxes payable at the

trust level trust level –– income from the trust is taxed in the hands of the income from the trust is taxed in the hands of the beneficiary/unitholderbeneficiary/unitholder


2 - 50

beneficiary/unitholderbeneficiary/unitholder

ExamplesExamples–– Intervivos and testamentary trusts for estate and tax planning purposesIntervivos and testamentary trusts for estate and tax planning purposes–– OpenOpen--ended mutual funds organized as unit trustsended mutual funds organized as unit trusts–– Many corporations have restructured themselves as income and royalty Many corporations have restructured themselves as income and royalty

truststrusts

FormalityFormality–– Established through a formal trust agreement naming trustee, Established through a formal trust agreement naming trustee,

beneficiary.beneficiary.

Types of Business OrganizationsTypes of Business OrganizationsIncome and Royalty TrustsIncome and Royalty Trusts

Nature of the BusinessNature of the Business–– Invest in both shares and debt of one companyInvest in both shares and debt of one company–– All net cash flows from the business operations pass through the trust All net cash flows from the business operations pass through the trust

without taxationwithout taxationPurpose of the StructurePurpose of the Structure

–– To see as much of the cash flow generated by the underlying business, To see as much of the cash flow generated by the underlying business, pass to the unitholders in the trust without income taxation.pass to the unitholders in the trust without income taxation.


2 - 51

pass to the unitholders in the trust without income taxation.pass to the unitholders in the trust without income taxation.–– Tax efficiency Tax efficiency –– more cash flow passes to the unitholders than through more cash flow passes to the unitholders than through

a traditional common stock investment in the same enterprise.a traditional common stock investment in the same enterprise.StatusStatus

–– Total market capitalization $192 billion (March, 2006)Total market capitalization $192 billion (March, 2006)–– TSX incorporate trusts into the S&P/TSX Composite Index as of March TSX incorporate trusts into the S&P/TSX Composite Index as of March

20062006–– Finance Minister Flaherty announced on October 31, 2006 an intent to Finance Minister Flaherty announced on October 31, 2006 an intent to

tax any newly established Income and Royalty Trust as a corporation. tax any newly established Income and Royalty Trust as a corporation. PreviouslyPreviously--established Trusts will be taxed effective 2011.established Trusts will be taxed effective 2011.

Types of Business OrganizationsTypes of Business OrganizationsTrustsTrusts


•• No taxation of funds flowing No taxation of funds flowing through the trustthrough the trust

•• Separates ownership and Separates ownership and


•• Governance structure may Governance structure may only be appropriate for well only be appropriate for well established firms with little established firms with little


2 - 52

•• Separates ownership and Separates ownership and controlcontrol

established firms with little established firms with little further capital investment further capital investment needsneeds

Types of Business OrganizationsTypes of Business OrganizationsCorporation CharacteristicsCorporation Characteristics

Nature of the BusinessNature of the Business–– A separate legal entity (person) under the law A separate legal entity (person) under the law

•• Incorporated either federally or provinciallyIncorporated either federally or provincially–– Governed by the Board of Directors, managed by professional Governed by the Board of Directors, managed by professional

managers and owned by shareholdersmanagers and owned by shareholders

FinancingFinancing


2 - 53

FinancingFinancing–– Highly flexible and long term including issuing stocks, bonds and Highly flexible and long term including issuing stocks, bonds and

other hybrid securities to raise capital for research and other hybrid securities to raise capital for research and development and overall corporate growthdevelopment and overall corporate growth

FormalityFormality–– Articles of Incorporation, bylaws, practices are governed by Articles of Incorporation, bylaws, practices are governed by

corporate and securities lawcorporate and securities law

Types of Business OrganizationsTypes of Business OrganizationsCorporationsCorporations


•• Immortal Immortal –– issue securities issue securities with very long terms to maturitywith very long terms to maturity

•• Potential to attract great Potential to attract great amounts of financing by amounts of financing by


•• Formality and structure may Formality and structure may slow the speed of response of slow the speed of response of the organizationthe organization

•• Corporate taxation means that Corporate taxation means that


2 - 54

amounts of financing by amounts of financing by expanding the base of expanding the base of shareholdersshareholders

•• Potential to attract and use Potential to attract and use expertise of its board of expertise of its board of directorsdirectors

•• Potential to hire professional Potential to hire professional managers to build valuemanagers to build value

•• Corporate taxation means that Corporate taxation means that shareholder income shareholder income (dividends) are paid out after(dividends) are paid out after--tax and then are taxed in the tax and then are taxed in the hands of shareholders when hands of shareholders when received.received.

Governance of the CorporationGovernance of the CorporationCorporationsCorporations

•• Shareholders are the owners of the corporationShareholders are the owners of the corporation–– Residual claims to profits and assetsResidual claims to profits and assets–– Rights to vote to:Rights to vote to:

•• Elect the board of directorsElect the board of directors


2 - 55

•• Elect the board of directorsElect the board of directors•• Adopt the financial statementsAdopt the financial statements•• Approve the auditors for the coming yearApprove the auditors for the coming year

•• Board of Directors and Managers are Board of Directors and Managers are responsible for dayresponsible for day--toto--day operation of the day operation of the corporation in accordance with standards set out corporation in accordance with standards set out in the corporations act.in the corporations act.

Governance of the CorporationGovernance of the CorporationDirector and Officer ResponsibilitiesDirector and Officer Responsibilities

Canada Business Corporations Act (CBCA Canada Business Corporations Act (CBCA S122.1)S122.1)Every director and officer of a corporation in exercising Every director and officer of a corporation in exercising

their powers and discharging their duties shall:their powers and discharging their duties shall:


2 - 56

their powers and discharging their duties shall:their powers and discharging their duties shall:a)a) Act honestly and in good faith with a view to the best Act honestly and in good faith with a view to the best

interests of the corporation, andinterests of the corporation, andb)b) Exercise the care, diligence and skill that a reasonably Exercise the care, diligence and skill that a reasonably

prudent person would exercise in comparable prudent person would exercise in comparable circumstances.circumstances.

Governance of the CorporationGovernance of the CorporationSeparation of Ownership and ManagementSeparation of Ownership and Management

•• In the modern publiclyIn the modern publicly--traded corporation, professional traded corporation, professional managers and directors manage the corporation; they are managers and directors manage the corporation; they are agents of the shareholders who are the principal ownersagents of the shareholders who are the principal owners

•• It is possible for agents (management) to pursue their own It is possible for agents (management) to pursue their own goals at the expense of the principal (shareholder).goals at the expense of the principal (shareholder).


2 - 57

•• The fact that owners (shareholders) have limited access to The fact that owners (shareholders) have limited access to information about the company they own, and managers and information about the company they own, and managers and the board hold superior information, creates further potential the board hold superior information, creates further potential for conflict.for conflict.

•• Corporate law anticipates the potential for principal/agent Corporate law anticipates the potential for principal/agent conflict and imposes responsibilities and reporting controls on conflict and imposes responsibilities and reporting controls on management to reduce the probability of such conflicts.management to reduce the probability of such conflicts.

Governance of the CorporationGovernance of the CorporationInformation AsymmetryInformation Asymmetry

The fact that owners (shareholders) have limited access to The fact that owners (shareholders) have limited access to information about the company they own, and managers and the information about the company they own, and managers and the board hold superior information, creates the potential for abuse of board hold superior information, creates the potential for abuse of position by management.position by management.

To reduce the potential for conflict arising out of information To reduce the potential for conflict arising out of information


2 - 58

To reduce the potential for conflict arising out of information To reduce the potential for conflict arising out of information asymmetry corporate and securities law requires regular release of asymmetry corporate and securities law requires regular release of information about corporate performance and the right to require information about corporate performance and the right to require approval from shareholders for major changes in the corporation approval from shareholders for major changes in the corporation including:including:

•• Annual shareholders meetings required by proper noticeAnnual shareholders meetings required by proper notice•• Audited financial statementsAudited financial statements•• Approval of auditors for the coming yearApproval of auditors for the coming year•• Shareholder approval for changes to bylaws and articles of Shareholder approval for changes to bylaws and articles of

incorporation incorporation

The Goals of the CorporationThe Goals of the CorporationSeparation of Ownership and Management in the CorporationSeparation of Ownership and Management in the Corporation

Shareholders Shareholders -- PrincipalPrincipal

Board of Directors

Shareholders Elect the Board

There is a separation between

ownership and

management


2 - 59

Chief Executive Officer

Chief Financial Officer Vice President Operations Vice President Marketing

The Board of Directors and Management are

Agents of the Shareholders

The Goals of the CorporationThe Goals of the CorporationProfit MaximizationProfit Maximization

Profit maximization is an inadequate goal to Profit maximization is an inadequate goal to guide officers and directors of the corporation.guide officers and directors of the corporation.

–– It fails to consider the risks undertaken by the firm in It fails to consider the risks undertaken by the firm in


2 - 60

–– It fails to consider the risks undertaken by the firm in It fails to consider the risks undertaken by the firm in pursuit of profitpursuit of profit

–– Its focus is on accounting profitIts focus is on accounting profit–– Its focus is on one year’s accounting profit, Its focus is on one year’s accounting profit,

potentially at the expense of longerpotentially at the expense of longer--term interests of term interests of the shareholderthe shareholder

The Goals of the CorporationThe Goals of the CorporationPressures on ManagementPressures on Management

Professional managers of corporations face Professional managers of corporations face pressures and have responsibilities to many pressures and have responsibilities to many different ‘stakeholders’ different ‘stakeholders’


2 - 61

(See Figure 2(See Figure 2--1 on the following slide.) 1 on the following slide.)

The Goals of the CorporationThe Goals of the CorporationThe Firm As an InputThe Firm As an Input--Output FunctionOutput Function

FIGURE 2-2

PRODUCT/

SOCIAL PRESSURESLABOUR


2 - 62

MANAGERSMANAGERS

GOVERNMENTS

FREE GOODS

PRODUCT/ CONSUMERS

SUPPLIERS

CAPITAL

FREE GOODS

The Goals of the CorporationThe Goals of the CorporationShareholder Wealth MaximizationShareholder Wealth Maximization

Shareholder wealth maximization is considered Shareholder wealth maximization is considered the most appropriate goal to guide officers and the most appropriate goal to guide officers and directors of the corporation.directors of the corporation.


2 - 63

–– Its focus is on genuine economic profitIts focus is on genuine economic profit–– It reflects the value of all economic profits of the It reflects the value of all economic profits of the

corporation now and into the future.corporation now and into the future.

The Goals of the CorporationThe Goals of the CorporationShareholder Wealth Maximization and Negative ExternalitiesShareholder Wealth Maximization and Negative Externalities

Despite the attention given to major Despite the attention given to major corporations because of negative externalities, corporations because of negative externalities, the agents of the corporation must:the agents of the corporation must:


2 - 64

the agents of the corporation must:the agents of the corporation must:–– Operate legally and in compliance with contractual Operate legally and in compliance with contractual

responsibilities,responsibilities,–– In the interests of its owners by creating value for In the interests of its owners by creating value for

them.them.

Role of Management and Agency IssuesRole of Management and Agency IssuesDefinitionsDefinitions

•• Agency RelationshipAgency Relationship–– Managers work on behalf of the shareholdersManagers work on behalf of the shareholders

•• Agency ProblemsAgency Problems–– Problems that arise due to potential divergence of Problems that arise due to potential divergence of


2 - 65

–– Problems that arise due to potential divergence of Problems that arise due to potential divergence of interest between managers, shareholders and interest between managers, shareholders and creditorscreditors

•• Agency CostsAgency Costs–– The costs associated with agency problemsThe costs associated with agency problems

Agency CostsAgency CostsDirect CostsDirect Costs

•• Direct Agency CostsDirect Agency Costs–– Arise because suboptimal decisions are made by Arise because suboptimal decisions are made by

managers when the act in a manner that is not in the managers when the act in a manner that is not in the best interests of shareholdersbest interests of shareholders


2 - 66

best interests of shareholdersbest interests of shareholders–– Examples:Examples:

•• Managers avoiding high risk projects because they have an Managers avoiding high risk projects because they have an undiversified stake in the health of the corporation (they undiversified stake in the health of the corporation (they could lose their job if the outcome is negative)could lose their job if the outcome is negative)

•• Managers spending corporate resources on luxurious offices, Managers spending corporate resources on luxurious offices, executive aircraft, pension plans and poison pills that favour executive aircraft, pension plans and poison pills that favour their own self interest at the expense of shareholderstheir own self interest at the expense of shareholders

Agency CostsAgency CostsIndirect CostsIndirect Costs

•• Indirect Agency CostsIndirect Agency Costs–– Are incurred by the corporation in the attempt to avoid direct Are incurred by the corporation in the attempt to avoid direct

agency costsagency costs–– Examples:Examples:

•• Shareholder approval required before management can change the Shareholder approval required before management can change the


2 - 67

•• Shareholder approval required before management can change the Shareholder approval required before management can change the articles of incorporate or bylaws or make major changes in share articles of incorporate or bylaws or make major changes in share capitalcapital

•• Reporting requirements placed on management including, annual Reporting requirements placed on management including, annual report, audited financial statements, requirements for notice of report, audited financial statements, requirements for notice of annual and special shareholders meetingsannual and special shareholders meetings

•• Elaborate compensation schemes including use of stock options Elaborate compensation schemes including use of stock options used to try to align the interests of managers with shareholders.used to try to align the interests of managers with shareholders.

Agency CostsAgency CostsAreas of For Potential DisagreementAreas of For Potential Disagreement

•• Managers and shareholders may have differing Managers and shareholders may have differing goals, attitudes toward risk, and differential goals, attitudes toward risk, and differential access to information.access to information.–– This can lead to areas of disagreementThis can lead to areas of disagreement


2 - 68

–– This can lead to areas of disagreementThis can lead to areas of disagreement

See Table 2See Table 2--2 on the following slide. 2 on the following slide.

Role of Management and Agency IssuesRole of Management and Agency IssuesAreas of Disagreement between Shareholders and ManagersAreas of Disagreement between Shareholders and Managers

Managers Shareholders

Performance Appraisal Accounting

ROI/cash Market Prices

Table 2-2 Areas of Disagreement


2 - 69

ROI/cash Market Prices

Investment Analysis IRR of best division WACC external

Financing Retentions DebtDebt RetentionsNew Equity New equity

Risk Preservation of firm Portfolio

Agency CostsAgency CostsExecutive CompensationExecutive Compensation

•• In an attempt to align managements interests with In an attempt to align managements interests with shareholders, Boards of Directors have tried to tie shareholders, Boards of Directors have tried to tie compensation to performance measures.compensation to performance measures.

•• These compensation schemes are not always effective in These compensation schemes are not always effective in achieving their goal and have lead to concerns about achieving their goal and have lead to concerns about


2 - 70

achieving their goal and have lead to concerns about achieving their goal and have lead to concerns about excessive management compensation.excessive management compensation.

See Table 2See Table 2--3 on the following slide. 3 on the following slide.

Role of Management and Agency Issues Role of Management and Agency Issues Compensation Arrangements for CEOsCompensation Arrangements for CEOs

CEO Company Salary ($million)

Bonus ($million)

Shares/ Options ($million)

Other ($million)

Total ($million)

Hank Swartout Precision Drilling Trust 0.84 3.36 55.03 15.59 74.82

Hunter Harrison Canadian National Railway Co. 1.67 4.67 48.18 1.71 56.22

Table 2-3 Canadian Executive Compensation, 2005


2 - 71

Hunter Harrison Canadian National Railway Co. 1.67 4.67 48.18 1.71 56.22Mike Zafirovski Nortel Networks Corp. 0.31 0.00 8.42 28.70 37.43

John Hunkin CIBC 0.75 0.00 28.72 0.00 29.47

James Buckee Talisman Energy Inc. 1.10 1.99 20.09 0.15 23.33

William Doyle Potash Corp. of Saskatchewan Inc. 1.15 1.28 19.53 0.16 22.13

Donald Walker Magna International Inc. 0.20 6.06 13.26 0.04 19.56

Andre Desmarais Power Corp. of Canada 0.91 0.70 16.69 0.55 18.84

Gwyn Morgan EnCana Corp. 1.48 2.66 13.87 0.16 18.16Richard Waugh Bank of Nova Scotia 1.00 1.50 14.40 0.28 17.18

Source: "Executive Compensation 2005." Report on Business w ebsite: <w w w .globeandmail.com>.

What Is Corporate Finance? What Is Corporate Finance?

•• The financial management of assets and The financial management of assets and corporate financing decisionscorporate financing decisions


2 - 72

(See Table 2(See Table 2--4 on the following slide for a 4 on the following slide for a snapshot of the Canadian Corporate Balance Sheet) snapshot of the Canadian Corporate Balance Sheet)

Corporate Finance Corporate Finance Corporate Balance SheetCorporate Balance Sheet

($ billion) Liabilities ($billion)

Real AssetsBuildings 815Machinery and Equipment 362

Inventories 191

Table 2-4 Non-Financial Corporate Canada Balance Sheet, 2005

Assets


2 - 73

Land 281 Payables 203

Financial Assets Loans 321

Deposits 259 Paper 53

Receivables 249 Mortgages 114

Paper 29 Bonds 321

Debt 22 Claims 296

Claims 509 Shares 1659

Other 294 Other 44

Source: Statistics Canada. National Balance Sheet Accounts, Quarterly Estimates, Fourth Quarter 2005.

Ottaw a: Minister of Industry, 2006 (Catalogue No. 13-214-XIE).

Corporate Finance Corporate Finance What Senior Managers DoWhat Senior Managers Do

•• Financial Management of AssetsFinancial Management of Assets–– Capital budgeting decisionsCapital budgeting decisions

•• Analysis and decision making with respect to asset Analysis and decision making with respect to asset investment, acquisition, and replacementinvestment, acquisition, and replacement


2 - 74

investment, acquisition, and replacementinvestment, acquisition, and replacement

–– Credit decisions, cash management, investment Credit decisions, cash management, investment decisionsdecisions

•• Corporate Financing DecisionsCorporate Financing Decisions–– Ratio of debt and equity, raising equity capital through Ratio of debt and equity, raising equity capital through

profit retention or new share issues, dividend policy, profit retention or new share issues, dividend policy, borrowing decisions, liability managementborrowing decisions, liability management

Finance Careers Finance Careers In NonIn Non--Financial FirmsFinancial Firms

•• Chief Financial Officer (CFO)/Senior viceChief Financial Officer (CFO)/Senior vice--president of financepresident of finance

•• Treasurer (pure finance)Treasurer (pure finance)–– Forecasting, pension management, capital budgeting, Forecasting, pension management, capital budgeting,


2 - 75

–– Forecasting, pension management, capital budgeting, Forecasting, pension management, capital budgeting, cash management, credit management, financing, cash management, credit management, financing, risk managementrisk management

•• Controller (finance and accounting)Controller (finance and accounting)–– Compliance, tax management, systems, internal Compliance, tax management, systems, internal

audit, accounting, budgetingaudit, accounting, budgeting(See Figure 2(See Figure 2--2 on the following slide)2 on the following slide)

Organization of the Finance FunctionOrganization of the Finance FunctionFinance in the NonFinance in the Non--Financial CompanyFinancial Company

TREASURER

CFO

CONTROLLER

FIGURE 2-1


2 - 76

ComplianceTax Management

Systems / MISInternal Audit

AccountingBudgeting

ComplianceTax Management

Systems / MISInternal Audit

AccountingBudgeting

ForecastingPension Management

Capital BudgetingCash Management

Credit ManagementFinancing

Risk Management

ForecastingPension Management

Capital BudgetingCash Management

Credit ManagementFinancing

Risk Management

Finance Careers Finance Careers In Financial InstitutionsIn Financial Institutions

•• AnalystsAnalysts•• AssociatesAssociates•• ManagersManagers•• Account ManagersAccount Managers

•• Financial and Investment Financial and Investment AnalystsAnalysts

•• Portfolio ManagersPortfolio Managers•• Fixed income or equity Fixed income or equity

traderstraders


2 - 77

•• Banking AssociatesBanking Associates•• Security AnalystsSecurity Analysts•• Sales and Trading peopleSales and Trading people•• Private BankersPrivate Bankers•• Retail BrokersRetail Brokers

traderstraders•• Corporate finance Corporate finance

associates and consultantsassociates and consultants

SummarySummary

•• In this chapter you have learned:In this chapter you have learned:–– About alternative ways to organize business enterprisesAbout alternative ways to organize business enterprises–– About the pressures on corporations to create shareholder About the pressures on corporations to create shareholder

valuevalue–– That agency relationships pose unique challenges on That agency relationships pose unique challenges on


2 - 78

–– That agency relationships pose unique challenges on That agency relationships pose unique challenges on corporations that result in additional costs to be borne by the corporations that result in additional costs to be borne by the firmfirm

–– About the major decisions facing financial managers, andAbout the major decisions facing financial managers, and–– About the major types of finance jobs in financial and nonAbout the major types of finance jobs in financial and non--

financial companies.financial companies.


CORPORATE FINANCECORPORATE FINANCELaurence Booth Laurence Booth •• W. Sean ClearyW. Sean ClearyLaurence Booth Laurence Booth •• W. Sean ClearyW. Sean Cleary

CHAPTER 3CHAPTER 3Financial StatementsFinancial StatementsFinancial StatementsFinancial Statements


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• Accounting PrinciplesAccounting Principles

www.bookfiesta4u.com ContentsCHAPTER 3 – Financial Statements

3 - 81

•• Accounting PrinciplesAccounting Principles•• Organizing a Firm’s TransactionsOrganizing a Firm’s Transactions•• Preparing Accounting StatementsPreparing Accounting Statements•• The Canadian Tax SystemThe Canadian Tax System•• Summary and ConclusionsSummary and Conclusions



1.1. The importance of preparing financial statements in accordance The importance of preparing financial statements in accordance with a given set of guidelines or principles, and what the most with a given set of guidelines or principles, and what the most important principles areimportant principles are

2.2. The fact that preparing accounting statements involves the use of The fact that preparing accounting statements involves the use of judgementjudgement

3.3. How the basic financial statements for a company are constructedHow the basic financial statements for a company are constructed


3 - 82

3.3. How the basic financial statements for a company are constructedHow the basic financial statements for a company are constructed4.4. The important information that can be found on a company’s The important information that can be found on a company’s

balance sheet, income statement and cash flow statementbalance sheet, income statement and cash flow statement5.5. Why accounting income differs from income for tax purposesWhy accounting income differs from income for tax purposes6.6. How the capital cost allowance (CCA) system worksHow the capital cost allowance (CCA) system works7.7. How different forms of investment income are taxed for How different forms of investment income are taxed for

corporations and for individuals.corporations and for individuals.


•• AmortizationAmortization•• Balance sheetBalance sheet•• Capital gainCapital gain•• Capital lossCapital loss

•• Generally accepted accounting Generally accepted accounting principles (GAAP)principles (GAAP)

•• HalfHalf--year ruleyear rule•• Income statementIncome statement•• LiquidityLiquidity


3 - 83

•• Cash flow from operationsCash flow from operations•• Cash flow statementCash flow statement•• CCA recaptureCCA recapture•• Current assetsCurrent assets•• DepreciationDepreciation•• Free cash flowFree cash flow

•• LiquidityLiquidity•• Operating lossOperating loss•• Terminal lossTerminal loss•• Traditional cash flowTraditional cash flow•• Undepreciated capital cost Undepreciated capital cost

(UCC)(UCC)

Importance of Understanding AccountingImportance of Understanding Accounting

•• Accounting is an organized way of summarizing Accounting is an organized way of summarizing the activities of business.the activities of business.

•• Internal and external users of accounting Internal and external users of accounting information rely on accounting information to information rely on accounting information to


3 - 84

information rely on accounting information to information rely on accounting information to make decisions.make decisions.

•• A strong understanding of accounting is required A strong understanding of accounting is required of financial managers because they use that of financial managers because they use that information to make significant management information to make significant management decisions that will affect the future financial decisions that will affect the future financial reports of the organization.reports of the organization.

Accounting PrinciplesAccounting Principles

•• Generally Accepted Accounting Principals Generally Accepted Accounting Principals (GAAP) are contained in the CICA Handbook (GAAP) are contained in the CICA Handbook and have the force of law in Canada.and have the force of law in Canada.

•• The Income Tax Act (ITA) requires use of the The Income Tax Act (ITA) requires use of the CICA Handbook, except where specifically, the CICA Handbook, except where specifically, the Act requires other treatment.Act requires other treatment.–– This has led to the practice of Canadian This has led to the practice of Canadian


3 - 85

–– This has led to the practice of Canadian This has led to the practice of Canadian companies reporting to shareholders using CICA companies reporting to shareholders using CICA GAAP, and preparing separate financial GAAP, and preparing separate financial statements for Canada Revenue Agency (CRA)statements for Canada Revenue Agency (CRA)

•• Reporting of financial performance in a Reporting of financial performance in a consistent manner over time and between firms consistent manner over time and between firms enhances the usefulness of those reports enhances the usefulness of those reports allowing comparative analysis.allowing comparative analysis.

Accounting PrinciplesAccounting PrinciplesInternational ConvergenceInternational Convergence

•• Different countries have different accounting standards:Different countries have different accounting standards:–– Canada Canada –– (CICA) Canadian Institute of Chartered Accountants (CICA) Canadian Institute of Chartered Accountants

HandbookHandbook–– United States United States –– (FASB) Financial Accounting Standards Board(FASB) Financial Accounting Standards Board–– Japan Japan –– (ASBJ) Accounting Standards Board of Japan(ASBJ) Accounting Standards Board of Japan


3 - 86

–– Japan Japan –– (ASBJ) Accounting Standards Board of Japan(ASBJ) Accounting Standards Board of Japan•• Given the growing importance of international trade, Given the growing importance of international trade,

integration of product and financial markets, there is a need integration of product and financial markets, there is a need for countries to move to a common set of accounting for countries to move to a common set of accounting standards.standards.–– (IASB) London(IASB) London--based International Accounting Standards Board based International Accounting Standards Board

has been working with FASB and other accounting boards from has been working with FASB and other accounting boards from numerous countries to work toward a common standard.numerous countries to work toward a common standard.

Accounting PrinciplesAccounting PrinciplesRecent Accounting ScandalsRecent Accounting Scandals

•• ENRONENRON–– Bankruptcy of one of the largest U.S. firms because of Bankruptcy of one of the largest U.S. firms because of

financial statement misrepresentation involving the financial statement misrepresentation involving the external auditor (Arthur Andersen), management, and external auditor (Arthur Andersen), management, and financial partners including Merrill Lynch, Citigroup, financial partners including Merrill Lynch, Citigroup,


3 - 87

financial partners including Merrill Lynch, Citigroup, financial partners including Merrill Lynch, Citigroup, CIBC and othersCIBC and others

•• Other accounting/investment scandals involving Other accounting/investment scandals involving WorldCom, Tyco, BristolWorldCom, Tyco, Bristol--Myers, Nortel and Myers, Nortel and others demonstrate that the ENRON issue was others demonstrate that the ENRON issue was not an isolated incident.not an isolated incident.

Accounting PrinciplesAccounting PrinciplesImpact of Recent Accounting ScandalsImpact of Recent Accounting Scandals

•• Investors base investment decisions and Investors base investment decisions and estimate the value of stock using accounting estimate the value of stock using accounting information.information.

•• Recent accounting scandals where financial Recent accounting scandals where financial statements were found either to misstate the statements were found either to misstate the


3 - 88

statements were found either to misstate the statements were found either to misstate the financial results, or later required revision has financial results, or later required revision has shaken the confidence of investors in financial shaken the confidence of investors in financial markets.markets.

•• U.S. Congress in 2002 passed the SarbanesU.S. Congress in 2002 passed the Sarbanes--Oxley Act (SOX) in an attempt to restore Oxley Act (SOX) in an attempt to restore investor confidence. investor confidence.

Accounting PrinciplesAccounting PrinciplesMain Provisions SarbanesMain Provisions Sarbanes--Oxley Act 2002Oxley Act 2002

•• Creation of the Public Company Accounting Oversight BoardCreation of the Public Company Accounting Oversight Board–– Register and inspect public accounting firmsRegister and inspect public accounting firms–– Establish audit standards Establish audit standards

•• Separation of the audit function from other services provided by Separation of the audit function from other services provided by auditing firmsauditing firms

•• Improve governance standardsImprove governance standards


3 - 89

•• Improve governance standardsImprove governance standards–– Separate board committees for finance and auditSeparate board committees for finance and audit–– External auditors must report to the audit committeeExternal auditors must report to the audit committee–– Audit committee independence (membership must be dominated by Audit committee independence (membership must be dominated by

external directors) and financial expertiseexternal directors) and financial expertise•• Requires the annual report to indicate the state of the firm’s internal Requires the annual report to indicate the state of the firm’s internal

controls and assess their effectivenesscontrols and assess their effectiveness•• CEO and CFO must ‘certify’ that the firms financial statements CEO and CFO must ‘certify’ that the firms financial statements

“fairly present in all material respects, the operations and financial “fairly present in all material respects, the operations and financial condition of the issuer”condition of the issuer”

Organizing a Firm’s TransactionsOrganizing a Firm’s TransactionsBookkeeping Versus AccountingBookkeeping Versus Accounting

BookkeepingBookkeeping•• is the mechanical act of managing and recording is the mechanical act of managing and recording

transactions.transactions.


3 - 90

AccountingAccounting•• is the application of GAAP principles and is the application of GAAP principles and

conventions to the bookkeeping data to produce conventions to the bookkeeping data to produce financial statements that fairly represent the financial statements that fairly represent the financial condition and operations of the financial condition and operations of the economic entity.economic entity.

Organizing a Firm’s TransactionsOrganizing a Firm’s TransactionsAccounting Conventions: The Basic PrinciplesAccounting Conventions: The Basic Principles

The most basic principles of GAAP are:The most basic principles of GAAP are:1.1. The entity conceptThe entity concept2.2. The going concern principleThe going concern principle3.3. A period of analysisA period of analysis


3 - 91

3.3. A period of analysisA period of analysis4.4. A monetary valueA monetary value5.5. The matching principleThe matching principle6.6. Revenue recognitionRevenue recognition


The most basic principles of GAAP are:The most basic principles of GAAP are:1.1. The entity conceptThe entity concept

•• The accounting is for a specific economic entityThe accounting is for a specific economic entity2.2. The going concern principleThe going concern principle

•• The statements are prepared on the basis that the economic entity will The statements are prepared on the basis that the economic entity will continue to operate into the future (hence liquidation values, for example, continue to operate into the future (hence liquidation values, for example, are not relevant)are not relevant)

3.3. A period of analysisA period of analysis


3 - 92

3.3. A period of analysisA period of analysis•• Usually a fiscal year, although quarterly and monthly financial statements Usually a fiscal year, although quarterly and monthly financial statements

are also producedare also produced4.4. A monetary valueA monetary value

•• Historical costs are used because the objectivity inherent in armsHistorical costs are used because the objectivity inherent in arms--length length transactionstransactions

5.5. The matching principleThe matching principle•• Expenses incurred must be matched to the revenue earned in the period of Expenses incurred must be matched to the revenue earned in the period of

analysis.analysis.6.6. Revenue recognitionRevenue recognition

•• Revenue is recognized when it has been earned (even though the cash Revenue is recognized when it has been earned (even though the cash may not yet have been received).may not yet have been received).


The major conventions of GAAP are:The major conventions of GAAP are:1.1. Procedures Procedures 2.2. Standards Standards 3.3. Consistency Consistency


3 - 93

3.3. Consistency Consistency 4.4. MaterialityMateriality5.5. DisclosureDisclosure


The major conventions of GAAP are:The major conventions of GAAP are:1.1. ProceduresProcedures

•• Assets are on the left, liabilities and equities on the rightAssets are on the left, liabilities and equities on the right--hand side hand side of the balance sheet of the balance sheet

2.2. StandardsStandards•• CICA Handbook CICA Handbook

3.3. Consistency Consistency


3 - 94

3.3. Consistency Consistency •• The firm should consistently apply the same accounting principles The firm should consistently apply the same accounting principles

over time to ensure comparability of financial statements from prior over time to ensure comparability of financial statements from prior periodsperiods

4.4. MaterialityMateriality•• All significant information is disclosedAll significant information is disclosed

5.5. DisclosureDisclosure•• The financial statements should fully and fairly disclose the firm’s The financial statements should fully and fairly disclose the firm’s

financial position. Objectivity, consistency and conformity to financial position. Objectivity, consistency and conformity to GAAP are all aspects of full disclosureGAAP are all aspects of full disclosure

Preparing Accounting StatementsPreparing Accounting StatementsThe Balance SheetThe Balance Sheet

•• The balance sheet is a financial ‘snapshot’ at The balance sheet is a financial ‘snapshot’ at one point in time (usually on the last day of the one point in time (usually on the last day of the firm’s fiscal year)firm’s fiscal year)

•• It is an ‘inventory’ of what the firm owns (assets) It is an ‘inventory’ of what the firm owns (assets)


3 - 95

•• It is an ‘inventory’ of what the firm owns (assets) It is an ‘inventory’ of what the firm owns (assets) and how those assets were financed (liabilities and how those assets were financed (liabilities and owners equity)and owners equity)–– LeftLeft--hand side lists assetshand side lists assets–– RightRight--hand side list liabilities and owners equityhand side list liabilities and owners equity–– Top to bottom items are listed from most liquid, to Top to bottom items are listed from most liquid, to

least liquidleast liquid

Preparing Accounting StatementsPreparing Accounting StatementsThe Balance Sheet The Balance Sheet –– Basic StructureBasic Structure

ABC Corporation LimitedBalance Sheet

as at March 31, 200X

Basic Balance Sheet Structure


3 - 96

Cash 5 Accrued wages and taxes 5Marketable Securities 10 Accounts payable 5Accounts Receivable 10 Long-term debt 20Inventory 25 Common stock 40Net fixed assets 100 Retained earnings 80Total assets 150 Total liabilities and owners equity 150

Preparing Accounting StatementsPreparing Accounting StatementsThe Income StatementThe Income Statement

•• Also known as the profit and loss statementAlso known as the profit and loss statement•• Reports the income earned over a given period Reports the income earned over a given period

of timeof time–– Usually prepared to report on one fiscal yearUsually prepared to report on one fiscal year


3 - 97

–– Usually prepared to report on one fiscal yearUsually prepared to report on one fiscal year–– Can be prepared for a quarter of a year (3 months) or Can be prepared for a quarter of a year (3 months) or

even a montheven a month

•• Reports expenses incurred in order to earn that Reports expenses incurred in order to earn that income (application of the matching principle)income (application of the matching principle)

•• Shows sales, expenses and net profit for a given Shows sales, expenses and net profit for a given period.period.

Preparing Accounting StatementsPreparing Accounting StatementsThe Income Statement The Income Statement –– Basic StructureBasic Structure

ABC Corporation LimitedIncome Statement

for the year ended March 31, 200X

Revenues $6,700,000Cost of goods sold 4,020,000

Basic Income Statement Structure

Variable Costs including

direct materials and direct labour.


3 - 98

Cost of goods sold 4,020,000Gross margin 2,680,000Selling and administrative expenses 1,500,000Earnings before Interest and Taxes 1,180,000Interest expense 450,000Earnings before tax 730,000Income taxes 233,600Net income $496,400

Dividends $100,000Retained earnings $396,400






Fixed period costs

including


3 - 99



including salaries, rent and

depreciation.






Financing costs.

Interest expense is


3 - 100



expense is tax-

deductible.






Profit after tax may be retained in whole or in


3 - 101



whole or in part to be

reinvested in the firm and

fuel the firm’s

growth.

Preparing Accounting StatementsPreparing Accounting StatementsChanging Accounting AssumptionsChanging Accounting Assumptions

•• GAAP provides flexibility in the accounting treatment of things GAAP provides flexibility in the accounting treatment of things such as:such as:–– When to recognize revenueWhen to recognize revenue–– Capitalizing expenses as assets versus expensing expendituresCapitalizing expenses as assets versus expensing expenditures–– Rates of accounting depreciationRates of accounting depreciation

•• Managements may have strong pressures on them to make Managements may have strong pressures on them to make the financial performance of the firm look as good as possible the financial performance of the firm look as good as possible


3 - 102

the financial performance of the firm look as good as possible the financial performance of the firm look as good as possible (indeed often their personal compensation may be affected by (indeed often their personal compensation may be affected by the accounting results)the accounting results)–– Consequently, managements may seek to change accounting Consequently, managements may seek to change accounting

assumptions (within the limits allowed by GAAP) to suit their assumptions (within the limits allowed by GAAP) to suit their needs and current circumstances facing the firm.needs and current circumstances facing the firm.

•• Any change in application of GAAP must be disclosed in the audited Any change in application of GAAP must be disclosed in the audited financial statements and could jeopardize the audit opinion offered financial statements and could jeopardize the audit opinion offered by the external auditors.by the external auditors.

Preparing Accounting StatementsPreparing Accounting StatementsTax StatementsTax Statements

•• In Canada businesses must report to CRA and remit income taxes In Canada businesses must report to CRA and remit income taxes in accordance with the Income Tax Act.in accordance with the Income Tax Act.–– They are required to use CCA instead of depreciationThey are required to use CCA instead of depreciation

•• Firms in Canada also tend to produce a separate set of financial Firms in Canada also tend to produce a separate set of financial statements for shareholders, prepared in accordance with GAAP.statements for shareholders, prepared in accordance with GAAP.

•• Because CCA is an ‘accelerated’ method of amortization, and Because CCA is an ‘accelerated’ method of amortization, and because assets are often replaced more frequently than they are because assets are often replaced more frequently than they are


3 - 103

because assets are often replaced more frequently than they are because assets are often replaced more frequently than they are fully depreciated, then fully depreciated, then –– Actual income tax liability in accordance with ITA using CCA is usually Actual income tax liability in accordance with ITA using CCA is usually

less than what is ‘estimated’ when reporting to shareholders.less than what is ‘estimated’ when reporting to shareholders.–– This ‘interThis ‘inter--temporal’ difference in tax liability is called ‘deferred taxes’ temporal’ difference in tax liability is called ‘deferred taxes’

and capitalized on balance sheets when reporting to shareholders.and capitalized on balance sheets when reporting to shareholders.

NOTE: deferred taxes DOES NOT mean that the firm hasn’t paid its full tax NOTE: deferred taxes DOES NOT mean that the firm hasn’t paid its full tax liability to the government…it has.liability to the government…it has.

Preparing Accounting StatementsPreparing Accounting StatementsAccounting Income, Income for Tax and Economic IncomeAccounting Income, Income for Tax and Economic Income

Accounting IncomeAccounting Income–– Net profit arrived at using GAAP and accounting depreciationNet profit arrived at using GAAP and accounting depreciation

Income for Tax PurposesIncome for Tax Purposes–– Net profit arrived at using GAAP and CCA in accordance with ITANet profit arrived at using GAAP and CCA in accordance with ITA

Economic IncomeEconomic Income–– The amount of funds a firm could withdraw from the firm at the end of an The amount of funds a firm could withdraw from the firm at the end of an

accounting period, and leave the firm in the same income earning accounting period, and leave the firm in the same income earning


3 - 104

accounting period, and leave the firm in the same income earning accounting period, and leave the firm in the same income earning position as it started the periodposition as it started the period

Generally:Generally:Accounting Income > Tax Income > Economic IncomeAccounting Income > Tax Income > Economic Income

–– Accounting income is usually greater than income for tax because the CCA Accounting income is usually greater than income for tax because the CCA deductions are usually greater than accounting depreciationdeductions are usually greater than accounting depreciation

–– Economic income is less than income for tax because CCA and accounting Economic income is less than income for tax because CCA and accounting depreciation amounts are based on historical cost, and this understates the depreciation amounts are based on historical cost, and this understates the amount of money the firm must retain, to replace its asset base at higher amount of money the firm must retain, to replace its asset base at higher replacement costs.replacement costs.

Preparing Accounting StatementsPreparing Accounting StatementsCash Flow StatementsCash Flow Statements

•• Accounting profit may not reflect the cash flow reality facing Accounting profit may not reflect the cash flow reality facing the firm.the firm.

•• The cash flow statement helps to provide a clearer picture of The cash flow statement helps to provide a clearer picture of where cash is coming from and where it is going.where cash is coming from and where it is going.

•• Analysts are very interested in the cash flow realities of the Analysts are very interested in the cash flow realities of the


3 - 105

•• Analysts are very interested in the cash flow realities of the Analysts are very interested in the cash flow realities of the firm because they realize that accounting profit is often not firm because they realize that accounting profit is often not available to manage to pay bills.available to manage to pay bills.

•• There are two ways to calculate the cash flow statement:There are two ways to calculate the cash flow statement:1.1. Examine changes in the balance sheet accountsExamine changes in the balance sheet accounts2.2. Add by nonAdd by non--cash items to net income.cash items to net income.

The Cash Flow StatementThe Cash Flow StatementChanges in Balance Sheet AccountsChanges in Balance Sheet Accounts

Sources of CashSources of Cash–– Any decrease in an assetAny decrease in an asset–– Any increase in a liabilityAny increase in a liability–– Any increase in common stock (capital account)Any increase in common stock (capital account)


3 - 106

–– Any increase in common stock (capital account)Any increase in common stock (capital account)–– Any increase in retained earningsAny increase in retained earnings

Uses of CashUses of Cash–– Any increase in an assetAny increase in an asset–– Any decrease in a liabilityAny decrease in a liability

The Cash Flow StatementThe Cash Flow StatementChanges in Balance Sheet Accounts Changes in Balance Sheet Accounts -- ExampleExample

Sources and Uses of Funds for Jim's Widgets

Sources of FundsIncrease in payables $5,000Increase in accruals 1,000Increase in loans 10,000Increase in deferred taxes 1,500

Example of Sources and Uses of Funds


3 - 107

Increase in deferred taxes 1,500Increase in owner's equity 44,000Increased retained earnings 2,000 Total sources of cash 63,500

Uses of FundsIncrease in receivables $5,000Increase in inventory 2,000Increase in prepaid expenses 3,500Increase in machinery 28,000 Total uses of cash 38,500Increase in cash 25,000

The Cash Flow StatementThe Cash Flow StatementNet Income Plus NonNet Income Plus Non--cash Itemscash Items

–– Start with net incomeStart with net income–– Add back the nonAdd back the non--cash items in the income cash items in the income

statement (usually depreciation/amortization and statement (usually depreciation/amortization and deferred income taxes)deferred income taxes)


3 - 108

deferred income taxes)deferred income taxes)

The Cash Flow StatementThe Cash Flow StatementNet Income Plus NonNet Income Plus Non--cash Items cash Items -- ExampleExample

Cash Flow Statement for Jim's Widgets

Net income $2,000Depreciation 2,000Deferred income taxes 1,500

Example of Cash Flow Statement

www.bookfiesta4u.com ContentsCHAPTER 3 – Financial Statements 3 - 109

Traditional cash flow 5,500Increase in receivables -5,000Increase in prepaids -3,500Increase in inventory -2,000Increase in accruals 1,000Increase in payables 5,000Increase in net working capital -$4,500Cash flow from operations 1,000Capital expenditures -30,000Free cash flow -29,000

The Canadian Tax SystemThe Canadian Tax System

•• Federal and Provincial Governments in Canada tax Federal and Provincial Governments in Canada tax individuals and corporations based on income earned.individuals and corporations based on income earned.

•• Corporations pay income taxes, and then, out of afterCorporations pay income taxes, and then, out of after--tax tax profit, distribute dividends to shareholders.profit, distribute dividends to shareholders.


3 - 110

•• Dividends received by shareholders are taxed again as one Dividends received by shareholders are taxed again as one form of personal investment income.form of personal investment income.–– Recognizing the doubleRecognizing the double--taxation of dividends, dividends from taxation of dividends, dividends from

Canadian corporations are given some partial relief through the Canadian corporations are given some partial relief through the ‘dividend gross‘dividend gross--up, tax credit system’ up, tax credit system’

–– Dividends received from nonDividends received from non--Canadian companies do not qualify Canadian companies do not qualify for this special tax treatment.for this special tax treatment.

Corporate Income TaxationCorporate Income Taxation

•• Corporate tax is paid at a ‘flat’ or fixed rate on ‘taxable income’Corporate tax is paid at a ‘flat’ or fixed rate on ‘taxable income’–– Small businesses (income of $300,000 or less) face approximately (the Small businesses (income of $300,000 or less) face approximately (the

actual rate varies by province) a 20% tax on income (combined federal actual rate varies by province) a 20% tax on income (combined federal and provincial)and provincial)

•• Companies are free to chose their own taxation year (fiscal year) but Companies are free to chose their own taxation year (fiscal year) but once established cannot alter it without justification and approval.once established cannot alter it without justification and approval.

•• Taxable income generally is income earned during the fiscal year Taxable income generally is income earned during the fiscal year less expenses incurred in order to earn that income.less expenses incurred in order to earn that income.


3 - 111

•• Taxable income generally is income earned during the fiscal year Taxable income generally is income earned during the fiscal year less expenses incurred in order to earn that income.less expenses incurred in order to earn that income.–– The income statement shows that variable costs and period overhead The income statement shows that variable costs and period overhead

costs can be subtracted in determining EBITcosts can be subtracted in determining EBIT–– For tax purposes, the ITA requires that the Capital Cost Allowance For tax purposes, the ITA requires that the Capital Cost Allowance

system be used instead of accounting depreciation (amortization)system be used instead of accounting depreciation (amortization)–– Interest expense on debt borrowed to earn income is generally Interest expense on debt borrowed to earn income is generally

deductible from earnings before the tax is determined.deductible from earnings before the tax is determined.

CCACCA

Capital Cost Allowance (CCA) is the Capital Cost Allowance (CCA) is the ‘depreciation’ method used by taxpayers in ‘depreciation’ method used by taxpayers in Canada when reporting business income to CRA Canada when reporting business income to CRA


3 - 112

Canada when reporting business income to CRA Canada when reporting business income to CRA Canada Revenue Agency for tax purposes.Canada Revenue Agency for tax purposes.

Importance of CCA to Financial Importance of CCA to Financial DecisionsDecisions

•• Taxation issues must be explicitly addressed in Taxation issues must be explicitly addressed in each financial decision you make.each financial decision you make.

•• Since CCA affects the net income from a Since CCA affects the net income from a


3 - 113

•• Since CCA affects the net income from a Since CCA affects the net income from a business (and especially affects net cash flow), business (and especially affects net cash flow), knowledge of the CCA system is essential for all knowledge of the CCA system is essential for all business decisionbusiness decision--makers.makers.

CCA gives rise to a ‘Tax Shield Benefit’ to CCA gives rise to a ‘Tax Shield Benefit’ to the Companythe Company

•• CCA is a CCA is a nonnon--cashcash deduction from income that would otherwise be deduction from income that would otherwise be subject to income taxation.subject to income taxation.

•• As a result of the CCA deduction, taxable income is reduced.As a result of the CCA deduction, taxable income is reduced.•• This results in a savings in tax payable.This results in a savings in tax payable.•• The tax shield benefits is equal to: T(CCA)The tax shield benefits is equal to: T(CCA)

www.bookfiesta4u.com ContentsCHAPTER 3 – Financial Statements 3 - 114

t = corporate tax ratet = corporate tax rate

CCA = the dollar amount of CCA claimedCCA = the dollar amount of CCA claimed•• A firm with a 40% corporate tax rate and a $2,000 CCA deduction will A firm with a 40% corporate tax rate and a $2,000 CCA deduction will

save $800 in taxes.save $800 in taxes.

$800 $2,00040%

CCA RateTax Corporate CCA on SavingsTax

=×=×=

Example:Example:Consider two firms that report $10,000 in earnings before CCA and taxes, face a 40% tax rate. One Consider two firms that report $10,000 in earnings before CCA and taxes, face a 40% tax rate. One

firm has no CCA to claim, the other can claim $2,000 in CCAfirm has no CCA to claim, the other can claim $2,000 in CCA

Company ACompany A Company BCompany BEarnings Before CCA & TaxEarnings Before CCA & Tax $10,000$10,000 $10,000$10,000CCACCA 2,0002,000 00Taxable IncomeTaxable Income $ 8,000$ 8,000 $ 10,000$ 10,000


3 - 115

Taxes @ 40%Taxes @ 40% 3,2003,200 4,0004,000Net IncomeNet Income $ 4,800$ 4,800 $ 6,000$ 6,000Add back nonAdd back non--cash expensecash expense 2,0002,000 00Cash flow from OperationsCash flow from Operations $ 6,800$ 6,800 $ 6,000$ 6,000

Note that company A is better off by $800 because of the $2,000 non-cash deduction of CCA. That is the amount of taxes saved.

If you look at net income, Company A appears to be worse off, however, that is only an accounting illusion!!

CCA vs. Accounting DepreciationCCA vs. Accounting Depreciation

CCACCA•• like assets are grouped into like assets are grouped into

pools or classespools or classes•• the CCA rate used in each the CCA rate used in each

asset class is setout in the asset class is setout in the regulations to the Income Tax regulations to the Income Tax Act and may or may not reflect Act and may or may not reflect

Accounting DepreciationAccounting Depreciation•• choose the method that will choose the method that will

best represent the economic best represent the economic wastage of the asset wastage of the asset (declining balance, sum(declining balance, sum--ofof--thethe--year’s digits, straightyear’s digits, straight--line, line,


3 - 116

Act and may or may not reflect Act and may or may not reflect economic wastage of the economic wastage of the assetasset

•• no estimate of useful life or of no estimate of useful life or of salvage valuesalvage value

•• as long as the firm remains in as long as the firm remains in existence, and assets remain existence, and assets remain in the pool, residual UCC in the pool, residual UCC values will remain in the pool.values will remain in the pool.

thethe--year’s digits, straightyear’s digits, straight--line, line, etc.)etc.)

•• individual assets are individual assets are depreciateddepreciated

•• estimate of useful life and estimate of useful life and salvage value is includedsalvage value is included

CCA Over Time CCA Over Time -- A Simple ExampleA Simple ExampleAssume you acquire a depreciable asset with a cost base of $100,000 and there are no Assume you acquire a depreciable asset with a cost base of $100,000 and there are no other assets in this pool. The CCA rate for the pool is 10%. Note you are allowed only other assets in this pool. The CCA rate for the pool is 10%. Note you are allowed only

1/2 the regular CCA rate on the net additions to the pool in the year of acquisition.1/2 the regular CCA rate on the net additions to the pool in the year of acquisition.

Year UCC of pool Addition CCA @ 10%1 $0 $100,000 $5,0002 95,000 0 9,500


3 - 117

2 95,000 0 9,5003 85,500 0 8,5504 76,950 0 7,695

etc.

CCA Tax Shield Over TimeCCA Tax Shield Over Time(Assume a corporate Tax Rate ‘T’ of 40%)(Assume a corporate Tax Rate ‘T’ of 40%)

Year UCC of pool Addition CCA @ 10% T(CCA)1 $0 $100,000 $5,000 $2,0002 95,000 0 9,500 3,8003 85,500 0 8,550 3,420


3 - 118

3 85,500 0 8,550 3,4204 76,950 0 7,695 3,0785 69,255 0 6,926 2,7706 62,330 0 6,233 2,4937 56,097 0 5,610 2,2448 50,487 0 5,049 2,0199 45,438 0 4,544 1,818

Tax Shield Over TimeTax Shield Over Time(A Graphical Representation)(A Graphical Representation)

35004000

T(CCA) at 10% on $100,000


3 - 119

0500

10001500200025003000

Tax Shield

1 3 5 7 9 11 13 15 17 19

Year

Asymptotic Curve

ObservationsObservations

•• In the foregoing you can now readily see:In the foregoing you can now readily see:�� CCA a firm claims changes each and every year on a CCA a firm claims changes each and every year on a

‘declining balance’‘declining balance’--like basislike basis�� CCA provides the largest tax shields in the early years CCA provides the largest tax shields in the early years

of the asset’s lifeof the asset’s life


3 - 120

of the asset’s lifeof the asset’s life�� residual values remain in the pool long after the asset residual values remain in the pool long after the asset

was acquired…this means that the firm will never fully was acquired…this means that the firm will never fully recoup the original cost of the asset … as the firm’s recoup the original cost of the asset … as the firm’s asset base ages, cash flows generated from CCA will asset base ages, cash flows generated from CCA will not enable the firm to replace the original asset.not enable the firm to replace the original asset.

Disposition of Assets and CCADisposition of Assets and CCACapital GainsCapital Gains

•• A taxable capital gain would occur if the firm sold A taxable capital gain would occur if the firm sold a depreciable asset for greater than it’s original a depreciable asset for greater than it’s original cost.cost.


3 - 121

Capital Gain = Original Cost Base Capital Gain = Original Cost Base -- Salvage ValueSalvage Value

Disposition of Assets and CCADisposition of Assets and CCARecapture of DepreciationRecapture of Depreciation

•• If the salvage value of the asset exceeds the UCC of the If the salvage value of the asset exceeds the UCC of the poolpoolthere is a recapture of depreciationthere is a recapture of depreciation

•• recaptured depreciation is subject to taxrecaptured depreciation is subject to tax


3 - 122

Recaptured Depreciation = UCCRecaptured Depreciation = UCCpool pool -- Salvage ValueSalvage Value

Disposition of Assets and CCADisposition of Assets and CCATerminal LossTerminal Loss

•• When the last physical asset in the pool is sold and not When the last physical asset in the pool is sold and not replaced, the pool will be closed out. replaced, the pool will be closed out.

•• If there is a positive balance remaining in the pool after If there is a positive balance remaining in the pool after disposition, that balance is called a disposition, that balance is called a terminal lossterminal loss and is and is


3 - 123

disposition, that balance is called a disposition, that balance is called a terminal lossterminal loss and is and is deductible from income in that year….it is a nondeductible from income in that year….it is a non--cash cash deduction just like CCA.deduction just like CCA.

CRA Form for Capital Cost AllowanceCRA Form for Capital Cost AllowanceAn ExampleAn Example

Assume you want to calculate the CCA for Class Assume you want to calculate the CCA for Class Six (10% CCA rate) given an opening UCC of Six (10% CCA rate) given an opening UCC of $91,874; additions to the class of $32,880 and $91,874; additions to the class of $32,880 and $25,000 as proceeds on disposals from the $25,000 as proceeds on disposals from the class.class.


3 - 124

class.class.

CCA = $9,581CCA = $9,581

1

Class number

2

Undepreciated capital cost (UCC) at the start of the

year

3

Cost of additions in

the year

4

Proceeds of dispositions in the year

5

UCC af ter additions

and dispositions (col. 2 plus 3

minus 4)

6

Adjustments for current year

additions (1/2 times (col. 3 minues 4)) If

negative, enter

7

Base amount for capital

cost allow ance

(col. 5 minus 6)

8

Rate %

9

CCA for the year (col. 7 times

8 or an adjusted amount)

10

UCC at the end of the

year (col. 5 minus 9)

6 91,874.00 32,880.00 25,000.00 99,754.00 3,940.00 95,814.00 10% 9,581.40 90,172.60

Personal Income TaxationPersonal Income Taxation

•• Canadians are taxed on their worldCanadians are taxed on their world--wide incomewide income•• The taxation year is the calendar year, starting on January 1 The taxation year is the calendar year, starting on January 1

and ending December 31and ending December 31•• The personal tax system is a ‘progressive’ one…as taxable The personal tax system is a ‘progressive’ one…as taxable


3 - 125

•• The personal tax system is a ‘progressive’ one…as taxable The personal tax system is a ‘progressive’ one…as taxable income increases, it is taxed at progressive higher rates. income increases, it is taxed at progressive higher rates.

•• Table 3 Table 3 –– 7 on the following slide illustrates the top marginal 7 on the following slide illustrates the top marginal tax rates in Canada on investment income (interest, dividends tax rates in Canada on investment income (interest, dividends and capital gains).and capital gains).

(Please see the following slide with Table 3 (Please see the following slide with Table 3 --7)7)

The Canadian Tax SystemThe Canadian Tax SystemPersonal Income TaxationPersonal Income Taxation

Taxable Income Ordinary Income

Capital Gains

Eligible Non-eligible

Federal Only 29.00% 14.50% 14.55% 19.58%

Alberta 39.00% 19.50% 17.45% 25.21%British Columbia 43.70% 21.85% 18.47% 31.58%

Manitoba 46.40% 23.20% 23.83% 36.75%

New Brunswick* 46.95% 23.48% 23.18% 35.40%

Table 3-7 Top 2007 Personal Tax Rates

Dividends


3 - 126

New Brunswick* 46.95% 23.48% 23.18% 35.40%

Newfoundland and Labrador 48.64% 24.32% 32.52% 37.32%

Non-resident 42.92% 21.46% 21.53% 28.98%

Northwest Territories 43.05% 21.53% 18.25% 29.65%

Nova Scotia 48.25% 24.13% 28.35% 33.06%

Nunavut 40.50% 20.25% 22.24% 28.96%

Ontario 46.41% 23.20% 24.64% 31.34%

Prince Edward Island 47.37% 23.69% 24.44% 33.61%

Quebec 48.22% 24.11% 29.69% 36.35%

Saskatchewan 44.00% 22.00% 20.35% 30.83%Yukon 42.40% 21.20% 17.23% 30.49%

*New Brunsw ick's 2007 budget revised the top combined rates.

The Canadian Tax SystemThe Canadian Tax SystemPersonal Income Taxation of Investment IncomePersonal Income Taxation of Investment Income

Investment income can be earned by investors Investment income can be earned by investors in three different forms:in three different forms:


3 - 127

–– InterestInterest–– DividendsDividends–– Capital gainsCapital gains

Taxation of Interest IncomeTaxation of Interest Income

•• Interest income is taxed at the person’s personal marginal tax Interest income is taxed at the person’s personal marginal tax rate (the same rate that employment and business income is rate (the same rate that employment and business income is taxed at)taxed at)

•• We use the ‘marginal’ rate because when a person invests, We use the ‘marginal’ rate because when a person invests, they are seeking to add to income in the future…that added they are seeking to add to income in the future…that added income will face the marginal tax rate.income will face the marginal tax rate.


3 - 128

income will face the marginal tax rate.income will face the marginal tax rate.•• All sources of interest must be claimed each calendar year All sources of interest must be claimed each calendar year

(both cash interest received, and interest income that has (both cash interest received, and interest income that has accrued)accrued)–– Accrued interest is interest that has been earned, but not yet Accrued interest is interest that has been earned, but not yet

received (for example, from compound interest Canada Savings received (for example, from compound interest Canada Savings Bonds that have yet to be redeemed)Bonds that have yet to be redeemed)


Taxation of Interest IncomeTaxation of Interest IncomeOntario Tax Rates Ontario Tax Rates –– Interest IncomeInterest Income

Lower Limit Upper Limit

Basic Tax Rate on Excess

Dividend Income

Capital Gains

$ - to $8,148 $ - 0.00% 0.00% 0.00%

$8,149 to 11,336 $ - 16.00 3.33 8.00

Table 3-6 Ontario Taxable Income

Marginal Rate on

Interest income is taxed at the investor’s personal

marginal rate.

All interest income, whether received in cash or accrued is subject to

tax in each tax year.


3 - 129

$8,149 to 11,336 $ - 16.00 3.33 8.00$11,337 to 14,477 510 28.10 5.63 14.05

$14,478 to 34,010 1,393 22.05 4.48 11.03

$34,011 to 35,595 5,700 25.15 8.36 12.58

$35,596 to 59,882 6,098 31.15 15.86 15.58

$59,883 to 68,020 13,664 32.98 16.86 16.49

$68,021 to 70,559 16,348 35.39 19.88 17.70

$70,560 to 71,190 17,246 39.41 22.59 19.70

$71,191 to 115,739 17,495 43.41 27.59 21.70$115,740 and up 36,833 46.41 31.34 23.20

Source: Ernst & Young w ebsite: <w w w .ey.com>.

Taxation of Dividend IncomeTaxation of Dividend Income

•• Dividends from Canadian companies are taxed Dividends from Canadian companies are taxed using the ‘grossusing the ‘gross--up, tax credit system’up, tax credit system’–– Cash dividends are grossed up by 45% and this total Cash dividends are grossed up by 45% and this total

amount is included in taxable incomeamount is included in taxable income–– A federal dividend tax credit of 18.97% and provincial A federal dividend tax credit of 18.97% and provincial


3 - 130

–– A federal dividend tax credit of 18.97% and provincial A federal dividend tax credit of 18.97% and provincial dividend tax credit of 6.5% (Ontario) is deducted from dividend tax credit of 6.5% (Ontario) is deducted from taxes that would otherwise be payable.taxes that would otherwise be payable.

–– The effect of this system is to effectively reduce the The effect of this system is to effectively reduce the marginal tax rate applied to dividend income.marginal tax rate applied to dividend income.


Taxation of DividendTaxation of Dividend



Dividend Income

Capital Gains

$ - to $8,148 $ - 0.00% 0.00% 0.00%

$8,149 to 11,336 $ - 16.00 3.33 8.00


Marginal Rate on

The dividend gross-up, tax credit system makes dividend income the

lowest taxed investment income in the lower tax

brackets.


3 - 131

$8,149 to 11,336 $ - 16.00 3.33 8.00$11,337 to 14,477 510 28.10 5.63 14.05

$14,478 to 34,010 1,393 22.05 4.48 11.03

$34,011 to 35,595 5,700 25.15 8.36 12.58

$35,596 to 59,882 6,098 31.15 15.86 15.58

$59,883 to 68,020 13,664 32.98 16.86 16.49

$68,021 to 70,559 16,348 35.39 19.88 17.70

$70,560 to 71,190 17,246 39.41 22.59 19.70

$71,191 to 115,739 17,495 43.41 27.59 21.70$115,740 and up 36,833 46.41 31.34 23.20


Taxation of Capital Gain IncomeTaxation of Capital Gain Income

•• Only realized capital gains are taxedOnly realized capital gains are taxed–– This is a very important feature for high income earners who do This is a very important feature for high income earners who do

not need investment income to fund their everyday living not need investment income to fund their everyday living expenses…they can afford to wait to sell their investments expenses…they can afford to wait to sell their investments indefinitely…and indefinitely delay paying taxes on the capital indefinitely…and indefinitely delay paying taxes on the capital gainsgains


3 - 132

gainsgains

•• 50% of a realized capital gain is subject to tax at the person’s 50% of a realized capital gain is subject to tax at the person’s marginal tax rate.marginal tax rate.

•• Capital losses can only be used to offset taxable capital gains.Capital losses can only be used to offset taxable capital gains.


The Canadian Tax SystemThe Canadian Tax SystemPersonal Income Tax Rates Personal Income Tax Rates –– Capital GainsCapital Gains



Dividend Income

Capital Gains

$ - to $8,148 $ - 0.00% 0.00% 0.00%

$8,149 to 11,336 $ - 16.00 3.33 8.00


Marginal Rate on

At the higher marginal tax brackets, taxpayers will prefer to receive their

investment income in the form of capital gains

because they are taxed at a 23.2% marginal rate.

Only ‘realized’ capital gains are subject to tax.


3 - 133

$8,149 to 11,336 $ - 16.00 3.33 8.00$11,337 to 14,477 510 28.10 5.63 14.05

$14,478 to 34,010 1,393 22.05 4.48 11.03

$34,011 to 35,595 5,700 25.15 8.36 12.58

$35,596 to 59,882 6,098 31.15 15.86 15.58

$59,883 to 68,020 13,664 32.98 16.86 16.49

$68,021 to 70,559 16,348 35.39 19.88 17.70

$70,560 to 71,190 17,246 39.41 22.59 19.70

$71,191 to 115,739 17,495 43.41 27.59 21.70$115,740 and up 36,833 46.41 31.34 23.20


gains are subject to tax.

Summary and ConclusionsSummary and Conclusions

In this chapter you have developed:In this chapter you have developed:–– A basic overview of accounting statementsA basic overview of accounting statements–– An understanding of the importance of generally An understanding of the importance of generally

accepted accounting principlesaccepted accounting principles


3 - 134

accepted accounting principlesaccepted accounting principles–– An understanding of the Canadian tax system An understanding of the Canadian tax system

and the importance of tax considerations in and the importance of tax considerations in financial decisionfinancial decision--making.making.

CHAPTER 4CHAPTER 4Financial Statement Financial Statement Financial Statement Financial Statement

Analysis and ForecastingAnalysis and Forecasting


•• Learning objectivesLearning objectives•• Important termsImportant terms•• Consistent financial analysisConsistent financial analysis•• Leverage ratiosLeverage ratios•• Efficiency ratiosEfficiency ratios

www.bookfiesta4u.com ContentsCHAPTER 4 – Financial Statement Analysis and

Forecasting

4 - 137

•• Efficiency ratiosEfficiency ratios•• Productivity ratiosProductivity ratios•• Liquidity ratiosLiquidity ratios•• Valuation ratiosValuation ratios•• Financial forecastingFinancial forecasting•• Formula forecastingFormula forecasting•• Summary and ConclusionsSummary and Conclusions



1.1. Why return on equity is one of the key financial ratios used for Why return on equity is one of the key financial ratios used for assessing a firm’s performance, and how it can be used to provide assessing a firm’s performance, and how it can be used to provide information about three areas of a firm’s operationsinformation about three areas of a firm’s operations

2.2. Why outsiders and insiders are concerned with a company’s ratios Why outsiders and insiders are concerned with a company’s ratios related to leverage, efficiency, productivity, liquidity and valuerelated to leverage, efficiency, productivity, liquidity and value

3.3. How to calculate, interpret, and evaluate the key ratios related to How to calculate, interpret, and evaluate the key ratios related to leverage, efficiency, productivity, liquidity, and valueleverage, efficiency, productivity, liquidity, and value


Forecasting

4 - 138

leverage, efficiency, productivity, liquidity, and valueleverage, efficiency, productivity, liquidity, and value4.4. Why financial forecasts provide critical information for both Why financial forecasts provide critical information for both

management and external partiesmanagement and external parties5.5. How to prepare financial forecasts by using the percentage of sales How to prepare financial forecasts by using the percentage of sales

approachapproach6.6. How external financing requirements are related to sales growth, How external financing requirements are related to sales growth,

profitability, dividend payouts, and sustainable growth rates.profitability, dividend payouts, and sustainable growth rates.


•• Acid test ratioAcid test ratio•• Average collection periodAverage collection period•• Average days sales in Average days sales in

inventory inventory •• BreakBreak--even pointeven point

•• EBITDA multipleEBITDA multiple•• Efficiency ratiosEfficiency ratios•• Equity book value per shareEquity book value per share•• External financing External financing

requirementsrequirements•• Financial leverageFinancial leverage•• Fixed asset turnoverFixed asset turnover


Forecasting

4 - 139

•• Cash flow to debt ratioCash flow to debt ratio•• Current ratioCurrent ratio•• Debt ratioDebt ratio•• DebtDebt--equity ratioequity ratio•• Degree of total leverageDegree of total leverage•• Dividend payoutDividend payout•• Dividend yieldDividend yield

•• Fixed asset turnoverFixed asset turnover•• Forward P/E ratioForward P/E ratio•• Gross profit marginGross profit margin•• Inventory turnoverInventory turnover•• Invested capitalInvested capital

Important Chapter Terms …Important Chapter Terms …

•• Leverage ratioLeverage ratio•• LiquidityLiquidity•• MarketMarket--toto--book ratiobook ratio•• Net operating income (NOI)Net operating income (NOI)•• Net profit marginNet profit margin

•• Receivables turnoverReceivables turnover•• Retention (plowback) ratioRetention (plowback) ratio•• Return on assets (ROA)Return on assets (ROA)•• Return on equity (ROE)Return on equity (ROE)•• Spontaneous liabilitiesSpontaneous liabilities•• Stock ratiosStock ratios


Forecasting

4 - 140

•• Net profit marginNet profit margin•• OffOff--balancebalance--sheet liabilitiessheet liabilities•• Operating marginOperating margin•• Percentage of sales methodPercentage of sales method•• PricePrice--earnings (P/E) ratioearnings (P/E) ratio•• Productivity ratios Productivity ratios •• Quick ratioQuick ratio

•• Stock ratiosStock ratios•• Sustainable growth rateSustainable growth rate•• Times interest earnedTimes interest earned•• Total enterprise valueTotal enterprise value•• Turnover ratioTurnover ratio•• Working capitalWorking capital•• Working capital ratioWorking capital ratio

Consistent Financial AnalysisConsistent Financial Analysis

•• Your text describes the importance of Your text describes the importance of consistent financial analysis across consistent financial analysis across companies, across industries, across companies, across industries, across countriescountries

•• Morgan Stanley’s ModelWare is a start Morgan Stanley’s ModelWare is a start on this.on this.

•• It is up to you, the analyst, to It is up to you, the analyst, to


Forecasting

4 - 141

•• It is up to you, the analyst, to It is up to you, the analyst, to understand the challenges to understand the challenges to comparability and you must attempt to comparability and you must attempt to ascertain the financial health of the ascertain the financial health of the organizations you study, understanding organizations you study, understanding the limitations inherent in financial the limitations inherent in financial accounting practice. accounting practice.

Consistent Financial AnalysisConsistent Financial AnalysisIntraIntra--Company ComparisonsCompany Comparisons

•• GAAP provides considerable latitude for the company.GAAP provides considerable latitude for the company.•• Once a firm chooses an acceptable accounting treatment for:Once a firm chooses an acceptable accounting treatment for:

–– Revenue recognitionRevenue recognition–– Capitalization of expensesCapitalization of expenses–– Inventory valuation, etc.Inventory valuation, etc.


Forecasting

4 - 142

–– Inventory valuation, etc.Inventory valuation, etc.then the firm must use these same provisions year after year.then the firm must use these same provisions year after year.

•• Any change in accounting principles must be noted in the financial Any change in accounting principles must be noted in the financial statements and prior years restated to ensure there is a common statements and prior years restated to ensure there is a common basis of comparison to the present.basis of comparison to the present.

•• Therefore internal comparisons, year over year, are possible and Therefore internal comparisons, year over year, are possible and supported by GAAP.supported by GAAP.

Consistent Financial AnalysisConsistent Financial AnalysisInterInter--Company ComparisonsCompany Comparisons

•• Making comparisons between companies, even Making comparisons between companies, even in the same industry are much more difficult in the same industry are much more difficult because:because:–– Widely divergence accounting treatment under GAAPWidely divergence accounting treatment under GAAP


Forecasting

4 - 143

–– Widely divergence accounting treatment under GAAPWidely divergence accounting treatment under GAAP–– Historical costHistorical cost--based accounting can seriously affect based accounting can seriously affect

efficiency, leverage and profitability ratios.efficiency, leverage and profitability ratios.

Analysis of Financial StatementsAnalysis of Financial Statements

•• Study the absolute numbers, and the Study the absolute numbers, and the comparative statements for the company to:comparative statements for the company to:–– Ascertain trends in the balance sheet, income Ascertain trends in the balance sheet, income

statement and statement of cash flowsstatement and statement of cash flows–– Ascertain areas of concernAscertain areas of concern


Forecasting

4 - 144

–– Ascertain areas of concernAscertain areas of concern–– Ascertain areas of strengthAscertain areas of strength

•• Complement your study of the absolute numbers Complement your study of the absolute numbers by using ratios again to:by using ratios again to:–– Ascertain trendsAscertain trends–– Identify areas of concernIdentify areas of concern–– Identify areas of strengthIdentify areas of strength

A Framework for Financial AnalysisA Framework for Financial AnalysisReturn on Equity (ROE) and DuPont SystemReturn on Equity (ROE) and DuPont System

•• The DuPont System gives a framework for the The DuPont System gives a framework for the analysis of financial statements through the analysis of financial statements through the decomposition of the Return on Equity ratiodecomposition of the Return on Equity ratio


Forecasting

4 - 145(See Figure 4 (See Figure 4 --2 that illustrates the constituent parts of ROE )2 that illustrates the constituent parts of ROE )

Equity rs'Shareholde

IncomeNet Equity on Return =

=SE

NIROE

[4-1]

Framework for Financial AnalysisFramework for Financial AnalysisDu Pont SystemDu Pont System

NIROA =

4 - 2 FIGURE

GOOD OR BAD?

LEVERAGE RATIOS

ROE

TA


Forecasting

4 - 146

TA

Sales

Sales

NI

TAROA

×

=

= LEVERAGE RATIOS

EFFICIENCY RATIOS

PRODUCTIVITY RATIOS

SE

TA

A Framework for Financial AnalysisA Framework for Financial AnalysisDuPont System and Decomposition of ROEDuPont System and Decomposition of ROE

•• As Figure 4 As Figure 4 –– 2 illustrates, ROE is a function of:2 illustrates, ROE is a function of:–– Corporate use of leverage (use of debt)Corporate use of leverage (use of debt)–– Efficiency ratios (ability of the firm to control costs in relationship to Efficiency ratios (ability of the firm to control costs in relationship to

sales)sales)–– Productivity ratios (the degree to which the firm can generate sales in Productivity ratios (the degree to which the firm can generate sales in

relationship to assets employed)relationship to assets employed)


Forecasting

4 - 147

relationship to assets employed)relationship to assets employed)



=SE

NIROE

[4-1]

A Framework for Financial AnalysisA Framework for Financial AnalysisReturn on Equity (ROE) and DuPont SystemReturn on Equity (ROE) and DuPont System

•• ROE is not a pure ratio because it involves dividing an income ROE is not a pure ratio because it involves dividing an income statement item (flow) by a balance sheet (stock) item.statement item (flow) by a balance sheet (stock) item.

=SE

NIROE

[4-1]


Forecasting

4 - 148

•• Instead of using ending SE, many argue you should use average SE Instead of using ending SE, many argue you should use average SE (beginning SE plus ending SE divided by 2) because SE changes (beginning SE plus ending SE divided by 2) because SE changes over the year as income is earned and retained earnings grow.over the year as income is earned and retained earnings grow.



SE [4-1]

A Framework for Financial AnalysisA Framework for Financial AnalysisReturn on Equity (ROE)Return on Equity (ROE)

TASalesNINI

ROA

Leverage


Forecasting

4 - 149

SE

TA

TA

Sales

Sales

NI

SE

NIROE ×

×== [4- 7]

ROE when decomposed shows that it is a function of the return earned on assets and of the leverage used by the firm.

A Framework for Financial AnalysisA Framework for Financial AnalysisReturn on Total AssetsReturn on Total Assets

•• ROA shows the ratio of income to assets that ROA shows the ratio of income to assets that have been used to produce them.have been used to produce them.

= NIROA


Forecasting

4 - 150

•• ROA can be further decomposed as shown and ROA can be further decomposed as shown and the following slidethe following slide

Assets Total

IncomeNet Assetson Return =

=TA

ROA[4-2]

A Framework for Financial AnalysisA Framework for Financial AnalysisReturn on Assets (ROA)Return on Assets (ROA)

•• ROA is the product of the net profit margin and ROA is the product of the net profit margin and the sales to total asset ratio:the sales to total asset ratio:


Forecasting

4 - 151

•• The sales cancel and we are left with NI / TAThe sales cancel and we are left with NI / TA

TA

Sales

Sales

NI

TA

NIROA ×== [4- 6]

A Framework for Financial AnalysisA Framework for Financial AnalysisLeverage RatioLeverage Ratio

•• If ROA is multiplied by TA and divided by SE, the TA’s cancel If ROA is multiplied by TA and divided by SE, the TA’s cancel out and produces ROE.out and produces ROE.

•• TA / SE is the leverage ratioTA / SE is the leverage ratio

TA


Forecasting

4 - 152

•• It measures how many dollars of total assets are supported by It measures how many dollars of total assets are supported by each dollar of Shareholders Equity.each dollar of Shareholders Equity.


Assets Total Leverage

Leverage

=

=SE

TA[4-3]

DuPont SystemDuPont System

•• The DuPont system provides a good starting point for any The DuPont system provides a good starting point for any financial analysisfinancial analysis–– It shows that financial strength comes from many sources It shows that financial strength comes from many sources

(profitability, asset utilization, leverage)(profitability, asset utilization, leverage)–– It reinforces the concept that good financial analysis requires It reinforces the concept that good financial analysis requires


Forecasting

4 - 153

–– It reinforces the concept that good financial analysis requires It reinforces the concept that good financial analysis requires looking at each ratio in the context of the otherlooking at each ratio in the context of the other

–– Whenever you are presented with financial statements it is Whenever you are presented with financial statements it is important that you look at a sample of ratios from each major important that you look at a sample of ratios from each major category to identify areas of strength and weaknesscategory to identify areas of strength and weakness

(Table 4 (Table 4 --1 illustrates E1 illustrates E--Trade Canada’s ROE analysis of Rothmans)Trade Canada’s ROE analysis of Rothmans)

A Framework for Financial AnalysisA Framework for Financial AnalysisReturn on Equity (ROE) and the DuPont SystemReturn on Equity (ROE) and the DuPont System

Return on Equity 3/31/2006 3/31/2005 3/31/2004 3/31/2003(1) Net Sales 652,271 636,771 620,104 575,469(2) Pretax Income 274,829 261,345 252,683 240,197(3) Net Income 99,464 92,997 90,277 86,678(4) Total assets 449,075 528,528 496,757 429,965

Table 4-1 E-Trade Canada's Rothman's Dupont ROE An alysis


Forecasting

4 - 154

(4) Total assets 449,075 528,528 496,757 429,965(5) Shareholders' equity 113,860 193,708 168,497 130,537Pretax margin % (2/1) 42.13% 41.04% 40.75% 41.74%× Tax retent % (3/2) 36.19% 35.58% 35.73% 36.09%=profit margin % (3/1) 15.25% 14.60% 14.56% 15.06%× Asset Utilization % (1/4) 145.25% 120.48% 124.83% 133.84%= ROA % (3/4) 22.15% 17.60% 18.17% 20.16%× Leverage % (4/5) 394.41% 272.85% 294.82% 329.38%=ROE % (3/5) 87.36% 48.01% 53.58% 66.40%

Source: Data fro m E-Trade Canada

Interpreting RatiosInterpreting Ratios

•• A ratio is just one number over another number A ratio is just one number over another number –– by itself, there is little ‘information’by itself, there is little ‘information’

•• To judge whether a ratio is ‘good’ or ‘bad’ To judge whether a ratio is ‘good’ or ‘bad’ requires that it be compared to something else requires that it be compared to something else such as:such as:


Forecasting

4 - 155

such as:such as:–– The company’s own ratios over time to ascertain The company’s own ratios over time to ascertain

trendstrends–– Other comparable companies or industry averagesOther comparable companies or industry averages

(Table 4 (Table 4 --2 illustrates Rothmans DuPont ratios over time)2 illustrates Rothmans DuPont ratios over time)

A Framework for Financial AnalysisA Framework for Financial AnalysisInterpreting RatiosInterpreting Ratios

Rothmans (March 31)

2004 2005 2006

ROE 0.5358 0.4801 0.8736

Table 4-2 Rothman's Dupont Ratios


Forecasting

4 - 156

ROE 0.5358 0.4801 0.8736ROA 0.1817 0.1760 0.2215Net profit margin 0.1456 0.1460 0.1525Turnover 1.2483 1.2048 1.4525Leverage 2.9482 2.7285 3.9441

Do you see trends here?

What factors are driving the trend in ROE?

A Framework for Financial AnalysisA Framework for Financial AnalysisInterpreting RatiosInterpreting Ratios

Altria (December 31)

2003 2004 2005

ROE 0.3670 0.3066 0.2922

Table 4-3 Altria's Dupont Ratios


Forecasting

4 - 157

ROE 0.3670 0.3066 0.2922ROA 0.0957 0.0926 0.0967Net profit margin 0.1132 0.1051 0.1066Turnover 0.8455 0.8816 0.9065Leverage 3.8352 3.3095 3.0232

Do you see trends here?

What factors are driving the trend in ROE?

How do these results compare to Rothmans on the pre vious slide?

LeverageLeverage

•• Leverage = magnificationLeverage = magnification•• Financial leverage occurs when a firm uses Financial leverage occurs when a firm uses

sources of financing that carry a fixed cost (such sources of financing that carry a fixed cost (such as longas long--term debt), and uses this to generate term debt), and uses this to generate


Forecasting

4 - 158

as longas long--term debt), and uses this to generate term debt), and uses this to generate greater returns than result in magnified returns greater returns than result in magnified returns to shareholders.to shareholders.

•• Leverage means magnification of either profits Leverage means magnification of either profits or losses.or losses.

Leverage RatiosLeverage Ratios

•• Include:Include:–– Debt ratioDebt ratio–– Debt to equity ratioDebt to equity ratio–– Times interest earned ratioTimes interest earned ratio


Forecasting

4 - 159

–– Times interest earned ratioTimes interest earned ratio–– Cash flow to debt ratioCash flow to debt ratio

Leverage RatiosLeverage RatiosDebt RatioDebt Ratio

•• Is a stock ratio indicating the proportion of total Is a stock ratio indicating the proportion of total assets financed by debt at a particular point in assets financed by debt at a particular point in time (the balance sheet date)time (the balance sheet date)


Forecasting

4 - 160

Assets Total

sLiabilitie Total ratioDebt ==TA

TL [4- 8]

Leverage RatiosLeverage RatiosDebtDebt--Equity RatioEquity Ratio

•• Is a stock ratio indicating the proportion that total Is a stock ratio indicating the proportion that total debt represents in relationship to the debt represents in relationship to the shareholders equity (common stock and shareholders equity (common stock and retained earnings) at the balance sheet date.retained earnings) at the balance sheet date.


Forecasting

4 - 161


Debt Total ratioy Debt/Equit ==SE

D[4- 9]

Leverage RatiosLeverage RatiosTimes Interest Earned (TIE)Times Interest Earned (TIE)

•• Is an income statement (flow) ratio indicating the Is an income statement (flow) ratio indicating the number of times the firm’s prenumber of times the firm’s pre--tax income tax income exceeds its fixed financial obligations to its exceeds its fixed financial obligations to its lenders (debt holders)lenders (debt holders)


Forecasting

4 - 162

ExpenseInterest

Taxes andInterest Before Earnings

EarnedInterest Times

=

=

TIE

I

EBIT[4- 10]

Leverage RatiosLeverage RatiosCash Flow to Debt RatioCash Flow to Debt Ratio

•• Measures how long it would take to payoff a Measures how long it would take to payoff a firm’s debt (D)firm’s debt (D)


Forecasting

4 - 163

Debt Total

Operations from FlowCash /

ratiodebt toflowCash

=

=

DCF

D

CFO[4- 11]

Leverage RatiosLeverage RatiosCash Flow to Debt RatioCash Flow to Debt Ratio

2004 2005 2006 2003 2004 2005

Leverage 2.9482 2.7285 3.9441 3.8352 3.3095 3.0232

Table 4-4 Leverage Ratios

Rothmans (March 31) Altria (December 31)


Forecasting

4 - 164

Leverage 2.9482 2.7285 3.9441 3.8352 3.3095 3.0232Debt ratio 0.6608 0.6335 0.7465 0.7393 0.6978 0.6692D/E ratio 0.8902 0.7729 1.3152 0.9785 0.7482 0.6703TIE 46.7842 36.1270 42.7356 13.7035 12.9082 14.3405Cash flow to debt 1.5037 1.0823 1.2235 0.4408 0.4739 0.4621

Which firm exhibits greater use of leverage?

Which exhibits greater capacity to take on and serv ice debt?

Efficiency RatiosEfficiency Ratios

Efficiency ratios measure how efficiently a dollar Efficiency ratios measure how efficiently a dollar of sales is turned into profits.of sales is turned into profits.


Forecasting

4 - 165

•• Gives insight to the firm’s cost structure Gives insight to the firm’s cost structure •• Whether problems exist with variable costs or fixed costs Whether problems exist with variable costs or fixed costs

(overhead) or both(overhead) or both

Efficiency RatiosEfficiency Ratios

•• Include:Include:–– Degree of total leverageDegree of total leverage–– BreakBreak--even pointeven point


Forecasting

4 - 166

–– BreakBreak--even pointeven point–– Gross profit marginGross profit margin–– Operating marginOperating margin

Efficiency RatiosEfficiency RatiosInterpreting RatiosInterpreting Ratios

Sales 120 132 108Contribution margin (40%) 48 53 43Fixed cost 31 51 31Interest 5 5 5

Table 4-5 Profit Margin and Sales Variability


Forecasting

4 - 167

Interest 5 5 5Tax 6 8.5 3.5Net income 6 8.5 3.5

Net profit margin 5.0% 6.4% 3.2%

The focus of efficiency ratios is with the income s tatement. This example demonstrates the leverage effect of using fixed cos ts in lieu of variable costs in the

cost structure.

Sales varied by +/- of 10% yet profits varied by +/- 40%.

Efficiency RatiosEfficiency RatiosDegree of Total Leverage RatioDegree of Total Leverage Ratio

•• An income statement ratio that measures the An income statement ratio that measures the exposure of profits to changes in sales.exposure of profits to changes in sales.

•• The greater the DTL, the greater leverage effect.The greater the DTL, the greater leverage effect.


Forecasting

4 - 168

Taxes Before Earnings

Marginon Contributi

Leverage Total of Degree

=

=

DTL

EBT

CM[4- 12]

Efficiency RatiosEfficiency RatiosBreak Even PointBreak Even Point

•• Estimates the volume of units that must be produced and sold Estimates the volume of units that must be produced and sold in order for the firm to cover all costs both fixed and variable.in order for the firm to cover all costs both fixed and variable.

Point Even Break =CM

FC[4- 13]


Forecasting

4 - 169

•• The break even point tends to increase as the use of fixed The break even point tends to increase as the use of fixed costs increases.costs increases.

Marginon Contributi

Costs Fixed =BEP

CM [4- 13]

Efficiency RatiosEfficiency RatiosGross Profit MarginGross Profit Margin

•• Demonstrates the percentage of sales that are available to Demonstrates the percentage of sales that are available to cover fixed (period) costs and financing expenses after cover fixed (period) costs and financing expenses after variable costs have been paid.variable costs have been paid.

Margin Profit Gross −=

S

CGSS[4- 14]


Forecasting

4 - 170

•• A declining gross profit margin raises concerns about the A declining gross profit margin raises concerns about the firm’s ability to control variable costs such as direct materials firm’s ability to control variable costs such as direct materials and direct labour.and direct labour.

Sales

Sold Goods ofCost -Sales

Margin Profit Gross

=

=

GPM

S [4- 14]

Efficiency RatiosEfficiency RatiosOperating MarginOperating Margin

•• Operating margin measures the cumulative Operating margin measures the cumulative effect of both variable and period costs on the effect of both variable and period costs on the ability of the firm to turn sales into operating ability of the firm to turn sales into operating profits to cover, interest, taxes, depreciation and profits to cover, interest, taxes, depreciation and amortization (EBITDA).amortization (EBITDA).


Forecasting

4 - 171

amortization (EBITDA).amortization (EBITDA).

Sales

Income OperatingNet

Margin Operating

=

=

OM

Sales

NOI[4- 15]

Efficiency RatiosEfficiency RatiosInterpreting RatiosInterpreting Ratios

2004 2005 2006 2003 2004 2005

Net profit margin 0.1456 0.1460 0.1525 0.1132 0.1051 0.1066

Table 4-6 Efficiency Ratios



Forecasting

4 - 172

Net profit margin 0.1456 0.1460 0.1525 0.1132 0.1051 0.1066Gross profit margin 0.4261 0.4305 0.4426 0.3519 0.3348 0.3286Operating margin 0.4102 0.4155 0.4263 0.1938 0.1867 0.1696

Which firm is able to produce a greater percentage of sales as profits?

Which firm is able to produce strong and consistent profitability?

Productivity RatiosProductivity Ratios

•• Measure the ability of the firm to generate sales Measure the ability of the firm to generate sales from the assets that it employs.from the assets that it employs.

•• Excessive investment in assets with little or no Excessive investment in assets with little or no


Forecasting

4 - 173

•• Excessive investment in assets with little or no Excessive investment in assets with little or no increase in sales reduces the rate of return on increase in sales reduces the rate of return on both assets and equity (ROA) and (ROE)both assets and equity (ROA) and (ROE)

Productivity RatiosProductivity Ratios

•• Include:Include:–– Receivables turnoverReceivables turnover–– Average collection period (ACP)Average collection period (ACP)–– Inventory turnoverInventory turnover


Forecasting

4 - 174

–– Average days sales in inventory (ADSI)Average days sales in inventory (ADSI)–– Fixed asset turnoverFixed asset turnover

Productivity RatiosProductivity RatiosReceivables TurnoverReceivables Turnover

•• Measures the sales generated by every dollar of Measures the sales generated by every dollar of receivables.receivables.


Forecasting

4 - 175

Receivable Accounts

Sales

turnover sReceivable

=

=

RT

AR

S[4- 16]

Productivity RatiosProductivity RatiosAverage Collection PeriodAverage Collection Period

•• Estimates the number of days it takes a firm to collect on its Estimates the number of days it takes a firm to collect on its accounts receivable.accounts receivable.

ARTurnover sReceivable

365 Period Collection Average ==ADS

AR[4- 17]


Forecasting

4 - 176

•• If ACP is 40 days, and the firm’s credit policy is net 30, If ACP is 40 days, and the firm’s credit policy is net 30, clearly, customers are not paying in keeping with the firm’s clearly, customers are not paying in keeping with the firm’s policy, and there may be concerns about the quality of the policy, and there may be concerns about the quality of the firm’s customers, and what might happen if economic firm’s customers, and what might happen if economic conditions deteriorate.conditions deteriorate.

turnoversReceivable

AR =ACP

Productivity RatiosProductivity RatiosInventory TurnoverInventory Turnover

•• Estimates the number of times, ending inventory was ‘turned Estimates the number of times, ending inventory was ‘turned over’ (sold) in the year.over’ (sold) in the year.

Turnover Inventory INV

CGS=[4- 18]


Forecasting

4 - 177

•• A ratio that involves both ‘stock’ and ‘flow’ valuesA ratio that involves both ‘stock’ and ‘flow’ values•• Is strongly a function of ending inventory value…managers Is strongly a function of ending inventory value…managers

often try to improve this ratio as they approach year end often try to improve this ratio as they approach year end through inventory reduction strategies (cash and carry through inventory reduction strategies (cash and carry sales/inventory clearance, etc.) sales/inventory clearance, etc.)

INV


•• When Cost of Goods Sold is not available, it may be When Cost of Goods Sold is not available, it may be necessary to estimate inventory turnover using sales.necessary to estimate inventory turnover using sales.


Sales=[4- 19]


Forecasting

4 - 178

•• Use of the sales figure is less valid than Cost of Goods Sold Use of the sales figure is less valid than Cost of Goods Sold because Cost of Goods Sold is based on inventoried cost, but because Cost of Goods Sold is based on inventoried cost, but Sales includes a profit margin on top of inventoried cost.Sales includes a profit margin on top of inventoried cost.


=

Productivity RatiosProductivity RatiosAverage Days Sales in Inventory (ADSI)Average Days Sales in Inventory (ADSI)

•• Estimates the number of days of sales tied up in Estimates the number of days of sales tied up in inventory (based on ending inventory values)inventory (based on ending inventory values)


Forecasting

4 - 179

turnoverInventory

ADS

INV

365

(ADSI)inventory in sales days Average

=

= [4- 20]

Productivity RatiosProductivity RatiosFixed Asset TurnoverFixed Asset Turnover

•• Estimates the number of dollars of sales Estimates the number of dollars of sales produced by each dollar of net fixed assets.produced by each dollar of net fixed assets.


Forecasting

4 - 180

AssetsFixedNet

SalesNFA

S

=

= Turnover Asset Fixed [4- 21]

Productivity RatiosProductivity RatiosInterpreting RatiosInterpreting Ratios

2004 2005 2006 2003 2004 2005

Turnover 1.2483 1.2048 1.4525 0.8455 0.8816 0.9065

Table 4-7 Productivity Ratios



Forecasting

4 - 181

Turnover 1.2483 1.2048 1.4525 0.8455 0.8816 0.9065Receivables turnover 19.3825 19.8254 55.3006 NA 15.5735 18.2529ACP 18.8314 18.4108 6.6003 NA 23.4372 19.9968Inventory turnover (using sales) 3.1170 3.0349 3.1597 8.5241 8.9244 9.2455ADSI 117.0988 120.2692 115.5165 42.8197 40.8991 39.4788Fixed asset turnover 11.0158 9.2087 8.5490 5.0613 5.4959 5.8673

Which firm has been improving its efficiency ratios to a greater degree?

Liquidity RatiosLiquidity Ratios

•• Measure the ability of the firm to meet its Measure the ability of the firm to meet its maturing financial obligations through liquid maturing financial obligations through liquid (cash and near cash) resources(cash and near cash) resources

•• Include:Include:


Forecasting

4 - 182

•• Include:Include:–– Working capital ratioWorking capital ratio–– Current ratioCurrent ratio–– Quick (acidQuick (acid--test) ratiotest) ratio

Liquidity RatiosLiquidity RatiosWorking Capital RatioWorking Capital Ratio

•• Measures the percentage of total assets that is Measures the percentage of total assets that is invested in current assets.invested in current assets.

•• Helps to analyze capital intensity as well as Helps to analyze capital intensity as well as corporate liquidity.corporate liquidity.


Forecasting

4 - 183

corporate liquidity.corporate liquidity.

AssetsTotal

AssetsCurrentTA

CA

=

= Ratio Capital Working[4- 22]

Liquidity RatiosLiquidity RatiosCurrent RatioCurrent Ratio

•• Measures the number of dollars of current Measures the number of dollars of current assets for each dollar of current liabilities.assets for each dollar of current liabilities.

•• Helps to estimate the capacity of the firm to Helps to estimate the capacity of the firm to meet its maturing financial obligations.meet its maturing financial obligations.


Forecasting

4 - 184

meet its maturing financial obligations.meet its maturing financial obligations.

RatioCurrent

sLiabilitieCurrent

AssetsCurrentCL

CA

=

=[4- 23]

Liquidity RatiosLiquidity RatiosQuick RatioQuick Ratio

•• Recognizing that inventories may be less liquid than other Recognizing that inventories may be less liquid than other current assets, and in some cases, when liquidated quickly current assets, and in some cases, when liquidated quickly result in cash flows that are less than book value, the quick result in cash flows that are less than book value, the quick ratio gives a clearer indication of the firm’s ability to meet its ratio gives a clearer indication of the firm’s ability to meet its maturing financial obligations out of current, liquid assets.maturing financial obligations out of current, liquid assets.


Forecasting

4 - 185

RatioQuick

sLiabilitieCurrent

sInventorieAssetsCurrentCL

ARMSC

−=

++=[4- 24]

Liquidity RatiosLiquidity RatiosInterpreting RatiosInterpreting Ratios

2004 2005 2006 2003 2004 2005

Current ratio 2.8868 2.9310 2.4756 NA 1.0987 0.9856

Table 4-8 Liquidity Ratios



Forecasting

4 - 186

Current ratio 2.8868 2.9310 2.4756 NA 1.0987 0.9856Quick ratio 1.4981 1.5092 1.0037 NA 0.4877 0.4442Working capital ratio 0.8414 0.8235 0.7800 NA 0.2548 0.2388

Which firm has greater liquidity and capacity to me et its financial obligations?

Estimating Net Realizable ValuesEstimating Net Realizable ValuesInterpreting RatiosInterpreting Ratios

•• When firm’s are financiallyWhen firm’s are financially--strained and no longer a ‘going strained and no longer a ‘going concern,’ book (accounting) become less validconcern,’ book (accounting) become less valid

•• Net liquidation values can be estimated by discounting asset Net liquidation values can be estimated by discounting asset values based on their degree of liquidityvalues based on their degree of liquidity–– Liquid assets are valued close to or the same as book valueLiquid assets are valued close to or the same as book value–– Illiquid assets are discounted from book value based on the Illiquid assets are discounted from book value based on the

degree of illiquiditydegree of illiquidity


Forecasting

4 - 187

degree of illiquiditydegree of illiquidity–– Liabilities are stated in nominal terms because it takes those Liabilities are stated in nominal terms because it takes those

dollars to satisfy debt obligationsdollars to satisfy debt obligations–– Preferred stock value is based on residual values (if there is any Preferred stock value is based on residual values (if there is any

estimated residual value)estimated residual value)

(Table 4 (Table 4 –– 9 is an example of E9 is an example of E--Trade Canada’s Risk Ratings for Rothmans)Trade Canada’s Risk Ratings for Rothmans)

Estimating Net Liquidation ValueEstimating Net Liquidation ValueInterpreting RatiosInterpreting Ratios

Growth Rates 2006 2005 2004 2003

Net ROA % 22.15% 17.60% 18.17% 20.16%Long-term debt growth (YTY %) 3.00% -0.19% 0.00% N/AAsset growth (YTY %) -15.03% 6.40% 15.53% N/AComponents of Net Liquidated ValueCash @ 100% 130,231 191,995 184,907 113,270Marketable securities @ 98% N/A N/A N/A N/A

Table 4-9 E-Trade Canada's Risk Ratings


Forecasting

4 - 188

Marketable securities @ 98% N/A N/A N/A N/AReceivables @ 90% 10,616 28,907 28,794 75,373Other current assets @ 80% 1,468 1,058 1,698 2,027Inventory @ 50% 103,217 104,910 99,471 76,767Net plant @ 25% 19,075 17,287 14,073 13,654Total Liquid Assets 264,607 344,157 328,943 281,091Current liabilities (100%) 141,496 148,498 144,786 110,964Long-term debt (100%) 149,751 149,708 150,000 150,000Other liabilities (100%) 10,761 0 0 0Net of Liabilities = net liquidation value -37,401 45,951 34,157 20,127Average shares 67,745 67,492 33,610 33,299Net Liquidation Value per Share ($0.55) $0.68 $1.02 $0.60

Source: Data from E-Trade Canada.

Valuation RatiosValuation Ratios

•• Used to assess how the market is valuing the Used to assess how the market is valuing the firm (share price) in relationship to assets and firm (share price) in relationship to assets and current earnings, profits and dividendscurrent earnings, profits and dividends

•• Include:Include:–– Equity book value per share (BVPS)Equity book value per share (BVPS)


Forecasting

4 - 189

–– Equity book value per share (BVPS)Equity book value per share (BVPS)–– Dividend yieldDividend yield–– Dividend payoutDividend payout–– PricePrice--earnings (P/E) ratioearnings (P/E) ratio–– Forward (P/E) ratio Forward (P/E) ratio –– MarketMarket--toto--book (M/B) ratiobook (M/B) ratio–– EBITDA multipleEBITDA multiple

Valuation RatiosValuation RatiosInterpreting Ratios Interpreting Ratios –– Book Value per ShareBook Value per Share

•• Expresses shareholders’ equity on a per share Expresses shareholders’ equity on a per share basis.basis.


Forecasting

4 - 190

Shares ofNumber

Equity rs'Shareholde SharePer ValueBook = [4- 25]

Valuation RatiosValuation RatiosInterpreting Ratios Interpreting Ratios –– Dividend YieldDividend Yield

•• Expresses dividend payout as a percentage of Expresses dividend payout as a percentage of the current share price.the current share price.

SharePer Dividend

Yield Dividend DPS== [4- 26]


Forecasting

4 - 191

•• Can be compared to other investment Can be compared to other investment instruments such bonds (current yield) or with instruments such bonds (current yield) or with other dividendother dividend--paying companies.paying companies.

Shareper Price

SharePer Dividend Yield Dividend

P

DPS== [4- 26]

Valuation RatiosValuation RatiosInterpreting Ratios Interpreting Ratios –– Dividend Payout RatioDividend Payout Ratio

•• Expresses dividends as a percentage of Expresses dividends as a percentage of earnings on a per share basis.earnings on a per share basis.


Forecasting

4 - 192

Shareper Earnings

SharePer Dividend Payout Dividend

EPS

DPS== [4- 27]

Valuation RatiosValuation RatiosInterpreting Ratios Interpreting Ratios –– Trailing P/E RatioTrailing P/E Ratio

•• Earnings multiple based on the most recent earnings.Earnings multiple based on the most recent earnings.•• Often used in estimating the value of a stock.Often used in estimating the value of a stock.

Price Share

ratio earnings-Price P== [4- 28]


Forecasting

4 - 193

•• A stock trading at a P/E multiple of 10 will take ten years at A stock trading at a P/E multiple of 10 will take ten years at current earnings to recover the price of the stock.current earnings to recover the price of the stock.

•• A stock trading at a P/E multiple of 100 will take 100 years at A stock trading at a P/E multiple of 100 will take 100 years at current annual earnings to recover the price of the stock.current annual earnings to recover the price of the stock.

Shareper Earnings

ratio earnings-Price EPS

== [4- 28]

Valuation RatiosValuation RatiosInterpreting Ratios Interpreting Ratios –– Forward P/E RatioForward P/E Ratio

•• Earnings multiple based on forecast earnings per share.Earnings multiple based on forecast earnings per share.•• Often used in estimating the value of a stock especially with Often used in estimating the value of a stock especially with

companies with rapid growth in earnings per share.companies with rapid growth in earnings per share.


Forecasting

4 - 194

•• Low P/E shares are regarded as Low P/E shares are regarded as value stocksvalue stocks•• High P/E shares are regarded as High P/E shares are regarded as growth stocksgrowth stocks

Shareper Earnings Estimated

Price Share ratio earnings-Price Forward

EEPS

P== [4- 29]

Valuation RatiosValuation RatiosInterpreting Ratios Interpreting Ratios –– Market to Book RatioMarket to Book Ratio

•• Estimates the dollars of Share Price per dollar of book value Estimates the dollars of Share Price per dollar of book value per share.per share.

Shareper ValueBook

Price Share ratiobook -to-Market

BVPS

P== [4- 30]


Forecasting

4 - 195

•• Given historical cost accounting as the basis for book value Given historical cost accounting as the basis for book value per share, the degree to which market value per share per share, the degree to which market value per share exceeds BVPS indicates the value that has been added to the exceeds BVPS indicates the value that has been added to the company by management.company by management.

Shareper ValueBook

ratiobook -to-Market BVPS

==

Valuation RatiosValuation RatiosInterpreting Ratios Interpreting Ratios –– EBITDA MultipleEBITDA Multiple

•• Total enterprise value is an estimate of the total market value Total enterprise value is an estimate of the total market value of the firm (market value of equity plus market value of debt)of the firm (market value of equity plus market value of debt)

•• EBITDA multiple expresses total enterprise value for each EBITDA multiple expresses total enterprise value for each dollar of operating income (EBITDA)dollar of operating income (EBITDA)


Forecasting

4 - 196

EBITDA

TEV=

= onamortizati andon depreciati taxes,interest, before Earnings

Value Enterprise Total multipleEBITDA

Valuation RatiosValuation RatiosInterpreting RatiosInterpreting Ratios

2004 2005 2006 2003 2004 2005

Dividend yield 0.0474 0.0438 0.1333 0.0485 0.0462 0.0410Dividend payout 0.6063 0.7664 1.8621 0.5841 0.6184 0.6132

Table 4-10 Value Ratios



Forecasting

4 - 197

Dividend payout 0.6063 0.7664 1.8621 0.5841 0.6184 0.6132P/E 12.7799 17.5109 13.9655 12.0398 13.3991 14.9739M/B 6.8451 8.3685 12.0682 4.4208 4.0979 4.6319EBITDA multiple 4.8535 6.3545 5.2095 7.8436 8.8194 9.7774Dividend yield (excl. special dividend) N/A N/A 0.0593 N/A N/A N/ADividend payout (excl. special dividend) N/A N/A 0.8276 N/A N/A N/A

Can you draw any conclusions for the comparative va luation ratio data summarized in this table?

Financial ForecastingFinancial ForecastingPurposePurpose

Financial managers must produce forecasts for Financial managers must produce forecasts for the financial results of corporate plans to:the financial results of corporate plans to:–– Determine whether the corporate plans will require Determine whether the corporate plans will require

additional external financing additional external financing –– Determine whether the corporate plans will produce Determine whether the corporate plans will produce


Forecasting

4 - 198

–– Determine whether the corporate plans will produce Determine whether the corporate plans will produce surplus cash resources that could be distributed to surplus cash resources that could be distributed to shareholders as dividendsshareholders as dividends

–– Assess the financial forecasts to determine the financial Assess the financial forecasts to determine the financial feasibility of corporate plans feasibility of corporate plans –– if poor financial results are if poor financial results are forecast, this gives management the opportunity to forecast, this gives management the opportunity to reexamine and amend corporate plans to produce better reexamine and amend corporate plans to produce better results before resources and people are committed.results before resources and people are committed.

Financial ForecastingFinancial Forecasting

The basis for all financial forecasts is the sales forecast.The basis for all financial forecasts is the sales forecast.

The most recent balance sheet values are the starting point.The most recent balance sheet values are the starting point.

Pro forma (forecast) balance sheets are projected assuming Pro forma (forecast) balance sheets are projected assuming some relationship with projected sales (constant percentage some relationship with projected sales (constant percentage


Forecasting

4 - 199

some relationship with projected sales (constant percentage some relationship with projected sales (constant percentage of sales)of sales)

Current liabilities are usually assumed to rise and fall in a Current liabilities are usually assumed to rise and fall in a constant percentage with sales constant percentage with sales –– we call them ‘we call them ‘spontaneous spontaneous liabilitiesliabilities’ because they change without negotiation with ’ because they change without negotiation with creditors.creditors.

Financial ForecastingFinancial ForecastingThe Percentage of Sales MethodThe Percentage of Sales Method

The percentage of sales method involves the The percentage of sales method involves the following steps:following steps:

1.1. Determine which financial policy variables you are Determine which financial policy variables you are interested ininterested in

2.2. Set all the nonSet all the non--financial policy variables as a financial policy variables as a percentage of salespercentage of sales


Forecasting

4 - 200

percentage of salespercentage of sales3.3. Extrapolate the balance sheet based on a percentage Extrapolate the balance sheet based on a percentage

of salesof sales4.4. Estimate future retained earningsEstimate future retained earnings5.5. Modify and reModify and re--iterate until the forecast makes sense.iterate until the forecast makes sense.

This process most often results in a balance sheet that does not This process most often results in a balance sheet that does not balance balance –– a ‘plug’ (balancing) amount is the external funds a ‘plug’ (balancing) amount is the external funds required (or surplus funds forecast)required (or surplus funds forecast)


Cash 5 Accruals 5

Table 4-11 Balance Sheet

The historical balance sheet.

If sales increase,

assets used to produce those sales must grow.

Spontaneous liabilities


Forecasting

4 - 201

Cash 5 Accruals 5Securities 10 Payables 5Receivables 10 Bank debt 20Inventory 25Current assets 50 Current liabilities 30Net fixed assets 100 Long-term debt 40

Common equity 80

Total assets 150 Total Liabilities 150

Policy variables requiring decision.


%Sales 120 100.0% 132 145 160

Cash 5 4.2% 5.5 6.0 6.7Securities 10 8.3% 11.0 12.1 13.3Receivables 10 8.3% 11.0 12.1 13.3Inventory 25 20.8% 27.5 30.2 33.3

Table 4-12 Initial Forecast

percentages

Sales projections and the base case of

$120

Naïve increases in balance sheet

accounts in same

proportion to projected sales

Accounts First pass


Forecasting

4 - 202

Inventory 25 20.8% 27.5 30.2 33.3Net fixed assets 100 83.3% 110.0 120.8 133.3Total assets 150 125.0% 165.0 181.3 200.0

Accruals 5 4.2% 5.5 6.0 6.7Payables 5 4.2% 5.5 6.0 6.7Short-term debt 20 16.7% 20.0 20.0 20.0Long-term debt 40 33.3% 40.0 40.0 40.0Equity 80 66.7% 80.0 80.0 80.0Total liabilities and equity 150 125.0% 151.0 152.1 153.3

Cumulative (EFR) 14.0 29.2 46.7

percentages of sales

Balance Sheet Values

calculated as a percentage of

sales.

requiring decision are assumed to

remain constant on first pass.

First pass funding shortfall

projected.

Percentage of Sale MethodPercentage of Sale MethodImproving the Pro Forma Balance SheetImproving the Pro Forma Balance Sheet

•• The prior pro form balance sheet was developed The prior pro form balance sheet was developed using very naïve assumptions:using very naïve assumptions:–– Policy variables held constantPolicy variables held constant–– Asset growth in all accounts held at the same Asset growth in all accounts held at the same

percentage of salespercentage of sales


Forecasting

4 - 203

percentage of salespercentage of sales–– Spontaneous liabilities increased at a constant Spontaneous liabilities increased at a constant

percentage of sales.percentage of sales.

•• One improvement is to realize that the firm’s One improvement is to realize that the firm’s equity will grow by the amount of retained equity will grow by the amount of retained earnings.earnings.

(See the following income statement)(See the following income statement)


Sales 120Gross operating profit 48Fixed costs 31

Table 4-13 Income Statement

Retained earnings = net income less dividends.

Assuming the firm holds this percentage

constant we can project increases in equity on the balance sheet as 50% of the 5% profit

margin or 2.5% of sales.


Forecasting

4 - 204

Fixed costs 31EBIT 17Interest 5Taxes @ 50% 6Net Income 6Dividends 3

margin or 2.5% of sales.


%Sales 120 100.0% 132 145 160


Table 4-14 First Revision of Forecast Equity accounts increased by

projected retained

earnings that increase in

proportion to sales.

Notice how the retained

earnings has reduced the

projected External Funds

Required.


Forecasting

4 - 205



Cumulative (EFR) 10.7 22.3 35.8

Percentage of Sale MethodPercentage of Sale MethodSecond Revision the Pro Forma Balance SheetSecond Revision the Pro Forma Balance Sheet

•• Further improvements to the pro forma balance sheet include:Further improvements to the pro forma balance sheet include:–– Recognizing that cash balances may not have to rise as a Recognizing that cash balances may not have to rise as a

constant percentage of salesconstant percentage of sales•• Cash balances are required for a variety of reasonsCash balances are required for a variety of reasons

–– To support transactionTo support transaction–– As a safety cushion against unforeseen cash needsAs a safety cushion against unforeseen cash needs


Forecasting

4 - 206

–– As a safety cushion against unforeseen cash needsAs a safety cushion against unforeseen cash needs–– As a speculative balance to take advantage of unforeseen opportunitiesAs a speculative balance to take advantage of unforeseen opportunities

•• Even at low levels of sales, cash balances are required Even at low levels of sales, cash balances are required •• As sales increase, additional cash on hand may be required, but at As sales increase, additional cash on hand may be required, but at

a decreasing percentage of sales.a decreasing percentage of sales.

–– The following slide illustrates the difference between a simple The following slide illustrates the difference between a simple percentage of sales forecast, and perhaps a more realistic percentage of sales forecast, and perhaps a more realistic forecast that includes a base amount (constant) and a forecast that includes a base amount (constant) and a decreasing percentage of salesdecreasing percentage of sales

Percentage of Sales MethodPercentage of Sales MethodSecond Revision the Pro Forma Balance SheetSecond Revision the Pro Forma Balance Sheet

4-3 FIGURE4 - 3 FIGURE

Cas

h 14.0

12.0

Cash Forecast

Linear with

Simple %


Forecasting

4 - 207

Sales

10.0

8.0

6.0

4.0

2.0

0.0

0 20 40 60 80 100 120 140 160 180 200 220 240 260 280 300

Linear with constant

Percentage of Sale MethodPercentage of Sale MethodSecond Revision the Pro Forma Balance SheetSecond Revision the Pro Forma Balance Sheet

•• Further improvements to the pro forma balance sheet include Further improvements to the pro forma balance sheet include reexamining asset growth assumptions:reexamining asset growth assumptions:

–– Refinement of the cash forecast (as per the previous two slidesRefinement of the cash forecast (as per the previous two slides–– Realization that EFR can be offset by marketable securities that can easily be Realization that EFR can be offset by marketable securities that can easily be

liquidated to finance growth needs.liquidated to finance growth needs.–– Reexamine our assumptions about growth in Accounts Receivable and whether Reexamine our assumptions about growth in Accounts Receivable and whether

we want to change our credit policies in the context of the forecast macro we want to change our credit policies in the context of the forecast macro economic and competitive environmenteconomic and competitive environment


Forecasting

4 - 208

economic and competitive environmenteconomic and competitive environment–– Reexamine our inventory management policies taking into account the Reexamine our inventory management policies taking into account the

macroeconomic and competitive environment macroeconomic and competitive environment –– Realization that increases in net fixed assets is ‘lumpy’ and not continuously Realization that increases in net fixed assets is ‘lumpy’ and not continuously

incremental (if we have excess production capacity, we may not need to invest incremental (if we have excess production capacity, we may not need to invest any further in fixed assets until we are forecast to exceed that capacity) any further in fixed assets until we are forecast to exceed that capacity)

•• Further improvements to the pro forma balance sheet include Further improvements to the pro forma balance sheet include reexamining assumptions regarding the growth in reexamining assumptions regarding the growth in spontaneous liabilitiesspontaneous liabilities

(See the effects of these changes on the pro forma balance sheet on the following slide)(See the effects of these changes on the pro forma balance sheet on the following slide)


%Sales 120 100.0% 132 145 160


Table 4-15 Second Revision of Forecast Assuming cash remains constant,

we liquidate marketable

securities and we retain 50% of our

profits dramatically affects the forecast.

We now have


Forecasting

4 - 209



Cumulative (EFR) -10.8 -21.7 -32.6

We now have surplus resources!

Percentage of Sale MethodPercentage of Sale MethodFinal Revisions to the Pro Forma Income StatementFinal Revisions to the Pro Forma Income Statement

•• Given our assumptions about capacity, and there being no need for Given our assumptions about capacity, and there being no need for further expansion in plant and equipment to support anticipated sales further expansion in plant and equipment to support anticipated sales growth, we can reexamine our assumptions about the cost structure of growth, we can reexamine our assumptions about the cost structure of the firm.the firm.

Variable CostsVariable Costs•• Variable costs (direct materials and direct labour) will likely grow in proportion to sales.Variable costs (direct materials and direct labour) will likely grow in proportion to sales.Fixed CostsFixed Costs


Forecasting

4 - 210

Fixed CostsFixed Costs•• Fixed costs, however should remain fixed.Fixed costs, however should remain fixed.•• By modifying the income statement for this change in assumptions, we see the net result of By modifying the income statement for this change in assumptions, we see the net result of

this is an increase in forecast net income.this is an increase in forecast net income.DividendsDividends•• Most firms do not follow a constant payout ratio, but hold dividends constant over multiple Most firms do not follow a constant payout ratio, but hold dividends constant over multiple

years.years.•• Assume that we hold dividends at $3 for the next three years.Assume that we hold dividends at $3 for the next three years.

(See the effects of these changes on the final pro forma income statement on the following slide)(See the effects of these changes on the final pro forma income statement on the following slide)


Sales $120 $132 $145 $160Gross operating profit 48 53 58 64Fixed costs 31 31 31 31EBIT 17 22 27 33

Table 4-16 Profit Margin and Sales


Forecasting

4 - 211

EBIT 17 22 27 33Interest 5 5.0 5.0 5.0Taxes @ 50% 6 8.5 11.0 14.0Net Income 6.0 8.5 11.0 14.0Net profit margin 5.0% 6.4% 7.6% 8.8%

Dividends $3.0 $3.0 $3.0 $3.0Additions to Retained earnings $3.0 $5.5 $8.0 $11.0

Percentage of Sale MethodPercentage of Sale MethodFinal Revisions to the Pro Forma Balance SheetFinal Revisions to the Pro Forma Balance Sheet

•• Given our modified income statement and assumptions Given our modified income statement and assumptions regarding net profit and cash dividends we can prepare a regarding net profit and cash dividends we can prepare a final revised balance sheetfinal revised balance sheet

•• This balance sheet now shows that we forecast This balance sheet now shows that we forecast significant surplus cash resources and must make some significant surplus cash resources and must make some decisions about how we will manage them:decisions about how we will manage them:


Forecasting

4 - 212

decisions about how we will manage them:decisions about how we will manage them:–– Investment temporarily in marketable securities in anticipation of further Investment temporarily in marketable securities in anticipation of further

investment opportunities in growing the firm?investment opportunities in growing the firm?–– Distribute them in the form of cash dividends?Distribute them in the form of cash dividends?

(See the effects of these changes on the final pro forma balance sheet on the following (See the effects of these changes on the final pro forma balance sheet on the following slide)slide)


%Sales 120 100.0% 132 145 160


Table 4-17 Final Revision of Forecast


Forecasting

4 - 213



Cumulative (EFR) -13.0 -28.3 -46.2

Formula ForecastingFormula ForecastingThe Simple Percentage of Sales Forecasting MethodThe Simple Percentage of Sales Forecasting Method

We can express the foregoing percentage of sales method forecasting We can express the foregoing percentage of sales method forecasting using equations rather than spreadsheets.using equations rather than spreadsheets.

When we subtract spontaneous liabilities from total assets we get the When we subtract spontaneous liabilities from total assets we get the firm’s invested capital or net assets as a percentage of sales.firm’s invested capital or net assets as a percentage of sales.


Forecasting

4 - 214

firm’s invested capital or net assets as a percentage of sales.firm’s invested capital or net assets as a percentage of sales.

We will denote this by We will denote this by ‘a’‘a’‘a’‘a’ is the treasurer’s financial policy variable because it is the total is the treasurer’s financial policy variable because it is the total

invested capital requirement of the firm as a percentage of sales.invested capital requirement of the firm as a percentage of sales.

Formula ForecastingFormula ForecastingThe PerThe Per

External Funds Required can now be expressed as a formula of External Funds Required can now be expressed as a formula of relationships:relationships:

)1( EFR SgPMbgSa ×+××−××= [4- 32]


Forecasting

4 - 215

Where:Where:‘a’ ‘a’ -- treasurer’s financial policy variabletreasurer’s financial policy variablegg -- sales growth ratesales growth rateSS -- current salescurrent salesS S ×× gg -- next period’s sales growthnext period’s sales growtha a ×× S S ×× gg -- incremental capital requiredincremental capital requiredPMPM -- profit margin on salesprofit margin on salesbb -- payout ratiopayout ratio1 1 –– bb -- retention or plowback ratioretention or plowback ratio

Formula ForecastingFormula ForecastingThe PerThe Per

External Funds Required can also be expressed as a linear function of External Funds Required can also be expressed as a linear function of the sales growth rate (g) and this can be seen more easily by the sales growth rate (g) and this can be seen more easily by dividing both sides of Equation 4 dividing both sides of Equation 4 –– 32 by the current sales level and 32 by the current sales level and rearranging:rearranging:

)( gPMbaPMbS

EFR ×−+×−= [4- 33]


Forecasting

4 - 216

This line can be graphed to show the relationship between the sales This line can be graphed to show the relationship between the sales growth rate and External Funds Required.growth rate and External Funds Required.

(See Figure 4 (See Figure 4 --4 found on the following slide)4 found on the following slide)

)( gPMbaPMbS

×−+×−=

External Financing RequirementsExternal Financing Requirements

4-3 FIGURE4 - 4 FIGURE

EF

R /

S 0.15

0.1

Sustainable growth rate ( g*)


Forecasting

4 - 217

Sales Growth Rate

0.05

0.0

-0.05

-0.1

-0.15

-0.2

-0.1

-0.0

8

-0.0

6

-.00

4

-.00

2 0

0.02

0.04

0.06

0.08 0.1

0.12

0.14

0.16

0.18

Formula ForecastingFormula ForecastingThe Sustainable Growth Rate (g*)The Sustainable Growth Rate (g*)

The sustainable growth rate is the sales growth rate at which the firm The sustainable growth rate is the sales growth rate at which the firm neither generates nor needs external financing neither generates nor needs external financing –– that is, it can that is, it can sustain its own rate of growth through reinvestment of profits sustain its own rate of growth through reinvestment of profits earned.earned.

The sustainable growth rate (g*) is the point in Figure 4 The sustainable growth rate (g*) is the point in Figure 4 –– 4 at which the 4 at which the line crosses the horizontal axis.line crosses the horizontal axis.


Forecasting

4 - 218

line crosses the horizontal axis.line crosses the horizontal axis.

Using equation 4 Using equation 4 –– 33 we can rearrange and solve for g*:33 we can rearrange and solve for g*:

)(

*g PMba

PMb

×−×= [4- 34]


In this chapter you have learned:In this chapter you have learned:

–– The importance of understanding the sources of a firm’s The importance of understanding the sources of a firm’s profitability or where the challenges to profitability exist.profitability or where the challenges to profitability exist.


Forecasting

4 - 219

profitability or where the challenges to profitability exist.profitability or where the challenges to profitability exist.–– How to calculate and interpret operating, profitability, How to calculate and interpret operating, profitability,

liquidity, leverage and efficiency ratiosliquidity, leverage and efficiency ratios–– How to prepare financial forecasts and understand the How to prepare financial forecasts and understand the

assumptions underlying the percentage of sales method assumptions underlying the percentage of sales method of financial forecasting.of financial forecasting.

CHAPTER 5CHAPTER 5Time Value of MoneyTime Value of MoneyTime Value of MoneyTime Value of Money


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• CompoundingCompounding•• DiscountingDiscounting

www.bookfiesta4u.com ContentsCHAPTER 5 – Time Value of Money

5 - 222

•• DiscountingDiscounting•• Annuities and LoansAnnuities and Loans•• PerpetuitiesPerpetuities•• Effective Rates of ReturnEffective Rates of Return•• Summary and ConclusionsSummary and Conclusions

–– Concept Review QuestionsConcept Review Questions–– Practice ProblemsPractice Problems


•• Understand the importance of the time value of moneyUnderstand the importance of the time value of money•• Understand the difference between simple interest and Understand the difference between simple interest and

compound interest compound interest •• Know how to solve for present value, future value, time Know how to solve for present value, future value, time


5 - 223

•• Know how to solve for present value, future value, time Know how to solve for present value, future value, time or rateor rate

•• Understand annuities and perpetuitiesUnderstand annuities and perpetuities•• Know how to construct an amortization tableKnow how to construct an amortization table


•• AmortizeAmortize•• AnnuityAnnuity•• Annuity dueAnnuity due•• Basis pointBasis point•• Cash flowsCash flows

•• LesseeLessee•• Medium of exchangeMedium of exchange•• MortgageMortgage•• Ordinary annuitiesOrdinary annuities•• PerpetuitiesPerpetuities•• Present value interest factor Present value interest factor


5 - 224

•• Compound interestCompound interest•• Compound interest factor Compound interest factor

(CVIF)(CVIF)•• Discount rateDiscount rate•• DiscountingDiscounting•• Effective rate Effective rate

•• Present value interest factor Present value interest factor (PVIF)(PVIF)

•• ReinvestedReinvested•• Required rate of returnRequired rate of return•• Simple interestSimple interest•• Time value of moneyTime value of money

The Time Value of Money ConceptThe Time Value of Money Concept

•• Cannot directly compare $1 today with $1 to be Cannot directly compare $1 today with $1 to be received at some future datereceived at some future date–– Money received today can be invested to earn a rate Money received today can be invested to earn a rate

of returnof return


5 - 225

of returnof return–– Thus $1 today is worth more than $1 to be received at Thus $1 today is worth more than $1 to be received at

some future datesome future date

•• The interest rate or discount rate is the variable The interest rate or discount rate is the variable that equates a present value today with a future that equates a present value today with a future value at some later date value at some later date

Opportunity CostOpportunity Cost

Opportunity cost = Alternative useOpportunity cost = Alternative use

–– The opportunity cost of money is the interest rate that The opportunity cost of money is the interest rate that would be earned by investing itwould be earned by investing it


5 - 226

would be earned by investing itwould be earned by investing it–– It is the underlying reason for the time value of moneyIt is the underlying reason for the time value of money–– Money today can be invested to be some greater Money today can be invested to be some greater

amount in the futureamount in the future–– Conversely, if you are promised a cash flow in the Conversely, if you are promised a cash flow in the

future, it’s present value today is less than what is future, it’s present value today is less than what is promised!promised!

Choosing from Investment AlternativesChoosing from Investment AlternativesRequired Rate of Return or Discount RateRequired Rate of Return or Discount Rate

•• You have three choices:You have three choices:1.1. $20,000 received today$20,000 received today2.2. $31,000 received in 5 years$31,000 received in 5 years3.3. $3,000 per year indefinitely$3,000 per year indefinitely


5 - 227

3.3. $3,000 per year indefinitely$3,000 per year indefinitely

•• To make a decision, you need to know what To make a decision, you need to know what interest rate to useinterest rate to use

•• This interest rate is known as your This interest rate is known as your required rate required rate of returnof return or or discount ratediscount rate..

Simple InterestSimple Interest

•• Simple interest is interest paid or received on Simple interest is interest paid or received on only the initial investment (or principal)only the initial investment (or principal)

•• At the end of the investment period, the principal At the end of the investment period, the principal plus interest is receivedplus interest is received


5 - 228

plus interest is receivedplus interest is received

0 1 2 3 … n

I1 I2 I3 In+P

0 1 2 3 … n

I1 I2 I3 In+P

Simple InterestSimple InterestExampleExample

PROBLEM:PROBLEM:Invest $1,000 today for a fiveInvest $1,000 today for a five--year term and receive 8 year term and receive 8 percent annual simple interest.percent annual simple interest.

Year Beginning Amount Ending Amount1 $1,000 $1,0802 1,080 1,1603 1,160 1,2404 1,240 1,3205 1,320 $1,400

www.bookfiesta4u.com ContentsCHAPTER 5 – Time Value of Money 5 - 229

400,1$

400$000,1$

)80$5(000,1$

)08.000,1$5(000,1$5

=+=

×+=××+=

××+=Value

k)P(nPe n)Value (timSOLUTION:SOLUTION:Annual interest = $1,000 Annual interest = $1,000 ××××××××

.08 = $80 per year..08 = $80 per year..08 = $80 per year..08 = $80 per year..08 = $80 per year..08 = $80 per year..08 = $80 per year..08 = $80 per year.

Simple InterestSimple InterestGeneral FormulaGeneral Formula

k)P(nPe n)Value (tim ××+=[ 5-1]


5 - 230

k)P(nPe n)Value (tim ××+=

Where:P = principal invested

n = number of yearsk = interest rate

Compound InterestCompound InterestCompounding (Computing Future Values)Compounding (Computing Future Values)

•• Simple interest problems are rare; in finance we Simple interest problems are rare; in finance we are most interested in are most interested in compound interestcompound interest

•• Compound interest is interest that is earned on Compound interest is interest that is earned on


5 - 231

•• Compound interest is interest that is earned on Compound interest is interest that is earned on the principal amount invested and on any the principal amount invested and on any accrued interestaccrued interest

Compound InterestCompound InterestExampleExample

PROBLEM:PROBLEM:Invest $1,000 today for a fiveInvest $1,000 today for a five--year term and receive 8 percent year term and receive 8 percent annual compound interest. How much will the accumulated annual compound interest. How much will the accumulated value be at time 5?value be at time 5?

SOLUTION:SOLUTION:


YearBeginning

AmountEnding Amount

1 $1,000.00 $1,080.00

2 1,080.00 1,166.40

3 1,166.40 1,259.71

4 1,259.71 1,360.49

5 1,360.49 1,469.33 33.469,1$)08.1(

49.360,1$)08.1()08.1)(08.1)(08.1)(08.1(

71.259,1$)08.1()08.1)(08.1)(08.1(

40.166,1$)08.1()08.1)(08.1(

080,1$)08.1(

1

55

44

33

22

11

=+=

===

==+++=

=+=++=

=+=+×=

PFV

PPFV

PPFV

PPFV

PFV

k)(PValueFuture n

Compound InterestCompound InterestExample of Interest Earned on InterestExample of Interest Earned on Interest

PROBLEM:PROBLEM:Invest $1,000 today for a fiveInvest $1,000 today for a five--year term and receive 8 percent annual year term and receive 8 percent annual compound interest.compound interest.

The Interest earned on Interest Effect:The Interest earned on Interest Effect:Interest (year 1) = $1,000 Interest (year 1) = $1,000 ×× .08 = $80.08 = $80

××


Interest (year 2 ) =($1,000 + $80)Interest (year 2 ) =($1,000 + $80)××.08 = $86.40.08 = $86.40Interest (year 3) = ($1,000+$80+$86.40) Interest (year 3) = ($1,000+$80+$86.40) ×× .08 = $93.31.08 = $93.31

Year Beginning Amount Ending AmountInterest earned

in the year1 $1,000.00 $1,080.00 $80.002 1,080.00 1,166.40 $86.403 1,166.40 1,259.71 $93.314 1,259.71 1,360.49 $100.785 1,360.49 1,469.33 $108.84

Compound InterestCompound InterestGeneral FormulaGeneral Formula

10n

n k)(PVFV +=[ 5-2]

Where:FV= future value

P = principal investedn = number of years

k = interest rate


5 - 234

factor interest compound theasknown is 1 nk)( +

k = interest rate

Compound InterestCompound InterestSolution Using a Financial Calculator (TI BA II Plus)Solution Using a Financial Calculator (TI BA II Plus)

PMT PV I/Y N

Input the following variables:

0 → ; -1,000 → ; 10 → ; and 5 →

CPT FVPress (Compute) and then


5 - 235

CPT FVPress (Compute) and then

PMT refers to regular paymentsFV is the future value

I/Y is the period interest rateN is the number of periods

PV is entered with a negative sign to reflect inves tors must pay money now to get money in the future.

Answer = $1,610.51

Compound InterestCompound InterestSimple versus Compound InterestSimple versus Compound Interest

•• Compounding of interest magnifies the returns on Compounding of interest magnifies the returns on an investmentan investment

•• RReturns are magnifiedeturns are magnified

•• The longer they are compoundedThe longer they are compounded


5 - 236

•• The longer they are compoundedThe longer they are compounded•• The higher the rate they are compoundedThe higher the rate they are compounded

(See Figure 5(See Figure 5--1 to compare simple and compound interest effects over time)1 to compare simple and compound interest effects over time)

Compound InterestCompound InterestSimple versus Compound InterestSimple versus Compound Interest

FIGURE 5-1

DO

LLA

RS

8,000

7,000

6,000

5,000


5 - 237

DO

LLA

RS

Simple Compound

5,000

4,000

3,000

2,000

1,000

0

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Compound InterestCompound InterestCompounded Returns over Time for Various Asset ClassesCompounded Returns over Time for Various Asset Classes

Annual Arithmetic

Average (%)

Annual Geometric Mean (%)

Yeark-End Value, 2005 ($)

Table 5-1 Ending Wealth of $1,000 Invested From 19 38 to 2005 in Various Asset Classes


5 - 238

Average (%) Mean (%)

Government of Canada treasury bills 5.20 5.11 $29,711Government of Canada bonds 6.62 6.24 61,404Canadian stocks 11.79 10.60 946,009U.S. stocks 13.15 11.76 1,923,692

Source: Data are from the Canadian Institute o f Actuaries

Compound InterestCompound InterestDiscounting (Computing Present Values)Discounting (Computing Present Values)

1

0 nnnn FV

FVPV

+×=

+=[ 5-3]


5 - 239

1)1(0 nnn k)(

FVk

PV+

×=+

=[ 5-3]

Computing Present ValueComputing Present Value

•• The The present Valuepresent Value is an amount today that equates to is an amount today that equates to some larger amount in the futuresome larger amount in the future

•• ExampleExample: We know we want $1,000,000 when we retire 40 : We know we want $1,000,000 when we retire 40 years from today. If we can earn a 10% return on our years from today. If we can earn a 10% return on our money, how much should we invest today? money, how much should we invest today?


( )

( )

0

40

1,000,000

1.10

= $22,094.93

nn

FVPV =

1+k

=

Calculator Approach:1,000,000 FV

0 PMT40 N

10 I/YCPT PV 22,094.93

Compound InterestCompound InterestDetermining Rates of Return or Holding PeriodsDetermining Rates of Return or Holding Periods

nn kPVFV )1( +=


5 - 241

n kPVFV )1( +=

Calculating the Rate of ReturnCalculating the Rate of Return

•• If we know the present value, the future value and the number of If we know the present value, the future value and the number of time periods, we can calculate the rate of return we have earnedtime periods, we can calculate the rate of return we have earned

•• For example, suppose we invested $5,000 six years ago For example, suppose we invested $5,000 six years ago Today, it is worth $10,000. What is the annually compounded Today, it is worth $10,000. What is the annually compounded rate of returned?rate of returned?

( )n+


5 - 242

( )0

1

0

1

6

1

1

10, 0001

5, 000

12.25%

n

n

nn

FV = PV k

FVk =

PV

+

−

= −

=

Calculator Approach:10,000 FV

0 PMT5,000 +/- PV

6 NCPT I/Y 12.25%

•• Thus far, we have dealt only with single Thus far, we have dealt only with single payments, either today or in the futurepayments, either today or in the future

•• An annuity is a stream of payments that An annuity is a stream of payments that continues for a finite period of timecontinues for a finite period of time

Annuities and PerpetuitiesAnnuities and PerpetuitiesAnnuitiesAnnuities


5 - 243

continues for a finite period of timecontinues for a finite period of time•• If the payment occurs at the end of the period, If the payment occurs at the end of the period,

it is an it is an ordinary annuityordinary annuity•• If the payment occurs at the start of the time If the payment occurs at the start of the time

period, it is an period, it is an annuity dueannuity due

Difference Between Annuity TypesDifference Between Annuity Types

0 1 2 3

$100 $100 $100

Ordinary Annuity


5 - 244

$100 $100 $100

0 1 2 3

$100$100

Annuity Due

Annuities and PerpetuitiesAnnuities and PerpetuitiesOrdinary AnnuitiesOrdinary Annuities

11

k

k)(PMTFV

n

n

−+=[ 5-4]


5 - 245

)1(

11

0

+−

=k

kPMTPV

n

[ 5-5]

Annuities and PerpetuitiesAnnuities and PerpetuitiesAnnuities DueAnnuities Due

)111

k (k

k)(PMTFV

n

n +

−+=[ 5-6]


5 - 246

k)(1 )1(

11

0 +

+−

=k

kPMTPV

n[ 5-7]

Future Value of an Ordinary AnnuityFuture Value of an Ordinary Annuity

•• Assume that we want to save $2,000 at the Assume that we want to save $2,000 at the endend of each year of each year for the next 10 years. If we can earn 10% on our investments, for the next 10 years. If we can earn 10% on our investments, how much will we have saved?how much will we have saved?

( )1 1n

kFV = PMT

+ −

Calculator Approach:


( )

( )10

1 1

1.10 12,000

0.10

$31,874.85

OrdinaryAnnuity

kFV = PMT

k

+ −

−=

=

Calculator Approach:2,000 PMT

0 PV10 N

10 I/YCPT FV 31,874.85

Future Value of an Annuity DueFuture Value of an Annuity Due

•• Assume that we want to save $2,000 at the Assume that we want to save $2,000 at the beginningbeginning of of each year for the next 10 years. If we can earn 10% on our each year for the next 10 years. If we can earn 10% on our investments, how much will we have saved?investments, how much will we have saved?

( )n + − Calculator Approach:


( ) ( )

( ) ( )10

1 11

1.10 12,000 1.10

0.10

$35,062.33

n

AnnuityDue

kFV = PMT k

k

+ −+

−=

=

Calculator Approach:2nd BGN 2nd Set

2,000 PMT0 PV

10 N10 I/Y

CPT FV 35,062.33

Relationship Between An Annuity Due and An Relationship Between An Annuity Due and An Ordinary AnnuityOrdinary Annuity

•• The future value of the ordinary annuity is $ The future value of the ordinary annuity is $ 31,874.8531,874.85•• The FV of the annuity due is $ The FV of the annuity due is $ 35,062.3335,062.33•• The interest rate is 10%The interest rate is 10%•• Now calculate how much larger the annuity due is compared Now calculate how much larger the annuity due is compared

to the ordinary annuityto the ordinary annuity


to the ordinary annuityto the ordinary annuity

1 0

0

%

35,062.33 31,874.85

31,874.85

10%

P P

P

−∆ =

−=

=

Present Value of an Ordinary AnnuityPresent Value of an Ordinary Annuity

•• You have just won a lottery. The Lottery Corporation gives You have just won a lottery. The Lottery Corporation gives you two options. You can take $1,000,000 at the you two options. You can take $1,000,000 at the end end of of each year for 25 years or a lump sum of $10,000,000 today. each year for 25 years or a lump sum of $10,000,000 today. If the appropriate discount rate is 10%, what should you do?If the appropriate discount rate is 10%, what should you do?


( )

( ) 25

1 1

1 1.101,000,000

0.10

$9,077,040.02

n

OrdinaryAnnuity

kPV = PMT

k

−

−

− +

−=

=

Calculator Approach:1,000,000 PMT

0 FV25 N

10 I/YCPT PV

9,077,040.02

Present Value of an Annuity DuePresent Value of an Annuity Due

•• Lets continue with the example from the previous Lets continue with the example from the previous page, but now the Lottery Corporation gives you the page, but now the Lottery Corporation gives you the option of taking $1,000,000 at the beginningoption of taking $1,000,000 at the beginning of each of each

year for 25 years or a lump sum of $10,000,000 toda y. year for 25 years or a lump sum of $10,000,000 toda y. If the appropriate discount rate is 10%, what shoul d If the appropriate discount rate is 10%, what shoul d

you do?you do?


5 - 251

Calculator Approach:2nd BGN 2nd Set

1,000,000 PMT0 FV

25 N10 I/Y

CPT PV 9,984,744.02

( ) ( )

( ) ( )25

1 11

1 1.101,000,000 1.10

0.10

$9,984,744.02

n

AnnuityDue

kPV = PMT k

k

−

−

− ++

−=

=

you do?you do?

Annuities and PerpetuitiesAnnuities and PerpetuitiesPerpetuitiesPerpetuities

•• A perpetuity is a stream of cash flows that goes A perpetuity is a stream of cash flows that goes on foreveron forever

•• Examples of perpetuities in financial markets Examples of perpetuities in financial markets includes:includes:


5 - 252

includes:includes:–– Common stockCommon stock–– Preferred stockPreferred stock–– Consol bonds (bonds with no maturity date)Consol bonds (bonds with no maturity date)

∞0 1 2 3

$100 $100 $100

Annuities and PerpetuitiesAnnuities and PerpetuitiesPV of a PerpetuityPV of a Perpetuity

[ 5-8] 0 k

PMTPV =


5 - 253

Where:

PV0 = Present value of the perpetuity

PMT = the periodic cash

K = the discount rate

Perpetuity: An ExamplePerpetuity: An Example

•• While acting as executor for a distant relative, While acting as executor for a distant relative, you discover a $1,000 Consol Bond issued by you discover a $1,000 Consol Bond issued by Great Britain in 1814, issued to help fund the Great Britain in 1814, issued to help fund the Napoleonic War. If the bond pays annual Napoleonic War. If the bond pays annual interest of 3.0% and other long U.K. Government interest of 3.0% and other long U.K. Government


5 - 254

interest of 3.0% and other long U.K. Government interest of 3.0% and other long U.K. Government bonds are currently paying 5%, what would each bonds are currently paying 5%, what would each $1,000 Consol Bond sell for in the market?$1,000 Consol Bond sell for in the market?

Perpetuity: SolutionPerpetuity: Solution

( )0

$1,000 0.03

PMTPV

k=

=


5 - 255

0.05$30

0.05$600

=

=

=

Nominal Versus Effective Interest RatesNominal Versus Effective Interest Rates

•• So far, we have assumed annual compoundingSo far, we have assumed annual compounding•• When rates are compounded annually, the When rates are compounded annually, the

quoted ratequoted rate and the and the effective rateeffective rate are equalare equal•• As the number of compounding periods per year As the number of compounding periods per year


5 - 256

•• As the number of compounding periods per year As the number of compounding periods per year increases, the effective rate will become larger increases, the effective rate will become larger than the quoted ratethan the quoted rate

Nominal versus Effective RatesNominal versus Effective RatesDetermining Effective Annual RatesDetermining Effective Annual Rates

•• Effective rate Effective rate for a period is the rate at which a for a period is the rate at which a dollar invested grows over that perioddollar invested grows over that period

Determining effective annual rate for a given compo und intervalDetermining effective annual rate for a given compo und interval


5 - 257

1)1( −+= m

m

QRk[ 5-9]

Nominal versus Effective RatesNominal versus Effective RatesDetermining Effective Annual RatesDetermining Effective Annual Rates

Determining effective annual rate when compounding is Determining effective annual rate when compounding is conducted on a continuous basisconducted on a continuous basis


5 - 258

1−= QRek[ 5-10]

Nominal versus Effective RatesNominal versus Effective RatesEffective Rates for “Any” PeriodEffective Rates for “Any” Period

QRm

Determining effective rate for any period, given an y quoted Determining effective rate for any period, given an y quoted ratesrates


5 - 259

11 -)m

QR(k f

m

+=[ 5-11]

Calculating the Effective RateCalculating the Effective Rate

1 1m

Effective

QRk

m = + −


5 - 260

Where:

kEffective = Effective annual interest rate

QR = the quoted interest rate

M = the number of compounding periods per year

Example: Effective Rate CalculationExample: Effective Rate Calculation

•• A bank is offering loans at 6%, compounded monthly. What is A bank is offering loans at 6%, compounded monthly. What is the effective annual interest rate on its loans?the effective annual interest rate on its loans?

1 1m

QRk

= + −


12

1 1

.061 1

12

6.17%

Effective

QRk

m = + −

= + −

=

Continuous CompoundingContinuous Compounding

•• When compounding occurs continuously, we When compounding occurs continuously, we calculate the effective annual rate using calculate the effective annual rate using ee, the , the base of the natural logarithms (approximately base of the natural logarithms (approximately 2.7183)2.7183)


5 - 262

1QREffectivek e= −

10% Compounded At Various Frequencies10% Compounded At Various Frequencies

Compounding Compounding FrequencyFrequency

Effective Annual Effective Annual Interest RateInterest Rate

22 10.25%10.25%

44 10.3813%10.3813%


44 10.3813%10.3813%

1212 10.4713%10.4713%

5252 10.5065%10.5065%

365365 10.5156%10.5156%

ContinuousContinuous 10.5171%10.5171%

Calculating the Rate of ReturnCalculating the Rate of Return

•• If we know the present value, the future value and the number of If we know the present value, the future value and the number of time periods, we can calculate the rate of return we have earnedtime periods, we can calculate the rate of return we have earned

•• For example, suppose we invested $5,000 six years ago For example, suppose we invested $5,000 six years ago Today, it is worth $10,000. What is the annually compounded Today, it is worth $10,000. What is the annually compounded rate of returned?rate of returned?

( )n+


5 - 264

( )0

1

0

1

6

1

1

10, 0001

5, 000

12.25%

n

n

nn

FV = PV k

FVk =

PV

+

−

= −

=


0 PMT5,000 +/- PV

6 NCPT I/Y 12.25%

Calculating the Number of PeriodsCalculating the Number of Periods

•• If we know the present value, the future value and the rate If we know the present value, the future value and the rate of return, we can calculate the number of time periods the of return, we can calculate the number of time periods the money needs to be invested for.money needs to be invested for.

•• For example, suppose we invested $25,000 at 8%. Today, For example, suppose we invested $25,000 at 8%. Today, it is worth $40,000. How long has the money been it is worth $40,000. How long has the money been invested?invested?


invested?invested?( )

( )

( )

0

0

1

ln

ln 1

4 0 , 0 0 0ln

2 5 , 0 0 0

ln 1 .0 8

6 .1 1

n

n

n

F V = P V k

F V

P Vn =

k

y e a r s

+

+

=

=


0 PMT25,000 +/- PV8.0 I/Y

CPT N 6.11 years

Calculating the Quoted RateCalculating the Quoted Rate

•• If we know the effective annual interest rate, (kIf we know the effective annual interest rate, (kEffEff) and we ) and we know the number of compounding periods, (m) we can know the number of compounding periods, (m) we can solve for the Quoted Rate, as follows:solve for the Quoted Rate, as follows:


( )1

1 1mEffQR k m

= + −

When Payment & Compounding Periods DifferWhen Payment & Compounding Periods Differ

•• When the number of payments per year is When the number of payments per year is different from the number of compounding different from the number of compounding periods per year, you must calculate the interest periods per year, you must calculate the interest rate per payment period, using the following rate per payment period, using the following formula formula m


5 - 267

formula formula 1 1

m

f

PerPeriod

QRk

m = + −

Where:f = the payment frequency per year

Loan AmortizationLoan Amortization

•• A blended payment loan is repaid in equal A blended payment loan is repaid in equal periodic paymentsperiodic payments

•• However, the amount of principal and interest However, the amount of principal and interest varies each periodvaries each period


5 - 268

varies each periodvaries each period•• Assume that we want to calculate an Assume that we want to calculate an

amortization table showing the amount of amortization table showing the amount of principal and interest paid each period for a principal and interest paid each period for a $5,000 loan at 10% repaid in three equal annual $5,000 loan at 10% repaid in three equal annual instalments. instalments.

Loan Amortization: SolutionLoan Amortization: Solution

•• First calculate the annual paymentsFirst calculate the annual payments

( )1 1n

Annuity

kPV PMT

k

PV

− − +=

Calculator Approach:5,000 PV


( )

( ) 3

1 1

5,000

1 1.10

0.10

$2,010.57

Annuity

n

PVPMT

k

k

−

−

= − +

= −

=

0 FV3 N

10 I/YCPT PMT $2,010.57

Amortization TableAmortization Table

PeriodPeriod Principal: Principal: Start of Start of PeriodPeriod

PaymentPayment InterestInterest PrincipalPrincipal Principal:Principal:End of End of PeriodPeriod

11 5,000.005,000.00 2010.572010.57 500.00500.00 1,510.571,510.57 3,489.433,489.43


22 3,489.433,489.43 2010.572010.57 348.94348.94 1,661.631,661.63 1,827.801,827.80

33 1,827.801,827.80 2010.572010.57 182.78182.78 1,827.781,827.78 00

Calculating the Balance O/SCalculating the Balance O/S

•• At any point in time, the balance outstanding on At any point in time, the balance outstanding on the loan (the principal not yet repaid) is the PV of the loan (the principal not yet repaid) is the PV of the loan payments not yet made.the loan payments not yet made.

•• For example, using the previous example, we For example, using the previous example, we


5 - 271

•• For example, using the previous example, we For example, using the previous example, we can calculate the balance outstanding at the end can calculate the balance outstanding at the end of the first year, as shown on the next slideof the first year, as shown on the next slide

Calculating the Balance O/S after the 1Calculating the Balance O/S after the 1stst YearYear

( )

( )

1

2

1 1

1 1.102,010.57

n

t

kPV PMT

k

−

=

−

− +=

−=


5 - 272

2,010.57.10

$3, 489.42

=

=

Loan or Mortgage ArrangementsLoan or Mortgage ArrangementsMortgagesMortgages

•• MortgagesMortgages –– a loan involving equal ‘blended’ a loan involving equal ‘blended’ payments (interest and principal) over a payments (interest and principal) over a specified payment period specified payment period

•• Important to distinguish between “term” and Important to distinguish between “term” and


5 - 273

•• Important to distinguish between “term” and Important to distinguish between “term” and “amortization period”“amortization period”–– TermTerm –– the period for which investors can ‘lock in’ the period for which investors can ‘lock in’

at a fixed rateat a fixed rate–– Amortization periodAmortization period –– the period over which the the period over which the

loan is to be repaidloan is to be repaid

Canadian Residential MortgagesCanadian Residential Mortgages

•• By law, banks in Canada can only compound the By law, banks in Canada can only compound the interest twice per year on a conventional interest twice per year on a conventional mortgage, but payments are typically made at mortgage, but payments are typically made at least monthlyleast monthly


5 - 274

•• To solve for the payment, you must first To solve for the payment, you must first calculate the correct periodic interest ratecalculate the correct periodic interest rate

Canadian Residential MortgagesCanadian Residential Mortgages

•• For example, suppose we want to calculate the monthly For example, suppose we want to calculate the monthly payment on a $100,000 mortgage amortized over 25 years payment on a $100,000 mortgage amortized over 25 years with a 6% annual interest rate.with a 6% annual interest rate.

•• First, calculate the monthly interest rate:First, calculate the monthly interest rate:


2

12

1 1

.061 1

2

.004938622 0.4938622%

m

f

PerPeriod

QRk

m

or

= + −

= + −

=

Calculating the Monthly PaymentCalculating the Monthly Payment

•• Now, calculate the monthly payment on the mortgageNow, calculate the monthly payment on the mortgage

( )0

0

1 1n

t

t

kPV PMT

k

PVPMT

−

=

=

− +=

=

Calculator Approach:100,000 PV0 FV


( )

( )

0

300

1 1

100,000

1 1.004938622

.004938622

$639.81

tn

PVPMT

k

k

=−

−

= − +

= −

=

0 FV300 N

.4938622 I/YCPT PMT $639.81


In this chapter you have learned:In this chapter you have learned:–– To compare cash flows that occur at different points in timeTo compare cash flows that occur at different points in time–– To determine economically equivalent future values from values To determine economically equivalent future values from values

that occur in previous periods through compounding.that occur in previous periods through compounding.–– To determine economically equivalent present values from cash To determine economically equivalent present values from cash


5 - 277

–– To determine economically equivalent present values from cash To determine economically equivalent present values from cash flows that occur in the future through discountingflows that occur in the future through discounting

–– To find present value and future values of annuities, andTo find present value and future values of annuities, and–– To determine effective annual rates of return from quoted To determine effective annual rates of return from quoted

interest rates.interest rates.

Practice Problem 1Practice Problem 1Loan Payments Loan Payments

Your sister has been forced to borrow money to Your sister has been forced to borrow money to pay her tuition this year. If she makes annual pay her tuition this year. If she makes annual payments on the loan at year end for the next payments on the loan at year end for the next three years, and the loan is for $2,500 at a three years, and the loan is for $2,500 at a simple interest rate of 6 percent, how much will simple interest rate of 6 percent, how much will


5 - 278

simple interest rate of 6 percent, how much will simple interest rate of 6 percent, how much will she pay each year?she pay each year?

Practice Problem 1Practice Problem 1Loan Payments Loan Payments

Your sister has been forced to borrow money to Your sister has been forced to borrow money to pay her tuition this year. If she makes annual pay her tuition this year. If she makes annual payments on the loan at year end for the next payments on the loan at year end for the next three years, and the loan is for $2,500 at a three years, and the loan is for $2,500 at a simple interest rate of 6 percent, how much will simple interest rate of 6 percent, how much will


5 - 279

simple interest rate of 6 percent, how much will simple interest rate of 6 percent, how much will she pay each year?she pay each year?

33.983$

00.150$33.833$

)06.500,2($3

500,2$

=+=

×+

=PMT[ 5-5]

CHAPTER 6CHAPTER 6Bond Valuation and Interest Bond Valuation and Interest Bond Valuation and Interest Bond Valuation and Interest

RatesRates


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• Basic Structure of BondsBasic Structure of Bonds•• Bond ValuationBond Valuation

www.bookfiesta4u.com ContentsCHAPTER 6 – Bond Valuation and Interest Rates

6 - 282

•• Bond ValuationBond Valuation•• Bond YieldsBond Yields•• Interest Rate DeterminantsInterest Rate Determinants•• Other Types of Bonds/Debt InstrumentsOther Types of Bonds/Debt Instruments•• Summary and ConclusionsSummary and Conclusions



•• The basic features of different types of bondsThe basic features of different types of bonds•• How to value bonds given an appropriate discount rateHow to value bonds given an appropriate discount rate•• How to determine the discount rate or yield given the market How to determine the discount rate or yield given the market

value of a bondvalue of a bond•• How market interest rates or yields affect bond investorsHow market interest rates or yields affect bond investors


6 - 283

•• How market interest rates or yields affect bond investorsHow market interest rates or yields affect bond investors•• How bond prices change over timeHow bond prices change over time•• The factors (both domestic and global) that affect interest ratesThe factors (both domestic and global) that affect interest rates


•• Balloon paymentBalloon payment•• BillsBills•• Bond indentureBond indenture•• Bullet paymentBullet payment•• Call pricesCall prices•• Callable bondsCallable bonds

•• Default riskDefault risk•• Discount (premium)Discount (premium)•• DurationDuration•• Equipment trust certificatesEquipment trust certificates•• Expectations theoryExpectations theory•• Extendible bondsExtendible bonds•• Face valueFace value


6 - 284

•• Callable bondsCallable bonds•• Canada Savings BondsCanada Savings Bonds•• Collateral trust bondsCollateral trust bonds•• CouponsCoupons•• Current yieldCurrent yield•• DebenturesDebentures•• Debt ratingsDebt ratings•• Default freeDefault free

•• Face valueFace value•• Floating rate bondsFloating rate bonds•• Interest paymentsInterest payments•• Interest rate parity (IRP) theoryInterest rate parity (IRP) theory•• Interest rate riskInterest rate risk•• IssueIssue--specific premiumsspecific premiums•• Liquidity preference theoryLiquidity preference theory•• Maturity valueMaturity value


•• Mortgage bondsMortgage bonds•• Nominal interest ratesNominal interest rates•• NotesNotes•• PaperPaper•• Par valuePar value

•• Retractable bondsRetractable bonds•• RiskRisk--free ratefree rate•• Sinking fund provisionsSinking fund provisions•• SpreadSpread•• Term structure of interest Term structure of interest

ratesrates


6 - 285

•• Protective covenantsProtective covenants•• Purchase fund provisionsPurchase fund provisions•• Real return bondsReal return bonds

ratesrates•• Term to maturityTerm to maturity•• Yield curveYield curve•• Yield to maturityYield to maturity•• Zero coupon bondZero coupon bond

The Basic Structure of BondsThe Basic Structure of Bonds

•• What is a What is a bondbond??•• In its broadest sense, a bond is any debt In its broadest sense, a bond is any debt

instrument that promises a fixed income stream instrument that promises a fixed income stream


6 - 286

instrument that promises a fixed income stream instrument that promises a fixed income stream to the holderto the holder

•• Fixed income securities are often classified Fixed income securities are often classified according to maturity, as follows:according to maturity, as follows:–– Less than one year Less than one year –– Bills or “Paper”Bills or “Paper”–– 1 year 1 year < Maturity < 7 years < Maturity < 7 years –– NotesNotes–– < 7 years < 7 years –– BondsBonds


•• A typical bond has the following characteristics:A typical bond has the following characteristics:–– A fixed face or par value, paid to the holder of the A fixed face or par value, paid to the holder of the

bond, at maturitybond, at maturity–– A fixed coupon, which specifies the interest payable A fixed coupon, which specifies the interest payable

over the life of the bondover the life of the bond


6 - 287

over the life of the bondover the life of the bond•• Coupons are usually paid either annually or semiCoupons are usually paid either annually or semi--annuallyannually

–– A fixed maturity dateA fixed maturity date

•• Bonds may be either:Bonds may be either:–– Bearer bondsBearer bonds–– Registered bondsRegistered bonds

•• Bond indenture Bond indenture -- the contract between the issuer the contract between the issuer



6 - 288

•• Bond indenture Bond indenture -- the contract between the issuer the contract between the issuer of the bond and the investors who hold itof the bond and the investors who hold it

•• The market price of a bond is equal to the The market price of a bond is equal to the present value of the payments promised by the present value of the payments promised by the bondbond

(See the basic pattern of cash flows from a traditional bond on the next slide)

The The Basic Structure of BondsBasic Structure of BondsCash Flow Pattern for a Traditional CouponCash Flow Pattern for a Traditional Coupon--Paying BondPaying Bond

0 1 2 3 … n

I I I I I

0 1 2 3 … n

I I I I I

FIGURE 6-1


6 - 289

I I I I I

F

I I I I I

F

I = interest payments, and F = principal repayment

Cash Flow Pattern of a BondCash Flow Pattern of a Bond

0 2 3 4 n1

Coupon Coupon Coupon Coupon Coupon +Face Value

Purchase Price


6 - 290

The Purchase Price or Market Price of a bond is simply the present value of the cash inflows, discounted at the bond’s yield-

to-maturity

Cash Inflows to the Investor

Cash Outflows to the Investor

•• Bond indentureBond indenture is the contract between the is the contract between the issuer and the holder. It specifies:issuer and the holder. It specifies:–– Details regarding payment termsDetails regarding payment terms–– CollateralCollateral



6 - 291

–– Positive and negative covenantsPositive and negative covenants–– Par or face value (usually increments of $1,000)Par or face value (usually increments of $1,000)–– Bond pricing Bond pricing –– usually shown as the price per $100 of usually shown as the price per $100 of

par value, which is equal to the percentage of the par value, which is equal to the percentage of the bond’s face valuebond’s face value

•• TermTerm--toto--maturitymaturity –– the time remaining to the the time remaining to the bond’s maturity datebond’s maturity date

•• Coupon rateCoupon rate –– the annual percentage interest the annual percentage interest paid on the bond’s face value; to calculate the paid on the bond’s face value; to calculate the dollar value of the annual coupon, multiply the dollar value of the annual coupon, multiply the



6 - 292

dollar value of the annual coupon, multiply the dollar value of the annual coupon, multiply the coupon rate by the face valuecoupon rate by the face value–– If the coupon is paid twice a year, divide the annual If the coupon is paid twice a year, divide the annual

coupon by twocoupon by two–– Example: A $1,000 bond with an 8% coupon rate will Example: A $1,000 bond with an 8% coupon rate will

have an $80 coupon if paid annually or a $40 coupon have an $80 coupon if paid annually or a $40 coupon if paid semiif paid semi--annuallyannually

Security and Protective ProvisionsSecurity and Protective Provisions

•• Mortgage bondsMortgage bonds –– secured by real assetssecured by real assets•• DebenturesDebentures –– either unsecured or secured with either unsecured or secured with

a floating charge over the firm’s assetsa floating charge over the firm’s assets•• Collateral trust bondsCollateral trust bonds –– secured by a pledge of secured by a pledge of


6 - 293

•• Collateral trust bondsCollateral trust bonds –– secured by a pledge of secured by a pledge of financial assets, such as common stock, other financial assets, such as common stock, other bonds or treasury billsbonds or treasury bills

•• Equipment trust certificatesEquipment trust certificates –– secured by a secured by a pledge of equipment, such as railway rolling pledge of equipment, such as railway rolling stockstock

Security and Protective ProvisionsSecurity and Protective Provisions

•• CovenantsCovenants–– Positive covenantsPositive covenants –– things the firm agrees things the firm agrees toto dodo

•• Supply periodic financial statementsSupply periodic financial statements•• Maintain certain ratiosMaintain certain ratios


6 - 294

•• Maintain certain ratiosMaintain certain ratios

–– Negative covenantsNegative covenants –– things the firm agrees things the firm agrees not to not to dodo

•• Restricts the amount of debt the firm can take onRestricts the amount of debt the firm can take on•• Prevents the firm from acquiring or disposing of Prevents the firm from acquiring or disposing of

assetsassets

More Bond FeaturesMore Bond Features

•• Call featureCall feature –– allows the issuer to redeem or pay allows the issuer to redeem or pay off the bond prior to maturity, usually at a off the bond prior to maturity, usually at a premiumpremium

•• Retractable bondsRetractable bonds –– allows the holder to sell the allows the holder to sell the bonds back to the issuer before maturitybonds back to the issuer before maturity


6 - 295

bonds back to the issuer before maturitybonds back to the issuer before maturity•• Extendible bondsExtendible bonds –– allows the holder to extend allows the holder to extend

the maturity of the bondthe maturity of the bond•• Sinking fundsSinking funds –– funds set aside by the issuer to funds set aside by the issuer to

ensure the firm is able to redeem the bond at ensure the firm is able to redeem the bond at maturity maturity

•• Convertible bondsConvertible bonds –– can be converted into can be converted into common stock at a precommon stock at a pre--determined conversion determined conversion priceprice

Bond ValuationBond Valuation

•• The value of a bond is a function of:The value of a bond is a function of:–– Par valuePar value–– Term to maturityTerm to maturity


6 - 296

–– Coupon rateCoupon rate–– Investor’s required rate of return (discount rate is also Investor’s required rate of return (discount rate is also

known as the bond’s yield to maturity)known as the bond’s yield to maturity)

Bond ValueBond ValueGeneral FormulaGeneral Formula

)k(

Fk

)k(IB

n

nb

+×+

+−

×=1

111

1

[ 6-1]


6 - 297

)k(k bb +

1

Where:I = interest (or coupon ) payments

kb = the bond discount rate (or market rate)n = the term to maturity

F = Face (or par) value of the bond

Bond Valuation: ExampleBond Valuation: Example

•• What is the market price of a tenWhat is the market price of a ten--year, $1,000 bond with a year, $1,000 bond with a 5% coupon, if the bond’s yield5% coupon, if the bond’s yield--toto--maturity is 6%?maturity is 6%?

( )1 1n

k F− − + Calculator Approach:

www.bookfiesta4u.com ContentsCHAPTER 6 – Bond Valuation and Interest Rates 6 - 298

( )( )

( )( )

10

10

1 1

1

1 1.06 1,00050

0.06 1.06

$926.40

bn

b b

k FB I

k k

−

− += +

+

−= +

=


50 PMT10 NI/Y 6

CPT PV926.40

Factors Affecting Bond PricesFactors Affecting Bond PricesBond PriceBond Price--Yield CurveYield Curve

FIGURE 6-2

Price

When interest rates increase, bond prices fallWhen interest rates increase, bond prices fall


Market Yield (%)

Price ($)

•• The relationship between the coupon rate and the bond’s The relationship between the coupon rate and the bond’s yieldyield--toto--maturity (YTM) determines if the bond will sell at a maturity (YTM) determines if the bond will sell at a premium, at a discount, or at parpremium, at a discount, or at par

Factors Affecting Bond PricesFactors Affecting Bond Prices


If Then Bond Sells at a:

Coupon < YTMCoupon < YTM Market < FaceMarket < Face DiscountDiscount

Coupon = YTMCoupon = YTM Market = FaceMarket = Face ParPar

Coupon > YTMCoupon > YTM Market > FaceMarket > Face PremiumPremium

Bond Valuation: SemiBond Valuation: Semi--Annual CouponsAnnual Coupons

•• So far, we have assumed that all bonds have So far, we have assumed that all bonds have annual pay coupons. While this is true for many annual pay coupons. While this is true for many Eurobonds, it is not true for most domestic bond Eurobonds, it is not true for most domestic bond issues, which have coupons that are paid semiissues, which have coupons that are paid semi--annuallyannually


6 - 301

annuallyannually•• To adjust for semiTo adjust for semi--annual coupons, we must annual coupons, we must

make three changes:make three changes:–– Size of the coupon payment (divide by 2)Size of the coupon payment (divide by 2)–– Number of periods (multiply by 2)Number of periods (multiply by 2)–– YieldYield--toto--maturity (divide by 2)maturity (divide by 2)

Bond Valuation: SemiBond Valuation: Semi--Annual CouponsAnnual Coupons

For example, suppose you want to value a fiveFor example, suppose you want to value a five--year, year, $10,000 Government of Canada bond with a 4% coupon, $10,000 Government of Canada bond with a 4% coupon, paid twice a year, given a YTM of 6%.paid twice a year, given a YTM of 6%.

2

1 12

n

bkI F

B

− − + = +



2

2 5

2 5

22

12 2

.061 1

400 10,00020.062 .06

12 2

$9,146.98

nb b

x

x

I FB

k k

−

= + +

− + = +

+

=

10,000 FV400 ÷ 2 = PMT

5 x 2 = N6 ÷ 2 = I/Y

CPT PV926.40


•• There are three factors that affect the price There are three factors that affect the price volatility of a bondvolatility of a bond–– Yield to maturityYield to maturity–– Time to maturityTime to maturity


6 - 303

–– Size of couponSize of coupon


•• Yield to maturityYield to maturity–– Bond prices go down when the YTM goes upBond prices go down when the YTM goes up–– Bond prices go up when the YTM goes downBond prices go up when the YTM goes down

•• Look at the graph on the next slide. It shows Look at the graph on the next slide. It shows


6 - 304

•• Look at the graph on the next slide. It shows Look at the graph on the next slide. It shows how the price of a 25 year, 10% coupon bond how the price of a 25 year, 10% coupon bond changes as the bond’s YTM varies from 1% to changes as the bond’s YTM varies from 1% to 30%30%

•• Note that the graph is not linear Note that the graph is not linear –– instead it is instead it is said to be convex to the originsaid to be convex to the origin

Factors Affecting Bond Prices Factors Affecting Bond Prices Price and Yield: 25 Year Bond, 10% CouponPrice and Yield: 25 Year Bond, 10% Coupon

Price/Yield Relationship

250

300

350

Pric

e pe

r $1

00 o

f Fac

e


6 - 305

0

50

100

150

200

250

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

Percent YTM

Pric

e pe

r $1

00 o

f Fac

e V

alue

•• The convexity of the price/YTM graph reveals The convexity of the price/YTM graph reveals two important insights:two important insights:–– The price rise due to a fall in YTM is greater than the The price rise due to a fall in YTM is greater than the

price decline due to a rise in YTM, given an identical price decline due to a rise in YTM, given an identical change in the YTMchange in the YTM

Factors Affecting Bond Prices Factors Affecting Bond Prices Bond ConvexityBond Convexity


6 - 306

change in the YTMchange in the YTM–– For a given change in YTM, bond prices will change For a given change in YTM, bond prices will change

more when interest rates are low than when they are more when interest rates are low than when they are high high


•• Time to maturityTime to maturity–– Long bonds have greater price volatility than short Long bonds have greater price volatility than short

bondsbonds•• The longer the bond, the longer the period for which the The longer the bond, the longer the period for which the


6 - 307

•• The longer the bond, the longer the period for which the The longer the bond, the longer the period for which the cash flows are fixedcash flows are fixed

•• Size of couponSize of coupon–– Low coupon bonds have greater price volatility Low coupon bonds have greater price volatility

than high coupon bondsthan high coupon bonds•• High coupons act like a stabilizing device, since a greater High coupons act like a stabilizing device, since a greater

proportion of the bond’s total cash flows occur closer to proportion of the bond’s total cash flows occur closer to today & are therefore less affected by a change in YTMtoday & are therefore less affected by a change in YTM

Interest Rate Risk & DurationInterest Rate Risk & Duration

•• The sensitivity of bond prices to changes in The sensitivity of bond prices to changes in interest rates is a measure of the bond’s interest interest rates is a measure of the bond’s interest rate riskrate risk

•• A bond’s interest rate risk is affected by:A bond’s interest rate risk is affected by:


6 - 308

•• A bond’s interest rate risk is affected by:A bond’s interest rate risk is affected by:–– Yield to maturityYield to maturity–– Term to maturityTerm to maturity–– Size of couponSize of coupon

•• These three factors are all captured in one These three factors are all captured in one number called number called durationduration

DurationDuration

•• Duration is a measure of interest rate riskDuration is a measure of interest rate risk•• The higher the duration, the more sensitive the The higher the duration, the more sensitive the

bond is to changes in interest ratesbond is to changes in interest rates•• A bond’s duration will be higher if its:A bond’s duration will be higher if its:


6 - 309

•• A bond’s duration will be higher if its:A bond’s duration will be higher if its:–– YTM is lowerYTM is lower–– Term to maturity is longerTerm to maturity is longer–– Coupon is lowerCoupon is lower

Bond QuotationsBond Quotations

Issuer Coupon Maturity Price Yield

Canada 5.500 2009-Jun-01 103.79 4.16


Cash Versus Quoted PricesCash Versus Quoted Prices

•• The quoted price is the price reported by the The quoted price is the price reported by the mediamedia

•• The cash price is the price paid by an investorThe cash price is the price paid by an investor


6 - 311

•• The cash price includes both the quoted price The cash price includes both the quoted price plus any interest that has accrued since the last plus any interest that has accrued since the last coupon payment datecoupon payment date

Cash Versus Quoted Price: ExampleCash Versus Quoted Price: Example

•• Assume you want to purchase a $1,000 bond with a 5% Assume you want to purchase a $1,000 bond with a 5% coupon, paid semicoupon, paid semi--annually. Today is July 15annually. Today is July 15thth. The last . The last coupon was paid June 30coupon was paid June 30thth. If the quoted price is $902, . If the quoted price is $902, how much is the cash price? how much is the cash price?

•• Solution: The cash price is equal to:Solution: The cash price is equal to:–– Quoted price of $902Quoted price of $902


–– Quoted price of $902Quoted price of $902–– Plus 15 days of interestPlus 15 days of interest

( )( ) 15902 1,000 0.05

365

902 2.05

$904.05

Cash price = Quoted Price+ Accrued Interest

= +

= +=

Bond YieldsBond Yields

•• YieldYield--toto--maturity (YTM) maturity (YTM) –– the discount rate used the discount rate used to evaluate bondsto evaluate bonds–– The yield earned by a bond investor who:The yield earned by a bond investor who:

•• Purchases the bond at the current market pricePurchases the bond at the current market price


6 - 313

•• Purchases the bond at the current market pricePurchases the bond at the current market price•• Held the bond to maturityHeld the bond to maturity•• Reinvested all of the coupons at the YTMReinvested all of the coupons at the YTM

–– Is the bond’s Internal Rate of Return (IRR) Is the bond’s Internal Rate of Return (IRR)

Bond Yield to MaturityBond Yield to Maturity

YTM)(

FYTM

YTM)(IB

n

n

+×+

+−

×=1

111

1

[ 6-2]


6 - 314

•• The yield to maturity is that discount rate that causes the sum The yield to maturity is that discount rate that causes the sum of the present value of promised cash flows to equal the of the present value of promised cash flows to equal the current bond price.current bond price.

YTM)(YTM +

1

Solving for YTMSolving for YTM

•• To solve for YTM, solve for YTM in the following formula:To solve for YTM, solve for YTM in the following formula:

( )( )

1 1

1

n

n

YTM FB I

YTM YTM

− − += +

+


•• ProblemProblem: can’t solve for YTM algebraically; therefore, must : can’t solve for YTM algebraically; therefore, must either use a financial calculator, spreadsheet, trial and either use a financial calculator, spreadsheet, trial and error, or approximation formula.error, or approximation formula.

( )1nB I

YTM YTM= +

+

Solving for YTMSolving for YTM

•• Example: What is the YTM on a 10 year, 5% coupon bond Example: What is the YTM on a 10 year, 5% coupon bond (annual pay coupons) that is selling for $980?(annual pay coupons) that is selling for $980?

( )1 1n

YTM F− − + Financial Calculator


( )( )

( )( )

10

10

1 1

1

1 1 1,000980 50

1

5.26%

n

n

YTM FB I

YTM YTM

YTM

YTM YTM

YTM

−

−

− += +

+

− += +

+

=

Financial Calculator1,000 FV980 +/- PV

50 PMT10 N

I/Y 5.26%

Solving for YTM: SemiSolving for YTM: Semi--annual Couponsannual Coupons

•• When solving for YTM with a semiWhen solving for YTM with a semi--annual pay annual pay coupon, the yield obtained must be multiplied by coupon, the yield obtained must be multiplied by two to obtain the annual YTMtwo to obtain the annual YTM

•• Example: What is the YTM for a 20 year, $1,000 Example: What is the YTM for a 20 year, $1,000


6 - 317

•• Example: What is the YTM for a 20 year, $1,000 Example: What is the YTM for a 20 year, $1,000 bond with a 6% coupon, paid semibond with a 6% coupon, paid semi--annually, annually, given a current market price of $1,030?given a current market price of $1,030?

Solving for YTM: SemiSolving for YTM: Semi--annual Couponsannual Coupons

( )( )

1 1

1

n

n

YTM FB I

YTM YTM

− − += +

+

Financial Calculator1,000 FV1,030 +/- PV


6 - 318

( )( )

40

40

1 1 1,0001,030 30

1

2.87 2 5.74%

YTM

YTM YTM

YTM x

−

− += +

+

= =

1,030 +/- PV30 PMT

40 NI/Y 2.87 x 2

= 5.746%

The Approximation FormulaThe Approximation Formula

WhereWhereF = Face Value = Par Value = $1,000F = Face Value = Par Value = $1,000B = Bond PriceB = Bond PriceI = the semi annual coupon interestI = the semi annual coupon interestN = number of semiN = number of semi--annual periods left to maturityannual periods left to maturity


N = number of semiN = number of semi--annual periods left to maturityannual periods left to maturity

1YTM) annual-semi (1YTM

YTM annual-semi 2YTM2

nB-F

Maturity toYield annual-Semi

2 −+=×=

+

+=

BF

I

ExampleExample

•• Find the yieldFind the yield--toto--maturity of a 5 year 6% coupon maturity of a 5 year 6% coupon bond that is currently priced at $850. (Always bond that is currently priced at $850. (Always assume the coupon interest is paid semiassume the coupon interest is paid semi--annually.)annually.)


6 - 320

•• Therefore there is coupon interest of $30 paid Therefore there is coupon interest of $30 paid semisemi--annuallyannually

•• There are 10 semiThere are 10 semi--annual periods left until maturity annual periods left until maturity

SolutionSolution

9.3%0.0927320.0486YTM annual-semi 2YTM

0486.0925$

30$15$

2850,1$

30$10

850$000,1$

2

nB-F

Maturity toYield annual-Semi

==×=×=

=+=+−

=+

+=

BF

I


The actual answer is 9.87%...so of course, the appr oximation approach only gives us an approximate answer…but that is just fine for tests and exams.

%97.91)0486.1(1YTM) annual-semi (1YTM 22 =−=−+=

The Logic of the EquationThe Logic of the EquationApproximation Formula for YTMApproximation Formula for YTM

•• The numerator simply represents the average semiThe numerator simply represents the average semi--annual annual returns on the investment; it is made up of two components:returns on the investment; it is made up of two components:–– The first component is the average capital gain (if it is a discount The first component is the average capital gain (if it is a discount

bond) or capital loss (if it is a premium priced bond) per semibond) or capital loss (if it is a premium priced bond) per semi--annual period.annual period.

–– The second component is the semiThe second component is the semi--annual coupon interest annual coupon interest


6 - 322

–– The second component is the semiThe second component is the semi--annual coupon interest annual coupon interest received.received.

•• The denominator represents the average price of the bond.The denominator represents the average price of the bond.•• Therefore the formula is basically, average semiTherefore the formula is basically, average semi--annual return annual return

on average investment.on average investment.•• Of course, we annualize the semiOf course, we annualize the semi--annual return so that we annual return so that we

can compare this return to other returns on other investments can compare this return to other returns on other investments for comparison purposes.for comparison purposes.

Yield to CallYield to Call

•• If a bond has a call feature, the issuer can call If a bond has a call feature, the issuer can call the bond prior to its stated maturitythe bond prior to its stated maturity

•• To calculate the yield to call, replace the maturity To calculate the yield to call, replace the maturity date with the first call datedate with the first call date


6 - 323

date with the first call datedate with the first call date

Yield to CallYield to Call

YTC)(

CPYTC

YTC)(IB

n

n

+×+

+−

×=1

111

1

[ 6-3]


6 - 324

•• The yield to call is that discount rate that causes the present The yield to call is that discount rate that causes the present value of all promised cash flows including the call price (CP) value of all promised cash flows including the call price (CP) to equal the current bond price.to equal the current bond price.

YTC)(YTC +

1

Solving for YTC: SemiSolving for YTC: Semi--Annual CouponsAnnual Coupons

Financial Calculator1,050 FV1,030 +/- PV

30 PMT

YTC on a 20-year 6 percent bond that is callable in five years at a call price of $1,050. The bond pa ys semi-annual coupons and is selling for $1,030.

111

1×+

+−

×= CPYTC)(

IBn


6 - 325

30 PMT10 N

I/Y 3.081 x 2= 6.16%

%16.62%081.3

%081.3

1

050,1$11

130$030,1$

11

10

10

=×=−=

++

+−

=

+×+

+×=

YTC

annuallysemiYTC

YTC)(YTC

YTC)(

YTC)(

CPYTC

YTC)(IB

n

Current YieldCurrent Yield

•• The current yield is the yield on the bond’s current market The current yield is the yield on the bond’s current market price provided by the annual couponprice provided by the annual coupon–– It is not a true measure of the return to the bondholder because it It is not a true measure of the return to the bondholder because it

does not consider potential capital gain or capital losses based does not consider potential capital gain or capital losses based on the relationship between the purchase price of the bond and on the relationship between the purchase price of the bond and it’s par value.it’s par value.


it’s par value.it’s par value.

B

interestAnnualCY =[ 6-4]

Current YieldCurrent YieldExampleExample

•• The current yield is the yield on the bond’s current market The current yield is the yield on the bond’s current market price provided by the annual couponprice provided by the annual coupon

•• Example:Example: If a bond has a 5.5% annual pay coupon and the If a bond has a 5.5% annual pay coupon and the current market price of the bond is $1,050, the current yield is:current market price of the bond is $1,050, the current yield is:


55

1,050

5.24%

Annual CouponCurrent Yield =

Current Market Price

=

=

Interest Rate DeterminantsInterest Rate Determinants

•• Interest is the “price” of moneyInterest is the “price” of money•• Basis points Basis points –– 1/100 of 1%1/100 of 1%•• Interest rates go:Interest rates go:


6 - 328

–– Up Up –– when the demand for loanable funds riseswhen the demand for loanable funds rises–– DownDown –– when the demand for loanable funds fallswhen the demand for loanable funds falls

RiskRisk--free Interest Ratefree Interest Rate

•• Usually use the yield on short federal government Usually use the yield on short federal government treasury bills as a proxy for the risktreasury bills as a proxy for the risk--free rate (RF)free rate (RF)

•• The riskThe risk--free rate is comprised of two free rate is comprised of two components:components:


6 - 329

components:components:–– Real rateReal rate –– compensation for deferring consumptioncompensation for deferring consumption–– Expected inflationExpected inflation –– compensation for the expected compensation for the expected

loss in purchasing power loss in purchasing power

(See Figure 6-3 to see rates of inflation and yields on long Canada bonds since 1961)

Inflation and Yields over TimeInflation and Yields over Time

FIGURE 6-3


6 - 330

Fisher EquationFisher Equation

•• If we call the riskIf we call the risk--free rate the nominal rate, then the free rate the nominal rate, then the relationship between the real rate, the nominal rate and relationship between the real rate, the nominal rate and expected inflation is usually referred to as the Fisher expected inflation is usually referred to as the Fisher Equation (after Irving Fisher)Equation (after Irving Fisher)


inflation Expectedrate RealRF +=[ 6-5]

Fisher EquationFisher Equation

•• When inflation is low, can safely use the approximation When inflation is low, can safely use the approximation formula:formula:

Nominal RealR = R + Expected Inflation


•• When inflation is high, use the exact form of the Fisher When inflation is high, use the exact form of the Fisher Equation:Equation:

( ) ( )( )1 1 1Nominal RealR = R Expected Inflation+ + +

Fisher Equation Fisher Equation ExampleExample

•• If the real rate is 3% and the nominal rate is 5.5%, what is If the real rate is 3% and the nominal rate is 5.5%, what is the approximate expected future inflation rate?the approximate expected future inflation rate?

R = R + Expected Inflation


5.5 3

2.5%

Nominal RealR = R + Expected Inflation

Expected Inflation

Expected Inflation

= +=

Global Influences on Interest RatesGlobal Influences on Interest Rates

•• Canadian domestic interest rates are heavily Canadian domestic interest rates are heavily influenced by global interest ratesinfluenced by global interest rates

•• Interest rate parity (IRP) theory states that FX Interest rate parity (IRP) theory states that FX forward rates will be established that equalize forward rates will be established that equalize


6 - 334

forward rates will be established that equalize forward rates will be established that equalize the yield an investor can earn, whether investing the yield an investor can earn, whether investing domestically or in a foreign jurisdictiondomestically or in a foreign jurisdiction–– A country with high inflation and high interest rates A country with high inflation and high interest rates

will have a depreciating currencywill have a depreciating currency

Term Structure of Interest RatesTerm Structure of Interest Rates

•• Is that set of rates (YTM) for a given riskIs that set of rates (YTM) for a given risk--class of class of debt securities (for example, Government of debt securities (for example, Government of Canada Bonds) at a given point in time.Canada Bonds) at a given point in time.


6 - 335

•• When plotted on a graph, the line is called a When plotted on a graph, the line is called a Yield CurveYield Curve

Term Structure of Interest RatesTerm Structure of Interest Rates

•• The Yield Curve is the graph created by putting The Yield Curve is the graph created by putting term to maturity on the X axis, YTM on the Y term to maturity on the X axis, YTM on the Y axis and then plotting the yield at each maturity.axis and then plotting the yield at each maturity.

•• The four typical shapes of yield curves:The four typical shapes of yield curves:


6 - 336

•• The four typical shapes of yield curves:The four typical shapes of yield curves:•• Upward sloping (the most common shape)Upward sloping (the most common shape)•• Downward slopingDownward sloping•• FlatFlat•• HumpedHumped

(See Figure 6-4 for Yield curves that existed at various times in Canada)

Historical Yield CurvesHistorical Yield Curves1990, 1994, 1998, 20041990, 1994, 1998, 2004

Per

cent

16

14

12

10

FIGURE 6-4


6 - 337

Per

cent

Term Left to Maturity

10

8

6

4

2

0

1 mth 3 mths 6 mths 1 yr 2yrs 5 yrs 7 yrs 10 yrs 30 yrs

1990 1994 1998 2004

Theories of the Term StructureTheories of the Term Structure

•• Three theories are used to explain the shape of Three theories are used to explain the shape of the term structurethe term structure–– Liquidity preference theoryLiquidity preference theory

•• Investors must be paid a “liquidity premium” to hold less Investors must be paid a “liquidity premium” to hold less liquid, longliquid, long--term debtterm debt


6 - 338

liquid, longliquid, long--term debtterm debt

–– Expectations theoryExpectations theory•• The long rate is the average of expected future short interest The long rate is the average of expected future short interest

ratesrates

–– Market segmentation theoryMarket segmentation theory•• Distinct markets exist for securities of different maturitiesDistinct markets exist for securities of different maturities

Term Structure of Interest RatesTerm Structure of Interest RatesRisk PremiumsRisk Premiums

•• More risky bonds (i.e.. BBB rated Corporate Bonds) will have More risky bonds (i.e.. BBB rated Corporate Bonds) will have their own yield curve and it will plot at higher YTM at every their own yield curve and it will plot at higher YTM at every term to maturity because of the default risk that BBBs carryterm to maturity because of the default risk that BBBs carry

•• The difference between the YTM on a 10The difference between the YTM on a 10--year BBB corporate year BBB corporate


6 - 339

•• The difference between the YTM on a 10The difference between the YTM on a 10--year BBB corporate year BBB corporate bond and a 10bond and a 10--year Government of Canada bond is called a year Government of Canada bond is called a yield spreadyield spread and represents a and represents a defaultdefault--risk premiumrisk premium investors investors demand for investing in more risky securities.demand for investing in more risky securities.

•• Spreads will increase when pessimism increases in the Spreads will increase when pessimism increases in the economyeconomy

•• Spreads will narrow during times of economic expansion Spreads will narrow during times of economic expansion (confidence)(confidence)

Yield Curves for Different Risk ClassesYield Curves for Different Risk ClassesRisk Premiums (Yield Spreads)Risk Premiums (Yield Spreads)

Per

cent

16

14

12

10

Yield Spread


6 - 340

Term Left to Maturity

8

6

4

2

0

1 mth 3 mths 6 mths 1 yr 2yrs 5 yrs 7 yrs 10 yrs 30 yrs

BBB Corporates Government of Canada Bonds

Risk PremiumsRisk Premiums

•• The YTM on a corporate bond is comprised of:The YTM on a corporate bond is comprised of:

Spread aldifferenti yieldMaturity -/ RFkb ++== YTM[ 6-6]


•• The maturity yield differential is explained by the term The maturity yield differential is explained by the term structurestructure

•• Spread is the additional yield due to default riskSpread is the additional yield due to default risk

b

Debt RatingsDebt Ratings

•• All publicly traded bonds are assigned a “risk All publicly traded bonds are assigned a “risk rating” by a rating agency, such as Dominion rating” by a rating agency, such as Dominion Bond Rating Service (DBRS), Standard & Poors Bond Rating Service (DBRS), Standard & Poors (S&P), Moodys, Fitch, etc.(S&P), Moodys, Fitch, etc.


6 - 342

•• Bonds are categorized asBonds are categorized as–– Investment grade Investment grade –– top four rating categories (AAA, top four rating categories (AAA,

AA, A & BBB)AA, A & BBB)–– Junk or high yield Junk or high yield –– everything below investment everything below investment

grade (BB, B, CCC, CC, D, Suspended)grade (BB, B, CCC, CC, D, Suspended)

Why Do Bonds Have Different Yields?Why Do Bonds Have Different Yields?

•• Default riskDefault risk –– the higher the default risk, the the higher the default risk, the higher the required YTMhigher the required YTM

•• LiquidityLiquidity –– the less liquid the bond, the higher the less liquid the bond, the higher


6 - 343

•• LiquidityLiquidity –– the less liquid the bond, the higher the less liquid the bond, the higher the required YTMthe required YTM

•• Call featuresCall features –– increase required YTMincrease required YTM•• Extendible featureExtendible feature –– reduce required YTMreduce required YTM•• Retractable featureRetractable feature –– reduce required YTMreduce required YTM

Treasury BillsTreasury Bills

•• Treasury billsTreasury bills are shortare short--term obligations of government with term obligations of government with an initial term to maturity of one year or lessan initial term to maturity of one year or less

•• Issued at a discount and mature at face valueIssued at a discount and mature at face value•• The difference between the issue price and the face value is The difference between the issue price and the face value is

treated as interest incometreated as interest income


treated as interest incometreated as interest income•• To calculate the price of a TTo calculate the price of a T--bill, use the following formulabill, use the following formula

1T Bill

FP

nBEY

B

= +

Where:P = market price of the T Bill

F = face value of the T BillBEY = the bond equivalent yield

n = the number of days until maturityB = the annual basis (365 days in

Canada)

Treasury Bills: ExampleTreasury Bills: Example

•• What is the price of a $1,000,000 Canadian T bill with 80 What is the price of a $1,000,000 Canadian T bill with 80 days to maturity and a BEY of 4.5%?days to maturity and a BEY of 4.5%?

1T Bill

FP

nBEY

= +


1

1,000,00080

1 .045365

$990, 233.32

BEYB

+

= +

=

Solving for Yield on a T BillSolving for Yield on a T Bill

•• To solve for the yield on a T bill, rearrange the previous To solve for the yield on a T bill, rearrange the previous formula and solve for BEY. formula and solve for BEY.

•• ExampleExample: What is the yield on a $100,000 T bill with 180 days : What is the yield on a $100,000 T bill with 180 days to maturity and a market price of $98,200?to maturity and a market price of $98,200?


100,000 98, 200 365

98, 200 180

3.72%

F P BBEY

P n

− =

− =

=

Zero Coupon BondsZero Coupon Bonds

•• A A zero coupon bondzero coupon bond is a bond issued at a is a bond issued at a discount that matures at par or face valuediscount that matures at par or face value

•• A zero coupon bond has no reinvestment rate A zero coupon bond has no reinvestment rate risk, since there are no coupons to be reinvestedrisk, since there are no coupons to be reinvested


6 - 347

risk, since there are no coupons to be reinvestedrisk, since there are no coupons to be reinvested•• To calculate the price of a zero coupon bond, To calculate the price of a zero coupon bond,

solve for the PV of the face amount solve for the PV of the face amount

Zero Coupon BondsZero Coupon Bonds

•• Example: What is the market price of a $50,000 zero Example: What is the market price of a $50,000 zero coupon bond with 25 years to maturity that is currently coupon bond with 25 years to maturity that is currently yielding 6%?yielding 6%?

FB =


( )

( )25

F

1

50,000

1.06

$11,649.93

n

b

Bk

=+

=

=

Floating Rate & Real Return BondsFloating Rate & Real Return Bonds

•• Floating rate bondsFloating rate bonds have a coupon that floats have a coupon that floats with some reference rate, such as the yield on T with some reference rate, such as the yield on T billsbills–– Because the coupon floats, the market price will Because the coupon floats, the market price will

typically be close to the bond’s face valuetypically be close to the bond’s face value


6 - 349

typically be close to the bond’s face valuetypically be close to the bond’s face value

•• Real return bondsReal return bonds are issued by the are issued by the Government of Canada to protect investors Government of Canada to protect investors against unexpected inflationagainst unexpected inflation–– Each period, the face value of the bond is grossed up Each period, the face value of the bond is grossed up

by the inflation rate. The coupon is then paid on the by the inflation rate. The coupon is then paid on the grossed up face value.grossed up face value.

Canada Savings BondsCanada Savings Bonds

•• A Canada Savings Bond (CSB) is a special type A Canada Savings Bond (CSB) is a special type of bond issued by the Government of Canadaof bond issued by the Government of Canada

•• It is issued in two forms:It is issued in two forms:–– Regular interest Regular interest –– interest is paid annuallyinterest is paid annually


6 - 350

–– Regular interest Regular interest –– interest is paid annuallyinterest is paid annually–– Compound interest Compound interest –– interest compounds over the life interest compounds over the life

of the bondof the bond

•• CSBs are redeemable at any chartered bank in CSBs are redeemable at any chartered bank in Canada at their face valueCanada at their face value

•• There is no secondary market for CSBsThere is no secondary market for CSBs


In this chapter you have learned:In this chapter you have learned:–– About the nature of bonds as an investmentAbout the nature of bonds as an investment–– How to value a bond using discounted cash flow How to value a bond using discounted cash flow

conceptsconcepts


6 - 351

conceptsconcepts–– About the determinants of interest rates and theories About the determinants of interest rates and theories

used to explain the term structure of interest ratesused to explain the term structure of interest rates

CHAPTER 7CHAPTER 7Equity ValuationEquity ValuationEquity ValuationEquity Valuation


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• The Nature of Equity SecuritiesThe Nature of Equity Securities•• Valuation of EquitiesValuation of Equities

www.bookfiesta4u.com ContentsCHAPTER 7 – Equity Valuation

7 - 354

•• Valuation of EquitiesValuation of Equities•• Preferred Share ValuationPreferred Share Valuation•• Dividend Discount ModelDividend Discount Model•• Using Multiples to Value SharesUsing Multiples to Value Shares•• Summary and ConclusionsSummary and Conclusions



•• Understand the basic characteristics of equity Understand the basic characteristics of equity securitiessecurities

•• How these securities are valuedHow these securities are valued•• Some of the major factors that affect stock pricesSome of the major factors that affect stock prices


7 - 355

•• Some of the major factors that affect stock pricesSome of the major factors that affect stock prices•• Understand the sensitivity of the valuation estimate to Understand the sensitivity of the valuation estimate to

the input values usedthe input values used•• How to relate valuation models to commonly used How to relate valuation models to commonly used

ratios or “multiples”ratios or “multiples”


•• Common shareCommon share•• Constant growth DDMConstant growth DDM•• Dividend discount modelDividend discount model•• Equity securitiesEquity securities

•• Preferred sharePreferred share•• PricePrice--earnings ratioearnings ratio•• PricePrice--toto--cashcash--flow ratioflow ratio•• PricePrice--toto--sales ratiosales ratio•• Relative valuationRelative valuation


7 - 356

•• Equity securitiesEquity securities•• Market value to EBIT ratioMarket value to EBIT ratio•• Market value to EBITDA Market value to EBITDA

ratioratio•• MarketMarket--toto--book ratiobook ratio

•• Relative valuationRelative valuation•• Sustainable growth rateSustainable growth rate

Equity SecuritiesEquity SecuritiesIntroductionIntroduction

•• Equities represent ownership claims on Equities represent ownership claims on businessesbusinesses

•• Despite having Despite having residual claimsresidual claims to to earnings after earnings after


7 - 357

•• Despite having Despite having residual claimsresidual claims to to earnings after earnings after taxtax and to and to assets upon dissolutionassets upon dissolution equities offer equities offer the prospect for participation in the growth and the prospect for participation in the growth and profitability of the businessprofitability of the business

•• Equity securities can be valued based on Equity securities can be valued based on approaches using the present value of expected approaches using the present value of expected future dividend streamfuture dividend stream

Equity SecuritiesEquity SecuritiesNature of these SecuritiesNature of these Securities

Equity SecuritiesEquity Securities–– Include preferred and common sharesInclude preferred and common shares–– Represent ownership claimsRepresent ownership claims on the underlying entityon the underlying entity–– Usually have no specified maturity date, and since the Usually have no specified maturity date, and since the


7 - 358

–– Usually have no specified maturity date, and since the Usually have no specified maturity date, and since the underlying entity has a life separate and apart from underlying entity has a life separate and apart from it’s owners, equities are treated as investments with it’s owners, equities are treated as investments with infinite lifeinfinite life

–– Equities may pay dividends from afterEquities may pay dividends from after--tax earnings at tax earnings at the discretion of the board of directorsthe discretion of the board of directors

Equity SecuritiesEquity SecuritiesCommon SharesCommon Shares

•• According to the Canada Business Corporations Act (CBCA) According to the Canada Business Corporations Act (CBCA) corporations must have at least one share class with the corporations must have at least one share class with the following rights:following rights:–– Rights to residual earnings afterRights to residual earnings after--tax (after all legal obligations to tax (after all legal obligations to

other claimants have been satisfied)other claimants have been satisfied)


7 - 359

–– Rights to residual assets upon dissolution/liquidationRights to residual assets upon dissolution/liquidation–– Exert control over the corporation through voting rights to elect Exert control over the corporation through voting rights to elect

board of directors, accept financial statements, appoint auditors board of directors, accept financial statements, appoint auditors and approve major issues such as takeovers and corporate and approve major issues such as takeovers and corporate restructuring.restructuring.

•• Equities with the foregoing characteristics are typically called Equities with the foregoing characteristics are typically called Common SharesCommon Shares

Equity SecuritiesEquity SecuritiesPreferred SharesPreferred Shares

•• Have some preference over the common share classHave some preference over the common share class•• Usually have the following characteristics:Usually have the following characteristics:

–– A fixed annual dividend (not legally enforceable by shareholders A fixed annual dividend (not legally enforceable by shareholders if not declared)if not declared)

–– Have prior claim to dividends and assets upon Have prior claim to dividends and assets upon


7 - 360

–– Have prior claim to dividends and assets upon Have prior claim to dividends and assets upon dissolution/liquidation over and above the common sharesdissolution/liquidation over and above the common shares

–– NonNon--voting voting –– except if dividends are seriously in arrearsexcept if dividends are seriously in arrears–– No maturity date No maturity date –– Often have a cumulative feature (dividends in arrears must be Often have a cumulative feature (dividends in arrears must be

paid before common shareholders can receive dividends)paid before common shareholders can receive dividends)–– Often called a Often called a ‘fixed income’‘fixed income’ investment because the regular investment because the regular

annual dividend is fixed (set) at the time the shares are originally annual dividend is fixed (set) at the time the shares are originally issued. issued.

Valuation of Equity SecuritiesValuation of Equity SecuritiesRiskRisk--Premium ApproachPremium Approach

•• Valuation of equities can follow a discounted Valuation of equities can follow a discounted cash flow approachcash flow approach

•• The discount rate used reflects current level of The discount rate used reflects current level of interest rates (based on the riskinterest rates (based on the risk--free rate) plus a free rate) plus a


7 - 361

interest rates (based on the riskinterest rates (based on the risk--free rate) plus a free rate) plus a risk premiumrisk premium

•• This relationship is expressed as: This relationship is expressed as:

PremiumRisk RF +=k[ 7-1]

Valuation of Equity SecuritiesValuation of Equity SecuritiesRiskRisk--Premium ApproachPremium Approach

•• The The riskrisk--free ratefree rate is is equal to the real rate of equal to the real rate of return plus expected return plus expected

PremiumRisk RF +=k[ 7-1]

Required Return (%)

Required


7 - 362

return plus expected return plus expected inflation (Fisher inflation (Fisher Equation)Equation)

•• The The risk premiumrisk premium is is based on an estimate of based on an estimate of the risk associated with the risk associated with the security.the security.

•• Equation 7Equation 7--1 can be 1 can be described graphically as described graphically as follows:follows:

Risk of Equity Security M

RF

Risk

Required return on

Equity Security (M) Risk

Premium

Real Return

Expected Inflation Rate

Preferred Share ValuationPreferred Share ValuationCash Flow Pattern for a Straight Preferred ShareCash Flow Pattern for a Straight Preferred Share

0 1 2 3 … ∞0 1 2 3 … ∞

FIGURE 7-1


7 - 363

Dp Dp Dp Dp DpDp Dp Dp Dp Dp

•• Preferred shares can be viewed as Preferred shares can be viewed as perpetuitiesperpetuities because of the because of the nature of the dividend stream they offernature of the dividend stream they offer

•• A perpetuity is an infinite series of equal and periodic cash flows.A perpetuity is an infinite series of equal and periodic cash flows.

Preferred Share ValuationPreferred Share ValuationValue of a PerpetuityValue of a Perpetuity

pps k

DP =[ 7-2]


7 - 364

PPpsps is the market price (or present value)is the market price (or present value)DDpp is the annual dividend amountis the annual dividend amountkkpp is the required rate of return investors demand (or discount rate)is the required rate of return investors demand (or discount rate)

pps k

P =

Determine the market price of a $100 par value preferred share Determine the market price of a $100 par value preferred share that pays dividend based on a 7 percent dividend rate when that pays dividend based on a 7 percent dividend rate when investors require a return of 10 percent on the investment. investors require a return of 10 percent on the investment.

Preferred Share ValuationPreferred Share ValuationValue of a Perpetuity Value of a Perpetuity -- ExampleExample

00.70$10.0

00.7$

10.0

100$07. ==×== pps k

DP[ 7-2]


7 - 365

What happens to the market price if interest rates rise and What happens to the market price if interest rates rise and investors now require a 12 percent rate of return on the investors now require a 12 percent rate of return on the investment?investment?

00.70$10.010.0

====p

ps kP

33.58$12.0

00.7$

12.0

100$07. ==×==p

pps k

DP[ 7-2]

What happens to the market price if interest rates fall and What happens to the market price if interest rates fall and investors now require a investors now require a 7 percent rate of return7 percent rate of return on the on the investment?investment?

Preferred Share ValuationPreferred Share ValuationValue of a Perpetuity Value of a Perpetuity –– Example …Example …

00.100$00.7$100$07. ==×== pD

P


7 - 366

Like bonds, when the required return is equal to the preferredLike bonds, when the required return is equal to the preferreddividend rate, the preferred will be priced to equal its par value.dividend rate, the preferred will be priced to equal its par value.

00.100$07.0

00.7$

07.0

100$07. ==×==p

pps k

DP[ 7-2]

•• The preferred share valuation equation can be The preferred share valuation equation can be modified to solve for the investor’s required rate of modified to solve for the investor’s required rate of returnreturn

•• Remember, for market traded preferred shares, the Remember, for market traded preferred shares, the stock price will be observable (known) and so too will stock price will be observable (known) and so too will

Preferred Share ValuationPreferred Share ValuationEstimating the Required Rate of ReturnEstimating the Required Rate of Return


7 - 367

stock price will be observable (known) and so too will stock price will be observable (known) and so too will the annual dividend, so this type of calculation is very the annual dividend, so this type of calculation is very commoncommon

ps

pp P

Dk =

[ 7-3]

Assuming the previous 7%, $100 par value preferred share is Assuming the previous 7%, $100 par value preferred share is currently trading for $57.25, what is the implied marketcurrently trading for $57.25, what is the implied market--demanded required return?demanded required return?

Preferred Share ValuationPreferred Share ValuationEstimating the Required Rate of Return Estimating the Required Rate of Return –– An ExampleAn Example

00.7$100$07. ==×== pD


7 - 368

You knew that the share was trading for less than its par value, You knew that the share was trading for less than its par value, so even before trying to solve for the answer, you should have so even before trying to solve for the answer, you should have known that investors were requiring a higher rate of return than known that investors were requiring a higher rate of return than 7%. 7%.

%22.1225.57$

00.7$

25.57$

100$07. ==×==ps

pp P

Dk[ 7-3]

Common Share ValuationCommon Share ValuationDiscount ModelsDiscount Models

•• All discount valuation models All discount valuation models estimate the current estimate the current economic value of any security as the sum of the economic value of any security as the sum of the discounted (present) value of all promised future cash discounted (present) value of all promised future cash flowsflows

•• The current value is therefore a function of the timing, The current value is therefore a function of the timing,

www.bookfiesta4u.com ContentsCHAPTER 7 – Equity Valuation 7 - 369

•• The current value is therefore a function of the timing, The current value is therefore a function of the timing, magnitude, and riskiness of all future cash flows:magnitude, and riskiness of all future cash flows:

∑= +

=

+++

++

+=

n

ii

i

nn

k

FlowCash

k

FlowCash

k

FlowCash

k

FlowCashV

1

22

11

0

)1(

)1(

...)1()1(


•• In the case of common stock the cash flows of a goingIn the case of common stock the cash flows of a going--concern business are expected to go on in perpetuity concern business are expected to go on in perpetuity (forever).(forever).

+++

++

+= α

α2

21

10

)1(...

)1()1( k

FlowCash

k

FlowCash

k

FlowCashV


•• The purchaser exchanges the price she/he paid for the The purchaser exchanges the price she/he paid for the investment at time 0 with a possible series of future cash investment at time 0 with a possible series of future cash flows.flows.

•• Risk factored into the equation through Risk factored into the equation through kk (investor’s (investor’s required return)required return)

∑= +

=α

1 )1(ii

i

k

FlowCash


∑= +

=

+++

++

+=

α

αα

1

22

11

0

)1(

)1(

...)1()1(

ii

i

k

FlowCash

k

FlowCash

k

FlowCash

k

FlowCashV


The formula can be illustrated graphically as follows:The formula can be illustrated graphically as follows:

V0 = Market Price Paid $

CF1 CF2 CF3 CFα0

1 2 3 α


∑ +=

+++

++

+=

α

αα

22

11

0 )1(

...)1()1(

iFlowCash

k

FlowCash

k

FlowCash

k

FlowCashV


Remember, the amount and timing of future dividends (if that is Remember, the amount and timing of future dividends (if that is the cash flow you are using) is highly uncertain for most the cash flow you are using) is highly uncertain for most businesses because dividends are not fixed obligation of the businesses because dividends are not fixed obligation of the firm, but rather are declared at the discretion of the board of firm, but rather are declared at the discretion of the board of directors, when, and if the firm is profitable, and doesn’t have directors, when, and if the firm is profitable, and doesn’t have other uses for the cash.other uses for the cash.

∑= +

=1 )1(i

ik

Common Share Valuation using DDMCommon Share Valuation using DDMThe Basic Dividend Discount Model The Basic Dividend Discount Model –– Intrinsic Value EstimateIntrinsic Value Estimate

–– The DDM says the The DDM says the intrinsic valueintrinsic value or inherent or inherent economic worth of the stock is equal to the sum of the economic worth of the stock is equal to the sum of the present value of all future dividends to be receivedpresent value of all future dividends to be received


7 - 373

nc

n

cc k

D

k

D

k

DP

)1(...

)1()1( 22

11

0 +++

++

+=[ 7-4]

Common Share Valuation using DDMCommon Share Valuation using DDMFundamental Analysts and the Basic Dividend Discount ModelFundamental Analysts and the Basic Dividend Discount Model

Security analysts that use the DDM model are called Security analysts that use the DDM model are called fundamental analystsfundamental analysts because they base the estimate of because they base the estimate of inherent worth on the economic fundamentals of the stockinherent worth on the economic fundamentals of the stock

∑=+++=α

α21 ... tDDDDP[ 7-5]


7 - 374

Once they have estimated the inherent worth, they compare their Once they have estimated the inherent worth, they compare their estimate with the actual stock price in the market to determine estimate with the actual stock price in the market to determine whether the stock is UNDER, OVER, or FAIRLY valuedwhether the stock is UNDER, OVER, or FAIRLY valued

∑= +

=+

+++

++

= αα

12

21

10 )1()1(

...)1()1( t

tc

t

ccc kkkkP[ 7-5]

Common Share Valuation using DDMCommon Share Valuation using DDMThe Constant Growth DDMThe Constant Growth DDM

When the firm’s dividends are growing at a slow, constant rate, When the firm’s dividends are growing at a slow, constant rate, and can be expected to do so for the foreseeable future, we use and can be expected to do so for the foreseeable future, we use the constant growth dividend discount model.the constant growth dividend discount model.

α

α

)1(

)1(...

)1(

)1(

)1(

)1( 02

20

1

10

0ccc k

gD

k

gD

k

gDP

++++

+++

++=[ 7-6]


7 - 375

Which can be simplified by multiplying DWhich can be simplified by multiplying D00 by a factor of by a factor of (1+g)/(1+k(1+g)/(1+kcc) every period to get:) every period to get:

)1()1()1( ccc kkk +++

gk

D

gk

gDP

cc −=

−+= 10

0

)1([ 7-7]

Common Share Valuation using DDMCommon Share Valuation using DDMEstimating the Required Rate of ReturnEstimating the Required Rate of Return

The Constant Growth DDM can be reorganized to solve for the The Constant Growth DDM can be reorganized to solve for the investor’s required returninvestor’s required return

gP

Dkc +=

0

1[ 7-8]


This formula can be decomposed into two components, This formula can be decomposed into two components, demonstrating that equity investors receive two forms of prospective demonstrating that equity investors receive two forms of prospective income from their investment, dividends and capital gains.income from their investment, dividends and capital gains.

0

[ ] [ ] [ ] YieldGain Capital Yield DividendCurrent

0

1 +=+

= g

P

Dkc

Common Share Valuation using DDMCommon Share Valuation using DDMEstimating the Value of Growth OpportunitiesEstimating the Value of Growth Opportunities

•• Assuming the firm has no profitable growth opportunities Assuming the firm has no profitable growth opportunities ggshould be equal to 0, and should be equal to 0, and DD11=EPS=EPS11

•• The Constant Growth DDM reduces to:The Constant Growth DDM reduces to:

ck

EPSP 1

0 =[ 7-9]


7 - 377

Therefore, the share price of any constant growth common stock Therefore, the share price of any constant growth common stock is made up of two components:is made up of two components:

•• The noThe no--growth components andgrowth components and•• The present value of growth opportunitiesThe present value of growth opportunities

This can be expressed as:This can be expressed as:

(See the following slide) (See the following slide)

Constant Growth DDM Two ComponentsConstant Growth DDM Two ComponentsEstimating the Value of Growth OpportunitiesEstimating the Value of Growth Opportunities

[ ] [ ]iesopportunitgrowthofvaluepresentcomponentgrowthno

PVGOk

EPSP

c

+−=

+= 10[ 7-10]


7 - 378

Decomposing the constantDecomposing the constant--growth DDM into its two growth DDM into its two components gives us an analytical tool to examine the two components gives us an analytical tool to examine the two sources of current value of the firm.sources of current value of the firm.

[ ] [ ]iesopportunitgrowthofvaluepresentcomponentgrowthno +−=

The Constant Growth DDMThe Constant Growth DDMExamining the Importance of the Growth AssumptionExamining the Importance of the Growth Assumption

gk

DP

c −= 1

0[ 7-7]

Earnings

5% growth rate

... 321 αgggg ====


The formula assumes that the growth rate will remain the same in The formula assumes that the growth rate will remain the same in period 1 through infinity.period 1 through infinity.

•• This is a very long period of timeThis is a very long period of time

Time α

... 321 αgggg ====

The Constant Growth DDMThe Constant Growth DDMExamining the Importance of the Growth AssumptionExamining the Importance of the Growth Assumption

The formula assumes that the growth rate will remain the The formula assumes that the growth rate will remain the same in period 1 through infinity.same in period 1 through infinity.

gk

DP

c −= 1

0[ 7-7]


7 - 380

same in period 1 through infinity.same in period 1 through infinity.•• This is a very long period of timeThis is a very long period of time•• Because of compounding over time, small changes in Because of compounding over time, small changes in gg will will

have dramatic effects on the estimated stock value today.have dramatic effects on the estimated stock value today.•• If If gg is assumed to be greater than is assumed to be greater than kkcc a nona non--sensical answer sensical answer

would result. In practice this could never happen because no would result. In practice this could never happen because no company can continue to grow at compound rates of return company can continue to grow at compound rates of return to infinity at a rate that exceeds the longto infinity at a rate that exceeds the long--term rate of growth term rate of growth in the economy.in the economy.

The Constant Growth DDM The Constant Growth DDM Examining the Inputs of the Constant Growth DDMExamining the Inputs of the Constant Growth DDM

•• The formula predicts stock price increases if:The formula predicts stock price increases if:

gk

DP

c −= 1

0[ 7-7]


7 - 381

•• The formula predicts stock price increases if:The formula predicts stock price increases if:–– DD11 is increasedis increased–– gg is increasedis increased–– kkcc is decreasedis decreased

•• Conversely, the formula predicts stock price increases if:Conversely, the formula predicts stock price increases if:–– DD11 is decreasedis decreased–– gg is decreasedis decreased–– kkcc is increasedis increased

Common Share Valuation using DDMCommon Share Valuation using DDMEstimating DDM Inputs Estimating DDM Inputs –– Sustainable GrowthSustainable Growth

Sustainable growth can be estimated using the following Sustainable growth can be estimated using the following equation:equation:

Where: Where: bb = the firm’s earnings retention ratio= the firm’s earnings retention ratio

ROEbg ×=[ 7-11]


7 - 382

= (1 = (1 –– firm’s dividend payout ratio)firm’s dividend payout ratio)andand

ROEROE = firm’s return on common equity= firm’s return on common equity= net profit/common equity= net profit/common equity

Clearly, the value of the firm will rise if the fir m retains and reinvests its profits at a Clearly, the value of the firm will rise if the fir m retains and reinvests its profits at a rate of return rate of return (ROE)(ROE) greater than greater than kk cc

Under such conditions, Under such conditions, gg increases more than increases more than kk cc

Common Share Valuation using DDMCommon Share Valuation using DDMEstimating DDM Inputs Estimating DDM Inputs –– Sustainable GrowthSustainable Growth

ROEbg ×=[ 7-11]

Ratio Leverage RatioTurnover Margin Profit Net

Equity

Assets Total

Assets Total

Sales

Sales

incomeNet ROE

××=

××=[ 7-12]


7 - 383

Decomposing Decomposing ROEROE using the DuPont system allows managers using the DuPont system allows managers to see how they can increase the value of the firm:to see how they can increase the value of the firm:

–– increase the profit margin on salesincrease the profit margin on sales–– Increase the turnover rate on salesIncrease the turnover rate on sales–– Leverage the firm using less equity and more debt (although Leverage the firm using less equity and more debt (although

use of more debt implies higher risk and the benefits may be use of more debt implies higher risk and the benefits may be offset by a higher offset by a higher kkcc))

Ratio Leverage RatioTurnover Margin Profit Net ××=

Common Share Valuation using DDMCommon Share Valuation using DDMThe Multiple Stage Growth Version of the DDMThe Multiple Stage Growth Version of the DDM

•• Firms with earnings that Firms with earnings that are growing rapidly (more are growing rapidly (more rapid than the general rate rapid than the general rate of economic expansion) of economic expansion) require another approach.require another approach.

•• Remember, no firm’s Remember, no firm’s growth in earnings can growth in earnings can

Earnings

g2= 30%

g3= g4= gα=4%


growth in earnings can growth in earnings can exceed the general rate of exceed the general rate of economic expansion economic expansion forever…at some point, forever…at some point, earnings growth will fall.earnings growth will fall.

... 54321 αgggggg ====>>

Time

g1= 50%

Multiple Stage Growth Version of DDMMultiple Stage Growth Version of DDMThe Cash Flow Pattern for Multiple Stage Growth in DividendsThe Cash Flow Pattern for Multiple Stage Growth in Dividends

tc

tt

cc k

PD

k

D

k

DP

)1(...

)1()1( 22

11

0 ++++

++

+=[ 7-13]

7-2 FIGURE

0 1 2 … t t +10 1 2 … t t +1

Growth rate ≠ long-term growth rate (g) Growth rat e = g from tto α


7 - 385

0 1 2 … t t +1

D1 D2 … Dt Dt+1

0 1 2 … t t +1

D1 D2 … Dt Dt+1

to α

gk

DP

c

tt −

= +1

Multiple Stage Growth Version of DDMMultiple Stage Growth Version of DDMUsing Multiple Stage Growth Version of the DDMUsing Multiple Stage Growth Version of the DDM

–– Predict each dividend during the high growth yearsPredict each dividend during the high growth years–– Predict the first dividend during the constant growth yearsPredict the first dividend during the constant growth years–– Discount the individual dividends to the present and sum together with Discount the individual dividends to the present and sum together with

the price at time t when the constant growth model is used.the price at time t when the constant growth model is used.

The following is the formula you would use for two years of high earnings The following is the formula you would use for two years of high earnings


7 - 386

The following is the formula you would use for two years of high earnings The following is the formula you would use for two years of high earnings growth followed by a constant growth in years three through infinity.growth followed by a constant growth in years three through infinity.

22

22

11

2

3210

2210

110

0

)1()1()1(

)1(

)1)(1)(1(

)1(

)1)(1(

)1(

)1(

ccc

c

c

cc

k

P

k

D

k

D

k

gk

gggD

k

ggD

k

gDP

++

++

+=

+−

+++

++

++++

+=

Example of TwoExample of Two--stage DDMstage DDMUsing a Spreadsheet Modeling ApproachUsing a Spreadsheet Modeling Approach

Forecast Assumptions:Forecast Assumptions:•• Investor’s required return = Investor’s required return = k k = 10.9%= 10.9%•• Most recent dividend per share = Most recent dividend per share = DD00 = =

$0.25$0.25•• Growth rate in first year = Growth rate in first year = gg11 ==14.8%14.8%•• Growth rate in second year= Growth rate in second year= gg22 = 10%= 10%•• Growth rate in years three through Growth rate in years three through

08.5$)109.1(

62.5$

)109.1(

32.0$

)109.1(

29.0$

)109.1(05.109.

)05.1)(1.1)(148.1(25.0$

)109.1(

)1.1)(148.1(25.0$

)109.1(

)148.1(25.0$

)1()1()1(

22

221

22

210

=++=

+−+

++

+=

++

++

+=

ccc k

P

k

D

k

DP


•• Growth rate in years three through Growth rate in years three through infinity = infinity = gg33--αα = 5%= 5%

TimeDividend / Price

CalculationDividend

/Price

Present Value Factor

Present Value

1 $0.25 X (1+.148) = $0.29 0.901713 $0.262 $0.287 X (1+.1) = $0.32 0.813087 $0.262 P(2) = D(3)/ (.109 - .05) = $5.62 0.813087 $4.57

Intrinsic Value Estimate = $5.08

Constant Growth DDMConstant Growth DDMLimitations of the DDMLimitations of the DDM

The Model predictions are highly sensitive to changes in The Model predictions are highly sensitive to changes in

gk

DP

c −= 1

0[ 7-7]


7 - 388

The Model predictions are highly sensitive to changes in The Model predictions are highly sensitive to changes in gg and and kkcc

Not helpful in valuing nonNot helpful in valuing non--dividend paying firms.dividend paying firms.

Constant Growth DDMConstant Growth DDMBest Application of the Constant Growth DDMBest Application of the Constant Growth DDM

•• Use of the model is best suited to:Use of the model is best suited to:–– Firms that pay dividends based on a stable dividend Firms that pay dividends based on a stable dividend

payout history that are likely to maintain that practice payout history that are likely to maintain that practice


7 - 389

into the futureinto the future–– Are growing at a steady and sustainable rate.Are growing at a steady and sustainable rate.

•• This model works for large corporations in This model works for large corporations in mature industries such as banks and utility mature industries such as banks and utility companies.companies.

Using Multiples to Value SharesUsing Multiples to Value SharesThe Basic ApproachThe Basic Approach

•• Relative valuation approaches estimate the Relative valuation approaches estimate the value of common shares by comparing market value of common shares by comparing market prices of similar companies, relative to some prices of similar companies, relative to some variable such as:variable such as:


7 - 390

variable such as:variable such as:–– EarningsEarnings–– EBITDAEBITDA–– Cash flowCash flow–– Book valueBook value–– SalesSales

•• The challenge is finding the right comparator!The challenge is finding the right comparator!

Using Multiples to Value SharesUsing Multiples to Value SharesThe PriceThe Price--earnings (P/E) Ratioearnings (P/E) Ratio

•• Also known as the priceAlso known as the price--earnings multipleearnings multiple•• The ratio tells you how many times projected annual earnings (per The ratio tells you how many times projected annual earnings (per

share) the share is currently tradingshare) the share is currently trading

0

10

PEPS

ratio P/E JustifiedEPS Estimated

×=

×=P[ 7-13]


7 - 391

•• If you buy a company that is trading 10 times projected earnings, it If you buy a company that is trading 10 times projected earnings, it may take 10 years of those earnings to recover your investment.may take 10 years of those earnings to recover your investment.

•• If you buy a company trading 100 times projected earnings, it may If you buy a company trading 100 times projected earnings, it may take 100 years of those earnings to simply recover your investment take 100 years of those earnings to simply recover your investment (not including any time value of money or return on your (not including any time value of money or return on your investment).investment).

1

01 E

PEPS×=

[ 7-13]

Using Multiples to Value SharesUsing Multiples to Value SharesP/E Multiples Over TimeP/E Multiples Over Time

•• Figure 7Figure 7--3 illustrates the aggregate P/E ratios for the 3 illustrates the aggregate P/E ratios for the S&P/TSX from 1956 through 2005.S&P/TSX from 1956 through 2005.–– This figure is based on ‘trailing’ multiples (i.e.. Using actual This figure is based on ‘trailing’ multiples (i.e.. Using actual

earnings per share rather than forecast)earnings per share rather than forecast)–– The volatility of these aggregate multiples is driven by the The volatility of these aggregate multiples is driven by the

volatility of corporate earnings.volatility of corporate earnings.


7 - 392

•• Falling earnings can result in skyrocketing P/E ratios that are not a Falling earnings can result in skyrocketing P/E ratios that are not a reflection of the increasing value of stock (in fact, the market price of reflection of the increasing value of stock (in fact, the market price of the stock could be falling), but rather, the fact that earnings have the stock could be falling), but rather, the fact that earnings have dropped dramatically, in relation to the stock pricedropped dramatically, in relation to the stock price

•• This phenomenon should be expected since one year’s earnings This phenomenon should be expected since one year’s earnings can fall, but a stock price (according to the DDM approach) is a can fall, but a stock price (according to the DDM approach) is a function of many years of forecast cash flowsfunction of many years of forecast cash flows

(See Figure (See Figure 7 7 --3 on the next slide)3 on the next slide)

P/E MultiplesP/E MultiplesThe S&P/TSX Composite P/EThe S&P/TSX Composite P/E

FIGURE 7-3


7 - 393

P/E MultiplesP/E MultiplesImplementing the P/E Ratio ApproachImplementing the P/E Ratio Approach

•• Estimate EPSEstimate EPS1 1 using:using:–– Historical earnings dataHistorical earnings data–– Projected trendsProjected trends–– Use of analyst estimatesUse of analyst estimates

•• Estimate justifiable P/E ratio using where appropriate:Estimate justifiable P/E ratio using where appropriate:


7 - 394

•• Estimate justifiable P/E ratio using where appropriate:Estimate justifiable P/E ratio using where appropriate:–– Industry averageIndustry average–– Range of P/EsRange of P/Es–– Subjectively adjusted industry averages based on risk Subjectively adjusted industry averages based on risk

assessmentassessment

•• Obtain corroborating estimates based on:Obtain corroborating estimates based on:–– Economic, industry and company fundamentals, and/orEconomic, industry and company fundamentals, and/or–– Relate P/E to the fundamentals in the DDM Relate P/E to the fundamentals in the DDM

P/E MultiplesP/E MultiplesImplementing the P/E Ratio ApproachImplementing the P/E Ratio Approach

•• Estimate EPSEstimate EPS1 1 using:using:–– Historical earnings dataHistorical earnings data–– Projected trendsProjected trends–– Use of analyst estimatesUse of analyst estimates

•• Estimate justifiable P/E ratio using where appropriate:Estimate justifiable P/E ratio using where appropriate:


7 - 395

•• Estimate justifiable P/E ratio using where appropriate:Estimate justifiable P/E ratio using where appropriate:–– Industry averageIndustry average–– Range of P/EsRange of P/Es–– Subjectively adjusted industry averages based on risk Subjectively adjusted industry averages based on risk

assessmentassessment

•• Obtain corroborating estimates based on:Obtain corroborating estimates based on:–– Economic, industry and company fundamentals, and/orEconomic, industry and company fundamentals, and/or–– Relate P/E to the fundamentals in the DDM Relate P/E to the fundamentals in the DDM

P/E MultiplesP/E MultiplesRelating the P/E Multiple to Fundamentals in the DDMRelating the P/E Multiple to Fundamentals in the DDM

•• Given the constant growth DDMGiven the constant growth DDM

•• Divide both sides by expected earnings per share, to get Equation 7Divide both sides by expected earnings per share, to get Equation 7--1515

gk

DP

c −= 1

0[ 7-7]


7 - 396

•• Notice that DNotice that D11/EPS/EPS11 is the expected dividend payout ratio at time 1.is the expected dividend payout ratio at time 1.

•• Equations 7Equations 7--17 indicates:17 indicates:–– The higher the expected payout ratio, the higher the P/EThe higher the expected payout ratio, the higher the P/E–– The higher the expected growth rate, The higher the expected growth rate, gg, the higher the P/E, the higher the P/E–– The higher the required rate of return, The higher the required rate of return, kkcc, the lower the P/E , the lower the P/E

gk

EPS

D

E

P

EPS

P

c −== 1

1

1

0[ 7-15]

Using P/E Multiples to Value SharesUsing P/E Multiples to Value SharesLimitations of P/E RatiosLimitations of P/E Ratios

•• P/Es are uninformative when companies have negative (or very P/Es are uninformative when companies have negative (or very small) earningssmall) earnings

•• The volatility in earnings creates great volatility in P/Es throughout The volatility in earnings creates great volatility in P/Es throughout the business cycle.the business cycle.


7 - 397

Given the foregoing problems, analysts normally use Given the foregoing problems, analysts normally use smoothedsmoothed or or normalizednormalized estimates of earnings for the forecast year, as well as estimates of earnings for the forecast year, as well as

using a variety of different approaches to develop a range of using a variety of different approaches to develop a range of potential values for the stock.potential values for the stock.

(The issues compromising P/Es are illustrated in Table 7 (The issues compromising P/Es are illustrated in Table 7 --1 on the following slides)1 on the following slides)

Limitations of P/E Ratios Limitations of P/E Ratios Examples in the Forest IndustryExamples in the Forest Industry

Company Price 2006 EPS

Forecast EPS

P/E P/E Forecast

Yield TSX Symbol

Abitibi 2.72 -0.30 0.12 nm 22.67 0.00 A

Canfor 11.13 -0.27 0.47 nm 23.68 0.00 CFPCascades 11.54 0.71 0.60 16.25 19.23 1.39 CAS

Canfor Pulp 11.56 1.38 1.20 8.38 9.63 7.51 CFX.UN

Catalyst 3.22 -0.07 0.03 nm nm 0.00 CTL

Table 7-1 P/E Ratios in the Paper and Forest Prod ucts SectorLarge

number of firms

with negativ

e earning


7 - 398


Fraser Papers 7.01 -1.35 -0.41 nm nm 0.00 FPS

International 6.6 0.26 0.53 25.38 12.45 0.00 IFPA

Mercer 9.69 -0.07 0.14 nm 54.35 0.00 MERC

Norbord 8.41 0.74 0.40 10.24 18.95 4.76 NBD

PRT 11.2 0.69 0.70 16.23 16.00 9.38 PRT.UN

SFK Pulp 4.14 0.64 0.82 6.47 5.05 4.19 SFK.UN

Tembec 1.43 -2.00 -1.11 nm nm 0.00 TBC

TimberWest Forest 14.07 0.01 -0.27 nm nm 7.65 TWF.UNWest Fraser Timber 37.45 0.94 2.35 39.84 15.94 1.50 WFT

Note: nm = note meaningful

Source: RBC Dominion Securities Inc., Foundations Research Report, September 2006.

earnings



Forecast EPS

P/E P/E Forecast

Yield TSX Symbol

Abitibi 2.72 -0.30 0.12 nm 22.67 0.00 A




Table 7-1 P/E Ratios in the Paper and Forest Prod ucts Sector

P/E ratio is highly variable across

the industry


7 - 399




Mercer 9.69 -0.07 0.14 nm 54.35 0.00 MERC

Norbord 8.41 0.74 0.40 10.24 18.95 4.76 NBD

PRT 11.2 0.69 0.70 16.23 16.00 9.38 PRT.UN

SFK Pulp 4.14 0.64 0.82 6.47 5.05 4.19 SFK.UN

Tembec 1.43 -2.00 -1.11 nm nm 0.00 TBC

TimberWest Forest 14.07 0.01 -0.27 nm nm 7.65 TWF.UNWest Fraser Timber 37.45 0.94 2.35 39.84 15.94 1.50 WFT



industry… there

is no ‘average’

or consistent pattern.



Forecast EPS

P/E P/E Forecast

Yield TSX Symbol

Abitibi 2.72 -0.30 0.12 nm 22.67 0.00 A



Table 7-1 P/E Ratios in the Paper and Forest Prod ucts SectorData mixes

normal corporation

s with Income Trust

structures.


7 - 400




Mercer 9.69 -0.07 0.14 nm 54.35 0.00 MERC

Norbord 8.41 0.74 0.40 10.24 18.95 4.76 NBD

PRT 11.2 0.69 0.70 16.23 16.00 9.38 PRT.UN

SFK Pulp 4.14 0.64 0.82 6.47 5.05 4.19 SFK.UN

Tembec 1.43 -2.00 -1.11 nm nm 0.00 TBC

TimberWest Forest 14.07 0.01 -0.27 nm nm 7.65 TWF.UN

West Fraser Timber 37.45 0.94 2.35 39.84 15.94 1.50 WFT



structures.

Income Trusts have more stable

earnings, so their P/E ratios are

more stable.

Other Multiples or Relative Value RatiosOther Multiples or Relative Value Ratios

•• MarketMarket--toto--book (M/B) ratiobook (M/B) ratio•• PricePrice--toto--sales (P/S) ratiosales (P/S) ratio•• PricePrice--toto--cashcash--flow (P/CF) ratioflow (P/CF) ratio


7 - 401

•• PricePrice--toto--cashcash--flow (P/CF) ratioflow (P/CF) ratio•• Market value to EBIT ratioMarket value to EBIT ratio•• Market value to EBITDA ratioMarket value to EBITDA ratio

MarketMarket--toto--Book RatioBook Ratio

•• Multiply justifiable M/B ratio times the firm’s book value per share to get an Multiply justifiable M/B ratio times the firm’s book value per share to get an estimate of intrinsic valueestimate of intrinsic value

Shareper ValueBook

Shareper PriceMarket / =ratioBM


7 - 402

estimate of intrinsic valueestimate of intrinsic value•• AdvantagesAdvantages

–– Book values provide a relatively stable, intuitive measure of value relative to Book values provide a relatively stable, intuitive measure of value relative to market valuesmarket values

–– Eliminates problems associated with P/E multiples because book values are Eliminates problems associated with P/E multiples because book values are rarely negative and are not volatilerarely negative and are not volatile

•• DisadvantagesDisadvantages–– Book values may be sensitive to accounting standardsBook values may be sensitive to accounting standards–– Book values may be uninformative for companies with few fixed assetsBook values may be uninformative for companies with few fixed assets

•• M/B ratio fell out of favour in the 1980s and 90s because high rates of M/B ratio fell out of favour in the 1980s and 90s because high rates of inflation distorted book valuesinflation distorted book values

PricePrice--toto--Sales (P/S) RatioSales (P/S) Ratio

•• Multiply justifiable P/S ratio times the firm’s sales per share to Multiply justifiable P/S ratio times the firm’s sales per share to get an estimate of intrinsic valueget an estimate of intrinsic value

•• AdvantagesAdvantages–– Sales are relatively insensitive to accounting decisions and are Sales are relatively insensitive to accounting decisions and are


7 - 403

–– Sales are relatively insensitive to accounting decisions and are Sales are relatively insensitive to accounting decisions and are never negativenever negative

–– Sales are not as volatile as earningsSales are not as volatile as earnings–– Sales provide useful information about corporate decisions such Sales provide useful information about corporate decisions such

as product pricingas product pricing

•• DisadvantagesDisadvantages–– Sales do not provide information about expenses and profit Sales do not provide information about expenses and profit

margins which are key determinants of corporate performancemargins which are key determinants of corporate performance

PricePrice--toto--CashCash--Flow (P/CF) RatioFlow (P/CF) Ratio

•• Cash flowCash flow is estimated as Net Income + Depreciation and is estimated as Net Income + Depreciation and Amortization + Deferred TaxesAmortization + Deferred Taxes

•• Multiply justifiable P/CF ratio times the firm’s cash flow per Multiply justifiable P/CF ratio times the firm’s cash flow per share to get an estimate of intrinsic valueshare to get an estimate of intrinsic value


7 - 404

share to get an estimate of intrinsic valueshare to get an estimate of intrinsic value•• AdvantagesAdvantages

–– Reduces accounting concerns regarding earnings measurementReduces accounting concerns regarding earnings measurement

Market Value to EBIT or EBITDAMarket Value to EBIT or EBITDA

•• Multiply justifiable ratio times the firm’s Multiply justifiable ratio times the firm’s forecast forecast EBIT or EBIT or EBITDA per share to get an estimate of intrinsic valueEBITDA per share to get an estimate of intrinsic value

•• Use Market Value of both Debt and Equity reflecting the fact Use Market Value of both Debt and Equity reflecting the fact


7 - 405

•• Use Market Value of both Debt and Equity reflecting the fact Use Market Value of both Debt and Equity reflecting the fact that EBIT or EBITDA represents income available to satisfy that EBIT or EBITDA represents income available to satisfy the claims of both debt and equity holdersthe claims of both debt and equity holders

•• AdvantagesAdvantages–– Using EBIT and EBITDA instead of net income eliminates Using EBIT and EBITDA instead of net income eliminates

volatility caused by EPSvolatility caused by EPS

(A Forecast Income Statement that could be used wi th EBIT and (A Forecast Income Statement that could be used wi th EBIT and EBITDA ratios is illustrated in Table 7EBITDA ratios is illustrated in Table 7--2 on the f ollowing slide)2 on the following slide)

EBIT and EBITDA Ratios EBIT and EBITDA Ratios Examples using Forecast Income StatementExamples using Forecast Income Statement

Sales Volume 1 million units

Unit price $10 $10 millionVariable costs 5.0

Fixed cash costs 1.7

EBITDA 3.3

Table 7-2 Forecast Income Statement ==+=3.3

MV

EBITDA

EquityDebtMVratioEBITDA


EBITDA 3.3

Depreciation 0.8

EBIT 2.5

Interest 0.5

EBT 2.0

Income Tax @ 50 percent 1.0

Net Income 1.0

Dividends 0.5

Book value of equity 5.0Book value of debt 5.0

2.5

MV =+=

EBIT

EquityDebtMVratioEBIT

Using Multiples to Value SharesUsing Multiples to Value SharesConcluding RemarksConcluding Remarks

•• Use of comparative multiples is a popular Use of comparative multiples is a popular approach to valuing stockapproach to valuing stock

•• Despite apparent simplicity of generating the Despite apparent simplicity of generating the


7 - 407

•• Despite apparent simplicity of generating the Despite apparent simplicity of generating the ratios, consideration of the accounting, volatility ratios, consideration of the accounting, volatility and other issues affecting the usefulness of and other issues affecting the usefulness of these approaches.these approaches.


In this chapter you have learned:In this chapter you have learned:–– Basic approaches to valuing preferred and Basic approaches to valuing preferred and

common shares including:common shares including:•• Dividend discount modelsDividend discount models


7 - 408

•• Relative valuation modelsRelative valuation models

–– The importance of recognizing the The importance of recognizing the sensitivity of the valuation process to sensitivity of the valuation process to assumptions regarding input variables assumptions regarding input variables such as growth rates, discount rates and such as growth rates, discount rates and general market conditions.general market conditions.

CHAPTER 8CHAPTER 8Risk, Return, and Portfolio Risk, Return, and Portfolio Risk, Return, and Portfolio Risk, Return, and Portfolio

TheoryTheory


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• Measurement of ReturnsMeasurement of Returns•• Measuring RiskMeasuring Risk

www.bookfiesta4u.com ContentsCHAPTER 8 – Risk, Return and Portfolio Theory

8 - 411

•• Measuring RiskMeasuring Risk•• Expected Return and Risk for PortfoliosExpected Return and Risk for Portfolios•• The Efficient FrontierThe Efficient Frontier•• DiversificationDiversification•• Summary and ConclusionsSummary and Conclusions



•• The difference among the most important types of The difference among the most important types of returnsreturns

•• How to estimate expected returns and risk for How to estimate expected returns and risk for individual securitiesindividual securities


8 - 412

individual securitiesindividual securities•• What happens to risk and return when securities are What happens to risk and return when securities are

combined in a portfoliocombined in a portfolio•• What is meant by an “efficient frontier”What is meant by an “efficient frontier”•• Why diversification is so important to investorsWhy diversification is so important to investors


•• Arithmetic meanArithmetic mean•• Attainable portfoliosAttainable portfolios•• Capital gain/lossCapital gain/loss•• Correlation coefficientCorrelation coefficient•• CovarianceCovariance•• Day traderDay trader

•• Mark to marketMark to market•• Market riskMarket risk•• Minimum variance frontierMinimum variance frontier•• Minimum variance portfolioMinimum variance portfolio•• Modern portfolio theoryModern portfolio theory•• Naïve or random diversificationNaïve or random diversification


8 - 413

•• DiversificationDiversification•• Efficient frontierEfficient frontier•• Efficient portfoliosEfficient portfolios•• Ex ante returnsEx ante returns•• Ex post returnsEx post returns•• Expected returnsExpected returns•• Geometric meanGeometric mean•• Income yieldIncome yield

•• Paper lossesPaper losses•• PortfolioPortfolio•• RangeRange•• Risk averseRisk averse•• Standard deviationStandard deviation•• Total returnTotal return•• Unique (or nonUnique (or non--systematic) or systematic) or

diversifiable riskdiversifiable risk•• VarianceVariance

Introduction to Risk and ReturnIntroduction to Risk and Return

•• Risk and return are the two most important attributes of Risk and return are the two most important attributes of an investment.an investment.

•• Research has shown that the two are linked in the Research has shown that the two are linked in the capital markets and that generally, higher returns can capital markets and that generally, higher returns can only be achieved by taking on greater risk.only be achieved by taking on greater risk.


8 - 414

only be achieved by taking on greater risk.only be achieved by taking on greater risk.•• Risk isn’t just the potential loss of return, it is the Risk isn’t just the potential loss of return, it is the

potential loss of the entire investment itself (loss of potential loss of the entire investment itself (loss of both principal and interest).both principal and interest).

•• Consequently, taking on additional risk in search of Consequently, taking on additional risk in search of higher returns is a decision that should not be taking higher returns is a decision that should not be taking lightly.lightly.

Introduction to Risk and ReturnIntroduction to Risk and Return

Return %

Risk


8 - 415

RF

Risk

Risk Premium

Real Return


Measuring ReturnsMeasuring ReturnsIntroductionIntroduction

Ex Ante ReturnsEx Ante Returns•• Return calculations may be done ‘beforeReturn calculations may be done ‘before--thethe--

fact,’ in which case, assumptions must be made fact,’ in which case, assumptions must be made about the futureabout the future


8 - 416

about the futureabout the futureEx Post ReturnsEx Post Returns•• Return calculations done ‘afterReturn calculations done ‘after--thethe--fact,’ in fact,’ in

order to analyze what rate of return was earned.order to analyze what rate of return was earned.

Measuring ReturnsMeasuring ReturnsIntroductionIntroduction

In Chapter 7 you learned that the constant growth DDM can be In Chapter 7 you learned that the constant growth DDM can be decomposed into the two forms of income that equity investors may decomposed into the two forms of income that equity investors may receive, dividends and capital gains.receive, dividends and capital gains.

[ ] [ ] [ ] Yield loss)(or Gain Capital Yield Dividend / Income

1 +=+

= g

P

Dkc

www.bookfiesta4u.com ContentsCHAPTER 8 – Risk, Return and Portfolio Theory 8 - 417

WHEREASWHEREASFixedFixed--income investors (bond investors for example) can expect to income investors (bond investors for example) can expect to earn interest income as well as (depending on the movement of earn interest income as well as (depending on the movement of interest rates) either capital gains or capital losses.interest rates) either capital gains or capital losses.

[ ] [ ] [ ] Yield loss)(or Gain Capital Yield Dividend / Income 0

+=+

= gP

kc

Measuring ReturnsMeasuring ReturnsIncome YieldIncome Yield

•• Income yield is the return earned in the form of a Income yield is the return earned in the form of a periodic cash flow received by investors.periodic cash flow received by investors.

•• The income yield return is calculated by the The income yield return is calculated by the periodic cash flow divided by the purchase price.periodic cash flow divided by the purchase price.


8 - 418

periodic cash flow divided by the purchase price.periodic cash flow divided by the purchase price.

Where CFWhere CF11 = the expected cash flow to be received= the expected cash flow to be receivedPP00 = the purchase price= the purchase price

yield Income 0

1

P

CF=[8-1]

Income YieldIncome YieldStocks versus BondsStocks versus Bonds

•• The dividend yield is calculated using trailing The dividend yield is calculated using trailing rather than forecast earns (because next year’s rather than forecast earns (because next year’s dividends cannot be predicted in aggregate), dividends cannot be predicted in aggregate), nevertheless dividend yields have exceeded nevertheless dividend yields have exceeded income yields on bondsincome yields on bonds


8 - 419

income yields on bondsincome yields on bonds•• Reason Reason –– riskrisk•• The risk of earning bond income is much less The risk of earning bond income is much less

than the risk incurred in earning dividend incomethan the risk incurred in earning dividend income(Remember, bond investors, as secured creditors of the (Remember, bond investors, as secured creditors of the

first have a legallyfirst have a legally--enforceable contractual claim to enforceable contractual claim to interest.)interest.)

Measuring ReturnsMeasuring ReturnsCommon Share and Long Canada Bond Yield GapCommon Share and Long Canada Bond Yield Gap

–– Table 8Table 8--1 illustrates 1 illustrates the income yield gap the income yield gap between stocks and between stocks and bonds over recent bonds over recent decadesdecades

–– The main reason that The main reason that

Average Yield Gap (%)

1950s 0.821960s 2.351970s 4.54

Table 8-1 Average Yield Gap


8 - 420

–– The main reason that The main reason that this yield gap has this yield gap has varied so much over varied so much over time is that the return time is that the return to investors is not to investors is not just the income yield just the income yield but also the capital but also the capital gain (or loss) yield as gain (or loss) yield as well.well.

1970s 4.541980s 8.141990s 5.512000s 3.55Overall 4.58

Measuring ReturnsMeasuring ReturnsDollar ReturnsDollar Returns

•• Investors in marketInvestors in market--traded securities (bonds or stock) traded securities (bonds or stock) receive investment returns in two different form:receive investment returns in two different form:

•• Income yieldIncome yield•• Capital gain (or loss) yieldCapital gain (or loss) yield

•• The investor will receive dollar returns, for example:The investor will receive dollar returns, for example:


8 - 421

•• The investor will receive dollar returns, for example:The investor will receive dollar returns, for example:•• $1.00 of dividends$1.00 of dividends•• Share price rise of $2.00Share price rise of $2.00

To be useful, dollar returns must be converted to percentage returns To be useful, dollar returns must be converted to percentage returns as a function of the original investment. (Because a $3.00 return on as a function of the original investment. (Because a $3.00 return on a $30 investment might be good, but a $3.00 return on a $300 a $30 investment might be good, but a $3.00 return on a $300 investment would be unsatisfactory!)investment would be unsatisfactory!)

Measuring ReturnsMeasuring ReturnsConverting Dollar Returns to Percentage ReturnsConverting Dollar Returns to Percentage Returns

An investor receives the following dollar returns a stock An investor receives the following dollar returns a stock investment of $25:investment of $25:

•• $1.00 of dividends$1.00 of dividends•• Share price rise of $2.00Share price rise of $2.00

The capital gain (or loss) return component of total return is The capital gain (or loss) return component of total return is calculated: ending price calculated: ending price –– minus beginning price, divided by minus beginning price, divided by


8 - 422

calculated: ending price calculated: ending price –– minus beginning price, divided by minus beginning price, divided by beginning pricebeginning price

%808.$25

$25-$27 return (loss)gain Capital

0

01 ===−=P

PP[8-2]

Measuring ReturnsMeasuring ReturnsTotal Percentage ReturnTotal Percentage Return

•• The investor’s total return (holding period return) The investor’s total return (holding period return) is:is:

yield loss)(or gain Capital yield Income return Total +=


8 - 423

%1212.008.004.025$

25$27$

25$

00.1$

0

01

0

1

0

011

==+=

−+

=

−+

=

−+=

P

PP

P

CF

P

PPCF

[8-3]

Measuring ReturnsMeasuring ReturnsTotal Percentage Return Total Percentage Return –– General FormulaGeneral Formula

•• The general formula for holding period return is:The general formula for holding period return is:

yield loss)(or gain Capital yield Income return Total +=


8 - 424

0

01

0

1

0

011

−+

=

−+=

P

PP

P

CF

P

PPCF

[8-3]

Measuring Average ReturnsMeasuring Average ReturnsEx Post ReturnsEx Post Returns

•• Measurement of historical rates of return that Measurement of historical rates of return that have been earned on a security or a class of have been earned on a security or a class of securities allows us to identify trends or securities allows us to identify trends or tendencies that may be useful in predicting the tendencies that may be useful in predicting the


8 - 425

tendencies that may be useful in predicting the tendencies that may be useful in predicting the future.future.

•• There are two different types of ex post mean or There are two different types of ex post mean or average returns used:average returns used:–– Arithmetic averageArithmetic average–– Geometric meanGeometric mean

Measuring Average ReturnsMeasuring Average ReturnsArithmetic AverageArithmetic Average

(AM) Average Arithmetic 1

n

rn

ii∑

==[8-4]


8 - 426

Where:Where:rrii = the individual returns= the individual returnsnn = the total number of observations= the total number of observations

•• Most commonly used value in statisticsMost commonly used value in statistics•• Sum of all returns divided by the total number of observationsSum of all returns divided by the total number of observations

Measuring Average ReturnsMeasuring Average ReturnsGeometric MeanGeometric Mean

11111(GM)Mean Geometric 1

321 -)]r)...(r)(r)(r [( nn++++=[8-5]


8 - 427

•• Measures the average or compound growth rate Measures the average or compound growth rate over multiple periods.over multiple periods.

Measuring Average ReturnsMeasuring Average ReturnsGeometric Mean versus Arithmetic AverageGeometric Mean versus Arithmetic Average

•• If all returns (values) are identical the geometric mean = If all returns (values) are identical the geometric mean = arithmetic averagearithmetic average

•• If the return values are volatile the geometric mean < If the return values are volatile the geometric mean < arithmetic averagearithmetic average


8 - 428

•• The greater the volatility of returns, the greater the The greater the volatility of returns, the greater the difference between geometric mean and arithmetic difference between geometric mean and arithmetic average.average.

(Table 8(Table 8--2 illustrates this principle on major asset classes 2 illustrates this principle on major asset classes 1938 1938 –– 2005)2005)

Measuring Average ReturnsMeasuring Average ReturnsAverage Investment Returns and Standard DeviationsAverage Investment Returns and Standard Deviations

Annual Arithmetic

Average (%)


Standard Deviation of Annual Returns

(%)

Table 8 - 2 Average Investment Returns and Standar d Deviations, 1938-2005


8 - 429

Government of Canada treasury bills 5.20 5.11 4.32Government of Canada bonds 6.62 6.24 9.32Canadian stocks 11.79 10.60 16.22U.S. stocks 13.15 11.76 17.54

Source: Data are from the Canadian Institute o f Actuaries

The greater the difference, the greater the volatility of

annual returns.

Measuring Expected (Ex Ante) ReturnsMeasuring Expected (Ex Ante) Returns

•• While past returns might be interesting, While past returns might be interesting, investor’s are most concerned with future investor’s are most concerned with future returns.returns.

•• Sometimes, historical average returns will not be Sometimes, historical average returns will not be


8 - 430

•• Sometimes, historical average returns will not be Sometimes, historical average returns will not be realized in the future.realized in the future.

•• Developing an independent estimate of ex ante Developing an independent estimate of ex ante returns usually involves use of forecasting returns usually involves use of forecasting discrete scenarios with outcomes and discrete scenarios with outcomes and probabilities of occurrence.probabilities of occurrence.

Estimating Expected ReturnsEstimating Expected ReturnsEstimating Ex Ante (Forecast) ReturnsEstimating Ex Ante (Forecast) Returns

•• The general formulaThe general formula

)Prob((ER)Return Expected i∑ ×=n

ir[8-6]


8 - 431

Where:Where:ERER = the expected return on an investment= the expected return on an investmentRRii = the estimated return in scenario = the estimated return in scenario iiProbProbi i = the probability of state = the probability of state i i occurringoccurring

)Prob((ER)Return Expected 1

i∑=

×=i

ir[8-6]

Estimating Expected ReturnsEstimating Expected ReturnsEstimating Ex Ante (Forecast) ReturnsEstimating Ex Ante (Forecast) Returns

Example:Example:This is type of forecast data that are required to make an This is type of forecast data that are required to make an ex ante estimate of expected return.ex ante estimate of expected return.


State of the EconomyProbability of Occurrence

Possible Returns on

Stock A in that State

Economic Expansion 25.0% 30%Normal Economy 50.0% 12%Recession 25.0% -25%

Estimating Expected ReturnsEstimating Expected ReturnsEstimating Ex Ante (Forecast) Returns Using a Spreadsheet ApproachEstimating Ex Ante (Forecast) Returns Using a Spreadsheet Approach

Example Solution:Example Solution:Sum the products of the probabilities and possible Sum the products of the probabilities and possible returns in each state of the economy.returns in each state of the economy.

(1) (2) (3) (4)=(2)×(1)


(1) (2) (3) (4)=(2)×(1)

State of the EconomyProbability of Occurrence

Possible Returns on

Stock A in that State

Weighted Possible

Returns on the Stock

Economic Expansion 25.0% 30% 7.50%Normal Economy 50.0% 12% 6.00%Recession 25.0% -25% -6.25%

Expected Return on the Stock = 7.25%

Estimating Expected ReturnsEstimating Expected ReturnsEstimating Ex Ante (Forecast) Returns Using a Formula ApproachEstimating Ex Ante (Forecast) Returns Using a Formula Approach

Example Solution:Example Solution:Sum the products of the probabilities and possible Sum the products of the probabilities and possible returns in each state of the economy.returns in each state of the economy.


7.25%

)25.0(-25%0.5)(12% .25)0(30%

)Prob(r)Prob(r )Prob(r

)Prob((ER)Return Expected

332211

1i

=×+×+×=

×+×+×=

×=∑=

n

iir

RiskRisk

•• Probability of incurring harmProbability of incurring harm•• For investors, risk is theFor investors, risk is the probability of earning an probability of earning an

inadequate return.inadequate return.


8 - 435

inadequate return.inadequate return.–– If investors require a 10% rate of return on a given If investors require a 10% rate of return on a given

investment, then any return less than 10% is investment, then any return less than 10% is considered harmful.considered harmful.

RiskRiskIllustratedIllustrated

Probability

Outcomes that produce harm

The range of total possible returns on the stock A runs from -

30% to more than +40%. If the required return on the stock is

10%, then those outcomes less than 10% represent risk to the

investor.A


8 - 436

Possible Returns on the Stock-30% -20% -10% 0% 10% 20% 30% 40%

A

RangeRange

•• The difference between the maximum and The difference between the maximum and minimum values is called the rangeminimum values is called the range–– Canadian common stocks have had a range of Canadian common stocks have had a range of


8 - 437

–– Canadian common stocks have had a range of Canadian common stocks have had a range of annual returns of 74.36 % over the 1938annual returns of 74.36 % over the 1938--2005 period2005 period

–– Treasury bills had a range of 21.07% over the same Treasury bills had a range of 21.07% over the same period.period.

•• As a rough measure of risk, range tells us that As a rough measure of risk, range tells us that common stock is more risky than treasury bills.common stock is more risky than treasury bills.

Differences in Levels of RiskDifferences in Levels of RiskIllustratedIllustrated

ProbabilityOutcomes that produce harm The wider the range of probable

outcomes the greater the risk of the investment.

A is a much riskier investment than B

B

A


8 - 438

Possible Returns on the Stock-30% -20% -10% 0% 10% 20% 30% 40%

A

Historical Returns on Different Asset Historical Returns on Different Asset ClassesClasses

•• Figure 8Figure 8--2 illustrates the volatility in annual returns on three 2 illustrates the volatility in annual returns on three different assets classes from 1938 different assets classes from 1938 –– 2005.2005.

•• Note:Note:–– Treasury bills always yielded returns greater than 0%Treasury bills always yielded returns greater than 0%


8 - 439

–– Treasury bills always yielded returns greater than 0%Treasury bills always yielded returns greater than 0%–– Long Canadian bond returns have been less than 0% in some Long Canadian bond returns have been less than 0% in some

years, and the range of returns has been greater than Tyears, and the range of returns has been greater than T--bills but bills but less than stocksless than stocks

–– Common stock returns have experienced the greatest range of Common stock returns have experienced the greatest range of returnsreturns

(See Figure 8(See Figure 8--2 on the following slide)2 on the following slide)

Measuring RiskMeasuring RiskAnnual Returns by Asset Class, 1938 Annual Returns by Asset Class, 1938 -- 20052005

FIGURE 8-2


8 - 440

Refining the Measurement of RiskRefining the Measurement of RiskStandard Deviation (Standard Deviation (σσ))

•• Range measures risk based on only two Range measures risk based on only two observations (minimum and maximum value)observations (minimum and maximum value)

•• Standard deviation uses all observationsStandard deviation uses all observations


8 - 441

•• Standard deviation uses all observationsStandard deviation uses all observations–– Standard deviation can be calculated on forecast or Standard deviation can be calculated on forecast or

possible returns as well as historical or ex post possible returns as well as historical or ex post returnsreturns

Measuring RiskMeasuring RiskEx post Standard DeviationEx post Standard Deviation

2_

−∑n deviation standard the

:

=Where

σ


1

)(post Ex 1

2_

−

−=∑

=

n

rrn

ii

σ[8-7]

nsobservatio ofnumber the

year in return the

return average the

deviation standard the_

===

=

n

ir

r

i

σ

Measuring RiskMeasuring RiskExample Using the Ex post Standard DeviationExample Using the Ex post Standard Deviation

ProblemProblemEstimate the standard deviation of the historical returns on investment A Estimate the standard deviation of the historical returns on investment A that were: 10%, 24%, that were: 10%, 24%, --12%, 8% and 10%.12%, 8% and 10%.

Step 1 Step 1 –– Calculate the Historical Average ReturnCalculate the Historical Average Return

∑ rn


Step 2 Step 2 –– Calculate the Standard DeviationCalculate the Standard Deviation

%88.121664

664

4

404002564

4

2020162

15

)814()88()812()824(8)-(10

1

)(post Ex

22222

222221

2_

===++++=++−+=

−−+−+−−+−+=

−

−=∑

=

n

rrn

ii

σ

%0.85

40

5

10812-2410 (AM) Average Arithmetic 1 ==+++==∑

=

n

ri

i

Ex Post RiskEx Post RiskStability of Risk Over TimeStability of Risk Over Time

•• Figure 8Figure 8--3 demonstrates that the relative riskiness of 3 demonstrates that the relative riskiness of equities and bonds has changed over timeequities and bonds has changed over time

•• Until the 1960s, the annual returns on common shares Until the 1960s, the annual returns on common shares were about four times more variable than those on were about four times more variable than those on bondsbonds

•• Over the past 20 years, they have only been twice as Over the past 20 years, they have only been twice as


•• Over the past 20 years, they have only been twice as Over the past 20 years, they have only been twice as variablevariable

•• Consequently, scenarioConsequently, scenario--based estimates of risk based estimates of risk (standard deviation) is required when seeking to (standard deviation) is required when seeking to measure risk in the futuremeasure risk in the future

•• ScenarioScenario--based estimates of risk is done through ex based estimates of risk is done through ex ante estimates and calculationsante estimates and calculations

Relative UncertaintyRelative UncertaintyEquities versus BondsEquities versus Bonds

FIGURE 8-3


8 - 445

Measuring RiskMeasuring RiskEx ante Standard DeviationEx ante Standard Deviation

A ScenarioA Scenario--Based Estimate of RiskBased Estimate of Risk

n


8 - 446

)()(Prob anteEx 2

1i ii

n

i

ERr −×= ∑=

σ[8-8]

ScenarioScenario--based Estimate of Riskbased Estimate of RiskExample Using the Ex ante Standard Deviation Example Using the Ex ante Standard Deviation –– Raw DataRaw Data

GIVEN INFORMATION INCLUDES:

- Possible returns on the investment for different discrete states

- Associated probabilities for those possible returns


State of the Economy Probability

Possible Returns on Security A

Recession 25.0% -22.0%Normal 50.0% 14.0%Economic Boom 25.0% 35.0%

ScenarioScenario--Based Estimate of RiskBased Estimate of RiskEx ante Standard Deviation Spreadsheet Approach: First Step Ex ante Standard Deviation Spreadsheet Approach: First Step ––

Calculate the Expected ReturnCalculate the Expected Return



Weighted Possible Returns

Determined by multiplying the probability times the possible return.


Economy Security A Returns

Recession 25.0% -22.0% -5.5%Normal 50.0% 14.0% 7.0%Economic Boom 25.0% 35.0% 8.8%

Expected Return = 10.3%

Expected return equals the sum of the weighted possible returns.

ScenarioScenario--Based Estimate of RiskBased Estimate of RiskSecondSecond Step Step –– Measure the Weighted and Squared DeviationsMeasure the Weighted and Squared Deviations

First calculate the deviation of possible returns from the expected.

Now multiply the square deviations by their probability of occurrence.


Second, square those deviations from the mean.

The sum of the weighted and square deviations is th e variance in percent squared terms.The standard deviation is the square root of the va riance (in

percent terms).

ScenarioScenario--Based Estimate of RiskBased Estimate of RiskExample Using the Ex ante Standard Deviation FormulaExample Using the Ex ante Standard Deviation Formula



Weighted Possible Returns

Recession 25.0% -22.0% -5.5%Normal 50.0% 14.0% 7.0%Economic Boom 25.0% 35.0% 8.8%

Expected Return = 10.3%


8 - 450

%5.20205.

0420.

)06126(.25.)00141(.5.)10401(.25.

)8.24(25.)8.3(5.)3.32(25.

)3.1035(25.)3.1014(5.)3.1022(25.

)()()(

)()(Prob anteEx

222

222

2331

2222

2111

2

1i

===

++=

++−=

−+−+−−=

−+−+−=

−×= ∑=

ERrPERrPERrP

ERr ii

n

i

σ

PortfoliosPortfolios

•• A portfolio is a collection of different securities such as A portfolio is a collection of different securities such as stocks and bonds, that are combined and considered a stocks and bonds, that are combined and considered a single assetsingle asset

•• The riskThe risk--return characteristics of the portfolio is return characteristics of the portfolio is


8 - 451

•• The riskThe risk--return characteristics of the portfolio is return characteristics of the portfolio is demonstrably different than the characteristics of the demonstrably different than the characteristics of the assets that make up that portfolio, especially with regard assets that make up that portfolio, especially with regard to riskto risk

•• Combining different securities into portfolios is done to Combining different securities into portfolios is done to achieve achieve diversificationdiversification..

DiversificationDiversification

Diversification has two faces:Diversification has two faces:

1.1. Diversification results in an overall reduction in portfolio risk Diversification results in an overall reduction in portfolio risk (return volatility over time) with little sacrifice in returns(return volatility over time) with little sacrifice in returns

2.2. Diversification helps to immunize the portfolio from potentially Diversification helps to immunize the portfolio from potentially


8 - 452

catastrophic events such as the outright failure of one of the catastrophic events such as the outright failure of one of the constituent investmentsconstituent investments

(If only one investment is held, and the issuing firm goes (If only one investment is held, and the issuing firm goes bankrupt, the entire portfolio value and returns are lost. If a bankrupt, the entire portfolio value and returns are lost. If a portfolio is made up of many different investments, the outright portfolio is made up of many different investments, the outright failure of one is more than likely to be offset by gains on others, failure of one is more than likely to be offset by gains on others, helping to make the portfolio immune to such events.)helping to make the portfolio immune to such events.)

Expected Return of a PortfolioExpected Return of a PortfolioModern Portfolio TheoryModern Portfolio Theory

The Expected Return on a Portfolio is simply the weighted The Expected Return on a Portfolio is simply the weighted average of the returns of the individual assets that make up the average of the returns of the individual assets that make up the portfolio:portfolio:

n

∑


8 - 453

The portfolio weight of a particular security is the percentage of The portfolio weight of a particular security is the percentage of the portfolio’s total value that is invested in that security.the portfolio’s total value that is invested in that security.

)( n

1i∑

=

×= iip ERwER[8-9]

Expected Return of a PortfolioExpected Return of a PortfolioExampleExample

Portfolio value = $2,000 + $5,000 = $7,000Portfolio value = $2,000 + $5,000 = $7,000rrAA = 14%, r= 14%, rBB = 6%, = 6%,

wwAA = weight of security A= weight of security A = $2,000 / $7,000 = 28.6%= $2,000 / $7,000 = 28.6%wwBB = weight of security B= weight of security B = $5,000 / $7,000 = (1= $5,000 / $7,000 = (1--28.6%)= 71.4%28.6%)= 71.4%


8 - 454

%288.8%284.4%004.4

) %6(.714)%14(.286)( n

1i

=+=

×+×=×=∑=

iip ERwER

Range of Returns in a Two Asset PortfolioRange of Returns in a Two Asset Portfolio

•• In a two asset portfolio, simply by changing the weight In a two asset portfolio, simply by changing the weight of the constituent assets, different portfolio returns of the constituent assets, different portfolio returns can be achievedcan be achieved

•• Because the expected return on the portfolio is a Because the expected return on the portfolio is a simple weighted average of the individual returns of simple weighted average of the individual returns of


8 - 455

simple weighted average of the individual returns of simple weighted average of the individual returns of the assets, you can achieve portfolio returns bounded the assets, you can achieve portfolio returns bounded by the highest and the lowest individual asset returnsby the highest and the lowest individual asset returnsExample 1:Example 1:Assume ERAssume ERA A = 8% and ER= 8% and ERBB = 10%= 10%

(See the following 6 slides based on Figure 8(See the following 6 slides based on Figure 8--4)4)

Expected Portfolio ReturnExpected Portfolio ReturnAffect on Portfolio Return of Changing Relative Weights in A and BAffect on Portfolio Return of Changing Relative Weights in A and B

Exp

ecte

d R

etur

n % 10.50

10.00

FIGURE 8-4

ERB= 10%


Exp

ecte

d R

etur

n %

Portfolio Weight

9.50

9.00

8.50

8.00

7.50

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

ERA=8%


FIGURE 8-4

Exp

ecte

d R

etur

n % 10.50

10.00 ERB= 10%

A portfolio manager can select the relative weights of the two assets in the portfolio to get a desired return between

8% (100% invested in A) and 10% (100% invested in B )


Exp

ecte

d R

etur

n %

Portfolio Weight

9.50

9.00

8.50

8.00

7.50

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

ERA=8%


Exp

ecte

d R

etur

n % 10.50

10.00

FIGURE 8-4

ERB= 10%


Exp

ecte

d R

etur

n %

Portfolio Weight

9.50

9.00

8.50

8.00

7.50

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

ERA=8%

The potential returns of the portfolio are

bounded by the highest and lowest returns of the individual assets

that make up the portfolio.

Exp

ecte

d R

etur

n % 10.50

10.00

FIGURE 8-4

ERB= 10%



Exp

ecte

d R

etur

n %

Portfolio Weight

9.50

9.00

8.50

8.00

7.50

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

ERA=8%

The expected return on the portfolio if 100% is invested in Asset A is

8%.

%8%)10)(0(%)8)(0.1( =+=+= BBAAp ERwERwER


FIGURE 8-4

Exp

ecte

d R

etur

n % 10.50

10.00ERB= 10%

The expected return on the portfolio if 100% is invested in Asset B is

10%.


Exp

ecte

d R

etur

n %

Portfolio Weight

9.50

9.00

8.50

8.00

7.50

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

ERA=8%

%10%)10)(0.1(%)8)(0( =+=+= BBAAp ERwERwER


FIGURE 8-4

Exp

ecte

d R

etur

n % 10.50

10.00ERB= 10%

The expected return on the portfolio if 50% is

invested in Asset A and 50% in B is 9%.


Exp

ecte

d R

etur

n %

Portfolio Weight

9.50

9.00

8.50

8.00

7.50

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

ERA=8%

%9%5%4

%)10)(5.0(%)8)(5.0(

=+=+=

+= BBAAp ERwERwER

Range of Returns in a Two Asset PortfolioRange of Returns in a Two Asset PortfolioExample 1: (r)Example 1: (r)AA= 14%, E(r)= 14%, E(r)BB= 6%= 6%

Expected return on Asset A = 14.0%Expected return on Asset B = 6.0%

Weight of Asset A

Weight of Asset B

Expected Return on the

Portfolio0.0% 100.0% 6.0%

10.0% 90.0% 6.8%


8 - 462

A graph of this relationship is

found on the following slide.

10.0% 90.0% 6.8%20.0% 80.0% 7.6%30.0% 70.0% 8.4%40.0% 60.0% 9.2%50.0% 50.0% 10.0%60.0% 40.0% 10.8%70.0% 30.0% 11.6%80.0% 20.0% 12.4%90.0% 10.0% 13.2%100.0% 0.0% 14.0%

Range of Returns in a TwoRange of Returns in a Two--Asset PortfolioAsset PortfolioE(r)E(r)AA= 14%, E(r)= 14%, E(r)BB= 6%= 6%

Range of Portfolio Returns

10.00%12.00%14.00%16.00%

Exp

ecte

d R

etur

n on

Tw

o A

sset

Por

tfolio


8 - 463

0.00%2.00%4.00%6.00%8.00%

10.00%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

100.0

%

Weight Invested in Asset A

Exp

ecte

d R

etur

n on

Tw

o A

sset

Por

tfolio

Expected Portfolio ReturnsExpected Portfolio ReturnsExample of a Three Asset PortfolioExample of a Three Asset Portfolio

Relative Weight

Expected Return

Weighted Return


8 - 464K. Hartviksen

Weight Return ReturnStock X 0.400 8.0% 0.03Stock Y 0.350 15.0% 0.05Stock Z 0.250 25.0% 0.06 Expected Portfolio Return = 14.70%

Modern Portfolio Theory (MPT)Modern Portfolio Theory (MPT)

•• Prior to the establishment of Modern Portfolio Theory Prior to the establishment of Modern Portfolio Theory (MPT), most people only focused upon investment (MPT), most people only focused upon investment returnsreturns——they ignored riskthey ignored risk

•• With MPT, investors had a tool that they could use to With MPT, investors had a tool that they could use to dramatically reduce the riskdramatically reduce the risk of the portfolio of the portfolio without a without a


8 - 465

dramatically reduce the riskdramatically reduce the risk of the portfolio of the portfolio without a without a significant reductionsignificant reduction in the expected return of the in the expected return of the portfolioportfolio

Expected Return and Risk For PortfoliosExpected Return and Risk For PortfoliosStandard Deviation of a TwoStandard Deviation of a Two--Asset Portfolio using CovarianceAsset Portfolio using Covariance

))()((2)()()()( ,2222

BABABBAAp COVwwww ++= σσσ[8-11]


8 - 466

,BABABBAAp

Risk of Asset A adjusted for weight in the

portfolio

Risk of Asset B adjusted for weight in the

portfolio

Factor to take into account co-

movement of returns. This factor can be

negative.

Expected Return and Risk For PortfoliosExpected Return and Risk For PortfoliosStandard Deviation of a TwoStandard Deviation of a Two--Asset Portfolio using Correlation Asset Portfolio using Correlation

CoefficientCoefficient

))()()()((2)()()()( ,2222

BABABABBAAp wwww σσρσσσ ++=[8-15]


8 - 467

, BABABABBAAp

Factor that takes into account the degree of

co-movement of returns. It can have a

negative value if correlation is negative.

Grouping Individual Assets into PortfoliosGrouping Individual Assets into Portfolios

•• The riskiness of a portfolio that is made of different risky The riskiness of a portfolio that is made of different risky assets is a function of three different factors:assets is a function of three different factors:–– the riskiness of the individual assets that make up the the riskiness of the individual assets that make up the

portfolioportfolio–– the relative weights of the assets in the portfoliothe relative weights of the assets in the portfolio


8 - 468

–– the relative weights of the assets in the portfoliothe relative weights of the assets in the portfolio–– the degree of cothe degree of co--movement of returns of the assets movement of returns of the assets

making up the portfoliomaking up the portfolio

•• The standard deviation of a twoThe standard deviation of a two--asset portfolio may be asset portfolio may be measured using the Markowitz model:measured using the Markowitz model:

BABABABBAAp wwww σσρσσσ ,2222 2++=

Risk of a ThreeRisk of a Three--Asset PortfolioAsset Portfolio

• The data requirements for a three-asset portfolio grows dramatically if we are using Markowitz

Portfolio selection formulae• Needed: Three correlation coefficients between A

and B; A and C; and B and C


8 - 469

and B; A and C; and B and CA

B C

ρa,b

ρb,c

ρa,c

CACACACBCBCBBABABACCBBAAp wwwwwwwww σσρσσρσσρσσσσ ,,,222222 222 +++++=

Risk of a FourRisk of a Four--asset Portfolioasset Portfolio

The data requirements for a four-asset portfolio grows dramatically if we are using Markowitz

Portfolio selection formulae

Needed: Six correlation coefficients between A


8 - 470

Needed: Six correlation coefficients between A and B; A and C; A and D; B and C; C and D; and B

and DA

C

B D

ρa,b ρa,d

ρb,c ρc,d

ρa,c

ρb,d

CovarianceCovariance

•• A statistical measure of the correlation of the A statistical measure of the correlation of the fluctuations of the annual rates of return of fluctuations of the annual rates of return of different investments.different investments.


8 - 471

)-)((Prob _

,1

_

,i BiB

n

iiiAAB rrrrCOV ∑

=

−=[8-12]

CorrelationCorrelation

•• The degree to which the returns of two stocks coThe degree to which the returns of two stocks co--move is measured by the correlation coefficient (move is measured by the correlation coefficient (ρρ))..

•• The correlation coefficient (The correlation coefficient (ρρ)) between the returns on between the returns on two securities will lie in the range of +1 through two securities will lie in the range of +1 through -- 1.1.

+1 is perfect positive correlation+1 is perfect positive correlation


8 - 472

+1 is perfect positive correlation+1 is perfect positive correlation--1 is perfect negative correlation1 is perfect negative correlation

BA

ABAB

COV

σσρ =[8-13]

Covariance and Correlation CoefficientCovariance and Correlation Coefficient

•• Solving for covariance given the correlation Solving for covariance given the correlation coefficient and standard deviation of the two coefficient and standard deviation of the two assets:assets:


8 - 473

BAABABCOV σσρ= [8-14]

Importance of CorrelationImportance of Correlation

•• Correlation is important because it affects the degree Correlation is important because it affects the degree to which diversification can be achieved using various to which diversification can be achieved using various assets.assets.

•• Theoretically, if two assets returns are perfectly Theoretically, if two assets returns are perfectly


8 - 474

•• Theoretically, if two assets returns are perfectly Theoretically, if two assets returns are perfectly positively correlated, it is possible to build a riskless positively correlated, it is possible to build a riskless portfolio with a return that is greater than the riskportfolio with a return that is greater than the risk--free free rate.rate.

Affect of Perfectly Negatively Correlated ReturnsAffect of Perfectly Negatively Correlated ReturnsElimination of Portfolio RiskElimination of Portfolio Risk

If returns of A and B are perfectly negatively correlated, a two-asset portfolio made up

of equal parts of Stock A and B would be riskless. There would

be no variabilityof the portfolios returns over

Returns%

15%

20%


8 - 475

Time 0 1 2

time.

Returns on Stock A

Returns on Stock B

Returns on Portfolio

10%

5%

Example of Perfectly Positively Correlated ReturnsExample of Perfectly Positively Correlated ReturnsNo Diversification of Portfolio RiskNo Diversification of Portfolio Risk

If returns of A and B are perfectly positively correlated, a two-asset portfolio made up

of equal parts of Stock A and B would be risky. There would

be no diversification (reduction of portfolio risk).

Returns%

15%

20%


8 - 476

Time 0 1 2

10%

5%

Returns on Stock A

Returns on Stock B


Affect of Perfectly Negatively Correlated ReturnsAffect of Perfectly Negatively Correlated ReturnsElimination of Portfolio RiskElimination of Portfolio Risk

If returns of A and B are perfectly negatively correlated, a two-asset portfolio made up

of equal parts of Stock A and B would be riskless. There would

be no variabilityof the portfolios returns over

Returns%

15%

20%


8 - 477

Time 0 1 2

time.

10%


5%Returns on Stock B

Returns on Stock A

Affect of Perfectly Negatively Correlated ReturnsAffect of Perfectly Negatively Correlated ReturnsNumerical ExampleNumerical Example

Weight of Asset A = 50.0%Weight of Asset B = 50.0%

YearReturn on

Asset AReturn on

Asset B

Expected Return on the

Portfolio %10%5.7%5.2

) %15(.5)%5(.5)( n

1i

=+=

×+×=×=∑=

iip ERwER


8 - 478

Year Asset A Asset B Portfolioxx07 5.0% 15.0% 10.0%xx08 10.0% 10.0% 10.0%xx09 15.0% 5.0% 10.0%

Perfectly Negatively Correlated Returns over time

%10%5.2%5.7

) %5(.5)%15(.5)( n

1i

=+=

×+×=×=∑=

iip ERwER

Diversification PotentialDiversification Potential

•• The potential of an asset to diversify a portfolio is dependent upon The potential of an asset to diversify a portfolio is dependent upon the degree of cothe degree of co--movement of returns of the asset with those other movement of returns of the asset with those other assets that make up the portfolioassets that make up the portfolio

•• In a simple, twoIn a simple, two--asset case, if the returns of the two assets are asset case, if the returns of the two assets are perfectly negatively correlated it is possible (depending on the perfectly negatively correlated it is possible (depending on the


8 - 479

perfectly negatively correlated it is possible (depending on the perfectly negatively correlated it is possible (depending on the relative weighting) to eliminate all portfolio riskrelative weighting) to eliminate all portfolio risk

•• This is demonstrated through the following series of spreadsheets, This is demonstrated through the following series of spreadsheets, and then summarized in graph formatand then summarized in graph format

Example of Portfolio Combinations and Example of Portfolio Combinations and CorrelationCorrelation

AssetExpected

ReturnStandard Deviation

Correlation Coefficient

A 5.0% 15.0% 1B 14.0% 40.0%

Weight of A Weight of BExpected


Portfolio Components Portfolio Characteristics

Perfect Positive

Correlation – no

diversification

Both


8 - 480

Weight of A Weight of B Return Deviation

100.00% 0.00% 5.00% 15.0%90.00% 10.00% 5.90% 17.5%80.00% 20.00% 6.80% 20.0%70.00% 30.00% 7.70% 22.5%60.00% 40.00% 8.60% 25.0%50.00% 50.00% 9.50% 27.5%40.00% 60.00% 10.40% 30.0%30.00% 70.00% 11.30% 32.5%20.00% 80.00% 12.20% 35.0%10.00% 90.00% 13.10% 37.5%0.00% 100.00% 14.00% 40.0%

Both portfolio

returns and risk are

bounded by the range set by the

constituent assets

when ρ=+1


AssetExpected



A 5.0% 15.0% 0.5B 14.0% 40.0%




Positive Correlation

– weak diversification potential


8 - 481


100.00% 0.00% 5.00% 15.0%90.00% 10.00% 5.90% 15.9%80.00% 20.00% 6.80% 17.4%70.00% 30.00% 7.70% 19.5%60.00% 40.00% 8.60% 21.9%50.00% 50.00% 9.50% 24.6%40.00% 60.00% 10.40% 27.5%30.00% 70.00% 11.30% 30.5%20.00% 80.00% 12.20% 33.6%10.00% 90.00% 13.10% 36.8%0.00% 100.00% 14.00% 40.0%

When ρ=+0.5 these

portfolio combinations

have lower risk –

expected portfolio return is

unaffected.


AssetExpected



A 5.0% 15.0% 0B 14.0% 40.0%




No Correlation

– some diversification potential


8 - 482


100.00% 0.00% 5.00% 15.0%90.00% 10.00% 5.90% 14.1%80.00% 20.00% 6.80% 14.4%70.00% 30.00% 7.70% 15.9%60.00% 40.00% 8.60% 18.4%50.00% 50.00% 9.50% 21.4%40.00% 60.00% 10.40% 24.7%30.00% 70.00% 11.30% 28.4%20.00% 80.00% 12.20% 32.1%10.00% 90.00% 13.10% 36.0%0.00% 100.00% 14.00% 40.0%

Portfolio risk is lower

than the risk of either

asset A or B.


AssetExpected



A 5.0% 15.0% -0.5B 14.0% 40.0%




Negative Correlation

– greater diversification potential


8 - 483


100.00% 0.00% 5.00% 15.0%90.00% 10.00% 5.90% 12.0%80.00% 20.00% 6.80% 10.6%70.00% 30.00% 7.70% 11.3%60.00% 40.00% 8.60% 13.9%50.00% 50.00% 9.50% 17.5%40.00% 60.00% 10.40% 21.6%30.00% 70.00% 11.30% 26.0%20.00% 80.00% 12.20% 30.6%10.00% 90.00% 13.10% 35.3%0.00% 100.00% 14.00% 40.0%

Portfolio risk for more

combinations is lower

than the risk of either

asset


AssetExpected



A 5.0% 15.0% -1B 14.0% 40.0%




Perfect Negative

Correlation – greatest

diversification potential


8 - 484

Weight of A Weight of B Return Deviation100.00% 0.00% 5.00% 15.0%90.00% 10.00% 5.90% 9.5%80.00% 20.00% 6.80% 4.0%70.00% 30.00% 7.70% 1.5%60.00% 40.00% 8.60% 7.0%50.00% 50.00% 9.50% 12.5%40.00% 60.00% 10.40% 18.0%30.00% 70.00% 11.30% 23.5%20.00% 80.00% 12.20% 29.0%10.00% 90.00% 13.10% 34.5%0.00% 100.00% 14.00% 40.0%

Risk of the portfolio is

almost eliminated at 70% invested

in asset A

Diversification of a Two Asset Portfolio Demonstrated

GraphicallyThe Effect of Correlation on Portfolio Risk:

The Two-Asset Case

Expected Return

12%

B

ρρρρAB = -0.5ρρρρAB = -1


8 - 485

Standard Deviation

0%

0% 10%

4%

8%

20% 30% 40%

ρρρρAB= +1

A

ρρρρAB = 0

Impact of the Correlation CoefficientImpact of the Correlation Coefficient

•• Figure 8Figure 8--7 illustrates the relationship between 7 illustrates the relationship between portfolio risk (portfolio risk (σσ) ) and the correlation coefficientand the correlation coefficient–– The slope is not linear a significant amount of The slope is not linear a significant amount of

diversification is possible with assets with no diversification is possible with assets with no


8 - 486

diversification is possible with assets with no diversification is possible with assets with no correlation (it is not necessary, nor is it possible to correlation (it is not necessary, nor is it possible to find, perfectly negatively correlated securities in the find, perfectly negatively correlated securities in the real world)real world)

–– With perfect negative correlation, the variability of With perfect negative correlation, the variability of portfolio returns is reduced to nearly zero.portfolio returns is reduced to nearly zero.

Expected Portfolio ReturnExpected Portfolio ReturnImpact of the Correlation CoefficientImpact of the Correlation Coefficient

FIGURE 8-7

15

10

Sta

ndar

d D

evia

tion

(%)

of P

ortfo

lio R

etur

ns


10

5

0

Sta

ndar

d D

evia

tion

(%)

of P

ortfo

lio R

etur

ns

Correlation Coefficient ( ρ)

-1 -0.5 0 0.5 1

Zero Risk PortfolioZero Risk Portfolio

•• We can calculate the portfolio that removes all We can calculate the portfolio that removes all risk.risk.

•• When When ρρ = = --1, then1, then ))()()()((2)()()()( ,

2222BABABABBAAp wwww σσρσσσ ++=[8-15]


8 - 488

•• Becomes:Becomes:BAp ww σσσ )1( −−=[8-16]

))()()()((2)()()()( , BABABABBAAp wwww σσρσσσ ++=

An Exercise using TAn Exercise using T--bills, Stocks and Bondsbills, Stocks and Bonds

Base Data: Stocks T-bills BondsExpected Return(%) 12.73383 6.151702 7.0078723

Standard Deviation (%) 0.168 0.042 0.102

Correlation Coefficient Matrix:Stocks 1 -0.216 0.048T-bills -0.216 1 0.380Bonds 0.048 0.380 1

Portfolio Combinations:

Historical averages for

returns and risk for three asset

classes

Historical

Each achievable portfolio combination is plotted on

expected return, risk ( σ) space, found on the

following slide.


8 - 489

Portfolio Combinations:

Combination Stocks T-bills BondsExpected Return Variance

Standard Deviation

1 100.0% 0.0% 0.0% 12.7 0.0283 16.8%2 90.0% 10.0% 0.0% 12.1 0.0226 15.0%3 80.0% 20.0% 0.0% 11.4 0.0177 13.3%4 70.0% 30.0% 0.0% 10.8 0.0134 11.6%5 60.0% 40.0% 0.0% 10.1 0.0097 9.9%6 50.0% 50.0% 0.0% 9.4 0.0067 8.2%7 40.0% 60.0% 0.0% 8.8 0.0044 6.6%8 30.0% 70.0% 0.0% 8.1 0.0028 5.3%9 20.0% 80.0% 0.0% 7.5 0.0018 4.2%10 10.0% 90.0% 0.0% 6.8 0.0014 3.8%

Weights Portfolio

correlation coefficients between the

asset classes

Portfolio characteristics

for each combination of

securities

Results Using only Three Asset ClassesResults Using only Three Asset Classes

Attainable Portfolio Combinationsand Efficient Set of Portfolio Combinations

10.0

12.0

14.0

Por

tfolio

Exp

ecte

d R

etur

n (%

)

Efficient Set

Minimum Variance

Portfolio

The efficient set is that set of achievable portfolio

combinations that offer the highest rate of return for a

given level of risk. The solid blue line indicates the

efficient set.


8 - 490

0.0

2.0

4.0

6.0

8.0

10.0

0.0 5.0 10.0 15.0 20.0

Standard Deviation of the Portfolio (%)

Por

tfolio

Exp

ecte

d R

etur

n (%

)

The plotted points are attainable portfolio

combinations.

TwoTwo--Security PortfoliosSecurity PortfoliosModern Portfolio TheoryModern Portfolio Theory

FIGURE 8-9

Exp

ecte

d R

etur

n %

13

12

This line represents the set

of portfolio combinations that are achievable by

varying relative weights and using

two non -correlated


8 - 491

Exp

ecte

d R

etur

n %

Standard Deviation (%)

11

10

9

8

7

6

0 10 20 30 40 50 60

two non -correlated securities.

DominanceDominance

•• It is assumed that investors are rational, wealthIt is assumed that investors are rational, wealth--maximizing and risk aversemaximizing and risk averse

•• If so, then some investment choices dominate If so, then some investment choices dominate othersothers


8 - 492

othersothers

Investment ChoicesInvestment ChoicesThe Concept of Dominance IllustratedThe Concept of Dominance Illustrated

A B

Return%10%

A dominates B because it offers the same return but

for less risk.

A dominates C because it offers a higher return but


8 - 493

C

Risk

5%

To the risk-averse wealth maximizer, the choices are clear, A dominates B,A dominates C.

offers a higher return but for the same risk.

20%5%

Efficient FrontierEfficient FrontierModern Portfolio TheoryModern Portfolio Theory

FIGURE 8-10

Exp

ecte

d R

etur

n % A B

A is not attainable

B,E lie on the efficient

frontier and are attainable


8 - 494

Exp

ecte

d R

etur

n %


E

C

D

are attainable

E is the minimum variance portfolio

C, D are attainable but

are dominated by superior

portfolios

Efficient FrontierEfficient FrontierModern Portfolio TheoryModern Portfolio Theory

8 - 10 FIGURE

Exp

ecte

d R

etur

n % A B

Rational, risk averse investors will only want to

hold portfolios such B.

The actual choice


8 - 495

Exp

ecte

d R

etur

n %


E

C

D

The actual choice will depend on

her/his risk preferences.

DiversificationDiversification

•• Risk of a portfolio can be reduced by spreading the value of Risk of a portfolio can be reduced by spreading the value of the portfolio across, two, three, four or more assetsthe portfolio across, two, three, four or more assets

•• The key is to choose assets whose returns are less than The key is to choose assets whose returns are less than perfectly positively correlatedperfectly positively correlated

•• Even with random or naïve diversification, risk of the portfolio Even with random or naïve diversification, risk of the portfolio


8 - 496

•• Even with random or naïve diversification, risk of the portfolio Even with random or naïve diversification, risk of the portfolio can be reducedcan be reduced–– This is illustrated in Figure 8This is illustrated in Figure 8--11 and Table 811 and Table 8--3 found on the 3 found on the

following slidesfollowing slides•• As the portfolio is divided across more and more securities, the risk As the portfolio is divided across more and more securities, the risk

of the portfolio falls rapidly at first, until a point is reached where, of the portfolio falls rapidly at first, until a point is reached where, further division of the portfolio does not result in a reduction in riskfurther division of the portfolio does not result in a reduction in risk

•• Going beyond this point is known as superfluous diversificationGoing beyond this point is known as superfluous diversification

DiversificationDiversificationDomestic DiversificationDomestic Diversification

FIGURE 8-11

14

12

10

Average Portfolio RiskJanuary 1985 to December 1997


8 - 497

10

8

6

4

2

0

Sta

ndar

d D

evia

tion

(%)

Number of Stocks in Portfolio

0 50 100 150 200 250 300

DiversificationDiversificationDomestic DiversificationDomestic Diversification


Average Monthly Portfolio

Return (%)

Standard Deviation of Average

Monthly Portfolio Return (%)

Ratio of Portfolio Standard Deviation to

Standard Deviation of a Single Stock

Percentage of Total Achievable Risk Reduction

1 1.51 13.47 1.00 0.002 1.51 10.99 0.82 27.503 1.52 9.91 0.74 39.564 1.53 9.30 0.69 46.37

Table 8-3 Monthly Canadian Stock Portfolio Returns , January 1985 to December 1997


8 - 498

4 1.53 9.30 0.69 46.375 1.52 8.67 0.64 53.316 1.52 8.30 0.62 57.507 1.51 7.95 0.59 61.358 1.52 7.71 0.57 64.029 1.52 7.52 0.56 66.17

10 1.51 7.33 0.54 68.30

14 1.51 6.80 0.50 74.1940 1.52 5.62 0.42 87.2450 1.52 5.41 0.40 89.64100 1.51 4.86 0.36 95.70200 1.51 4.51 0.34 99.58222 1.51 4.48 0.33 100.00

Source: Cleary, S. and Copp D. "Diversification with Canadian Stocks: How M uch is Enough?" Canadian Investment Review (Fall 1999), Table 1.

Total Risk of an Individual AssetTotal Risk of an Individual AssetEquals the Sum of Market and Unique RiskEquals the Sum of Market and Unique Risk

•• This graph illustrates This graph illustrates that total risk of a that total risk of a stock is made up of stock is made up of market risk (that market risk (that cannot be diversified cannot be diversified away because it is a away because it is a function of the function of the economic ‘system’) economic ‘system’) and unique, companyand unique, company--

[8-19]

Sta

ndar

d D

evia

tion

(%)

Average Portfolio Risk

Diversifiable (unique) risk


8 - 499

and unique, companyand unique, company--specific risk that is specific risk that is eliminated from the eliminated from the portfolio through portfolio through diversification.diversification.

Sta

ndar

d D

evia

tion

(%)


Nondiversifiable (systematic) risk

risk )systematic-(non Uniquerisk c)(systematiMarket risk Total +=[8-19]

International DiversificationInternational Diversification

•• Clearly, diversification adds value to a portfolio Clearly, diversification adds value to a portfolio by reducing risk while not reducing the return on by reducing risk while not reducing the return on the portfolio significantlythe portfolio significantly

•• Most of the benefits of diversification can be Most of the benefits of diversification can be


8 - 500

•• Most of the benefits of diversification can be Most of the benefits of diversification can be achieved by investing in 40 to 50 different achieved by investing in 40 to 50 different ‘positions’ (investments)‘positions’ (investments)

•• However, if the investment universe is expanded However, if the investment universe is expanded to include investments beyond the domestic to include investments beyond the domestic capital markets, additional risk reduction is capital markets, additional risk reduction is possiblepossible

(See Figure 8 (See Figure 8 --12 on the following slide.)12 on the following slide.)

DiversificationDiversificationInternational DiversificationInternational Diversification

FIGURE 8-12

100

Per

cent

risk


8 - 501

80

60

40

20

0

Per

cent

risk

Number of Stocks0 10 20 30 40 50 60

International stocks

U.S. stocks

11.7


In this chapter you have learned:In this chapter you have learned:–– How to measure different types of returnsHow to measure different types of returns–– How to calculate the standard deviation and How to calculate the standard deviation and

interpret its meaninginterpret its meaning


8 - 502

interpret its meaninginterpret its meaning–– How to measure returns and risk of portfolios and How to measure returns and risk of portfolios and

the importance of correlation in the diversification the importance of correlation in the diversification processprocess

CHAPTER 9CHAPTER 9The Capital Asset Pricing The Capital Asset Pricing The Capital Asset Pricing The Capital Asset Pricing

Model (CAPM)Model (CAPM)


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• The New Efficient FrontierThe New Efficient Frontier•• The Capital Asset Pricing ModelThe Capital Asset Pricing Model

www.bookfiesta4u.com ContentsCHAPTER 9 – The Capital Asset Pricing Model

(CAPM)

9 - 505

•• The CAPM and Market RiskThe CAPM and Market Risk•• Alternative Asset Pricing ModelsAlternative Asset Pricing Models•• Summary and ConclusionsSummary and Conclusions

–– Concept Review QuestionsConcept Review Questions–– Appendix 1 Appendix 1 –– Calculating the Ex Ante BetaCalculating the Ex Ante Beta–– Appendix 2 Appendix 2 –– Calculating the Ex Post BetaCalculating the Ex Post Beta


1.1. What happens if all investors are rational and risk averse.What happens if all investors are rational and risk averse.

2.2. How modern portfolio theory is extended to develop the capital How modern portfolio theory is extended to develop the capital market line, which determines how expected returns on market line, which determines how expected returns on portfolios are determined.portfolios are determined.


(CAPM)

9 - 506

portfolios are determined.portfolios are determined.

3.3. How to assess the performance of mutual fund managersHow to assess the performance of mutual fund managers

4.4. How the Capital Asset Pricing Model’s (CAPM) security market How the Capital Asset Pricing Model’s (CAPM) security market line is developed from the capital market line.line is developed from the capital market line.

5.5. How the CAPM has been extended to include other riskHow the CAPM has been extended to include other risk--based based pricing models.pricing models.


•• Arbitrage pricing theory Arbitrage pricing theory (APT)(APT)

•• Capital Asset Pricing Model Capital Asset Pricing Model (CAPM)(CAPM)

•• Capital market line (CML)Capital market line (CML)

•• Market risk premiumMarket risk premium•• New (or super) efficient New (or super) efficient

frontierfrontier•• NoNo--arbitrage principlearbitrage principle•• Required rate of returnRequired rate of return•• Risk premiumRisk premium


(CAPM)

9 - 507

•• Capital market line (CML)Capital market line (CML)•• Characteristic lineCharacteristic line•• FamaFama--French (FF) modelFrench (FF) model•• Insurance premiumInsurance premium•• Market portfolioMarket portfolio•• Market price of riskMarket price of risk

•• Risk premiumRisk premium•• Security market line (SML)Security market line (SML)•• Separation theorumSeparation theorum•• Sharpe ratioSharpe ratio•• Short positionShort position•• Tangent portfolioTangent portfolio

Achievable Portfolio CombinationsAchievable Portfolio CombinationsThe TwoThe Two--Asset CaseAsset Case

•• It is possible to construct a series of portfolios with different It is possible to construct a series of portfolios with different risk/return characteristics just by varying the weights of the risk/return characteristics just by varying the weights of the two assets in the portfolio.two assets in the portfolio.

•• Assets A and B are assumed to have a correlation coefficient Assets A and B are assumed to have a correlation coefficient of of --0.379 and the following individual return/risk 0.379 and the following individual return/risk characteristicscharacteristics


(CAPM)

9 - 508

characteristicscharacteristics

Expected ReturnExpected Return Standard DeviationStandard DeviationAsset AAsset A 8%8% 8.72%8.72%Asset BAsset B 10%10% 22.69%22.69%

The following table shows the portfolio characteristics for 100 The following table shows the portfolio characteristics for 100 different weighting schemes for just these two securities:different weighting schemes for just these two securities:


AssetExpected



A 8.0% 8.7% -0.379B 10.0% 22.7%




The first combination

simply assumes you invest solely

in Asset A

The second portfolio

assumes 99%

You repeat this procedure

down until you have determine

the portfolio characteristics

for all 100 portfolios.


(CAPM)

9 - 509

Weight of A Weight of B Return Deviation100% 0% 8.00% 8.7%99% 1% 8.02% 8.5%98% 2% 8.04% 8.4%97% 3% 8.06% 8.2%96% 4% 8.08% 8.1%95% 5% 8.10% 7.9%94% 6% 8.12% 7.8%93% 7% 8.14% 7.7%92% 8% 8.16% 7.5%91% 9% 8.18% 7.4%90% 10% 8.20% 7.3%89% 11% 8.22% 7.2%

in Asset Aassumes 99% in A and 1% in B. Notice the

increase in return and the

decrease in portfolio risk!

Next plot the returns on a

graph (see the next slide)

Example of Example of Portfolio Portfolio

Combinations Combinations and and

CorrelationCorrelation

Attainable Portfolio Combinations for a Two Asset Portfolio

6.00%

8.00%

10.00%

12.00%E

xpec

ted

Ret

urn

of th

e P

ortfo

lio


(CAPM)

9 - 510

0.00%

2.00%

4.00%

6.00%

0.0% 5.0% 10.0% 15.0% 20.0% 25.0%

Standard Deviation of Returns

Exp

ecte

d R

etur

n of

the

Por

tfolio

Two Asset Efficient FrontierTwo Asset Efficient Frontier

•• Figure 8 Figure 8 –– 10 describes five different portfolios 10 describes five different portfolios (A,B,C,D and E in reference to the attainable set (A,B,C,D and E in reference to the attainable set of portfolio combinations of this two asset of portfolio combinations of this two asset portfolio.portfolio.


(CAPM)

9 - 511

portfolio.portfolio.

(See Figure 8 (See Figure 8 --10 on the following slide)10 on the following slide)

Efficient FrontierEfficient FrontierThe TwoThe Two--Asset Portfolio CombinationsAsset Portfolio Combinations

A is not attainable

B,E lie on the efficient frontier

and are attainable

E is the minimum variance portfolio

8 - 10 FIGURE

Exp

ecte

d R

etur

n % A B


(CAPM)

9 - 512

variance portfolio (lowest risk

combination)

C, D are attainable but are dominated

by superior portfolios that line

on the line above E

Exp

ecte

d R

etur

n %


E

C

D

Achievable Set of Portfolio CombinationsAchievable Set of Portfolio CombinationsGetting to the ‘n’ Asset CaseGetting to the ‘n’ Asset Case

•• In a real world investment universe with all of the In a real world investment universe with all of the investment alternatives (stocks, bonds, money market investment alternatives (stocks, bonds, money market securities, hybrid instruments, gold real estate, etc.) it is securities, hybrid instruments, gold real estate, etc.) it is possible to construct many different alternative portfolios possible to construct many different alternative portfolios out of risky securities.out of risky securities.

•• Each portfolio will have its own unique expected return Each portfolio will have its own unique expected return


(CAPM)

9 - 513

•• Each portfolio will have its own unique expected return Each portfolio will have its own unique expected return and risk.and risk.

•• Whenever you construct a portfolio, you can measure Whenever you construct a portfolio, you can measure two fundamental characteristics of the portfolio:two fundamental characteristics of the portfolio:–– Portfolio expected return (Portfolio expected return (ERERpp))–– Portfolio risk (Portfolio risk (σσpp))

The Achievable Set of Portfolio The Achievable Set of Portfolio CombinationsCombinations

•• You could start by randomly assembling ten You could start by randomly assembling ten risky portfolios.risky portfolios.

•• The results (in terms of ER The results (in terms of ER pp and and σσpp ))might look might look


(CAPM)

9 - 514

•• The results (in terms of ER The results (in terms of ER pp and and σσpp ))might look might look like the graph on the following page:like the graph on the following page:

Achievable Portfolio CombinationsAchievable Portfolio CombinationsThe First Ten Combinations CreatedThe First Ten Combinations Created

10 Achievable Risky Portfolio Combinations

ERp


(CAPM)

9 - 515

Portfolio Risk ( σp)

Combinations

The Achievable Set of Portfolio The Achievable Set of Portfolio CombinationsCombinations

•• You could continue randomly assembling more You could continue randomly assembling more portfolios.portfolios.

•• Thirty risky portfolios Thirty risky portfolios might look like the graph might look like the graph


(CAPM)

9 - 516

•• Thirty risky portfolios Thirty risky portfolios might look like the graph might look like the graph on the following slide:on the following slide:

Achievable Portfolio CombinationsAchievable Portfolio CombinationsThirty Combinations Naively CreatedThirty Combinations Naively Created

30 Risky Portfolio

ERp


(CAPM)

9 - 517


30 Risky Portfolio Combinations

Achievable Set of Portfolio CombinationsAchievable Set of Portfolio CombinationsAll Securities All Securities –– Many Hundreds of Different CombinationsMany Hundreds of Different Combinations

•• When you construct many hundreds of different When you construct many hundreds of different portfolios naively varying the weight of the portfolios naively varying the weight of the individual assets and the number of types of individual assets and the number of types of assets themselves, you get a set of achievable assets themselves, you get a set of achievable


(CAPM)

9 - 518

assets themselves, you get a set of achievable assets themselves, you get a set of achievable portfolio combinations as indicated on the portfolio combinations as indicated on the following slide: following slide:

ERp

Achievable Portfolio CombinationsAchievable Portfolio CombinationsMore Possible Combinations CreatedMore Possible Combinations Created

E is the minimum variance

The highlighted portfolios are

‘efficient’ in that they offer the

highest rate of return for a given

level of risk. Rationale investors


(CAPM)

9 - 519


E

variance portfolio Achievable Set of

Risky Portfolio Combinations

Rationale investors will choose only

from this efficient set.

ERp

Achievable Portfolio CombinationsAchievable Portfolio CombinationsEfficient Frontier (Set)Efficient Frontier (Set)

Efficient frontier is the set of

achievable portfolio

combination


(CAPM)

9 - 520


Achievable Set of Risky Portfolio Combinations

E

combinations that offer the highest

rate of return for a given level

of risk.

The New Efficient FrontierThe New Efficient FrontierEfficient PortfoliosEfficient Portfolios

Figure 9 – 1 illustrates three

achievable portfolio combinations that are ‘efficient’ (no other achievable

portfolio that offers the same risk, offers

a higher return.)

9 - 1 FIGURE

Efficient FrontierER


(CAPM)

9 - 521

a higher return.)

Risk

MVP

A

B

Underlying AssumptionUnderlying AssumptionInvestors are Rational and RiskInvestors are Rational and Risk--AverseAverse

•• We assume investors are riskWe assume investors are risk--averse wealth maximizers.averse wealth maximizers.•• This means they will not willingly undertake fair gamble.This means they will not willingly undertake fair gamble.

–– A riskA risk--averse investor prefers the riskaverse investor prefers the risk--free situation.free situation.–– The corollary of this is that the investor needs a risk premium to The corollary of this is that the investor needs a risk premium to


(CAPM)

9 - 522

–– The corollary of this is that the investor needs a risk premium to The corollary of this is that the investor needs a risk premium to be induced into a risky situation.be induced into a risky situation.

–– Evidence of this is the willingness of investors to pay insurance Evidence of this is the willingness of investors to pay insurance premiums to get out of risky situations.premiums to get out of risky situations.

•• The implication of this, is that investors will only choose The implication of this, is that investors will only choose portfolios that are members of the efficient set (frontier).portfolios that are members of the efficient set (frontier).

RiskRisk--free Investingfree Investing

•• When we introduce the presence of a riskWhen we introduce the presence of a risk--free free investment, a whole new set of portfolio investment, a whole new set of portfolio combinations becomes possible.combinations becomes possible.

•• We can estimate the return on a portfolio made We can estimate the return on a portfolio made


(CAPM)

9 - 523

•• We can estimate the return on a portfolio made We can estimate the return on a portfolio made up of up of RF RF asset and a risky asset asset and a risky asset A A letting the letting the weight weight ww invested in the risky asset and the invested in the risky asset and the weight invested in RF as weight invested in RF as (1 (1 –– w)w)

The New Efficient FrontierThe New Efficient FrontierRiskRisk--Free InvestingFree Investing

–– Expected return on a two asset portfolio made up of Expected return on a two asset portfolio made up of risky asset risky asset AA and and RFRF::


(CAPM)

9 - 524

The possible combinations of A and RF are found graphed on the following slide.The possible combinations of A and RF are found graphed on the following slide.

RF) - (ER RF ER Ap w+=[9-1]

The New Efficient FrontierThe New Efficient FrontierAttainable Portfolios Using Attainable Portfolios Using RFRF and and AA

9 - 2 FIGURE

ER

Equation 9 – 2 illustrates what you

can see…portfolio risk increases in

direct proportion to the amount invested

Rearranging 9 -2 where w=σ p / σA

and substituting in Equation 1 we get an equation for a

straight line with a

This means you can achieve any

portfolio combination along

the blue coloured line simply by changing the

relative weight of RF


(CAPM)

9 - 525

Risk

RF

A

Ap σσ w=[9-2]the amount invested

in the risky asset.

RF - )E(R RF ER

A

APP σ

σ

+=[9-3]

straight line with a constant slope.

relative weight of RFand A in the two

asset portfolio.

The New Efficient FrontierThe New Efficient FrontierAttainable Portfolios using the Attainable Portfolios using the RF RF and and A, A, and and RFRF and and TT

Which risky portfolio would a

rational risk-averse investor choose in

the presence of a RF investment?

Portfolio A?

9 - 3 FIGURE

ER

T


(CAPM)

9 - 526

Tangent Portfolio T?

Risk

RF

A

T

The New Efficient FrontierThe New Efficient FrontierEfficient Portfolios using the Tangent Portfolio Efficient Portfolios using the Tangent Portfolio TT

9 - 3 FIGURE

ER

T

Clearly RF with T (the tangent portfolio) offers a series of

portfolio combinations that

dominate those produced by RF and

A.

Further, they dominate


(CAPM)

9 - 527

Risk

RF

A

T Further, they dominate all but one portfolio

on the efficient frontier!

The New Efficient FrontierThe New Efficient FrontierLending PortfoliosLending Portfolios

9 - 3 FIGURE

ER

T

Portfolios between RFand T are ‘lending’

portfolios, because they are achieved by

investing in the Tangent Portfolio and

lending funds to the government

(purchasing a T-bill, the RF).

Lending Portfolios


(CAPM)

9 - 528

Risk

RF

A

T the RF).

The New Efficient FrontierThe New Efficient FrontierBorrowing PortfoliosBorrowing Portfolios

9 - 3 FIGURE

ER

T

The line can be extended to risk levels

beyond ‘T’ by borrowing at RF and

investing it in T. This is a levered

investment that increases both risk

and expected return of the portfolio.

Lending Portfolios Borrowing Portfolios


(CAPM)

9 - 529

Risk

RF

A

T the portfolio.

9 - 4 FIGURE

ER

T B

B2

Capital Market Line

The New Efficient FrontierThe New Efficient FrontierThe New (Super) Efficient FrontierThe New (Super) Efficient Frontier

The optimal risky portfolio

(the market portfolio ‘M’)

Clearly RF with T (the market portfolio) offers a series of

portfolio combinations that

dominate those produced by RF and

A.

This is now called the new (or super)

efficient frontier of risky portfolios.

Investors can achieve any one of these

portfolio combinations by

borrowing or investing in RF in


(CAPM)

9 - 530

σρ

RF

A2

T

A

BFurther, they dominate

all but one portfolio on the efficient

frontier!

investing in RF in combination with the

market portfolio.

The New Efficient FrontierThe New Efficient FrontierThe Implications The Implications –– Separation Theorem Separation Theorem –– Market PortfolioMarket Portfolio

•• All investors will only hold individuallyAll investors will only hold individually--determined determined combinations of:combinations of:–– The risk free asset (RF) andThe risk free asset (RF) and–– The model portfolio (market portfolio)The model portfolio (market portfolio)

•• The separation theoremThe separation theorem–– The investment decision (how to construct the portfolio of risky The investment decision (how to construct the portfolio of risky

assets) is separate from the financing decision (how much assets) is separate from the financing decision (how much


(CAPM)

9 - 531

–– The investment decision (how to construct the portfolio of risky The investment decision (how to construct the portfolio of risky assets) is separate from the financing decision (how much assets) is separate from the financing decision (how much should be invested or borrowed in the riskshould be invested or borrowed in the risk--free asset)free asset)

–– The tangent portfolio T is optimal for every investor regardless of The tangent portfolio T is optimal for every investor regardless of his/her degree of risk aversion.his/her degree of risk aversion.

•• The Equilibrium ConditionThe Equilibrium Condition–– The market portfolio must be the tangent portfolio T if everyone The market portfolio must be the tangent portfolio T if everyone

holds the same portfolio holds the same portfolio –– Therefore the market portfolio (M) is the tangent portfolio (T)Therefore the market portfolio (M) is the tangent portfolio (T)

ER

M

CML

The New Efficient FrontierThe New Efficient FrontierThe Capital Market LineThe Capital Market Line

The optimal risky portfolio

(the market portfolio ‘M’)

The CML is that set of superior portfolio

combinations that are achievable in the

presence of the equilibrium condition.


(CAPM)

9 - 532

σρ

RF

M

The Capital Asset Pricing ModelThe Capital Asset Pricing ModelWhat is it?What is it?

–– An hypothesis by Professor William SharpeAn hypothesis by Professor William Sharpe•• Hypothesizes that investors require higher rates of Hypothesizes that investors require higher rates of

return for greater levels of relevant risk.return for greater levels of relevant risk.


(CAPM)9 - 533

return for greater levels of relevant risk.return for greater levels of relevant risk.•• There are no prices on the model, instead it There are no prices on the model, instead it

hypothesizes the relationship between risk and hypothesizes the relationship between risk and return for individual securities.return for individual securities.

•• It is often used, however, the price securities and It is often used, however, the price securities and investments.investments.

The Capital Asset Pricing ModelThe Capital Asset Pricing ModelHow is it Used?How is it Used?

–– Uses include:Uses include:•• Determining the cost of equity capital.Determining the cost of equity capital.•• The relevant risk in the dividend discount model to estimate a stock’s intrinsic The relevant risk in the dividend discount model to estimate a stock’s intrinsic

(inherent economic worth) value.(inherent economic worth) value. (As illustrated below)(As illustrated below)


(CAPM)9 - 534

Estimate Investment’s Risk (Beta Coefficient)

Determine Investment’s Required Return

Estimate the Investment’s Intrinsic

Value

Compare to the actual stock price in the market

2iM

i,M

σ

COV=β )( iMi RFERRFk β−+=

gk

DP

c −= 1

0

Is the stock fairly priced?

The Capital Asset Pricing ModelThe Capital Asset Pricing ModelAssumptionsAssumptions

–– CAPM is based on the following assumptions:CAPM is based on the following assumptions:1.1. All investors have identical expectations about expected All investors have identical expectations about expected

returns, standard deviations, and correlation coefficients for all returns, standard deviations, and correlation coefficients for all securities.securities.

2.2. All investors have the same oneAll investors have the same one--period investment time period investment time horizon.horizon.


(CAPM)

9 - 535

horizon.horizon.3.3. All investors can borrow or lend money at the riskAll investors can borrow or lend money at the risk--free rate of free rate of

return (RF).return (RF).4.4. There are no transaction costs.There are no transaction costs.5.5. There are no personal income taxes so that investors are There are no personal income taxes so that investors are

indifferent between capital gains an dividends.indifferent between capital gains an dividends.6.6. There are many investors, and no single investor can affect There are many investors, and no single investor can affect

the price of a stock through his or her buying and selling the price of a stock through his or her buying and selling decisions. Therefore, investors are pricedecisions. Therefore, investors are price--takers.takers.

7.7. Capital markets are in equilibrium.Capital markets are in equilibrium.

Market Portfolio and Capital Market LineMarket Portfolio and Capital Market Line

•• The assumptions have the following The assumptions have the following implications:implications:1.1. The “optimal” risky portfolio is the one that is The “optimal” risky portfolio is the one that is

tangent to the efficient frontier on a line that is drawn tangent to the efficient frontier on a line that is drawn from RF. This portfolio will be the same for all from RF. This portfolio will be the same for all


(CAPM)

9 - 536

from RF. This portfolio will be the same for all from RF. This portfolio will be the same for all investors.investors.

2.2. This optimal risky portfolio will be the This optimal risky portfolio will be the market market portfolioportfolio (M) which contains all risky securities.(M) which contains all risky securities.

(Figure 9 (Figure 9 –– 4 illustrates the Market Portfolio ‘M’)4 illustrates the Market Portfolio ‘M’)

The Capital Market LineThe Capital Market Line

9 - 5 FIGURE

ER

MERM M RFERRFk σ

−+=

CML

The CML is that set of

achievable The market

portfolio is the The CML has


(CAPM)

9 - 537

σρ

RF

MERM

σM

PM

MP RFk σ

σ

+= achievable portfolio

combinations that are

possible when investing in

only two assets (the market

portfolio and the risk-free asset (RF).

portfolio is the optimal risky portfolio, it contains all

risky securities and lies

tangent (T) on the efficient

frontier.

The CML has standard

deviation of portfolio

returns as the independent

variable.

The Capital Asset Pricing ModelThe Capital Asset Pricing ModelThe Market Portfolio and the Capital Market Line (CML)The Market Portfolio and the Capital Market Line (CML)

–– The slope of the CML is the incremental expected The slope of the CML is the incremental expected return divided by the incremental risk.return divided by the incremental risk.


(CAPM)

9 - 538

–– This is called This is called the market price for risk. Orthe market price for risk. Or–– The equilibrium price of risk in the capital market.The equilibrium price of risk in the capital market.

RF - ER

CML theof Slope M

M

σ=[9-4]

The Capital Asset Pricing ModelThe Capital Asset Pricing ModelThe Market Portfolio and the Capital Market Line (CML)The Market Portfolio and the Capital Market Line (CML)

–– Solving for the expected return on a portfolio in the presence of a Solving for the expected return on a portfolio in the presence of a RF asset and given the RF asset and given the market price for risk :market price for risk :

)( - RFER

RFRE PM

P σ

+=[9-5]


(CAPM)

9 - 539

–– Where:Where:•• ERERMM = expected return on the market portfolio M= expected return on the market portfolio M•• σσMM = the standard deviation of returns on the market portfolio= the standard deviation of returns on the market portfolio•• σσPP = the standard deviation of returns on the efficient portfolio being = the standard deviation of returns on the efficient portfolio being

consideredconsidered

)( σ

RFRE PM

P σ

+=[9-5]

The Capital Market LineThe Capital Market LineUsing the CML Using the CML –– Expected versus Required ReturnsExpected versus Required Returns

–– In an efficient capital market investors will require a In an efficient capital market investors will require a return on a portfolio that compensates them for the return on a portfolio that compensates them for the riskrisk--free return as well as the market price for risk.free return as well as the market price for risk.

–– This means that portfolios should offer returns along This means that portfolios should offer returns along


(CAPM)

9 - 540

–– This means that portfolios should offer returns along This means that portfolios should offer returns along the CML.the CML.

The Capital Asset Pricing ModelThe Capital Asset Pricing ModelExpected and Required Rates of Return Expected and Required Rates of Return

A is an undervalued

portfolio. Expected return is

greater than the required return.

Demand for

Expected return on A

B is a portfolio that offers and

expected return equal to the

required return.

9 - 6 FIGURE

ER

A

CML

C is an overvalued portfolio.

Expected return is less than the

required return.

Selling pressure will cause the

Required Return on C


(CAPM)

9 - 541

Demand for Portfolio A will

increase driving up the price, and

therefore the expected return

will fall until expected equals required (market

equilibrium condition is

achieved.)

Required return on A

σρ

RF

B

Cwill cause the

price to fall and the yield to rise

until expected equals the

required return.Expected Return on C

The Capital Asset Pricing ModelThe Capital Asset Pricing ModelRiskRisk--Adjusted Performance and the Sharpe RatiosAdjusted Performance and the Sharpe Ratios

–– William Sharpe identified a ratio that can be used to assess the riskWilliam Sharpe identified a ratio that can be used to assess the risk--adjusted performance of managed funds (such as mutual funds and adjusted performance of managed funds (such as mutual funds and pension plans).pension plans).

–– It is called the Sharpe ratio:It is called the Sharpe ratio:

RF - ER

ratio Sharpe P=[9-6]


(CAPM)

9 - 542

–– Sharpe ratio is a measure of portfolio performance that describes how Sharpe ratio is a measure of portfolio performance that describes how well an asset’s returns compensate investors for the risk taken.well an asset’s returns compensate investors for the risk taken.

–– It’s value is the premium earned over the RF divided by portfolio It’s value is the premium earned over the RF divided by portfolio risk…so it is measuring valued added per unit of risk.risk…so it is measuring valued added per unit of risk.

–– Sharpe ratios are calculated ex post (afterSharpe ratios are calculated ex post (after--thethe--fact) and are used to fact) and are used to rank portfolios or assess the effectiveness of the portfolio manager in rank portfolios or assess the effectiveness of the portfolio manager in adding value to the portfolio over and above a benchmark.adding value to the portfolio over and above a benchmark.

RF - ER

ratio Sharpe P

P

σ=[9-6]

The Capital Asset Pricing ModelThe Capital Asset Pricing ModelSharpe Ratios and Income TrustsSharpe Ratios and Income Trusts

–– Table 9 Table 9 –– 1 (on the following slide) illustrates return, 1 (on the following slide) illustrates return, standard deviation, Sharpe and beta coefficient for standard deviation, Sharpe and beta coefficient for four very different portfolios from 2002 to 2004.four very different portfolios from 2002 to 2004.

–– Income Trusts did exceedingly well during this time, Income Trusts did exceedingly well during this time,


(CAPM)

9 - 543

–– Income Trusts did exceedingly well during this time, Income Trusts did exceedingly well during this time, however, the recent announcement of Finance however, the recent announcement of Finance Minister Flaherty and the subsequent drop in Income Minister Flaherty and the subsequent drop in Income Trust values has done much to eliminate this Trust values has done much to eliminate this historical performance.historical performance.

Income Trust Estimated ValuesIncome Trust Estimated Values

Return σP Sharpe β

Table 9-1 Income Trusts Estimated Values


(CAPM)

9 - 544

Median income trusts 25.83% 18.66% 1.37 0.22Equally weighted trust portfolio 29.97% 8.02% 3.44 0.28S&P/TSX Composite Index 8.97% 13.31% 0.49 1.00Scotia Capital government bond index 9.55% 6.57% 1.08 20.02

Source: Adapted from L. Kryzanowski, S. Lazrak, and I. Ratika, " The True Cost of Income Trusts," Canadian Investment Review 19, no. 5 (Spring 2006), Table 3, p. 15.

Diversifiable and NonDiversifiable and Non--Diversifiable RiskDiversifiable Risk

•• CML applies to efficient portfoliosCML applies to efficient portfolios•• Volatility (risk) of Volatility (risk) of individual security returnsindividual security returns are caused by two are caused by two

different factors:different factors:–– NonNon--diversifiable risk (system wide changes in the economy and diversifiable risk (system wide changes in the economy and

markets that affect all securities in varying degrees)markets that affect all securities in varying degrees)


(CAPM)

9 - 545

markets that affect all securities in varying degrees)markets that affect all securities in varying degrees)–– Diversifiable risk (companyDiversifiable risk (company--specific factors that affect the returns specific factors that affect the returns

of only one security)of only one security)

•• Figure 9 Figure 9 –– 7 illustrates what happens to portfolio risk as the 7 illustrates what happens to portfolio risk as the portfolio is first invested in only one investment, and then portfolio is first invested in only one investment, and then slowly invested, naively, in more and more securities. slowly invested, naively, in more and more securities.

The CAPM and Market RiskThe CAPM and Market RiskPortfolio Risk and DiversificationPortfolio Risk and Diversification

9 - 7 FIGURE

Total Risk ( σ)

Unique (Non-systematic) Risk

Market or systematic risk is risk that cannot


(CAPM)

9 - 546

Number of Securities

Market (Systematic) Risk

that cannot be eliminated

from the portfolio by

investing the portfolio into

more and different

securities.

Relevant RiskRelevant RiskDrawing a Conclusion from Figure 9 Drawing a Conclusion from Figure 9 -- 77

•• Figure 9 Figure 9 –– 7 demonstrates that an individual securities’ 7 demonstrates that an individual securities’ volatility of return comes from two factors:volatility of return comes from two factors:–– Systematic factorsSystematic factors–– CompanyCompany--specific factorsspecific factors

•• When combined into portfolios, companyWhen combined into portfolios, company--specific risk is specific risk is


(CAPM)

9 - 547

•• When combined into portfolios, companyWhen combined into portfolios, company--specific risk is specific risk is diversified away.diversified away.

•• Since all investors are ‘diversified’ then in an efficient market, Since all investors are ‘diversified’ then in an efficient market, nono--one would be willing to pay a ‘premium’ for companyone would be willing to pay a ‘premium’ for company--specific risk.specific risk.

•• Relevant risk to diversified investors then is systematic risk.Relevant risk to diversified investors then is systematic risk.•• Systematic risk is measured using the Beta Coefficient.Systematic risk is measured using the Beta Coefficient.

The Beta CoefficientThe Beta CoefficientWhat is the Beta Coefficient?What is the Beta Coefficient?

•• A measure of systematic (nonA measure of systematic (non--diversifiable) riskdiversifiable) risk•• As a ‘coefficient’ the beta is a pure number and As a ‘coefficient’ the beta is a pure number and

has no units of measure.has no units of measure.


(CAPM)

9 - 548

has no units of measure.has no units of measure.

The Beta CoefficientThe Beta CoefficientHow Can We Estimate the Value of the Beta Coefficient?How Can We Estimate the Value of the Beta Coefficient?

•• There are two basic approaches to estimating There are two basic approaches to estimating the beta coefficient:the beta coefficient:


(CAPM)

9 - 549

1.1. Using a formula (and subjective forecasts)Using a formula (and subjective forecasts)2.2. Use of regression (using past holding period returns)Use of regression (using past holding period returns)

(Figure 9 (Figure 9 –– 8 on the following slide illustrates the characteristic line used to estimate 8 on the following slide illustrates the characteristic line used to estimate the beta coefficient) the beta coefficient)

The CAPM and Market RiskThe CAPM and Market RiskThe Characteristic Line for Security AThe Characteristic Line for Security A

9 - 8 FIGURE

6

4

Security A Returns (%)

Mar

ket R

etur

ns (

%)

The slope of the regression

The plotted points are the


(CAPM)

9 - 550

2

0

-2

-4

-6

-6 -4 -2 0 2 4 6 8

Mar

ket R

etur

ns (

%)

the regression line is beta.

The line of best fit is known in

finance as the characteristic

line.

points are the coincident

rates of return earned on the

investment and the market portfolio over past periods.

The Formula for the Beta CoefficientThe Formula for the Beta Coefficient

Beta is equal to the covariance of the returns of the Beta is equal to the covariance of the returns of the stock with the returns of the market, divided by the stock with the returns of the market, divided by the variance of the returns of the market:variance of the returns of the market:


(CAPM)

9 - 551

,2i

M

iMi

M

i,M

σ

COV

σσρ

β ==[9-7]

The Beta CoefficientThe Beta CoefficientHow is the Beta Coefficient Interpreted?How is the Beta Coefficient Interpreted?

•• The beta of the market portfolio is ALWAYS = 1.0The beta of the market portfolio is ALWAYS = 1.0

•• The beta of a security compares the volatility of its returns to the volatility of the The beta of a security compares the volatility of its returns to the volatility of the market returns:market returns:

ββss = 1.0= 1.0 -- the security has the same volatility as the market as a wholethe security has the same volatility as the market as a whole

ββ > 1.0> 1.0 -- aggressive investment with volatility of returns greater than aggressive investment with volatility of returns greater than


(CAPM)

9 - 552

ββss > 1.0> 1.0 -- aggressive investment with volatility of returns greater than aggressive investment with volatility of returns greater than the marketthe market

ββss < 1.0< 1.0 -- defensive investment with volatility of returns less than the defensive investment with volatility of returns less than the marketmarket

ββss < 0.0< 0.0 -- an investment with returns that are negatively correlated with an investment with returns that are negatively correlated with the returns of the marketthe returns of the market

Table 9 Table 9 –– 2 illustrates beta coefficients for a variety of Canadian Investments2 illustrates beta coefficients for a variety of Canadian Investments

Canadian BETASCanadian BETASSelectedSelected

Company Industry Classification Beta

Abitibi Consolidated Inc. Materials - Paper & Forest 1.37Algoma Steel Inc. Materials - Steel 1.92Bank of Montreal Financials - Banks 0.50

Table 9-2 Canadian BETAS


(CAPM)

9 - 553

Bank of Montreal Financials - Banks 0.50Bank of Nova Scotia Financials - Banks 0.54Barrick Gold Corp. Materials - Precious Metals & Minerals 0.74BCE Inc. Communications - Telecommunications 0.39Bema Gold Corp. Materials - Precious Metals & Minerals 0.26CIBC Financials - Banks 0.66Cogeco Cable Inc. Consumer Discretionary - Cable 0.67Gammon Lake Resources Inc. Materials - Precious Metals & Minerals 2.52Imperial Oil Ltd. Energy - Oil & Gas: Integrated Oils 0.80

Source: Research Insight, Compustat North American database, June 2006.

The Beta of a PortfolioThe Beta of a Portfolio

The beta of a portfolio is simply the weighted average of the The beta of a portfolio is simply the weighted average of the betas of the individual asset betas that make up the portfolio.betas of the individual asset betas that make up the portfolio.

ββββ +++=


(CAPM)

9 - 554

Weights of individual assets are found by dividing the value of Weights of individual assets are found by dividing the value of the investment by the value of the total portfolio.the investment by the value of the total portfolio.

... nnBBAAP www ββββ +++=[9-8]

The CAPM and Market RiskThe CAPM and Market RiskThe Security Market Line (SML)The Security Market Line (SML)

–– The SML is the hypothesized relationship between return (the The SML is the hypothesized relationship between return (the dependent variable) and systematic risk (the beta coefficient).dependent variable) and systematic risk (the beta coefficient).

–– It is a straight line relationship defined by the following formula:It is a straight line relationship defined by the following formula:

)( RFERRFk β−+=[9-9]


(CAPM)

9 - 555

–– Where:Where:kkii = the required return on security ‘i’= the required return on security ‘i’ERERMM –– RF = market premium for riskRF = market premium for riskΒΒi i = the beta coefficient for security ‘i’= the beta coefficient for security ‘i’

(See Figure 9 (See Figure 9 -- 9 on the following slide for the graphical representation)9 on the following slide for the graphical representation)

)( iMi RFERRFk β−+=[9-9]

The CAPM and Market RiskThe CAPM and Market RiskThe Security Market Line (SML)The Security Market Line (SML)

9 - 9 FIGURE

ER

MER

iMi RFERRFk β)( −+=The SML is used

to predict The SML uses the beta coefficient as


(CAPM)

9 - 556

βM = 1

RF

β

ERMto predict

required returns for individual

securities

beta coefficient as the measure of relevant risk.

9 - 10 FIGURE

ER

SML

The CAPM and Market RiskThe CAPM and Market RiskThe SML and Security ValuationThe SML and Security Valuation

iMi RFERRFk β)( −+=Required returns are

forecast using this equation.

You can see that the required return on any

security is a function of its systematic risk ( β) and

A is an undervalued security because its

expected return is greater than the required return.

Investors will ‘flock’ to A and bid up the price

causing expected return

Similarly, B is an overvalued security.

Investor’s will sell to lock in gains, but the selling pressure will cause the

market price to fall, causing the expected


(CAPM)

9 - 557

βA

RF

β

B

A

βB

its systematic risk ( β) and market factors ( RF and

market premium for risk)

causing expected return to fall till it equals the

required return.

Required Return A

Expected Return A

causing the expected return to rise until it equals the required

return.

The CAPM in SummaryThe CAPM in SummaryThe SML and CMLThe SML and CML

–– The CAPM is well entrenched and widely used by The CAPM is well entrenched and widely used by investors, managers and financial institutions.investors, managers and financial institutions.

–– It is a single factor model because it based on the It is a single factor model because it based on the


(CAPM)

9 - 558

–– It is a single factor model because it based on the It is a single factor model because it based on the hypothesis that required rate of return can be hypothesis that required rate of return can be predicted using one factor predicted using one factor –– systematic risksystematic risk

–– The SML is used to price individual investments and The SML is used to price individual investments and uses the beta coefficient as the measure of risk.uses the beta coefficient as the measure of risk.

–– The CML is used with diversified portfolios and uses The CML is used with diversified portfolios and uses the standard deviation as the measure of risk.the standard deviation as the measure of risk.

Challenges to CAPMChallenges to CAPM

•• Empirical tests suggest:Empirical tests suggest:–– CAPM does not hold well in practice:CAPM does not hold well in practice:

•• Ex post SML is an upward sloping lineEx post SML is an upward sloping line•• Ex ante Ex ante y (vertical)y (vertical) –– intercept is higher that RFintercept is higher that RF•• Slope is less than what is predicted by theorySlope is less than what is predicted by theory

–– Beta possesses no explanatory power for predicting stock Beta possesses no explanatory power for predicting stock


(CAPM)

9 - 559

–– Beta possesses no explanatory power for predicting stock Beta possesses no explanatory power for predicting stock returns (Fama and French, 1992)returns (Fama and French, 1992)

•• CAPM remains in widespread use despite the foregoing.CAPM remains in widespread use despite the foregoing.–– Advantages include Advantages include –– relative simplicity and intuitive logic.relative simplicity and intuitive logic.

•• Because of the problems with CAPM, other models have Because of the problems with CAPM, other models have been developed including:been developed including:–– FamaFama--French (FF) ModelFrench (FF) Model–– Abitrage Pricing Theory (APT)Abitrage Pricing Theory (APT)

Alternative Asset Pricing ModelsAlternative Asset Pricing ModelsThe Fama The Fama –– French ModelFrench Model

–– A pricing model that uses three factors to relate A pricing model that uses three factors to relate expected returns to risk including:expected returns to risk including:

1.1. A market factor related to firm size.A market factor related to firm size.2.2. The market value of a firm’s common equity (MVE)The market value of a firm’s common equity (MVE)


(CAPM)

9 - 560

2.2. The market value of a firm’s common equity (MVE)The market value of a firm’s common equity (MVE)3.3. Ratio of a firm’s book equity value to its market value of Ratio of a firm’s book equity value to its market value of

equity. (BE/MVE)equity. (BE/MVE)

–– This model has become popular, and many think it This model has become popular, and many think it does a better job than the CAPM in explaining ex does a better job than the CAPM in explaining ex ante stock returns.ante stock returns.

Alternative Asset Pricing ModelsAlternative Asset Pricing ModelsThe Arbitrage Pricing TheoryThe Arbitrage Pricing Theory

–– A pricing model that uses multiple factors to relate expected A pricing model that uses multiple factors to relate expected returns to risk by assuming that asset returns are linearly related returns to risk by assuming that asset returns are linearly related to a set of indexes, which proxy risk factors that influence to a set of indexes, which proxy risk factors that influence security returns.security returns.

... FbFbFbaER ++++=


(CAPM)

9 - 561

–– It is based on the noIt is based on the no--arbitrage principle which is the rule that two arbitrage principle which is the rule that two otherwise identical assets cannot sell at different prices.otherwise identical assets cannot sell at different prices.

–– Underlying factors represent broad economic forces which are Underlying factors represent broad economic forces which are inherently unpredictable.inherently unpredictable.

... 11110 niniii FbFbFbaER ++++=[9-10]

Alternative Asset Pricing ModelsAlternative Asset Pricing ModelsThe Arbitrage Pricing Theory The Arbitrage Pricing Theory –– the Modelthe Model

–– Underlying factors represent broad economic forces which are Underlying factors represent broad economic forces which are inherently unpredictable.inherently unpredictable.

... 11110 niniii FbFbFbaER ++++=[9-10]


(CAPM)

9 - 562

–– Where:Where:•• ERERii = the expected return on security i= the expected return on security i•• aa00 = the expected return on a security with zero systematic risk= the expected return on a security with zero systematic risk•• bbii = the sensitivity of security i to a given risk factor= the sensitivity of security i to a given risk factor•• FFii = the risk premium for a given risk factor= the risk premium for a given risk factor

–– The model demonstrates that a security’s risk is based on its sensitivity The model demonstrates that a security’s risk is based on its sensitivity to broad economic forces.to broad economic forces.

Alternative Asset Pricing ModelsAlternative Asset Pricing ModelsThe Arbitrage Pricing Theory The Arbitrage Pricing Theory –– ChallengesChallenges

–– Underlying factors represent broad economic forces Underlying factors represent broad economic forces which are inherently unpredictable.which are inherently unpredictable.

–– Ross and Roll identify five systematic factors:Ross and Roll identify five systematic factors:1.1. Changes in expected inflationChanges in expected inflation2.2. Unanticipated changes in inflationUnanticipated changes in inflation


(CAPM)

9 - 563

3.3. Unanticipated changes in industrial productionUnanticipated changes in industrial production4.4. Unanticipated changes in the defaultUnanticipated changes in the default--risk premiumrisk premium5.5. Unanticipated changes in the term structure of interest ratesUnanticipated changes in the term structure of interest rates

•• Clearly, something that isn’t forecast, can’t be used Clearly, something that isn’t forecast, can’t be used to price securities today…they can only be used to to price securities today…they can only be used to explain prices after the fact.explain prices after the fact.



–– How the efficient frontier can be expanded by introducing riskHow the efficient frontier can be expanded by introducing risk--free borrowing and lending leading to a super efficient frontier free borrowing and lending leading to a super efficient frontier


(CAPM)

9 - 564

free borrowing and lending leading to a super efficient frontier free borrowing and lending leading to a super efficient frontier called the Capital Market Line (CML)called the Capital Market Line (CML)

–– The Security Market Line can be derived from the CML and The Security Market Line can be derived from the CML and provides a way to estimate a marketprovides a way to estimate a market--based, required return for based, required return for any security or portfolio based on market risk as measured by any security or portfolio based on market risk as measured by the beta.the beta.

–– That alternative asset pricing models exist including the FamaThat alternative asset pricing models exist including the Fama--French Model and the Arbitrage Pricing Theory.French Model and the Arbitrage Pricing Theory.

Estimating the Ex Ante (Forecast) BetaEstimating the Ex Ante (Forecast) Beta

APPENDIX 1APPENDIX 1

Calculating a Beta Coefficient Using Ex Ante Calculating a Beta Coefficient Using Ex Ante ReturnsReturns

•• Ex Ante means forecast…Ex Ante means forecast…•• You would use ex ante return data if historical rates of return You would use ex ante return data if historical rates of return

are somehow not indicative of the kinds of returns the are somehow not indicative of the kinds of returns the company will produce in the future.company will produce in the future.


(CAPM)

9 - 566

•• A good example of this is Air Canada or American Airlines, A good example of this is Air Canada or American Airlines, before and after September 11, 2001. After the World Trade before and after September 11, 2001. After the World Trade Centre terrorist attacks, a fundamental shift in demand for air Centre terrorist attacks, a fundamental shift in demand for air travel occurred. The historical returns on airlines are not travel occurred. The historical returns on airlines are not useful in estimating future returns.useful in estimating future returns.

Appendix 1 AgendaAppendix 1 Agenda

•• The beta coefficientThe beta coefficient•• The formula approach to beta measurement The formula approach to beta measurement

using ex ante returnsusing ex ante returns–– Ex ante returnsEx ante returns


(CAPM)

9 - 567

–– Ex ante returnsEx ante returns–– Finding the expected returnFinding the expected return–– Determining variance and standard deviationDetermining variance and standard deviation–– Finding covarianceFinding covariance–– Calculating and interpreting the beta coefficientCalculating and interpreting the beta coefficient

The Beta CoefficientThe Beta Coefficient

•• Under the theory of the Capital Asset Pricing Model total risk is Under the theory of the Capital Asset Pricing Model total risk is partitioned into two parts:partitioned into two parts:–– Systematic riskSystematic risk–– Unsystematic risk Unsystematic risk –– diversifiable riskdiversifiable risk

Total Risk of the Investment


(CAPM)

9 - 568

•• Systematic risk is nonSystematic risk is non--diversifiable risk.diversifiable risk.•• Systematic risk is the only relevant risk to the diversified Systematic risk is the only relevant risk to the diversified

investorinvestor•• The beta coefficient measures systematic riskThe beta coefficient measures systematic risk

Systematic Risk Unsystematic Risk

The Beta CoefficientThe Beta CoefficientThe FormulaThe Formula

ReturnsMarket theof Variance

market theand returns i''stock between Returns of CovarianceBeta=


(CAPM)

9 - 569

,2i

M

iMi

M

i,M

σ

COV

σσρ

β ==[9-7]

The Term The Term –– “Relevant Risk”“Relevant Risk”

•• What does the term “relevant risk” mean in the context of the CAPM?What does the term “relevant risk” mean in the context of the CAPM?–– It is generally assumed that all investors are wealth maximizing risk It is generally assumed that all investors are wealth maximizing risk

averse peopleaverse people–– It is also assumed that the markets where these people trade are highly It is also assumed that the markets where these people trade are highly

efficientefficient–– In a highly efficient market, the prices of all the securities adjust instantly In a highly efficient market, the prices of all the securities adjust instantly


(CAPM)

9 - 570

–– In a highly efficient market, the prices of all the securities adjust instantly In a highly efficient market, the prices of all the securities adjust instantly to cause the expected return of the investment to equal the required to cause the expected return of the investment to equal the required returnreturn

–– When E(r) = R(r) then the market price of the stock equals its inherent When E(r) = R(r) then the market price of the stock equals its inherent worth (intrinsic value)worth (intrinsic value)

–– In this perfect world, the R(r) then will justly and appropriately In this perfect world, the R(r) then will justly and appropriately compensate the investor only for the risk that they perceive as compensate the investor only for the risk that they perceive as relevant…relevant…

–– Hence investors are only rewarded for systematic risk.Hence investors are only rewarded for systematic risk.

NOTE: The amount of systematic risk varies by inve stment. High systematic risk occurs when R-square is high, and the beta coeffici ent is greater than 1.0

The Proportion of Total Risk that is SystematicThe Proportion of Total Risk that is Systematic

•• Every investment in the financial markets vary with respect to Every investment in the financial markets vary with respect to the percentage of total risk that is systematic.the percentage of total risk that is systematic.

•• Some stocks have virtually Some stocks have virtually no systematicno systematic risk.risk.–– Such stocks are not influenced by the health of the economy in Such stocks are not influenced by the health of the economy in

general…their financial results are predominantly influenced by general…their financial results are predominantly influenced by companycompany--specific factors.specific factors.


(CAPM)

9 - 571

companycompany--specific factors.specific factors.–– An example is cigarette companies…people consume cigarettes An example is cigarette companies…people consume cigarettes

because they are addicted…so it doesn’t matter whether the because they are addicted…so it doesn’t matter whether the economy is healthy or not…they just continue to smoke.economy is healthy or not…they just continue to smoke.

•• Some stocks have a high proportion of their total risk that is Some stocks have a high proportion of their total risk that is systematicsystematic–– Returns on these stocks are strongly influenced by the health of Returns on these stocks are strongly influenced by the health of

the economy.the economy.–– Durable goods manufacturers tend to have a high degree of Durable goods manufacturers tend to have a high degree of

systematic risk.systematic risk.

The Formula Approach to Measuring the BetaThe Formula Approach to Measuring the Beta

)Var(k

)kCov(kBeta

M

Mi=


(CAPM)

9 - 572

You need to calculate the covariance of the returns between the stock and the market…as well as the variance of the market returns. To do this you must follow these steps:

• Calculate the expected returns for the stock and th e market• Using the expected returns for each, measure the va riance and standard deviation of

both return distributions• Now calculate the covariance

• Use the results to calculate the beta

Ex ante Return Data Ex ante Return Data A Sample A Sample

A set of estimates of possible returns and their respective probabilities A set of estimates of possible returns and their respective probabilities looks as follows:looks as follows:

Possible Future State

of the Possible

Returns on Possible

Returns on By observation you

can see the range is

Since the beta relates the stock

returns to the market returns,


(CAPM)9 - 573

of the Economy Probability


Returns on the Market

Boom 25.0% 28.0% 20.0%Normal 50.0% 17.0% 11.0%Recession 25.0% -14.0% -4.0%

can see the range is much greater for the

stock than the market and they move in the

same direction.

market returns, the greater range

of stock returns changing in the

same direction as the market

indicates the beta will be greater

than 1 and will be positive.

(Positively correlated to the market returns.)

The Total of the Probabilities must Equal 100% The Total of the Probabilities must Equal 100%

This means that we have considered all of the possible outcomes in this This means that we have considered all of the possible outcomes in this discrete probability distributiondiscrete probability distribution

Possible Future State

of the Possible

Returns on Possible

Returns on


(CAPM)9 - 574




Boom 25.0% 28.0% 20.0%Normal 50.0% 17.0% 11.0%Recession 25.0% -14.0% -4.0%

100.0%

Measuring Measuring Expected Return on the StockExpected Return on the StockFrom Ex Ante Return DataFrom Ex Ante Return Data

The expected return is weighted average returns from the given The expected return is weighted average returns from the given ex ante dataex ante data

(1) (2) (3) (4)Possible

Future State Possible


(CAPM)9 - 575

Future State of the

Economy Probability

Possible

Returns on the Stock (4) = (2)*(3)

Boom 25.0% 28.0% 0.07Normal 50.0% 17.0% 0.085Recession 25.0% -14.0% -0.035

Expected return on the Stock = 12.0%

Measuring Measuring Expected Return on the MarketExpected Return on the MarketFrom Ex Ante Return DataFrom Ex Ante Return Data

The expected return is weighted average returns from the given The expected return is weighted average returns from the given ex ante dataex ante data

(1) (2) (3) (4)Possible

Future State Possible


(CAPM)9 - 576

Future State of the

Economy Probability

Possible

Returns on the Market (4) = (2)*(3)

Boom 25.0% 20.0% 0.05Normal 50.0% 11.0% 0.055Recession 25.0% -4.0% -0.01

Expected return on the Market = 9.5%

Measuring Variances, Standard Deviations of Measuring Variances, Standard Deviations of the Forecast Stock Returnsthe Forecast Stock Returns

Using the expected return, calculate the deviations away from the mean, square those Using the expected return, calculate the deviations away from the mean, square those deviations and then weight the squared deviations by the probability of their occurrence. deviations and then weight the squared deviations by the probability of their occurrence.

Add up the weighted and squared deviations from the mean and you have found the Add up the weighted and squared deviations from the mean and you have found the variance!variance!

(1) (2) (3) (4) (5) (6) (7)Possible Weighted


(CAPM)9 - 577

Possible

Future State of the

Economy Probability

Possible

Returns on the Stock (4) = (2)*(3) Deviations

Squared

Deviations

Weighted

and Squared

Deviations

Boom 25.0% 0.28 0.07 0.16 0.0256 0.0064Normal 50.0% 0.17 0.085 0.05 0.0025 0.00125Recession 25.0% -0.14 -0.035 -0.26 0.0676 0.0169

Expected return (stock) = 12.0% Variance (stock)= 0.02 455Standard Deviation (stock) = 15.67%

Measuring Variances, Standard Deviations of Measuring Variances, Standard Deviations of the Forecast Market Returnsthe Forecast Market Returns

Now do this for the possible returns on the marketNow do this for the possible returns on the market

(1) (2) (3) (4) (5) (6) (7)Possible

Future State of the

Possible

Returns on Squared

Weighted

and Squared


(CAPM)9 - 578


Returns on the Market (4) = (2)*(3) Deviations

Squared

DeviationsSquared

Deviations

Boom 25.0% 0.2 0.05 0.105 0.011025 0.002756Normal 50.0% 0.11 0.055 0.015 0.000225 0.000113Recession 25.0% -0.04 -0.01 -0.135 0.018225 0.004556

Expected return (market) = 9.5% Variance (market) = 0. 007425Standard Deviation (market)= 8.62%

CovarianceCovariance

From Chapter 8 you know the formula for the covariance between From Chapter 8 you know the formula for the covariance between the returns on the stock and the returns on the market is:the returns on the stock and the returns on the market is:

__n

∑ −=


(CAPM)

9 - 579

Covariance is an absolute measure of the degree of ‘coCovariance is an absolute measure of the degree of ‘co--movement’ movement’ of returns. of returns.

)-)((Prob _

,1

_

,i BiB

n

iiiAAB kkkkCOV ∑

=

−=[8-12]

Correlation CoefficientCorrelation Coefficient

Correlation is covariance normalized by the product of the standard deviations of both Correlation is covariance normalized by the product of the standard deviations of both securities. It is a ‘relative measure’ of cosecurities. It is a ‘relative measure’ of co--movement of returns on a scale from movement of returns on a scale from --1 to 1 to +1.+1.

The formula for the correlation coefficient between the returns on the stock and the The formula for the correlation coefficient between the returns on the stock and the returns on the market is:returns on the market is:

COV


(CAPM)

9 - 580

The correlation coefficient will always have a value in the range of +1 to The correlation coefficient will always have a value in the range of +1 to --1.1.+1 +1 –– is perfect positive correlation (there is no diversification potential when combining these two is perfect positive correlation (there is no diversification potential when combining these two

securities together in a twosecurities together in a two--asset portfolio.)asset portfolio.)-- 1 1 -- is perfect negative correlation (there should be a relative weighting mix of these two is perfect negative correlation (there should be a relative weighting mix of these two

securities in a twosecurities in a two--asset portfolio that will eliminate all portfolio risk) asset portfolio that will eliminate all portfolio risk)

BA

ABAB

COV

σσρ =[8-13]

Measuring CovarianceMeasuring Covariancefrom Ex Ante Return Datafrom Ex Ante Return Data

Using the expected return (mean return) and given data measure the Using the expected return (mean return) and given data measure the deviations for both the market and the stock and multiply them together with deviations for both the market and the stock and multiply them together with

the probability of occurrence…then add the products up.the probability of occurrence…then add the products up.

(1) (2) (3) (4) (5) (6) (7) (8) "(9)


(CAPM)9 - 581

Possible Future

State of the Economy Prob.

Possible Returns on the Stock

(4) = (2)*(3)

Possible Returns on the Market (6)=(2)*(5)

Deviations from the mean for the stock

Deviations from the mean for

the market (8)=(2)(6)(7)

Boom 25.0% 28.0% 0.07 20.0% 0.05 16.0% 10.5% 0.0042Normal 50.0% 17.0% 0.085 11.0% 0.055 5.0% 1.5% 0.000375Recession 25.0% -14.0% -0.035 -4.0% -0.01 -26.0% -13.5% 0.008775

E(kstock ) = 12.0% E(kmarket ) = 9.5% Covariance = 0.01335

The Beta MeasuredThe Beta MeasuredUsing Ex Ante Covariance (stock, market) and Market VarianceUsing Ex Ante Covariance (stock, market) and Market Variance

Now you can substitute the values for covariance and the variance of Now you can substitute the values for covariance and the variance of the returns on the market to find the beta of the stock:the returns on the market to find the beta of the stock:

01335.Cov MS, ===


(CAPM)9 - 582

8.1007425.

01335.

Var

CovBeta

M

MS, ===

• A beta that is greater than 1 means that the invest ment is aggressive…its returns are more volatile than the market as a whole.

• If the market returns were expected to go up by 10% , then the stock returns are expected to rise by 18%. If the market returns are expected to fall by 10%, then the stock returns are expected to fall b y

18%.

Lets Prove the Beta of the Market is 1.0Lets Prove the Beta of the Market is 1.0

Let us assume we are comparing the possible market returns Let us assume we are comparing the possible market returns against itself…what will the beta be?against itself…what will the beta be?

(1) (2) (3) (4) (5) (6) (6) (7) (8)

Possible Future

Possible Returns

Possible Returns

Deviations from the

Deviations from the 007425.Cov


(CAPM)9 - 583

Future State of the Economy Prob.


(4) = (2)*(3)

Returns on the Market (6)=(2)*(5)

from the mean for the stock

from the mean for

the market(8)=(2)(6)(7

)

Boom 25.0% 20.0% 0.05 20.0% 0.05 10.5% 10.5% 0.002756Normal 50.0% 11.0% 0.055 11.0% 0.055 1.5% 1.5% 0.000113Recession 25.0% -4.0% -0.01 -4.0% -0.01 -13.5% -13.5% 0.004556

E(kM) = 9.5% E(kM) = 9.5% Covariance = 0.007425

Since the variance of the returns on the market is = .007425 …the beta for the market is indeed equal to 1.0 !!!

0.1007425.

007425.

Var

CovBeta

M

M`M, ===

Proving the Beta of Market = 1Proving the Beta of Market = 1

If you now place the covariance of the market with itself value in If you now place the covariance of the market with itself value in the beta formula you get:the beta formula you get:

007425.Cov ===


(CAPM)9 - 584

0.1007425.

007425.

)Var(R

CovBeta

M

MM ===

The beta coefficient of the market will always be 1 .0 because you are measuring the market returns against market returns .

How Do We use Expected and Required Rates How Do We use Expected and Required Rates of Return?of Return?

% Return

R(ks) = 4.76%

E(Rs) = 5.0%

Once you have estimated the expected and required r ates of return, you can Once you have estimated the expected and required r ates of return, you can plot them on the SML and see if the stock is under or overpriced.plot them on the SML and see if the stock is under or overpriced.


(CAPM)

9 - 585

Risk-free Rate = 3%

BBBBMMMM= 1.0= 1.0= 1.0= 1.0

E(kM)= 4.2%

BBBBssss= 1.464= 1.464= 1.464= 1.464

R(ks) = 4.76%SML

Since E(r)>R(r) the stock is underpriced.

How Do We use Expected and Required Rates How Do We use Expected and Required Rates of Return?of Return?

% Return

•• The stock is fairly priced if the expected return = the required return.The stock is fairly priced if the expected return = the required return.•• This is what we would expect to see ‘normally’ or most of the time in an efficient market where This is what we would expect to see ‘normally’ or most of the time in an efficient market where

securities are properly priced.securities are properly priced.


(CAPM)

9 - 586

% Return

Risk-free Rate = 3%

BBBBMMMM= 1.0= 1.0= 1.0= 1.0

E(RM)= 4.2%

BBBBSSSS= 1.464= 1.464= 1.464= 1.464

E(Rs) = R(Rs) 4.76%SML

Use of the Forecast BetaUse of the Forecast Beta

•• We can use the forecast beta, together with an estimate of the riskWe can use the forecast beta, together with an estimate of the risk--free rate free rate and the market premium for risk to calculate the investor’s required return and the market premium for risk to calculate the investor’s required return on the stock using the CAPM:on the stock using the CAPM:

RF]k[EβRF −+= )( Return Required


(CAPM)9 - 587

•• This is a ‘marketThis is a ‘market--determined’ return based on the current riskdetermined’ return based on the current risk--free rate (RF) free rate (RF) as measured by the 91as measured by the 91--day, government of Canada Tday, government of Canada T--bill yield, and a bill yield, and a current estimate of the market premium for risk (kcurrent estimate of the market premium for risk (kMM –– RF)RF)

RF]k[EβRF Mi −+= )( Return Required

ConclusionsConclusions

•• Analysts can make estimates or forecasts for the returns on Analysts can make estimates or forecasts for the returns on stock and returns on the market portfolio.stock and returns on the market portfolio.

•• Those forecasts can be analyzed to estimate the beta Those forecasts can be analyzed to estimate the beta coefficient for the stock. coefficient for the stock.


(CAPM)

9 - 588

coefficient for the stock. coefficient for the stock. •• The required return on a stock can then be calculated using The required return on a stock can then be calculated using

the CAPM the CAPM –– but you will need the stock’s beta coefficient, the but you will need the stock’s beta coefficient, the expected return on the market portfolio and the riskexpected return on the market portfolio and the risk--free rate.free rate.

•• The required return is then using in Dividend Discount Models The required return is then using in Dividend Discount Models to estimate the ‘intrinsic value’ (inherent worth) of the stock.to estimate the ‘intrinsic value’ (inherent worth) of the stock.

Calculating the Beta using Trailing Calculating the Beta using Trailing Holding Period ReturnsHolding Period Returns

APPENDIX 2APPENDIX 2

The Regression Approach to Measuring the The Regression Approach to Measuring the BetaBeta

• You need to gather historical data about the stock and the market

• You can use annual data, monthly data, weekly data or daily data. However, monthly holding period returns are most commonly used.

• Daily data is too ‘noisy’ (short-term random volati lity)

• Annual data will extend too far back in to time

• You need at least thirty (30) observations of histo rical data.

• Hopefully, the period over which you study the hist orical returns of the stock is representative of the normal condition of the firm and its relationsh ip to the market.


(CAPM)

9 - 590

the normal condition of the firm and its relationsh ip to the market.

• If the firm has changed fundamentally since these d ata were produced (for example, the firm may have merged with another firm or have divested itse lf of a major subsidiary) there is good reason to

believe that future returns will not reflect the pa st…and this approach to beta estimation SHOULD NOT be used….rather, use the ex ante approach.

Historical Beta EstimationHistorical Beta EstimationThe Approach Used to Create the Characteristic LineThe Approach Used to Create the Characteristic Line

Period HPR(Stock) HPR(TSE 300)2006.4 -4.0% 1.2%2006.3 -16.0% -7.0%2006.2 32.0% 12.0%

Ch a r a c te r ist ic L ine (Re g r e ssion )

25.0%

30.0%

In this example, we have regressed the quarterly returns on the stock against the quarterly returns of a surrogate for th e market (TSE 300 total

return composite index) and then using Excel…used th e charting feature to plot the historical points and add a regression tre nd line.

The ‘cloud’ of plotted points represents ‘diversifiable or company specific’ risk in the securities returns that can be eliminated from a portfolio

through diversification. Since


(CAPM)

9 - 591

2006.2 32.0% 12.0%2006.1 16.0% 8.0%2005.4 -22.0% -11.0%2005.3 15.0% 16.0%2005.2 28.0% 13.0%2005.1 19.0% 7.0%2004.4 -16.0% -4.0%2004.3 8.0% 16.0%2004.2 -3.0% -11.0%2004.1 34.0% 25.0% -15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

-40.0% -20.0% 0.0% 20.0% 40.0%

Returns on TSE 300

Ret

urns

on

Sto

ck

The regression line is a line of ‘best fit’ that describes the inherent

relationship between the returns on the stock and the returns on the

market. The slope is the beta coefficient.

through diversification. Since company-specific risk can be

eliminated, investors don’t require compensation for it according to

Markowitz Portfolio Theory.

Characteristic LineCharacteristic Line

•• The characteristic line is a regression line that represents the relationship The characteristic line is a regression line that represents the relationship between the returns on the stock and the returns on the market over a past between the returns on the stock and the returns on the market over a past period of time. (It will be used to forecast the future, assuming the future period of time. (It will be used to forecast the future, assuming the future will be similar to the past.)will be similar to the past.)

•• The The slope of the Characteristic Lineslope of the Characteristic Line is the Beta Coefficient.is the Beta Coefficient.

•• The degree to which the characteristic line explains the variability in the The degree to which the characteristic line explains the variability in the


(CAPM)

9 - 592

•• The degree to which the characteristic line explains the variability in the The degree to which the characteristic line explains the variability in the dependent variable (returns on the stock) is measured by the coefficient of dependent variable (returns on the stock) is measured by the coefficient of determination. (also known as the determination. (also known as the RR22 (r(r--squared or coefficient of squared or coefficient of determination)).determination)).

•• If the coefficient of determination equals 1.00, this would mean that all of If the coefficient of determination equals 1.00, this would mean that all of the points of observation would lie on the line. This would mean that the the points of observation would lie on the line. This would mean that the characteristic line would explain 100% of the variability of the dependent characteristic line would explain 100% of the variability of the dependent variable.variable.

•• The The alpha alpha is the vertical intercept of the regression (characteristic line). is the vertical intercept of the regression (characteristic line). Many stock analysts search out stocks with high alphas.Many stock analysts search out stocks with high alphas.

Low RLow R22

•• An RAn R22 that approaches 0.00 (or 0%) indicates that the characteristic that approaches 0.00 (or 0%) indicates that the characteristic (regression) line explains virtually none of the variability in the (regression) line explains virtually none of the variability in the dependent variable.dependent variable.

•• This means that virtually of the risk of the security is ‘companyThis means that virtually of the risk of the security is ‘company--specific’. specific’.


(CAPM)

9 - 593

specific’. specific’. •• This also means that the regression model has virtually no predictive This also means that the regression model has virtually no predictive

ability.ability.•• In this case, you should use other approaches to value the In this case, you should use other approaches to value the

stock…do not use the estimated beta coefficient.stock…do not use the estimated beta coefficient.

(See the following slide for an illustration of a low r(See the following slide for an illustration of a low r--square)square)

Characteristic Line for Imperial TobaccoCharacteristic Line for Imperial TobaccoAn Example of Volatility that is Primarily CompanyAn Example of Volatility that is Primarily Company--SpecificSpecific

Returns on Imperial

Tobacco %

Characteristic Line for Imperial Tobacco

• High alpha

• R-square is very low ≈ 0.02


(CAPM)

9 - 594

Returns on the Market % (S&P

TSX)

• Beta is largely irrelevant

High RHigh R22

•• An RAn R22 that approaches 1.00 (or 100%) indicates that the that approaches 1.00 (or 100%) indicates that the characteristic (regression) line explains virtually all of the variability characteristic (regression) line explains virtually all of the variability in the dependent variable.in the dependent variable.

•• This means that virtually of the risk of the security is ‘systematic’. This means that virtually of the risk of the security is ‘systematic’. •• This also means that the regression model has a strong predictive This also means that the regression model has a strong predictive


(CAPM)

9 - 595

•• This also means that the regression model has a strong predictive This also means that the regression model has a strong predictive ability. … if you can predict what the market will do…then you can ability. … if you can predict what the market will do…then you can predict the returns on the stock itself with a great deal of accuracy.predict the returns on the stock itself with a great deal of accuracy.

Characteristic Line General MotorsCharacteristic Line General MotorsA Positive Beta with Predictive PowerA Positive Beta with Predictive Power

Returns on General Motors

%

Characteristic Line for GM

(high R2)

• Positive alpha

• R-square is very high ≈ 0.9


(CAPM)

9 - 596


TSX)

very high ≈ 0.9

• Beta is positive and close to 1.0

An Unusual Characteristic LineAn Unusual Characteristic LineA Negative Beta with Predictive PowerA Negative Beta with Predictive Power

Returns on a Stock %

Characteristic Line for a stock that will provide excellent portfolio diversification

(high R2)

• Positive alpha

• R-square is very high


(CAPM)

9 - 597


TSX)

• Beta is negative <0.0 and > -1.0

Diversifiable RiskDiversifiable Risk(Non(Non--systematic Risk)systematic Risk)

•• Volatility in a security’s returns caused by companyVolatility in a security’s returns caused by company--specific specific factors (both positive and negative) such as:factors (both positive and negative) such as:–– a single company strikea single company strike–– a spectacular innovation discovered through the company’s R&D a spectacular innovation discovered through the company’s R&D

programprogram–– equipment failure for that one companyequipment failure for that one company


(CAPM)

9 - 598

–– equipment failure for that one companyequipment failure for that one company–– management competence or management incompetence for that management competence or management incompetence for that

particular firmparticular firm–– a jet carrying the senior management team of the firm crashes (this a jet carrying the senior management team of the firm crashes (this

could be either a positive or negative event, depending on the could be either a positive or negative event, depending on the competence of the management team)competence of the management team)

–– the patented formula for a new drug discovered by the firm.the patented formula for a new drug discovered by the firm.

•• Obviously, diversifiable risk is that unique factor that influences only Obviously, diversifiable risk is that unique factor that influences only the one firm. the one firm.

OK OK –– lets go back and look at raw data lets go back and look at raw data gathering and data normalizationgathering and data normalization

•• A common source for stock of information is Yahoo.comA common source for stock of information is Yahoo.com•• You will also need to go to the library a use the TSX Review (a You will also need to go to the library a use the TSX Review (a

monthly periodical) monthly periodical) –– to obtain:to obtain:–– Number of shares outstanding for the firm each monthNumber of shares outstanding for the firm each month–– Ending values for the total return composite index (surrogate for the Ending values for the total return composite index (surrogate for the


(CAPM)

9 - 599

–– Ending values for the total return composite index (surrogate for the Ending values for the total return composite index (surrogate for the market)market)

•• You want data for at least 30 months.You want data for at least 30 months.•• For each month you will need:For each month you will need:

–– Ending stock priceEnding stock price–– Number of shares outstanding for the stockNumber of shares outstanding for the stock–– Dividend per share paid during the month for the stockDividend per share paid during the month for the stock–– Ending value of the market indicator series you plan to use (ie. TSE Ending value of the market indicator series you plan to use (ie. TSE

300 total return composite index)300 total return composite index)

Demonstration Through ExampleDemonstration Through Example

The following slides will be based on The following slides will be based on Alcan Aluminum (AL.TO)Alcan Aluminum (AL.TO)

Five Year Stock Price Chart for AL.TOFive Year Stock Price Chart for AL.TO


(CAPM)

9 - 601

Spreadsheet Data From YahooSpreadsheet Data From Yahoo

Process:Process:

–– Go to Go to http://ca.finance.yahoo.comhttp://ca.finance.yahoo.com–– Use the symbol lookup function to search for the Use the symbol lookup function to search for the


(CAPM)

9 - 602

–– Use the symbol lookup function to search for the Use the symbol lookup function to search for the company you are interested in studying.company you are interested in studying.

–– Use the historical quotes button…and get 30 months Use the historical quotes button…and get 30 months of historical data.of historical data.

–– Use the download in spreadsheet format feature to Use the download in spreadsheet format feature to save the data to your hard drive.save the data to your hard drive.

Spreadsheet Data From YahooSpreadsheet Data From YahooAlcan ExampleAlcan Example

The raw downloaded data should look like this:The raw downloaded data should look like this:

Date Open High Low Close Volume01-May-02 57.46 62.39 56.61 59.22 753874


(CAPM)9 - 603

01-May-02 57.46 62.39 56.61 59.22 75387401-Apr-02 62.9 63.61 56.25 57.9 87921001-Mar-02 64.9 66.81 61.68 63.03 97436801-Feb-02 61.65 65.67 58.75 64.86 83637302-Jan-02 57.15 62.37 54.93 61.85 98903003-Dec-01 56.6 60.49 55.2 57.15 83328001-Nov-01 49 58.02 47.08 56.69 779509

Spreadsheet Data From Yahoo Spreadsheet Data From Yahoo Alcan ExampleAlcan Example

The raw downloaded data should look like this:The raw downloaded data should look like this:

Date Open High Low Close Volume01-May-02 57.46 62.39 56.61 59.22 753874


(CAPM)9 - 604

01-May-02 57.46 62.39 56.61 59.22 75387401-Apr-02 62.9 63.61 56.25 57.9 879210

Volume of trading done in the stock on the TSE in the month in numbers

of board lots

The day, month and year

Opening price per share, the highest price per share during the month, the lowest price per

share achieved during the month and the closing price per share at the end of the month

Spreadsheet Data From Yahoo Spreadsheet Data From Yahoo Alcan ExampleAlcan Example

From Yahoo, the only information you can use is the closing From Yahoo, the only information you can use is the closing price per share and the date. Just delete the other columns.price per share and the date. Just delete the other columns.


(CAPM)9 - 605

Date Close01-May-02 59.2201-Apr-02 57.901-Mar-02 63.0301-Feb-02 64.8602-Jan-02 61.85

Acquiring the Additional Information You Need Acquiring the Additional Information You Need Alcan ExampleAlcan Example

In addition to the closing price of the stock on a per share basis, you In addition to the closing price of the stock on a per share basis, you will need to find out how many shares were outstanding at the end will need to find out how many shares were outstanding at the end of the month and whether any dividends were paid during the of the month and whether any dividends were paid during the month.month.


(CAPM)9 - 606

You will also want to find the endYou will also want to find the end--ofof--thethe--month value of the S&P/TSX month value of the S&P/TSX Total Return Composite Index (look in the green pages of the TSX Total Return Composite Index (look in the green pages of the TSX Review)Review)

You can find all of this in You can find all of this in The TSX ReviewThe TSX Review periodical.periodical.

Raw Company Data Raw Company Data Alcan ExampleAlcan Example

DateIssued Capital

Closing Price for Alcan

AL.TO

Cash Dividends per Share

01-May-02 321,400,589 $59.22 $0.00


(CAPM)9 - 607

01-May-02 321,400,589 $59.22 $0.0001-Apr-02 321,400,589 $57.90 $0.1501-Mar-02 321,400,589 $63.03 $0.0001-Feb-02 321,400,589 $64.86 $0.0002-Jan-02 160,700,295 $123.70 $0.3001-Dec-01 160,700,295 $119.30 $0.00

Number of shares doubled and share price fell by ha lf between January and February 2002 – this is indicative of a 2 for 1 stock split.

Normalizing the Raw Company Data Normalizing the Raw Company Data Alcan ExampleAlcan Example

DateIssued Capital

Closing Price for

Alcan AL.TO

Cash Dividends per Share

Adjustment Factor

Normalized Stock Price

Normalized Dividend

01-May-02 321,400,589 $59.22 $0.00 1.00 $59.22 $0.00


(CAPM)9 - 608

01-May-02 321,400,589 $59.22 $0.00 1.00 $59.22 $0.0001-Apr-02 321,400,589 $57.90 $0.15 1.00 $57.90 $0.1501-Mar-02 321,400,589 $63.03 $0.00 1.00 $63.03 $0.0001-Feb-02 321,400,589 $64.86 $0.00 1.00 $64.86 $0.0002-Jan-02 160,700,295 $123.70 $0.30 0.50 $61.85 $0.1501-Dec-01 145,000,500 $111.40 $0.00 0.45 $50.26 $0.00

The adjustment factor is just the value in the issu ed capital cell divided by 321,400,589.

Calculating the HPR on the stock from the Calculating the HPR on the stock from the Normalized DataNormalized Data

DateNormalized Stock Price

Normalized Dividend HPR

01-May-02 $59.22 $0.00 2.28%01-Apr-02 $57.90 $0.15 -7.90%

%28.2

$57.90

$0.00$57.90-$59.22

)(

0

101

=

+=

+−=P

DPPHPR


(CAPM)

9 - 609

01-Mar-02 $63.03 $0.00 -2.82%01-Feb-02 $64.86 $0.00 4.87%02-Jan-02 $61.85 $0.15 23.36%01-Dec-01 $50.26 $0.00

Use $59.22 as the ending price, $57.90 as the begin ning price and during the month of May, no dividend was declared.

%28.2 =

Now Put the data from the S&P/TSX Total Now Put the data from the S&P/TSX Total Return Composite Index inReturn Composite Index in



Ending TSX

Value01-May-02 $59.22 $0.00 2.28% 16911.33


(CAPM)

9 - 610

01-May-02 $59.22 $0.00 2.28% 16911.3301-Apr-02 $57.90 $0.15 -7.90% 16903.3601-Mar-02 $63.03 $0.00 -2.82% 17308.4101-Feb-02 $64.86 $0.00 4.87% 16801.8202-Jan-02 $61.85 $0.15 23.36% 16908.1101-Dec-01 $50.26 $0.00 16881.75

You will find the Total Return S&P/TSX Composite In dex values in TSX Review found in the library.

Now Calculate the HPR on the Market IndexNow Calculate the HPR on the Market Index



Ending TSX

ValueHPR on the TSX

01-May-02 $59.22 $0.00 2.28% 16911.33 0.05%

%05.0

16,903.36

16,903.36-16,911.33

)(

0

01

=

=

−=P

PPHPR


(CAPM)

9 - 611

01-May-02 $59.22 $0.00 2.28% 16911.33 0.05%01-Apr-02 $57.90 $0.15 -7.90% 16903.36 -2.34%01-Mar-02 $63.03 $0.00 -2.82% 17308.41 3.02%01-Feb-02 $64.86 $0.00 4.87% 16801.82 -0.63%02-Jan-02 $61.85 $0.15 23.36% 16908.11 0.16%01-Dec-01 $50.26 $0.00 16881.75

Again, you simply use the HPR formula using the end ing values for the total return composite index.

Regression In ExcelRegression In Excel

•• If you haven’t already…go to the tools If you haven’t already…go to the tools menu…down to addmenu…down to add--ins and check off the VBA ins and check off the VBA Analysis PacAnalysis Pac


(CAPM)

9 - 612

Analysis PacAnalysis Pac•• When you go back to the tools menu, you should When you go back to the tools menu, you should

now find the Data Analysis bar, under that find now find the Data Analysis bar, under that find regression, define your dependent and regression, define your dependent and independent variable ranges, your output range independent variable ranges, your output range and run the regression.and run the regression.

RegressionRegressionDefining the Data RangesDefining the Data Ranges



Ending TSX

ValueHPR on the TSX

01-May-02 $59.22 $0.00 2.28% 16911.33 0.05%


(CAPM)

9 - 613

01-May-02 $59.22 $0.00 2.28% 16911.33 0.05%01-Apr-02 $57.90 $0.15 -7.90% 16903.36 -2.34%01-Mar-02 $63.03 $0.00 -2.82% 17308.41 3.02%01-Feb-02 $64.86 $0.00 4.87% 16801.82 -0.63%02-Jan-02 $61.85 $0.15 23.36% 16908.11 0.16%01-Dec-01 $50.26 $0.00 16881.75

The independent variable is the returns on the Mark et.The dependent variable is the returns on the Stock.

Now Use the Regression Function in Excel to Now Use the Regression Function in Excel to regress the returns of the stock against the regress the returns of the stock against the

returns of the marketreturns of the market

SUMMARY OUTPUT

Regression StatisticsMultiple R 0.05300947R Square 0.00281Adjusted R Square -0.2464875Standard Error 5.79609628Observations 6

R-square is the coefficient of determination = 0.0028=.3%


(CAPM)

9 - 614

ANOVAdf SS MS F Significance F

Regression 1 0.3786694 0.37866937 0.011271689 0.920560274Residual 4 134.37893 33.5947321Total 5 134.7576

CoefficientsStandard Error t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%Intercept 59.3420816 2.8980481 20.4765686 3.3593E-05 51.29579335 67.38836984 51.2957934 67.38837X Variable 1 3.55278937 33.463777 0.10616821 0.920560274 -89.35774428 96.46332302 -89.3577443 96.46332

Beta Coefficient is

the X-Variable 1

The alpha is the vertical intercept.

Finalize Your Chart Finalize Your Chart Alcan ExampleAlcan Example

•• You can use the charting feature in Excel to create a scatter You can use the charting feature in Excel to create a scatter plot of the points and to put a line of best fit (the characteristic plot of the points and to put a line of best fit (the characteristic line) through the points.line) through the points.

•• In Excel, you can edit the chart after it is created by placing In Excel, you can edit the chart after it is created by placing the cursor over the chart and ‘rightthe cursor over the chart and ‘right--clicking’ your mouse.clicking’ your mouse.


(CAPM)

9 - 615

the cursor over the chart and ‘rightthe cursor over the chart and ‘right--clicking’ your mouse.clicking’ your mouse.•• In this edit mode, you can ask it to add a trendline (regression In this edit mode, you can ask it to add a trendline (regression

line)line)•• Finally, you will want to interpret the Beta (XFinally, you will want to interpret the Beta (X--coefficient) the coefficient) the

alpha (vertical intercept) and the coefficient of determination.alpha (vertical intercept) and the coefficient of determination.

The Beta The Beta Alcan ExampleAlcan Example

•• Obviously the beta (XObviously the beta (X--coefficient) can simply be coefficient) can simply be read from the regression output.read from the regression output.–– In this case it was 3.56 making Alcan’s returns more In this case it was 3.56 making Alcan’s returns more


(CAPM)

9 - 616

–– In this case it was 3.56 making Alcan’s returns more In this case it was 3.56 making Alcan’s returns more than 3 times as volatile as the market as a whole.than 3 times as volatile as the market as a whole.

–– Of course, in this simple example with only 5 Of course, in this simple example with only 5 observations, you wouldn’t want to draw any serious observations, you wouldn’t want to draw any serious conclusions from this estimate.conclusions from this estimate.

CHAPTER 10CHAPTER 10Market EfficiencyMarket EfficiencyMarket EfficiencyMarket Efficiency


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• The Importance of Market EfficiencyThe Importance of Market Efficiency•• Market Efficiency DefinedMarket Efficiency Defined

www.bookfiesta4u.com ContentsCHAPTER 10 – Market Efficiency

10 - 619

•• Market Efficiency DefinedMarket Efficiency Defined•• The Efficient Market HypothesisThe Efficient Market Hypothesis•• Empirical Evidence Regarding Market EfficiencyEmpirical Evidence Regarding Market Efficiency•• Implications of EMHImplications of EMH•• Summary and ConclusionsSummary and Conclusions



1.1. What is meant by market efficiencyWhat is meant by market efficiency2.2. How to differentiate among different levels of efficiencyHow to differentiate among different levels of efficiency3.3. How to use the concepts in this chapter to judge How to use the concepts in this chapter to judge

corporate decisionscorporate decisions


10 - 620

corporate decisionscorporate decisions4.4. How the concepts in this chapter are used in regulating How the concepts in this chapter are used in regulating

market activitymarket activity


•• Abnormal returnsAbnormal returns•• Allocational efficiencyAllocational efficiency•• AnomaliesAnomalies•• Buy side analystsBuy side analysts•• DisclosureDisclosure

•• Operational efficiencyOperational efficiency•• Random walk hypothesisRandom walk hypothesis•• Securities lawSecurities law•• Sell side analystsSell side analysts•• SemiSemi--strong form efficient strong form efficient


10 - 621

•• Efficient marketEfficient market•• Efficient market hypothesis Efficient market hypothesis

(EMH)(EMH)•• Event studyEvent study•• Informational efficiencyInformational efficiency•• Material factsMaterial facts•• MomentumMomentum

market hypothesismarket hypothesis•• Size effectSize effect•• Strong form efficient market Strong form efficient market

hypothesishypothesis•• Technical analysisTechnical analysis•• Weak form efficient market Weak form efficient market

hypothesishypothesis

The Importance of Market EfficiencyThe Importance of Market Efficiency

•• Understanding how securities are valued Understanding how securities are valued provides guidelines to managers about how they provides guidelines to managers about how they should manage businesses on behalf of should manage businesses on behalf of shareholdersshareholders

•• The discount rate that represents shareholders’ The discount rate that represents shareholders’


10 - 622

•• The discount rate that represents shareholders’ The discount rate that represents shareholders’ required rate of return is established as a result required rate of return is established as a result of benchmark rates in the capital markets, such of benchmark rates in the capital markets, such as the riskas the risk--free rate (RF) and the market risk free rate (RF) and the market risk premium.premium.

•• Do market prices reflect the actions of Do market prices reflect the actions of managers?managers?–– If they do, then managers must learn what actions If they do, then managers must learn what actions

they should take in order to fulfill their legal and they should take in order to fulfill their legal and managerial responsibilities to shareholders.managerial responsibilities to shareholders.

The Importance of Market EfficiencyThe Importance of Market EfficiencyThree Elements to Market EfficiencyThree Elements to Market Efficiency

•• Operational EfficiencyOperational Efficiency–– Transactions costs are low, thereby enhancing Transactions costs are low, thereby enhancing

trading of securitiestrading of securities


10 - 623

•• Allocational EfficiencyAllocational Efficiency–– There are enough securities to efficiently allocate riskThere are enough securities to efficiently allocate risk

•• Informational EfficiencyInformational Efficiency–– Market prices fairly and quickly reflect all available Market prices fairly and quickly reflect all available

informationinformation

The Importance of Market EfficiencyThe Importance of Market EfficiencyInformational EfficiencyInformational Efficiency

•• The closer the link between managers’ actions The closer the link between managers’ actions and the value of the firm, the more and the value of the firm, the more informationally efficient the capital marketinformationally efficient the capital market


10 - 624

The Importance of Market EfficiencyThe Importance of Market EfficiencySecurities Laws Affecting PublicSecurities Laws Affecting Public--Issuers of SecuritiesIssuers of Securities

•• The closer the link between managers’ actions and the value The closer the link between managers’ actions and the value of the firm, the more informationally efficient the capital of the firm, the more informationally efficient the capital marketmarket

•• Securities laws in Canada reflect the belief that there is (or Securities laws in Canada reflect the belief that there is (or should be) a strong connection between information and stock should be) a strong connection between information and stock prices and these laws reflect a number of common principles prices and these laws reflect a number of common principles


10 - 625

prices and these laws reflect a number of common principles prices and these laws reflect a number of common principles related to parties, transactions, and access to information:related to parties, transactions, and access to information:–– Continuous disclosure of all material information about the Continuous disclosure of all material information about the

firmfirm–– Fair and equal treatment of all market participants through Fair and equal treatment of all market participants through

disclosure requirements that ensure all participants have disclosure requirements that ensure all participants have simultaneous access to the same information about simultaneous access to the same information about publiclypublicly--traded firmstraded firms

Asymmetric InformationAsymmetric Information

•• Asymmetric information is when one party to a Asymmetric information is when one party to a transaction has access to more a complete and transaction has access to more a complete and accurate set of facts than the other party.accurate set of facts than the other party.–– When this condition exists, it is possible for the party When this condition exists, it is possible for the party


10 - 626

–– When this condition exists, it is possible for the party When this condition exists, it is possible for the party with better information to use that at their own with better information to use that at their own personal gain, and at the expense of the other.personal gain, and at the expense of the other.

Asymmetric InformationAsymmetric InformationAn Example An Example –– The Used Car!The Used Car!

•• An example of asymmetric information from everyday life might be An example of asymmetric information from everyday life might be the situation between a buyer and seller of a used car in a private the situation between a buyer and seller of a used car in a private transactiontransaction

–– The seller has intimate knowledge of recent car history including past owners, The seller has intimate knowledge of recent car history including past owners, collisions, repairs, and problemscollisions, repairs, and problems

–– The buyer (presuming no expertise as a mechanic) has only limited skills of The buyer (presuming no expertise as a mechanic) has only limited skills of observation and investigation to inform the purchase decisionobservation and investigation to inform the purchase decision


10 - 627

observation and investigation to inform the purchase decisionobservation and investigation to inform the purchase decision

•• It is possible, in the absence of rules and regulations, for the seller It is possible, in the absence of rules and regulations, for the seller to take advantage of the buyer because of information asymmetryto take advantage of the buyer because of information asymmetry

•• This means the buyer is likely to pay more for the car than the car is This means the buyer is likely to pay more for the car than the car is worth; the seller reaps the rewards of superior informationworth; the seller reaps the rewards of superior information

–– In some provinces, before such a transaction can occur, a sellers information In some provinces, before such a transaction can occur, a sellers information package must be obtained from the Ministry of Transportation. This package will package must be obtained from the Ministry of Transportation. This package will include an estimate of wholesale and retail price of the used car, and a list of include an estimate of wholesale and retail price of the used car, and a list of past owners; this is an example of government regulation to try to reduce the past owners; this is an example of government regulation to try to reduce the information advantage sellers have over buyersinformation advantage sellers have over buyers

Disclosure and Market EfficiencyDisclosure and Market EfficiencyThe Asymmetric Information ChallengeThe Asymmetric Information Challenge

•• If informational advantages were widely permitted, and if If informational advantages were widely permitted, and if there were a persistent advantage of some market there were a persistent advantage of some market participants over others, the credibility of the markets participants over others, the credibility of the markets would be shakenwould be shaken

•• Under such circumstances, many people would choose Under such circumstances, many people would choose not to invest in securities, choosing, instead to put their not to invest in securities, choosing, instead to put their


10 - 628

not to invest in securities, choosing, instead to put their not to invest in securities, choosing, instead to put their money into managed deposits, or worse, choosing to money into managed deposits, or worse, choosing to hide their money under a pillow.hide their money under a pillow.

•• This would significantly reduce the number of market This would significantly reduce the number of market participants, and the amounts of money invested in the participants, and the amounts of money invested in the marketsmarkets

Disclosure and Market EfficiencyDisclosure and Market EfficiencyThe Asymmetric Information ChallengeThe Asymmetric Information Challenge

•• The result would be: less market efficiency; lower The result would be: less market efficiency; lower security prices, infrequent trading of securitiessecurity prices, infrequent trading of securities

•• Ultimately, the capital market would not be able to Ultimately, the capital market would not be able to channel sufficient surplus funds to underwrite economic channel sufficient surplus funds to underwrite economic activity such as plant expansions, research and activity such as plant expansions, research and development, etc. In the end, companies would lack development, etc. In the end, companies would lack


10 - 629

development, etc. In the end, companies would lack development, etc. In the end, companies would lack capital, and increasingly become inefficient and capital, and increasingly become inefficient and ineffective in their markets. Jobs would be lost and the ineffective in their markets. Jobs would be lost and the standard of living of all would declinestandard of living of all would decline

Defining Market EfficiencyDefining Market Efficiency

•• An An efficient marketefficient market is a market that reacts is a market that reacts quickly and relatively accurately to new public quickly and relatively accurately to new public information, which results in prices that are information, which results in prices that are correct, on averagecorrect, on average


10 - 630

correct, on averagecorrect, on average

Market EfficiencyMarket EfficiencyRequisite ConditionsRequisite Conditions

For markets to operate efficiently some conditions must exist:For markets to operate efficiently some conditions must exist:1.1. A large number of rational, profitA large number of rational, profit--maximizing investors exist, maximizing investors exist,

who actively participate in the market by analyzing, valuing, who actively participate in the market by analyzing, valuing, and trading securities. The markets must be competitive, and trading securities. The markets must be competitive, meaning no one investor can significantly affect the price of the meaning no one investor can significantly affect the price of the security through their own buying or selling.security through their own buying or selling.


10 - 631

security through their own buying or selling.security through their own buying or selling.2.2. Information is costless and widely available to market Information is costless and widely available to market

participants at the same time.participants at the same time.3.3. Information arrives randomly and therefore announcements Information arrives randomly and therefore announcements

over time are not serially connected.over time are not serially connected.4.4. Investors react quickly and fully (and reasonably accurately) to Investors react quickly and fully (and reasonably accurately) to

the new information, which is reflected in stock prices.the new information, which is reflected in stock prices.

Efficient Market Hypothesis (EMH)Efficient Market Hypothesis (EMH)

•• The The efficient market hypothesisefficient market hypothesis is the theory that is the theory that markets are efficient and therefore, in its strictest markets are efficient and therefore, in its strictest sense, implies that prices accurately reflect all sense, implies that prices accurately reflect all available information at any given timeavailable information at any given time


10 - 632

available information at any given timeavailable information at any given time


•• Weak form EMHWeak form EMH is the theory that security is the theory that security prices reflect all market data, referring to all past prices reflect all market data, referring to all past price and volume trading informationprice and volume trading information


10 - 633

•• Implication:Implication:–– If weak form efficient, historical trading data will If weak form efficient, historical trading data will

already be reflected (discounted) in current prices and already be reflected (discounted) in current prices and should be of no value in predicting future price should be of no value in predicting future price changeschanges


•• SemiSemi--strong formstrong form EMH is the theory that all publicly known EMH is the theory that all publicly known and available information is reflected in security pricesand available information is reflected in security prices

•• Assumes the weakAssumes the weak--form set of information as well as all public form set of information as well as all public information pertinent to the security such as:information pertinent to the security such as:–– EarningsEarnings


10 - 634

–– EarningsEarnings–– DividendsDividends–– Corporate investments,Corporate investments,–– Management changesManagement changes

•• Implication:Implication:–– If semiIf semi--strong efficient, it is futile to analyze public information strong efficient, it is futile to analyze public information

such as earnings projections and financial statements in an such as earnings projections and financial statements in an attempt to identify underpriced or overpriced securitiesattempt to identify underpriced or overpriced securities


•• Strong form EMHStrong form EMH is the theory that stock prices is the theory that stock prices fully reflect all information, which includes both fully reflect all information, which includes both public and private informationpublic and private information


10 - 635

•• Implications:Implications:–– Stock prices are fairly priced.Stock prices are fairly priced.–– It is not possible to use public information to identify It is not possible to use public information to identify

overover--priced or underpriced or under--priced stockspriced stocks–– It is not possible to use insider information to identify It is not possible to use insider information to identify

overover--priced or underpriced or under--priced stockspriced stocks

Efficient Market Hypothesis (EMH)Efficient Market Hypothesis (EMH)Tests of EMHTests of EMH

•• All tests of the EMH try to demonstrate that using a particular All tests of the EMH try to demonstrate that using a particular source of information allows an investor to consistently earn source of information allows an investor to consistently earn ‘abnormal’ returns‘abnormal’ returns

•• Abnormal returns are percentage returns that are greater than Abnormal returns are percentage returns that are greater than a naïve buya naïve buy--andand--hold strategy where the investor passively hold strategy where the investor passively


10 - 636

a naïve buya naïve buy--andand--hold strategy where the investor passively hold strategy where the investor passively buying a market index portfolio such as the S&P/TSX 60 buying a market index portfolio such as the S&P/TSX 60 composite indexcomposite index

In other words, can an active investment strategy, using a In other words, can an active investment strategy, using a particular trading rule or source of information, generate particular trading rule or source of information, generate greater riskgreater risk--adjusted returns than a passive, naïve, yet adjusted returns than a passive, naïve, yet

achievable, investment strategy?achievable, investment strategy?

Empirical Evidence on Market EfficiencyEmpirical Evidence on Market EfficiencyAnomaliesAnomalies

•• AnomaliesAnomalies are exceptions to a rule or theoryare exceptions to a rule or theory–– An identified anomaly may not violate the theory, An identified anomaly may not violate the theory,

especially if it cannot be exploited profitably after especially if it cannot be exploited profitably after


10 - 637

especially if it cannot be exploited profitably after especially if it cannot be exploited profitably after transactions costs and taxes, or if it cannot be transactions costs and taxes, or if it cannot be exploited consistentlyexploited consistently

Empirical Evidence on Market EfficiencyEmpirical Evidence on Market EfficiencyWeak Form EvidenceWeak Form Evidence

•• The The Random Walk HypothesisRandom Walk Hypothesis states prices states prices follow a random walk with price changes over follow a random walk with price changes over time being independent of one anothertime being independent of one another–– This hypothesis is logical if information arrives This hypothesis is logical if information arrives


10 - 638

–– This hypothesis is logical if information arrives This hypothesis is logical if information arrives randomly, as it should, and if investors react quickly randomly, as it should, and if investors react quickly to itto it

•• Tests of weak form efficiency include:Tests of weak form efficiency include:–– Serial correlation testsSerial correlation tests–– Runs (or signs tests)Runs (or signs tests)–– Testing of trading rules used by technical analystsTesting of trading rules used by technical analysts

Empirical Evidence on Market EfficiencyEmpirical Evidence on Market EfficiencyWeak Form Evidence Weak Form Evidence -- AnomaliesAnomalies

Anomalies that contest weak form market efficiency are:Anomalies that contest weak form market efficiency are:–– Investors have been found to overreact to new information and Investors have been found to overreact to new information and

this leads to stock prices overthis leads to stock prices over--shooting and undershooting their shooting and undershooting their intrinsic value and this results in stock price reversals favouring intrinsic value and this results in stock price reversals favouring in some cases, contrarian trading strategiesin some cases, contrarian trading strategies


10 - 639

in some cases, contrarian trading strategiesin some cases, contrarian trading strategies–– Evidence of momentum in stock returns Evidence of momentum in stock returns (See Figure 10(See Figure 10--1)1)–– Evidence of seasonal patterns in stock returns including the Evidence of seasonal patterns in stock returns including the

January effect, the January effect for smaller firms, the dayJanuary effect, the January effect for smaller firms, the day--ofof--the week effect (average negative Monday returns statistically the week effect (average negative Monday returns statistically different than the other trading days of the week), and the different than the other trading days of the week), and the tendency for returns to be higher on the last trading day of each tendency for returns to be higher on the last trading day of each monthmonth

Weak Form EvidenceWeak Form EvidenceMomentum in Canadian Stock Returns, 1980 Momentum in Canadian Stock Returns, 1980 -- 19991999

January 1980 – December 1999Six-Month Holding Period Returns (%)

25 20.76

FIGURE 10-1


10 - 640

Top 30

20

15

10

5

0

5.99

14.75

6.10

Bottom 30 Top-Bottom TSX

Empirical Evidence on Market EfficiencyEmpirical Evidence on Market EfficiencyWeak Form Evidence Weak Form Evidence -- ConclusionConclusion

•• The anomalies identified are very difficult and The anomalies identified are very difficult and risky to exploit:risky to exploit:–– Transactions costs reduce or eliminate the economic Transactions costs reduce or eliminate the economic

advantageadvantage


10 - 641

advantageadvantage–– The anomalies don’t happen consistently enough to The anomalies don’t happen consistently enough to

make them a reliable source of abnormal returnsmake them a reliable source of abnormal returns

In conclusion, the capital markets appear to be weak In conclusion, the capital markets appear to be weak form efficient.form efficient.

Empirical Evidence on SemiEmpirical Evidence on Semi--strong Efficiencystrong EfficiencySemiSemi--Strong Form EvidenceStrong Form Evidence

•• Tests of the SemiTests of the Semi--strong Form of EMH include:strong Form of EMH include:–– Event (announcement) studies including ‘earnings Event (announcement) studies including ‘earnings

surprises’ and corporate announcements to examine surprises’ and corporate announcements to examine the impact of particular events on stock pricesthe impact of particular events on stock prices


10 - 642

the impact of particular events on stock pricesthe impact of particular events on stock prices–– Examination of the performance of investors to see if Examination of the performance of investors to see if

they can use publicly available information to they can use publicly available information to consistently generate abnormal returnsconsistently generate abnormal returns

Empirical Evidence on SemiEmpirical Evidence on Semi--strong Efficiencystrong EfficiencyEvent StudiesEvent Studies

•• Event studies examine stock returns to determine the impact of Event studies examine stock returns to determine the impact of a particular event on stock prices, in particular, what happens to a particular event on stock prices, in particular, what happens to the stock price, before, during and following the eventthe stock price, before, during and following the eventFigure 10Figure 10--2 illustrates the price adjustment process for:2 illustrates the price adjustment process for:

(A)(A) –– an efficient marketan efficient market


10 - 643

(A)(A) –– an efficient marketan efficient market(B)(B) -- overreaction in an efficient marketoverreaction in an efficient market(C)(C)-- slow reaction in an efficient marketslow reaction in an efficient market

•• Events include:Events include:–– companycompany--specific announcements such as stock splits, specific announcements such as stock splits,

takeover announcements, dividend changes, accounting takeover announcements, dividend changes, accounting changes.changes.

–– EconomyEconomy--wide changes such as unexpected interest rate wide changes such as unexpected interest rate changeschanges

Empirical Evidence on SemiEmpirical Evidence on Semi--strong Efficiencystrong EfficiencyEfficient (A) and Inefficient Markets (B) and (C)Efficient (A) and Inefficient Markets (B) and (C)

FIGURE 10-2

Stock Price

A

B

C


10 - 644

Announcement Date

$23

$20

tTime

C

Empirical Evidence on SemiEmpirical Evidence on Semi--strong Efficiencystrong EfficiencyTypical Event Study ResultsTypical Event Study Results

•• Most event studies have shown that stock prices change Most event studies have shown that stock prices change before before the announcement, as demonstrated in Figure the announcement, as demonstrated in Figure 1010--3 3

•• These results demonstrate that an investor cannot move These results demonstrate that an investor cannot move


10 - 645

•• These results demonstrate that an investor cannot move These results demonstrate that an investor cannot move quickly enough at the time an event occurs quickly enough at the time an event occurs (announcement is made) to profit from the change, so (announcement is made) to profit from the change, so this speaks to market efficiency in the semithis speaks to market efficiency in the semi--strong form, strong form,

On the other hand…On the other hand…•• This evidence does not provide support for the strong This evidence does not provide support for the strong

form of the EMH because some investors are profiting form of the EMH because some investors are profiting from private information about impending price changes.from private information about impending price changes.

Empirical Evidence on SemiEmpirical Evidence on Semi--strong EMHstrong EMHTypical Event Study Result for Good News EventTypical Event Study Result for Good News Event

FIGURE 10 - 3

Stock Price

A

B

C


10 - 646

Announcement Date

$23

$20

tTime

C

SemiSemi--strong Anomaliesstrong AnomaliesEarnings SurprisesEarnings Surprises

•• Several studies have confirmed a lag exists when Several studies have confirmed a lag exists when earnings either exceed or fall short of concensus earnings either exceed or fall short of concensus earnings estimatesearnings estimates–– Largest positive earnings surprises displayed superior Largest positive earnings surprises displayed superior


10 - 647

–– Largest positive earnings surprises displayed superior Largest positive earnings surprises displayed superior subsequent performancesubsequent performance

–– Low or negative earnings surprises displayed poor Low or negative earnings surprises displayed poor subsequent performancesubsequent performance

•• The substantial adjustments The substantial adjustments after after the announcement the announcement date contradicts the semidate contradicts the semi--strong form of the EMH strong form of the EMH

SemiSemi--strong Anomaly Tests on Investorsstrong Anomaly Tests on Investors

•• These are tests to determine whether investors can use These are tests to determine whether investors can use publiclypublicly--available information to obtain abnormal returns.available information to obtain abnormal returns.

•• The strongest evidence of semiThe strongest evidence of semi--strong market efficiency is the strong market efficiency is the fact that professional fund managers with all the training, fact that professional fund managers with all the training, expertise, technological capability and access to data expertise, technological capability and access to data do not do not


10 - 648

expertise, technological capability and access to data expertise, technological capability and access to data do not do not outperform the market on a riskoutperform the market on a risk--adjusted basisadjusted basis, on average., on average.

•• After expenses, average professional fund manager After expenses, average professional fund manager performance is substantially worse than their performance performance is substantially worse than their performance benchmarks (by as much as 50 to 200 basis points)benchmarks (by as much as 50 to 200 basis points)

SemiSemi--strong Anomaly Tests on Investorsstrong Anomaly Tests on InvestorsInvestment StylesInvestment Styles

•• Tests to determine whether investors can use publiclyTests to determine whether investors can use publicly--available information to obtain abnormal returns have shown available information to obtain abnormal returns have shown that ‘value’ investment styles have consistently outperformed that ‘value’ investment styles have consistently outperformed ‘growth’ styles‘growth’ styles

•• Value stocks are those that have:Value stocks are those that have:–– belowbelow--average priceaverage price--toto--earnings (P/E) and marketearnings (P/E) and market--toto--book (M/B) book (M/B)

ratios, and ratios, and


10 - 649

–– belowbelow--average priceaverage price--toto--earnings (P/E) and marketearnings (P/E) and market--toto--book (M/B) book (M/B) ratios, and ratios, and

–– aboveabove--average dividend yieldsaverage dividend yields•• Growth stocks are those that investors are prepared to pay a Growth stocks are those that investors are prepared to pay a

premium price for because expected future growth in earnings premium price for because expected future growth in earnings and share price and have:and share price and have:–– aboveabove--average P/E and M/B ratios, and average P/E and M/B ratios, and –– belowbelow--average dividend yieldsaverage dividend yields

(Figure 10(Figure 10--4 shows the relative performance of the two investment styles from 1982 4 shows the relative performance of the two investment styles from 1982 to 2006)to 2006)

Empirical Evidence on SemiEmpirical Evidence on Semi--strong Efficiencystrong EfficiencyGrowth and Value Stocks in CanadaGrowth and Value Stocks in Canada

FIGURE 10-4


10 - 650

SemiSemi--strong Anomaliesstrong AnomaliesSmall Firm EffectSmall Firm Effect

•• Figure 10Figure 10--5 depicts the returns on Canadian small cap stocks 5 depicts the returns on Canadian small cap stocks versus the broad marketversus the broad market

•• Over this period small caps outperformed the broader index Over this period small caps outperformed the broader index providing an annual return of 16.25% versus 11.91%providing an annual return of 16.25% versus 11.91%–– Smaller cap stock returns are much more volatile (24.8% versus Smaller cap stock returns are much more volatile (24.8% versus

15.12%), and15.12%), and


10 - 651

15.12%), and15.12%), and–– Transactions costs are greater for small cap stocksTransactions costs are greater for small cap stocks

Therefore, attempting to capitalize on the small firm effect is not a Therefore, attempting to capitalize on the small firm effect is not a ‘free lunch’‘free lunch’

Empirical Evidence on SemiEmpirical Evidence on Semi--strong EMHstrong EMHS&P/TSX Composite Index versus Small Cap Stocks in CanadaS&P/TSX Composite Index versus Small Cap Stocks in Canada

FIGURE 10-5


10 - 652

SemiSemi--strong Anomaliesstrong AnomaliesValue Line Investment Survey EffectValue Line Investment Survey Effect

–– Value Line Investment Survey is a widely followed Value Line Investment Survey is a widely followed stock publication that ranks a large universe of stocks stock publication that ranks a large universe of stocks from 1 (best) to 5 (worst)from 1 (best) to 5 (worst)

–– Substantial evidence suggests that stocks ranked 1 or Substantial evidence suggests that stocks ranked 1 or


10 - 653

–– Substantial evidence suggests that stocks ranked 1 or Substantial evidence suggests that stocks ranked 1 or 2 experience superior performance over the following 2 experience superior performance over the following 12 months…and those in lower12 months…and those in lower--ranked categories ranked categories perform poorly.perform poorly.

•• These findings contradict the semiThese findings contradict the semi--strong EMHstrong EMH

•• However, again, transactions costs make it difficult to profit However, again, transactions costs make it difficult to profit from this anomalyfrom this anomaly

Empirical Evidence on Market EfficiencyEmpirical Evidence on Market EfficiencySemiSemi--Strong Form Evidence Strong Form Evidence -- ConclusionsConclusions

•• Most studies support the semiMost studies support the semi--strong form of the strong form of the EMHEMH

•• A number of anomalies (or exceptions) have A number of anomalies (or exceptions) have been identified including:been identified including:


10 - 654

been identified including:been identified including:–– The “value” investment style has consistently The “value” investment style has consistently

outperformed the “growth” styleoutperformed the “growth” style–– The “size effect” that shows that small market cap The “size effect” that shows that small market cap

stock tend to outperform large cap stocks on a riskstock tend to outperform large cap stocks on a risk--adjusted return basisadjusted return basis

–– The Value Line Investment Survey effect The Value Line Investment Survey effect

Empirical Evidence on Strong Form EfficiencyEmpirical Evidence on Strong Form EfficiencyStrong Form EvidenceStrong Form Evidence

•• The strong form asserts that prices reflect all public and The strong form asserts that prices reflect all public and private informationprivate information

•• If a market is strongIf a market is strong--form efficient, then insiders could form efficient, then insiders could not profit from inside information not known by the publicnot profit from inside information not known by the public


10 - 655

•• Tests of this hypothesis include determining whether any Tests of this hypothesis include determining whether any group of investors has information that allows them to group of investors has information that allows them to earn abnormal profits consistentlyearn abnormal profits consistently–– Several studies found consistent abnormal profitsSeveral studies found consistent abnormal profits–– Others found only slightly better than average returnsOthers found only slightly better than average returns

Empirical Evidence on Strong Form EfficiencyEmpirical Evidence on Strong Form EfficiencyStrong Form Evidence Strong Form Evidence -- ConclusionsConclusions

On balance, evidence does not support the strong On balance, evidence does not support the strong form of the EMHform of the EMH

It should be noted that insider trading laws do restrict the It should be noted that insider trading laws do restrict the ability of insiders to act and therefore, profit from their ability of insiders to act and therefore, profit from their


10 - 656

ability of insiders to act and therefore, profit from their ability of insiders to act and therefore, profit from their inside information, so this is one reason why evidence inside information, so this is one reason why evidence

may be muted of the ‘degree’ of advantage insiders may be muted of the ‘degree’ of advantage insiders enjoy under current lawenjoy under current law

Summary of Empirical EvidenceSummary of Empirical Evidence

1.1. Weak form efficiency is very well supported, and it is Weak form efficiency is very well supported, and it is reasonable to conclude that markets are weak form reasonable to conclude that markets are weak form efficient, although a few anomalies do exist.efficient, although a few anomalies do exist.

2.2. SemiSemi--strong form efficiency is well supported; strong form efficiency is well supported;


10 - 657

2.2. SemiSemi--strong form efficiency is well supported; strong form efficiency is well supported; however, more contradictory evidence exists for this however, more contradictory evidence exists for this version of the EMH than for the weak form.version of the EMH than for the weak form.

3.3. Strong form efficiency is not very well supported by Strong form efficiency is not very well supported by the evidence, and it is reasonable to conclude that the evidence, and it is reasonable to conclude that markets are not strong form efficient in the strictest markets are not strong form efficient in the strictest sense.sense.

Implications of Market EfficiencyImplications of Market Efficiency

•• Empirical Evidence suggests:Empirical Evidence suggests:–– Markets reach quickly and relatively accurately to new Markets reach quickly and relatively accurately to new

public informationpublic information


10 - 658

–– Market prices are correct Market prices are correct on averageon average

•• Markets may not be perfectly efficient, but they Markets may not be perfectly efficient, but they are relatively efficientare relatively efficient

Implications of Market EfficiencyImplications of Market EfficiencyImplications for InvestorsImplications for Investors

1.1. Technical analysis is not likely to be rewarded.Technical analysis is not likely to be rewarded.2.2. Fundamental analysis is also unlikely to be Fundamental analysis is also unlikely to be

successful at generating abnormal profits after successful at generating abnormal profits after transactions costs, research costs and taxes.transactions costs, research costs and taxes.


10 - 659

transactions costs, research costs and taxes.transactions costs, research costs and taxes.3.3. Active trading strategies are unlikely to outperform Active trading strategies are unlikely to outperform

“passive” buy“passive” buy--andand--hold strategies…favouring index hold strategies…favouring index mutual funds or exchangemutual funds or exchange--traded funds (ETFs)traded funds (ETFs)

4.4. Investors should focus on the basics of good Investors should focus on the basics of good investing by defining investment goals in terms of investing by defining investment goals in terms of expected return and acceptable risk levels.expected return and acceptable risk levels.

Implications of Market EfficiencyImplications of Market EfficiencyImplications for Corporate OfficersImplications for Corporate Officers

1.1. Timing of security issues or share repurchases in Timing of security issues or share repurchases in unimportant because prices are correct on average.unimportant because prices are correct on average.

2.2. Management should monitor the price of the firm’s Management should monitor the price of the firm’s


10 - 660

2.2. Management should monitor the price of the firm’s Management should monitor the price of the firm’s securities to see whether price changes reflect new securities to see whether price changes reflect new information or shortinformation or short--run momentum and/or run momentum and/or overreaction.overreaction.


In this chapter you have learned:In this chapter you have learned:–– That an efficient market is one that reacts quickly and That an efficient market is one that reacts quickly and

relatively accurately to new information, and relatively accurately to new information, and therefore its prices are correct therefore its prices are correct on averageon average..

–– That the Efficient Market Hypothesis (EMH) is tested That the Efficient Market Hypothesis (EMH) is tested


10 - 661

–– That the Efficient Market Hypothesis (EMH) is tested That the Efficient Market Hypothesis (EMH) is tested in three forms; weak, semiin three forms; weak, semi--strong and strong.strong and strong.

–– That empirical evidence suggests that markets are That empirical evidence suggests that markets are reasonably efficient, but not perfectly so.reasonably efficient, but not perfectly so.

–– Investors and corporate officers should modify their Investors and corporate officers should modify their behaviours and expectations in light of the evidence behaviours and expectations in light of the evidence of market efficiency.of market efficiency.

CHAPTER 11CHAPTER 11Forwards, Futures, and Forwards, Futures, and Forwards, Futures, and Forwards, Futures, and

SwapsSwaps


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• Forward ContractsForward Contracts

www.bookfiesta4u.com ContentsCHAPTER 11 – Forwards, Futures and Swaps

11 - 664

•• Forward ContractsForward Contracts•• Futures ContractsFutures Contracts•• SwapsSwaps•• Summary and ConclusionsSummary and Conclusions



1.1. The payoff associated with long and short positions in forward The payoff associated with long and short positions in forward contractscontracts

2.2. How to price simple forward contracts and how interest rate parity How to price simple forward contracts and how interest rate parity is a variation of the forward pricing relationshipis a variation of the forward pricing relationship

3.3. The nature of futures contracts, and why they can be viewed as the The nature of futures contracts, and why they can be viewed as the


11 - 665

3.3. The nature of futures contracts, and why they can be viewed as the The nature of futures contracts, and why they can be viewed as the public market version of forward contractspublic market version of forward contracts

4.4. The mechanics of a basic interest rate swap and a basic currency The mechanics of a basic interest rate swap and a basic currency swapswap

5.5. The evolution of swap markets and how swaps can be used to The evolution of swap markets and how swaps can be used to lower borrowing costs and to hedge interest rate or foreign lower borrowing costs and to hedge interest rate or foreign currency exposurescurrency exposures


•• Basis riskBasis risk•• Clearing corporationClearing corporation•• CommodityCommodity•• Comparative advantageComparative advantage•• Convenience yieldConvenience yield

•• Daily resettlementDaily resettlement•• Forward interest rateForward interest rate•• Forward contractForward contract•• Forward rate agreement Forward rate agreement •• Futures contractFutures contract


11 - 666

•• Convenience yieldConvenience yield•• Cost of carryCost of carry•• CounterpartiesCounterparties•• CoveringCovering•• Credit riskCredit risk•• Currency swapCurrency swap

•• Futures contractFutures contract•• HedgingHedging•• Initial marginInitial margin•• Interest rate swapInterest rate swap

Important Chapter Terms…Important Chapter Terms…

•• London InterLondon Inter--Bank Bank Offered Rate (LIBOR)Offered Rate (LIBOR)

•• LongLong•• Maintenance marginMaintenance margin•• MarginMargin•• Margin callMargin call

•• Plain vanilla interest rate Plain vanilla interest rate swapswap

•• Settlement priceSettlement price•• ShortShort•• SpeculateSpeculate•• Spot contractSpot contract


11 - 667

•• Margin callMargin call•• Naked positionNaked position•• Net paymentsNet payments•• Notional amountNotional amount•• OffsettingOffsetting•• Open interestOpen interest

•• Spot contractSpot contract•• Storage costsStorage costs•• SwapSwap•• Total return swapTotal return swap•• Underlying assetsUnderlying assets

Derivative SecuritiesDerivative SecuritiesDefinedDefined

•• Derivative securities have price behaviours that Derivative securities have price behaviours that are derived from some other underlying asset.are derived from some other underlying asset.

•• There are two basic types of derivative There are two basic types of derivative securities:securities:


11 - 668

securities:securities:1.1. Forwards, futures, and swaps (linear payoff Forwards, futures, and swaps (linear payoff

derivative contracts)derivative contracts)2.2. Options (nonOptions (non--linear payoff derivative contracts)linear payoff derivative contracts)

Derivative SecuritiesDerivative SecuritiesRelevance to Corporate FinanceRelevance to Corporate Finance

•• Derivative securities offer corporations the tools to manage Derivative securities offer corporations the tools to manage prepre--defined risks and/or capitalize on comparative defined risks and/or capitalize on comparative advantage.advantage.

•• Risks that can be mitigated through derivatives include:Risks that can be mitigated through derivatives include:–– Foreign exchange risk Foreign exchange risk


11 - 669

–– Foreign exchange risk Foreign exchange risk –– Credit riskCredit risk–– Interest rate riskInterest rate risk

NOTE: because it costs the firm money to engage in NOTE: because it costs the firm money to engage in derivative positions, the costs of these practices can be derivative positions, the costs of these practices can be thought of as ‘insurance premiums’ the firm is willing to pay thought of as ‘insurance premiums’ the firm is willing to pay to reduce it’s overall exposure. (ie. To hedge)to reduce it’s overall exposure. (ie. To hedge)

Forward versus Spot ContractsForward versus Spot ContractsBasic CharacteristicsBasic Characteristics

•• A A spot contractspot contract is a price that is established today for is a price that is established today for immediate delivery.immediate delivery.–– Immediate delivery depends on the nature of the underlying Immediate delivery depends on the nature of the underlying

contract.contract.

•• A A forward contractforward contract is a price that is established today for is a price that is established today for


11 - 670

•• A A forward contractforward contract is a price that is established today for is a price that is established today for future delivery.future delivery.–– Can be specified for almost any future date because forward Can be specified for almost any future date because forward

contracts are custom contracts between two parties.contracts are custom contracts between two parties.

(Table 11 (Table 11 –– 1 illustrates foreign exchange quotes for spot and forward delivery)1 illustrates foreign exchange quotes for spot and forward delivery)

Forward ContractsForward ContractsBasic CharacteristicsBasic Characteristics

Foreign Exchange Rates (Canadian dollars per foreig n currency)

US ($) GB (£) JAP (¥) Euro (€)

Spot 1.107 2.040 0.009721 1.3991

1 month 1.1063 2.0393 0.009754 1.4007

Table 11-1 Foreign Exchange QuotesReflects the

importance of the US as a Canadian

trading partner. (Remember,

forward contracts occur

www.bookfiesta4u.com ContentsCHAPTER 11 – Forwards, Futures and Swaps 11 - 671

1 month 1.1063 2.0393 0.009754 1.4007

3 month 1.1044 2.0383 0.009821 1.4039

6 month 1.1017 2.0368 0.009920 1.4082

1 year 1.0971 2.0340 0.010116 1.4159

3 year 1.0697 n/a n/a n/a

5 year 1.0622 n/a n/a n/a

10 year 1.0312 n/a n/a n/a

Source: Data from Bank of Montreal (BMO) Nesbitt Burns, Globe and Mail , June 10, 2006.

contracts occur between

corporations and their Canadian

banks.)

Reflects the time value of

money…forward rates the price

TODAY for future delivery…so the further away, the

lower the present value.

Forward ContractsForward ContractsBasic CharacteristicsBasic Characteristics

•• Are bank instruments:Are bank instruments:–– There is no organized exchange (they are an OTC instrument)There is no organized exchange (they are an OTC instrument)–– Requires that the customer have a banking relationship.Requires that the customer have a banking relationship.

•• Involves credit risk for the bank when investors suffer losses.Involves credit risk for the bank when investors suffer losses.•• Banks will only sell forward contracts for legitimate business Banks will only sell forward contracts for legitimate business


11 - 672

•• Banks will only sell forward contracts for legitimate business Banks will only sell forward contracts for legitimate business purposes.purposes.

•• Will only sell up to a company’s approved credit limit.Will only sell up to a company’s approved credit limit.•• Consequently, forward contracts are used for hedging purposes by Consequently, forward contracts are used for hedging purposes by

firms wishing to mitigate exposure to specific risks.firms wishing to mitigate exposure to specific risks.

–– As customized instruments Forwards can be tailored to any As customized instruments Forwards can be tailored to any specific date in the future and for any amount of money.specific date in the future and for any amount of money.

–– Contracts must be fulfilled.Contracts must be fulfilled.

Using Forward ContractsUsing Forward Contracts

•• Like all derivative securities, forward contracts Like all derivative securities, forward contracts can be used theoretically to:can be used theoretically to:–– Hedge Hedge –– mitigate or eliminate risk.mitigate or eliminate risk.–– Speculate Speculate –– make an educated guess about the make an educated guess about the


11 - 673

–– Speculate Speculate –– make an educated guess about the make an educated guess about the future value of something in hopes of profiting from it.future value of something in hopes of profiting from it.

•• Canadian banks, performing their transmission Canadian banks, performing their transmission of Monetary Policy role, will only provide forward of Monetary Policy role, will only provide forward contracts for legitimate business purposes contracts for legitimate business purposes (hedging purposes) …so speculative purposes (hedging purposes) …so speculative purposes aren’t not supported.aren’t not supported.

Using Forward ContractsUsing Forward ContractsSpeculatingSpeculating

•• Speculation on a forward contract requires that Speculation on a forward contract requires that the investor NOT own the underlying asset.the investor NOT own the underlying asset.–– This is a ‘naked’ position This is a ‘naked’ position –– a position that leaves the a position that leaves the

investor exposed to changes in the value of the investor exposed to changes in the value of the


11 - 674

investor exposed to changes in the value of the investor exposed to changes in the value of the underlying asset.underlying asset.

Using Forward ContractsUsing Forward ContractsHedgingHedging

•• Hedging using a forward contract requires that Hedging using a forward contract requires that the investor have an opposite exposure to the the investor have an opposite exposure to the contract.contract.–– This is a ‘covered’ position.This is a ‘covered’ position.


11 - 675

–– This is a ‘covered’ position.This is a ‘covered’ position.

Using Forward ContractsUsing Forward ContractsLong and ShortLong and Short

•• Long investing Long investing is owning an assetis owning an asset in the hopes it in the hopes it will increase in value and the investor gains by will increase in value and the investor gains by its capital appreciation.its capital appreciation.–– It is based on a bullish outlook (forecast increase) for It is based on a bullish outlook (forecast increase) for


11 - 676

–– It is based on a bullish outlook (forecast increase) for It is based on a bullish outlook (forecast increase) for the underlying asset.the underlying asset.

•• Short investors owe something.Short investors owe something.–– It is based on a bearish outlook (forecast price It is based on a bearish outlook (forecast price

declines) for the underlying asset.declines) for the underlying asset.

Using Forward ContractsUsing Forward ContractsExample of a Naked Long Position in the U.S. DollarExample of a Naked Long Position in the U.S. Dollar

•• A U.S. company can speculate on the exchange rate between the Canadian and U.S. A U.S. company can speculate on the exchange rate between the Canadian and U.S. dollars:dollars:(Companies often do this to offset (mitigate) exchange rate risk it is exposed to as a (Companies often do this to offset (mitigate) exchange rate risk it is exposed to as a normal course of its operations …for example, it expects to receive $1million normal course of its operations …for example, it expects to receive $1million Canadian in accounts receivable one year from now ).Canadian in accounts receivable one year from now ).

Initial ConditionsInitial Conditions–– Canadian dollar is at par with U.S.Canadian dollar is at par with U.S.–– Both spot and 1Both spot and 1--year forward rates are both at 1.0 (this implies a ratio of 1:1)year forward rates are both at 1.0 (this implies a ratio of 1:1)


11 - 677

–– Both spot and 1Both spot and 1--year forward rates are both at 1.0 (this implies a ratio of 1:1)year forward rates are both at 1.0 (this implies a ratio of 1:1)ActionAction–– Canadian buys US $ 1.0 million forwardCanadian buys US $ 1.0 million forward

•• Obligates the investor to pay C$1million and receive U.S.$1million in one year.Obligates the investor to pay C$1million and receive U.S.$1million in one year.ExposureExposure–– Exposed to changes in the underlying asset US$ vis a vis the Canadian dollarExposed to changes in the underlying asset US$ vis a vis the Canadian dollar

•• Long U.S. dollarsLong U.S. dollars•• Short Canadian dollarsShort Canadian dollars

PayoffsPayoffs–– U.S.$ rises against Canadian $ U.S.$ rises against Canadian $ –– investor gains (gains offset losses in dollars received from investor gains (gains offset losses in dollars received from

accounts receivable)accounts receivable)–– Canadian dollar rises against U.S.$ Canadian dollar rises against U.S.$ –– investor looses (losses are offset by appreciated investor looses (losses are offset by appreciated

Canadian dollars in accounts receivable)Canadian dollars in accounts receivable)

(Payoffs from this position are illustrated in Figure 11(Payoffs from this position are illustrated in Figure 11--1)1)

Forward ContractsForward ContractsLong Position in U.S. DollarsLong Position in U.S. Dollars

11 - 1 FIGURE

profit

The payoff is linear.

45 degree angle.

Passes through the forward rate F.


11 - 678

F = 1.0

loss

C$ 1.0 per US $

forward rate F.

If spot exchange rate in the future

exceeds the forward rate by $0.01, then the

speculator earns $0.01 profit for

every Canadian dollar sold forward

for U.S. dollars.

Forward ContractsForward ContractsProfit from a Long Forward ContractProfit from a Long Forward Contract

–– The profit (loss) from the long position is U.S. dollars The profit (loss) from the long position is U.S. dollars is equal to the difference between the future spot is equal to the difference between the future spot price (Sprice (STT) and the forward price (rate) ) and the forward price (rate) FF times the times the number of contracts entered into (number of contracts entered into (nn):):


11 - 679

number of contracts entered into (number of contracts entered into (nn):):

n F]-[ position long from (loss)Profit ×= TS[11-1]

Using Forward ContractsUsing Forward ContractsA Naked Short Position in the U.S. DollarA Naked Short Position in the U.S. Dollar

•• A naked short position in the U.S. dollar is the A naked short position in the U.S. dollar is the opposite of the firm’s long position in U.S. opposite of the firm’s long position in U.S. dollars.dollars.

•• The company needs to sell U.S. dollars forward The company needs to sell U.S. dollars forward


11 - 680

•• The company needs to sell U.S. dollars forward The company needs to sell U.S. dollars forward for Canadian dollars.for Canadian dollars.

(Payoffs from this position are illustrated in Figure 11(Payoffs from this position are illustrated in Figure 11--2)2)

Forward ContractsForward ContractsShort Position in U.S. DollarsShort Position in U.S. Dollars

11 – 2 FIGURE

profit

The payoff from a naked sale of U.S.

forward.

If U.S. $1 million is sold forward for

C$1.0 million, and the Canadian dollar


11 - 681

F = 1.0

loss

C$ 1.0 per US $

the Canadian dollar depreciates to

C$1.20 then the forward contract

loses money.

The profit (loss) of the short position

is identically opposite of the

long position.n ][ position short from (loss)Profit ×−= TSF[11-2]

Forward ContractsForward ContractsHedgingHedging

•• Hedging is reducing the risk of adverse price Hedging is reducing the risk of adverse price movement by taking an offsetting position in a movement by taking an offsetting position in a derivative to eliminate exposure to an underlying derivative to eliminate exposure to an underlying


11 - 682

derivative to eliminate exposure to an underlying derivative to eliminate exposure to an underlying price.price.

Forward ContractsForward ContractsLong and Short Forward Positions in U.S. DollarsLong and Short Forward Positions in U.S. Dollars

•• As mentioned previously, Canadian banks will not negotiate As mentioned previously, Canadian banks will not negotiate forward contracts for speculative purposes.forward contracts for speculative purposes.

•• So inherently, companies take ‘covered’ positions (not naked So inherently, companies take ‘covered’ positions (not naked ones) where they already have a given exposure, and they ones) where they already have a given exposure, and they wish to wish to hedgehedge (mitigate the risk in that exposure)(mitigate the risk in that exposure)


11 - 683

•• Figure 11 Figure 11 –– 3 illustrates a the combined position of a firm with 3 illustrates a the combined position of a firm with a long US$ exposure of US $1million that buys a forward a long US$ exposure of US $1million that buys a forward contract to sell U.S. dollars forward for Canadian dollars.contract to sell U.S. dollars forward for Canadian dollars.

•• The combined position is simply the sum…so the payoffs are The combined position is simply the sum…so the payoffs are offsetting and the firm is insulated for foreign exchange risk.offsetting and the firm is insulated for foreign exchange risk.

Forward ContractsForward ContractsLong and Short Forward Positions in U.S. DollarsLong and Short Forward Positions in U.S. Dollars

11 - 3 FIGURE

profit

Offsetting long and short

exposures insulate the firm

for foreign exchange risk

during the life of

The firm is long in the underlying

asset, so a short forward contract

gives this net position.

Long US $ exposure is what

Canadian


11 - 684

F = 1.0

loss

C$ 1.0 per US $

Long Exposure

Short Exposure

during the life of the contract.

Canadian exporters face.

Forward ContractsForward ContractsExposures of the Bank Making the Market for Forward ContractsExposures of the Bank Making the Market for Forward Contracts

•• Forward foreign exchange market is a bank market.Forward foreign exchange market is a bank market.•• The bank sells forward contracts to its customers to allow The bank sells forward contracts to its customers to allow

them to manage their foreign exchange exposure.them to manage their foreign exchange exposure.•• The banks are not buying and selling foreign exchange for The banks are not buying and selling foreign exchange for

speculative purposes.speculative purposes.


11 - 685

speculative purposes.speculative purposes.•• If the bank finds, however, that its has sold too many US $ If the bank finds, however, that its has sold too many US $

forward contracts so that it has now become exposed, it can:forward contracts so that it has now become exposed, it can:–– Enter the interEnter the inter--bank market to offset its exposure by trading bank market to offset its exposure by trading

with other banks, orwith other banks, or–– Synthetically create forward foreign exchange contracts using Synthetically create forward foreign exchange contracts using

the Interest rate parity (the Interest rate parity (IRPIRP) condition.) condition.

Forward ContractsForward ContractsInterest Rate Parity (IRP) RevisitedInterest Rate Parity (IRP) Revisited

•• Equation 11 Equation 11 –– 3 shows that the ratio of the 3 shows that the ratio of the forward to the spot rate must equal the ratio of forward to the spot rate must equal the ratio of one plus the interest rate in both markets.one plus the interest rate in both markets.


11 - 686

Interest Rate Parity (IRP)Interest Rate Parity (IRP)IRP ConditionIRP Condition

•• Equation 11 Equation 11 –– 3 shows that the ratio of the forward to the 3 shows that the ratio of the forward to the spot rate must equal the ratio of one plus the interest rate in spot rate must equal the ratio of one plus the interest rate in both markets.both markets.

)k(1+F


•• This equation can be rearranged to solve for the forward rate This equation can be rearranged to solve for the forward rate ((F F ):):

)k1(

)k(1

foreign

domestic

++=

S

F[11-3]

Interest Rate Parity (IRP)Interest Rate Parity (IRP)Using Forward ContractsUsing Forward Contracts

•• The forward rate is the ratio of one plus the interest rate in The forward rate is the ratio of one plus the interest rate in both markets times the spot rate.both markets times the spot rate.

S)k(1

F domestic ×+=[11-4]


•• The current spot rate The current spot rate SS is observableis observable•• The two inflation rates can be estimated using each country’s The two inflation rates can be estimated using each country’s

statistical reports.statistical reports.

S)k1(

F foreign

×+

=[11-4]

Pricing Forward ContractsPricing Forward ContractsInterest Rate Parity ConditionInterest Rate Parity Condition

–– IRP is a special case for pricing forward contracts.IRP is a special case for pricing forward contracts.–– The general condition is that investors can create a The general condition is that investors can create a

forward position in a storable commodity by buying it forward position in a storable commodity by buying it


11 - 689

forward position in a storable commodity by buying it forward position in a storable commodity by buying it spot and holding it for future delivery.spot and holding it for future delivery.

Pricing Forward ContractsPricing Forward ContractsThe General Condition The General Condition –– Storable Commodity Pricing ModelStorable Commodity Pricing Model

–– The general condition is that investors can create a forward position in The general condition is that investors can create a forward position in a storable commodity by buying it spot and holding it for future a storable commodity by buying it spot and holding it for future delivery.delivery.

–– The only difference between the spot price (The only difference between the spot price (SS) and forward () and forward (FF) should ) should be the costs of carry (interest costs on financing the purchase and be the costs of carry (interest costs on financing the purchase and storage costs).storage costs).


11 - 690

–– Important terms:Important terms:•• Commodity Commodity –– something traded based solely on price, because it is something traded based solely on price, because it is

undifferentiated and can be traded without requiring physical examination.undifferentiated and can be traded without requiring physical examination.•• Storage costs Storage costs –– the price charged for holding a commodity for future the price charged for holding a commodity for future

deliverydelivery•• Convenience yield Convenience yield –– the benefit or premium derived from holding the asset the benefit or premium derived from holding the asset

rather than holding a derivative.rather than holding a derivative.•• Cost of carry Cost of carry –– the total cost of buying a commodity spot and then carrying the total cost of buying a commodity spot and then carrying

it or effecting physical delivery when the forward contract expires (this it or effecting physical delivery when the forward contract expires (this includes both storage costs and financing costs)includes both storage costs and financing costs)

Pricing Forward ContractsPricing Forward ContractsCommodity Pricing ModelCommodity Pricing Model

–– The Commodity Pricing Model is equation 11 The Commodity Pricing Model is equation 11 –– 5 and shows 5 and shows that the cost of carry links the Forward and Spot prices:that the cost of carry links the Forward and Spot prices:

S)1(F ×+= c


Where:Where:cc = the cost of carry, as percentage of = the cost of carry, as percentage of SS, over the period in question., over the period in question.SS = spot price= spot priceFF = forward price= forward price

S)1(F ×+= c[11-5]

Futures ContractsFutures ContractsThe Mechanics of Futures ContractsThe Mechanics of Futures Contracts

•• Futures contracts are a standardized exchangeFutures contracts are a standardized exchange--traded traded contract in which the seller agrees to deliver a commodity to contract in which the seller agrees to deliver a commodity to the buyer at some point in the future.the buyer at some point in the future.

•• Organized futures exchanges with standardized futures Organized futures exchanges with standardized futures contracts:contracts:–– Reduce credit risk through: Reduce credit risk through:


11 - 692

–– Reduce credit risk through: Reduce credit risk through: •• Clearing corporation being the counterparty in all transactionsClearing corporation being the counterparty in all transactions•• margin requirements (both initial and maintenance margins) andmargin requirements (both initial and maintenance margins) and•• daily markdaily mark--toto--market daily resettlement.market daily resettlement.

–– Allow the contract features and volumes to be reportedAllow the contract features and volumes to be reported–– Allow the futures positions to be liquid (executing offsetting Allow the futures positions to be liquid (executing offsetting

transaction to cancel the futures position) increasing the transaction to cancel the futures position) increasing the flexibility in their use. flexibility in their use.

Futures ContractsFutures ContractsFutures Contracts MarketsFutures Contracts Markets

•• The term of the contract is set by individual exchanges.The term of the contract is set by individual exchanges.•• Delivery months areDelivery months are

–– MarchMarch–– JuneJune–– SeptemberSeptember–– December December

•• Standardized underlying asset so that even if delivery rarely takes place, Standardized underlying asset so that even if delivery rarely takes place, people know what they are getting.people know what they are getting.


11 - 693

•• The exchange sets how much of the asset is traded in each contract. (ie. The exchange sets how much of the asset is traded in each contract. (ie. The notional amount)The notional amount)

•• For financial futures, most exchanges follow the lead of the major For financial futures, most exchanges follow the lead of the major markets in Chicago:markets in Chicago:–– Chicago Board of Trade (CBOT)Chicago Board of Trade (CBOT)–– Chicago Mercantile Exchange (CME)Chicago Mercantile Exchange (CME)

•• Commodity futures trading in Canada is concentrated on the Commodity futures trading in Canada is concentrated on the Winnipeg Commodity Exchange (WCE)Winnipeg Commodity Exchange (WCE)

•• Financial futures trading is concentrated since 2000 on the Financial futures trading is concentrated since 2000 on the Montreal Exchange (ME) in Canada.Montreal Exchange (ME) in Canada.

Futures ContractsFutures ContractsFutures ExchangesFutures Exchanges

•• Formal exchanges develop the market in Formal exchanges develop the market in futures contracts.futures contracts.

•• There is significant competition across There is significant competition across exchanges, however, some are separated by exchanges, however, some are separated by different time zones.different time zones.


11 - 694

different time zones.different time zones.•• Competition is a source of innovation:Competition is a source of innovation:

–– New types of contracts are developedNew types of contracts are developed–– As interest declines or needs change, some die out.As interest declines or needs change, some die out.

•• Interest in Financial futures has grown Interest in Financial futures has grown dramatically as companies learn to hedge their dramatically as companies learn to hedge their risk exposures through these instruments.risk exposures through these instruments.

Futures ContractsFutures ContractsTypes of FuturesTypes of Futures

•• Commodity futures include:Commodity futures include:–– Traditional agricultural products such as corn, wheat, hogs, etc.Traditional agricultural products such as corn, wheat, hogs, etc.–– Energy productsEnergy products–– Base metalsBase metals

•• Financial futuresFinancial futures


11 - 695

•• Financial futuresFinancial futures–– S&P index / BAs/Canada bonds/S&P TSX 60 indexS&P index / BAs/Canada bonds/S&P TSX 60 index

•• OtherOther–– Weather derivativesWeather derivatives–– Futures contracts on real estateFutures contracts on real estate–– Futures contracts on the consumer price index (CPI)Futures contracts on the consumer price index (CPI)

(See Table 11 (See Table 11 –– 2 for a useful summary)2 for a useful summary)

Futures Contracts and MarketsFutures Contracts and MarketsBasic CharacteristicsBasic Characteristics

Underyling Asset ExchangeCommodities

Wheat/oats/soybeans Chicago Board of Trade (CBOT)Cattle/pigs/lumber Chicago Mercantile Exch. (CME)Crude oil/heating oil/natural gas New York Merchantile ExchangeCotton/orange juice NY Cotton ExchangeGold/silver/copper The Commodity Exchange (Comex)

Table 11- 2 Futures Contracts and Markets


Gold/silver/copper The Commodity Exchange (Comex)Lead/nickel/tin London Metal Exchange (LME)Canola/western barley/wheat Winnipeg Commodity Exchange

Financial FuturesTreasury notes and bonds/DJIA CBOTS&P index/Nikkei225 / C$ / € / £ CMEBAs/Canada bonds/TSX/S&P 60 index Montreal ExchangeGerman bonds/European equities Euronext/Liffe

OtherWeather derivatives CME

Futures ContractsFutures ContractsMarked to Market ProcessMarked to Market Process

The Marked to market process helps to limit The Marked to market process helps to limit exposure to credit risk for the exchange.exposure to credit risk for the exchange.–– All futures contracts are marked to market each day.All futures contracts are marked to market each day.–– All profits and losses on a futures contract are All profits and losses on a futures contract are


11 - 697

–– All profits and losses on a futures contract are All profits and losses on a futures contract are credited to investors’ accounts every day to credited to investors’ accounts every day to calculate their equity position.calculate their equity position.•• If the equity position increases, these profits can be If the equity position increases, these profits can be

withdrawn.withdrawn.•• When the equity position drops below the maintenance When the equity position drops below the maintenance

margin (usually 75% of the initial margin) the investor will margin (usually 75% of the initial margin) the investor will receive a margin call and be forced to contribute more receive a margin call and be forced to contribute more money to increase the equity position.money to increase the equity position.

Trading/Hedging with Futures ContractsTrading/Hedging with Futures ContractsExample of a Bond Portfolio ManagerExample of a Bond Portfolio Manager

•• A fixedA fixed--income portfolio manager holds a diversified portfolio of income portfolio manager holds a diversified portfolio of bonds that are predominantly Canadas.bonds that are predominantly Canadas.

•• The manager believes interest rates will rise, causing the each The manager believes interest rates will rise, causing the each bond price to fall.bond price to fall.

•• The manager can:The manager can:1.1. Sell bonds and hold cash till the threat of rising interest rates pass, or Sell bonds and hold cash till the threat of rising interest rates pass, or

until the change in rates has occurred, and then repurchase the bondsuntil the change in rates has occurred, and then repurchase the bonds


11 - 698

until the change in rates has occurred, and then repurchase the bondsuntil the change in rates has occurred, and then repurchase the bonds2.2. Sell long term bonds and replace with shorter term bonds (reducing the Sell long term bonds and replace with shorter term bonds (reducing the

portfolio duration and thereby limiting the losses if interest rates rise)portfolio duration and thereby limiting the losses if interest rates rise)3.3. Hold the portfolio and use a Hold the portfolio and use a short hedgeshort hedge (short position in a futures (short position in a futures

contract in government bonds) …the losses in the portfolio will be contract in government bonds) …the losses in the portfolio will be offset by gains on the short hedge.offset by gains on the short hedge.–– The third alternative is often the best one, because buying and selling The third alternative is often the best one, because buying and selling

bonds will incur transactions costs and upset the structure of the portfolio.bonds will incur transactions costs and upset the structure of the portfolio.–– If the hedge cannot be perfectly constructed the portfolio will be exposed to If the hedge cannot be perfectly constructed the portfolio will be exposed to

basis riskbasis risk because losses on the long portfolio may not be exactly offset by because losses on the long portfolio may not be exactly offset by the short future position.the short future position.

Futures Contracts and MarketsFutures Contracts and MarketsSummary of Forward and Future ContractsSummary of Forward and Future Contracts

•• Forward and Future Contracts serve the same Forward and Future Contracts serve the same purpose.purpose.

•• Forward contracts offer more flexibility because Forward contracts offer more flexibility because they are customized OTC contracts.they are customized OTC contracts.


11 - 699

they are customized OTC contracts.they are customized OTC contracts.•• Forward contracts, however, face additional Forward contracts, however, face additional

risks:risks:–– Not actively traded (created by a bank for customers)Not actively traded (created by a bank for customers)–– Possess credit riskPossess credit risk

Differences are listed in Table 11 Differences are listed in Table 11 –– 3 on the following slide.3 on the following slide.

Forwards versus FuturesForwards versus Futures

Forwards Futures

Contracts Customized Standardized

Table 11- 3 Forwards versus Futures


Trading Dealer or OTC markets Exchanges

Default (credit risk) Important Unimportant - guaranteed by clearinghouse

Initial deposit Not required Initial margin and maintenance margin required

Settlement On maturity date Marked to market daily

SwapsSwapsDefinedDefined

•• Is an agreement between two parties, called Is an agreement between two parties, called counterpartiescounterparties, to exchange cash flows in the , to exchange cash flows in the future.future.–– No formal exchange to guarantee performance, so No formal exchange to guarantee performance, so


11 - 701

–– No formal exchange to guarantee performance, so No formal exchange to guarantee performance, so the arrangement involves a dealer or OTC market the arrangement involves a dealer or OTC market and there is credit risk.and there is credit risk.

–– Have evolved into a bank instrument, with banks or Have evolved into a bank instrument, with banks or swap dealers serving as intermediaries.swap dealers serving as intermediaries.

SwapsSwapsInterest Rate SwapsInterest Rate Swaps

•• An interest rate swap is:An interest rate swap is:–– An exchange of interest payments on a principal amount in An exchange of interest payments on a principal amount in

which borrowers switch loan rates.which borrowers switch loan rates.–– Often this involves one counterparty trading fixed loan payments Often this involves one counterparty trading fixed loan payments

for variable rate loan payments.for variable rate loan payments.

•• A plain vanilla interest rate swap is:A plain vanilla interest rate swap is:


11 - 702

•• A plain vanilla interest rate swap is:A plain vanilla interest rate swap is:–– The fixed for floating interest rate swap denominated in one The fixed for floating interest rate swap denominated in one

currency.currency.

•• Table 11 Table 11 –– 4 illustrates a plain vanilla interest rate swap 4 illustrates a plain vanilla interest rate swap between counterparties A and B and is structured to benefit between counterparties A and B and is structured to benefit both parties equally. This is rarely the case.both parties equally. This is rarely the case.

SwapsSwapsExample of an Interest Rate SwapExample of an Interest Rate Swap

A BQuotes (AAA) (BBB)

Floating LIBOR + 0.25 LIBOR + 0.75

Fixed 10.8 12.0

Table 11- 4 An Interest Rate Swap


Initial

Floating - (LIBOR + 0.75)

Fixed -10.8

Swap B pays A fixed and A pays B floating

+10.9 - 10.9

- LIBOR + LIBOR

Net - (LIBOR - 0.10) - 11.65

Saving 0.35% 0.35%

SwapsSwapsComparative AdvantageComparative Advantage

•• Comparative advantage is:Comparative advantage is:–– A benefit that one firm has relative to another.A benefit that one firm has relative to another.–– Any firm offered a good deal in floating rate funds but Any firm offered a good deal in floating rate funds but

doesn’t need them should borrow them anyway and doesn’t need them should borrow them anyway and


11 - 704

doesn’t need them should borrow them anyway and doesn’t need them should borrow them anyway and use a swap to exchange it for what is needed and use a swap to exchange it for what is needed and lock in the financing advantage.lock in the financing advantage.

Swap ArrangementsSwap ArrangementsChallenge and ResponseChallenge and Response

•• In swap arrangements, counterparties are often ‘unequal’ partners to In swap arrangements, counterparties are often ‘unequal’ partners to the contract.the contract.–– One counterparty may be AAA rated…the other BBBOne counterparty may be AAA rated…the other BBB

•• There is credit risk and it is borne by the higher rated counterparty. There is credit risk and it is borne by the higher rated counterparty. –– AAA may have to honour its own and the other interest obligations if AAA may have to honour its own and the other interest obligations if

BBB defaults.BBB defaults.


11 - 705

BBB defaults.BBB defaults.•• Strategies to control credit risk include:Strategies to control credit risk include:

–– SetSet--off rights in the swap agreement allowing the other party to stop off rights in the swap agreement allowing the other party to stop making payments if the other party defaultsmaking payments if the other party defaults

–– Net payments Net payments –– instead of exchanging total interest amounts, only the instead of exchanging total interest amounts, only the difference between the two streams are exchanged and structuring the difference between the two streams are exchanged and structuring the payments into subpayments into sub--periods (every six months)periods (every six months)

(Table 11 (Table 11 –– 5 illustrates a Net Payments swap structure over time)5 illustrates a Net Payments swap structure over time)

Interest Rate SwapsInterest Rate Swaps

Period LIBOR (%)Floating Pay

(%)Fixed Pay

(%)Net Pay (%)

1 8.0 -4.00 +5.45 + 1.45

Table 11- 5 Interest Rate Swap Net Payments


1 8.0 -4.00 +5.45 + 1.45

2 9.0 -4.50 +5.45 + 0.95

3 9.80 -4.90 +5.45 + 0.55

4 11.00 -5.50 +5.45 - 0.05

5 12.00 -6.00 +5.45 - 0.55

The Evolution of Swap MarketsThe Evolution of Swap MarketsCurrency SwapsCurrency Swaps

•• Currency swaps require exchange of all cash flows.Currency swaps require exchange of all cash flows.•• Currency swaps permit the firms to adjust their foreign exchange Currency swaps permit the firms to adjust their foreign exchange

exposure.exposure.–– This means that there is increased credit risk…but it presents This means that there is increased credit risk…but it presents

opportunities.opportunities.•• The first swap was a currency swap between IBM and the World The first swap was a currency swap between IBM and the World

Bank.Bank.


11 - 707

Bank.Bank.–– This swap was motivated by comparative advantageThis swap was motivated by comparative advantage–– It was a primary market transaction It was a primary market transaction –– both IBM and the World Bank both IBM and the World Bank

used it to raise new capital cheaply.used it to raise new capital cheaply.–– Once swaps became standardized, it became possible to constantly Once swaps became standardized, it became possible to constantly

change the nature of the institution’s liability stream.change the nature of the institution’s liability stream.•• Today currency swaps have become a bank market through their Today currency swaps have become a bank market through their

links to the forward foreign exchange market.links to the forward foreign exchange market.–– The bank is capable of executing a secondary market transaction with The bank is capable of executing a secondary market transaction with

itself as the counterparty because a currency swap can be though of as itself as the counterparty because a currency swap can be though of as a series of forward transactions.a series of forward transactions.

The Evolution of Swap MarketsThe Evolution of Swap MarketsSwap RateSwap Rate

•• Standardization has helped to grow the swap market.Standardization has helped to grow the swap market.•• Interest rate swaps have also become a bank market through Interest rate swaps have also become a bank market through

standardization.standardization.–– Floating rates are fixed against LIBORFloating rates are fixed against LIBOR–– Fixed rates are fixed against the government bond rateFixed rates are fixed against the government bond rate


11 - 708

–– Fixed rates are fixed against the government bond rateFixed rates are fixed against the government bond rate•• The choice of rate depends on whether it is a five year, 10 year or The choice of rate depends on whether it is a five year, 10 year or

other maturity contract.other maturity contract.•• This becomes the This becomes the swap rateswap rate..

•• The swap rate is the rate of the fixed portion of a swap which The swap rate is the rate of the fixed portion of a swap which is used for quoting swaps.is used for quoting swaps.

Table 11 Table 11 –– 6 revisits the previous interest rate swap assuming a swap rate of 10.65%6 revisits the previous interest rate swap assuming a swap rate of 10.65%

Percent Interest Rate SwapPercent Interest Rate SwapThe Swap RateThe Swap Rate

A BQuotes (AAA) (BBB)

Floating LIBOR + 0.25 LIBOR + 0.75

Fixed 10.8 12.0

Table 11- 6 Percent Interest Rate Swap

The Swap


Initial

Floating - (LIBOR + 0.75)

Fixed -10.8

Swap B pays A fixed and A pays B floating

+10.65 - 10.65

- LIBOR + LIBOR

Net - (LIBOR - 0.15) - 11.40

Saving 0.10% 0.60%

The Swap rate

Integration of the Swap and Forward Integration of the Swap and Forward MarketsMarkets

–– Interest rate swaps are found around the world.Interest rate swaps are found around the world.–– Table 11 Table 11 –– 7 gives swap rates for the euro, U.S. 7 gives swap rates for the euro, U.S.

dollar and the pound sterling for June 7, 2006.dollar and the pound sterling for June 7, 2006.


11 - 710

dollar and the pound sterling for June 7, 2006.dollar and the pound sterling for June 7, 2006.–– Swap rates follow the full spectrum of the yield curve Swap rates follow the full spectrum of the yield curve

from 1 year to 30 years.from 1 year to 30 years.•• This allows swaps to manage interest rate exposure.This allows swaps to manage interest rate exposure.•• It also links swaps to forward rate agreements (FRAs)It also links swaps to forward rate agreements (FRAs)

–– A FRA is an agreement that uses forward rates to manage a A FRA is an agreement that uses forward rates to manage a firm’s exposure to interest rate risk; agreements to borrow or firm’s exposure to interest rate risk; agreements to borrow or lend at a specified future date at an interest rate that is fixed lend at a specified future date at an interest rate that is fixed today.today.

Interest Rate Swap QuotesInterest Rate Swap Quotes

Fixed Rate Euro (€) Current US ($) Current UK (£) Current

1 year 3.41% 5.41% 4.95%

2 year 3.61% 5.38% 5.30%

3 year 3.73% 5.38% 5.08%

5 year 3.87% 5.43% 5.09%

Table 11-7 Interest Rate Swap Quotes


5 year 3.87% 5.43% 5.09%

7 year 4.00% 5.50% 5.07%

10 year 4.16% 5.57% 5.00%

12 year 4.24% 5.61% 4.96%

15 year 4.34% 5.66% 4.90%

20 year 4.44% 5.70% 4.80%

25 year 4.48% 5.71% 4.70%

30 year 4.49% 5.71% 4.62%

Source: Data from CLP Structured Finance, June 7, 2006.

SwapsSwapsEvolution of Swap MarketsEvolution of Swap Markets

–– Integration of swap markets with the forward market Integration of swap markets with the forward market has fueled expansion of the markethas fueled expansion of the market

–– Firms wanting to change a floating rate liability into a Firms wanting to change a floating rate liability into a fixed rate liability simply calls their bank and fixed rate liability simply calls their bank and


11 - 712

fixed rate liability simply calls their bank and fixed rate liability simply calls their bank and executes the interest rate swap as a secondary executes the interest rate swap as a secondary market transaction executed against a line of credit.market transaction executed against a line of credit.

–– Creating swaps is a key component of the services Creating swaps is a key component of the services provided by major banks for their corporate clients.provided by major banks for their corporate clients.

SwapsSwapsRecent DevelopmentsRecent Developments

•• The focus of the text is on major vehicles used to manage The focus of the text is on major vehicles used to manage interest and currency exposure:interest and currency exposure:–– Interest rate swapsInterest rate swaps–– Currency swapsCurrency swaps

•• Other swap opportunities exist and evolve including the total Other swap opportunities exist and evolve including the total


11 - 713

•• Other swap opportunities exist and evolve including the total Other swap opportunities exist and evolve including the total return swap especially between private sector return swap especially between private sector counterparties:counterparties:–– The more specialized the swap:The more specialized the swap:

•• The less tradable it isThe less tradable it is•• The greater the counterparty riskThe greater the counterparty risk

–– Only standardized swaps are done with banks.Only standardized swaps are done with banks.•• An Example is the Total Return Swap.An Example is the Total Return Swap.

Recent Developments in SwapsRecent Developments in SwapsTotal Return SwapTotal Return Swap

Total return swap is an exchange of an interest rate Total return swap is an exchange of an interest rate return for the total return on for the total return on an return for the total return on for the total return on an equity index plus or minus a spread.equity index plus or minus a spread.


11 - 714


In this chapter you have learned:In this chapter you have learned:–– How to diagnose long and short positions in foreign How to diagnose long and short positions in foreign

currency and how these positions can be hedged by using currency and how these positions can be hedged by using forward foreign currency contracts.forward foreign currency contracts.


11 - 715

–– How interest rate parity can be used to derive forward How interest rate parity can be used to derive forward interest rates and how banks could create synthetic interest rates and how banks could create synthetic securitiessecurities

–– Future contracts can be viewed as the public version of Future contracts can be viewed as the public version of forward contracts.forward contracts.

–– How swap markets operate and can be used to hedge How swap markets operate and can be used to hedge interest rate or foreign currency exposures.interest rate or foreign currency exposures.

CHAPTER 12CHAPTER 12OptionsOptionsOptionsOptions


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• Call OptionsCall Options•• Put OptionsPut Options

www.bookfiesta4u.com ContentsCHAPTER 12 – Options

12 - 718

•• Put OptionsPut Options•• PutPut--Call ParityCall Parity•• Option PricingOption Pricing•• Options MarketsOptions Markets•• Summary and ConclusionsSummary and Conclusions



1.1. The basic nature of optionsThe basic nature of options2.2. The payoffs associated with long and short positions in call and put The payoffs associated with long and short positions in call and put

optionsoptions3.3. The factors affecting option values, and how those factors influence The factors affecting option values, and how those factors influence

option valuesoption values


12 - 719

option valuesoption values4.4. How to use putHow to use put--call parity to estimate call and put prices, and how it call parity to estimate call and put prices, and how it

can be used to synthetically create call, put, and underlying can be used to synthetically create call, put, and underlying positionspositions

5.5. How options can be used for hedging purposesHow options can be used for hedging purposes6.6. How to use the BlackHow to use the Black--Scholes option pricing model to price call Scholes option pricing model to price call

optionsoptions7.7. How options are traded, and what is meant by implied volatilityHow options are traded, and what is meant by implied volatility


•• American optionsAmerican options•• Binomial modelBinomial model•• Call optionCall option•• CollarCollar•• Covered call writingCovered call writing

•• Expiration dateExpiration date•• GammaGamma•• Greeks, theGreeks, the•• Hedge ratioHedge ratio•• Implied volatilityImplied volatility•• In the moneyIn the money


12 - 720

•• Covered call writingCovered call writing•• DeepDeep•• DeltaDelta•• European optionsEuropean options•• ExerciseExercise•• Exercise priceExercise price

•• In the moneyIn the money•• Intrinsic value (IV)Intrinsic value (IV)•• Option premiumOption premium•• Option writerOption writer•• Out of the moneyOut of the money

OptionsOptionsWhat are They?What are They?

•• Option contracts offer nonOption contracts offer non--linear payoffs.linear payoffs.•• Options give the holder the right (BUT NOT THE Options give the holder the right (BUT NOT THE

OBLIGATION) to buy (put option) or sell (call OBLIGATION) to buy (put option) or sell (call


12 - 721

OBLIGATION) to buy (put option) or sell (call OBLIGATION) to buy (put option) or sell (call option) an underlying asset for a specified price option) an underlying asset for a specified price (strike price) over a given period of time.(strike price) over a given period of time.

OptionsOptionsTypes Types –– Put OptionsPut Options

•• Put options give the holder the right to Put options give the holder the right to sellsell the the underlying asset at the strike price prior to the underlying asset at the strike price prior to the expiry of the option.expiry of the option.


12 - 722

expiry of the option.expiry of the option.•• Put option holders have a ‘bearish’ outlook for Put option holders have a ‘bearish’ outlook for

the price of the underlying asset (they will profit if the price of the underlying asset (they will profit if the underlying stock price falls prior to the expiry the underlying stock price falls prior to the expiry of the option)of the option)

OptionsOptionsTypes Types –– Call OptionsCall Options

•• Call options give the holder the right to Call options give the holder the right to buybuy the the underlying asset at the strike price prior to the underlying asset at the strike price prior to the expiry of the option.expiry of the option.


12 - 723

expiry of the option.expiry of the option.•• Call option holders have a ‘bullish’ outlook for Call option holders have a ‘bullish’ outlook for

the price of the underlying asset (they will profit if the price of the underlying asset (they will profit if the underlying stock price rises prior to expiry of the underlying stock price rises prior to expiry of the option.)the option.)

OptionsOptionsTypes Types –– Where they are Created/TradedWhere they are Created/Traded

•• OTC options are ‘customized’ through negotiation between writer OTC options are ‘customized’ through negotiation between writer and buyer.and buyer.–– This is normally between an individual (corporation) and a bankThis is normally between an individual (corporation) and a bank–– Credit risk is attached to the counterpartyCredit risk is attached to the counterparty–– Because of the custom nature of the option, it may be difficult or Because of the custom nature of the option, it may be difficult or

impossible to liquidate (reverse the contract) the position prior to expiry.impossible to liquidate (reverse the contract) the position prior to expiry.•• ExchangedExchanged--traded options are standardized option contracts:traded options are standardized option contracts:


12 - 724

•• ExchangedExchanged--traded options are standardized option contracts:traded options are standardized option contracts:–– Lives of 3, 6 and 9 monthsLives of 3, 6 and 9 months–– Standardized expiry date Standardized expiry date –– usually 4:00 pm EST on the third Friday of usually 4:00 pm EST on the third Friday of

every monthevery month–– Traded in contracts consisting of 100 optionsTraded in contracts consisting of 100 options–– Standardization allows for public reporting of trading details and Standardization allows for public reporting of trading details and

contracts outstanding.contracts outstanding.–– The options exchange is party to every contract and stands ready to The options exchange is party to every contract and stands ready to

make a market for those options.make a market for those options.•• This ensure continuous liquidity andThis ensure continuous liquidity and•• Virtually eliminates counterparty riskVirtually eliminates counterparty risk

OptionsOptionsRelevance to Corporate FinanceRelevance to Corporate Finance

•• Option contracts can be written against many different underlying Option contracts can be written against many different underlying assets:assets:–– Individual stocksIndividual stocks–– Stock indicesStock indices–– Exchange rates, etc.Exchange rates, etc.

•• Corporations can mitigate risk exposures to a variety of risks Corporations can mitigate risk exposures to a variety of risks


12 - 725

•• Corporations can mitigate risk exposures to a variety of risks Corporations can mitigate risk exposures to a variety of risks through the use of options.through the use of options.–– Exchange ratesExchange rates–– Commodity pricesCommodity prices–– Market volatilityMarket volatility

•• ExchangeExchange--traded options, because of their nontraded options, because of their non--linear payoffs and linear payoffs and because of the ability to close out positions by reversing because of the ability to close out positions by reversing transactions, gives the corporate treasurer flexibility in risk transactions, gives the corporate treasurer flexibility in risk management that other derivative products may not offer.management that other derivative products may not offer.

Call OptionsCall OptionsDefinitionsDefinitions

Call Option DefinedCall Option Defined–– The right, but not the obligation, to buy an underlying asset at a The right, but not the obligation, to buy an underlying asset at a

fixed price for a specified time.fixed price for a specified time.Exercise Price or Strike PriceExercise Price or Strike Price

–– The price at which an investor can buy the underlying asset.The price at which an investor can buy the underlying asset.ExerciseExercise


12 - 726

ExerciseExercise–– To implement the rights of options by buying (in the case of call To implement the rights of options by buying (in the case of call

options) or selling (in the case of put options).options) or selling (in the case of put options).Expiration DateExpiration Date

–– The last date on which options can be converted or exercised.The last date on which options can be converted or exercised.PayoffPayoff

–– The proceeds that would be generated from the option if today The proceeds that would be generated from the option if today was the expiration date.was the expiration date.

Call OptionsCall OptionsCall Option BasicsCall Option Basics

Call WriterCall Writer–– When investor sells the right to the Options Exchange to When investor sells the right to the Options Exchange to

purchase a given asset for a given price for a given period of purchase a given asset for a given price for a given period of time.time.

–– The writer assumes a The writer assumes a short positionshort position–– The payoff for the call writer is the mirror image of the payoff for The payoff for the call writer is the mirror image of the payoff for


12 - 727

–– The payoff for the call writer is the mirror image of the payoff for The payoff for the call writer is the mirror image of the payoff for the call holder.the call holder.

Call Purchase (Call Holder)Call Purchase (Call Holder)–– When the underlying asset price rises above the strike price, the When the underlying asset price rises above the strike price, the

intrinsic value of the call option climbs above $0.00.intrinsic value of the call option climbs above $0.00.–– The call holder has a The call holder has a long positionlong position

(Figure 12 (Figure 12 --1 illustrates the Call Holder’s Payoff)1 illustrates the Call Holder’s Payoff)

Call OptionsCall OptionsCall Holder’s Option BasicsCall Holder’s Option Basics

•• The purchaser of a call option has a ‘bullish’ outlook for the The purchaser of a call option has a ‘bullish’ outlook for the underlying asset.underlying asset.

•• Intrinsic value = Underlying asset price Intrinsic value = Underlying asset price –– strike pricestrike price

OutOut--ofof--thethe--MoneyMoney


12 - 728

•• When the underlying asset price is below the strike price the When the underlying asset price is below the strike price the ‘intrinsic value’ of the call option is $0.00.‘intrinsic value’ of the call option is $0.00.

InIn--thethe--MoneyMoney•• When the underlying asset price rises above the strike price, When the underlying asset price rises above the strike price,

the intrinsic value of the call option climbs above $0.00.the intrinsic value of the call option climbs above $0.00.

(Figure 12 (Figure 12 --1 illustrates the Call Holder’s Payoff)1 illustrates the Call Holder’s Payoff)

Call OptionsCall OptionsCall Holder’s PayoffCall Holder’s Payoff

12 - 1 FIGURE

Option Payoff

Long Underlying

Intrinsic Value of Option

Out- of-the-money In-the-moneyIf the underyling Asset Price was

$60, then the intrinsic value

would be $10.00 ($60 – strike

If the underlying asset price is

$40, the option is worthless.

If this condition remained until


12 - 729

$500

Underlying Asset Price

Strike Price = $50

($60 – strike price).

This would be an in-the-money call option at the

$60 price.$60

$10

$40

remained until expiry, the

option would expire without

being exercised.

This is an example of an

‘out-of-the-money’ call

option.

Call OptionsCall OptionsCall Holder PayoffsCall Holder Payoffs

12 - 1 FIGURE

Option Payoff

Long Underlying

Intrinsic Value of Option$20

www.bookfiesta4u.com ContentsCHAPTER 12 – Options 12 - 730

$500


Asset Price $30 $40 $50 $55 $60 $70

Call holder payoff $0 $0 $0 $5 $10 $20

IV = Underlying Asset Price – Strike Price

$70

Call OptionsCall OptionsCall Writer’s Option BasicsCall Writer’s Option Basics

•• The option writer is the person who sells an optionThe option writer is the person who sells an option•• The writer of a call option has a ‘bearish’ outlook for the The writer of a call option has a ‘bearish’ outlook for the

underlying asset and hopes to profit from that.underlying asset and hopes to profit from that.•• The call writer receives the call premium (price) when she The call writer receives the call premium (price) when she


12 - 731

•• The call writer receives the call premium (price) when she The call writer receives the call premium (price) when she sells the option.sells the option.–– She hopes the underlying asset price will stay the same or fall, She hopes the underlying asset price will stay the same or fall,

and the call option will remain outand the call option will remain out--ofof--thethe--money, and expire money, and expire worthless in the hands of the call holder.worthless in the hands of the call holder.

–– In this way the call writer earns a call premium.In this way the call writer earns a call premium.

(Figure 12 (Figure 12 --2 illustrates the Call Writer’s Payoff)2 illustrates the Call Writer’s Payoff)

Call OptionsCall OptionsCall Writer’s PayoffCall Writer’s Payoff

12 – 2 FIGURE

Short Option Payoff


12 - 732

$500


Call Option ValuesCall Option ValuesCall Option Intrinsic Value (IV)Call Option Intrinsic Value (IV)

•• The Intrinsic value is the value of an option at expiration, it is The Intrinsic value is the value of an option at expiration, it is positive when the option is inpositive when the option is in--thethe--money, and zero when it is out money, and zero when it is out of the money as illustrated in equation 12 of the money as illustrated in equation 12 –– 1.1.

)0,()( XSMaxcallIV −=


•• Before expiration, the value of the call will exceed it’s intrinsic Before expiration, the value of the call will exceed it’s intrinsic value (IV) because of the option’s time value (TV) (also known value (IV) because of the option’s time value (TV) (also known as it’s speculative value)as it’s speculative value)

)0,()( XSMaxcallIV −=[12-1]

Call Option ValuesCall Option ValuesOption Premium and Time Value (TV)Option Premium and Time Value (TV)

–– The Option Premium is the actual price of the option prior to The Option Premium is the actual price of the option prior to expiration.expiration.

–– At expiration TV=0, so the option premium = IV:At expiration TV=0, so the option premium = IV:


–– Equation 12 Equation 12 –– 2 can be rearranged to solve for TV:2 can be rearranged to solve for TV:

TV IV premiumOption +=[12-2]

Call OptionsCall OptionsTime Value (TV)Time Value (TV)

–– The Time Value (speculative value) of a call option occurs The Time Value (speculative value) of a call option occurs because time remains until the option expires:because time remains until the option expires:•• The longer the time to expiry, the greater the possibility that the The longer the time to expiry, the greater the possibility that the

underlying stock price will rise and the call will be worth more:underlying stock price will rise and the call will be worth more:


•• Clearly, the longer the time to expiry, the greater the TV.Clearly, the longer the time to expiry, the greater the TV.

(See Figure 12 (See Figure 12 –– 3 that illustrates the Call Option Premium)3 that illustrates the Call Option Premium)

IV PremiumOption TV +=[12-3]

Call Premium with 9 months left to

expiry.

Call OptionsCall OptionsThe Value of a Call Option (Call Premium) and Changing TVThe Value of a Call Option (Call Premium) and Changing TV

12 - 3 FIGURE

Option Value

Long Stock


expiry.


expiry.

As time expires, the Time Value

decreases across the whole range of

underlying asset prices.

Deep in-the-money and out-of-the-

money premiums are closer to their


12 - 736

$500

Asset Price

are closer to their Intrinsic Values.

Call Option PremiumsCall Option PremiumsFactors affecting Call Option Prices (Values)Factors affecting Call Option Prices (Values)

Call option premium (values):Call option premium (values):–– Approach their intrinsic value for deep in and deep out of the money Approach their intrinsic value for deep in and deep out of the money

callscalls–– Increase with the price of the underlying assetIncrease with the price of the underlying asset–– Increase if the underlying asset is riskierIncrease if the underlying asset is riskier


12 - 737

–– Increase if the underlying asset is riskierIncrease if the underlying asset is riskier–– Increase as the time to expiration increasesIncrease as the time to expiration increases–– Decrease as the dividend payments of the underlying asset increaseDecrease as the dividend payments of the underlying asset increase–– Increase as interest rates increaseIncrease as interest rates increase

•• The Greeks are used to measure the sensitivity of the option The Greeks are used to measure the sensitivity of the option premium to the five primary factors that affect option premiums (this premium to the five primary factors that affect option premiums (this is covered in later slides).is covered in later slides).

Call OptionsCall OptionsPut Option BasicsPut Option Basics

A put option is the opposite of a call option:A put option is the opposite of a call option:–– A put gives the owner the right, but not the obligation, A put gives the owner the right, but not the obligation,

to sell an underlying asset at a fixed price for a to sell an underlying asset at a fixed price for a specified period of time.specified period of time.


12 - 738

specified period of time.specified period of time.

A put holder is in a A put holder is in a short position on the underlying short position on the underlying assetasset..

(Figure 12 (Figure 12 --4 illustrates the Put Holder’s Payoff)4 illustrates the Put Holder’s Payoff)

Call OptionsCall OptionsPut Holder’s PayoffPut Holder’s Payoff

12 - 4 FIGURE

Put Payoff

Intrinsic Value of Option (floor price)

Put options pay off when the

asset price drops below the

strike price.

Payoff increases by $1 for every


$50 Asset Price

Asset Price $30 $40 $50 $55 $60 $70

Put holder payoffs $20 $10 $0 $0 $0 $0

by $1 for every $1 decrease in the underlying

asset price.

The put allows the investor to

take advantage of the downside risk attached to

an asset.

Put OptionsPut OptionsPut Writer PayoffsPut Writer Payoffs

•• The writer of a put option has a short position in the put.The writer of a put option has a short position in the put.

•• The put writer’s payoff is the opposite of the put holder’s.The put writer’s payoff is the opposite of the put holder’s.

•• The put writer earns the option premium at the time it is originally The put writer earns the option premium at the time it is originally sold.sold.


12 - 740

•• When the underlying asset price is above the strike price the When the underlying asset price is above the strike price the ‘intrinsic value’ of the put option is $0.00 and if it stays there till ‘intrinsic value’ of the put option is $0.00 and if it stays there till expiry, the put will expire worthless.expiry, the put will expire worthless.

•• When the underlying asset price falls below the strike price, to say When the underlying asset price falls below the strike price, to say $45, the owner of the put buys the asset for $45 in the open market $45, the owner of the put buys the asset for $45 in the open market and sells it to the put writer for $50, making a $5 profit.and sells it to the put writer for $50, making a $5 profit.

(Figure 12 (Figure 12 --5 illustrates the Put Writer’s Payoffs)5 illustrates the Put Writer’s Payoffs)

Call OptionsCall OptionsPut Writer’s PayoffPut Writer’s Payoff

12 - 5 FIGURE

Short Put Payoff

Below $50 strike price, the payoff

decreases by $1 for every $1 decrease in the underlying asset

price, because the put writer has

agreed to buy the asset for $50.


$50 Asset Price

Put Writer PayoffsAsset Price $30 $40 $50 $55 $60 $70Put Writer Payoffs -$20 -$10 $0 $0 $0 $0

asset for $50.

Put Option ValuesPut Option ValuesIntrinsic ValueIntrinsic Value

–– The intrinsic value (IV) of a put is:The intrinsic value (IV) of a put is:

S,0) - Max(X (put) IV =[12-4]


–– IV of a put equals X IV of a put equals X –– S when the put is in the money, and S when the put is in the money, and equals 0 otherwise.equals 0 otherwise.

S,0) - Max(X (put) IV =[12-4]

Put Option ValuesPut Option ValuesFactors Affecting Time PremiumFactors Affecting Time Premium

•• The same factors that drive put prices are the same factors The same factors that drive put prices are the same factors that affect call prices that affect call prices –– usually in the opposite direction.usually in the opposite direction.

1.1. When the asset price greatly exceeds strike price, the put is deep When the asset price greatly exceeds strike price, the put is deep out of the money out of the money –– and the price approaches IV.and the price approaches IV.

2.2. When the asset price is well below the strike price, the put is deep When the asset price is well below the strike price, the put is deep inin--thethe--money and the put’s price approaches IV.money and the put’s price approaches IV.


inin--thethe--money and the put’s price approaches IV.money and the put’s price approaches IV.3.3. The put’s maximum time value occurs at the strike price when it’s The put’s maximum time value occurs at the strike price when it’s

IV = 0.IV = 0.4.4. An increase in asset price will lead to a decrease in put price.An increase in asset price will lead to a decrease in put price.5.5. An increase in either expiration date or risk in the underlying asset An increase in either expiration date or risk in the underlying asset

will increase the put price.will increase the put price.6.6. A decrease in interest rates or an increase in cash dividend A decrease in interest rates or an increase in cash dividend

payments will increase the put price.payments will increase the put price.

European Versus American OptionsEuropean Versus American Options

•• European options are options that can be European options are options that can be exercised only at maturity.exercised only at maturity.

•• American options can be exercise throughout American options can be exercise throughout


12 - 744

•• American options can be exercise throughout American options can be exercise throughout their life up to and including the expiration date.their life up to and including the expiration date.

These two types of options are not confined by geography. European options These two types of options are not confined by geography. European options are traded in North America.are traded in North America.

SummarySummaryFactors Affecting Option PricesFactors Affecting Option Prices

Call Prices Put Prices

Higher asset price (S) ↑ ↓

Higher strike price (X) ↓ ↑

Table 12-1 Factors Affecting Option Prices


Higher strike price (X) ↓ ↑

Longer time to expiration ↑ ↑

Increased volatility ↑ ↑

Increase in interest rates ↑ ↓

Increased dividends ↓ ↑

PutPut--Call ParityCall ParityThe Four Basic Option PositionsThe Four Basic Option Positions

•• The four basic option positions are:The four basic option positions are:1.1. Long callLong call2.2. Short callShort call3.3. Long putLong put4.4. Short putShort put


12 - 746

4.4. Short putShort put

•• These positions are combined in Figure 12 These positions are combined in Figure 12 –– 6:6:–– This shows how a This shows how a long call + shortlong call + short put add to a forward put add to a forward

contract (remember Chapter 11 on forward contracts?)contract (remember Chapter 11 on forward contracts?)–– A A long put + short calllong put + short call is a short forward contract.is a short forward contract.–– If an investor simultaneously established all four basic option If an investor simultaneously established all four basic option

positions, the net position is zero.positions, the net position is zero.–– The four contracts are a The four contracts are a zero sum gamezero sum game..

PutPut--Call ParityCall ParityCombining Option PositionsCombining Option Positions

12 - 6 FIGURE

Payoff Long CallLong Put

Long call and short put =

forward contract

Long put + short call = short

forward contract

Net position of all four positions

is a zero sum game.


12 - 747

$50 Asset Price

Short CallShort Put

PutPut--Call ParityCall Parity

•• PutPut--call parity is the relationship between the call parity is the relationship between the price of a call option and a put option that have price of a call option and a put option that have the same strike price and expiry dates the same strike price and expiry dates


12 - 748

the same strike price and expiry dates the same strike price and expiry dates (assuming they are not exercised before their (assuming they are not exercised before their expiration).expiration).

PutPut--Call ParityCall ParityDeriving the PutDeriving the Put--Call Parity RelationshipCall Parity Relationship

•• Consider Two Portfolios A and B and assume European Consider Two Portfolios A and B and assume European options:options:

Portfolio A:Portfolio A:–– Buy a put (P) with X = $50Buy a put (P) with X = $50–– Simultaneously purchase the underlying asset (S)Simultaneously purchase the underlying asset (S)


12 - 749

–– Simultaneously purchase the underlying asset (S)Simultaneously purchase the underlying asset (S)Portfolio B:Portfolio B:

–– Buy a call (C) with X = $50Buy a call (C) with X = $50–– Invest the Present value of the exercise price PV(X) in a riskInvest the Present value of the exercise price PV(X) in a risk--free free

asset paying interest at RF; the investor has $50 available to asset paying interest at RF; the investor has $50 available to exercise the call option.exercise the call option.

Table 12 Table 12 –– 2 shows the payoffs from these two portfolios assuming underlying asset price is 2 shows the payoffs from these two portfolios assuming underlying asset price is either $45 or $55.either $45 or $55.

PutPut--Call ParityCall ParityCombining PositionsCombining Positions

Underlying Price $55 $45

Portfolio A

Long put payoff 0 +$5

Table 12-2 Payoff from Combining Calls, Puts and U nderyling Asset Positions

Pay off is the same,


Long asset payoff +$55 +$45

Total payoff for A +$55 +$50

Portfolio B

Long call payoff +$5 0

Invest present vvalue of $50 at RF +$50 +$50

Total payoff for B +$55 +$50

the same, regardless

of the ending

share price.

Table 12 – 3 demonstrates that the payoffs from thes e two portfolios will always be the same.

PutPut--Call ParityCall ParityCombining PositionsCombining Positions

Underlying Price at Expiration Date (S T) (ST) > X (ST) < X

Portfolio A

Long put payoff 0 X - ST

Long asset payoff S S

Table 12-3 Payoff from Combining Calls, Puts and U nderyling Asset Positions: The General


Long asset payoff ST ST

Total payoff for A ST X

Portfolio B

Long call payoff ST - X 0

Invest X at RF short asset payoff +X +X

Total payoff for B ST X

Put Call ParityPut Call ParityPutPut--Call RelationshipCall Relationship

•• Because the payoffs at expiration (T) will always be the same, Because the payoffs at expiration (T) will always be the same, the the costcost of constructing each portfolio must be the same.of constructing each portfolio must be the same.

•• With put as P, cost of the call C, and S as the price of the With put as P, cost of the call C, and S as the price of the underlying asset, we can therefore obtain Equation 12 underlying asset, we can therefore obtain Equation 12 –– 5:5:


underlying asset, we can therefore obtain Equation 12 underlying asset, we can therefore obtain Equation 12 –– 5:5:


PV(X) C S P +=+[12-5]


PV(X) S P -C −=[12-6]

Rearranging Equation 12 -5 we get the basic put-cal l relationship:


PV(X) - S P C +=[12-7]

We can reorganize and solve for the call price give n P, S, X and RF:


PV(X) S -C P +=[12-8]

Or we can reorganize and solve for the put option p rice given C, S, X and RF:


PV(X) P - C S +=[12-9]

The put-call parity equation can also be solved for S:


PV(X) P - C S +=[12-9]

Put Call ParityPut Call ParityPutPut--Call ImportanceCall Importance

–– The putThe put--call parity relationship allows us to price the call parity relationship allows us to price the call, given the price of the put and vice versa.call, given the price of the put and vice versa.

–– It demonstrates that these contracts are all It demonstrates that these contracts are all derivative.derivative.


12 - 756

derivative.derivative.–– These relationships are particularly useful for These relationships are particularly useful for

hedging purposes (an important issue for financial hedging purposes (an important issue for financial managers seeking to manage their exposure to risk).managers seeking to manage their exposure to risk).

PutPut--Call ParityCall ParityCreating Synthetic Positions Using PutCreating Synthetic Positions Using Put--Call ParityCall Parity

•• Synthetic positions can be created to protect Synthetic positions can be created to protect against anticipated losses and at the same time against anticipated losses and at the same time generate returns or participate in appreciation in generate returns or participate in appreciation in the underlying asset.the underlying asset.


12 - 757

the underlying asset.the underlying asset.

•• This section will address:This section will address:–– Protective putsProtective puts–– Covered call writingCovered call writing–– CollarsCollars

Synthetic PositionsSynthetic PositionsProtective PutsProtective Puts

•• The purchase of a put option to protect a long The purchase of a put option to protect a long position in an underlying asset.position in an underlying asset.–– If the underlying asset declines in value, those losses If the underlying asset declines in value, those losses


12 - 758

–– If the underlying asset declines in value, those losses If the underlying asset declines in value, those losses are insulated by gains on the put.are insulated by gains on the put.

•• The net payoff from a protective put resembles a The net payoff from a protective put resembles a long call position as indicated in the solid blue long call position as indicated in the solid blue line in Figure 12 line in Figure 12 –– 7 …7 …

Synthetic PositionsSynthetic PositionsA Protective PutA Protective Put

12 - 7 FIGURE

Protective Put Payoff


12 - 759

0.90

Exchange rate CDN$ to US$F

Synthetic PositionsSynthetic PositionsWriting Covered Call OptionsWriting Covered Call Options

•• Selling call options while owning the underlying asset.Selling call options while owning the underlying asset.–– The writer receives the option premium at the time of writing the The writer receives the option premium at the time of writing the

call.call.–– The strike price can be set above the current market price…so The strike price can be set above the current market price…so

some increase in the underlying asset will not automatically some increase in the underlying asset will not automatically


12 - 760

some increase in the underlying asset will not automatically some increase in the underlying asset will not automatically cause the holder of the call to exercise the option (this means cause the holder of the call to exercise the option (this means writing an outwriting an out--ofof--thethe--money call)money call)

–– If the underlying asset price stays the same or falls during the life If the underlying asset price stays the same or falls during the life of the option, the call won’t be exercised, and the writer won’t be of the option, the call won’t be exercised, and the writer won’t be forced to sell the underlying asset.forced to sell the underlying asset.

See Figure 12 See Figure 12 –– 8 for the payoff diagram from Writing Covered Calls8 for the payoff diagram from Writing Covered Calls

Synthetic PositionsSynthetic PositionsCovered Call WritingCovered Call Writing

12 - 8 FIGURE


12 - 761

F

Covered Call Payoff

Synthetic PositionsSynthetic PositionsCollarCollar

•• Collar is a position between the floor and ceiling price.Collar is a position between the floor and ceiling price.–– The investor is long the assetThe investor is long the asset–– Buying a put places a floor under how much can be lost (SBuying a put places a floor under how much can be lost (S11))–– Selling a call places a ceiling on how much can be earned. (SSelling a call places a ceiling on how much can be earned. (S ))


12 - 762

–– Selling a call places a ceiling on how much can be earned. (SSelling a call places a ceiling on how much can be earned. (S22))–– The net position is the bold blue line in Figure 12 The net position is the bold blue line in Figure 12 –– 9 and is 9 and is

called a collar because the put and call options provide a collar called a collar because the put and call options provide a collar for the price range.for the price range.

See Figure 12 See Figure 12 –– 9 for the payoff diagram from a Collar9 for the payoff diagram from a Collar

Synthetic PositionsSynthetic PositionsA CollarA Collar

12 - 9 FIGURE


12 - 763

F

Collar Payoff

S2S1

Synthetic PositionsSynthetic PositionsSummarySummary

•• The potential option strategies are limited only The potential option strategies are limited only by an investor’s imagination.by an investor’s imagination.

•• Corporate financial managers usually have risk Corporate financial managers usually have risk


12 - 764

•• Corporate financial managers usually have risk Corporate financial managers usually have risk management objectives that must be achieved, management objectives that must be achieved, and these drive the search for appropriate option and these drive the search for appropriate option strategies.strategies.

BlackBlack--Scholes Option Pricing ModelScholes Option Pricing Model

•• One of the most significant advances in finance One of the most significant advances in finance in the 20in the 20thth Century.Century.

•• Option pricing, once understood, has been Option pricing, once understood, has been applied to:applied to:


12 - 765

applied to:applied to:–– Equity valuationEquity valuation–– Security valuation involving options such as Security valuation involving options such as

convertible bonds and convertible preferred sharesconvertible bonds and convertible preferred shares–– Valuation of contingent liabilities Valuation of contingent liabilities

Option PricingOption PricingThe BlackThe Black--Scholes Option Pricing ModelScholes Option Pricing Model

•• Technically developed to price European call options on nonTechnically developed to price European call options on non--dividend paying stocks.dividend paying stocks.

•• Most of the input variables are readily observable:Most of the input variables are readily observable:SS = current asset price= current asset priceXX = strike price of the option= strike price of the optionr r = risk= risk--free ratefree rate


12 - 766

r r = risk= risk--free ratefree ratett = time to expiration of the option= time to expiration of the option

•• N[dN[d11]] and and N[dN[d22]] are cumulative standard normal density are cumulative standard normal density functions of variables functions of variables dd11 and and dd22 (it is assumed that the (it is assumed that the underlying asset followed a lognormal distribution)underlying asset followed a lognormal distribution)–– dd11 is the number of standard deviations that the call is expected is the number of standard deviations that the call is expected

to be in the money (expected moneyness)to be in the money (expected moneyness)–– N[dN[d11]] is the cumulative probability of being in the moneyis the cumulative probability of being in the money

Option PricingOption PricingThe BlackThe Black--Scholes Option Pricing ModelScholes Option Pricing Model

•• The plugThe plug--in Blackin Black--Scholes formula:Scholes formula:

•• Where:Where:

-][ C 21 ]N[dXedSN -rt=[12-10]


12 - 767

•• Where:Where:SS = current asset price= current asset priceXX = strike price= strike priceee--rtrt = present value formula for continuous compounding= present value formula for continuous compoundingXeXe--rtrt = is the present value of the strike price= is the present value of the strike pricer r = risk= risk--free ratefree ratett = time to expiration of the option= time to expiration of the optionN[dN[d11]] = cumulative normal density function for = cumulative normal density function for dd11N[dN[d22]] = cumulative normal density function for = cumulative normal density function for dd22

(N[d(N[d11]] =and =and N[dN[d22]] can be calculated using Excel or from standard statistical tables such can be calculated using Excel or from standard statistical tables such as Table 12 as Table 12 –– 4 on the following slide.)4 on the following slide.)

Option PricingOption PricingBlackBlack--Scholes Option Pricing ModelScholes Option Pricing Model

d N(d) d N(d) d N(d) d N(d) d N(d)-0.50 0.3085 -0.48 0.3156 -0.46 0.3228 20.44 0.3300 -0.42 0.3373

-0.40 0.3446 -0.38 0.3520 -0.36 0.3594 20.34 0.3669 -0.32 0.3745

-0.30 0.3821 -0.28 0.3897 -0.26 0.3974 20.24 0.4052 -0.22 0.4129

-0.20 0.4207 -0.18 0.4286 -0.16 0.4365 20.14 0.4443 -0.12 0.4523

-0.10 0.4602 -0.08 0.4681 -0.06 0.4761 20.04 0.4841 -0.02 0.4920

Table 12-4 The Cumulative Probabilities for a Stan dard Normal Distribution

Rather than using a

spreadsheet, you can also

use one of


-0.10 0.4602 -0.08 0.4681 -0.06 0.4761 20.04 0.4841 -0.02 0.4920

0.00 0.5000 0.02 0.5080 0.04 0.5160 0.06 0.5239 0.08 0.5319

0.10 0.5398 0.12 0.5478 0.14 0.5557 0.16 0.5636 0.18 0.5714

0.20 0.5793 0.22 0.5871 0.24 0.5948 0.26 0.6026 0.28 0.6103

0.30 0.6179 0.32 0.6255 0.34 0.6331 0.36 0.6406 0.38 0.6480

0.40 0.6556 0.42 0.6628 0.44 0.6700 0.46 0.6773 0.48 0.6844

..

2.00 0.9772 2.10 0.9821 2.20 0.9861 2.30 0.9893 2.40 0.9918

2.50 0.9938 2.60 0.9953 2.70 0.9965 2.80 0.9974 2.90 0.9981

3.00 0.9986 - - - - - - - -

use one of several

calculators available on the Internet, such as the

one found on the Montreal

Exchange website (MX).

The GreeksThe Greeks

•• The values that give the sensitivity of the option price to The values that give the sensitivity of the option price to changes in the underlying parameters:changes in the underlying parameters:–– Delta (Delta (δδ))–– Gamma (Gamma (γγ))–– Theta (Theta (θθ))–– Rho (Rho (ρρ))


12 - 769

–– Rho (Rho (ρρ))–– VegaVega

•• The Greek Coefficients allows the analyst to assess the The Greek Coefficients allows the analyst to assess the sensitivities of put and call options to the five variables at a sensitivities of put and call options to the five variables at a glance.glance.

•• The Montreal Exchange (MX) has an online The Montreal Exchange (MX) has an online pricing calculatorpricing calculatorthat will return the theoretical option price and Greek that will return the theoretical option price and Greek coefficients.coefficients.

The GreeksThe GreeksDelta (Delta (δδ))

•• Delta (Delta (δδ) is the change in option price for a given ) is the change in option price for a given change in the price of the underlying assetchange in the price of the underlying asset..–– As stock prices increase, the value of a call option As stock prices increase, the value of a call option

increases.increases.

δ


12 - 770

increases.increases.–– 0.42 delta indicates that the value of the call will rise 0.42 delta indicates that the value of the call will rise

by $0.42 for every $1.00 increase in the price of the by $0.42 for every $1.00 increase in the price of the underlying asset.underlying asset.

Gamma (Gamma (γγ) measures ) measures the the change in deltachange in deltawith with respect to a respect to a change in the value of change in the value of the underlying assetthe underlying asset..

–– Because the actual Because the actual call option value is call option value is a curivlinear a curivlinear

The GreeksThe GreeksGamma (Gamma (ƔƔ))

Option Value

Long Stock

12 - 3 FIGURE

ƔƔƔƔ


12 - 771

a curivlinear a curivlinear function of the function of the underlying asset underlying asset price, the price, the sensitivity of the sensitivity of the option value to a option value to a change in the change in the underlying asset underlying asset price depends on price depends on where the option is where the option is currently priced as currently priced as illustrated in Figure illustrated in Figure 12 12 –– 3:3:

∆∆∆∆PPPP

∆Option

$500

Asset Price

∆∆∆∆PPPP

∆Option

The GreeksThe GreeksTheta (Theta (θθ))

•• Theta (Theta (θθ) is the change in the call option value ) is the change in the call option value with respect to timewith respect to time..

•• The longer the time to expiry, the greater the The longer the time to expiry, the greater the option value.option value.

θθθθ


12 - 772

option value.option value.•• Time expires after the option is created, so the Time expires after the option is created, so the

value of Theta is negative.value of Theta is negative.–– This indicates that the value of option drops as time This indicates that the value of option drops as time

elapses.elapses.

The GreeksThe GreeksRho (Rho (ρρ))

•• Rho (Rho (ρρ) is the change in the option value with ) is the change in the option value with respect to a change in the interest raterespect to a change in the interest rate–– As interest rates rise, option prices increaseAs interest rates rise, option prices increase–– 0.091 Rho indicates that for every 1 percent increase 0.091 Rho indicates that for every 1 percent increase

in interest rate, the value of the call option will in interest rate, the value of the call option will

ρρρρ


12 - 773

in interest rate, the value of the call option will in interest rate, the value of the call option will increase by $0.091increase by $0.091

The GreeksThe GreeksVegaVega

•• Vega is not a Greek letter.Vega is not a Greek letter.•• Vega is the change in the option value with respect to a Vega is the change in the option value with respect to a

change in the volatility of the underlying assetchange in the volatility of the underlying asset..–– A more volatile asset, all other things being equal, will have a A more volatile asset, all other things being equal, will have a

higher call option value (because there is a greater probability, higher call option value (because there is a greater probability,


12 - 774

higher call option value (because there is a greater probability, higher call option value (because there is a greater probability, that over the remaining life of the option, the price of the that over the remaining life of the option, the price of the underlying asset may rise, leading to a higher call option value.)underlying asset may rise, leading to a higher call option value.)

–– A 0.138 Vega means that a 1% increase in the standard A 0.138 Vega means that a 1% increase in the standard deviation in the underlying asset’s volatility will increase the deviation in the underlying asset’s volatility will increase the option value by $0.138.option value by $0.138.

Options MarketsOptions Markets

•• Options are traded:Options are traded:–– OTC OTC –– mainly with major banks as the counter partymainly with major banks as the counter party–– On organized exchanges where the exchange is the counter party for On organized exchanges where the exchange is the counter party for

both option buyers and option writers.both option buyers and option writers.•• Organized exchanges with standardized options make it easier for option Organized exchanges with standardized options make it easier for option

buyers and writers to reverse their transactions and close out their positions.buyers and writers to reverse their transactions and close out their positions.


12 - 775

buyers and writers to reverse their transactions and close out their positions.buyers and writers to reverse their transactions and close out their positions.

•• In Canada trading is focused on the Montreal Exchange (MX)In Canada trading is focused on the Montreal Exchange (MX)–– MX quotes can be found daily in MX quotes can be found daily in The Globe and Mail Report on The Globe and Mail Report on

BusinessBusiness–– MX quotes on the companies that make up the S&P/TSX 60 Index and MX quotes on the companies that make up the S&P/TSX 60 Index and

the S&P/TSX MidCap Indexthe S&P/TSX MidCap Index–– Each option class has two market makers who stand ready to buy and Each option class has two market makers who stand ready to buy and

sell the options and create an orderly market.sell the options and create an orderly market.

(Sample RBC Options Quotes are found in Table 12 (Sample RBC Options Quotes are found in Table 12 –– 5)5)

Options MarketsOptions MarketsRBC Option Quotes on June 9, 2006 for Options Expiring January 2007.RBC Option Quotes on June 9, 2006 for Options Expiring January 2007.

January 07 Strike Bid Ask Last Volume Open

45 3.05 3.20 3.05 10 1043

45p 2.6 2.75 2.7 10 874

Table 12-5 RBC Option Quotes


• Quotes are per contract• A contract is 100 options• ‘p’ indicates a put option

• The range of option in a class often provides inves tors with information about the market’s consensus outlook fo r the

underlying stock.

47.75 1.9 2.00 2.05 24 735

50p 5.75 5.95 5.8 30 246

Option ClassMonth/year of expiryThe closing price on the previous day for the stock was $45.15. With a strike price of $45.00 the call option was ‘in-the-money’ and had an intrinsic value of

$0.14 ($45.15 - $45.00)

The spread between the bid and ask prices is the ma rket maker’s profit per option contract ($3.20 - $3.05).

If the investor bought the call the offered or ask price was $3.20.

If the investor sold, the price was $3.05.

The last trade for RBC calls with a $45 strike pric e in the previous trading day was $3.05.

The number of RBC $45 call option contracts traded in the last trading session.The total number of RBC $45 call contracts remainin g open is 1043.

Implied VolatilityImplied Volatility

•• An estimate of the price volatility of the underlying asset An estimate of the price volatility of the underlying asset based on observed option prices.based on observed option prices.

•• Since all of the data about an option is observable through Since all of the data about an option is observable through quotes except the volatility of the underlying stock, you can quotes except the volatility of the underlying stock, you can use the MX option calculator to determine the volatility that use the MX option calculator to determine the volatility that


12 - 777

use the MX option calculator to determine the volatility that use the MX option calculator to determine the volatility that creates those verifiable statistics.creates those verifiable statistics.–– Implied volatility is therefore, the standard deviation of the Implied volatility is therefore, the standard deviation of the

underlying stock returns that the market data infers.underlying stock returns that the market data infers.–– Implied volatility (standard deviation) in option prices provides Implied volatility (standard deviation) in option prices provides

very useful information about the state of equity markets.very useful information about the state of equity markets.

(See Figure 12 (See Figure 12 –– 11 for implied volatility of the S&P/TSX 60 Index over time)11 for implied volatility of the S&P/TSX 60 Index over time)

Option PricingOption PricingImplied Volatilities for the S&P/TSX 60 IndexImplied Volatilities for the S&P/TSX 60 Index

12 - 11 FIGURE

Note the implied volatility changes

over time where the option market

indicates the state of the equity markets.


the equity markets.


In this chapter you have learned:In this chapter you have learned:–– About the ideas of Fischer Black, Myron Scholes and Robert About the ideas of Fischer Black, Myron Scholes and Robert

MertonMerton–– NonNon--linear payoffs where either gains or losses were truncated linear payoffs where either gains or losses were truncated

or changed at some pointsor changed at some points


12 - 779

or changed at some pointsor changed at some points–– Payoffs from calls and puts are determined by the underlying Payoffs from calls and puts are determined by the underlying

asset’s price and volatility, the strike price and time to expiration asset’s price and volatility, the strike price and time to expiration of the option, and the conditions in the economy in terms of the of the option, and the conditions in the economy in terms of the riskrisk--free rate.free rate.

–– How options can be valued using the BlackHow options can be valued using the Black--Scholes option Scholes option pricing model.pricing model.

CHAPTER 13CHAPTER 13Capital Budgeting, Risk Capital Budgeting, Risk

Considerations and Other Considerations and Other Considerations and Other Considerations and Other Special IssuesSpecial Issues


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• The Nature of Capital Expenditure DecisionsThe Nature of Capital Expenditure Decisions•• The Appropriate Discount RateThe Appropriate Discount Rate•• Evaluation of Investment Alternatives using NPV, IRR, PI and Evaluation of Investment Alternatives using NPV, IRR, PI and

Payback ApproachesPayback Approaches

www.bookfiesta4u.com ContentsCHAPTER 13 – Capital Budgeting, Risk

Considerations and Other Special Issues

13 - 782

•• Evaluation of Investment Alternatives using NPV, IRR, PI and Evaluation of Investment Alternatives using NPV, IRR, PI and Payback ApproachesPayback Approaches

•• Capital RationingCapital Rationing•• Independent and Interdependent ProjectsIndependent and Interdependent Projects•• Comparing Mutually Exclusive Projects with Unequal LivesComparing Mutually Exclusive Projects with Unequal Lives•• International ConsiderationsInternational Considerations•• Summary and ConclusionsSummary and Conclusions



1.1. The similarities between corporate investment techniques and the The similarities between corporate investment techniques and the techniques used to value sharestechniques used to value shares

2.2. The basic capital budgeting processThe basic capital budgeting process3.3. The most important approaches used to determine the value of a The most important approaches used to determine the value of a



13 - 783

3.3. The most important approaches used to determine the value of a The most important approaches used to determine the value of a firm’s capital expenditures (capex)firm’s capital expenditures (capex)

4.4. The reasons that firms sometimes use techniques that may seem The reasons that firms sometimes use techniques that may seem inconsistent with value maximization.inconsistent with value maximization.


•• BottomBottom--up analysisup analysis•• Capital budgetingCapital budgeting•• Capital expendituresCapital expenditures•• Capital rationingCapital rationing•• Chain replication approachChain replication approach•• Contingent projectsContingent projects

•• Independent projectsIndependent projects•• Internal rate of return (IRR)Internal rate of return (IRR)•• Investment opportunity Investment opportunity

schedule (IOS)schedule (IOS)•• Mutually exclusive projectsMutually exclusive projects•• Net present value (NPV)Net present value (NPV)•• Payback periodPayback period



13 - 784

•• Contingent projectsContingent projects•• Crossover rateCrossover rate•• Discounted cash flow (DCF) Discounted cash flow (DCF)

methodologiesmethodologies•• Discounted payback periodDiscounted payback period•• Equivalent annual NPV Equivalent annual NPV

approachapproach•• Five ForcesFive Forces

•• Payback periodPayback period•• Profitability indexProfitability index•• Pure play approachPure play approach•• RiskRisk--adjusted discount rates adjusted discount rates

(RADRs)(RADRs)•• TopTop--down analysisdown analysis

Capital Expenditures (capex)Capital Expenditures (capex)

Capital expenditures are a firm’s investments in Capital expenditures are a firm’s investments in longlong--lived assets.lived assets.



13 - 785

LongLong--lived assets may be:lived assets may be:–– Tangible (property, plant and equipment)Tangible (property, plant and equipment)–– Intangible (research and development, patents, Intangible (research and development, patents,

copyrights, trademarks, brand names, and copyrights, trademarks, brand names, and franchise agreements)franchise agreements)

Capital ExpendituresCapital ExpendituresImportanceImportance

Capex decisions determine the future direction Capex decisions determine the future direction of the company.of the company.

•• CAPEX decisions are among the most important that CAPEX decisions are among the most important that the firm can make because:the firm can make because:



13 - 786

–– Often involve very significant outlay of money and Often involve very significant outlay of money and managerial timemanagerial time

–– Often take many years to demonstrate their returnsOften take many years to demonstrate their returns–– Are often irrevocableAre often irrevocable–– Because of their size and longBecause of their size and long--term nature, they can term nature, they can

significantly alter the risk of the entire firm.significantly alter the risk of the entire firm.

Capital Expenditure DecisionsCapital Expenditure DecisionsCapital BudgetingCapital Budgeting

Capital budgeting is the process through which Capital budgeting is the process through which a firm makes capital expenditure decisions by:a firm makes capital expenditure decisions by:

1.1. Identifying investment alternativesIdentifying investment alternatives2.2. Evaluating these alternativesEvaluating these alternatives



13 - 787

2.2. Evaluating these alternativesEvaluating these alternatives3.3. Implementing the chosen investment decisions, Implementing the chosen investment decisions,

andand4.4. Monitoring and evaluating the implemented Monitoring and evaluating the implemented

decisions.decisions.

Capital Expenditure DecisionsCapital Expenditure DecisionsFive ForcesFive Forces

Michael Porter’s Five Forces model identified five critical factors that Michael Porter’s Five Forces model identified five critical factors that determine the attractiveness of an industry:determine the attractiveness of an industry:

1.1. Entry barriersEntry barriers2.2. Threat of substitutesThreat of substitutes3.3. Bargaining power of buyersBargaining power of buyers4.4. Bargaining power of suppliersBargaining power of suppliers5.5. Rivalry among existing competitorsRivalry among existing competitors

Companies do exert control over how they strive to create a Companies do exert control over how they strive to create a



13 - 788

Companies do exert control over how they strive to create a Companies do exert control over how they strive to create a competitive advantage within their industry.competitive advantage within their industry.

They can strive for:They can strive for:1.1. Cost leadership: strive to be a lowCost leadership: strive to be a low--cost producercost producer2.2. Differentiation: offer “differentiated” productsDifferentiation: offer “differentiated” products

Once attained, competitive advantage is difficult to sustain, and this Once attained, competitive advantage is difficult to sustain, and this requires onrequires on--going planning and investment.going planning and investment.

CAPEX must be made with a strategic focus and be subject to and CAPEX must be made with a strategic focus and be subject to and pass rigorous financial analysis. pass rigorous financial analysis.

Capital Expenditure DecisionsCapital Expenditure DecisionsBottomBottom--up and Topup and Top--Down AnalysisDown Analysis

BottomBottom--up Analysis is an investment strategy in up Analysis is an investment strategy in which capex decisions are considered in which capex decisions are considered in isolation, without regard for whether the firm isolation, without regard for whether the firm should continue in this business or for general should continue in this business or for general industry and economic trends.industry and economic trends.



13 - 789

industry and economic trends.industry and economic trends.

TopTop--down Analysis is an investment strategy that down Analysis is an investment strategy that focuses on strategic decisions, such as which focuses on strategic decisions, such as which industries or products the firm should be industries or products the firm should be involved in, looking at the overall economic involved in, looking at the overall economic picture.picture.

Capital Expenditure DecisionsCapital Expenditure DecisionsDCF MethodolgiesDCF Methodolgies

Capex decisions, like security valuation, must take into Capex decisions, like security valuation, must take into account the account the timing, magnitude and riskinesstiming, magnitude and riskiness of the of the net net incremental, afterincremental, after--tax cash flow benefitstax cash flow benefits that an initial that an initial investment is forecast to produce.investment is forecast to produce.



13 - 790

Unlike security valuation decisions, analysts can change Unlike security valuation decisions, analysts can change the underlying cash flows by changing the structure of the underlying cash flows by changing the structure of the project.the project.

Capital Expenditure DecisionsCapital Expenditure DecisionsDCF MethodologiesDCF Methodologies

The ability to restructure capex proposals means that The ability to restructure capex proposals means that capex analysis can be iterative and circular as illustrated capex analysis can be iterative and circular as illustrated below:below:



13 - 791

Project Proposal Project Analysis

Forecast Outcome Positive (+ NPV)

Forecast Outcome Not Viable (- NPV)Restructure

Proposal

Proceed with Implementation

Planning

Capital Expenditure DecisionsCapital Expenditure DecisionsDCF MethodologiesDCF Methodologies

All discounted cash flow approaches require:All discounted cash flow approaches require:–– Estimate of the initial cost of the CAPEX Estimate of the initial cost of the CAPEX –– Estimate of the net incremental afterEstimate of the net incremental after--tax cash tax cash

flow benefits the investment is forecast to flow benefits the investment is forecast to



13 - 792

produce (we need to know when these cash flows produce (we need to know when these cash flows will occur and how large they will be)will occur and how large they will be)

–– Estimate of the required rate of return on the Estimate of the required rate of return on the project (relevant discount rate project (relevant discount rate kk))

Evaluating Investment AlternativesEvaluating Investment AlternativesThe Cash Flow Pattern for a Traditional Capital ExpenditureThe Cash Flow Pattern for a Traditional Capital Expenditure

0 1 2 3 … n0 1 2 3 … n

13-1 FIGURE



13 - 793

Where Where CFCFtt = estimated future after= estimated future after--tax incremental cash flow at tax incremental cash flow at time time tt

CFCF00 = the initial after= the initial after--tax incremental cash outlaytax incremental cash outlay

CF1 CF2 CF3 … CFn

CF0

CF1 CF2 CF3 … CFn

CF0

Firm’s Cost of Capital (WACC = Firm’s Cost of Capital (WACC = kk))

•• The firm’s cost of capital determines the minimum rate of return that The firm’s cost of capital determines the minimum rate of return that would be acceptable for a capital project. would be acceptable for a capital project.

•• WACC is the discount rate (k) we use in NPV analysis and the WACC is the discount rate (k) we use in NPV analysis and the hurdle rate when using IRRhurdle rate when using IRR



13 - 794

hurdle rate when using IRRhurdle rate when using IRR

•• The weighted average cost of capital (WACC) is the relevant The weighted average cost of capital (WACC) is the relevant discount rate for NPV analysis. (assuming the risk of the project discount rate for NPV analysis. (assuming the risk of the project being evaluated is similar to the risk of the overall firm)being evaluated is similar to the risk of the overall firm)

•• If the risk of the project differs from the risk of the overall firm a riskIf the risk of the project differs from the risk of the overall firm a risk--adjusted discount rate (RADR) should be used.adjusted discount rate (RADR) should be used.

RiskRisk--Adjusted Discount Rates (RADRs = Adjusted Discount Rates (RADRs = kk))

•• RADRs can be estimated using a number of alternative RADRs can be estimated using a number of alternative techniques:techniques:1.1. Use the CAPM formula after determining the project beta and using Use the CAPM formula after determining the project beta and using

the current riskthe current risk--free rate (RF) and an estimate of the market risk free rate (RF) and an estimate of the market risk premiumpremium



13 - 795

premiumpremium•• This approach involves forecast ROA that must be regressed against the This approach involves forecast ROA that must be regressed against the

ROA of the market index. Estimation errors can be significant.ROA of the market index. Estimation errors can be significant.

2.2. Pure play approach where you find the cost of capital of a firm in the Pure play approach where you find the cost of capital of a firm in the industry associated with the project. industry associated with the project. •• The key to this approach is that the firm must not be diversified across The key to this approach is that the firm must not be diversified across

industries but truly represent an investment solely in that industry.industries but truly represent an investment solely in that industry.

Evaluation of Investment AlternativesEvaluation of Investment AlternativesDCF MethodologiesDCF Methodologies

•• Net Present Value (NPV)Net Present Value (NPV)•• Internal Rate of Return (IRR)Internal Rate of Return (IRR)•• Payback Period and Discounted Payback PeriodPayback Period and Discounted Payback Period



13 - 796

•• Payback Period and Discounted Payback PeriodPayback Period and Discounted Payback Period•• Profitability Index (PI)Profitability Index (PI)

Project Evaluation TechniquesProject Evaluation TechniquesNet Present Value (NPV) FormulaNet Present Value (NPV) Formula

033

22

11 ...

)1()1()1(CF

k

CF

k

CF

k

CFNPV −+

++

++

+=



13 - 797

01

)1(

)1()1()1(

CFk

CF

kkk

t

n

it

−+

=

+++

∑=

[ 13-1]

Evaluating Investment AlternativesEvaluating Investment AlternativesNet Present Value (NPV) AnalysisNet Present Value (NPV) Analysis

NPV = the sum of the present value of all benefits minus the NPV = the sum of the present value of all benefits minus the present value of costspresent value of costs

1∑ −

+=

n

ii stInitial Co

k)(

BenefitsCash Flow NPV


Considerations and Other Special Issues13 - 798

If benefits > cost, NPV will be positive and the project is If benefits > cost, NPV will be positive and the project is acceptable.acceptable.

If benefits < cost, NPV will be negative and the project is If benefits < cost, NPV will be negative and the project is unacceptable because it destroys firm value.unacceptable because it destroys firm value.

11

∑=

−+

=i

istInitial Co

k)( NPV

Evaluating Investment AlternativesEvaluating Investment AlternativesNet Present Value InterpretedNet Present Value Interpreted

Example:Example:If NPV is forecast to be + $250,000, then the PV of incremental If NPV is forecast to be + $250,000, then the PV of incremental benefits exceeds the present value of costs today by $250,000. benefits exceeds the present value of costs today by $250,000. Remember the PV is determined by discounting the forecast cash Remember the PV is determined by discounting the forecast cash flows by the investor’s required return. A positive NPV indicates that flows by the investor’s required return. A positive NPV indicates that returns are greater than what investors require. This means a returns are greater than what investors require. This means a positive NPV adds value to the firm.positive NPV adds value to the firm.



positive NPV adds value to the firm.positive NPV adds value to the firm.

In this case, if there were 1,000,000 shares outstanding, acceptance In this case, if there were 1,000,000 shares outstanding, acceptance of a $250,000 NPV project in an efficient market means that the of a $250,000 NPV project in an efficient market means that the market price of each share should rise by:market price of each share should rise by:

25.0$000,000,1

000,250$

gOutstandin Shares ofNumber

NPV Price Sharein Increase

==

=

Evaluating Investment AlternativesEvaluating Investment AlternativesNet Present Value InterpretedNet Present Value Interpreted

NPV is an absolute measure (expressed in present NPV is an absolute measure (expressed in present dollars) of the net incremental benefits the project is dollars) of the net incremental benefits the project is forecast to bring to the shareholders.forecast to bring to the shareholders.

In a perfectly efficient market, the total value of the In a perfectly efficient market, the total value of the



In a perfectly efficient market, the total value of the In a perfectly efficient market, the total value of the firm should rise by the value of the NPV if the project firm should rise by the value of the NPV if the project is undertaken.is undertaken.

Remember Remember –– it is the manager’s responsibility to maximize it is the manager’s responsibility to maximize shareholder wealthshareholder wealth

NPV ExampleNPV ExampleThe FormulaThe Formula--based Approachbased Approach

Problem:Problem:•• Initial outlay = $12,000Initial outlay = $12,000•• AfterAfter--tax cash flow benefits:tax cash flow benefits:

–– Year 1 = $5,000Year 1 = $5,000–– Year 2 = $5,000Year 2 = $5,000 000,8$000,5$000,5$

)1()1()1(

033

22

11 −

++

++

+= CF

k

CF

k

CF

k

CFNPV



–– Year 2 = $5,000Year 2 = $5,000–– Year 3 = $8,000Year 3 = $8,000

•• Discount rate (k) = 15%Discount rate (k) = 15%

389,1$

000,12$260,6$781,3$348,4$

000,12$)15.1(

000,8$

)15.1(

000,5$

)15.1(

000,5$321

=−++=

−++=

NPV ExampleNPV ExampleThe Spreadsheet ApproachThe Spreadsheet Approach


–– Year 1 = $5,000Year 1 = $5,000–– Year 2 = $5,000Year 2 = $5,000 Initial cost = $12,000

Cost of Capital = 15.0%



13 - 802

–– Year 3 = $8,000Year 3 = $8,000•• Discount rate (k) = 15%Discount rate (k) = 15%


Year CashflowAfter-tax

incremental CF PV FactorPresent Value

0 Initial cost -$12,000 1 -$12,0001 ATCF operating benefit 5,000 0.869565 $4,3482 ATCF operating benefit 5,000 0.756144 $3,7813 ATCF operating benefit 8,000 0.657516 $5,260

NPV = $1,389

NPV ExampleNPV ExampleThe Financial Calculator ApproachThe Financial Calculator Approach





13 - 803

–– Year 3 = $8,000Year 3 = $8,000•• Discount rate (k) = 15%Discount rate (k) = 15%

NPV ExampleNPV ExampleSolution Using a Financial Calculator (TI BA II Plus)Solution Using a Financial Calculator (TI BA II Plus)

CF 2ND CLR WORK

-12000

5000

5000

8000

ENTER

ENTER

000,12$)15.1(

000,8$

)15.1(

000,5$

)15.1(

000,5$

321−++=NPV



13 - 804

8000

15

gives $1,388.67

ENTER

ENTER

ENTERNPV

CPT

389,1$

000,12$260,6$781,3$348,4$

=−++=

NPV ProfileNPV Profile

•• Is a set of NPVs for a project that are created by varying the Is a set of NPVs for a project that are created by varying the discount rate used to find the present value of the cash flows.discount rate used to find the present value of the cash flows.

•• The slope of the NPV line that is created when you graph The slope of the NPV line that is created when you graph these results, depends on the useful life of the project and on these results, depends on the useful life of the project and on



13 - 805

these results, depends on the useful life of the project and on these results, depends on the useful life of the project and on the timing of the receipt of the net incremental benefits.the timing of the receipt of the net incremental benefits.–– The longer the life of the project, the steeper the slope of the The longer the life of the project, the steeper the slope of the

NPV profile line because more distant cash flows are affected NPV profile line because more distant cash flows are affected more by the discounting process.more by the discounting process.

(The following slide demonstrates what an NPV Profile looks like)(The following slide demonstrates what an NPV Profile looks like)

NPV ProfileNPV Profile

NPV ($)



13 - 806

Discount Rate (k) (%)

NPV ExampleNPV ExampleA Spreadsheet Modeling ApproachA Spreadsheet Modeling Approach

Initial cost = $100,000AT cash flow benefits = $60,000Useful life(years) = 6

Here is a spreadsheet model used to calculate a $10 0,000 project that has a 6 year life, offers equal annual after-tax cash flow benefits over that life of $60,000 per annum when the relevant cost of capi tal

is 12%.

The NPV result is positive and the project is accep table because the project looks like it will increase the value of the firm with these assumptio ns.



13 - 807

Useful life(years) = 6Cost of Capital = 12%

Year Cashflow After-tax incremental CF PV Factor Present Value0 Initial cost -$100,000 1 -$100,0001 ATCF operating benefit 60,000 0.892857 $53,5712 ATCF operating benefit 60,000 0.797194 $47,8323 ATCF operating benefit 60,000 0.71178 $42,7074 ATCF operating benefit 60,000 0.635518 $38,1315 ATCF operating benefit 60,000 0.567427 $34,0466 ATCF operating benefit 60,000 0.506631 $30,398

NPV = $146,684

NPV ExampleNPV ExampleStress Testing the ProjectStress Testing the Project

Now, let us stress – test the model. We can start b y setting the discount rate to 0%. (ie. No time value to money)


Notice that at a 0% discount rate, all of the prese nt value factors become 1. And we work with absolute dollar values. NPV is forecast to be it’s greatest at a 0% discount

rate.



13 - 808

Cost of Capital = 0%

Year Cashflow After-tax incremental CF PV Factor Present Value0 Initial cost -$100,000 1 -$100,0001 ATCF operating benefit 60,000 1 $60,0002 ATCF operating benefit 60,000 1 $60,0003 ATCF operating benefit 60,000 1 $60,0004 ATCF operating benefit 60,000 1 $60,0005 ATCF operating benefit 60,000 1 $60,0006 ATCF operating benefit 60,000 1 $60,000

NPV = $260,000


Increasing the discount rate to 5%, we discount the more distant cash flows more heavily and the NPV of the project falls from $260, 000 to $204,542.




13 - 809



NPV = $204,542


Increasing the discount rate to 10%, the NPV of the project falls from $204,542 (at 5%) to $161,316.




13 - 810



NPV = $161,316


Increasing the discount rate to 20%, the NPV of the project falls to $99,531.




13 - 811



NPV = $99,531


Increasing the discount rate to 50%, the NPV of the project falls to $9,465. It is hard to imagine a project having risk that re quires a return of more than 50%. Even at a discount rate of 50%, the project has a p ositive NPV!




13 - 812



NPV = $9,465


Increasing the discount rate to 60%, the NPV of the project falls to -$5,960. At that discount rate, the project would decrease the value of the firm if accepted.


Somewhere between 50% and 60%, the NPV turned to $0 . Remember, the IRR of the project is that discount rate that causes the NPV t o be equal to $0.00



13 - 813



NPV = -$5,960



A discount rate of 55.8055% causes the NPV to be eq ual to $0. This is the project’s IRR.

Now we can graph the results of the stress test. NPV is on the vertical axis because it is the dependent variable and discount rate is on t he horizontal.



13 - 814



NPV = $0

Project NPV ProfileProject NPV Profile

NPV$

$260,000



13 - 815

Discount Rate (%)

IRR = 55.8%

0 0% 5% 10% 20% 40% 50% 60%


NPV$

$260,000

$146,684

IF the appropriate discount rate (k) is 12%, then the NPV is

forecast to be positive.



13 - 816

$146,684

Discount Rate (%)

IRR = 55.8%

0 0% 5% 10% 20% 40% 50% 60%


NPV$

$260,000

$146,684

Even if your estimate of the project’s required return (RADR) is wrong, the project’s NPV

remains positive over a wide range of values for k (from 0% to 55%)



13 - 817

$146,684

Discount Rate (%)

IRR = 55.8%

0 0% 5% 10% 20% 40% 50% 60%

NPV ProfilesNPV Profiles

•• The slope of the NPV profile depends on the The slope of the NPV profile depends on the timing and magnitude of cash flows.timing and magnitude of cash flows.

•• Projects with cash flows that occur late in the Projects with cash flows that occur late in the project’s life will have an NPV that is more project’s life will have an NPV that is more



13 - 818

project’s life will have an NPV that is more project’s life will have an NPV that is more sensitive to discount rate changes.sensitive to discount rate changes.

IRRIRR

•• The internal rate of return (IRR) is that discount rate that The internal rate of return (IRR) is that discount rate that causes the NPV of the project to equal zero.causes the NPV of the project to equal zero.

•• If IRR > WACC, then the project is acceptable because it will If IRR > WACC, then the project is acceptable because it will return a rate of return on invested capital that is likely to be return a rate of return on invested capital that is likely to be greater than the cost of funds used to invest in the project.greater than the cost of funds used to invest in the project.



13 - 819

greater than the cost of funds used to invest in the project.greater than the cost of funds used to invest in the project.

Project Evaluation TechniquesProject Evaluation TechniquesInternal Rate of Return (IRR)Internal Rate of Return (IRR)

033

22

11

)1(...

)1()1()1(

CF

CFIRR

CF

IRR

CF

IRR

CF

IRR

CF

n

t

nn =

++

++

++

+

∑[ 13-2]



13 - 820

01

)1(, CF

IRR

CFor

ti

t

=+

∑=

IRR ExampleIRR ExampleThis Example Will Be Used To Demonstrate Alternative Approaches to This Example Will Be Used To Demonstrate Alternative Approaches to

Solve for IRRSolve for IRR





13 - 821


•• Cost of Capital = 15%Cost of Capital = 15%

IRR ExampleIRR ExampleFormulaFormula--based Approach to the Solutionbased Approach to the Solution

)1(

000,8$

)1(

000,5$

)1(

000,5$000,12$

)1()1()1(

321

33

22

11

0

IRRIRRIRR

IRR

CF

IRR

CF

IRR

CFCF

++

++

+=

++

++

+=



13 - 822

equality.an becomes expression almathematic theuntil IRRfor

valuesdifferent substitute is,That IRR.for solving oapproach t iterative theuse tois formula theusecan you only way The



)1(

000,8$

)1(

000,5$

)1(

000,5$000,12$

)1()1()1(

321

33

22

11

0

++

++

+=

++

++

+=

IRRIRRIRR

IRR

CF

IRR

CF

IRR

CFCF



13 - 823

$12,000. equal they until flowscash future of PV

lower the toratediscount theincrease toneed then we$12,268.52$12,000 Since

52.268,12$)2.1(

000,8$

)2.1(

000,5$

)2.1(

000,5$000,12$

20% IRRLet

equality.an becomes expression almathematic theuntil IRRfor


321

<

=++=

=


296,11$)25.1(

000,8$

)25.1(

000,5$

)25.1(

000,5$000,12$

25% IRRLet

321=++=

=



13 - 824

IRR. theof valueeapproximat theESTIMATE ion tointerpolatlinear usecan you or IRR, thefind

yiterativel oequation t theinto valuesdifferent substitute tocontinuecan You

25%. and 20%between isIRR theknow then we$11,296$12,000 Since >

IRR ExampleIRR ExampleFormulaFormula--based Approach to the Solution based Approach to the Solution –– Linear InterpolationLinear Interpolation

Summarizing our results:Summarizing our results:Discount RateDiscount Rate Present Value of BenefitsPresent Value of Benefits

20%20% $12,268.52$12,268.52IRRIRR $12,000$12,000

25%25% $11,296$11,296

IRR is between 20% and

25%



We can now We can now estimateestimate the IRR assuming a linear relationship between PV of benefits (which isn’t the IRR assuming a linear relationship between PV of benefits (which isn’t exactly true because compound interest is a curvilinear relationship)exactly true because compound interest is a curvilinear relationship)

%38.21

3805.152.972

52.268520

50.268,12296,11

50.268,12000,12

2025

20

=

=−−×=−

−−=

−−

IRR

IRR

IRR

IRR ExampleIRR ExampleSolution Using a Financial Calculator (TI BA II Plus)Solution Using a Financial Calculator (TI BA II Plus)

CF 2ND CLR WORK

-12,000

5,000

5,000

8,000

ENTER

ENTER

theofcost initial hetax with t-after benefits flowcash

of PV theequates that ratediscount the

)1(

000,8$

)1(

000,5$

)1(

000,5$000,12$

321

==+

++

++

=

IRRk

kkk



13 - 826

8,000

gives 21.31%

ENTER

ENTER

IRR CPT

.acceptable isproject the(15%) WACC (21.3%) IRR Since

project.

theofcost initial hetax with t-after benefits flowcash

>

IRR ExampleIRR ExampleSpreadsheet ModelSpreadsheet Model--based Approach to the Solutionbased Approach to the Solution

A B C D E1 Time Type of Cash Flow ATCF2 0 Initial Project cost = -$12,0003 1 Incremental ATCF Benefit= $5,0004 2 Incremental ATCF Benefit= $5,0005 3 Incremental ATCF Benefit= $8,000



13 - 827

67 IRR = 21.31282726%

Simply place the cash flows into their own individu al cells on the spreadsheet, remembering that the cost of the proje ct is a negative

cash flow representing funds leaving the firm.

Next, insert the built-in IRR function ( fx) into a cell and provide the function values in the format of: =IRR(value 0, va lue 1, value 2,…,

guess)

=IRR(D2:D5,0.10)

IRR versus NPVIRR versus NPV

•• Both methods use the same basic decision Both methods use the same basic decision inputs.inputs.

•• The only difference is the assumed discount The only difference is the assumed discount



13 - 828

•• The only difference is the assumed discount The only difference is the assumed discount rate.rate.

•• The IRR assumes intermediate cashflows are The IRR assumes intermediate cashflows are reinvested at IRR…NPV assumes they are reinvested at IRR…NPV assumes they are reinvested at WACCreinvested at WACC–– This difference, however, can produce conflicting This difference, however, can produce conflicting

decision results under specific conditionsdecision results under specific conditions

Evaluating Investment AlternativesEvaluating Investment AlternativesComparing NPV and IRRComparing NPV and IRR

Issue NPV IRR1. Future cash flows

change signIt still works the same for both accept/reject and ranking decisions.

Multiple IRRs may result - in this case, the IRR cannot be used for either accept/reject or ranking decisions.

Table 13 - 1 NPV versus IRR



13 - 829

2. Ranking projects Higher NPV implies greater contribution to firm wealth - it is an absolute measure of wealth.

The higher IRR project may have a lower NPV, and vice versa, depending on the appropriate discount rate, and the size of the

3. Reinvestment rate assumed for future cash flows received

Assumes all future cash flows are reinvested at the discount rate. This is appropriate because it treats the reinvestment of all future cash flows consistently, and k is the investor's opportunity cost.

Assumes cash flows from each project are reinvested at that project's IRR. This is inappropriate, particularly when the IRR is high.

IRR versus NPVIRR versus NPVConditions Where NPV and IRR Will Give Conflicting Decision ResultsConditions Where NPV and IRR Will Give Conflicting Decision Results

1.1. Evaluating two or more mutually exclusive Evaluating two or more mutually exclusive investment proposalsinvestment proposals

2.2. NPV profiles of the projects have different NPV profiles of the projects have different



13 - 830

2.2. NPV profiles of the projects have different NPV profiles of the projects have different slopes and cross at a positive NPVslopes and cross at a positive NPV

3.3. The cost of capital (relevant discount rate The cost of capital (relevant discount rate kk) is ) is lower than the crossover discount rate.lower than the crossover discount rate.

Evaluating Investment AlternativesEvaluating Investment AlternativesTwo NPV ProfilesTwo NPV Profiles

13 - 2 FIGURE

NPV ($)

700

500



13 - 831

A

500

0


Crossover Rate = 9%

12 15

B

Evaluating Investment AlternativesEvaluating Investment AlternativesTwo NPV ProfilesTwo NPV Profiles

13 - 2 FIGURE

NPV ($)

700

500

If k is less than 9%, then project A will have a higher NPV

than B and A should be chosen to maximize the

IRRB>IRRAThe IRR approach would

lead us to believe the Project B is best!

However, NPV A is greater when k<9%



13 - 832

A

500

0


Crossover Rate = 9%

12 15

B

to maximize the value of the firm.

Evaluating Investment AlternativesEvaluating Investment AlternativesComparing NPV and IRRComparing NPV and IRR

•• Both techniques use the same inputsBoth techniques use the same inputs•• NPV measures in absolute terms, the estimated increase NPV measures in absolute terms, the estimated increase

in the value of the firm today the project is expected to in the value of the firm today the project is expected to produce.produce.–– NPV assumes cash flows are reinvested at WACCNPV assumes cash flows are reinvested at WACC



13 - 833

–– NPV assumes cash flows are reinvested at WACCNPV assumes cash flows are reinvested at WACC•• IRR estimates the rate of return on the projectIRR estimates the rate of return on the project

–– IRR assumes cash flows produced by the project are IRR assumes cash flows produced by the project are reinvested by the firm at the project’s IRR.reinvested by the firm at the project’s IRR.

The reason for the different accept/reject decisions is the The reason for the different accept/reject decisions is the different reinvestment rate assumptions used by the two different reinvestment rate assumptions used by the two

techniques.techniques.

Evaluating Investment AlternativesEvaluating Investment AlternativesNPV and IRR ComparedNPV and IRR Compared

Which method should be relied upon?Which method should be relied upon?–– It depends on which reinvestment assumption is It depends on which reinvestment assumption is

most realistic.most realistic.–– Most often, the NPV assumption of reinvestment at Most often, the NPV assumption of reinvestment at



13 - 834

–– Most often, the NPV assumption of reinvestment at Most often, the NPV assumption of reinvestment at WACC is the most realistic because no rational WACC is the most realistic because no rational manager would reinvest cash flows at rates lower manager would reinvest cash flows at rates lower than the firm’s cost of capital.than the firm’s cost of capital.

–– Projects with high IRRs are not common Projects with high IRRs are not common –– to to assume that future cash flows will be reinvested at assume that future cash flows will be reinvested at the inflated IRR rate is probably wrong.the inflated IRR rate is probably wrong.

Evaluation TechniquesEvaluation TechniquesCFO PreferencesCFO Preferences

Despite the inherent superiority of the NPV Despite the inherent superiority of the NPV approach, CFOs continue to use other approach, CFOs continue to use other approaches and do not favour NPV over IRR.approaches and do not favour NPV over IRR.



13 - 835

Perhaps, the reason for this is that it is difficult for Perhaps, the reason for this is that it is difficult for people to understand what a positive NPV really people to understand what a positive NPV really means.means.

(See Figure 13 (See Figure 13 –– 3 on the following slide.)3 on the following slide.)

CFO PreferencesCFO PreferencesEvaluation TechniqueEvaluation Technique

13 - 3 FIGURE

IRRNPV

Hurdle RatePayback

Evaluation Technique



13 - 836

0% 10% 20% 30% 40% 50% 60% 70% 80%

PaybackSensitivity

AnalysisP/E multiples

Discounted payback

Real optionsBook rate of return

Simulation analysis

Profitability Index

APVSource: Data from Graham, John R. and Harvey, Camp bell R. “The Theory and Practice of Corporate Fina nce: Evidence from the Field,” Journal of Financial Economics 60 (2001), p. 187-243.

Payback and Discounted PaybackPayback and Discounted Payback

Capital Budgeting, Risk Considerations Capital Budgeting, Risk Considerations and Other Special Issuesand Other Special Issues

Payback MethodPayback Method

•• This is a simple approach to capital budgeting that is designed to tell This is a simple approach to capital budgeting that is designed to tell you how many years it will take to recover the initial investment.you how many years it will take to recover the initial investment.

•• It is often used by financial managers as one of a set of investment It is often used by financial managers as one of a set of investment screens, because it gives the manager an intuitive sense of the screens, because it gives the manager an intuitive sense of the



13 - 838

project’s risk.project’s risk.

Simple Payback ExampleSimple Payback Example

Initial cost = $100,000AT cash flow benefits = $60,000Useful life(years) = 5Cost of Capital = N/A

Year CashflowAfter-tax incremental

Cash Flows PV FactorCumulative Cash Flows



13 - 839

Year Cashflow Cash Flows PV Factor Cash Flows0 Initial cost -$100,000 -$100,0001 ATCF operating benefit $60,000 -$40,0002 ATCF operating benefit $60,000 $20,0003 ATCF operating benefit $60,000 4 ATCF operating benefit $60,000 5 ATCF operating benefit $60,000 6 ATCF operating benefit $60,000

Payback period = 1.7 years

Discounted Payback ExampleDiscounted Payback Example

Initial cost = $100,000AT cash flow benefits = $60,000Useful life(years) = 5Cost of Capital = 10.0%

After-tax incremental Present Value of Cumulative



13 - 840

Year CashflowAfter-tax incremental

Cash Flows PV FactorValue of

ATCFsCumulative Cash Flows

0 Initial cost -$100,000 1 -$100,000 -$100,0001 ATCF operating benefit $60,000 0.90909091 $54,545 -$45,4552 ATCF operating benefit $60,000 0.82644628 $49,587 $4,1323 ATCF operating benefit $60,000 0.7513148 $45,079 $49,2114 ATCF operating benefit $60,000 0.68301346 $40,981 $90,1925 ATCF operating benefit $60,000 0.62092132 $37,255 $127,4476 ATCF operating benefit $60,000 0.56447393 $33,868 $161,316

Payback period = 1.9 years

Discounted Payback GraphedDiscounted Payback Graphed

NPV$ Discounted Payback

Point



13 - 841

Years

Point

Discounted PaybackDiscounted Payback

•• Overcomes the lack of consideration of the time Overcomes the lack of consideration of the time value of money…value of money…

•• Graphing the cumulative PV of cash flows can Graphing the cumulative PV of cash flows can



13 - 842

•• Graphing the cumulative PV of cash flows can Graphing the cumulative PV of cash flows can help us see the pattern of cash flows beyond the help us see the pattern of cash flows beyond the payback point.payback point.

•• If carried to the end of the project’s useful If carried to the end of the project’s useful life…will tell us the project’s NPV (if you are life…will tell us the project’s NPV (if you are using the firm’s WACC)using the firm’s WACC)

Profitability IndexProfitability Index

•• Uses exactly the same decision inputs as NPV Uses exactly the same decision inputs as NPV •• simply expresses the relative profitability of the projects incremental simply expresses the relative profitability of the projects incremental

afterafter--tax cashflow benefits as a ratio to the project’s initial cost.tax cashflow benefits as a ratio to the project’s initial cost.

PI = PI = PV of incremental ATCF benefitsPV of incremental ATCF benefits



13 - 843

PV of initial cost of projectPV of initial cost of project

If PI>1, then we accept; because the PV of benefits exceeds the PV of costs.If PI>1, then we accept; because the PV of benefits exceeds the PV of costs.

Project Evaluation TechniquesProject Evaluation TechniquesProfitability Index (PI)Profitability Index (PI)

outflows)(cash PV

inflows)PV(cash =PI[ 13-3]



13 - 844

•• PI is a ratio of the present value of benefits to costs.PI is a ratio of the present value of benefits to costs.•• As a pure coefficient, as long as it exceeds 1.00 the project As a pure coefficient, as long as it exceeds 1.00 the project

will increase the value of the firm if accepted.will increase the value of the firm if accepted.•• A PI of more than 1.0 indicates that the project is expected to A PI of more than 1.0 indicates that the project is expected to

earn a return greater than the required return.earn a return greater than the required return.

Independent and Interdependent ProjectsIndependent and Interdependent Projects

Independent ProjectsIndependent Projects–– Are projects that have no relationship with one anotherAre projects that have no relationship with one another–– Accepting one project has no impact on the decision to Accepting one project has no impact on the decision to

accept another projectaccept another projectContingent ProjectsContingent Projects



13 - 845

–– Are projects for which the acceptance of one requires the Are projects for which the acceptance of one requires the acceptance of another, either beforeacceptance of another, either before--hand or hand or simultaneously.simultaneously.

Mutually Exclusive ProjectsMutually Exclusive Projects–– Are projects that are substitutes of one anotherAre projects that are substitutes of one another–– Acceptance of one automatically means the other is Acceptance of one automatically means the other is

rejected.rejected.

Evaluating Mutually Exclusive Projects Evaluating Mutually Exclusive Projects with Unequal Liveswith Unequal Lives

There are two approaches to adjust for unequal lives There are two approaches to adjust for unequal lives among mutually exclusive projects:among mutually exclusive projects:1.1. Chain replication approachChain replication approach

•• A way to compare projects with unequal lives by finding a A way to compare projects with unequal lives by finding a time horizon into which all the project lives under time horizon into which all the project lives under



13 - 846

time horizon into which all the project lives under time horizon into which all the project lives under consideration divide equally, and then assuming each consideration divide equally, and then assuming each project repeats until it reaches this horizon.project repeats until it reaches this horizon.

2.2. Equivalent Annual NPV (EANPV) approachEquivalent Annual NPV (EANPV) approach•• A way to compare projects by finding the NPV of the A way to compare projects by finding the NPV of the

individual projects, and then determining the amount of an individual projects, and then determining the amount of an annual annuity that is economically equivalent to the NPV annual annuity that is economically equivalent to the NPV generated by each project over its respective time horizon.generated by each project over its respective time horizon.

Evaluating Mutually Exclusive Projects with Evaluating Mutually Exclusive Projects with Unequal LivesUnequal Lives

The Chain Replication ApproachThe Chain Replication Approach

Consider two mutually exclusive projects A and B.Consider two mutually exclusive projects A and B.–– Useful life of A is 2 years.Useful life of A is 2 years.–– Useful Life of B is 3 years.Useful Life of B is 3 years.

O 1 2

AO 1 2



13 - 847

O 1 2

O 1 2

O 1 2 3

BO 1 2 3

You can now calculate NPV for both alternatives ass uming replication over a six year time horizon.

Project Evaluation TechniquesProject Evaluation TechniquesEquivalent Annual NPV (EANPV) ApproachEquivalent Annual NPV (EANPV) Approach

1

-1

NPVProject

=PANPV[ 13-4]



13 - 848

k)(11

-1 n

+k

Capital RationingCapital Rationing

•• The corporate practice of limiting the amount of The corporate practice of limiting the amount of funds dedicated to capital investments in any funds dedicated to capital investments in any one year.one year.

•• Is academically illogical.Is academically illogical.



13 - 849

•• Is academically illogical.Is academically illogical.–– Why would a manager not invest in a project that will Why would a manager not invest in a project that will

offer a greater return than the cost of capital used to offer a greater return than the cost of capital used to finance it?finance it?

•• In the longIn the long--run could threaten a firm’s continuing run could threaten a firm’s continuing existence through erosion of its competitive existence through erosion of its competitive position.position.

Capital RationingCapital RationingPractical Reasons for This PracticePractical Reasons for This Practice

•• The firm may have owners who do not want to The firm may have owners who do not want to raise additional external equity because it will raise additional external equity because it will mean ownership dilution to themmean ownership dilution to them



13 - 850

mean ownership dilution to themmean ownership dilution to them•• The firm may have so many great investment The firm may have so many great investment

projects that they exceed the firm’s shortprojects that they exceed the firm’s short--term term managerial capacity to take advantage of them.managerial capacity to take advantage of them.

Capital RationingCapital RationingRanking ProjectsRanking Projects

•• Under capital rationing, the cost of capital is no longer Under capital rationing, the cost of capital is no longer the appropriate opportunity costthe appropriate opportunity cost

•• IRR may have more validity because the firm may be IRR may have more validity because the firm may be able to reinvest its cash flows at rates that are higher able to reinvest its cash flows at rates that are higher



13 - 851

able to reinvest its cash flows at rates that are higher able to reinvest its cash flows at rates that are higher than the cost of capital.than the cost of capital.

•• The PI may be a useful starting point because it ranks The PI may be a useful starting point because it ranks projects on PV per unit of investment.projects on PV per unit of investment.

•• In the absence of capital rationing, NPV, IRR and PI will In the absence of capital rationing, NPV, IRR and PI will select valueselect value--maximizing projects. maximizing projects.

See Figure 13 See Figure 13 –– 4 on the following slide for Rothman’s unconstrained 4 on the following slide for Rothman’s unconstrained Investment opportunity schedule.Investment opportunity schedule.

Optimal InvestmentOptimal InvestmentRothman’s Inc.’s Investment and Internal Fund Availability, 2006Rothman’s Inc.’s Investment and Internal Fund Availability, 2006

13 - 4 FIGURE

Rate of Return

OPTIMAL INVESTMENT

IOS



13 - 852

$11,976 Million

WACC

Internal Funds Available

$177,607 Million

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)

•• An Investment opportunity schedule is the prioritized list of An Investment opportunity schedule is the prioritized list of capital projects, ranked from highest to lowest.capital projects, ranked from highest to lowest.

•• At the same time, the cumulative investment required is listed.At the same time, the cumulative investment required is listed.Example:Example:



13 - 853

Consider a firm that has six different capital investment proposals this Consider a firm that has six different capital investment proposals this year. Each project has it’s own IRR, NPV, PI and capital cost. year. Each project has it’s own IRR, NPV, PI and capital cost.

(See the next slide)(See the next slide)

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)

Example:Example:Consider a firm that has six different capital investment proposals this year. Consider a firm that has six different capital investment proposals this year. Each project has it’s own IRR, NPV, PI and capital cost. Each project has the Each project has it’s own IRR, NPV, PI and capital cost. Each project has the same risk as the firm as a whole.same risk as the firm as a whole.

Firm's Cost of Capital = 10.00%



13 - 854

Capital Project Initial Cost

Annual ATCF

BenefitsUseful

Life NPV IRR PIA $1,500,000 $290,000 7 -$88,159 8.19% 0.94B $3,000,000 $700,000 6 $48,682 10.55% 1.02C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13D $70,000 $20,000 7 $27,368 21.08% 1.39E $1,000,000 $290,000 5 $99,328 13.82% 1.10F $960,000 $200,000 8 $106,985 12.99% 1.11

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)Projects Ranked by NPVProjects Ranked by NPV

Example:Example:In the absence of capital rationing the projects as ranked by NPV would be:In the absence of capital rationing the projects as ranked by NPV would be:


Capital Annual ATCF Useful



13 - 855

Project A would be unacceptable because of a forecast negative NPVProject A would be unacceptable because of a forecast negative NPV


ATCF Benefits

Useful Life NPV IRR PI

C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13F $960,000 $200,000 8 $106,985 12.99% 1.11E $1,000,000 $290,000 5 $99,328 13.82% 1.10B $3,000,000 $700,000 6 $48,682 10.55% 1.02D $70,000 $20,000 7 $27,368 21.08% 1.39

$9,030,000 $811,835A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)Projects Ranked by IRRProjects Ranked by IRR

Example:Example:In the absence of capital rationing the projects as ranked by IRR would be:In the absence of capital rationing the projects as ranked by IRR would be:


Capital Annual ATCF Useful



13 - 856

Project A would be unacceptable because forecast IRR < WACC.Project A would be unacceptable because forecast IRR < WACC.


ATCF Benefits


D $70,000 $20,000 7 $27,368 21.08% 1.39C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13E $1,000,000 $290,000 5 $99,328 13.82% 1.10F $960,000 $200,000 8 $106,985 12.99% 1.11B $3,000,000 $700,000 6 $48,682 10.55% 1.02

$9,030,000 $811,835

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)Projects Ranked by PIProjects Ranked by PI

Example:Example:In the absence of capital rationing the projects as ranked by PI would be:In the absence of capital rationing the projects as ranked by PI would be:



Annual ATCF

BenefitsUseful

Life NPV IRR PI



13 - 857

Project proposal A would be unacceptable because the forecast PI is less than 1.0.Project proposal A would be unacceptable because the forecast PI is less than 1.0.

Project Initial Cost Benefits Life NPV IRR PID $70,000 $20,000 7 $27,368 21.08% 1.39C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13F $960,000 $200,000 8 $106,985 12.99% 1.11E $1,000,000 $290,000 5 $99,328 13.82% 1.10B $3,000,000 $700,000 6 $48,682 10.55% 1.02

$9,030,000 $811,835

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Ranking of ProjectsRanking of ProjectsIn the Absence of Capital RationingIn the Absence of Capital Rationing

ProjectProject NPVNPV IRRIRR PIPI11 CC DD DD22 FF CC CC33 EE EE FF44 BB FF EE



13 - 858

44 BB FF EE55 DD BB BB

Capital BudgetCapital Budget $9,369,000$9,369,000 $9,369,000$9,369,000 $9,369,000$9,369,000Total NPVTotal NPV $679,803$679,803 $679,803$679,803 $679,803$679,803

Clearly, in the absence of capital rationing, all three methods choose value maximizing Clearly, in the absence of capital rationing, all three methods choose value maximizing projects and reject valueprojects and reject value--destroying projects.destroying projects.

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)Projects Selected by NPV under Capital Rationing Limit of $6 million Projects Selected by NPV under Capital Rationing Limit of $6 million

Example:Example:Under capital rationing the projects selected by NPV would be:Under capital rationing the projects selected by NPV would be:


Annual



13 - 859


ATCF Benefits


C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13F $960,000 $200,000 8 $106,985 12.99% 1.11E $1,000,000 $290,000 5 $99,328 13.82% 1.10

$5,960,000 $735,785B $3,000,000 $700,000 6 $48,682 10.55% 1.02D $70,000 $20,000 7 $27,368 21.08% 1.39

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)Projects Selected by IRR under Capital Rationing Limit of $6 millionProjects Selected by IRR under Capital Rationing Limit of $6 million

Example:Example:Under capital rationing the projects selected by IRR would be:Under capital rationing the projects selected by IRR would be:


Annual



13 - 860


ATCF Benefits


D $70,000 $20,000 7 $27,368 21.08% 1.39C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13E $1,000,000 $290,000 5 $99,328 13.82% 1.10

$5,070,000 $656,168F $960,000 $200,000 8 $106,985 12.99% 1.11B $3,000,000 $700,000 6 $48,682 10.55% 1.02

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)Projects Selected by PI under Capital Rationing Limit of $6 millionProjects Selected by PI under Capital Rationing Limit of $6 million

Example:Example:Under capital rationing the projects selected by PI would be:Under capital rationing the projects selected by PI would be:


Annual



13 - 861


ATCF Benefits


D $70,000 $20,000 7 $27,368 21.08% 1.39C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13

$4,070,000 $556,840F $960,000 $200,000 8 $106,985 12.99% 1.11E $1,000,000 $290,000 5 $99,328 13.82% 1.10B $3,000,000 $700,000 6 $48,682 10.55% 1.02

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Ranking of ProjectsRanking of ProjectsAssuming a Limit on Capital Expenditures to $6,000,000Assuming a Limit on Capital Expenditures to $6,000,000

ProjectProject NPVNPV IRRIRR PIPI11 CC DD DD22 FF CC CC33 EE EE



13 - 862

33 EE EE

Capital BudgetCapital Budget $5,960,000$5,960,000 $5,070,000$5,070,000 $4,070,000$4,070,000Total NPVTotal NPV $735,785$735,785 $656,168$656,168 $556,840$556,840

Capital rationing is an artificial limit on capex.Capital rationing is an artificial limit on capex.Only NPV ranking will ensure maximization of shareholder wealth Only NPV ranking will ensure maximization of shareholder wealth

under these constrained conditions.under these constrained conditions.

International ConsiderationsInternational Considerations

•• Capex decisions involving direct foreign Capex decisions involving direct foreign investment must take into account additional investment must take into account additional factors:factors:–– Political riskPolitical risk



13 - 863

–– Potential legal and regulatory issuesPotential legal and regulatory issues–– Adjust for foreign exchange riskAdjust for foreign exchange risk–– Adjust for foreign taxationAdjust for foreign taxation–– How can the project be financed if local capital How can the project be financed if local capital

markets are poorly developed?markets are poorly developed?

International InvestmentInternational Investment

•• Export Development Canada (EDC) is a federal crown Export Development Canada (EDC) is a federal crown corporation that helps Canadian firms export and make corporation that helps Canadian firms export and make foreign direct investment decisions (FDI)foreign direct investment decisions (FDI)

•• EDC provides insurance products to help mitigate some EDC provides insurance products to help mitigate some



13 - 864

•• EDC provides insurance products to help mitigate some EDC provides insurance products to help mitigate some of the risks of FDIof the risks of FDI

•• FDI outside Canada is a growing phenomenon in FDI outside Canada is a growing phenomenon in Canada as Canadian companies increasingly are Canada as Canadian companies increasingly are seeking international investment opportunities.seeking international investment opportunities.

•• EDC is encouraging Canadian companies to look EDC is encouraging Canadian companies to look beyond the U.S. as FDI targets.beyond the U.S. as FDI targets.


In this chapter you have learned:In this chapter you have learned:–– How capital decisions are made in companiesHow capital decisions are made in companies–– About capital expenditure evaluation tools including About capital expenditure evaluation tools including

NPV, IRR, profitability index, payback period and NPV, IRR, profitability index, payback period and



13 - 865

NPV, IRR, profitability index, payback period and NPV, IRR, profitability index, payback period and discounted payback perioddiscounted payback period

–– Why NPV is the preferred evaluation approachWhy NPV is the preferred evaluation approach–– How to adjust analysis for conditions of capital How to adjust analysis for conditions of capital

rationing, risk differences across corporate divisions, rationing, risk differences across corporate divisions, and effects of foreign direct investment.and effects of foreign direct investment.

CHAPTER 14CHAPTER 14Cash Flow Estimation and Cash Flow Estimation and Cash Flow Estimation and Cash Flow Estimation and

Capital Budgeting DecisionsCapital Budgeting Decisions


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• General Guidelines for Capital Project AnalysisGeneral Guidelines for Capital Project Analysis•• Estimating and Discounting Cash FlowsEstimating and Discounting Cash Flows

www.bookfiesta4u.com ContentsCHAPTER 14 – Cash Flow Estimation and Capital

Budgeting Decisions

14 - 868

•• Estimating and Discounting Cash FlowsEstimating and Discounting Cash Flows•• Sensitivity to InputsSensitivity to Inputs•• Replacement DecisionsReplacement Decisions•• Inflation and Capital Budgeting DecisionsInflation and Capital Budgeting Decisions•• Summary and ConclusionsSummary and Conclusions


1.1. How to estimate the future cash flows associated with How to estimate the future cash flows associated with potential investmentspotential investments

2.2. How to determine whether these investments are the How to determine whether these investments are the result of expansion or replacement decisionsresult of expansion or replacement decisions


Budgeting Decisions

14 - 869

result of expansion or replacement decisionsresult of expansion or replacement decisions3.3. How to conduct a sensitivity analysis to see how the How to conduct a sensitivity analysis to see how the

value changes as key inputs varyvalue changes as key inputs vary4.4. Why real option valuation techniques have become an Why real option valuation techniques have become an

important trend in project evaluationimportant trend in project evaluation5.5. How mistakes can easily be made in dealing with How mistakes can easily be made in dealing with

inflationinflation


•• Capital cost (CCapital cost (C00))•• Decision treeDecision tree•• Ending (or terminal) afterEnding (or terminal) after--

tax cash flow (ECFtax cash flow (ECFnn))•• Expansion projectsExpansion projects•• Expected annual afterExpected annual after--tax tax

•• NPV breakNPV break--even pointeven point•• Opportunity costsOpportunity costs•• Real option valuation (ROV)Real option valuation (ROV)•• Replacement projectsReplacement projects•• Salvage value (SVSalvage value (SVnn))•• Scenario analysisScenario analysis


Budgeting Decisions

14 - 870

•• Expected annual afterExpected annual after--tax tax cash flows (CFcash flows (CFtt))

•• ExternalitiesExternalities•• Initial afterInitial after--tax cash flow tax cash flow

(CF(CF00))•• Marginal or incremental Marginal or incremental

cash flowscash flows

•• Scenario analysisScenario analysis•• Sensitivity analysisSensitivity analysis•• Sunk costsSunk costs

Cash Flows and Capital BudgetingCash Flows and Capital BudgetingIntroductionIntroduction

•• Decisions are only as good as the information Decisions are only as good as the information used to make them.used to make them.

•• This chapter focuses on approaches used to This chapter focuses on approaches used to


Budgeting Decisions

14 - 871

•• This chapter focuses on approaches used to This chapter focuses on approaches used to estimate future cash flows associated with estimate future cash flows associated with capital project proposals capital project proposals

Project Evaluation TechniquesProject Evaluation TechniquesRequired Information and EstimatesRequired Information and Estimates

•• All evaluation approaches (NPV, IRR, Discounted Payback, All evaluation approaches (NPV, IRR, Discounted Payback, and PI) require the same data:and PI) require the same data:–– Estimate of initial cost (Estimate of initial cost (CFCF00))–– Net incremental afterNet incremental after--tax cash flows tax cash flows CFBT(1CFBT(1--T)T)–– Cost of Capital Cost of Capital (k)(k)


Budgeting Decisions

14 - 872

–– Estimate of useful life Estimate of useful life (n)(n)–– Ending Cash flows Ending Cash flows (ECF(ECFnn))–– Corporate tax rateCorporate tax rate (T)(T)–– Capital Cost Allowance Rate Capital Cost Allowance Rate (d)(d)

•• This chapter provides you with guidelines for identifying This chapter provides you with guidelines for identifying relevant information and testing the decision’s sensitivities to relevant information and testing the decision’s sensitivities to variations in those input variables.variations in those input variables.

Cash Flows EstimationCash Flows EstimationGeneral GuidelinesGeneral Guidelines

•• Cash flows should be:Cash flows should be:1.1. AfterAfter--taxtax2.2. Incremental or marginalIncremental or marginal3.3. Do not include interest or dividendsDo not include interest or dividends4.4. Adjust initial cash outlay and terminal cash flows for additional working Adjust initial cash outlay and terminal cash flows for additional working

capital requirementscapital requirements5.5. Treat sunk costs as irrelevantTreat sunk costs as irrelevant


Budgeting Decisions

14 - 873

5.5. Treat sunk costs as irrelevantTreat sunk costs as irrelevant6.6. Opportunity costs should be factored into the cash flow estimatesOpportunity costs should be factored into the cash flow estimates

•• Determine the appropriate time horizon for the projectDetermine the appropriate time horizon for the project•• Ignore intangible considerationsIgnore intangible considerations•• Ignore externalitiesIgnore externalities•• Consider the effect of all project interdependencies on cash flow Consider the effect of all project interdependencies on cash flow

estimates.estimates.•• Treat inflation consistentlyTreat inflation consistently•• Undertake all social investments required by law.Undertake all social investments required by law.

The Capital Budgeting Cash FlowsThe Capital Budgeting Cash FlowsThe Basic Cash Flow PatternThe Basic Cash Flow Pattern

•• The following slide graphically illustrates the The following slide graphically illustrates the basic cash flow patterns involved in a capital basic cash flow patterns involved in a capital project:project:–– There is an initial investment at t = 0 There is an initial investment at t = 0 (CF(CF00 ))–– There follows an annual stream of afterThere follows an annual stream of after--tax cash flow benefits tax cash flow benefits


Budgeting Decisions

14 - 874

–– There follows an annual stream of afterThere follows an annual stream of after--tax cash flow benefits tax cash flow benefits (CF (CF t t ))

–– At the end of the useful life, ending cash flow benefits after tax At the end of the useful life, ending cash flow benefits after tax are received are received (ECF(ECF nn ))

)()( 0 CFECFPVCFsAnnualPVNPV n −+=[ 14-5]

The Capital Budgeting Cash FlowsThe Capital Budgeting Cash FlowsThe Basic Cash Flow PatternThe Basic Cash Flow Pattern

Initial After-Tax Cash Flow

(CF0)

t=1 2 3 n-1 n

If CF 0 < PV of CF t , then benefits exceeds

costs, the NPV is positive.

ACCEPT the Project


Budgeting Decisions

14 - 875

Expected Annual After-Tax Operating Cash Flows ( CF tt)

t=1 2 3 n-1 n

CF1 CF2 CF3 CFN-1 CFN

Terminal Cash Flow ( ECFn)

∑= +

=n

tt

tt k

CFCFofPV

1 )1(

The Capital Budgeting Cash FlowsThe Capital Budgeting Cash FlowsDeconstructing the Basic Cash Flow PatternDeconstructing the Basic Cash Flow Pattern

•• The basic cash flow pattern can be The basic cash flow pattern can be deconstructed into:deconstructed into:–– Initial investment Initial investment (CF(CF00 ) ) –– Annual stream of afterAnnual stream of after--tax cash flows throughout the tax cash flows throughout the


Budgeting Decisions

14 - 876

–– Annual stream of afterAnnual stream of after--tax cash flows throughout the tax cash flows throughout the project life (project life (CF CF t t ) )

–– Ending cash flows Ending cash flows (ECF(ECF nn ) )


CF CF 00There is an initial investment at t = 0 There is an initial investment at t = 0 (CF(CF00 ) ) consists of:consists of:

•• CC 00 the initial capital cost of the assetthe initial capital cost of the asset•• ΔΔNWCNWC00 the change in net working capitalthe change in net working capital


Budgeting Decisions

14 - 877

•• ΔΔNWCNWC00 the change in net working capitalthe change in net working capital•• OC the opportunity costs associated with the projectOC the opportunity costs associated with the project

000 OCNWCCCF +∆+=[ 14-1]


CFCFtt

There follows an annual stream of after tax cash flow There follows an annual stream of after tax cash flow benefits (benefits (CF CF t t ) consisting of:) consisting of:


Budgeting Decisions

14 - 878

•• Operating afterOperating after--tax cash flow benefits (OCF tax cash flow benefits (OCF t t ) = CFBT) = CFBTtt (1 (1 –– T)T)•• Tax shield benefits from CCATax shield benefits from CCA

)()1( TCCAtCFBTCF ttt ++=[ 14-2]


ECFECFnn

At the end of the useful life, ending cash flow benefits At the end of the useful life, ending cash flow benefits received received (ECF(ECF nn ) in the absence of tax issues include) in the absence of tax issues include::

•• SV SV nn the estimated salvage value in year n for the asset the estimated salvage value in year n for the asset purchasedpurchased


Budgeting Decisions

14 - 879

purchasedpurchased•• ∆∆NWC NWC nn the net working capital investment released at the the net working capital investment released at the

end of the projectend of the project

NWCSVECF nnn ∆+=[ 14-4]


ECFECFnn

If there are If there are tax issuestax issues the the ECFECF nn consists of:consists of:•• SV SV nn the estimated salvage value in year n for the asset the estimated salvage value in year n for the asset

purchasedpurchased•• ∆∆NWC NWC nn the net working capital investment released at the the net working capital investment released at the

end of the projectend of the project


Budgeting Decisions

14 - 880

end of the projectend of the project•• Less any taxes payable on the salvage value (capital gains, Less any taxes payable on the salvage value (capital gains,

recapture of depreciation)recapture of depreciation)

])-

T]50.0)C-[(ns)ImplicatioTax With ( 0

TUCC[(SV

SVNWCSVECF

nn

nnnn

×−××−∆+=[ 14-3]


Putting It All TogetherPutting It All Together•• Once you have estimated the cash flows you Once you have estimated the cash flows you

must:must:–– Determine their afterDetermine their after--tax valuestax values


Budgeting Decisions

14 - 881

–– Determine their afterDetermine their after--tax valuestax values–– Discount them back to the presentDiscount them back to the present–– Sum them in determining the NPVSum them in determining the NPV

(The following slide graphically illustrates the deconstructed cash flow pattern (The following slide graphically illustrates the deconstructed cash flow pattern involved in a capital project)involved in a capital project)

The Capital Budgeting Cash FlowsThe Capital Budgeting Cash FlowsDeconstructing the Cash FlowsDeconstructing the Cash Flows

Initial After-Tax Cash Flow

(CF0)

t=1 2 3 n-1 n

CF0 = C0 +ΔΔΔΔ NWC0 + OCBecause the CCA tax shield benefit changes

each year in a predictable fashion, we can use a

formula to calculate their total present value.


Budgeting Decisions

14 - 882

Expected Annual After-Tax Operating Cash Flows (exc luding CCA Tax Shield) (O CFt) = CFBT(1 – T)


Terminal Cash Flow ( ECFn)

Expected Tax Shield Benefits from CCA deduction (CdT)

∑= +

=n

tt

tt k

CFCFofPV

1 )1(

Alternative Approaches to Finding the Tax Alternative Approaches to Finding the Tax Shield Benefit on CCAShield Benefit on CCA

•• You will recall that there are two approaches to You will recall that there are two approaches to determining cash flows.determining cash flows.

•• We will use alternative (2) found on Table 14We will use alternative (2) found on Table 14--11•• This allows us to deconstruct the analysis, This allows us to deconstruct the analysis,


Budgeting Decisions

14 - 883

•• This allows us to deconstruct the analysis, This allows us to deconstruct the analysis, separating operating cash flows from the tax separating operating cash flows from the tax shield benefits of CCA.shield benefits of CCA.

(See the following slide)(See the following slide)

Determining Cash Flows after CCADetermining Cash Flows after CCA

(1) Before-tax operating Income (OI) (2) Before-tax Operating Income (OI)

- CCA - Taxes payable on OI

Table 14 - 1 Two Ways to Determine Cash Flows Afte r Capital Cost Allowance


Budgeting Decisions

14 - 884

Taxable Income After-tax OI

-Taxes Payable + CCA tax savings

After-tax Income Net Cash Flow

+ CCA (non-cash expense)

Net Cash Flow

Separating Operating Cash Flows from Separating Operating Cash Flows from CCA Tax Shield BenefitsCCA Tax Shield Benefits

t=1 2 3 n-1 n

Typically operating cash


Budgeting Decisions

14 - 885


Typically operating cash flow benefits can be treated

as an annuity.

The CCA Tax Shield benefits are a growing

perpetuity with a constant negative growth rate.

The only exception to this is the first cash flow. (This

is ½ year rule effect.)

Tax Shield Benefit of CCATax Shield Benefit of CCA

•• The tax shield benefit from CCA is equal to the corporate tax The tax shield benefit from CCA is equal to the corporate tax rate rate (T) (T) ×× CCACCA amount.amount.

•• As demonstrated in the following slide, assuming the firm will As demonstrated in the following slide, assuming the firm will have taxable operating income in the future, we can predict have taxable operating income in the future, we can predict the maximum amount of CCA the firm can claim from the year the maximum amount of CCA the firm can claim from the year of acquisition through to infinity.of acquisition through to infinity.


Budgeting Decisions

14 - 886

of acquisition through to infinity.of acquisition through to infinity.•• You will note:You will note:

–– ½ rule effect in the first year½ rule effect in the first year–– We assume we claim the maximum CCA in each subsequent We assume we claim the maximum CCA in each subsequent

year.year.–– We forecast the tax shield benefit by: We forecast the tax shield benefit by: TT×× CCACCAtt

–– Tax shield benefits will be a perpetual stream of cash flows that Tax shield benefits will be a perpetual stream of cash flows that are going a constant negative compound growth rate are going a constant negative compound growth rate (d) where d (d) where d is the CCA rateis the CCA rate

CCA Tax Shield Over TimeCCA Tax Shield Over Time(Assume a corporate Tax Rate ‘T’ of 40%)(Assume a corporate Tax Rate ‘T’ of 40%)

Year UCC of pool Addition CCA @ 10% T(CCA)1 0 100,000 5,000 2,0002 95,000 0 9,500 3,8003 85,500 0 8,550 3,420

$100,000 asset is acquired in year 1. No asset pool disposals. CCA rate

(d) = 10%

Tax Shield = T(CCA)Lets graph this series

of tax shield

benefits the firm is

forecast to receive.


Budgeting Decisions

14 - 887

3 85,500 0 8,550 3,4204 76,950 0 7,695 3,0785 69,255 0 6,926 2,7706 62,330 0 6,233 2,4937 56,097 0 5,610 2,2448 50,487 0 5,049 2,0199 45,438 0 4,544 1,818

CCA Tax Shield Over TimeCCA Tax Shield Over Time(A Graphical Representation)(A Graphical Representation)

35004000

T(CCA) at 10% on $100,000


Budgeting Decisions

14 - 888

0500

10001500200025003000

Tax Shield

1 3 5 7 9 11 13 15 17 19

Year

Asymptotic Curve

ObservationsObservations

•• In the foregoing you can now readily see:In the foregoing you can now readily see:�� CCA provides large tax shields in the early years of the CCA provides large tax shields in the early years of the

asset’s lifeasset’s life�� residual values remain in the pool long after the asset residual values remain in the pool long after the asset

was acquired…this means that the firm will never fully was acquired…this means that the firm will never fully


Budgeting Decisions

14 - 889

was acquired…this means that the firm will never fully was acquired…this means that the firm will never fully recoup the original cost of the asset … as the firm’s recoup the original cost of the asset … as the firm’s asset base ages, cash flows generated from CCA will asset base ages, cash flows generated from CCA will not enable the firm to replace the original asset.not enable the firm to replace the original asset.

•• Now we can learn how to find the present value of a Now we can learn how to find the present value of a perpetual stream of forecast cash flows.perpetual stream of forecast cash flows.

Present Value of the CCA Tax ShieldPresent Value of the CCA Tax Shield(Assume a corporate Tax Rate ‘T’ of 40% and Discount rate of 12%)(Assume a corporate Tax Rate ‘T’ of 40% and Discount rate of 12%)

(1) (2) (3) (4) (5) (6) = (4) × (5)

Year UCC of pool Addition CCA @ 10% T(CCA)

Present Value

Factor at 12%

Present Value

Multiplying T(CCA) by the PVIF we can estimate the present value of the tax shield benefit for each year into the future.


Budgeting Decisions

14 - 890

Year UCC of pool Addition CCA @ 10% T(CCA) 12% Value1 0 100,000 5,000 2,000 0.893 $1,7862 95,000 0 9,500 3,800 0.797 3,0293 85,500 0 8,550 3,420 0.712 2,4344 76,950 0 7,695 3,078 0.636 1,9565 69,255 0 6,926 2,770 0.567 1,5726 62,330 0 6,233 2,493 0.507 1,2637 56,097 0 5,610 2,244 0.452 1,0158 50,487 0 5,049 2,019 0.404 816

Sum (1:8) = $13,871

This is the sum of the first 8 years of tax savings …it would be an infinitely long process to find the actual sum of a n infinite stream of

cash flows.

We must develop a formula-based solution to this pr oblem.

Present Value of the CCA Tax ShieldPresent Value of the CCA Tax Shield

•• In Chapter 7 you learned about the constant growth DDM:In Chapter 7 you learned about the constant growth DDM:

gk

D

gk

gDP

cc −=

−+= 10

0

)1([ 7-7]


Budgeting Decisions

14 - 891

•• This model assumes the first dividend becomes the base This model assumes the first dividend becomes the base amount and all future cash flows grow at a constant amount and all future cash flows grow at a constant compound rate from compound rate from t =1t =1 through infinity:through infinity:

α

α

)1(

)1(...

)1(

)1(

)1(

)1( 02

20

1

10

0ccc k

gD

k

gD

k

gDP

++++

+++

++=[ 7-6]

Present Value of the CCA Tax ShieldPresent Value of the CCA Tax Shield

•• The constant growth DDM:The constant growth DDM:

•• The Tax Shield benefit to CCA (ignoring the ½ year rule for a The Tax Shield benefit to CCA (ignoring the ½ year rule for a moment) is the same except:moment) is the same except:

10 gk

DP

c −=


Budgeting Decisions

14 - 892

moment) is the same except:moment) is the same except:–– Cash flow at time one is the CCA tax shield at Cash flow at time one is the CCA tax shield at t = 1 and is calculated ast = 1 and is calculated as

((TdCTdC00) ) –– this is the numeratorthis is the numerator–– The growth is negative (declining balance) The growth is negative (declining balance) –– two negatives equal a two negatives equal a

positive!positive!

)(

))()(()( 00

dk

dTC

dk

TdCShieldTaxCCAPV

+=

−−=

Present Value of Tax Savings Lost on Present Value of Tax Savings Lost on Salvage Value Salvage Value –– an an ECFECF

•• We will use this version of the formula to calculate the We will use this version of the formula to calculate the present value of tax savings lost on the salvage value of present value of tax savings lost on the salvage value of the asset (when the ½ net addition rule does not apply)the asset (when the ½ net addition rule does not apply)

•• The PV of tax savings lost at time The PV of tax savings lost at time nn ==


Budgeting Decisions

14 - 893

)(

))()((

dk

dTSV

dk

TdSVValueSalvageonLostShieldTaxCCAofPV nn

n +=

−−=

Present Value of Tax Savings Lost on Present Value of Tax Savings Lost on Salvage Value Salvage Value –– an an ECFECF

•• The PV of tax savings lost at time n =The PV of tax savings lost at time n =

)(

))()((1

dk

dTSV

dk

TdSVValueSalvageonLostShieldTaxCCAofPV nn

n +=

−−=−


Budgeting Decisions

14 - 894

•• The last step in finding the Present value of this amount is to The last step in finding the Present value of this amount is to discount the value back to t = 0.discount the value back to t = 0.

•• So…the equation becomes:So…the equation becomes:

k)(1

1

)1()(

))()((

n0 dk

dTSV

k

dk

TdSV

ValueSalvageonLostShieldTaxCCAofPV nn

n

+×

+=

+−−=

Present Value of the Tax Savings on CCAPresent Value of the Tax Savings on CCAAssuming the ½ Year RuleAssuming the ½ Year Rule

Adjusting the Formula for the ½ year Net Addition RuleAdjusting the Formula for the ½ year Net Addition Rule

1

501)( 0

k

)k.(

dk

dTCShieldTaxCCAPV

++×

+=


Budgeting Decisions

14 - 895

•• We multiply the first factor by (1+.5k) / (1+ k) to produce a formula We multiply the first factor by (1+.5k) / (1+ k) to produce a formula that will estimate the present value of tax savings from CCA (time 1 that will estimate the present value of tax savings from CCA (time 1 through infinity) assuming ½ year net addition rule.through infinity) assuming ½ year net addition rule.

•• For a graphical depiction of this formula see the following slide.For a graphical depiction of this formula see the following slide.


35004000

T(CCA) at 10% on $100,000

1

501)( 0

k

)k.(

dk

dTCShieldTaxCCAPV

++×

+=

This formula calculations the PV

of tax savings on CCA from time 1


Budgeting Decisions

14 - 896

0500

10001500200025003000

Tax Shield

1 3 5 7 9 11 13 15 17 19

Year

CCA from time 1 through infinity

assuming the ½ year net addition rule.

Present Value of the Tax Savings on CCAPresent Value of the Tax Savings on CCAAdjusting for ½ Year Rule Adjusting for ½ Year Rule –– An ExampleAn Example

•• We can now use the formula to solve for the present of the tax We can now use the formula to solve for the present of the tax savings on CCA for an asset that is never sold (no salvage value):savings on CCA for an asset that is never sold (no salvage value):

27.207,17$12.1

06.1

22.

000,4$

12.1

)12(.5.1

1.12.

)4)(.1(.000,100$

1

501)( 0

k

)k.(

dk

dTCShieldTaxCCAPV =×=

+

+=

++×

+=


Budgeting Decisions

14 - 897

•• This formula assumes:This formula assumes:–– CC00 = $100,000 = $100,000 (Initial cost of a depreciable asset)(Initial cost of a depreciable asset)–– dd = 10%= 10% (CCA rate)(CCA rate)–– k = 12%k = 12% (Cost(Cost of capital or discount rate)of capital or discount rate)–– T =T = 40%40% (Corporate tax rate)(Corporate tax rate)

•• Notice the answer is greater than the spread sheet example ($13,871) Notice the answer is greater than the spread sheet example ($13,871) because the spreadsheet summed only the first 8 cash flows whereas the because the spreadsheet summed only the first 8 cash flows whereas the formula finds the sum of the present values of the tax shield benefits for an formula finds the sum of the present values of the tax shield benefits for an infinite stream.infinite stream.

Formula for PV of Tax Savings on CCAFormula for PV of Tax Savings on CCAAssuming a Salvage Value at Assuming a Salvage Value at t = nt = n

•• Finally we can incorporate planned disposal of Finally we can incorporate planned disposal of the asset we will acquire.the asset we will acquire.

1))()(()5.01())()(( TdSVkTdC ×−+×=


Budgeting Decisions

14 - 898

•• Disposal value is the ‘salvage value’ (SV) at Disposal value is the ‘salvage value’ (SV) at t = t = nn

(See the following two slides for graphical depiction of the effect of a salvage value)(See the following two slides for graphical depiction of the effect of a salvage value)

)1(

1

)(

))()((

)1(

)5.01())()(()( 0

kkd

TdSV

k

k

kd

TdCShieldTaxCCAPV

nn

+×

+−

++×

+=[ 14-7]


300035004000

T(CCA) at 10% on $100,000 By selling the asset after the end

of the 10 th fiscal year, we lose CCA

in years 11 through infinity.

( ) 1

1)(0

kdk

dTSVSVonLostSavingsTaxCCAPV

nn

+×

+=


Budgeting Decisions

14 - 899

0500

10001500200025003000

Tax Shield

1 3 5 7 9 11 13 15 17 19

Year

through infinity.


300035004000

T(CCA) at 10% on $100,000 ( ) 1

1

)1(

)5.1()( 0

0 kdk

dTSV

k

k

dk

dTCSavingsTaxCCAPV

nn

+×

+−

++×

+=

We subtract the PV of tax savings


Budgeting Decisions

14 - 900

0500

10001500200025003000

Tax Shield

1 3 5 7 9 11 13 15 17 19

Year

PV of tax savings lost on the

Salvage Value from the PV of tax saving from t = 1

through infinity to get the PV of tax savings benefits

years 1 – 10.

Expected Annual AfterExpected Annual After--Tax Cash Flows Tax Cash Flows (CF(CFtt))

As illustrated in Equation 14As illustrated in Equation 14--2 expected Annual After2 expected Annual After--Tax Cash Flows are:Tax Cash Flows are:–– The cash flows that are estimated to occur as a result of The cash flows that are estimated to occur as a result of

the investment decision, comprisingthe investment decision, comprising•• the associated expected incremental increase in afterthe associated expected incremental increase in after--tax tax


Budgeting Decisions

14 - 901

•• the associated expected incremental increase in afterthe associated expected incremental increase in after--tax tax operating income andoperating income and

•• Any incremental tax savings (or additional taxes paid) that Any incremental tax savings (or additional taxes paid) that result from the initial investment outlay.result from the initial investment outlay.


Forecasting Expected Annual AfterForecasting Expected Annual After--Tax Tax Cash Flows (CFCash Flows (CFtt))Example 14 - 2 from your text

Approach 1Year 1 Year 2 Year 3 Year 4 Year 5

Operating Income $125,000 $125,000 $125,000 $125,000 $125,000- CCA Expense -97,500 -165,750 -116,025 -81,218 -56,852Taxable Income $27,500 -$40,750 $8,975 $43,782 $68,148- Taxes payable @ 45% 12,375 -18,338 4,039 19,702 30,667After-tax income $15,125 -$22,413 $4,936 $24,080 $37,481+ CCA expense $97,500 $165,750 $116,025 $81,218 $56,852

Spreadsheets Spreadsheets can be useful in can be useful in making detailed making detailed forecasts of the forecasts of the incremental incremental operating cost operating cost and benefits and benefits associated with associated with the project.the project.


Budgeting Decisions14 - 902

+ CCA expense $97,500 $165,750 $116,025 $81,218 $56,852Net cash flow $112,625 $143,338 $120,961 $105,298 $94,333

Approach 2Year 1 Year 2 Year 3 Year 4 Year 5

Operating Income $125,000 $125,000 $125,000 $125,000 $125,000- Taxes Payable on Operating income @ 45% 56250 56250 56250 56250 56250After-tax Operating Income $68,750 $68,750 $68,750 $68,750 $68,750+ CCA tax savings (CCA * T) 43,875 74,588 52,211 36,548 25,583Net cash flow $112,625 $143,338 $120,961 $105,298 $94,333

the project.the project.

Operating cash flows are

an annuity where as net cash flow is

not.

Decomposing Expected Annual AfterDecomposing Expected Annual After--Tax Tax Cash Flows (CFCash Flows (CFtt))

We have already seen that since the CCA tax We have already seen that since the CCA tax shield (CCAshield (CCAtt)(T) changes each year and )(T) changes each year and potentially involve an infinite series, we potentially involve an infinite series, we separately calculate its present value using a separately calculate its present value using a


Budgeting Decisions

14 - 903

formula.formula.


Decomposing Expected Annual AfterDecomposing Expected Annual After--Tax Tax Cash Flows (CFCash Flows (CFtt))

•• Since the operating cash flow benefits afterSince the operating cash flow benefits after--tax tax are often equal each year, we can find their are often equal each year, we can find their present value simply using the Present Value present value simply using the Present Value Factor of an Annuity:Factor of an Annuity:


Budgeting Decisions

14 - 904

)1(

11

)1()( k

kTCFBTFlowsCashOperatingPV

n

+−

×−=[ 14-6]

Decomposing Expected Annual AfterDecomposing Expected Annual After--Tax Cash Tax Cash Flows (CFFlows (CFtt))

Example of the PV of the Operating Cash Flow AnnuityExample of the PV of the Operating Cash Flow Annuity

Using Example 14 Using Example 14 –– 2:2:–– Operating income Operating income

excluding CCA before tax = excluding CCA before tax = $125,000$125,000

)1(

11

)1()(

+−

×−= k

kTCFBTFlowsCashOperatingPV

n


Budgeting Decisions

14 - 905

$125,000$125,000–– Tax rate = 45%Tax rate = 45%–– Useful life = 5 yearsUseful life = 5 years–– Discount rate (Discount rate (kk) = 10%) = 10%–– The present vale of the The present vale of the

operating income annuity =operating income annuity = 616,260$7908.3750,68$

.1

(1.1)1

-1.45) - $125,000(1

5

=×=

×=

Ending (or Terminal) AfterEnding (or Terminal) After--Tax Cash Tax Cash Flows (ECFFlows (ECFnn))

•• Ending cash flows include:Ending cash flows include:–– Salvage value of the asset (SVSalvage value of the asset (SVnn))–– Recovery of the net investment in working capital (NWCRecovery of the net investment in working capital (NWCnn))–– Less any taxes payable in the event of a capital gain on the sale of the Less any taxes payable in the event of a capital gain on the sale of the


Budgeting Decisions

14 - 906

–– Less any taxes payable in the event of a capital gain on the sale of the Less any taxes payable in the event of a capital gain on the sale of the asset or a recapture of depreciation.asset or a recapture of depreciation.

])-

T]50.0)C-[(ns)ImplicatioTax With ( 0

TUCC[(SV

SVNWCSVECF

nn

nnnn

×−××−∆+=[ 14-3]

CCA Tax Shield with a Recapture of CCA Tax Shield with a Recapture of DepreciationDepreciation

•• Equation 14 Equation 14 --8 Is used when the salvage value of the asset is 8 Is used when the salvage value of the asset is greater than the UCC of the pool of assets at the time of disposal.greater than the UCC of the pool of assets at the time of disposal.

•• A recapture of depreciation must be included in income in the year it A recapture of depreciation must be included in income in the year it occurs and is subject to tax at the firm’s tax rate (occurs and is subject to tax at the firm’s tax rate (TT ))


Budgeting Decisions

14 - 907

)1(

))((

)1(

1

)(

))()((

)1(

)5.01())()(()( 0

k

TUCCSV

kkd

TdSV

k

k

kd

TdCShieldTaxCCAPV

nnn

nn

+−−

+×

+−

++×

+=

[ 14-8]

Capital Gain on Asset DisposalCapital Gain on Asset Disposal

•• Equation 14 Equation 14 –– 9 is used when you expect to sell the asset for a price 9 is used when you expect to sell the asset for a price that is greater than its original cost.that is greater than its original cost.

•• The difference between the SV and CThe difference between the SV and C00 is the capital gain.is the capital gain.•• 50% of a realized capital gain is subject to tax at the corporate tax 50% of a realized capital gain is subject to tax at the corporate tax

rate (rate (T T ))


Budgeting Decisions

14 - 908

)1(

))(5)(.()( 0

k

TCSVPaidTaxesGainsCapitalPV

nn

+−=[ 14-9]

NPV Using the Decomposed NPV Using the Decomposed ComponentsComponents

•• Equation 14Equation 14--10, on the following slides, shows how the decomposed 10, on the following slides, shows how the decomposed components are recombined to determine the projects NPVcomponents are recombined to determine the projects NPV

•• Remember NPV =Remember NPV =++ Present value of afterPresent value of after--tax operating cash flowstax operating cash flows++ Present value of CCA tax shield Present value of CCA tax shield ++ Present value of the salvage value (ECF)Present value of the salvage value (ECF)


Budgeting Decisions

14 - 909

++ Present value of the salvage value (ECF)Present value of the salvage value (ECF)++ Present value of the recovery of net working capital investment (ECF)Present value of the recovery of net working capital investment (ECF)-- Taxes payable on realized capital gain and/or recapture of depreciation Taxes payable on realized capital gain and/or recapture of depreciation

(ECF)(ECF)-- Initial investment in the asset (CFInitial investment in the asset (CF00))-- Initial investment in net working capital (CFInitial investment in net working capital (CF00))

NPV Using the Decomposed NPV Using the Decomposed ComponentsComponents

)(

)()()(

CFPaidTaxesGainsCapitalPV

ECFPVShieldTaxCCAPVCFsOperatingPVNPV n

−−++=

[ 14-10]


Budgeting Decisions

14 - 910

)( 0 CFPaidTaxesGainsCapitalPV −−

Sensitivity to InputsSensitivity to Inputs

•• Stress testing NPV models to determine the Stress testing NPV models to determine the sensitivity of the decision to input variables is sensitivity of the decision to input variables is an important part of risk assessmentan important part of risk assessment

•• There are two common approaches:There are two common approaches:


Budgeting Decisions

14 - 911

•• There are two common approaches:There are two common approaches:–– Sensitivity analysis Sensitivity analysis –– an examination of how an an examination of how an

investment’s NPV changes as the value of one input investment’s NPV changes as the value of one input at a time is changedat a time is changed

–– Scenario analysis Scenario analysis –– an examination of how an an examination of how an investment’s NPV changes in response to varying investment’s NPV changes in response to varying scenarios in terms of one or more estimates, such scenarios in terms of one or more estimates, such as sales or costsas sales or costs

Sensitivity to InputsSensitivity to InputsScenario AnalysisScenario Analysis

Input variables are often given discrete forecast Input variables are often given discrete forecast ranges:ranges:

–– Best caseBest case–– Most likelyMost likely–– Worst caseWorst case


Budgeting Decisions

14 - 912

–– Worst caseWorst case

The analyst will be interested in what the NPV might The analyst will be interested in what the NPV might be in the worst combination of cases for example:be in the worst combination of cases for example:

–– Worst case operating cash flows (low)Worst case operating cash flows (low)–– Worst case initial cost (high)Worst case initial cost (high)–– Worst case new working capital investment (high)Worst case new working capital investment (high)

Sensitivity to InputsSensitivity to InputsReal Option Valuation (ROV)Real Option Valuation (ROV)

•• ROV and decision tree analysis have dramatically increased ROV and decision tree analysis have dramatically increased understanding of corporate decisionunderstanding of corporate decision--making and the value of making and the value of flexibility and strategic considerations.flexibility and strategic considerations.

•• Decision trees are a schematic way to represent alternative Decision trees are a schematic way to represent alternative decisions and the possible outcomes.decisions and the possible outcomes.

•• Table 14Table 14--2 (next slide) gives a real options example of three 2 (next slide) gives a real options example of three


Budgeting Decisions

14 - 913

•• Table 14Table 14--2 (next slide) gives a real options example of three 2 (next slide) gives a real options example of three alternative orealternative ore--price scenarios for a mine. (The most important price scenarios for a mine. (The most important variable in mining projects.)variable in mining projects.)

•• This table illustrates that the highest expected cash flows occur when This table illustrates that the highest expected cash flows occur when ore prices are most volatile (have the greatest range of prices).ore prices are most volatile (have the greatest range of prices).

•• This illustrates an option that is often overlooked in traditional project This illustrates an option that is often overlooked in traditional project analysis…the possibility of shutting down the mine when prices make analysis…the possibility of shutting down the mine when prices make it uneconomic. (Remember, the mine can be returned to production it uneconomic. (Remember, the mine can be returned to production when economic conditions turn more favourable.)when economic conditions turn more favourable.)

Real Option Valuation (ROV)Real Option Valuation (ROV)Comparing NPV and IRRComparing NPV and IRR

Scenario 1: Ore Price $12 or $8



Good price (ρ=.5) $12 $14 $16

Table 14 - 2 Real Options Example


Budgeting Decisions

14 - 914

Good price (ρ=.5) $12 $14 $16

Cash Flow $400 $600 $800

Bad price (ρ=.5) $8 $6 $4

Cash Flow $0 -$200 -$200

Expected cash flow $200 $200 $300

Sensitivity to InputsSensitivity to InputsNPV BreakNPV Break--Even AnalysisEven Analysis

Operating Cash Flow NPV BreakOperating Cash Flow NPV Break--even Pointeven Point•• Solving for the annual operating afterSolving for the annual operating after--tax cash tax cash

flows that cause NPV = 0.flows that cause NPV = 0.


Budgeting Decisions

14 - 915

flows that cause NPV = 0.flows that cause NPV = 0.–– PV (Operating CFs) is the source of value creationPV (Operating CFs) is the source of value creation–– The most important part of the viability analysis. The most important part of the viability analysis.

Sensitivity to InputsSensitivity to InputsOperating Cash Flow NPV BreakOperating Cash Flow NPV Break--Even PointEven Point

Example:Example:CFCF00 = $100,000= $100,000PVPV((CCA Tax Shield)CCA Tax Shield) = $20,453= $20,453

PV(ECFPV(ECFnn)) = $12,834= $12,834

Approach:Approach:–– Set NPV = 0 and solve for the Set NPV = 0 and solve for the

PV of the operating CFPV of the operating CF ::

713,66$)(

000,100$834,12$453,20$)(00.0$

)()()( 0

=−++=

−++=

CFsOperatingPV

CFsOperatingPV

CFECFPVShieldTaxCCAPVCFsOperatingPVNPV n



PV of the operating CFPV of the operating CFss::–– Now solve for the annual afterNow solve for the annual after--

tax CFtax CF

Conclusion:Conclusion:–– The operating cash flows could The operating cash flows could

fall to $10,770 without fall to $10,770 without destroying value.destroying value.

–– Now the decision makers can Now the decision makers can assess the threats to this key assess the threats to this key forecast and determine the forecast and determine the likelihood of this occurring.likelihood of this occurring.

770,10$

)194374.6(][713,66$

12.0

)12.1(1

1][)(

12

=−×−=

−×−=

CFOperatingevenBreak

CFOperatingevenBreak

CFOperatingevenBreakCFsOperatingPV

Sensitivity to InputsSensitivity to InputsOperating Cash Flow NPV BreakOperating Cash Flow NPV Break--Even PointEven Point

NPV$

$20,000

It is possible to vary the cash flow assumptions and test the sensitivity

of NPV to those changes.

NPV is the dependent variable.


Budgeting Decisions

14 - 917

Operating Cash Flow

Break-even cash flow

0 $50,000 $40,000 $30,000 $20,000 $10,000 $0

Sensitivity to InputsSensitivity to InputsNPV BreakNPV Break--Even Discount RateEven Discount Rate

Break Even Discount RateBreak Even Discount Rate•• IRR of the projectIRR of the project•• NPV profile illustrates the range of discount NPV profile illustrates the range of discount


Budgeting Decisions

14 - 918

•• NPV profile illustrates the range of discount NPV profile illustrates the range of discount rates that produce a positive NPV.rates that produce a positive NPV.

(See the following two slides as a review of NPV profiles from Chapter 13)(See the following two slides as a review of NPV profiles from Chapter 13)


NPV$

$260,000

Required rates of return can change if:

• The general level of interest rates rise in the economy, or

• The risk of the project increases.


Budgeting Decisions

14 - 919

Discount Rate (%)

IRR = 55.8%

0 0% 5% 10% 20% 40% 50% 60%


NPV$

$260,000

$146,684

Even if your estimate of the project’s required return (RADR) is wrong, the project’s NPV

remains positive over a wide range of values for k (from 0% to 55%)


Budgeting Decisions

14 - 920

$146,684

Discount Rate (%)

IRR = 55.8%

0 0% 5% 10% 20% 40% 50% 60%

Expansion DecisionsExpansion Decisions

•• Expansion projects add something extra to the Expansion projects add something extra to the firm in terms of sales or cost savings; their new firm in terms of sales or cost savings; their new cash flows are incremental cash flowscash flows are incremental cash flows


Budgeting Decisions

14 - 921

cash flows are incremental cash flowscash flows are incremental cash flows

Replacement DecisionsReplacement Decisions

•• Involve the replacement of an existing asset (or Involve the replacement of an existing asset (or assets) with a new one.assets) with a new one.–– In such cases we must clearly identify the In such cases we must clearly identify the

incremental cash flows paying particular attention to:incremental cash flows paying particular attention to:


Budgeting Decisions

14 - 922

incremental cash flows paying particular attention to:incremental cash flows paying particular attention to:•• The effect on the incremental capital cost (∆CThe effect on the incremental capital cost (∆C00) ) •• The effect on the CCA tax shieldThe effect on the CCA tax shield

Replacement DecisionsReplacement DecisionsIncremental Capital CostIncremental Capital Cost

•• Incremental Capital Cost (∆CIncremental Capital Cost (∆C00) = the difference ) = the difference between the purchase price of the new equipment between the purchase price of the new equipment and the salvage price of the old machine.and the salvage price of the old machine.

•• The equipment to be replaced is normally sold. The equipment to be replaced is normally sold.


Budgeting Decisions

14 - 923

•• The equipment to be replaced is normally sold. The equipment to be replaced is normally sold. Normally there are no tax consequences on Normally there are no tax consequences on disposal, except when assets are sold at a price disposal, except when assets are sold at a price greater than their original cost (which triggers capital greater than their original cost (which triggers capital gains taxes on the difference)gains taxes on the difference)

Replacement DecisionsReplacement DecisionsEffects on Capital Cost Allowance Tax ShieldEffects on Capital Cost Allowance Tax Shield

When an asset is removed from the Capital Cost Allowance Class:When an asset is removed from the Capital Cost Allowance Class:•• There is no CCA in the year of disposalThere is no CCA in the year of disposal•• The UCC of the pool/class is reduced by the disposal valueThe UCC of the pool/class is reduced by the disposal value

When an asset is added to the Capital Cost Allowance Class:When an asset is added to the Capital Cost Allowance Class:•• There is ½ of the normal CCA on the ‘net additions to the pool’ in There is ½ of the normal CCA on the ‘net additions to the pool’ in


Budgeting Decisions

14 - 924

•• There is ½ of the normal CCA on the ‘net additions to the pool’ in There is ½ of the normal CCA on the ‘net additions to the pool’ in that yearthat year

•• The UCC of the pool is increased by half of the net addition in the The UCC of the pool is increased by half of the net addition in the first year, and half of the net additions in the second yearfirst year, and half of the net additions in the second year

In replacement decisions we must modify the PV of Tax Shield In replacement decisions we must modify the PV of Tax Shield formula to account for the change (∆) in Cformula to account for the change (∆) in C00 and (∆) in SVand (∆) in SV

(See the following slide for the new formula)(See the following slide for the new formula)

Replacement DecisionsReplacement DecisionsEffects on Capital Cost Allowance Tax ShieldEffects on Capital Cost Allowance Tax Shield

1))()(()5.01())()((

)( 0 TdSVkTdC

ShieldTaxCCAPV n

×

∆−

+×

∆=∆

The replacement of old with new results in a change in the tax shield and affects both the net

cost of the new as well as the salvage value.


Budgeting Decisions

14 - 925

)1()()1(

)( 0 kkdkkd

ShieldTaxCCAPVn

n

+

×

+

−

+

×

+=∆

Replacement DecisionsReplacement DecisionsSimple Example Ignoring CCA Simple Example Ignoring CCA –– Formula ApproachFormula Approach

Problem:Problem:•• Cost of new machine = Cost of new machine =

$12,000$12,000•• Disposal value of old Disposal value of old

machine = $2,000machine = $2,000 CFCFCF

Incremental capital cost is the price of the new machine less the price

of the old.



machine = $2,000machine = $2,000

•• AfterAfter--tax cash flow benefits:tax cash flow benefits:–– Year 1 = $5,000Year 1 = $5,000–– Year 2 = $5,000Year 2 = $5,000–– Year 3 = $8,000Year 3 = $8,000

•• Discount rate (k) = 15%Discount rate (k) = 15% 389,3$

000,10$260,6$781,3$348,4$

)000,2$000,12($)15.1(

000,8$

)15.1(

000,5$

)15.1(

000,5$

)1()1()1(

321

033

22

11

=−++=

−−++=

∆−+

++

++

= Ck

CF

k

CF

k

CFNPV

Replacement DecisionsReplacement DecisionsSimple Example Ignoring CCA Simple Example Ignoring CCA –– Formula ApproachFormula Approach

Incremental Cost (new-old) = $10,000Cost of Capital = 15.0%

Problem:Problem:Cost of new machine = $12,000Cost of new machine = $12,000Disposal value of old machine = Disposal value of old machine =

$2,000$2,000


Budgeting Decisions

14 - 927

Year CashflowAfter-tax

incremental CF PV FactorPresent Value

0 Initial cost -$10,000 1 -$10,0001 ATCF operating benefit 5,000 0.869565 $4,3482 ATCF operating benefit 5,000 0.756144 $3,7813 ATCF operating benefit 8,000 0.657516 $5,260

NPV = $3,389

AfterAfter--tax cash flow benefits:tax cash flow benefits:Year 1 = $5,000Year 1 = $5,000Year 2 = $5,000Year 2 = $5,000Year 3 = $8,000Year 3 = $8,000

Discount rate (k) = 15%Discount rate (k) = 15%

Replacement DecisionsReplacement DecisionsThe Formula ApproachThe Formula Approach

The deconstructed NPV model can be used in The deconstructed NPV model can be used in replacement decisions.replacement decisions.

Again, in replacement decisions, the focus in on the net Again, in replacement decisions, the focus in on the net change in operating cash flows, net change in CCA tax change in operating cash flows, net change in CCA tax



change in operating cash flows, net change in CCA tax change in operating cash flows, net change in CCA tax shield, and net changes in ending and initial cash flows.shield, and net changes in ending and initial cash flows.

)()()( 0CFECFPVShieldTaxCCAPVCFsOperatingPVNPV n ∆−∆+∆+∆=

Inflation and Capital Budgeting DecisionsInflation and Capital Budgeting DecisionsThe Impact of InflationThe Impact of Inflation

•• Even small rates of inflation over time can have considerable Even small rates of inflation over time can have considerable effects on the economic viability of a project.effects on the economic viability of a project.

•• Although inflation is often measured by aggregate changes Although inflation is often measured by aggregate changes in prices at the retail (CPI consumer price index) or in prices at the retail (CPI consumer price index) or


Budgeting Decisions

14 - 929

in prices at the retail (CPI consumer price index) or in prices at the retail (CPI consumer price index) or wholesale level, these measures often do not reflect price wholesale level, these measures often do not reflect price changes specific to one company or one project.changes specific to one company or one project.

•• Inflation MUST be treated consistently in our project Inflation MUST be treated consistently in our project evaluation models (NPV, IRR, PI)evaluation models (NPV, IRR, PI)

Inflation and Capital Budgeting DecisionsInflation and Capital Budgeting DecisionsTwo Basic ApproachesTwo Basic Approaches

•• Inflation can be consistently incorporated by:Inflation can be consistently incorporated by:1.1. Removing it from the nominal discount rate and Removing it from the nominal discount rate and

using nominal cash flow forecastsusing nominal cash flow forecasts


Budgeting Decisions

14 - 930

using nominal cash flow forecastsusing nominal cash flow forecasts2.2. Leaving the discount rate with an expected inflation Leaving the discount rate with an expected inflation

component and estimating real (inflationcomponent and estimating real (inflation--adjusted) adjusted) cash flowscash flows

Inflation and Capital Budgeting DecisionsInflation and Capital Budgeting DecisionsRemoving Expected Inflation from the Discount RateRemoving Expected Inflation from the Discount Rate

•• As illustrated on the following slide, all discount rates used As illustrated on the following slide, all discount rates used have embedded into them an expected rate of inflation.have embedded into them an expected rate of inflation.

•• If we use nonIf we use non--inflation adjusted cash flow forecasts, and inflation adjusted cash flow forecasts, and then discount using a nominal discount rate, we are ‘over then discount using a nominal discount rate, we are ‘over discounting’ because we are using a higher rate…but not discounting’ because we are using a higher rate…but not


Budgeting Decisions

14 - 931

discounting’ because we are using a higher rate…but not discounting’ because we are using a higher rate…but not using inflated forecast cash flows.using inflated forecast cash flows.

•• You can use the Fisher equation to estimate the embedded You can use the Fisher equation to estimate the embedded inflationary expectations, and then reduce the nominal inflationary expectations, and then reduce the nominal discount rate by that amount.discount rate by that amount.

•• Then you are free to discount nominal cash flows.Then you are free to discount nominal cash flows.

Risk Adjusted Discount RatesRisk Adjusted Discount RatesUsing the CAPMUsing the CAPM

Required Return

MER

ProjectProject )( βRFERRFk M −+=

ERProject

Risk


Budgeting Decisions

14 - 932

βMarket = 1

RF

β

ERM

βProject = 1.5

Risk Premium for

project systematic

risk

Real rate of return

Premium for expected inflation

Required Rates of Return (RADR)Required Rates of Return (RADR)ComponentsComponents

•• The riskThe risk--free rate is free rate is equal to the real rate of equal to the real rate of return plus expected return plus expected

PremiumRisk RF +=RADR

Required Return (%)

Risk Adjusted


Budgeting Decisions

14 - 933

return plus expected return plus expected inflation (Fisher inflation (Fisher Equation)Equation)

•• The risk premium is The risk premium is based on an estimate of based on an estimate of the risk associated with the risk associated with the project.the project.

Beta of the Project

RF

Risk

Risk Adjusted Discount

Rate

Risk Premium

Real Return


Inflation and Capital Budgeting DecisionsInflation and Capital Budgeting DecisionsThe Inflation Adjustment ProcessThe Inflation Adjustment Process

The key thing to remember is:The key thing to remember is:–– If you use WACC unadjusted, then you must use If you use WACC unadjusted, then you must use

inflationinflation--adjusted cash flow estimates for operating adjusted cash flow estimates for operating


Budgeting Decisions

14 - 934

inflationinflation--adjusted cash flow estimates for operating adjusted cash flow estimates for operating cash flowscash flows

–– If you remove inflation from the discount rate If you remove inflation from the discount rate (WACC), you can use nominal cash flow estimates(WACC), you can use nominal cash flow estimates

The key is consistency.The key is consistency.


In this chapter you have learned:In this chapter you have learned:–– Several approaches and guidelines for estimating future Several approaches and guidelines for estimating future

cash flows associated with an investmentcash flows associated with an investment–– The equations used to estimate the present value of The equations used to estimate the present value of

future cash flows future cash flows


Budgeting Decisions

14 - 935

future cash flows future cash flows –– How to differentiate between expansion and replacement How to differentiate between expansion and replacement

decisionsdecisions–– How to use sensitivity analysis, scenario analysis, whatHow to use sensitivity analysis, scenario analysis, what--if if

decision tree analysis and NPV breakdecision tree analysis and NPV break--even analysis.even analysis.–– How to incorporate inflation into capital budgeting analysis.How to incorporate inflation into capital budgeting analysis.

CHAPTER 15CHAPTER 15Mergers and AcquisitionsMergers and AcquisitionsMergers and AcquisitionsMergers and Acquisitions


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• Types of TakeoversTypes of Takeovers•• Securities LegislationSecurities Legislation

www.bookfiesta4u.com ContentsCHAPTER 15 – Mergers and Acquisitions

15 - 938

•• Securities LegislationSecurities Legislation•• Friendly versus hostile takeoversFriendly versus hostile takeovers•• Motivations for Mergers and AcquisitionsMotivations for Mergers and Acquisitions•• Valuation IssuesValuation Issues•• Accounting for AcquisitionsAccounting for Acquisitions•• Summary and ConclusionsSummary and Conclusions



1.1. The different types of acquisitionsThe different types of acquisitions2.2. How a typical acquisition proceedsHow a typical acquisition proceeds3.3. What differentiates a friendly from a hostile acquisitionWhat differentiates a friendly from a hostile acquisition4.4. Different forms of combinations of firmsDifferent forms of combinations of firms


15 - 939

4.4. Different forms of combinations of firmsDifferent forms of combinations of firms5.5. Where to look for acquisition gainsWhere to look for acquisition gains6.6. How accounting may affect the acquisition decisionHow accounting may affect the acquisition decision


•• AcquisitionAcquisition•• AmalgamationAmalgamation•• ArbsArbs•• Asset purchaseAsset purchase•• Break feeBreak fee•• Cash transactionCash transaction

•• Extension M&AExtension M&A•• Fair market valueFair market value•• Fairness opinionFairness opinion•• Friendly acquisitionFriendly acquisition•• Geographic rollGeographic roll--upup•• Going private Going private

transaction/issuer bidtransaction/issuer bid


15 - 940

•• Confidentiality agreementConfidentiality agreement•• Conglomerate mergerConglomerate merger•• Creeping takeoversCreeping takeovers•• CrossCross--border (international) border (international)

M&AM&A•• Data roomData room•• Defensive tacticDefensive tactic•• Due diligenceDue diligence

transaction/issuer bidtransaction/issuer bid•• GoodwillGoodwill•• Horizontal mergerHorizontal merger•• Hostile takeoverHostile takeover•• Letter of intentLetter of intent•• Management buyouts Management buyouts

(MBOs)/leveraged buyouts (MBOs)/leveraged buyouts (LBOs)(LBOs)

•• MergerMerger


•• NoNo--shop clauseshop clause•• Offering memorandumOffering memorandum•• OverOver--capacity M&Acapacity M&A•• Proactive modelsProactive models•• Purchase methodPurchase method

•• TenderTender•• Tender offerTender offer•• Vertical mergerVertical merger•• White knightWhite knight


15 - 941

•• Purchase methodPurchase method•• Selling the crown jewelsSelling the crown jewels•• Share transactionShare transaction•• Shareholders rights Shareholders rights

plan/poison pillplan/poison pill•• SynergySynergy•• TakeoverTakeover

Types of TakeoversTypes of TakeoversGeneral GuidelinesGeneral Guidelines

TakeoverTakeover–– The transfer of control from one ownership group to another.The transfer of control from one ownership group to another.

AcquisitionAcquisition–– The purchase of one firm by anotherThe purchase of one firm by another

MergerMerger


15 - 942

–– The combination of two firms into a new legal entityThe combination of two firms into a new legal entity–– A new company is createdA new company is created–– Both sets of shareholders have to approve the transaction.Both sets of shareholders have to approve the transaction.

AmalgamationAmalgamation–– A genuine merger in which both sets of shareholders must A genuine merger in which both sets of shareholders must

approve the transactionapprove the transaction–– Requires a fairness opinion by an independent expert on the Requires a fairness opinion by an independent expert on the

true value of the firm’s shares when a public minority existstrue value of the firm’s shares when a public minority exists

Types of TakeoversTypes of TakeoversHow the Deal is FinancedHow the Deal is Financed

Cash TransactionCash Transaction–– The receipt of cash for shares by shareholders in the The receipt of cash for shares by shareholders in the

target company.target company.

Share TransactionShare Transaction


15 - 943

Share TransactionShare Transaction–– The offer by an acquiring company of shares or a The offer by an acquiring company of shares or a

combination of cash and shares to the target combination of cash and shares to the target company’s shareholders.company’s shareholders.

Going Private Transaction (Issuer bid)Going Private Transaction (Issuer bid)–– A special form of acquisition where the purchaser A special form of acquisition where the purchaser

already owns a majority stake in the target company.already owns a majority stake in the target company.

General Intent of the LegislationGeneral Intent of the Legislation

Transparency Transparency –– Information DisclosureInformation Disclosure•• To ensure complete and timely information be available to all To ensure complete and timely information be available to all

parties (especially minority shareholders) throughout the parties (especially minority shareholders) throughout the process while at the same time not letting this requirement process while at the same time not letting this requirement stall the process unduly.stall the process unduly.

Fair TreatmentFair Treatment


15 - 944

Fair TreatmentFair Treatment•• To avoid oppression or coercion of minority shareholders.To avoid oppression or coercion of minority shareholders.•• To permit competing bids during the process and not have the To permit competing bids during the process and not have the

first bidder have special rights. (In this way, shareholders first bidder have special rights. (In this way, shareholders have the opportunity to get the greatest and fairest price for have the opportunity to get the greatest and fairest price for their shares.)their shares.)

•• To limit the ability of a minority to frustrate the will of a To limit the ability of a minority to frustrate the will of a majority. (minority squeeze out provisions)majority. (minority squeeze out provisions)

Exempt TakeoversExempt Takeovers

•• Private companies are generally exempt from Private companies are generally exempt from provincial securities legislation.provincial securities legislation.

•• Public companies that have few shareholders in Public companies that have few shareholders in


15 - 945

•• Public companies that have few shareholders in Public companies that have few shareholders in one province may be subject to takeover laws of one province may be subject to takeover laws of another province where the majority of another province where the majority of shareholders reside. shareholders reside.

Exemption from Takeover Requirements Exemption from Takeover Requirements for Control Blocksfor Control Blocks

•• Purchase of securities from 5 or fewer Purchase of securities from 5 or fewer shareholders are permitted without a tender shareholders are permitted without a tender offer requirement provided the premium over the offer requirement provided the premium over the


15 - 946

offer requirement provided the premium over the offer requirement provided the premium over the market price is less than 15%market price is less than 15%

Creeping TakeoversCreeping TakeoversThe 5% RuleThe 5% Rule

The 5% ruleThe 5% rule•• Normal course tender offer is not required as Normal course tender offer is not required as

long as no more than 5% of the outstanding long as no more than 5% of the outstanding shares are purchased through the exchange shares are purchased through the exchange


15 - 947

shares are purchased through the exchange shares are purchased through the exchange over a oneover a one--year period of time.year period of time.

•• This allows creeping takeovers where the This allows creeping takeovers where the company acquires the target over a long period company acquires the target over a long period of time.of time.

Securities LegislationSecurities LegislationCritical Shareholder PercentagesCritical Shareholder Percentages

1.1. 10%: Early Warning10%: Early Warning•• When a shareholder hits this point a report is sent to OSC When a shareholder hits this point a report is sent to OSC •• This requirement alters other shareholders that a potential This requirement alters other shareholders that a potential

acquisitor is accumulating a position (toehold) in the firm.acquisitor is accumulating a position (toehold) in the firm.


15 - 948

2.2. 20%: Takeover Bid20%: Takeover Bid•• Not allowed further open market purchases but must make Not allowed further open market purchases but must make

a takeover bida takeover bid•• This allows all shareholders an equal opportunity to tender This allows all shareholders an equal opportunity to tender

shares and forces equal treatment of all at the same price.shares and forces equal treatment of all at the same price.•• This requirement also forces the acquisitor into disclosing This requirement also forces the acquisitor into disclosing

intentions publicly before moving to full voting control of the intentions publicly before moving to full voting control of the firm.firm.

Securities LegislationSecurities LegislationCritical Shareholder Percentages Continued …Critical Shareholder Percentages Continued …

3.3. 50.1%: Control50.1%: Control•• Shareholder controls voting decisions under normal voting Shareholder controls voting decisions under normal voting

(simple majority)(simple majority)•• Can replace board and control managementCan replace board and control management

4.4. 66.7%: Amalgamation66.7%: Amalgamation


15 - 949

4.4. 66.7%: Amalgamation66.7%: Amalgamation•• The single shareholder can approve amalgamation The single shareholder can approve amalgamation

proposals requiring a 2/3s majority vote (supermajority)proposals requiring a 2/3s majority vote (supermajority)

5.5. 90%: Minority Squeeze90%: Minority Squeeze--outout•• Once the shareholder owns 90% or more of the outstanding Once the shareholder owns 90% or more of the outstanding

stock minority shareholders can be forced to tender their stock minority shareholders can be forced to tender their shares.shares.

•• This provision prevents minority shareholders from This provision prevents minority shareholders from frustrating the will of the majority.frustrating the will of the majority.

The Takeover Bid ProcessThe Takeover Bid ProcessMoving Beyond the 20% ThresholdMoving Beyond the 20% Threshold

•• Takeover circular sent to all shareholders.Takeover circular sent to all shareholders.•• Target has 15 days to circulate letter to shareholders with the Target has 15 days to circulate letter to shareholders with the

recommendation of the board of directors to accept/reject.recommendation of the board of directors to accept/reject.•• Bid must be open for 35 days following public announcement.Bid must be open for 35 days following public announcement.•• Shareholders tender to the offer by signing authorizations.Shareholders tender to the offer by signing authorizations.


15 - 950

•• Shareholders tender to the offer by signing authorizations.Shareholders tender to the offer by signing authorizations.•• A Competing bid automatically increases the takeover window A Competing bid automatically increases the takeover window

by 10 days and shareholders during this time can with drawn by 10 days and shareholders during this time can with drawn authorization and accept the competing offer.authorization and accept the competing offer.

The Takeover Bid ProcessThe Takeover Bid ProcessProrated Settlement and PriceProrated Settlement and Price

•• Takeover bid does not have to be for 100 % of Takeover bid does not have to be for 100 % of the shares.the shares.

•• Tender offer price cannot be for less than the Tender offer price cannot be for less than the average price that the acquirer bought shares in average price that the acquirer bought shares in


15 - 951

average price that the acquirer bought shares in average price that the acquirer bought shares in the previous 90 days. (prohibits coercive bids)the previous 90 days. (prohibits coercive bids)

•• If more shares are tendered than required under If more shares are tendered than required under the tender, everyone who tendered shares will the tender, everyone who tendered shares will get a prorated number purchased.get a prorated number purchased.

Friendly AcquisitionFriendly Acquisition

The acquisition of a target company that is willing to The acquisition of a target company that is willing to be taken over.be taken over.


15 - 952

Usually, the target will accommodate overtures and Usually, the target will accommodate overtures and provide access to confidential information to facilitate provide access to confidential information to facilitate the scoping and due diligence processes.the scoping and due diligence processes.

Friendly AcquisitionsFriendly AcquisitionsThe Friendly Takeover ProcessThe Friendly Takeover Process

1.1. Normally starts when the target voluntarily puts itself into play.Normally starts when the target voluntarily puts itself into play.•• Target uses an investment bank to prepare an Target uses an investment bank to prepare an offering offering

memorandummemorandum–– May set up a data room and use confidentiality agreements to permit May set up a data room and use confidentiality agreements to permit

access to interest parties practicing due diligenceaccess to interest parties practicing due diligence–– A signed letter of intent signals the willingness of the parties to move A signed letter of intent signals the willingness of the parties to move

to the next step to the next step –– (usually includes a no(usually includes a no--shop clause and a shop clause and a


15 - 953

to the next step to the next step –– (usually includes a no(usually includes a no--shop clause and a shop clause and a termination or break fee)termination or break fee)

–– Legal team checks documents, accounting team may seek advance Legal team checks documents, accounting team may seek advance tax ruling from CRAtax ruling from CRA

–– Final sale may require negotiations over the structure of the deal Final sale may require negotiations over the structure of the deal including:including:

»» Tax planningTax planning»» Legal structuresLegal structures

2.2. Can be initiated by a friendly overture by an acquisitor seeking Can be initiated by a friendly overture by an acquisitor seeking information that will assist in the valuation process.information that will assist in the valuation process.

(See Figure 15 (See Figure 15 --1 for a Friendly Acquisition timeline)1 for a Friendly Acquisition timeline)

Friendly AcquisitionFriendly Acquisition

15-1 FIGURE

Friendly Acquisition

Information memorandum

Confidentiality Main due Ratified


15 - 954

Approachtarget

Sign letterof intent

Final saleagreement

Confidentialityagreement

Main duediligence

Ratified

Friendly TakeoversFriendly TakeoversStructuring the AcquisitionStructuring the Acquisition

In friendly takeovers, both parties have the opportunity to In friendly takeovers, both parties have the opportunity to structure the deal to their mutual satisfaction including:structure the deal to their mutual satisfaction including:

1.1. Taxation Issues Taxation Issues –– cash for share purchases trigger capital gains cash for share purchases trigger capital gains so share exchanges may be a viable alternativeso share exchanges may be a viable alternative

2.2. Asset purchases rather share purchases that may:Asset purchases rather share purchases that may:•• Give the target firm cash to retire debt and restructure financingGive the target firm cash to retire debt and restructure financing


15 - 955

•• Give the target firm cash to retire debt and restructure financingGive the target firm cash to retire debt and restructure financing•• Acquiring firm will have a new asset base to maximize CCA Acquiring firm will have a new asset base to maximize CCA

deductionsdeductions•• Permit escape from some contingent liabilities (usually excluding Permit escape from some contingent liabilities (usually excluding

claims resulting from environmental lawsuits and control orders that claims resulting from environmental lawsuits and control orders that cannot severed from the assets involved)cannot severed from the assets involved)

3.3. Earn outsEarn outs where there is an agreement for an initial purchase price where there is an agreement for an initial purchase price with conditional later payments depending on the performance of with conditional later payments depending on the performance of the target after acquisition.the target after acquisition.

Hostile TakeoversHostile Takeovers

A takeover in which the target has no desire to be A takeover in which the target has no desire to be acquired and actively rebuffs the acquirer and acquired and actively rebuffs the acquirer and refuses to provide any confidential information.refuses to provide any confidential information.


15 - 956

refuses to provide any confidential information.refuses to provide any confidential information.

The acquirer usually has already accumulated an The acquirer usually has already accumulated an interest in the target (20% of the outstanding shares) interest in the target (20% of the outstanding shares) and this preemptive investment indicates the and this preemptive investment indicates the strength of resolve of the acquirer.strength of resolve of the acquirer.

Hostile TakeoversHostile TakeoversThe Typical ProcessThe Typical Process

The typical hostile takeover process:The typical hostile takeover process:1.1. Slowly acquire a toehold (beach head) by open market purchase of Slowly acquire a toehold (beach head) by open market purchase of

shares at market prices without attracting attention.shares at market prices without attracting attention.2.2. File statement with OSC at the 10% early warning stage while not File statement with OSC at the 10% early warning stage while not

trying to attract too much attention.trying to attract too much attention.3.3. Accumulate 20% of the outstanding shares through open market Accumulate 20% of the outstanding shares through open market

purchase over a longer period of timepurchase over a longer period of time


15 - 957

purchase over a longer period of timepurchase over a longer period of time4.4. Make a tender offer to bring ownership percentage to the desired level Make a tender offer to bring ownership percentage to the desired level

(either the control (50.1%) or amalgamation level (67%)) (either the control (50.1%) or amalgamation level (67%)) -- this offer this offer contains a provision that it will be made only if a certain minimum contains a provision that it will be made only if a certain minimum percentage is obtained.percentage is obtained.

During this process the acquirer will try to monitor management/board During this process the acquirer will try to monitor management/board reaction and fight attempts by them to put into effect shareholder reaction and fight attempts by them to put into effect shareholder rights plans or to launch other defensive tactics.rights plans or to launch other defensive tactics.

Hostile TakeoversHostile TakeoversCapital Market Reactions and Other DynamicsCapital Market Reactions and Other Dynamics

Market clues to the potential outcome of a hostile takeover attempt:Market clues to the potential outcome of a hostile takeover attempt:

1.1. Market price jumps above the offer priceMarket price jumps above the offer price•• A competing offer is likely orA competing offer is likely or•• The bid price is too lowThe bid price is too low

2.2. Market price stays close to the offer priceMarket price stays close to the offer price


15 - 958

•• The offer price is fair and the deal will likely go throughThe offer price is fair and the deal will likely go through

3.3. Little trading in the sharesLittle trading in the shares•• A bad sign for the acquirer because shareholders are reluctant to sell.A bad sign for the acquirer because shareholders are reluctant to sell.

4.4. Great deal of trading in the sharesGreat deal of trading in the shares•• Large numbers of shares being sold from normal investors to arbitrageurs Large numbers of shares being sold from normal investors to arbitrageurs

(arbs) who are, themselves building a position to negotiate an even bigger (arbs) who are, themselves building a position to negotiate an even bigger premium for themselves by coordinating a response to the tender offer.premium for themselves by coordinating a response to the tender offer.

Hostile TakeoversHostile TakeoversDefensive TacticsDefensive Tactics

Shareholders Rights PlanShareholders Rights Plan•• Known as a poison pill or deal killerKnown as a poison pill or deal killer•• Can take different forms but oftenCan take different forms but often

�� Gives nonGives non--acquiring shareholders get the right to buy 50 percent more acquiring shareholders get the right to buy 50 percent more shares at a discount price in the event of a takeover.shares at a discount price in the event of a takeover.

Selling the Crown JewelsSelling the Crown Jewels


15 - 959

Selling the Crown JewelsSelling the Crown Jewels•• The selling of a target company’s key assets that the acquiring The selling of a target company’s key assets that the acquiring

company is most interested in to make it less attractive for takeover.company is most interested in to make it less attractive for takeover.•• Can involve a large dividend to remove excess cash from the target’s Can involve a large dividend to remove excess cash from the target’s

balance sheet.balance sheet.

White KnightWhite Knight•• The target seeks out another acquirer considered friendly to make a The target seeks out another acquirer considered friendly to make a

counter offer and thereby rescue the target from a hostile takeovercounter offer and thereby rescue the target from a hostile takeover

Classifications Mergers and AcquisitionsClassifications Mergers and Acquisitions

1.1. HorizontalHorizontal•• A merger in which two firms in the same industry combine.A merger in which two firms in the same industry combine.•• Often in an attempt to achieve economies of scale and/or Often in an attempt to achieve economies of scale and/or

scope.scope.2.2. VerticalVertical

•• A merger in which one firm acquires a supplier or another firm A merger in which one firm acquires a supplier or another firm that is closer to its existing customers.that is closer to its existing customers.


15 - 960

that is closer to its existing customers.that is closer to its existing customers.•• Often in an attempt to control supply or distribution channels.Often in an attempt to control supply or distribution channels.

3.3. ConglomerateConglomerate•• A merger in which two firms in unrelated businesses combine.A merger in which two firms in unrelated businesses combine.•• Purpose is often to ‘diversify’ the company by combining Purpose is often to ‘diversify’ the company by combining

uncorrelated assets and income streamsuncorrelated assets and income streams4.4. CrossCross--border (International) M&Asborder (International) M&As

•• A merger or acquisition involving a Canadian and a foreign firm A merger or acquisition involving a Canadian and a foreign firm a either the acquiring or target company.a either the acquiring or target company.

Mergers and Acquisition ActivityMergers and Acquisition Activity

•• M&A activity seems to come in ‘waves’ through M&A activity seems to come in ‘waves’ through the economic cycle domestically, or in the economic cycle domestically, or in response to globalization issues such as:response to globalization issues such as:–– Formation and development of trading zones or Formation and development of trading zones or

blocks (EU, North America Free Trade Agreementblocks (EU, North America Free Trade Agreement


15 - 961

blocks (EU, North America Free Trade Agreementblocks (EU, North America Free Trade Agreement–– DeregulationDeregulation–– Sector booms such as energy or metalsSector booms such as energy or metals

•• Table 15 Table 15 --1 on the following slide depicts major 1 on the following slide depicts major M&A waves since the late 1800s.M&A waves since the late 1800s.

M&A Activity in CanadaM&A Activity in CanadaPeriod Major Characteristics of M&A Activity1895 - 1904 • Driven by economic expansion, U.S. transcontinental railroad, and the development of

national U.S. capital markets

• Characterized by horizontal M&As1922 - 1929 • 60 percent occurred in fragmented markets (chemical, food processing, mining)

• Driven by growth in transportation and merchandising, as well as by communications developments

1940 - 1947 • Characterized by vertical integration• Driven by evasion of price and quota controls

1960s • Characterized by conglomerate M&As• Driven by aerospace industry• Some firms merged to play the earnings per share "growth game" (discussed in the section

Table 15 - 1 M&A Activity in Canada


15 - 962

• Some firms merged to play the earnings per share "growth game" (discussed in the section The Effect of an Acquisition on Earnings per Share)

1980s • Characterized by leveraged buyouts and hostile takeovers1990s • Many international M&As (e.g., Chrysler and Daimler-Benz, Seagram and Martell)

• Strategic motives were advanced (although the jury is still out on whether this was truly achieved)

1999 - 2001 • High technology/Internet M&As• Many stock-financed takeovers, fuelled by inflated stock prices• Many were unsuccessful and/or fell through as the Internet "bubble" burst

2005 - ? • Resource-based/international M&A activity• Fuelled by strong industry fundamentals, low financing costs, strong economic conditions

Source: Adapted in part f rom Weston, J.F., Wang, F., Chung, S., and Hoag, S. Mergers, Restructuring, and Corporate Control. Toronto:

Prentice-Hall Canada, Inc., 1990.

Motivations for Mergers and AcquisitionsMotivations for Mergers and AcquisitionsCreation of Synergy Motive for M&AsCreation of Synergy Motive for M&As

The primary motive should be the creation of The primary motive should be the creation of synergy.synergy.


15 - 963

Synergy value is created from economies of Synergy value is created from economies of integrating a target and acquiring a company; integrating a target and acquiring a company; the amount by which the value of the combined the amount by which the value of the combined firm exceeds the sum value of the two firm exceeds the sum value of the two individual firms.individual firms.

Creation of Synergy Motive for M&AsCreation of Synergy Motive for M&As

Synergy is the additional value created (∆V) :Synergy is the additional value created (∆V) :

)V-(VVV TATA +=∆ −[ 15-1]


15 - 964

Where:Where:VVTT == the prethe pre--merger value of the target firmmerger value of the target firmVVA A -- TT == value of the post merger firmvalue of the post merger firmVVAA == value of the prevalue of the pre--merger acquiring firmmerger acquiring firm

)V-(VVV TATA +=∆ −

Value Creation Motivations for M&AsValue Creation Motivations for M&AsOperating SynergiesOperating Synergies

Operating SynergiesOperating Synergies1.1. Economies of ScaleEconomies of Scale

•• Reducing capacity (consolidation in the number of firms in the Reducing capacity (consolidation in the number of firms in the industry)industry)

•• Spreading fixed costs (increase size of firm so fixed costs per unit Spreading fixed costs (increase size of firm so fixed costs per unit are decreased)are decreased)


15 - 965

are decreased)are decreased)•• Geographic synergies (consolidation in regional disparate Geographic synergies (consolidation in regional disparate

operations to operate on a national or international basis) operations to operate on a national or international basis)

2.2. Economies of ScopeEconomies of Scope•• Combination of two activities reduces costsCombination of two activities reduces costs

3.3. Complementary StrengthsComplementary Strengths•• Combining the different relative strengths of the two firms creates Combining the different relative strengths of the two firms creates

a firm with both strengths that are complementary to one another. a firm with both strengths that are complementary to one another.

Value Creation Motivations for M&AValue Creation Motivations for M&AEfficiency Increases and Financing SynergiesEfficiency Increases and Financing Synergies

Efficiency IncreasesEfficiency Increases–– New management team will be more efficient and New management team will be more efficient and

add more value than what the target now has.add more value than what the target now has.–– The combined firm can make use of unused The combined firm can make use of unused

production/sales/marketing channel capacityproduction/sales/marketing channel capacity


15 - 966

production/sales/marketing channel capacityproduction/sales/marketing channel capacity

Financing SynergyFinancing Synergy–– Reduced cash flow variabilityReduced cash flow variability–– Increase in debt capacityIncrease in debt capacity–– Reduction in average issuing costsReduction in average issuing costs–– Fewer information problemsFewer information problems

Value Creation Motivations for M&AValue Creation Motivations for M&ATax Benefits and Strategic RealignmentsTax Benefits and Strategic Realignments

Tax BenefitsTax Benefits–– Make better use of tax deductions and creditsMake better use of tax deductions and credits

•• Use them before they lapse or expire (loss carryUse them before they lapse or expire (loss carry--back, carryback, carry--forward provisions)forward provisions)

•• Use of deduction in a higher tax bracket to obtain a large tax Use of deduction in a higher tax bracket to obtain a large tax shieldshield

•• Use of deductions to offset taxable income (nonUse of deductions to offset taxable income (non--operating capital operating capital


15 - 967

•• Use of deductions to offset taxable income (nonUse of deductions to offset taxable income (non--operating capital operating capital losses offsetting taxable capital gains that the target firm was losses offsetting taxable capital gains that the target firm was unable to use) unable to use)

•• New firm will have operating income to make full use of available New firm will have operating income to make full use of available CCA.CCA.

Strategic RealignmentsStrategic Realignments–– Permits new strategies that were not feasible for prior to the Permits new strategies that were not feasible for prior to the

acquisition because of the acquisition of new management acquisition because of the acquisition of new management skills, connections to markets or people, and new skills, connections to markets or people, and new products/services.products/services.

Managerial Motivations for M&AsManagerial Motivations for M&As

Managers may have their own motivations to pursue M&As. Managers may have their own motivations to pursue M&As. The two most common, are not necessarily in the best The two most common, are not necessarily in the best interest of the firm or shareholders, but do address common interest of the firm or shareholders, but do address common needs of managersneeds of managers

1.1. Increased firm sizeIncreased firm size–– Managers are often more highly rewarded financially for building a Managers are often more highly rewarded financially for building a

bigger business (compensation tied to assets under administration for bigger business (compensation tied to assets under administration for


15 - 968

bigger business (compensation tied to assets under administration for bigger business (compensation tied to assets under administration for example)example)

–– Many associate power and prestige with the size of the firm.Many associate power and prestige with the size of the firm.

2.2. Reduced firm risk through diversificationReduced firm risk through diversification•• Managers have an undiversified stake in the business (unlike Managers have an undiversified stake in the business (unlike

shareholders who hold a diversified portfolio of investments and don’t shareholders who hold a diversified portfolio of investments and don’t need the firm to be diversified) and so they tend to dislike risk need the firm to be diversified) and so they tend to dislike risk (volatility of sales and profits)(volatility of sales and profits)

•• M&As can be used to diversify the company and reduce volatility (risk) M&As can be used to diversify the company and reduce volatility (risk) that might concern managers.that might concern managers.

Empirical Evidence of Gains through Empirical Evidence of Gains through M&AsM&As

•• Target shareholders gain the mostTarget shareholders gain the most–– Through premiums paid to them to acquire their sharesThrough premiums paid to them to acquire their shares

•• 15 15 –– 20% for stock20% for stock--finance acquisitionsfinance acquisitions•• 25 25 –– 30% for cash30% for cash--financed acquisitions (triggering capital gains financed acquisitions (triggering capital gains

taxes for these shareholders)taxes for these shareholders)

–– Gains may be greater for shareholders will to wait for ‘arbs’ to Gains may be greater for shareholders will to wait for ‘arbs’ to


15 - 969

–– Gains may be greater for shareholders will to wait for ‘arbs’ to Gains may be greater for shareholders will to wait for ‘arbs’ to negotiate higher offers or bidding wars develop between negotiate higher offers or bidding wars develop between multiple acquirers.multiple acquirers.

•• Between 1995 and 2001, 302 deals worth US$500.Between 1995 and 2001, 302 deals worth US$500.–– 61% lost value over the following year 61% lost value over the following year –– The biggest losers were deals financed through shares which The biggest losers were deals financed through shares which

lost an average 8%.lost an average 8%.

Empirical Evidence of Gains through M&AsEmpirical Evidence of Gains through M&AsShareholder Value at Risk (SVAR)Shareholder Value at Risk (SVAR)

•• Shareholder Value at Risk (SVAR)Shareholder Value at Risk (SVAR)–– Is the potential in an M&A that synergies will not be Is the potential in an M&A that synergies will not be

realized or that the premium paid will be greater than realized or that the premium paid will be greater than the synergies that are realized.the synergies that are realized.•• When using cash, the acquirer bears all the riskWhen using cash, the acquirer bears all the risk


15 - 970

•• When using cash, the acquirer bears all the riskWhen using cash, the acquirer bears all the risk•• When using share swaps, the risk is borne by the When using share swaps, the risk is borne by the

shareholders in both companiesshareholders in both companies

•• SVAR supports the argument that firms making SVAR supports the argument that firms making cash deals are much more careful about the cash deals are much more careful about the acquisition price.acquisition price.

Valuation IssuesValuation IssuesWhat is Fair Market Value?What is Fair Market Value?

Fair market value (FMV) is the highest price obtainable in an Fair market value (FMV) is the highest price obtainable in an open and unrestricted market between knowledgeable, open and unrestricted market between knowledgeable, informed and prudent parties acting at arm’s length, with informed and prudent parties acting at arm’s length, with neither party being under any compulsion to transact.neither party being under any compulsion to transact.


15 - 971

Key phrases in this definition:Key phrases in this definition:1.1. Open and unrestricted market (where supply and demand can Open and unrestricted market (where supply and demand can

freely operate freely operate –– see Figure 15 see Figure 15 --2 on the following slide)2 on the following slide)2.2. Knowledgeable, informed and prudent partiesKnowledgeable, informed and prudent parties3.3. Arm’s lengthArm’s length4.4. Neither party under any compulsion to transact.Neither party under any compulsion to transact.

Valuation IssuesValuation IssuesValuation FrameworkValuation Framework

15-2 FIGURE

Demand Supply

S1

P


15 - 972

B1

S1

P*

Q

Valuation IssuesValuation IssuesTypes of AcquirersTypes of Acquirers

Determining fair market value depends on the perspective of the Determining fair market value depends on the perspective of the acquirer. Some acquirers are more likely to be able to realize acquirer. Some acquirers are more likely to be able to realize synergies than others and those with the greatest ability to generate synergies than others and those with the greatest ability to generate synergies are the ones who can justify higher prices.synergies are the ones who can justify higher prices.

Types of acquirers and the impact of their perspective on value include:Types of acquirers and the impact of their perspective on value include:1.1. Passive investors Passive investors –– use estimated cash flows currently presentuse estimated cash flows currently present2.2. Strategic investors Strategic investors –– use estimated synergies and changes that are use estimated synergies and changes that are


15 - 973

2.2. Strategic investors Strategic investors –– use estimated synergies and changes that are use estimated synergies and changes that are forecast to arise through integration of operations with their ownforecast to arise through integration of operations with their own

3.3. Financials Financials –– valued on the basis of reorganized and refinanced valued on the basis of reorganized and refinanced operationsoperations

4.4. Managers Managers –– value the firm based on their own job potential and ability value the firm based on their own job potential and ability to motivate staff and reorganize the firm’s operations. MBOs and to motivate staff and reorganize the firm’s operations. MBOs and LBOsLBOs

Market pricing will reflect these different buyers and their importance at Market pricing will reflect these different buyers and their importance at different stages of the business cycle.different stages of the business cycle.

Market Pricing ApproachesMarket Pricing Approaches

Reactive Pricing ApproachesReactive Pricing ApproachesModels reacting to general rules of thumb and the Models reacting to general rules of thumb and the relative pricing compared to other securitiesrelative pricing compared to other securities

1.1. Multiples or relative valuationMultiples or relative valuation2.2. Liquidation or breakup valuesLiquidation or breakup values


15 - 974

2.2. Liquidation or breakup valuesLiquidation or breakup values

Proactive ModelsProactive ModelsA valuation method to determine what a target firm’s A valuation method to determine what a target firm’s value should be based on future values of cash flow value should be based on future values of cash flow and earningsand earnings

1.1. Discounted cash flow (DCF) modelsDiscounted cash flow (DCF) models

Reactive ApproachesReactive ApproachesValuation Using MultiplesValuation Using Multiples

1.1. Find appropriate comparatorsFind appropriate comparators–– Individual firm that is highly comparable to the targetIndividual firm that is highly comparable to the target–– Industry average if appropriateIndustry average if appropriate

2.2. Adjust/normalize the data (income statement and balance sheet) for Adjust/normalize the data (income statement and balance sheet) for differences between target and comparator including:differences between target and comparator including:

–– Accounting differencesAccounting differences•• LIFO versus FIFO LIFO versus FIFO •• Accelerated versus straightAccelerated versus straight--line depreciationline depreciation


15 - 975

•• Accelerated versus straightAccelerated versus straight--line depreciationline depreciation•• Age of depreciable assetsAge of depreciable assets•• Pension liabilities, etc.Pension liabilities, etc.

–– Different capital structuresDifferent capital structures3.3. Calculate a variety of ratios for both the target and the comparator including:Calculate a variety of ratios for both the target and the comparator including:

–– PricePrice--earnings ratio (trailing)earnings ratio (trailing)–– Value/EBITDAValue/EBITDA–– Price/Book ValuePrice/Book Value–– Return on EquityReturn on Equity

4.4. Obtain a range of justifiable values based on the ratiosObtain a range of justifiable values based on the ratios

Reactive ApproachesReactive ApproachesLiquidation ValuationLiquidation Valuation

1.1. Estimate the liquidation value of current assetsEstimate the liquidation value of current assets2.2. Estimate the present value of tangible assetsEstimate the present value of tangible assets3.3. Subtract the value of the firm’s liability from Subtract the value of the firm’s liability from


15 - 976

3.3. Subtract the value of the firm’s liability from Subtract the value of the firm’s liability from estimated liquidation value of all the firm’s estimated liquidation value of all the firm’s assets = liquidation value of the firm.assets = liquidation value of the firm.

This approach values the firm based on existing assets and is not This approach values the firm based on existing assets and is not forward looking.forward looking.

The Proactive ApproachThe Proactive ApproachDiscounted Cash Flow ValuationDiscounted Cash Flow Valuation

•• The key to using the DCF approach to price a target firm is The key to using the DCF approach to price a target firm is to obtain good forecasts of free cash flowto obtain good forecasts of free cash flow

•• Free cash flows to equity holders represents cash flows left Free cash flows to equity holders represents cash flows left over after all obligations, including interest payments have over after all obligations, including interest payments have been paid.been paid.


15 - 977

been paid.been paid.•• DCF valuation takes the following steps:DCF valuation takes the following steps:

1.1. Forecast free cash flowsForecast free cash flows2.2. Obtain a relevant discount rate Obtain a relevant discount rate 3.3. Discount the forecast cash flows and sum to estimate the value Discount the forecast cash flows and sum to estimate the value

of the targetof the target

(See Equation 15 (See Equation 15 –– 2 on the following slide)2 on the following slide)

Discounted Cash Flow AnalysisDiscounted Cash Flow AnalysisFree Cash Flow to EquityFree Cash Flow to Equity

(/.),

,(/

cashincludingnotcapitalworkingnetinchangesetctaxesdeferred

onamortizatiitemscashnonincomenetequitytoflowcashFree

−+−−+=

[ 15-2]


15 - 978

esexpenditur)securities

(/.),

capitalnetmarketableand

cashincludingnotcapitalworkingnetinchangesetctaxesdeferred

−−+[ 15-2]

Discounted Cash Flow AnalysisDiscounted Cash Flow AnalysisThe General DCF ModelThe General DCF Model

•• Equation 15 Equation 15 –– 3 is the generalized version of the 3 is the generalized version of the DCF model showing how forecast free cash DCF model showing how forecast free cash flows are discounted to the present and then flows are discounted to the present and then summed.summed.


15 - 979

)1()1(

...)1(

)1( 1

22

11

0 ∑= +

=+

+++

++

=α

αα

tt

t

k

CF

k

CF

k

CF

k

CFV[ 15-3]

Discounted Cash Flow AnalysisDiscounted Cash Flow AnalysisThe Constant Growth DCF ModelThe Constant Growth DCF Model

•• Equation 15 Equation 15 –– 4 is the DCF model for a target firm where the 4 is the DCF model for a target firm where the free cash flows are expected to grow at a constant rate for the free cash flows are expected to grow at a constant rate for the foreseeable future.foreseeable future.


15 - 980

•• Many target firms are high growth firms and so a multiMany target firms are high growth firms and so a multi--stage stage model may be more appropriate.model may be more appropriate.

(See Figure 15 (See Figure 15 --3 on the following slide for the DCF Valuation Framework.)3 on the following slide for the DCF Valuation Framework.)

10 gk

CFV

−=[ 15-4]

Valuation IssuesValuation IssuesValuation FrameworkValuation Framework

15-3 FIGURE

Time Period Free Cash Flows

∑T VC


15 - 981

Terminal Value

Discount Rate

)1()1(1

0 ∑= +

++

=T

tT

Tt

t

k

V

k

CV

Discounted Cash Flow AnalysisDiscounted Cash Flow AnalysisThe Multiple Stage DCF ModelThe Multiple Stage DCF Model

•• The multiThe multi--stage DCF model can be amended to stage DCF model can be amended to include numerous stages of growth in the include numerous stages of growth in the forecast period.forecast period.

•• This is exhibited in equation 15 This is exhibited in equation 15 –– 5:5:


15 - 982

•• This is exhibited in equation 15 This is exhibited in equation 15 –– 5:5:

)1(

)1(1

0 TT

T

tt

t

k

V

k

CFV

++

+=∑

=[ 15-5]

Valuation IssuesValuation IssuesThe Acquisition Decision and Risks that Must be ManagedThe Acquisition Decision and Risks that Must be Managed

Once the value to the acquirer has been determined, the Once the value to the acquirer has been determined, the acquisition will only make sense if the target firm can be acquisition will only make sense if the target firm can be acquired at a price that is less.acquired at a price that is less.

As the acquirer enters the buying/tender process, the As the acquirer enters the buying/tender process, the outcome is not certain:outcome is not certain:

•• Competing bidders may appearCompeting bidders may appear


15 - 983

•• Competing bidders may appearCompeting bidders may appear•• Arbs may buy up outstanding stock and force price concessions Arbs may buy up outstanding stock and force price concessions

and lengthen the acquisition process (increasing the costs of and lengthen the acquisition process (increasing the costs of acquisitions)acquisitions)

•• In the end, the forecast synergies might not be realizedIn the end, the forecast synergies might not be realized

The acquirer can attempt to mitigate some of these risk through The acquirer can attempt to mitigate some of these risk through advance tax rulings from CRA, entering a friendly takeover and advance tax rulings from CRA, entering a friendly takeover and through due diligence.through due diligence.

Valuation IssuesValuation IssuesThe Effect of an Acquisition on Earnings per ShareThe Effect of an Acquisition on Earnings per Share

An acquiring firm can increase its EPS if it An acquiring firm can increase its EPS if it acquires a firm that has a P/E ratio lower than acquires a firm that has a P/E ratio lower than its own.its own.


15 - 984

its own.its own.

Accounting for Acquisitions Accounting for Acquisitions

Historically firms could use one of two Historically firms could use one of two approaches to account for business approaches to account for business combinationscombinations

1.1. Purchase method andPurchase method and2.2. PoolingPooling--ofof--interest method (no longer allowed)interest method (no longer allowed)


15 - 985

2.2. PoolingPooling--ofof--interest method (no longer allowed)interest method (no longer allowed)

While more popular in other countries, the pooling of While more popular in other countries, the pooling of interest is no longer allowed by:interest is no longer allowed by:•• CICA in CanadaCICA in Canada•• Financial Accounting Standards Board (FASB) in the U.S. Financial Accounting Standards Board (FASB) in the U.S.

andand•• Internal Accounting Standards Board (IASB)Internal Accounting Standards Board (IASB)

Accounting for Acquisitions Accounting for Acquisitions The Purchase MethodThe Purchase Method

One firm assumes all assets and liabilities and operating One firm assumes all assets and liabilities and operating results going forward of the target firm.results going forward of the target firm.

How is this done?How is this done?•• All assets and liabilities are expressed at their fair market value All assets and liabilities are expressed at their fair market value


15 - 986

•• All assets and liabilities are expressed at their fair market value All assets and liabilities are expressed at their fair market value (FMV) as of the acquisition date.(FMV) as of the acquisition date.

•• If the FMV > the target firm’s equity, the excess amount is If the FMV > the target firm’s equity, the excess amount is goodwill goodwill and reported as an intangible asset on the left hand side of the and reported as an intangible asset on the left hand side of the balance sheet.balance sheet.

•• Goodwill is no longer amortized but must be annually assessed to Goodwill is no longer amortized but must be annually assessed to determine if has been permanently ‘impaired’ in which case, the determine if has been permanently ‘impaired’ in which case, the value will be written down and charged against earnings per share.value will be written down and charged against earnings per share.

Example of the Purchase Method Example of the Purchase Method Accounting for AcquisitionsAccounting for Acquisitions

Acquisitor purchases Target firm for $1,250 in cash on June 30, 2006.Acquisitor purchases Target firm for $1,250 in cash on June 30, 2006.

Acquisitor Pre- Merger

Target Firm (Book Value)

Target Firm (Fair Market

Value)Current assets 10,000 1,200 1,300

www.bookfiesta4u.com ContentsCHAPTER 15 – Mergers and Acquisitions 15 - 987

Current assets 10,000 1,200 1,300Long-term assets 6,000 800 900GoodwillTotal Assets 16,000 2,000 2,200

Current liabilities 8,000 800 800Long-term debt 2,000 200 250Common stock 2,000 400 1,250Retained earnings 4,000 600Total Claims 16,000 2,000 2,300

Example of the Purchase Method Example of the Purchase Method Accounting for AcquisitionsAccounting for Acquisitions

Acquisitor Pre- Merger

Target Firm (Book Value)

Target Firm (Fair Market

Value)Acquisitor Post

MergerCurrent assets 10,000 1,200 1,300 11,300

Book Values are

Acquisitor Value pre merger + Target Firm (FMV) = A cquisitor Post MergerGoodwill = Price paid – MV of Target firm Equity

= $1,250 – (MV of target assets – MV of target Liabil ities)

= $1,250 – ($2,200 - $1,050)

= $100

www.bookfiesta4u.com ContentsCHAPTER 15 – Mergers and Acquisitions 15 - 988

Current assets 10,000 1,200 1,300 11,300Long-term assets 6,000 800 900 6,900Goodwill 100Total Assets 16,000 2,000 2,200 18,300

Current liabilities 8,000 800 800 8,800Long-term debt 2,000 200 250 2,250Common stock 2,000 400 1,250 3,250Retained earnings 4,000 600 4,000Total Claims 16,000 2,000 2,300 18,300

Values are not

relevant.

Good Will in Subsequent YearsGood Will in Subsequent YearsThe Purchase MethodThe Purchase Method

•• Good will is subject to an impairment test each year.Good will is subject to an impairment test each year.•• This will require FMV estimating using discounted cash This will require FMV estimating using discounted cash

flow approaches annually following the acquisition and flow approaches annually following the acquisition and capitalization of good will on the balance sheet.capitalization of good will on the balance sheet.


15 - 989

capitalization of good will on the balance sheet.capitalization of good will on the balance sheet.•• Good will is changed only if it is ‘impaired’ in subsequent Good will is changed only if it is ‘impaired’ in subsequent

years resulting in a write down and a charge against years resulting in a write down and a charge against earnings.earnings.


In this chapter you have learned:In this chapter you have learned:–– The various forms of business combinations The various forms of business combinations –– The common motives that exist for takeovers as well as The common motives that exist for takeovers as well as

the desirable characteristics of potential takeover “targets”the desirable characteristics of potential takeover “targets”


15 - 990

the desirable characteristics of potential takeover “targets”the desirable characteristics of potential takeover “targets”–– How to evaluate a potential takeover candidate using the How to evaluate a potential takeover candidate using the

multiples approach and using discounted cash flow multiples approach and using discounted cash flow analysisanalysis

–– How acquisitions should be accounted for in the financial How acquisitions should be accounted for in the financial statements including the impact that acquisitions can have statements including the impact that acquisitions can have on EPS.on EPS.

CHAPTER 16CHAPTER 16LeasingLeasingLeasingLeasing


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• Leasing ArrangementsLeasing Arrangements•• Accounting for LeasesAccounting for Leases•• Evaluating the Lease Evaluating the Lease

www.bookfiesta4u.com ContentsCHAPTER 16 – Leasing 16 - 993

•• Evaluating the Lease Evaluating the Lease DecisionDecision

•• Motivation for LeasingMotivation for Leasing•• Summary and ConclusionsSummary and Conclusions



•• The basic characteristics of leases and The basic characteristics of leases and how to differentiate between operating how to differentiate between operating and financial (or capital) leasesand financial (or capital) leases

•• The accounting treatment of both The accounting treatment of both

www.bookfiesta4u.com ContentsCHAPTER 16 – Leasing

16 - 994

•• The accounting treatment of both The accounting treatment of both operating and financial leasesoperating and financial leases

•• The benefits and disadvantages of The benefits and disadvantages of leasesleases

•• How the lease decision can be How the lease decision can be evaluated using the discounted cash evaluated using the discounted cash flow valuation methodsflow valuation methods


•• AssetAsset--based lendingbased lending•• Captive finance companiesCaptive finance companies•• Financial leaseFinancial lease•• LesseeLessee

•• Operating leaseOperating lease•• Sale and leaseback (SLB) Sale and leaseback (SLB)

agreementagreement•• Secured financingSecured financing•• Small and mediumSmall and medium--sized sized


16 - 995

•• LesseeLessee•• LessorLessor•• Leveraged leaseLeveraged lease•• OffOff--balancebalance--sheet financingsheet financing

•• Small and mediumSmall and medium--sized sized enterprises (SMEs)enterprises (SMEs)

Leasing ArrangementsLeasing ArrangementsIntroductionIntroduction

•• The decision to invest in an asset that has a long life is a The decision to invest in an asset that has a long life is a capital budgeting decision.capital budgeting decision.

•• The The decision decision to acquireto acquire is a separate decision from the is a separate decision from the decision on the decision on the method of financingmethod of financing the acquisitionthe acquisition

•• When these two decisions are combined, this is called When these two decisions are combined, this is called assetasset--


16 - 996

•• When these two decisions are combined, this is called When these two decisions are combined, this is called assetasset--based lending based lending because the financing is tied directly to a because the financing is tied directly to a particular asset.particular asset.

•• Examples of assetExamples of asset--based lending include:based lending include:–– Secured loansSecured loans–– Conditional sales contractsConditional sales contracts–– LeasesLeases

Leasing ArrangementsLeasing ArrangementsThe Institutional FrameworkThe Institutional Framework

•• Canadian Finance and Leasing Association (CFLA) acts as Canadian Finance and Leasing Association (CFLA) acts as the trade association for assetthe trade association for asset--based lendersbased lenders–– 160 members160 members–– Represents three group of financial companies:Represents three group of financial companies:

1.1. Independent assetIndependent asset--based finance companiesbased finance companies–– Involved in machinery and equipment financing with 60% of Involved in machinery and equipment financing with 60% of


16 - 997

–– Involved in machinery and equipment financing with 60% of Involved in machinery and equipment financing with 60% of customers begin SMEs.customers begin SMEs.

–– 40% of the assets financed are transportation equipment (buses, 40% of the assets financed are transportation equipment (buses, trucks, trailers or office equipment)trucks, trailers or office equipment)

2.2. Captive finance companies of major manufacturers (eg. GMC Captive finance companies of major manufacturers (eg. GMC Finance and Ford Credit Canada) where 1/3 of all new vehicles Finance and Ford Credit Canada) where 1/3 of all new vehicles are leased. are leased.

3.3. Chartered banksChartered banks–– Chartered banks are not allowed to lease consumer household Chartered banks are not allowed to lease consumer household

property and are therefore focussed on leasing commercial property and are therefore focussed on leasing commercial transportation equipment and real property such as land and buildingstransportation equipment and real property such as land and buildings

LeaseLeaseWhat is it?What is it?

A lease contract is an agreement where the owner A lease contract is an agreement where the owner conveys to the user the right to use an asset in return conveys to the user the right to use an asset in return for a number of specified payments over an agreed for a number of specified payments over an agreed period of timeperiod of time


16 - 998

LessorLessor is the owner of the assetis the owner of the assetLesseeLessee is the user of the assetis the user of the asset

LeasingLeasingTypes of LeasesTypes of Leases

Operating LeaseOperating Lease•• A lease where some of the benefits of ownership do not A lease where some of the benefits of ownership do not

transfer to the lessee and remain with the lessor. transfer to the lessee and remain with the lessor.


16 - 999

Financial (Capital) LeaseFinancial (Capital) Lease•• A lease where essentially all the benefits of ownership A lease where essentially all the benefits of ownership

transfer to the lessee; also known as a capital or full payout transfer to the lessee; also known as a capital or full payout lease.lease.

(See Table 16(See Table 16--1 on the following slide for the distinguishing features between 1 on the following slide for the distinguishing features between the two types of leases) the two types of leases)

Types of LeasesTypes of LeasesOperating versus Financial LeasesOperating versus Financial Leases

Lessee Lessor Lessee Lessor

Asset Not on balance sheet (B/S);

Report on B/S Report on B/S Not on B/S

Table 16-1 Operating versus Financial Leases

OPERATING FINANCIAL


16 - 1000

sheet (B/S); disclose in footnotes

Lease payments Expense the full amount as rental expense

Claim as rental income

Decompose into interest and principal repayment, and expense the interest portion

Claim the interest portion of payments received as interest income

Depreciation expense (associated with leased asset)

Cannot claim Claim Claim Cannot claim

Conditional Sales AgreementConditional Sales AgreementWhat is it? CRA PerspectiveWhat is it? CRA Perspective

According to Canada Revenue Agency (CRA) a conditional According to Canada Revenue Agency (CRA) a conditional sales agreement exists if one of the following occurs:sales agreement exists if one of the following occurs:

•• The lessee automatically acquires ownership at some pointThe lessee automatically acquires ownership at some point•• The lessee is required to buy the asset at some point or guarantee The lessee is required to buy the asset at some point or guarantee

that the lessor gets a certain value for itthat the lessor gets a certain value for it•• The lessee has the right to buy the asset at some point for The lessee has the right to buy the asset at some point for


16 - 1001

•• The lessee has the right to buy the asset at some point for The lessee has the right to buy the asset at some point for substantially less than the likely fair market valuesubstantially less than the likely fair market value

•• The lessee has the right to buy the asset at a price that would cause The lessee has the right to buy the asset at a price that would cause a reasonable person to conclude that they will buy it.a reasonable person to conclude that they will buy it.

CRA’s interest in this issue is that it must determine which party CRA’s interest in this issue is that it must determine which party to the contract has the legal right to claim CCA for tax purposes. to the contract has the legal right to claim CCA for tax purposes. If any of the other above conditions are satisfied, CRA regards If any of the other above conditions are satisfied, CRA regards the user (lessee) as having the right to claim CCA.the user (lessee) as having the right to claim CCA.

Financial/Capital/Full Payout LeaseFinancial/Capital/Full Payout LeaseWhat is it? Accounting PerspectiveWhat is it? Accounting Perspective

According to the Canadian Institute of Chartered Accountants According to the Canadian Institute of Chartered Accountants (CICA), all of the benefits of ownership transfer to the lessee with (CICA), all of the benefits of ownership transfer to the lessee with these lease agreements.these lease agreements.

The lessee is deemed to own the asset and will claim The lessee is deemed to own the asset and will claim depreciation on the firm’s income statement and record the value depreciation on the firm’s income statement and record the value as an asset and liability on the balance sheet.as an asset and liability on the balance sheet.


16 - 1002

as an asset and liability on the balance sheet.as an asset and liability on the balance sheet.

Such leases usually:Such leases usually:

•• Require the lessee to carry out maintenance and insure the assetRequire the lessee to carry out maintenance and insure the asset•• Provides the lessee with a fixed purchase optionProvides the lessee with a fixed purchase option•• The lease agreement covers 75% of the economic life of the assetThe lease agreement covers 75% of the economic life of the asset•• Is structured so that the present value of lease payments exceeds Is structured so that the present value of lease payments exceeds

90 % of the cost90 % of the cost•• Involves fixed rental payments.Involves fixed rental payments.

Operating LeaseOperating LeaseWhat is it? Accounting PerspectiveWhat is it? Accounting Perspective

•• If a lease is NOT a capital lease, then it is an If a lease is NOT a capital lease, then it is an operating leaseoperating lease

•• Operating leases do not transfer to the lessee the Operating leases do not transfer to the lessee the benefits of ownership (ability to deduct CCA)benefits of ownership (ability to deduct CCA)


16 - 1003

Sale and Leaseback AgreementSale and Leaseback AgreementWhat is it?What is it?

•• An agreement in which the owner of an asset sells it An agreement in which the owner of an asset sells it to another party and then leases the asset backto another party and then leases the asset back

•• Popular type of lease for organizations in low tax Popular type of lease for organizations in low tax brackets because they are unable to use the tax brackets because they are unable to use the tax shield offered by CCAshield offered by CCA

•• SLBs can mean that part of the tax savings can be SLBs can mean that part of the tax savings can be


16 - 1004

•• SLBs can mean that part of the tax savings can be SLBs can mean that part of the tax savings can be transferred back to the seller in the form of lower transferred back to the seller in the form of lower lease payments, reducing the cost of the assetlease payments, reducing the cost of the asset

•• 1989 federal budget significantly reduced the benefits 1989 federal budget significantly reduced the benefits from such agreements by forcing the lessor to deduct from such agreements by forcing the lessor to deduct depreciation on leased assets only from income depreciation on leased assets only from income derived from leasing.derived from leasing.

Leveraged LeaseLeveraged LeaseWhat is it?What is it?

•• A threeA three--way agreement among the lessee, the lessor, way agreement among the lessee, the lessor, and a third party lender in which the lessor buys the and a third party lender in which the lessor buys the asset with only a small down payment and the lender asset with only a small down payment and the lender supplies the financingsupplies the financing

•• Popular in U.S. because lessor puts up only a portion Popular in U.S. because lessor puts up only a portion


16 - 1005

•• Popular in U.S. because lessor puts up only a portion Popular in U.S. because lessor puts up only a portion of the asset purchase price, but receives all of the tax of the asset purchase price, but receives all of the tax benefits of ownershipbenefits of ownership

•• Not popular in Canada because CRA restricts use of Not popular in Canada because CRA restricts use of CCA to the party at risk, and CCA deductions cannot CCA to the party at risk, and CCA deductions cannot be carried over to offset taxes on other incomebe carried over to offset taxes on other income

Accounting for LeasesAccounting for LeasesAccounting for LeasesAccounting for Leases

•• Financial leases are included on the balance Financial leases are included on the balance sheet of the lesseesheet of the lessee–– Present value of all lease payments is recorded on Present value of all lease payments is recorded on

the rightthe right--hand side of the balance sheethand side of the balance sheet–– The same amount is recorded as an asset on the The same amount is recorded as an asset on the


16 - 1006

–– The same amount is recorded as an asset on the The same amount is recorded as an asset on the leftleft--hand side of the balancehand side of the balance

•• Operating leases are offOperating leases are off--balancebalance--sheet sheet financing for the lessee (included only in the financing for the lessee (included only in the notes to the financial statements)notes to the financial statements)

Accounting for LeasesAccounting for LeasesFinancial Statement Effects of Lease ClassificationFinancial Statement Effects of Lease Classification

Capital/Financial/Full Payout Leases:Capital/Financial/Full Payout Leases:Income EffectsIncome Effects1.1. Net income will generally be lower for capital leases in the early Net income will generally be lower for capital leases in the early

years and higher in the later years.years and higher in the later years.2.2. CFO will be higher with capital leases. CCA may be deducted CFO will be higher with capital leases. CCA may be deducted

in measuring Net Income after tax, however, CCA is added in measuring Net Income after tax, however, CCA is added


16 - 1007

in measuring Net Income after tax, however, CCA is added in measuring Net Income after tax, however, CCA is added back when determining CFO. Capital/ financial leases expense back when determining CFO. Capital/ financial leases expense only the interest portion of the payments in determining EBT.only the interest portion of the payments in determining EBT.

Balance Sheet EffectsBalance Sheet Effects1.1. Lower current ratios, higher debt and leverage ratios, lower Lower current ratios, higher debt and leverage ratios, lower

asset turnover and lower profitability ratios (especially in the asset turnover and lower profitability ratios (especially in the early years of asset life)early years of asset life)

Accounting for LeasesAccounting for LeasesFinancial Statement Effects of Lease ClassificationFinancial Statement Effects of Lease Classification

Operating Leases:Operating Leases:Income EffectsIncome Effects1.1. Net income will generally be higher for operating leases in the Net income will generally be higher for operating leases in the

early years and lower in the later years because interest early years and lower in the later years because interest expense charged for the financial lease declines as the liability expense charged for the financial lease declines as the liability is amortized by the lease payments.is amortized by the lease payments.


16 - 1008

is amortized by the lease payments.is amortized by the lease payments.2.2. CFO will be lower with operating leases since the full lease CFO will be lower with operating leases since the full lease

payment is subtracted from CFO, unlike financial leases where payment is subtracted from CFO, unlike financial leases where only the interest portion of the payments is subtracted.only the interest portion of the payments is subtracted.

Balance Sheet EffectsBalance Sheet Effects1.1. Higher current ratios, lower debt and leverage ratios, higher Higher current ratios, lower debt and leverage ratios, higher

asset turnover and higher profitability ratios (especially in the asset turnover and higher profitability ratios (especially in the early years of asset life)early years of asset life)

Evaluating the Lease DecisionEvaluating the Lease DecisionLease Versus BuyLease Versus Buy

•• Leasing is an alternative means of obtaining the use of an Leasing is an alternative means of obtaining the use of an assetasset

•• There are four main differences in the cash flows for a There are four main differences in the cash flows for a company that leases an asset instead of buying it:company that leases an asset instead of buying it:1.1. It does not have to pay for the asset up frontIt does not have to pay for the asset up front


16 - 1009

2.2. It does not get to sell the asset when it is finished with it, if it is It does not get to sell the asset when it is finished with it, if it is an operating lease, or if title is not transferred through a an operating lease, or if title is not transferred through a financial leasefinancial lease

3.3. It makes regular lease payments. If the lease is an operating It makes regular lease payments. If the lease is an operating lease, then the full amount of the lease payments is tax lease, then the full amount of the lease payments is tax deductible; only the interest portion is deductible for capital deductible; only the interest portion is deductible for capital leasesleases

4.4. Operating leases are not depreciated.Operating leases are not depreciated.

Evaluating the Lease DecisionEvaluating the Lease DecisionLease Versus Buy Evaluative FrameworksLease Versus Buy Evaluative Frameworks

IRR of Leasing AnalysisIRR of Leasing Analysis–– Estimate incremental cash flows that result from Estimate incremental cash flows that result from

leasingleasing–– Solve for the discount rate (IRR) that equates the Solve for the discount rate (IRR) that equates the

incremental cash flows with the initial value of the incremental cash flows with the initial value of the


16 - 1010

incremental cash flows with the initial value of the incremental cash flows with the initial value of the asset. (This is the asset. (This is the afterafter--tax IRRtax IRR or cost of leasing)or cost of leasing)

•• If IRR of leasing > afterIf IRR of leasing > after--tax cost of borrowing (borrow and tax cost of borrowing (borrow and buy the asset)buy the asset)

•• If IRR of leasing < afterIf IRR of leasing < after--tax cost of borrowing (lease the tax cost of borrowing (lease the asset)asset)

Evaluating the Lease DecisionEvaluating the Lease DecisionLease Versus Buy Evaluative FrameworksLease Versus Buy Evaluative Frameworks

NPV of Leasing AnalysisNPV of Leasing Analysis–– Estimate incremental cash flows that result from Estimate incremental cash flows that result from

leasingleasing


16 - 1011

–– Calculate NPV using afterCalculate NPV using after--tax cost of borrowing as tax cost of borrowing as the discount rate.the discount rate.

•• If NPV of leasing is If NPV of leasing is –– (borrow and buy the asset)(borrow and buy the asset)

•• If NPV of leasing If NPV of leasing ++ afterafter--tax cost of borrowing (lease the tax cost of borrowing (lease the asset)asset)

Motivation for LeasingMotivation for Leasing

1.1. Cheaper financing (which party can make Cheaper financing (which party can make better use of the CCA tax shield/)better use of the CCA tax shield/)

2.2. Reduce the risks of asset ownershipReduce the risks of asset ownership3.3. Implicit interest ratesImplicit interest rates


16 - 1012

3.3. Implicit interest ratesImplicit interest rates4.4. MaintenanceMaintenance5.5. ConvenienceConvenience6.6. FlexibilityFlexibility7.7. Capital budgeting restrictionsCapital budgeting restrictions8.8. Financial statement effectsFinancial statement effects


In this chapter you have learned:In this chapter you have learned:–– That firms can gain the use of assets through That firms can gain the use of assets through

leasing rather than outright ownershipleasing rather than outright ownership–– The general differences between operating and The general differences between operating and


16 - 1013

–– The general differences between operating and The general differences between operating and financial leasesfinancial leases

–– How to evaluate a potential lease decision using How to evaluate a potential lease decision using discounted cash flow analysisdiscounted cash flow analysis

–– The various reasons firms might have for The various reasons firms might have for entering into lease arrangementsentering into lease arrangements

CHAPTER 17CHAPTER 17Investment Banking and Investment Banking and Investment Banking and Investment Banking and

Securities LawsSecurities Laws


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• Conflicts between Issuers and InvestorsConflicts between Issuers and Investors

www.bookfiesta4u.com ContentsCHAPTER 17 – Investment Banking and Securities

Law

17 - 1016

•• Securities Legislation in CanadaSecurities Legislation in Canada•• IPOs and Investment BankingIPOs and Investment Banking•• PostPost--IPO Regulation and Seasoned OfferingsIPO Regulation and Seasoned Offerings•• Summary and ConclusionsSummary and Conclusions



You should understand the following:You should understand the following:

•• That the core problem in raising capital is information That the core problem in raising capital is information asymmetry, which, in extreme cases, can to lead to asymmetry, which, in extreme cases, can to lead to fraudulent activitiesfraudulent activities


Law

17 - 1017

•• The importance of securities laws and regulations in financial The importance of securities laws and regulations in financial marketsmarkets

•• The basic steps included in the initial public offering (IPO) The basic steps included in the initial public offering (IPO) processprocess

•• What is included in a prospectus and why it is critical for What is included in a prospectus and why it is critical for IPOsIPOs

•• Why continuous disclosure requirements are important for Why continuous disclosure requirements are important for investors, and how they affect secondary offerings.investors, and how they affect secondary offerings.


•• Agency theoryAgency theory•• Asymmetric informationAsymmetric information•• Banking (or dealer) syndicateBanking (or dealer) syndicate•• Bearer bondsBearer bonds•• Best efforts offeringBest efforts offering•• Bought dealBought deal

•• GreenshoeGreenshoe•• Initial public offering (IPO) Initial public offering (IPO)

Investment Dealers Investment Dealers AssociationAssociation

•• Lead investment dealerLead investment dealer•• Limit ordersLimit orders


Law

17 - 1018

•• Bought dealBought deal•• Continuous disclosureContinuous disclosure•• Distribution periodDistribution period•• Due diligenceDue diligence•• Exempt marketExempt market•• Fair disclosureFair disclosure•• Firm commitment offeringFirm commitment offering

•• Limit ordersLimit orders•• LockLock--up periodup period•• LongLong--form prospectusform prospectus•• Market or disaster “out” clauseMarket or disaster “out” clause•• Market ordersMarket orders•• Offering memorandumOffering memorandum•• OverallotmentOverallotment


•• Ponzi schemePonzi scheme•• Preliminary prospectusPreliminary prospectus•• Private equity Private equity •• ProspectusProspectus•• Reporting issuersReporting issuers•• Securities and Exchange Securities and Exchange

•• Standby or rights offeringStandby or rights offering•• UnderpricingUnderpricing•• UnderwriteUnderwrite•• Venture capitalVenture capital•• Waiting periodWaiting period


Law

17 - 1019

•• Securities and Exchange Securities and Exchange Commission (SEC)Commission (SEC)

•• Selling groupSelling group•• ShortShort--form prospectusform prospectus•• SpinningSpinning•• SpreadSpread

•• Waiting periodWaiting period

Issuers and Investors in SecuritiesIssuers and Investors in Securities

Issuers of SecuritiesIssuers of Securities•• Corporations must issue Corporations must issue

securities to raise capital in securities to raise capital in order to invest in order to invest in plant/equipment, working plant/equipment, working capital, research and capital, research and development in order to development in order to produce products and services produce products and services

Investors in SecuritiesInvestors in Securities•• Investors has surplus cash at Investors has surplus cash at

the moment, but hope to the moment, but hope to transform that cash into larger transform that cash into larger sums in the future by investing sums in the future by investing in appropriate securitiesin appropriate securities

•• Some investors have long Some investors have long


Law

17 - 1020

produce products and services produce products and services that meet needs in a that meet needs in a competitive market competitive market environment.environment.

•• Corporations must design Corporations must design securities that meet the securities that meet the investing needs of investors.investing needs of investors.

•• Some investors have long Some investors have long investment time horizons and investment time horizons and have the capacity to accept have the capacity to accept risk (for example a large risk (for example a large pension fund)pension fund)

•• Other investors have short Other investors have short investment time horizons, investment time horizons, require a liquid investment and require a liquid investment and do not have the capacity to do not have the capacity to accept riskaccept risk

Other Participants in the Markets for Other Participants in the Markets for SecuritiesSecurities

In addition to issuers and investors there are other In addition to issuers and investors there are other participants in the financial markets including:participants in the financial markets including:

•• Financial intermediaries that bring buyers and sellers of securities Financial intermediaries that bring buyers and sellers of securities together (brokers)together (brokers)

•• Underwriters (that help issuers bring new security issues to market)Underwriters (that help issuers bring new security issues to market)


Law

17 - 1021

•• SpeculatorsSpeculators•• Arbitrageurs Arbitrageurs

Given the diversity of parties, interests, goals, skills and Given the diversity of parties, interests, goals, skills and access to information, the financial marketplace is an access to information, the financial marketplace is an attractive target for scam artists who seek to try to take attractive target for scam artists who seek to try to take advantage of others.advantage of others.

Conflicts Between Issuers and InvestorsConflicts Between Issuers and InvestorsThe Basic Problem of Asymmetric InformationThe Basic Problem of Asymmetric Information

•• Information asymmetry occurs when one party to Information asymmetry occurs when one party to a transaction has information that the other party a transaction has information that the other party doesn’t.doesn’t.


Law

17 - 1022

•• Superior information creates a situation where Superior information creates a situation where one party can use that information for their own one party can use that information for their own benefit at the expense of the other.benefit at the expense of the other.

Conflicts Between Issuers and InvestorsConflicts Between Issuers and InvestorsRealReal--World Examples of Fraudulent ActivitiesWorld Examples of Fraudulent Activities

•• William E. Lyons attempting to sell US $220 William E. Lyons attempting to sell US $220 million in fraudulently issued zero coupon bonds million in fraudulently issued zero coupon bonds to Bear Stearns, Merrill Lynch, Goldman Sachs to Bear Stearns, Merrill Lynch, Goldman Sachs


Law

17 - 1023

to Bear Stearns, Merrill Lynch, Goldman Sachs to Bear Stearns, Merrill Lynch, Goldman Sachs Group and Chase ManhattanGroup and Chase Manhattan

•• Common use of bearer bonds in EuropeCommon use of bearer bonds in Europe•• Ponzi schemesPonzi schemes

Conflicts Between Issuers and InvestorsConflicts Between Issuers and InvestorsSome Canadian Examples of Fraudulent ActivitiesSome Canadian Examples of Fraudulent Activities

•• BrokerBroker--dealers (securities dealers) dealing in dealers (securities dealers) dealing in penny stocks known as “bucket shops”penny stocks known as “bucket shops”–– Issuing shares in highly speculative mining and real Issuing shares in highly speculative mining and real

estate companiesestate companies


Law

17 - 1024

estate companiesestate companies–– Use of ‘ wash sales’ and high pressure sales tacticsUse of ‘ wash sales’ and high pressure sales tactics

•• The case of Norbourg Asset Management Inc. The case of Norbourg Asset Management Inc. where founder Lacroix was accused of stealing where founder Lacroix was accused of stealing $84 million of investors money from the firm he $84 million of investors money from the firm he controlled.controlled.

Implications of Financial Fraud for Implications of Financial Fraud for Financial MarketsFinancial Markets

•• If investors are not convinced that the markets are reasonably If investors are not convinced that the markets are reasonably fair, they will not invest.fair, they will not invest.

–– Societies where individuals do not respect the rule of law, or Societies where individuals do not respect the rule of law, or where law breakers are not found and punished, find that where law breakers are not found and punished, find that financial markets cannot developfinancial markets cannot develop

–– In these cases, legitimate businesses operating those countries In these cases, legitimate businesses operating those countries


Law

17 - 1025

–– In these cases, legitimate businesses operating those countries In these cases, legitimate businesses operating those countries lack access to capital, cannot invest, cannot create jobs and lack access to capital, cannot invest, cannot create jobs and cannot compete in international markets for their products and cannot compete in international markets for their products and services.services.

–– In the end, the standard of living in countries with no respect for In the end, the standard of living in countries with no respect for the rule of law is extremely low, and they are often plunged into the rule of law is extremely low, and they are often plunged into political turmoil.political turmoil.

–– In such places, people bury their funds or hide them under their In such places, people bury their funds or hide them under their pillow cases…and everyone loses! pillow cases…and everyone loses!

Primer on Securities Legislation in CanadaPrimer on Securities Legislation in CanadaBasic ResponsibilitiesBasic Responsibilities

•• Provinces are responsible under the Canadian Constitution Provinces are responsible under the Canadian Constitution for securities regulation.for securities regulation.

•• Many argue that a national regulator would improve the Many argue that a national regulator would improve the efficiency of Canadian financial markets by harmonizing laws efficiency of Canadian financial markets by harmonizing laws and their enforcement.and their enforcement.

•• Provincial regulators (like the Ontario Securities Commission) Provincial regulators (like the Ontario Securities Commission)


Law

17 - 1026

•• Provincial regulators (like the Ontario Securities Commission) Provincial regulators (like the Ontario Securities Commission) meet regularly to coordinate efforts through the CSA meet regularly to coordinate efforts through the CSA (Canadian Securities Administrators)(Canadian Securities Administrators)

•• The CSA among other things:The CSA among other things:–– Issues National Policy statements that provide recommendations Issues National Policy statements that provide recommendations

for Provincial regulators to followfor Provincial regulators to follow–– Maintain SEDAR.com (System for Electronic Data Access and Maintain SEDAR.com (System for Electronic Data Access and

Retrieval) which is a website that maintains all information for Retrieval) which is a website that maintains all information for publiclypublicly--traded companies in Canada.traded companies in Canada.

Primer on Securities Legislation in CanadaPrimer on Securities Legislation in CanadaWhat is a Security?What is a Security?

A security includes “ any document, investment A security includes “ any document, investment or writing commonly known as a security”or writing commonly known as a security”

•• In determining whether a security exists, the In determining whether a security exists, the


Law

17 - 1027

•• In determining whether a security exists, the In determining whether a security exists, the following are factors that are considered:following are factors that are considered:–– Whether the promoter raises money and leads the Whether the promoter raises money and leads the

investor to expect a profitinvestor to expect a profit–– Whether the investor has any control on how the Whether the investor has any control on how the

money is spentmoney is spent–– Whether there is risk involved.Whether there is risk involved.

Primer on Securities Legislation in CanadaPrimer on Securities Legislation in CanadaOntario Securities Commission (OSC)OversightOntario Securities Commission (OSC)Oversight

•• Given that the markets for stocks are concentrated in Ontario Given that the markets for stocks are concentrated in Ontario (TSX, TSX Venture Exchange) the OSC has considerable (TSX, TSX Venture Exchange) the OSC has considerable responsibility and influence over securities regulation in responsibility and influence over securities regulation in Canada.Canada.


Law

17 - 1028

•• The OSC is involved in five major areas in which securities The OSC is involved in five major areas in which securities are transferred or traded:are transferred or traded:–– Primary market offeringsPrimary market offerings–– Secondary market tradingSecondary market trading–– Activities of investment professionalsActivities of investment professionals–– Insider tradingInsider trading–– Takeover bidsTakeover bids

Security OfferingsSecurity OfferingsThe Prospectus Versus Offering MemorandumThe Prospectus Versus Offering Memorandum

ProspectusProspectus•• A disclosure document in support of public offering of securitiesA disclosure document in support of public offering of securities•• Must provide “full, true and plain disclosure of all material Must provide “full, true and plain disclosure of all material

information pertaining to the security being issued”information pertaining to the security being issued”•• Consists of two parts:Consists of two parts:

–– LongLong--form prospectus form prospectus –– contains information about the corporate contains information about the corporate


Law

17 - 1029

–– LongLong--form prospectus form prospectus –– contains information about the corporate contains information about the corporate issuer, directors, financial performance, operations, etc.issuer, directors, financial performance, operations, etc.

–– ShortShort--term prospectus term prospectus –– contains information pertaining to the contains information pertaining to the particular securities that are being offered including price, type of particular securities that are being offered including price, type of security, intended use of the proceeds, etc.security, intended use of the proceeds, etc.

Offering MemorandumOffering Memorandum•• A disclosure document in support of an offering of securities in the A disclosure document in support of an offering of securities in the

exempt marketexempt market•• Has the same objectives of disclosure as a prospectus, however, Has the same objectives of disclosure as a prospectus, however,

offers significantly less information because of the nature of exempt offers significantly less information because of the nature of exempt /sophisticated investors/sophisticated investors

IPOs and Investment BankingIPOs and Investment Banking

•• IPO IPO –– Initial Public OfferingInitial Public Offering–– Primary offering of securities to the public ( a firstPrimary offering of securities to the public ( a first--time time

distribution by the issuer)distribution by the issuer)–– Difficult to ‘value’ or price because there is no prior Difficult to ‘value’ or price because there is no prior


Law

17 - 1030

–– Difficult to ‘value’ or price because there is no prior Difficult to ‘value’ or price because there is no prior history of trading in the securities by unrelated parties history of trading in the securities by unrelated parties in arms length tradingin arms length trading

–– Must be accompanied by a prospectus.Must be accompanied by a prospectus.

IPOs and Investment BankingIPOs and Investment BankingMotivation for IPOsMotivation for IPOs

•• Going public requires the firm to incur significant changes and Going public requires the firm to incur significant changes and costs including:costs including:–– Costs of meeting market listing requirements including the costs Costs of meeting market listing requirements including the costs

associated with information disclosure requirements expected of public associated with information disclosure requirements expected of public companiescompanies

–– Underwriting and distribution costs associated with the public offering Underwriting and distribution costs associated with the public offering including prospectus and underwriters spread and potentially including prospectus and underwriters spread and potentially underpricing costs associated with the IPOunderpricing costs associated with the IPO


Law

17 - 1031

underpricing costs associated with the IPOunderpricing costs associated with the IPO–– Listing feesListing fees

•• The motivation for going public include:The motivation for going public include:–– Access to capitalAccess to capital–– Greater public visibility (perhaps increasing the market demand for the Greater public visibility (perhaps increasing the market demand for the

firm’s products and services)firm’s products and services)–– Ability for venture capital firm and/or entrepreneur to ‘harvest’ their Ability for venture capital firm and/or entrepreneur to ‘harvest’ their

investmentinvestment–– Ability to reward managers through options that will now have a market Ability to reward managers through options that will now have a market

valuevalue

IPOs and Investment BankingIPOs and Investment BankingThe Stages of the IPO ProcessThe Stages of the IPO Process

17 - 1 FIGURE

Pricing, distribution, and


Law

17 - 1032

Discussion triggers IPO

Preliminary prospectus: three to

five months

Waiting period and road shows: one to two

months

Pricing, distribution, and after-market

stabilization: one-month

Initial filing: red herring

Final clearance

IPOs and Investment BankingIPOs and Investment BankingTypes of Public OfferingsTypes of Public Offerings

1.1. Best efforts offeringBest efforts offering2.2. Firm commitment offeringFirm commitment offering


Law

17 - 1033

2.2. Firm commitment offeringFirm commitment offering3.3. Bought dealBought deal4.4. Standby or rights offeringStandby or rights offering

IPOs and Investment BankingIPOs and Investment BankingIPO UnderpricingIPO Underpricing

•• Underpricing of an IPO occurs when the price of the IPO is Underpricing of an IPO occurs when the price of the IPO is less than its market valueless than its market value–– Measured as the difference between the initial offering price and Measured as the difference between the initial offering price and

the price on the first day of trading.the price on the first day of trading.•• There is evidence of systemic underpricing in most OECD There is evidence of systemic underpricing in most OECD


Law

17 - 1034

•• There is evidence of systemic underpricing in most OECD There is evidence of systemic underpricing in most OECD countries (see Table 17 countries (see Table 17 --1 on the following slide)1 on the following slide)

•• Reasons for underpricing and the various degrees of Reasons for underpricing and the various degrees of underpricing in different capital markets include:underpricing in different capital markets include:–– Degree of competition for underwriting businessDegree of competition for underwriting business–– Litigiousness of the investors in the countryLitigiousness of the investors in the country–– ‘Spinning’ where the underwriter allocates IPOs to favoured ‘Spinning’ where the underwriter allocates IPOs to favoured

clients knowing that they will make a large profit on the first day clients knowing that they will make a large profit on the first day of trading.of trading.

IPO Underpricing EvidenceIPO Underpricing Evidence

Country Sample Period Return

Canada 500 1971-1999 6.3

Table 17-1 IPO Underpricing Evidence


Law

17 - 1035

Canada 500 1971-1999 6.3

United Kingdom 3,122 1959-2001 17.4

United States 14,840 1960-2001 18.4

Australia 381 1976-1995 12.1

New Zealand 201 1981-1999 19.1

Source: Jay Ritter, "Dif ferences betw een European and American IPO Markets." European

Financial Management 9, no. 4 (2002), pp. 421-434.

PostPost--IPOs Regulation and Seasoned OfferingsIPOs Regulation and Seasoned OfferingsThe PostThe Post--IPO MarketIPO Market

•• Following the IPO a quiet period is required before the Following the IPO a quiet period is required before the investment dealer’s research analysts can initiate coverage investment dealer’s research analysts can initiate coverage on the company.on the company.–– The prospectus is assumed to provide sufficient information The prospectus is assumed to provide sufficient information

during the distribution phase.during the distribution phase.


Law

17 - 1036

during the distribution phase.during the distribution phase.•• Misleading research reports were identified in the U.S. during Misleading research reports were identified in the U.S. during

the internet bubble and analysts from major U.S. underwriters the internet bubble and analysts from major U.S. underwriters were charged for providing such reports.were charged for providing such reports.–– These practices were found to be encouraged and rewarded by These practices were found to be encouraged and rewarded by

the underwriting firms as a form of ‘selfthe underwriting firms as a form of ‘self--dealing’ where the dealing’ where the underwriter had a financial interest in the success of the security underwriter had a financial interest in the success of the security offering, and therefore, had it’s analysts write overly positive offering, and therefore, had it’s analysts write overly positive reports on the security.reports on the security.

PostPost--IPOs Regulation and Seasoned OfferingsIPOs Regulation and Seasoned OfferingsContinuous Disclosure RequirementsContinuous Disclosure Requirements

•• Following the IPO investors do not receive the Following the IPO investors do not receive the prospectus when investing in securitiesprospectus when investing in securities

•• Public companies are expected to become reporting Public companies are expected to become reporting issuers and provide continuous disclosure including:issuers and provide continuous disclosure including:–– Quarterly and annual financial statementsQuarterly and annual financial statements


Law

17 - 1037

–– Quarterly and annual financial statementsQuarterly and annual financial statements–– Annual information forms (AIF)Annual information forms (AIF)–– Proxy and information circularsProxy and information circulars–– Press releases on any material informationPress releases on any material information

•• All required information for public issuers in Canada is All required information for public issuers in Canada is available at SEDAR.comavailable at SEDAR.com

PostPost--IPOs Regulation and Seasoned OfferingsIPOs Regulation and Seasoned OfferingsSeasoned Offerings and ShortSeasoned Offerings and Short--Form ProspectusesForm Prospectuses

•• Reporting issuers in Canada can take advantage of the Reporting issuers in Canada can take advantage of the annual information form and shortannual information form and short--form prospectus (a system form prospectus (a system known as the Prompt Offering Prospectus (POP) system) in known as the Prompt Offering Prospectus (POP) system) in order to speed their access to capital markets.order to speed their access to capital markets.

•• The shortThe short--form prospectus system has given rise to the use of form prospectus system has given rise to the use of the ‘bought deal’ in Canada.the ‘bought deal’ in Canada.


Law

17 - 1038

the ‘bought deal’ in Canada.the ‘bought deal’ in Canada.–– In a bought deal, the underwriting contract is signed even before In a bought deal, the underwriting contract is signed even before

the drafting of the preliminary prospectusthe drafting of the preliminary prospectus•• The underwriting market in Canada has become extremely The underwriting market in Canada has become extremely

competitive as information requirements have been competitive as information requirements have been decreased through the POP system. decreased through the POP system.

(See Table 17 (See Table 17 --2 on the following slide for recent Canadian underwriting trends.)2 on the following slide for recent Canadian underwriting trends.)

Canadian FinancingsCanadian Financings

Book Runner Proceeds US$ (million)

Proceeds Rank

Share (%)

Number of Deals

CIBC World Markets 2,468.5 1 20.1 25

RBCDS 1,972.9 2 16.1 23TD Securities 1,309.5 3 10.7 21

Table 17-2 Canadian Financings (January to June 2 006)


Law

17 - 1039

TD Securities 1,309.5 3 10.7 21

Canaccord Capital 951.3 4 7.8 15

GMP Capital Trust 949.7 5 7.7 19

BMO Nesbitt Burns 693.1 6 5.7 15

Merrill Lynch 583.9 7 4.8 4

Scotia Capital 448.4 8 3.7 7

National Bank Financial 393.7 9 3.2 9

Sprott Securities 309.9 10 2.5 10

Top Ten 10,080.9 82.3 148

Industry 12,276.1 100.0 157

Source: Data from Thomson Financial Inc., Globe and Mail , July 12, 2006.



–– The basics of securities lawThe basics of securities law–– About information asymmetry and the impacts of this About information asymmetry and the impacts of this


Law

17 - 1040

–– About information asymmetry and the impacts of this About information asymmetry and the impacts of this on financial markets, market participants and the on financial markets, market participants and the occurrence of financial fraudoccurrence of financial fraud

–– The role of securities regulators and securities The role of securities regulators and securities regulation and the costs associated with regulation, regulation and the costs associated with regulation, monitoring and enforcement.monitoring and enforcement.

CHAPTER 18CHAPTER 18Debt InstrumentsDebt InstrumentsDebt InstrumentsDebt Instruments


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• What is Equity and what is Debt?What is Equity and what is Debt?•• ShortShort--term Debt and the Money Marketterm Debt and the Money Market

www.bookfiesta4u.com ContentsCHAPTER 18 – Debt Instruments

18 - 1043

•• ShortShort--term Debt and the Money Marketterm Debt and the Money Market•• Bank FinancingBank Financing•• LongLong--Term FinancingTerm Financing•• Bond RatingsBond Ratings•• Summary and ConclusionsSummary and Conclusions




•• The basic features of debt financingThe basic features of debt financing•• The main distinctions between shortThe main distinctions between short--term funds in the money term funds in the money

market and longmarket and long--term funds in the capital marketterm funds in the capital market


18 - 1044

market and longmarket and long--term funds in the capital marketterm funds in the capital market•• The types of debt financing that are provided by the banksThe types of debt financing that are provided by the banks•• The requirements that must typically be satisfied for public debt The requirements that must typically be satisfied for public debt

issuesissues•• How debt ratings are determined, what they mean, and how useful How debt ratings are determined, what they mean, and how useful

they are in predicting default and recovery rates associated with they are in predicting default and recovery rates associated with public debt issuespublic debt issues


•• AfterAfter--tax cost of debttax cost of debt•• Bankers’ acceptancesBankers’ acceptances•• Commercial paperCommercial paper•• CovenantsCovenants•• Credit watchCredit watch

•• Investment gradeInvestment grade•• Junk bondsJunk bonds•• Lines of credit (L/Cs)Lines of credit (L/Cs)•• Liquidity supportLiquidity support•• Negative pledgeNegative pledge•• Operating or demand L/COperating or demand L/C


18 - 1045

•• Credit watchCredit watch•• CrossCross--default clausedefault clause•• Fixed contractual Fixed contractual

commitmentscommitments•• Floating interest rateFloating interest rate•• Hierarchy principleHierarchy principle

•• Operating or demand L/COperating or demand L/C•• Prime lending ratePrime lending rate•• Promised yieldsPromised yields•• Promissory notePromissory note

What is Equity?What is Equity?

•• Unlike debt, equity renders no contractual Unlike debt, equity renders no contractual commitment (legal) to return the original amount commitment (legal) to return the original amount invested, or to necessarily pay dividends as a invested, or to necessarily pay dividends as a return on that investmentreturn on that investment


18 - 1046

return on that investmentreturn on that investment•• Equity represents ownership in the firm.Equity represents ownership in the firm.•• Owners are ‘residual claimants’ …they get what Owners are ‘residual claimants’ …they get what

is left over after all the firm’s legal commitments is left over after all the firm’s legal commitments have been satisfied.have been satisfied.

What is Debt?What is Debt?

•• Debt gives rise to fixed contractual Debt gives rise to fixed contractual commitments.commitments.

•• Those commitments at a minimum include:Those commitments at a minimum include:–– Repayment of the principal borrowedRepayment of the principal borrowed


18 - 1047

–– Repayment of the principal borrowedRepayment of the principal borrowed–– Payment of interest for the use of the amount Payment of interest for the use of the amount

borrowed.borrowed.–– Adherence to other agreed terms such as limiting the Adherence to other agreed terms such as limiting the

amount of additional debt taken on, maintaining amount of additional debt taken on, maintaining financial ratios, regular financial reporting, etc.financial ratios, regular financial reporting, etc.

ShortShort--Term Versus LongTerm Versus Long--Term DebtTerm Debt

ShortShort--term Debtterm Debt–– Maturity of 1 year or lessMaturity of 1 year or less–– Typically has a floating rate of interest (cost) to the borrower and Typically has a floating rate of interest (cost) to the borrower and

therefore exposes the borrower to interest rate risktherefore exposes the borrower to interest rate risk–– Because of the short life, the rates of interest are often lower Because of the short life, the rates of interest are often lower

than longthan long--term borrowings (a upward sloping yield curve is the term borrowings (a upward sloping yield curve is the


18 - 1048

than longthan long--term borrowings (a upward sloping yield curve is the term borrowings (a upward sloping yield curve is the most common term structure for interest rates)most common term structure for interest rates)

LongLong--term Debtterm Debt–– Maturities greater than 1 yearMaturities greater than 1 year–– Typically more expensive than shortTypically more expensive than short--term debtterm debt–– Often borrowed at a fixed rate immunizing the borrower from Often borrowed at a fixed rate immunizing the borrower from

interest rate risk by locking in a ‘coupon rate’ in the case of interest rate risk by locking in a ‘coupon rate’ in the case of bonds/debenturesbonds/debentures

DebtDebtTaxTax--deductibility of Interest Expensedeductibility of Interest Expense

•• Interest on debt is a taxInterest on debt is a tax--deductible expense for the firm.deductible expense for the firm.•• Consequently, there a tax shield benefit to the firm for using this Consequently, there a tax shield benefit to the firm for using this

type of financing.type of financing.•• The afterThe after--tax cost of debt can be found using Equation 18 tax cost of debt can be found using Equation 18 –– 11


18 - 1049

The higher the tax rate The higher the tax rate –– the greater the inducement to finance profitthe greater the inducement to finance profit--making activities through debt.making activities through debt.

)1(KK d T−=[ 18-1]

DebtDebtTax Shield Benefit Depends on the Corporate Tax RateTax Shield Benefit Depends on the Corporate Tax Rate

•• Small businesses in Canada face a corporate tax rate in the range Small businesses in Canada face a corporate tax rate in the range of 20%.of 20%.

•• Smaller businesses are riskier than larger businesses so they Smaller businesses are riskier than larger businesses so they borrow at higher rates.borrow at higher rates.

•• If a small business borrows at 200 basis points above prime, and If a small business borrows at 200 basis points above prime, and prime is 5.00%, the cost of debt is 5% + 2% = 7%prime is 5.00%, the cost of debt is 5% + 2% = 7%


18 - 1050

prime is 5.00%, the cost of debt is 5% + 2% = 7%prime is 5.00%, the cost of debt is 5% + 2% = 7%•• The afterThe after--tax cost of debt for the smaller business is therefore:tax cost of debt for the smaller business is therefore:

5.6%.2)- (1 7% )1(KK d ==−= T

DebtDebtTax Shield Benefit Depends on the Corporate Tax RateTax Shield Benefit Depends on the Corporate Tax Rate

•• Large corporations in Canada face a corporate tax rate in the range Large corporations in Canada face a corporate tax rate in the range of 34%.of 34%.

•• If the corporation borrows at 25 basis points above prime, and prime If the corporation borrows at 25 basis points above prime, and prime is 5.00%, the cost of debt is 5% + .25% = 5.25%is 5.00%, the cost of debt is 5% + .25% = 5.25%

•• The afterThe after--tax cost of debt for the corporation is therefore:tax cost of debt for the corporation is therefore:


18 - 1051

Given the very low afterGiven the very low after--tax cost of debt, corporations and individuals tax cost of debt, corporations and individuals who face high marginal tax rates, have a strong inducement to who face high marginal tax rates, have a strong inducement to finance their profitfinance their profit--seeking activities through the use of debt.seeking activities through the use of debt.

3.465%.34)- (1 5.25% )1(KK d ==−= T

DebtDebtCRA Tests to Ensure Interest is TaxCRA Tests to Ensure Interest is Tax--deductibledeductible

1.1. Interest is compensation for the use or retention of Interest is compensation for the use or retention of money owed to anothermoney owed to another

2.2. Interest must be referable to a principal sumInterest must be referable to a principal sum


18 - 1052

2.2. Interest must be referable to a principal sumInterest must be referable to a principal sum3.3. Interest accrues from day to day.Interest accrues from day to day.

Money Market InstrumentsMoney Market Instruments

•• ShortShort--term debt is traded in the money markets.term debt is traded in the money markets.•• ShortShort--term is any debt instrument sold with a life that is 365 term is any debt instrument sold with a life that is 365

days or shorter.days or shorter.•• Typically, money market securities have the following Typically, money market securities have the following

features:features:–– No stated rate of interest No stated rate of interest –– instead, sold at a price that is at a instead, sold at a price that is at a


18 - 1053

–– No stated rate of interest No stated rate of interest –– instead, sold at a price that is at a instead, sold at a price that is at a discount from the par or face value of the security.discount from the par or face value of the security.

–– The difference between the price purchased and the par value is The difference between the price purchased and the par value is treated as interest by CRAtreated as interest by CRA

•• Examples include:Examples include:–– Treasury billsTreasury bills–– Commercial PaperCommercial Paper–– Bankers AcceptancesBankers Acceptances

ShortShort--Term Debt and the Money MarketTerm Debt and the Money MarketGovernment Treasury BillsGovernment Treasury Bills

Government of Canada Treasury Bills are:Government of Canada Treasury Bills are:•• ShortShort--term (365 days or less), unsecured promissory notes of the term (365 days or less), unsecured promissory notes of the

Government of CanadaGovernment of Canada•• Sold through the Government of Canada’s fiscal agent, the Bank of Sold through the Government of Canada’s fiscal agent, the Bank of

Canada, to Canada, to primary dealersprimary dealers (GSD (GSD –– or Government Securities or Government Securities


18 - 1054

Canada, to Canada, to primary dealersprimary dealers (GSD (GSD –– or Government Securities or Government Securities Dealers)Dealers)

•• TT--bills issued by the Government of Canada are sold through bills issued by the Government of Canada are sold through weekly auction to the primary dealersweekly auction to the primary dealers

•• There is a strong secondary market in outstanding TThere is a strong secondary market in outstanding T--billsbills•• TT--bills, at the time of sale have three different maturities. They are:bills, at the time of sale have three different maturities. They are:

–– 3 month (91 day) T3 month (91 day) T--billsbills–– 6 month (182 day)6 month (182 day)–– 1 year1 year

ShortShort--Term DebtTerm Debt

Debt InstrumentsDebt Instruments

ShortShort--Term Debt and the Money MarketTerm Debt and the Money MarketGovernment Treasury Bill YieldsGovernment Treasury Bill Yields

Government of Canada Treasury Government of Canada Treasury Bills are sold at a discount from Bills are sold at a discount from their face value.their face value.

•• The difference between the price The difference between the price paid and the face value is treated paid and the face value is treated as interest.as interest.

•• Prices are quoted on the basis of Prices are quoted on the basis of maturity todays ofnumber

365Yield bill-T

0

01 ×

−=P

PP

www.bookfiesta4u.com ContentsCHAPTER 18 – Debt Instruments 18 - 1056

•• Prices are quoted on the basis of Prices are quoted on the basis of a $100 par value to four a $100 par value to four significant digits.significant digits.

•• Bills are normally purchased in Bills are normally purchased in denominations of $100,000 and denominations of $100,000 and greater.greater.

Example:Example:A 91A 91--day Tday T--bill is sold for a price bill is sold for a price of $99.0909 for a par value of of $99.0909 for a par value of $100.$100.

%7.3

010989011.4009174405.0

91

365

0909.99$

0909.99$100$

0

=×=

×

−=

ShortShort--Term Debt and the Money MarketTerm Debt and the Money MarketCommercial PaperCommercial Paper

•• ShortShort--term debt instruments, usually unsecured, term debt instruments, usually unsecured, issued by corporations.issued by corporations.

•• Involve credit risk because the financial health of Involve credit risk because the financial health of a corporation can deteriorate and jeopardize the a corporation can deteriorate and jeopardize the repayment of the amount borrowed.repayment of the amount borrowed.


18 - 1057

repayment of the amount borrowed.repayment of the amount borrowed.–– Sold at a discount from their face valueSold at a discount from their face value–– Maturities of 30 and 60 daysMaturities of 30 and 60 days

•• Because of the credit risk, usually there is only a Because of the credit risk, usually there is only a market for commercial paper offered by the most market for commercial paper offered by the most credit worthy corporate issuers.credit worthy corporate issuers.

ShortShort--Term Debt and the Money MarketTerm Debt and the Money MarketCommercial Paper PayoffsCommercial Paper Payoffs

•• Because there is a probability of default, the Because there is a probability of default, the forecast annualized return on commercial paper forecast annualized return on commercial paper is known as is known as promised yield.promised yield.

•• Payoff expectations must always take into Payoff expectations must always take into


18 - 1058

•• Payoff expectations must always take into Payoff expectations must always take into account the possibility of default as account the possibility of default as demonstrated in Figure 18 demonstrated in Figure 18 –– 1 found on the 1 found on the following slide.following slide.

ShortShort--Term Debt and the Money MarketTerm Debt and the Money MarketCommercial Paper PayoffsCommercial Paper Payoffs

18-1 FIGURE

Probability = 99%

Payoff: $100.5 million


18 - 1059

Value: $99 million

Payoff: $0 million

30 day yield 0.5%

Probability = 1%

ShortShort--Term Debt and the Money MarketTerm Debt and the Money MarketCommercial Paper Promised YieldCommercial Paper Promised Yield

•• Since commercial paper offers the possibility of Since commercial paper offers the possibility of default, the promised yield on commercial paper default, the promised yield on commercial paper is higher than the defaultis higher than the default--free Tfree T--bill yieldbill yield

•• The value of the 30 The value of the 30 –– day CP issue can be found day CP issue can be found


18 - 1060

•• The value of the 30 The value of the 30 –– day CP issue can be found day CP issue can be found from Equation 18 from Equation 18 –– 2 found on the following 2 found on the following slide:slide:


K)(1

P)-RECOVER(1R)PPAR(1V

+++=[ 18-2]


18 - 1061

Where:Where:Par value (PAR) is $1,000Par value (PAR) is $1,000RR is the promised yieldis the promised yieldPP is the probability of not defaultingis the probability of not defaulting(1 (1 –– P)P) is the probability of defaultingis the probability of defaultingRECOVERRECOVER is the recovery rate if the company defaults, andis the recovery rate if the company defaults, andK K is the investor’s required returnis the investor’s required return


•• Equation 18 Equation 18 –– 3 is 18 3 is 18 –– 2 assuming the recovery rate is 0 2 assuming the recovery rate is 0 and the investor’s required return is equal to the Tand the investor’s required return is equal to the T--bill yield.bill yield.

•• The promised yield necessary for CP to be issued at PAR The promised yield necessary for CP to be issued at PAR (PAR = V) equals:(PAR = V) equals:


18 - 1062

•• In the absence of default risk (In the absence of default risk (PP =1), the promised yield on =1), the promised yield on CP would be the same as the TCP would be the same as the T--bill yield.bill yield.

1-)1(

P

KR TB+=[ 18-3]

ShortShort--Term Debt and the Money MarketTerm Debt and the Money MarketCommercial Paper Yield SpreadCommercial Paper Yield Spread

•• The difference between the yield on CP and the The difference between the yield on CP and the equivalent maturity Tequivalent maturity T--bill is called bill is called yield spreadyield spread

Yield spreadsYield spreads


18 - 1063

Yield spreadsYield spreads–– Depend on the default risk of the CP issuerDepend on the default risk of the CP issuer–– Depend on market conditions:Depend on market conditions:

•• Yield spreads increase when the market becomes Yield spreads increase when the market becomes pessimistic about the future economy (ie. The probability of pessimistic about the future economy (ie. The probability of recession increases)recession increases)

•• Yield spreads decrease when the market becomes optimistic Yield spreads decrease when the market becomes optimistic about the future of the economy (ie. When economic about the future of the economy (ie. When economic recovery is forecast )recovery is forecast )

ShortShort--Term Debt and the Money MarketTerm Debt and the Money MarketCommercial Paper RatingsCommercial Paper Ratings

•• The Dominion Bond Rating Service (DBRS), Moody’s and The Dominion Bond Rating Service (DBRS), Moody’s and Standard & Poor’s (S&P) rate Canadian issuers of CP.Standard & Poor’s (S&P) rate Canadian issuers of CP.

•• DBRS has three basic ratings:DBRS has three basic ratings:

R R –– 11 Prime credit qualityPrime credit quality


18 - 1064

R R –– 11 Prime credit qualityPrime credit qualityR R –– 22 Adequate credit qualityAdequate credit qualityR R –– 33 SpeculativeSpeculative

•• CP ratings help to reduce uncertainty in the market helping to CP ratings help to reduce uncertainty in the market helping to make CP of different issuers interchangeable if they have the make CP of different issuers interchangeable if they have the same rating.same rating.

ShortShort--Term Debt and the Money MarketTerm Debt and the Money MarketCommercial Paper Liquidity SupportCommercial Paper Liquidity Support

•• In addition to ratings, CP issuers try to reduce In addition to ratings, CP issuers try to reduce uncertainty among investors by arranging uncertainty among investors by arranging liquidity supportliquidity support

•• Liquidity support is often in the form of a Liquidity support is often in the form of a


18 - 1065

•• Liquidity support is often in the form of a Liquidity support is often in the form of a dedicated line of credit from a bank that ensures dedicated line of credit from a bank that ensures that the company will have access to money to that the company will have access to money to pay off the CP on maturity if the firm finds it pay off the CP on maturity if the firm finds it cannot refinance the issue.cannot refinance the issue.

ShortShort--Term Debt and the Money MarketTerm Debt and the Money MarketBankers’ Acceptances (BAs)Bankers’ Acceptances (BAs)

•• ShortShort--term paper sold by an issuer to a bank, which term paper sold by an issuer to a bank, which guarantees or accepts it, obligating the bank to pay off the guarantees or accepts it, obligating the bank to pay off the debt instrument at maturity if the issuer defaults.debt instrument at maturity if the issuer defaults.

•• A type of CP that is guaranteed by a bank.A type of CP that is guaranteed by a bank.


18 - 1066

•• The yield on BAs reflect the credit risk of the guaranteeing The yield on BAs reflect the credit risk of the guaranteeing bank rather than the corporate issuer.bank rather than the corporate issuer.

•• Corporate issuers pay a ‘stamping’ fee to the bank for the Corporate issuers pay a ‘stamping’ fee to the bank for the guarantee (usually 0.50 to 0.75 percent)guarantee (usually 0.50 to 0.75 percent)

•• CP tends to be a lower cost alternative to BAs for the largest CP tends to be a lower cost alternative to BAs for the largest creditworthy corporations that do not need 100 percent creditworthy corporations that do not need 100 percent backup from a line of credit. backup from a line of credit.

The Canadian Money MarketThe Canadian Money MarketBankers’ Acceptances (BAs)Bankers’ Acceptances (BAs)

•• The Canadian Money Market is an important The Canadian Money Market is an important place where credit worthy governments and place where credit worthy governments and corporations can gain access to large sums of corporations can gain access to large sums of low cost, shortlow cost, short--term financing.term financing.


18 - 1067

low cost, shortlow cost, short--term financing.term financing.•• It is also a place where investors, banks, It is also a place where investors, banks,

corporations and governments can invest in very corporations and governments can invest in very high quality shorthigh quality short--term investments.term investments.

•• Table 18 Table 18 –– 1 gives a picture of the Canadian 1 gives a picture of the Canadian Money Market at August, 2006:Money Market at August, 2006:

Canadian Money MarketCanadian Money Market

$ Million

Corporate commercial paper 50,041

Table 18-1 Canadian Money Market (August 2006)


18 - 1068

Corporate commercial paper 50,041

Securitizations 91,202BAs 44,322

Provincial T-bills 13,942

Canada T-bills 185,165

Total 384,672

Bank FinancingBank FinancingShortShort--Term FinancingTerm Financing

•• Chartered Banks are an important source of Chartered Banks are an important source of financing for Canadian companies financing for Canadian companies

•• They provide:They provide:–– Lines of Credit in support of working capital needsLines of Credit in support of working capital needs


18 - 1069

–– Lines of Credit in support of working capital needsLines of Credit in support of working capital needs–– Term Loans in support of longer term investment in Term Loans in support of longer term investment in

equipmentequipment

Bank FinancingBank FinancingLines of CreditLines of Credit

•• Types of Lines of Credit include:Types of Lines of Credit include:–– Operating (demand) Operating (demand) –– Term (revolving)Term (revolving)

•• Used for working capital purposes:Used for working capital purposes:


18 - 1070

–– Financing receivablesFinancing receivables–– InventoryInventory–– Ongoing corporate activityOngoing corporate activity

•• Banks may require a ‘clean up’ period in which a firm has a Banks may require a ‘clean up’ period in which a firm has a zero balance on its L/C to ensure that the bank is not zero balance on its L/C to ensure that the bank is not providing permanent financing.providing permanent financing.

Bank FinancingBank FinancingOperating Line of CreditOperating Line of Credit

•• Made for operating purposes (not to back up a CP program)Made for operating purposes (not to back up a CP program)•• Technically can be cancelled at any time.Technically can be cancelled at any time.•• A maximum dollar amount the firm can draw down on A maximum dollar amount the firm can draw down on

electronically is established.electronically is established.•• Usually must be returned to a zero balance for a period time Usually must be returned to a zero balance for a period time

in the operating year (usually following the seasonal build up in the operating year (usually following the seasonal build up


18 - 1071

in the operating year (usually following the seasonal build up in the operating year (usually following the seasonal build up of inventory and receivables around the major sales season)of inventory and receivables around the major sales season)

•• The cost is usually set at the prime lending rate although it is The cost is usually set at the prime lending rate although it is not uncommon for the most creditworthy corporate customers not uncommon for the most creditworthy corporate customers to borrow at rates lower than prime.to borrow at rates lower than prime.

•• Less creditworthy customers pay prime plus 0.5% ,1.0%, Less creditworthy customers pay prime plus 0.5% ,1.0%, 1.5%, etc. 1.5%, etc.

Bank FinancingBank FinancingRevolving Line of CreditRevolving Line of Credit

•• Term is usually at least 364 days and out to five years, renewable Term is usually at least 364 days and out to five years, renewable every 6 months.every 6 months.

•• Revolving means that the L/C may be drawn upon, partially retired, Revolving means that the L/C may be drawn upon, partially retired, and then drawn down again without full retirement of the balance and then drawn down again without full retirement of the balance during the operating year.during the operating year.

•• For liquidity purposes and not credit enhancement For liquidity purposes and not credit enhancement –– the bank the bank reserves the right to withdraw the L/C if there is a material adverse reserves the right to withdraw the L/C if there is a material adverse


18 - 1072

reserves the right to withdraw the L/C if there is a material adverse reserves the right to withdraw the L/C if there is a material adverse change.change.

•• Borrowers have to meet a variety of restrictions/conditions Borrowers have to meet a variety of restrictions/conditions (covenants) such as:(covenants) such as:–– Minimum current ratio of 1.4 or net working capital of $100 millionMinimum current ratio of 1.4 or net working capital of $100 million–– Net worth in excess of $250 millionNet worth in excess of $250 million–– Minimum interest coverage ratioMinimum interest coverage ratio–– Asset coverage ratio in excess of 2 and a debt ratio less than 0.75Asset coverage ratio in excess of 2 and a debt ratio less than 0.75

•• In addition to interest costs, banks normally charge a commitment In addition to interest costs, banks normally charge a commitment fee of around 0.5 percent for setting up the L/Cfee of around 0.5 percent for setting up the L/C

Bank FinancingBank FinancingTerm LoansTerm Loans

•• Loans to finance longerLoans to finance longer--term requirements such term requirements such as equipment purchasesas equipment purchases

•• Have a fixed maturity and require repayment to Have a fixed maturity and require repayment to be made on a fixed schedule.be made on a fixed schedule.


18 - 1073

be made on a fixed schedule.be made on a fixed schedule.•• Rates based on prime and are therefore ‘floating Rates based on prime and are therefore ‘floating

rate’ loans that place the interest rate risk on the rate’ loans that place the interest rate risk on the borrower rather than the bank.borrower rather than the bank.

•• May be structured in a variety of ways involving May be structured in a variety of ways involving blended, bullet and balloon payments.blended, bullet and balloon payments.

LongLong--Term FinancingTerm Financing

•• LongLong--term financing is any debt issue with a term longer than 1 year term financing is any debt issue with a term longer than 1 year •• Also known as funded debtAlso known as funded debt•• Includes:Includes:

–– Mortgage BondsMortgage Bonds–– Secured DebenturesSecured Debentures–– Unsecured DebenturesUnsecured Debentures–– Subordinated DebtSubordinated Debt


18 - 1074

–– Subordinated DebtSubordinated Debt

Private PlacementsPrivate Placements•• PrivatelyPrivately--placed debt financing is commonly available through placed debt financing is commonly available through

insurance companies and other specialized financial institutions insurance companies and other specialized financial institutions through an through an offering memorandumoffering memorandum

Public Debt OfferingsPublic Debt Offerings•• Require an approved Require an approved prospectusprospectus by the provincial securities by the provincial securities

regulatorregulator

LongLong--Term FinancingTerm FinancingPublic Debt Offerings Public Debt Offerings -- TypesTypes

Mortgage bondsMortgage bonds–– Lender has a registered claim on the underlying real Lender has a registered claim on the underlying real

property that is financedproperty that is financed

First Mortgage bondsFirst Mortgage bonds


18 - 1075

First Mortgage bondsFirst Mortgage bonds–– Lender has first claim on the underlying assetsLender has first claim on the underlying assets

Second Mortgage bondsSecond Mortgage bonds–– Lender ranks behind the first mortgage bondsLender ranks behind the first mortgage bonds

Unsubordinated debtUnsubordinated debt–– Unsecured debt that ranks first with the companyUnsecured debt that ranks first with the company–– No other unsecured debt ranks ahead of itNo other unsecured debt ranks ahead of it

LongLong--Term FinancingTerm FinancingPublic Debt Offerings Public Debt Offerings -- IndentureIndenture

The bond indenture is the legal document that documents the The bond indenture is the legal document that documents the rights and responsibilities of the parties to the contractrights and responsibilities of the parties to the contract

Includes:Includes:–– Actions that could trigger defaultActions that could trigger default–– Covenants (promises) including:Covenants (promises) including:

•• Limits on additional borrowingLimits on additional borrowing•• Prohibition on subsequent issue of more senior debtProhibition on subsequent issue of more senior debt


18 - 1076

•• Prohibition on subsequent issue of more senior debtProhibition on subsequent issue of more senior debt•• Maintenance of financial ratios Maintenance of financial ratios

Bond investors realize they have a fixed financial claim on the Bond investors realize they have a fixed financial claim on the firm over a long period of time, so when financial contracting firm over a long period of time, so when financial contracting occurs, they seek to negotiate covenants that will protect their occurs, they seek to negotiate covenants that will protect their longlong--term financial exposure to the issuing firm. term financial exposure to the issuing firm.

Bond RatingsBond RatingsInterpreting Debt RatingsInterpreting Debt Ratings

•• Bond ratings vary from AAA (the highest quality) to CCC (the Bond ratings vary from AAA (the highest quality) to CCC (the lowest quality)lowest quality)

•• Bond ratings are changed by the bondBond ratings are changed by the bond--rating service over rating service over time as the financial health of the issuer changestime as the financial health of the issuer changes

•• Ratings reflect the downside risk faced if economic conditions Ratings reflect the downside risk faced if economic conditions deterioratedeteriorate


18 - 1077

deterioratedeteriorate•• The most common rating is A and is described as:The most common rating is A and is described as:

LongLong--term debt rated “A” is of satisfactory credit quality. term debt rated “A” is of satisfactory credit quality. Protection of interest and principal is still substantial, but the Protection of interest and principal is still substantial, but the degree of strength is less than that of AA rated entities. While degree of strength is less than that of AA rated entities. While “A” is a respectable rating, entities in this category are “A” is a respectable rating, entities in this category are considered to be more susceptible to adverse economic considered to be more susceptible to adverse economic conditions and have greater cyclical tendencies than higherconditions and have greater cyclical tendencies than higher--rated securities.rated securities.

Bond RatingsBond RatingsDBRS Debt RatingsDBRS Debt Ratings

AAAAAA Highest credit qualityHighest credit qualityAAAA Superior credit qualitySuperior credit qualityAA Satisfactory credit qualitySatisfactory credit qualityBBBBBB Adequate credit qualityAdequate credit quality

Investment Grade Bonds


18 - 1078

BBBBBB Adequate credit qualityAdequate credit quality

BBBB SpeculativeSpeculativeBB Highly speculativeHighly speculativeCCC/CC/CCCC/CC/C Very highly speculativeVery highly speculative

Junk / High Yield Bonds

Bond RatingsBond RatingsDetermining Bond RatingsDetermining Bond Ratings

•• Companies pay to have their bonds ratedCompanies pay to have their bonds rated–– They are willing to do this in order to reduce the market uncertainty They are willing to do this in order to reduce the market uncertainty

regarding the credit risk (in fact, it is unlikely there would be a public regarding the credit risk (in fact, it is unlikely there would be a public market for an unrated issue)market for an unrated issue)

•• Rating agencies conduct extensive analysis of the company Rating agencies conduct extensive analysis of the company including on site visits and historical review of the firms financial including on site visits and historical review of the firms financial performance.performance.

•• Ratings are on the bonds, not the issuer consequently, different Ratings are on the bonds, not the issuer consequently, different


18 - 1079

•• Ratings are on the bonds, not the issuer consequently, different Ratings are on the bonds, not the issuer consequently, different issues of bonds from the same issuer could have different quality issues of bonds from the same issuer could have different quality ratings.ratings.

•• Six factors are considered in the rating process:Six factors are considered in the rating process:1.1. Core profitabilityCore profitability2.2. Asset qualityAsset quality3.3. Strategy and management strengthStrategy and management strength4.4. Balance sheet strengthBalance sheet strength5.5. Business strengthBusiness strength6.6. Miscellaneous issuesMiscellaneous issues

Bond RatingsBond RatingsEmpirical Evidence Regarding Debt Rating as a Empirical Evidence Regarding Debt Rating as a

Predictor of DefaultPredictor of Default

•• The quality of DBRS ratings can be assessed by examining their The quality of DBRS ratings can be assessed by examining their correlation with future default rates (examine their degree of correlation with future default rates (examine their degree of predictive power)predictive power)

•• Table 18 Table 18 –– 2 (the following slide) examined the ratings for all firms 2 (the following slide) examined the ratings for all firms and then tracked the default rates for those classes in the future.and then tracked the default rates for those classes in the future.–– Default rates clearly increase as the DBRS goes down Default rates clearly increase as the DBRS goes down –– the rating is a the rating is a


18 - 1080

–– Default rates clearly increase as the DBRS goes down Default rates clearly increase as the DBRS goes down –– the rating is a the rating is a good indicator of credit riskgood indicator of credit risk

–– Default rates are very low for investment grade bondsDefault rates are very low for investment grade bonds–– There is an exponential increase in default as credit quality deterioratesThere is an exponential increase in default as credit quality deteriorates

•• DBRS modify ratings over time as the financial condition of the DBRS modify ratings over time as the financial condition of the issuer changes and this is not reflected in the table.issuer changes and this is not reflected in the table.

(See Table 18 (See Table 18 –– 2 on the following slide)2 on the following slide)

Bond RatingsBond RatingsEmpirical Evidence Regarding Debt RatingsEmpirical Evidence Regarding Debt Ratings

DBRS Rating 5 10 20

AAA 0.00 0.00 0.00

Table 18-2 Average Default Rates (% ) in Canada

The Number of Years Examined


18 - 1081

AAA 0.00 0.00 0.00

AA 0.56 0.63 0.63

A 0.95 1.60 2.33

BBB 2.34 3.82 5.03

BB 6.37 8.99 10.11

B 28.33 28.33 28.33

CCC 33.33 33.33 33.33

Bond RatingsBond RatingsEmpirical Evidence Regarding Default Recovery RatesEmpirical Evidence Regarding Default Recovery Rates

•• Table 18 Table 18 –– 3 indicates3 indicates–– The priority of the debt claim on the firm in the case of The priority of the debt claim on the firm in the case of

insolvency has a direct relationship to the degree of insolvency has a direct relationship to the degree of discount from face valuediscount from face value


18 - 1082

discount from face valuediscount from face value–– High risk bonds have both a higher probability of High risk bonds have both a higher probability of

default as well as a lower recovery ratedefault as well as a lower recovery rate

(See Table 18 (See Table 18 –– 3 on the following slide)3 on the following slide)

Bond RatingsBond RatingsDefault Recovery RatesDefault Recovery Rates

Type Market Value/Par Value

Senior secured 54.6%

Table 18-3 Default Recovery Rates


18 - 1083

Senior unsecured 40.6

Senior subordinated 31.3

Subordinated 30.1

Junior subordinated 23.0

All bonds 34.2

Bond RatingsBond RatingsEmpirical Evidence Regarding Bond Yield SpreadsEmpirical Evidence Regarding Bond Yield Spreads

•• Figure 18 Figure 18 –– 2 indicates:2 indicates:–– Yield spreads are greater with lowerYield spreads are greater with lower--rated debt, as rated debt, as

well as more variablewell as more variable–– During economic slowdowns there is a During economic slowdowns there is a flight to qualityflight to quality


18 - 1084

–– During economic slowdowns there is a During economic slowdowns there is a flight to qualityflight to qualityas investors abandon lower quality bonds and as investors abandon lower quality bonds and increasing yield spreads increasing yield spreads

–– Economic slowdowns can limit or eliminate access to Economic slowdowns can limit or eliminate access to longlong--term, marketterm, market--traded debt capital to low quality traded debt capital to low quality bond issuers.bond issuers.

(See Figure 18 (See Figure 18 –– 2 on the following slide)2 on the following slide)

Bond RatingsBond RatingsCanada Bond Yield SpreadsCanada Bond Yield Spreads


18 - 1085



–– The basic features of debtThe basic features of debt–– To distinguish between shortTo distinguish between short-- and longand long--term debt and term debt and


18 - 1086

their respective advantages and disadvantagestheir respective advantages and disadvantages–– The main components of a prospectus and the types of The main components of a prospectus and the types of

clauses and covenants that may be includedclauses and covenants that may be included–– How debt is rated and the usefulness of rating information How debt is rated and the usefulness of rating information

to predict recovery and default rates.to predict recovery and default rates.

CHAPTER 19CHAPTER 19Equity and Hybrid Equity and Hybrid Equity and Hybrid Equity and Hybrid

InstrumentsInstruments


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• Shareholders’ EquityShareholders’ Equity•• Preferred Share CharacteristicsPreferred Share Characteristics

www.bookfiesta4u.com ContentsCHAPTER 19 – Equity and Hybrid Instruments

19 - 1089

•• Preferred Share CharacteristicsPreferred Share Characteristics•• Income TrustsIncome Trusts•• Warrants and Convertible SecuritiesWarrants and Convertible Securities•• Other HybridsOther Hybrids•• Summary and ConclusionsSummary and Conclusions




•• The basic rights associated with share ownershipThe basic rights associated with share ownership•• How these rights are distributed differently across different classes of How these rights are distributed differently across different classes of

shareholdersshareholders


19 - 1090

•• How preferred shares differ from common shares and the different features How preferred shares differ from common shares and the different features that may be associated with preferred sharesthat may be associated with preferred shares

•• Why combining warrants with debt issues or issuing convertible bonds or Why combining warrants with debt issues or issuing convertible bonds or debentures can provide firms with attractive financing optionsdebentures can provide firms with attractive financing options

•• The wide variety of hybrid financing options available to firms, and how The wide variety of hybrid financing options available to firms, and how they are constructed by combining the basic characteristics of debt and they are constructed by combining the basic characteristics of debt and equity to various degreesequity to various degrees


•• Adjustable rate convertible Adjustable rate convertible subordinated securitiessubordinated securities

•• Canadian optional interest Canadian optional interest notesnotes

•• Cash flow bondsCash flow bonds•• Commodity bondCommodity bond

•• Floor valueFloor value•• Hard retractionHard retraction•• Hybrid securityHybrid security•• Income bondsIncome bonds•• Legal factorLegal factor•• Liquid Yield Option NotesLiquid Yield Option Notes


19 - 1091

•• Commodity bondCommodity bond•• Conversion priceConversion price•• Conversion ratioConversion ratio•• Conversion valueConversion value•• Cumulative provisionCumulative provision•• Dilution factorDilution factor•• Family trustFamily trust•• Floating rate preferred shareFloating rate preferred share

•• Liquid Yield Option NotesLiquid Yield Option Notes•• LowLow--yield notesyield notes•• NonNon--voting sharesvoting shares•• Original issue discount notesOriginal issue discount notes•• Permanence factorPermanence factor•• PrePre--emptive rightemptive right•• Preferred securitiesPreferred securities•• Prepaid bondsPrepaid bonds

Important Chapter Terms …Important Chapter Terms …

•• Residual ownersResidual owners•• Restricted sharesRestricted shares•• Retractable preferred shareRetractable preferred share•• Soft retractionSoft retraction

•• Subjective factorSubjective factor•• Subordination factorSubordination factor•• Tax value of moneyTax value of money•• WarrantsWarrants


19 - 1092

•• Soft retractionSoft retraction•• Straight bond value (SBV)Straight bond value (SBV)•• Straight preferred shareStraight preferred share

Equity SecuritiesEquity Securities

•• Ownership interest in an underlying business, usually a Ownership interest in an underlying business, usually a corporation.corporation.

•• With the 1980 revision of the Canada Business Corporations With the 1980 revision of the Canada Business Corporations Act, the term ‘preferred share’ was removed from legal Act, the term ‘preferred share’ was removed from legal parlance in Canada.parlance in Canada.

•• Par values were also removed since 1975 under the CBCA.Par values were also removed since 1975 under the CBCA.•• CBCA now allows corporations to issue any number of CBCA now allows corporations to issue any number of


19 - 1093

•• CBCA now allows corporations to issue any number of CBCA now allows corporations to issue any number of ‘classes’ of shares however, there must be:‘classes’ of shares however, there must be:–– One share class with voting rightsOne share class with voting rights–– One share class with residual rights to dividends and One share class with residual rights to dividends and –– One share class with residual rights to assets upon dissolution.One share class with residual rights to assets upon dissolution.

NOTE: We often call common shares those shares with both voting rights NOTE: We often call common shares those shares with both voting rights and residual rights to earnings and assets, but you will note that and residual rights to earnings and assets, but you will note that

technically, all those rights do not have to vest in a single share class.technically, all those rights do not have to vest in a single share class.

Preference Versus Common SharesPreference Versus Common Shares

•• As previously noted, the term preference share As previously noted, the term preference share was stricken from CBCA in 1980.was stricken from CBCA in 1980.

•• Nevertheless, the term remains in usage to Nevertheless, the term remains in usage to


19 - 1094

•• Nevertheless, the term remains in usage to Nevertheless, the term remains in usage to describe:describe:–– A share class with some preference over the A share class with some preference over the

‘common share class’‘common share class’

•• However, there can be any number of classes of However, there can be any number of classes of shares with different rights and privileges.shares with different rights and privileges.

Preferred SharesPreferred SharesThe Common Understanding of a Preferred ShareThe Common Understanding of a Preferred Share

•• The term preferred share is now typically used to The term preferred share is now typically used to describe a share class that:describe a share class that:–– Has no voting rights (unless the fixed dividend is in Has no voting rights (unless the fixed dividend is in

arrears for a given period of time)arrears for a given period of time)–– Offers to pay a ‘fixed’ dividend (although such Offers to pay a ‘fixed’ dividend (although such


19 - 1095

–– Offers to pay a ‘fixed’ dividend (although such Offers to pay a ‘fixed’ dividend (although such dividends are not a legally enforceable claim)dividends are not a legally enforceable claim)

–– Has a prior claim to the ‘residual’ share class to Has a prior claim to the ‘residual’ share class to assets upon dissolution.assets upon dissolution.

•• Additionally, most preferred shares also offer:Additionally, most preferred shares also offer:–– A cumulative feature wherein arrearages in dividends A cumulative feature wherein arrearages in dividends

must be paid before the ‘common share’ class can must be paid before the ‘common share’ class can receive dividendsreceive dividends

Shareholders’ EquityShareholders’ EquityShareholder RightsShareholder Rights

•• When a corporation has only one share class, When a corporation has only one share class, the rights are equal in all respects and include:the rights are equal in all respects and include:–– The right to vote at any meeting of the shareholders The right to vote at any meeting of the shareholders

of the corporation;of the corporation;–– To receive any dividend declared by the corporation;To receive any dividend declared by the corporation;


19 - 1096

–– To receive any dividend declared by the corporation;To receive any dividend declared by the corporation;–– To receive the remaining property of the corporation To receive the remaining property of the corporation

upon dissolution.upon dissolution.

•• Provincially incorporated firms operate under Provincially incorporated firms operate under similar provisions.similar provisions.

Shareholders’ EquityShareholders’ EquityVoting RightsVoting Rights

•• At an annual general shareholders meeting (AGM) the At an annual general shareholders meeting (AGM) the standing agenda includes a shareholders vote to:standing agenda includes a shareholders vote to:–– Elect members of the board of directorsElect members of the board of directors–– Appoint the external auditors of the firmAppoint the external auditors of the firm–– Receive the audited financial statementsReceive the audited financial statements

•• If fundamental/major changes are proposed, a special If fundamental/major changes are proposed, a special meeting of shareholders may be called (or typically, the AGM meeting of shareholders may be called (or typically, the AGM


19 - 1097

meeting of shareholders may be called (or typically, the AGM meeting of shareholders may be called (or typically, the AGM will be called a AGM and Special meeting of shareholders) will be called a AGM and Special meeting of shareholders) and the shareholders may be asked to vote on:and the shareholders may be asked to vote on:–– Changes to the articles of incorporationChanges to the articles of incorporation–– Changes to the bylaws of the corporationChanges to the bylaws of the corporation–– Major changes in operations, financial structure, acquisition of Major changes in operations, financial structure, acquisition of

another firm, etc.another firm, etc.

Shareholders’ EquityShareholders’ EquityPreemptive RightPreemptive Right

•• The preemptive right is the right of shareholders to maintain The preemptive right is the right of shareholders to maintain proportional ownership in a company when new shares are proportional ownership in a company when new shares are issued.issued.

•• When companies raise new capital under these conditions, When companies raise new capital under these conditions, they do so through a ‘rights’ offering which gives the current they do so through a ‘rights’ offering which gives the current shareholders the ‘first right of refusal’ on the issue of any new shareholders the ‘first right of refusal’ on the issue of any new


19 - 1098

shareholders the ‘first right of refusal’ on the issue of any new shareholders the ‘first right of refusal’ on the issue of any new shares.shares.

•• The preemptive right, if it exists, usually is contained in the The preemptive right, if it exists, usually is contained in the articles of incorporation and is one of the ‘rights’ of the share articles of incorporation and is one of the ‘rights’ of the share classes that the firm has.classes that the firm has.

•• Removal of the preemptive right from the articles of Removal of the preemptive right from the articles of incorporation requires approval by the shareholders at a incorporation requires approval by the shareholders at a special meeting of shareholders.special meeting of shareholders.

Shareholders’ EquityShareholders’ EquityResidual RightsResidual Rights

•• The right to receive a dividend, if declared by the The right to receive a dividend, if declared by the board of directors, andboard of directors, and

•• The right to receive a pro rata share of any The right to receive a pro rata share of any


19 - 1099

•• The right to receive a pro rata share of any The right to receive a pro rata share of any remaining property upon dissolution of the remaining property upon dissolution of the corporation after all other claims have been corporation after all other claims have been satisfied. satisfied.

Shareholders’ EquityShareholders’ EquityLimited Legal LiabilityLimited Legal Liability

•• Implicitly investors in shares in corporations have limited legal Implicitly investors in shares in corporations have limited legal liability.liability.–– In practice, this means that if the corporation fails, the worstIn practice, this means that if the corporation fails, the worst--case case

scenario for shareholders is that their shares will become worthless scenario for shareholders is that their shares will become worthless (they lose what they paid for those shares).(they lose what they paid for those shares).

–– If the firm’s activities outstrip its financial resources (for example, it is If the firm’s activities outstrip its financial resources (for example, it is found guilty of polluting and faces fines that it cannot pay, even when all found guilty of polluting and faces fines that it cannot pay, even when all assets are liquidated) shareholders are not liable, and cannot be asked assets are liquidated) shareholders are not liable, and cannot be asked


19 - 1100

assets are liquidated) shareholders are not liable, and cannot be asked assets are liquidated) shareholders are not liable, and cannot be asked to inject more funds into the firm, or to pay out of their own pockets for to inject more funds into the firm, or to pay out of their own pockets for damages.*damages.*

•• Limited legal liability ensures limited ‘downside’ risk for shareholders Limited legal liability ensures limited ‘downside’ risk for shareholders while at the same time, they enjoy unlimited ‘upside’ potential for while at the same time, they enjoy unlimited ‘upside’ potential for growth in their investment (similar to call options discussed in growth in their investment (similar to call options discussed in Chapter 12)Chapter 12)

*NOTE: Even though shareholders have limited legal liability, this is not *NOTE: Even though shareholders have limited legal liability, this is not true for members of the board of directors or the management team if true for members of the board of directors or the management team if they are found responsible (liable) for damages or illegal acts through they are found responsible (liable) for damages or illegal acts through

decisions and/or errors of omission or commission. decisions and/or errors of omission or commission.

Shareholders’ EquityShareholders’ EquityDifferent Classes of SharesDifferent Classes of Shares

•• The articles of incorporation spell out the number of share The articles of incorporation spell out the number of share classes and the rights of each share class.classes and the rights of each share class.

•• The CBCA says that the three rights of shareholders do not The CBCA says that the three rights of shareholders do not have to reside in one share class if there are multiple share have to reside in one share class if there are multiple share classes classes –– each right can be assigned to a different share each right can be assigned to a different share class, or shared between share classes.class, or shared between share classes.


19 - 1101

class, or shared between share classes.class, or shared between share classes.•• Under the CBCA the firm will not use the terms ‘common’ Under the CBCA the firm will not use the terms ‘common’

‘preferred’ ‘non‘preferred’ ‘non--voting’ instead they will designate different voting’ instead they will designate different share classes with different rights:share classes with different rights:

•• A ClassA Class•• B ClassB Class•• C ClassC Class

Shareholders’ EquityShareholders’ EquityDifferent Types of SharesDifferent Types of Shares

NonNon--voting / Restricted Sharesvoting / Restricted Shares–– Participate in dividends with the common share classParticipate in dividends with the common share class–– Typically no voting rights or perhaps latent voting rights (the right Typically no voting rights or perhaps latent voting rights (the right

to vote in the case of arrears in dividends)to vote in the case of arrears in dividends)Common sharesCommon shares

–– Full voting rightsFull voting rights–– Participates in receipt of dividendsParticipates in receipt of dividends


19 - 1102

–– Participates in receipt of dividendsParticipates in receipt of dividends–– Is the residual share class after other creditors and share Is the residual share class after other creditors and share

classes.classes.Preferred sharesPreferred shares

–– Stated dividend with a preference to dividends over the common Stated dividend with a preference to dividends over the common share classshare class

–– Latent voting rights in the case of arrearageLatent voting rights in the case of arrearage–– Preference to assets upon dissolution over the common share Preference to assets upon dissolution over the common share

class.class.

Shareholders’ EquityShareholders’ EquitySome Basic RatiosSome Basic Ratios

•• Your text demonstrates the application of ratios Your text demonstrates the application of ratios to the shareholders’ equity figures for Rothmans to the shareholders’ equity figures for Rothmans Inc.Inc.


19 - 1103

Inc.Inc.•• Table 19 Table 19 –– 1 presents the equity figures for fiscal 1 presents the equity figures for fiscal

years 2004, 2005, and 2006:years 2004, 2005, and 2006:

Some Basic RatiosSome Basic RatiosBook Value per ShareBook Value per Share

$ Million 2004 2005 2006

Preferred stock 0 0 0

Capital stock 38.869 41.974 45.347

Retained earnings 129.628 151.734 68.513

Total shareholders' equity 168.497 193.708 113.860

Total liabilities and equity 496.757 528.528 449.075

Table 19-1 Rothmans Inc. Shareholders' Equity

860.113$

2006 =sharesofNumber

EquityCommonBVPS


19 - 1104


Total common equity 168.497 193.708 113.860

Shares outstanding year end (million) 67.351 67.572 67.856

Book value per share ($) 2.5018 2.8667 1.6780

Diluted earnings per common share ($) 1.34 1.37 1.45

Common dividend per share ($) 0.8125 1.05 2.70*

*Includes a special dividend of $1.50

678.1$856.67

860.113$ ==

Some Basic RatiosSome Basic RatiosMarket to Book ValueMarket to Book Value

$ Million 2004 2005 2006


Capital stock 38.869 41.974 45.347




Table 19-1 Rothmans Inc. Shareholders' Equity

07.12678.1$

25.20$

/ 2006

times

BVPS

PBM

==

=


19 - 1105








A stock trading at 12 times its book value indicates that the stock is

highly regarding in financial markets (usually because of strong profits and

growth potential.)

Some Basic RatiosSome Basic RatiosDividend YieldDividend Yield

$ Million 2004 2005 2006


Capital stock 38.869 41.974 45.347




Table 19-1 Rothmans Inc. Shareholders' Equity 13.3%

25.20$

70.2$dividend) special(with ===

P

DPSYieldDividend

In Table 22 – 2 dividend yields vary from 0% to a high of 7.22% for Yellow


19 - 1106








high of 7.22% for Yellow Pages Income Fund.

Clearly Rothmans is on the high end of this metric.

What makes this so surprising is that we already

know the stock price is trading at a significant

multiple above Book Value.

Shareholders’ EquityShareholders’ EquityDividends and TaxesDividends and Taxes

•• Dividends are attractive from an income taxation Dividends are attractive from an income taxation point of view in Canada:point of view in Canada:–– Dividends received by one corporation from another Dividends received by one corporation from another

corporation are not subject to tax at the corporate corporation are not subject to tax at the corporate


19 - 1107

corporation are not subject to tax at the corporate corporation are not subject to tax at the corporate levellevel

–– Dividend income received by Canadians is subject to Dividend income received by Canadians is subject to the ‘grossthe ‘gross--up / dividend tax credit’ system that results up / dividend tax credit’ system that results in very low rates of taxes on individuals with low to in very low rates of taxes on individuals with low to moderate marginal tax rates (see the following slide) moderate marginal tax rates (see the following slide)

Taxation of Dividend IncomeTaxation of Dividend Income



Dividend Income

Capital Gains

$ - to $8,148 $ - 0.00% 0.00% 0.00%

$8,149 to 11,336 $ - 16.00 3.33 8.00


Marginal Rate on

The dividend gross-up, tax credit system makes dividend income the

lowest taxed investment income in the lower tax

brackets.

Dividends are taxed at a lower rate than interest in

all tax brackets.


19 - 1108

$8,149 to 11,336 $ - 16.00 3.33 8.00$11,337 to 14,477 510 28.10 5.63 14.05

$14,478 to 34,010 1,393 22.05 4.48 11.03

$34,011 to 35,595 5,700 25.15 8.36 12.58

$35,596 to 59,882 6,098 31.15 15.86 15.58

$59,883 to 68,020 13,664 32.98 16.86 16.49

$68,021 to 70,559 16,348 35.39 19.88 17.70

$70,560 to 71,190 17,246 39.41 22.59 19.70

$71,191 to 115,739 17,495 43.41 27.59 21.70$115,740 and up 36,833 46.41 31.34 23.20


all tax brackets.

Preferred Share CharacteristicsPreferred Share Characteristics

•• Table 19Table 19--2 (on the following slide) reports on 2 (on the following slide) reports on yields on three different types of preferred yields on three different types of preferred shares in Canada as at November, 2005:shares in Canada as at November, 2005:–– Straight preferredsStraight preferreds


19 - 1109

–– Retractable preferredsRetractable preferreds–– Floating rate preferredsFloating rate preferreds

Preferred Share YieldsPreferred Share Yields

Straight Preferreds (%)Dividend yield 5.22

Long Canada yield 4.19

After tax spread (corp.) 2.50

After tax spread (indiv.) 1.34

Retractable Preferreds (%)

Table 19-2 Preferred Share Yields, November 2005


19 - 1110

Retractable Preferreds (%)Dividend yield 3.33

Mid Canada yield 3.90

After tax spread (corp.) 0.80

After tax spread (indiv.) 0.20

Floating Rate Preferreds (%)Dividend yield 3.24

BA (3 month) 3.40

After-tax spread (corp.) 1.03

After-tax spread (indiv.) 0.40

Source: Data f rom Nesbitt Burns, Preferred Share Statistics , December 2005.

Types of Preferred SharesTypes of Preferred Shares

•• Straight preferredStraight preferred–– No maturity dateNo maturity date–– Pay a fixed dividend at regular intervals (quarterly)Pay a fixed dividend at regular intervals (quarterly)

•• Retractable preferredRetractable preferred–– Gives the investor the right to sell it back to the issuerGives the investor the right to sell it back to the issuer


19 - 1111

–– Gives the investor the right to sell it back to the issuerGives the investor the right to sell it back to the issuer–– Typical retraction feature is 5 yearsTypical retraction feature is 5 years

•• Floating rate preferredFloating rate preferred–– Periodically (every 3 to 6 months) the dividend is reset by an Periodically (every 3 to 6 months) the dividend is reset by an

auction mechanism so that the yield will remain consistent with auction mechanism so that the yield will remain consistent with current market interest rates.current market interest rates.

–– In some cases the dividend is connected to the prime lending In some cases the dividend is connected to the prime lending rate and changes as the prime rate changes.rate and changes as the prime rate changes.

Yield SpreadsYield Spreads

•• Preferred shares offer higher yields than bondsPreferred shares offer higher yields than bonds–– Greater default risk associated with an equity securityGreater default risk associated with an equity security

•• Bonds obligations are a legally enforceable claim (preferred Bonds obligations are a legally enforceable claim (preferred dividends are not)dividends are not)

•• Bondholders have a secured claim against assets of the Bondholders have a secured claim against assets of the corporation in the event of dissolution…preferred corporation in the event of dissolution…preferred


19 - 1112

corporation in the event of dissolution…preferred corporation in the event of dissolution…preferred shareholders are second to last in residual claims.shareholders are second to last in residual claims.

Tax Value of MoneyTax Value of Money•• Actual yield spreads are greater than the Actual yield spreads are greater than the

observable spread on an afterobservable spread on an after--tax basis tax basis because of the lower tax rate on dividends than because of the lower tax rate on dividends than on interest income.on interest income.

Preferred SharesPreferred SharesThe Cumulative ProvisionThe Cumulative Provision

•• A stipulation that no dividends can be paid on A stipulation that no dividends can be paid on common shares until preferred share dividends, common shares until preferred share dividends, both current and arrears, are paid in full.both current and arrears, are paid in full.

•• This feature is the reason boards of directors This feature is the reason boards of directors


19 - 1113

•• This feature is the reason boards of directors This feature is the reason boards of directors take the payment of preferred dividends very take the payment of preferred dividends very seriously.seriously.

Preferred Shares as a Hybrid InstrumentPreferred Shares as a Hybrid Instrument

•• Although preferred shares are equity securities because they are Although preferred shares are equity securities because they are often seen as a higher yield (and risk) substitute for fixed income often seen as a higher yield (and risk) substitute for fixed income securities.securities.

•• They are often seen as a hybrid instrument because, while they are They are often seen as a hybrid instrument because, while they are equity from a residual claim point of view, and therefore have equity from a residual claim point of view, and therefore have significantly higher default risk, they do promise to offer a steady significantly higher default risk, they do promise to offer a steady stream of dividends (similar to a debt instrument, but treated stream of dividends (similar to a debt instrument, but treated


19 - 1114

stream of dividends (similar to a debt instrument, but treated stream of dividends (similar to a debt instrument, but treated preferentially from a taxation perspective)preferentially from a taxation perspective)

•• The higher the quality of the issuer, the more like debt preferred The higher the quality of the issuer, the more like debt preferred stock is because of the lower likelihood of default and the greater stock is because of the lower likelihood of default and the greater the likelihood of an uninterrupted stream of dividends in a high the likelihood of an uninterrupted stream of dividends in a high quality issuer.quality issuer.

Preferred Share DividendsPreferred Share Dividends

•• While the preferred dividend is not a legallyWhile the preferred dividend is not a legally--enforceable financial obligations, issuers take enforceable financial obligations, issuers take the payment of those dividends very seriously the payment of those dividends very seriously for a number of reasons:for a number of reasons:–– Failure to pay could jeopardize the firms future ability Failure to pay could jeopardize the firms future ability


19 - 1115

–– Failure to pay could jeopardize the firms future ability Failure to pay could jeopardize the firms future ability to issue securities in the financial markets because of to issue securities in the financial markets because of a damaged reputationa damaged reputation

–– Normally arrears in dividends need to be addressed Normally arrears in dividends need to be addressed before the common share class can receive before the common share class can receive dividends, and as arrearages grow, increasingly the dividends, and as arrearages grow, increasingly the common shareholders will get concerned and voice common shareholders will get concerned and voice those concerns at the AGM.those concerns at the AGM.

Preferred Share RatingsPreferred Share Ratings

Dominion Bond Rating Service (DBRS)Dominion Bond Rating Service (DBRS)

Preferred RatingPreferred Rating Bond Equivalent RatingBond Equivalent Rating1.1. PFD PFD –– 11 AAA AAA -- AAAA


19 - 1116

1.1. PFD PFD –– 11 AAA AAA -- AAAA2.2. PFD PFD –– 22 AA3.3. PFD PFD –– 33 highly rated BBBhighly rated BBB4.4. PFD PFD –– 44 lower rated BBB and BBlower rated BBB and BB5.5. PFD PFD –– 55 B or lower rated bondsB or lower rated bonds

Income TrustsIncome TrustsStrong Popularity Driven by Tax ConsiderationsStrong Popularity Driven by Tax Considerations

•• A tax efficient financial structure allowing distribution of preA tax efficient financial structure allowing distribution of pre--tax corporate cash flows to trust investors resulting in:tax corporate cash flows to trust investors resulting in:–– Greater cash distributions to unitholders than the same firm Greater cash distributions to unitholders than the same firm

using a traditional capital structure involving debt and equityusing a traditional capital structure involving debt and equity–– Elimination of double taxation (which is the reason for the Elimination of double taxation (which is the reason for the

greater cash distributions because they are being made before greater cash distributions because they are being made before tax).tax).


19 - 1117

tax).tax).•• Represents a popular form of equity financing representing Represents a popular form of equity financing representing

more than half the IPOs in Canada in the 2000smore than half the IPOs in Canada in the 2000s•• As of March 2006:As of March 2006:

–– 238 income trusts listed on the TSX238 income trusts listed on the TSX–– Total market capitalization of income trusts $192 billion Total market capitalization of income trusts $192 billion

representing 10% of the quoted market value of the TSXrepresenting 10% of the quoted market value of the TSX

Income TrustsIncome TrustsThe Minister’s Announced Change in Tax TreatmentThe Minister’s Announced Change in Tax Treatment

•• Finance Minister Jim Flaherty made an unexpected Finance Minister Jim Flaherty made an unexpected announcement regarding income trusts on October 31, 2006announcement regarding income trusts on October 31, 2006–– It was unexpected because the Conservative Party had It was unexpected because the Conservative Party had

campaigned on a promise not to tax income trusts in the 2006 campaigned on a promise not to tax income trusts in the 2006 federal election. federal election.

•• Existing income trusts (prior to November 1, 2006) will Existing income trusts (prior to November 1, 2006) will


19 - 1118

•• Existing income trusts (prior to November 1, 2006) will Existing income trusts (prior to November 1, 2006) will continue to enjoy the tax benefits of that structure until 2011.continue to enjoy the tax benefits of that structure until 2011.

•• Newly created income trusts will be taxed like normal Newly created income trusts will be taxed like normal corporations.corporations.

•• In the first few days following the announcement almost $30 In the first few days following the announcement almost $30 billion in market capitalization was lost as income trust unit billion in market capitalization was lost as income trust unit values fell dramatically.values fell dramatically.

WarrantsWarrants

•• A longA long--term option to purchase new shares in a corporation at a term option to purchase new shares in a corporation at a specified price.specified price.

•• The corporate finance equivalent of call options that are used to The corporate finance equivalent of call options that are used to raise new capital for a firm.raise new capital for a firm.

•• Have long maturities and may be perpetual (no maturity date)Have long maturities and may be perpetual (no maturity date)•• Warrants are issued by the firm.Warrants are issued by the firm.•• The exercise price of the warrant at the time of issue is normally The exercise price of the warrant at the time of issue is normally


19 - 1119

•• The exercise price of the warrant at the time of issue is normally The exercise price of the warrant at the time of issue is normally greater than the current stock price of the firm.greater than the current stock price of the firm.

•• Warrants are often packaged with the sale of other new securities Warrants are often packaged with the sale of other new securities (preferred stock or bonds) and are ‘equity sweetners’ allowing the (preferred stock or bonds) and are ‘equity sweetners’ allowing the holder to exercise them to buy new shares in the company, and holder to exercise them to buy new shares in the company, and thereby participate in the growth of the firm along with shareholders.thereby participate in the growth of the firm along with shareholders.

(Table 19 (Table 19 –– 3 illustrates the first five warrants outstanding on Canadian exchanges in August, 3 illustrates the first five warrants outstanding on Canadian exchanges in August, 2006)2006)

Warrant ListingsWarrant Listings

Company Stock Close

Symbol Stock Exchange

Exercise Price

Recent Close

Bid/ Ask

Intrinsic Value

Time Value

Years Left

Expiry Date

Agnico-Eagles Mines Ltd 40.420 AEM.WT.U TSX US$19.000 US$19.500 US$19.5 18.920 3.147 1.3

Nov. 14, 2007

Ascendant Nov.21,

Table 19-3 Warrant Listings


19 - 1120

Copper Corp 0.500 ACX.WT TSX 2.500 0.150 0.150 -2.000 0.150 4.3

Nov.21, 2010

Aumega Discoveries Ltd 0.090 AUM.WT TSX-VEN 0.400 0.010 0.010 -0.310 0.010 0.5

Feb. 16, 2007

Avnel Gold Mining Ltd 1.100 AVK.WT TSX 1.060 0.550 0.550 0.040 0.510 3.9

June 30, 2010

Baja Mining Corp 1.500 BAJ.WT TSX-VEN 1.150 1.270 1.270 0.350 0.920 2.7

Apr. 19, 2009

Source: Data from Financial Post , August 29, 2006.

Warrants versus OptionsWarrants versus Options

WarrantsWarrants

•• Issued by the firm to investorsIssued by the firm to investors•• Issued to raise new capital for the Issued to raise new capital for the

firm (capital formation purpose)firm (capital formation purpose)•• Traded in the secondary market Traded in the secondary market

between investorsbetween investors

ExchangeExchange--traded Call Optionstraded Call Options

•• Created by investors interacting Created by investors interacting with the options exchange as the with the options exchange as the counterpartycounterparty

•• No capital formation, instead used No capital formation, instead used as an instrument of hedging or as an instrument of hedging or


19 - 1121

between investorsbetween investors•• LongLong--term or perpetual optionterm or perpetual option•• At the time of issue the exercise At the time of issue the exercise

price is typically greater than the price is typically greater than the current stock price (so the warrant current stock price (so the warrant does not have an intrinsic value does not have an intrinsic value immediately)immediately)

as an instrument of hedging or as an instrument of hedging or speculatingspeculating

•• ShortShort--term optionterm option•• May be created outMay be created out--ofof--thethe--money, money,

atat--thethe--money, or inmoney, or in--thethe--money.money.

Warrant ValuationWarrant Valuation

•• Using payoff diagrams normally associated with Using payoff diagrams normally associated with call options we can describe visually how call options we can describe visually how warrants are valued.warrants are valued.


19 - 1122

warrants are valued.warrants are valued.

(See the diagram on the following slide)(See the diagram on the following slide)

WarrantsWarrantsThe Value of a WarrantThe Value of a Warrant

Warrant Value


19 - 1123

$50 exercise

price

0Stock Price

At the time of issue the warrant

will have a speculative (time)

value only because the

market value of the stock is less than the exercise

price.

Over time the stock price may increase and

when it exceeds the exercise price of the warrant, the warrant value will have both intrinsic value and

speculative (time) value.

Payoff to Warrant HoldersPayoff to Warrant HoldersUsing a Variant of the Standard Options Pricing ModelUsing a Variant of the Standard Options Pricing Model

Where:Where:

mX)-mX(Vmn

mholderswarranttoPayoff +

+=[ 19-1]


19 - 1124

nn =existing number of shares=existing number of sharesmm = number of shares issued on exercise of the warrants= number of shares issued on exercise of the warrantsXX = exercise price of the warrant= exercise price of the warrantVV = stock price of the firm without the warrant= stock price of the firm without the warrant

This equation says that after the warrants are exercised, the value of the firm must be the This equation says that after the warrants are exercised, the value of the firm must be the value without the warrants (V) plus the proceeds to the firm from the exercise of the value without the warrants (V) plus the proceeds to the firm from the exercise of the warrants (mX), for a total value of V + mX. (The weighted average of the former stock price warrants (mX), for a total value of V + mX. (The weighted average of the former stock price and the warrant exercise price)and the warrant exercise price)

The percentage owned by the warrant holders is m/(n+m), whereas the cost to them is The percentage owned by the warrant holders is m/(n+m), whereas the cost to them is exercise value of mX.exercise value of mX.

Payoff to Warrant Holders Payoff to Warrant Holders

Equation 19Equation 19--1 reduces to 191 reduces to 19--2 when we multiply the exercise value 2 when we multiply the exercise value mXmXby by (n+m)/(n+m):(n+m)/(n+m):

nX)(Vmn

mholderswarranttoPayoff −

+=[ 19-2]


19 - 1125

The first term The first term m / (n+m)m / (n+m) is the dilution factor.is the dilution factor.

Therefore the value of the warrant is the dilution factor times the Therefore the value of the warrant is the dilution factor times the value of the secondary market call (whether you use the Blackvalue of the secondary market call (whether you use the Black--Scholes or binomial option pricing model)Scholes or binomial option pricing model)

mn +

WarrantsWarrants

•• As longAs long--term options warrants trade at significant premiums term options warrants trade at significant premiums over their intrinsic value.over their intrinsic value.–– This is known as a time (speculative) premiumThis is known as a time (speculative) premium

•• They are often used as They are often used as sweetnerssweetners to make other financial to make other financial securities more attractive to investors by being issued as a securities more attractive to investors by being issued as a


19 - 1126

package together with debt or preferred stock.package together with debt or preferred stock.•• If warrants are NOT detachable, issuing bonds plus a warrant If warrants are NOT detachable, issuing bonds plus a warrant

is similar to issuing convertible bonds (the holder holds a is similar to issuing convertible bonds (the holder holds a traditional bond, but an option to purchase equity and thereby traditional bond, but an option to purchase equity and thereby participate in the growth of the firm)participate in the growth of the firm)

Convertible BondsConvertible Bonds

•• Bonds that are convertible into a specified number of common Bonds that are convertible into a specified number of common shares at the option of the convertible holder.shares at the option of the convertible holder.

•• When converted, the bonds are exchanged for common When converted, the bonds are exchanged for common shares (bonds are no longer outstanding)shares (bonds are no longer outstanding)–– The firm does not obtain additional financing through conversion.The firm does not obtain additional financing through conversion.–– The debt level of the firm is reduced through conversion.The debt level of the firm is reduced through conversion.


19 - 1127

–– The debt level of the firm is reduced through conversion.The debt level of the firm is reduced through conversion.•• The convertible feature is a ‘sweetner’ used to encourage The convertible feature is a ‘sweetner’ used to encourage

investors to invest in the convertible and so convertibles tend investors to invest in the convertible and so convertibles tend to be issued by higher risk firms.to be issued by higher risk firms.

•• Convertibles are issued with a maturity date, however, they Convertibles are issued with a maturity date, however, they are also usually callable to ensure conversion does occur.are also usually callable to ensure conversion does occur.

(See Table 19 (See Table 19 –– 4 for some examples.)4 for some examples.)

Convertible Bond ListingsConvertible Bond Listings

Issuer Symbol Coupon Maturity Last Price

Parity Yield to Maturity

Premium Conversion

Ratio

Conversion Price

Symbol Share Price

Tuesday August

28, 2006

ACE

Table 19-4 Convertible Bond Listings


19 - 1128

ACE Aviation ACE.NT.A 4.25% 1-Jun-2035 94.50 67.19 4.60% 40.66% 2.23 44.88 ACE.A 30.15

Advantage Energy AVN.DB 10.00% 1-Nov-2007 134.62 132.78 -15.82% 1.33% 7.52 13.30 AVN.UN 17.67

AgricoreAU.DB 9.00% 30-Nov-2007 106.25 102.13 3.81% 4.03% 13.33 7.50 AU 7.66

Alamos Gold AGI.DB 5.50% 15-Feb-2010 172.00 154.91 -11.05% 9.83% 18.87 5.30 AGI 8.30

Alexis Nihon AN.DB 6.20% 30-Jun-2014 100.80 93.92 6.07% 7.08% 7.33 13.65 AN.UN 12.85

Source: Data f rom Financial Post , August 29, 2006.

Conversion Price Conversion Price

The conversion price (CP) is the price at which a The conversion price (CP) is the price at which a convertible security can be converted into common convertible security can be converted into common shares based on its conversion ratio.shares based on its conversion ratio.


19 - 1129

The conversion ratio (CR) is the number of shares that a The conversion ratio (CR) is the number of shares that a convertible security could be exchanged for.convertible security could be exchanged for.

CR

ParCP =[ 19-3]

Conversion Value (CV) Conversion Value (CV)

The Conversion Value (CV) is the value of a convertible The Conversion Value (CV) is the value of a convertible security if it is immediately converted into common shares.security if it is immediately converted into common shares.


19 - 1130

This value is denoted as “parity” in the Convertible Bond This value is denoted as “parity” in the Convertible Bond listings.listings.Obviously, if CV < Bond Price, conversion is not Obviously, if CV < Bond Price, conversion is not advantageous to the convertible holder.advantageous to the convertible holder.

PCRCV ×=[ 19-4]

Convertible Premium Convertible Premium

The convertible premium is the percentage the The convertible premium is the percentage the share must increase in order for conversion to share must increase in order for conversion to make sense:make sense:


19 - 1131

PremiumeConvertiblCV

CVP −=[ 19-5]

Straight Bond Value (SBV) Straight Bond Value (SBV)

Convertible bonds are bonds that have an inherent value in Convertible bonds are bonds that have an inherent value in themselves.themselves.The conversion feature of the bond is considered an option, in The conversion feature of the bond is considered an option, in addition to the basic bond value.addition to the basic bond value.


19 - 1132

)1(

1)1(1

1

SBVn

bb

nb

kF

k

kI

+×+

+×=[ 19-6]

Floor Value (FV) Floor Value (FV)

The Floor Value (FV) is the lowest price a convertible bond will sell The Floor Value (FV) is the lowest price a convertible bond will sell for, which is equal to the larger of its straight bond value and its for, which is equal to the larger of its straight bond value and its conversion value.conversion value.

),( CVSBVMaxFV =[ 19-7]


19 - 1133

Every convertible will always have a floor value (FV) because it will Every convertible will always have a floor value (FV) because it will always sell for no less than the larger of the straight bond value and always sell for no less than the larger of the straight bond value and its conversion value.its conversion value.

In practice, convertibles usually sell a higher prices because of the In practice, convertibles usually sell a higher prices because of the time value of the conversion option.time value of the conversion option.

Convertible FinancingConvertible Financing

•• Convertible financing helps firms obtain capital at a lower Convertible financing helps firms obtain capital at a lower coupon rate at the time of issue.coupon rate at the time of issue.

•• This is because the buyer is receiving an ‘equity call option’ This is because the buyer is receiving an ‘equity call option’ equal to the time premium.equal to the time premium.

•• In the event the value of the stock remains below parity, the In the event the value of the stock remains below parity, the firm has obtained cheap debtfirm has obtained cheap debt


19 - 1134

firm has obtained cheap debtfirm has obtained cheap debt•• In the event the value of the stock exceeds parity, the firm In the event the value of the stock exceeds parity, the firm

receives cheap equity (they sold equity at a price greater than receives cheap equity (they sold equity at a price greater than what they could have sold it at the time of issue)what they could have sold it at the time of issue)

•• The outcome, whether in the firm’s favour or not depends on The outcome, whether in the firm’s favour or not depends on the subsequent movement of the stock price until the subsequent movement of the stock price until conversion/maturity/call.conversion/maturity/call.

(See Figure 19 (See Figure 19 –– 1 for a graphic depiction of the ACE Holdings situation)1 for a graphic depiction of the ACE Holdings situation)

Convertible ScenariosConvertible Scenarios

19-1 FIGURE

P>$44.88

Conversion: Cheap Equity


19 - 1135

ACE Share price $35

No Conversion: Cheap Debt

P<$44.88

This ‘what-if’ scenario indicates that convertibles are rarely the ‘right’ decision, but they are never the ‘wrong’ decision because the firm gets either cheap debt

or cheap equity financing.

Other HybridsOther Hybrids

•• Warrants, convertible bonds and convertible Warrants, convertible bonds and convertible preferred shares are the most common hybrid preferred shares are the most common hybrid securities.securities.

•• Financial innovation takes place in order for Financial innovation takes place in order for companies to issue securities that meet the companies to issue securities that meet the


19 - 1136

companies to issue securities that meet the companies to issue securities that meet the needs of investors in the marketplace.needs of investors in the marketplace.

•• In this manner, firms that might not be able to In this manner, firms that might not be able to raise capital with traditional financing means are raise capital with traditional financing means are able to do so, OR, they are able to raise capital able to do so, OR, they are able to raise capital in a form that better suits their cash flow in a form that better suits their cash flow preferences.preferences.

Other HybridsOther HybridsCategorizing HybridsCategorizing Hybrids

DBRS uses four factors help to determine whether a hybrid DBRS uses four factors help to determine whether a hybrid instrument is more like debt or more like equity:instrument is more like debt or more like equity:

1.1. Permanence factorPermanence factorCommon stock is perpetual, where as CP is very shortCommon stock is perpetual, where as CP is very short--termterm

2.2. Subordination factorSubordination factorPlace on the prior of claims against income and assetsPlace on the prior of claims against income and assets


19 - 1137

Place on the prior of claims against income and assetsPlace on the prior of claims against income and assets

3.3. Legal factorLegal factorWhether the claim on income is legally enforceable or notWhether the claim on income is legally enforceable or not

4.4. Subjective factorSubjective factorThe purpose of the company when it issues the securities.The purpose of the company when it issues the securities.

Following a description of other hybrids we will present a Following a description of other hybrids we will present a hierarchy of securities.hierarchy of securities.

Other HybridsOther HybridsCreative Hybrids: Some ExamplesCreative Hybrids: Some Examples

•• Income bondsIncome bonds•• Cash flow bondsCash flow bonds•• Commodity bondsCommodity bonds•• Original issue discount bonds (OIDs) or lowOriginal issue discount bonds (OIDs) or low--yield yield

notesnotes


19 - 1138

•• Original issue discount bonds (OIDs) or lowOriginal issue discount bonds (OIDs) or low--yield yield notesnotes

•• Liquid Yield Option Notes (LYONs)Liquid Yield Option Notes (LYONs)•• Adjustable Rate Convertible Subordinated Adjustable Rate Convertible Subordinated

Securities (ARCS)Securities (ARCS)•• Preferred securitiesPreferred securities•• Canadian optional interest notes (COINS)Canadian optional interest notes (COINS)

Other HybridsOther HybridsCreative Hybrids: Income BondsCreative Hybrids: Income Bonds

•• Income bondsIncome bonds–– Bonds issued after a reorganization with the interest Bonds issued after a reorganization with the interest

tied to some cash flow level for the firm and with quite tied to some cash flow level for the firm and with quite long maturity dateslong maturity dates

–– Payments are not tax deductible in Canada and as Payments are not tax deductible in Canada and as


19 - 1139

–– Payments are not tax deductible in Canada and as Payments are not tax deductible in Canada and as classified by CRA as dividends.classified by CRA as dividends.

–– Seen as a ‘desperation play’ as the issuer may not Seen as a ‘desperation play’ as the issuer may not have much tax incentive to issue real bonds (little have much tax incentive to issue real bonds (little taxable income because of loss carried forward taxable income because of loss carried forward provisions under the Income Tax Act)provisions under the Income Tax Act)

Other HybridsOther HybridsCreative Hybrids: Cash Flow BondsCreative Hybrids: Cash Flow Bonds

•• Cash flow bondsCash flow bonds–– Bonds sold in the United States that have the same Bonds sold in the United States that have the same

objects as do income bonds in Canada.objects as do income bonds in Canada.–– Maturity dates are longMaturity dates are long–– Interest payments are conditional on the firm meeting Interest payments are conditional on the firm meeting


19 - 1140

–– Interest payments are conditional on the firm meeting Interest payments are conditional on the firm meeting certain thresholdscertain thresholds

Other HybridsOther HybridsCreative Hybrids: Commodity BondsCreative Hybrids: Commodity Bonds

•• Commodity bondsCommodity bonds–– A bond whose interest or principal is tied to the price A bond whose interest or principal is tied to the price

of an underlying commodity such as gold.of an underlying commodity such as gold.


19 - 1141

Other HybridsOther HybridsCreative Hybrids: Original Issue Discount BondsCreative Hybrids: Original Issue Discount Bonds

•• Original issue discount bonds (OIDs) or lowOriginal issue discount bonds (OIDs) or low--yield notesyield notes–– Bonds that sell at a discount from par value when issued by Bonds that sell at a discount from par value when issued by

firms.firms.–– The company doesn’t pay coupon interest annually, simply a The company doesn’t pay coupon interest annually, simply a

bullet payment on maturity.bullet payment on maturity.–– Investors must report ‘accrued’ interest income if the bond is Investors must report ‘accrued’ interest income if the bond is


19 - 1142

–– Investors must report ‘accrued’ interest income if the bond is Investors must report ‘accrued’ interest income if the bond is held in a taxable account (often, though investors place these held in a taxable account (often, though investors place these types of investments in taxtypes of investments in tax--deferred (registered plans) deferred (registered plans) investment accounts and thereby don’t have to pay interest until investment accounts and thereby don’t have to pay interest until the funds are with drawn) RESPs and RRSPs.the funds are with drawn) RESPs and RRSPs.

–– Investors have grown to like nonInvestors have grown to like non--coupon bearing bonds because coupon bearing bonds because there is no reinvestment rate problem (the ex post yield on the there is no reinvestment rate problem (the ex post yield on the bonds will equal the ex ante forecast if there is no default on the bonds will equal the ex ante forecast if there is no default on the issue) issue)

(Table 19 (Table 19 –– 5 illustrates the OID bond interest compared to a normal bond)5 illustrates the OID bond interest compared to a normal bond)

Creative HybridsCreative Hybrids

Principal "Interest"2 $4.24 $46.65 $4.243 4.24 51.32 4.67

Table 19-5 OID versus Regular Bond Payments

OID BondRegular Bond


19 - 1143

3 4.24 51.32 4.674 4.24 56.45 5.135 4.24 62.09 5.646 4.24 68.30 6.217 4.24 75.13 6.838 4.24 82.64 7.5519 4.24 90.91 8.26

10 46.65 100.00 9.09

Other HybridsOther HybridsCreative Hybrids: Liquid Yield Option NotesCreative Hybrids: Liquid Yield Option Notes

•• Liquid Yield Option Notes (LYONs)Liquid Yield Option Notes (LYONs)–– LowLow--yield notes that are combined with a convertible yield notes that are combined with a convertible

feature and are accretive convertibles, because the feature and are accretive convertibles, because the principal accretes or increases over time.principal accretes or increases over time.


19 - 1144

principal accretes or increases over time.principal accretes or increases over time.

Other HybridsOther HybridsCreative Hybrids: Adjustable Rate Convertible Subordinated SecuritiesCreative Hybrids: Adjustable Rate Convertible Subordinated Securities

•• Adjustable Rate Convertible Subordinated Adjustable Rate Convertible Subordinated Securities (ARCS)Securities (ARCS)–– Securities that have fixed principal and maturity, and Securities that have fixed principal and maturity, and


19 - 1145

–– Securities that have fixed principal and maturity, and Securities that have fixed principal and maturity, and interest that normally comprises a fixed interest rate interest that normally comprises a fixed interest rate and some function of the dividend paid in the previous and some function of the dividend paid in the previous six monthssix months

–– Typically convertible into common sharesTypically convertible into common shares

Other HybridsOther HybridsCreative Hybrids: Preferred SecuritiesCreative Hybrids: Preferred Securities

•• Preferred securitiesPreferred securities–– Not preferred sharesNot preferred shares–– Securities generated by a company by creating a 100 Securities generated by a company by creating a 100

percent owned subsidiary that issues the shares then percent owned subsidiary that issues the shares then loans the proceeds to the parent company, for whom loans the proceeds to the parent company, for whom


19 - 1146

loans the proceeds to the parent company, for whom loans the proceeds to the parent company, for whom the interest is tax deductible;the interest is tax deductible;

–– Interest flows to the subsidiary, where it is not taxed, Interest flows to the subsidiary, where it is not taxed, and is used to make dividend payments.and is used to make dividend payments.

Other HybridsOther HybridsCreative Hybrids: Canadian Optional Interest NotesCreative Hybrids: Canadian Optional Interest Notes

•• Canadian optional interest notes (COINS)Canadian optional interest notes (COINS)–– 9999--year bonds that are sold at their par values of year bonds that are sold at their par values of

$100, on which the firm immediately prepays the $100, on which the firm immediately prepays the


19 - 1147

interest from years 11 to 99 on issue, leaving it with a interest from years 11 to 99 on issue, leaving it with a net inflow and allowing it to continue to deduct annual net inflow and allowing it to continue to deduct annual interest payments of $100, even though it has interest payments of $100, even though it has effectively borrowed less.effectively borrowed less.

A Financing HierarchyA Financing Hierarchy

•• Table 19 Table 19 –– 6 shows a synopsis of the main securities 6 shows a synopsis of the main securities discussed in this chapter and shows using a rating system discussed in this chapter and shows using a rating system how like equity they are.how like equity they are.–– Equities are rated as 100% because they are equityEquities are rated as 100% because they are equity–– Commercial papers are rated Commercial papers are rated --100% because they are the most 100% because they are the most

debtdebt--like.like.


19 - 1148

debtdebt--like.like.•• Figure 19 Figure 19 –– 2 shows the spectrum of financing options 2 shows the spectrum of financing options

available to corporations and expresses them in terms of risk available to corporations and expresses them in terms of risk to the investor, and the required return investors demand (this to the investor, and the required return investors demand (this translates into the returns the firm must offer in order to translates into the returns the firm must offer in order to access that type of capital)access that type of capital)

(See the following two slides)(See the following two slides)

A Financing HierarchyA Financing Hierarchy

Equity Share (%)Common shares 100Mandatory convertible preferred shares* 90Straight preferred shares 50Trust preferred shares 40

Table 19-6 S&P Financing Rankings


19 - 1149

Trust preferred shares 40Convertible preferred shares 20Re-marketed preferred shares† -10Normal convertible debt -50Accreting convertible bonds (LYONS) -60Very long term bonds -70Medium term bonds -80Auction preferred shares -90Commercial paper -100* Preferred shares for w hich conversion into common shares is structured to be automatic.† Preferred shares that af ter f ive to seven years, are repriced and resold.

Other HybridsOther HybridsFinancing Hierarchy CostsFinancing Hierarchy Costs

19-2 FIGURE

Straight Preferred

Shares

Common Equity

Cost


19 - 1150

Mortgage Debt

Convertible Bonds

Convertible Preferred

SharesLong-term

Unsecured Debt

CP

Risk

MTNs

Bank Loans


In this chapter you have learned:In this chapter you have learned:–– That securities are financial contracts and their risk depends on the That securities are financial contracts and their risk depends on the

structure of the contractstructure of the contract–– Basic issues are tax treatment and equity weightBasic issues are tax treatment and equity weight–– Common stock imposes the least risk on a firm because it imposes no Common stock imposes the least risk on a firm because it imposes no

legally binding cash flow commitments and never matures, legally binding cash flow commitments and never matures, consequently, common stock provides a cushion to senior debt and consequently, common stock provides a cushion to senior debt and


19 - 1151

consequently, common stock provides a cushion to senior debt and consequently, common stock provides a cushion to senior debt and other commitments that is required in order to attract these other, more other commitments that is required in order to attract these other, more risky sources of financing.risky sources of financing.

–– Commercial Paper and Bankers’ Acceptances place the greatest Commercial Paper and Bankers’ Acceptances place the greatest financial risk on the firm because they place a fixed, timefinancial risk on the firm because they place a fixed, time--delimited delimited (short(short--term) financial and contractual obligation on the firm, including term) financial and contractual obligation on the firm, including repayment of principal.repayment of principal.

–– An offsetting advantage of CPs and BAs is the taxAn offsetting advantage of CPs and BAs is the tax--deductibility of deductibility of interest expense.interest expense.

–– Between these two extremes, hybrid financial instruments combine the Between these two extremes, hybrid financial instruments combine the characteristics of both debt and equity.characteristics of both debt and equity.

CHAPTER 20CHAPTER 20Cost of CapitalCost of CapitalCost of CapitalCost of Capital


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• Financing SourcesFinancing Sources•• The Cost of CapitalThe Cost of Capital•• Estimating the Component CostsEstimating the Component Costs

www.bookfiesta4u.com ContentsCHAPTER 20 – Cost of Capital

20 - 1154

•• The Effect of Operating and Financial LeverageThe Effect of Operating and Financial Leverage•• Growth Models and the Cost of Common EquityGrowth Models and the Cost of Common Equity•• RiskRisk--Based Models and the Cost of Common EquityBased Models and the Cost of Common Equity•• The Cost of Capital and InvestmentThe Cost of Capital and Investment•• Summary and ConclusionsSummary and Conclusions

–– Concept Review QuestionsConcept Review Questions–– Appendix 1 Appendix 1 –– Steep Hill Mines # 1Steep Hill Mines # 1


1.1. How ROE and the required return by common equity investors are How ROE and the required return by common equity investors are related to a firm’s growth opportunitiesrelated to a firm’s growth opportunities

2.2. How to apply the steps involved in estimating a firm’s weighted How to apply the steps involved in estimating a firm’s weighted average cost of capital, including how to estimate the market average cost of capital, including how to estimate the market


20 - 1155

average cost of capital, including how to estimate the market average cost of capital, including how to estimate the market values of the various components of capital, and how to estimate values of the various components of capital, and how to estimate the various costs of these componentsthe various costs of these components

3.3. How operating and financial leverage affect firmsHow operating and financial leverage affect firms

4.4. The advantages and limitations of using growth models and/or risk The advantages and limitations of using growth models and/or risk models to estimate the cost of common equity.models to estimate the cost of common equity.


•• Asset turnover ratioAsset turnover ratio•• Beta coefficientBeta coefficient•• Capital asset pricing modelCapital asset pricing model•• Capital structureCapital structure•• Cash cowCash cow

•• Issuing (or floatation) costsIssuing (or floatation) costs•• Marginal cost of capital (MCC)Marginal cost of capital (MCC)•• MarketMarket--toto--book (M/B) ratiobook (M/B) ratio•• Market risk premiumMarket risk premium•• MultiMulti--stage growth DDMstage growth DDM•• Operating leverageOperating leverage


20 - 1156

•• Cost of capitalCost of capital•• DebtDebt--toto--equity ratioequity ratio•• DogDog•• Earnings yieldEarnings yield•• Hurdle rateHurdle rate•• Investment opportunities Investment opportunities

schedule (IOS)schedule (IOS)

•• Present value of existing Present value of existing opportunities (PVEO)opportunities (PVEO)

•• Present value of growth Present value of growth opportunities (PVGO)opportunities (PVGO)

•• Return on assets (ROA)Return on assets (ROA)•• Return on invested capital Return on invested capital

(ROIC)(ROIC)•• Return on equity (ROE)Return on equity (ROE)


•• RiskRisk--based modelbased model•• RiskRisk--free rate of returnfree rate of return•• StarStar•• TurnaroundTurnaround•• Weighted average cost of Weighted average cost of


20 - 1157

•• Weighted average cost of Weighted average cost of capital (WACC)capital (WACC)

The Short Story of WACCThe Short Story of WACCPurposes/UsePurposes/Use

•• The weighted average cost of capital (WACC) The weighted average cost of capital (WACC) serves three primary purposes:serves three primary purposes:

1.1. To evaluate capital project proposals beforeTo evaluate capital project proposals before--thethe--fact.fact.


20 - 1158

1.1. To evaluate capital project proposals beforeTo evaluate capital project proposals before--thethe--fact.fact.2.2. To set performance targets in order for management to To set performance targets in order for management to

sustain or grow market values, and sustain or grow market values, and 3.3. to measure management performance afterto measure management performance after--thethe--fact.fact.

The Short Story of WACCThe Short Story of WACCWhat Costs are Measured?What Costs are Measured?

•• Costs associated with financing the firm’s Costs associated with financing the firm’s invested capital including:invested capital including:–– Debt Costs:Debt Costs:


20 - 1159

–– Debt Costs:Debt Costs:•• Bank loansBank loans•• LongLong--term debt term debt –– bonds/debenturesbonds/debentures

–– Equity Costs:Equity Costs:•• Preferred equity costsPreferred equity costs•• Common equity costsCommon equity costs

The Short Story of WACCThe Short Story of WACCWhy the Marginal Cost?Why the Marginal Cost?

•• What capital cost the firm 5 months, 5 years or 5 What capital cost the firm 5 months, 5 years or 5 decades ago is irrelevant.decades ago is irrelevant.


20 - 1160

•• What is relevant is what the next dollar of capital What is relevant is what the next dollar of capital will cost in today’s economic environment for this will cost in today’s economic environment for this particular firm.particular firm.

The Short Story of WACCThe Short Story of WACCSteps in Solving for the WACCSteps in Solving for the WACC

1.1. Identify the relevant sources of capital (debt Identify the relevant sources of capital (debt and equity).and equity).

2.2. Estimate the market values for the sources of Estimate the market values for the sources of capital and determine the market value weights.capital and determine the market value weights.


20 - 1161

capital and determine the market value weights.capital and determine the market value weights.3.3. Estimate the marginal, afterEstimate the marginal, after--tax, and aftertax, and after--

floatation cost for each source of capital.floatation cost for each source of capital.4.4. Calculate the weighted average.Calculate the weighted average.

The Short Story of WACCThe Short Story of WACCThe FormulaThe Formula

Once you have the specific marginal costs of capital (after accounting for taxes and floatation costs) and you have found the appropriate weights to use, the actual calculation of a WACC is a simple matter.


20 - 1162

)1(

−+

==V

DTK

V

SKKWACC dea

The cost of equity times the market value weight of

equity

The cost of debt after tax times the

market value weight of debt

The Short Story of WACCThe Short Story of WACCThe Spreadsheet ApproachThe Spreadsheet Approach

(1) (2) (3) (4) = (2)*(3)

Type of

Specific Marginal Cost after tax and

floatation Market Value

Weighted Specific Marginal


20 - 1163

Type of Capital

floatation costs

Value Weights

Marginal Cost

Long-Term Debt 5.5% 43.0% 0.02365Preferred Stock 11.4% 11.0% 0.01254Common Stock 12.9% 46.0% 0.05934

WACC = 9.55%

WACC is the sum of the weighted specific marginal costs of each

source of capital.

The Short Story of WACCThe Short Story of WACCFrequently Asked QuestionsFrequently Asked Questions

1.1. Why don’t we include the cost of accruals and Why don’t we include the cost of accruals and accounts payable in the cost of capital?accounts payable in the cost of capital?–– These are ‘spontaneous’ liabilities that rise and fall These are ‘spontaneous’ liabilities that rise and fall

with the volume of business activity, and are not with the volume of business activity, and are not subject to formal lending arrangements.subject to formal lending arrangements.


20 - 1164

subject to formal lending arrangements.subject to formal lending arrangements.–– Accruals (wages and taxes), it can be argued, don’t Accruals (wages and taxes), it can be argued, don’t

have an explicit cost.have an explicit cost.–– For major corporations, spontaneous liabilities are For major corporations, spontaneous liabilities are

often a very small part of the overall capitalization of often a very small part of the overall capitalization of the firm (are immaterial for cost of capital purposes).the firm (are immaterial for cost of capital purposes).


2.2. Why is the cost of capital an estimate and does this matter?Why is the cost of capital an estimate and does this matter?–– WACC is calculated based on a current estimate of what it will cost for WACC is calculated based on a current estimate of what it will cost for

the next dollar of debt and equity. Since that next dollar hasn’t yet the next dollar of debt and equity. Since that next dollar hasn’t yet been raised, we are attempting for forecast or estimate that cost.been raised, we are attempting for forecast or estimate that cost.

–– To estimate the cost of debt we often assume it is equal to the To estimate the cost of debt we often assume it is equal to the required rate of return on existing debt outstanding in the markets (Of required rate of return on existing debt outstanding in the markets (Of course, when a firm actually goes to the market, conditions may have course, when a firm actually goes to the market, conditions may have


20 - 1165

course, when a firm actually goes to the market, conditions may have course, when a firm actually goes to the market, conditions may have changed, underwriting costs may be greater, etc.)changed, underwriting costs may be greater, etc.)

–– Forecasting WACC also requires estimating the cost of equity. There Forecasting WACC also requires estimating the cost of equity. There may different approaches to this task, and will result in a range of may different approaches to this task, and will result in a range of estimates.estimates.

–– In the end, WACC will still be an estimate. The key thing to ensure is In the end, WACC will still be an estimate. The key thing to ensure is that the NPV of the project be positive over the range of possible that the NPV of the project be positive over the range of possible WACC’s. (Graph an NPV profile and determine the range of WACCs WACC’s. (Graph an NPV profile and determine the range of WACCs that will still produce a positive NPV.)that will still produce a positive NPV.)


3.3. Why is the component cost of capital greater than the investor’s Why is the component cost of capital greater than the investor’s required return ?required return ?

Accruals

Accounts payable

Short-term debt

Total current liabilitiesPrepaid expenses

Table 20-1 Main Balance Sheet Accounts

Cash and marketable securities

Accounts receivable

Inventory

Investment Dealer

$20.00$18.00

www.bookfiesta4u.com ContentsCHAPTER 20 – Cost of Capital 20 - 1166

Total current liabilities

Total current assets Long-term debt

Shareholders' equity

Total assets Total liabilities and shareholders' equity

Prepaid expenses

Net fixed assets

Investor buys one new share in a company and

pays the investment dealer

$20 for it.

Investment dealer gives the issuing

firm $18.00 for the share, and

pockets $2.00 for providing

underwriting services.

Issuing company receives $18.00.

Investor requires a 10% return on

her investment of $20. This is a

$2.00 return on invested capital.

Conclusion: The cost of external capital is greate r than the investor’s required return because of floatation costs.

The company must produce $2.00 income on an $18.00

investment to meet the investor’s expectations. This

is an 11.1% return.

The Short Story of WACCThe Short Story of WACCSummarySummary

•• WACC measures the firm’s cost of financing future growth today, WACC measures the firm’s cost of financing future growth today, based on current capital market conditions, and assuming the firm based on current capital market conditions, and assuming the firm use a longuse a long--term average of financing sources.term average of financing sources.

•• WACC is an estimate.WACC is an estimate.


20 - 1167

•• WACC is used to make capital investment decisions.WACC is used to make capital investment decisions.

•• WACC is used to set performance targets for sales, and ROE.WACC is used to set performance targets for sales, and ROE.

•• WACC is used to assess management’s performance, answering WACC is used to assess management’s performance, answering the question, “has management added value?”the question, “has management added value?”

Financing SourcesFinancing SourcesCapital StructureCapital Structure

•• Table 20 Table 20 -- 1 illustrates the basic structure of a firm’s balance 1 illustrates the basic structure of a firm’s balance sheet:sheet:–– This is a snapshot of the firm’s financial position at one point in This is a snapshot of the firm’s financial position at one point in

time.time.–– LeftLeft--hand side of the Balance Sheethand side of the Balance Sheet

•• Assets Assets –– the things the firm ownsthe things the firm owns


20 - 1168

•• Assets Assets –– the things the firm ownsthe things the firm owns•• Note the structure of assets (relative proportions of current assets Note the structure of assets (relative proportions of current assets

and net fixed assets)and net fixed assets)–– RightRight--hand side of the Balance Sheethand side of the Balance Sheet

•• Liabilities Liabilities –– the borrowed sources of financingthe borrowed sources of financing–– Note the structure of liabilities (the relative proportions of current versus Note the structure of liabilities (the relative proportions of current versus

longlong--term debt)term debt)

•• Shareholders’ equity Shareholders’ equity –– owner’s investment in the businessowner’s investment in the business–– Note the amount of capital invested versus the amount of earnings that Note the amount of capital invested versus the amount of earnings that

have been reinvested in the businesshave been reinvested in the business


Accruals

Accounts payable

Short-term debt

Table 20-1 Main Balance Sheet Accounts

Cash and marketable securities

Accounts receivable

Inventory


20 - 1169

Short-term debt

Total current liabilities

Total current assets Long-term debt

Shareholders' equity

Total assets Total liabilities and shareholders' equity

Prepaid expenses

Net fixed assets

Inventory

The Financial StructureCapital Structure

Important TermsImportant Terms

•• Financial StructureFinancial Structure–– The whole rightThe whole right--hand side of the balance sheethand side of the balance sheet–– Includes both shortIncludes both short--term and longterm and long--term sources of financing term sources of financing

(debt and equity)(debt and equity)•• Capital StructureCapital Structure

–– How the firm finances its invested capitalHow the firm finances its invested capital


20 - 1170

–– How the firm finances its invested capitalHow the firm finances its invested capital–– Excludes accruals and accounts payable Excludes accruals and accounts payable –– shortshort--term liabilities term liabilities

that are not strictly debt contracts, that spontaneously change in that are not strictly debt contracts, that spontaneously change in response to the operations of the business.response to the operations of the business.

–– Includes:Includes:•• Bank Loans Bank Loans •• LongLong--term debtterm debt•• Common stock and retained earningsCommon stock and retained earnings

(See Table 20 (See Table 20 –– 2 for a typical example)2 for a typical example)


$50 Accruals $100

200 Accounts payable 200

Table 20-2 A "Simplified" Balance Sheet

Cash and marketable securitiesAccounts receivable


20 - 1171

250 Short-term debt 50

0 Total current liabilities 350

Total current assets 500 Long-term debt 650

1,500 Shareholders' equity 1,000

Total assets $2,000 Total liabilities and shareholders' equity $2,000

Prepaid expenses

Net fixed assets

Inventory

Financial Structure = $2,000Capital Structure = $1,700

Financing SourcesFinancing SourcesInterpreting Balance SheetsInterpreting Balance Sheets

•• Balance sheets are prepared in accordance with GAAP:Balance sheets are prepared in accordance with GAAP:–– Represent historical costs which may not be relevant for current Represent historical costs which may not be relevant for current

decisiondecision--making purposes.making purposes.•• Analysis of reported data should include ratios such as:Analysis of reported data should include ratios such as:

–– Debt Debt –– to to –– Equity:Equity:


20 - 1172

•• Interest bearing debt to shareholder’s equity plus minority interestInterest bearing debt to shareholder’s equity plus minority interest–– Convert book values to market valuesConvert book values to market values

•• This is done by multiplying the marketThis is done by multiplying the market--toto--book ratio times the book book ratio times the book value.value.

•• Interpret the ratios again.Interpret the ratios again.

(Table 20 (Table 20 –– 2 will be used to illustrate the adjustment process from book values 2 will be used to illustrate the adjustment process from book values to market values)to market values)

Financing SourcesFinancing SourcesDebtDebt--toto--Equity RatioEquity Ratio

$50 Accruals $100

200 Accounts payable 200

250 Short-term debt 50

0 Total current liabilities 350Prepaid expenses


Cash and marketable securitiesAccounts receivableInventory

Debt =


20 - 1173

Total current assets 500 Long-term debt 650

1,500 Shareholders' equity 1,000

Total assets $2,000 Total liabilities and shareholders' equity $2,000

Net fixed assets

70.0000,1$

$650$50 RatioEquity -to-Debt =+=

Equity =

Financing SourcesFinancing SourcesConverting Book Value to Market ValuesConverting Book Value to Market Values

Book Values$50 Accruals $100200 Accounts payable 200250 Short-term debt 50




20 - 1174

0 Total current liabilities 350Total current assets 500 Long-term debt 650

1,500 Shareholders' equity 1,000Total assets $2,000 Total liabilities and shareholders' equity $2,000

Prepaid expenses

Net fixed assets

Market value of debt will be very close (if not equ al) to the book values stated on the balance sheet. This is because

these are contractual claims that are not negotiabl e (traded in secondary markets). The amounts stated are the amounts

that are required to satisfy the financial claims o f these creditors.

The market value of long-term debt will depend on i nterest rate changes since the debt was originally issued. As the

bonds approach maturity, their market price will mo ve progressively to equal their par (face) value. It is the face

value of the debt that is presented here.

Equity =

The market value of equity is greatly affected by management. It is not uncommon to see market-to-bo ok

ratios of 2 or more, reflecting the growth prospect s the market sees for the firm. Lets convert the book va lue of

equity by a market-to-book ratio of 2.5.

Financing SourcesFinancing SourcesConverting Book Value to Market ValuesConverting Book Value to Market Values

Book Values Market Values$50 Accruals $100 $100200 Accounts payable 200 200250 Short-term debt 50 50




20 - 1175

0 Total current liabilities 350 350Total current assets 500 Long-term debt 650 650

1,500 Shareholders' equity 1,000 2,500Total assets $2,000 Total liabilities and shareholders' equity $2,000 $3,500

Prepaid expenses

Net fixed assets

28.0500,2$

$650$50 RatioEquity -to-Debt ued"Market val" =+=

When adjusted for market value effects, the apparen t “high” debt to equity ratio (.7) is a much lower 0.28.

This confirms the importance of using relevant data when making decisions.

The Most Important Corporate Finance The Most Important Corporate Finance DecisionsDecisions

•• It is the managers job to maximize shareholders’ wealth.It is the managers job to maximize shareholders’ wealth.•• In this and the next chapter we will address two of the most In this and the next chapter we will address two of the most

important ways manager can add value to the firm:important ways manager can add value to the firm:


20 - 1176

important ways manager can add value to the firm:important ways manager can add value to the firm:–– Changing the mix of financing used by the firm (changing the Changing the mix of financing used by the firm (changing the

relative proportions of debt and equity), andrelative proportions of debt and equity), and–– Determining the minimum rate of return needed to maintain the Determining the minimum rate of return needed to maintain the

current market value.current market value.

Valuation Equation for a PerpetuityValuation Equation for a PerpetuityThree Ways of Using the Valuation EquationThree Ways of Using the Valuation Equation

•• In Chapter 5 you learned how to determine the present value In Chapter 5 you learned how to determine the present value of an infinite stream of equal, periodic cash flows (an infinite of an infinite stream of equal, periodic cash flows (an infinite annuity).annuity).

X

S = $20.0000.2$ ==S

If the annual cash flow is $2.00 and the investor’s

required return is 10%, the present

value of theperpetuity is $20.


20 - 1177

•• Where:Where:SS = the present value of the perpetuity= the present value of the perpetuityXX = the forecast annual earnings= the forecast annual earningsKKee = the investor’s required return= the investor’s required return

eK

XS =[ 20-1] $20.00

10.0

00.2$ ==S[ 20-1]perpetuity is $20.


•• The equation can be rearranged to solve for the required The equation can be rearranged to solve for the required return return KKe e also known as the also known as the earnings yieldearnings yield::

X

Ke =[ 20-2] 10%$2.00 === X

Ke[ 20-2]


20 - 1178

•• The earnings yield is not normally used as the investor’s The earnings yield is not normally used as the investor’s required return because it simply measures forecast earnings required return because it simply measures forecast earnings as a percentage of the market price, ignoring growth as a percentage of the market price, ignoring growth opportunities.opportunities.

S

Ke =[ 20-2] 10%$20.00

===S

Ke[ 20-2]


•• The perpetuity valuation model can be further rearranged to The perpetuity valuation model can be further rearranged to solve for the forecast earnings given the current market price solve for the forecast earnings given the current market price and investor’s required return.and investor’s required return.

SKX ×=[ 20-3] $2.00 $20.00 0.10 =×=×= SKX e


•• This helps managers determine their earnings target that must This helps managers determine their earnings target that must be met to support the current market value.be met to support the current market value.

•• If the manager knows the investor requires a 10% rate of return If the manager knows the investor requires a 10% rate of return and the market price is $20.00, she knows the firm must and the market price is $20.00, she knows the firm must generate $2.00 in EPS to sustain the stock price.generate $2.00 in EPS to sustain the stock price.

SKX e ×=[ 20-3] $2.00 $20.00 0.10 =×=×= SKX e

Setting Performance TargetsSetting Performance TargetsUsing Required Returns and Market ValuesUsing Required Returns and Market Values

•• Given market values and required rates of return, it is possible to Given market values and required rates of return, it is possible to establish performance targets for management to sustain market establish performance targets for management to sustain market values:values:

•• For a firm financed by bondholders and stockholders, the firm must For a firm financed by bondholders and stockholders, the firm must plan to earn sufficient returns as follows:plan to earn sufficient returns as follows:


•• Working back from these requirements we can forecast the level of Working back from these requirements we can forecast the level of sales the firm must earn in order to achieve these operating sales the firm must earn in order to achieve these operating results…thereby setting a sales performance target for management.results…thereby setting a sales performance target for management.

(1) (2) (3) =(1)×(2)

Market ValueRequired Return

Earnings Required

Debt (D) $700 6.0% $42Equity (S) 2500 12.0% 300V=D+S = $3,200 $342

Setting Performance TargetsSetting Performance TargetsDeriving the Deriving the RequiredRequired Income StatementIncome Statement

Sales ? $1,000Variable costs 300 300Fixed costs 158 158

Table 20-3 A Forecasted Income StatementGiven the need to earn $42 to cover

interest, and to earn $300 after-

tax for shareholders,

and given a fixed

542$500$42$.4)-(1

$300$42

)1(

=+=+=

−+=

T

IncomeNetInterestEBIT

$1,000 $542 $158 $300

EBIT Costs Fixed Costs Variable

=++=++=Sales


20 - 1181

Fixed costs 158 158EBIT ? $542Interest 42 42Tax (40%) #VALUE! 200Net Income $300 $300

and given a fixed corporate tax

rate and other costs, we can determine the

Sales required to achieve these

goals.

It is $1,000

This is the very process that is used by regulators to approve regulated utility rates based on market -determined required rates of return.

So, the cost of capital drives utility rate increas es.

Setting Performance TargetsSetting Performance TargetsHow Market Value is Related to Book Value and ROEHow Market Value is Related to Book Value and ROE

•• Once you have the sales performance target you can establish other Once you have the sales performance target you can establish other operating targets through the application of ratios.operating targets through the application of ratios.

•• Since equity in this case is a perpetuity we can express the price per Since equity in this case is a perpetuity we can express the price per share as:share as:


20 - 1182

•• Dividing both sides of Equation 20 Dividing both sides of Equation 20 –– 4 by BVPS we get the basic 4 by BVPS we get the basic relationship that drives the M/B ratio:relationship that drives the M/B ratio:

ee K

BVPSROE

K

EPSP

×==[ 20-4]

Setting Performance TargetsSetting Performance TargetsThe Relationship Between BVPS and MVPS The Relationship Between BVPS and MVPS –– How to Increase How to Increase

Shareholder ValueShareholder Value

•• Equation 20 Equation 20 –– 5 tells us:5 tells us:–– If the ROE exceeds the investors required return (If the ROE exceeds the investors required return (KKee) )

then the price of the stock will rise above book value.then the price of the stock will rise above book value.


20 - 1183

–– This is a crucial goal of the financial manager This is a crucial goal of the financial manager –– to add to add to shareholder value.to shareholder value.

eK

ROE

BVPS

P =[ 20-5]

The Cost of CapitalThe Cost of CapitalDetermining the Weighted Average Cost of Capital (WACC)Determining the Weighted Average Cost of Capital (WACC)

•• The overall market value of the firm is:The overall market value of the firm is:

V = D + SV = D + S


20 - 1184

–– In our example V= $3,200In our example V= $3,200–– AfterAfter--tax ROI tax ROI = 19.13% = 19.13%

= (EBIT)(1= (EBIT)(1--T) = ($542 (1T) = ($542 (1--.4)).4))= $325.20 = $325.20

This is the required net income if the firm is financed 100% with This is the required net income if the firm is financed 100% with equity (no deduction for interest.)equity (no deduction for interest.)


•• Where the value of the firm is $3,200 and EBIT (1 Where the value of the firm is $3,200 and EBIT (1 ––T) is $325.60, T) is $325.60, we can find the discount rate that sets them equal.we can find the discount rate that sets them equal.

•• First rewrite EBIT minus taxes as ROI First rewrite EBIT minus taxes as ROI ×× IC and reIC and re--express the express the valuation equation as:valuation equation as:


20 - 1185

•• Equation 20 Equation 20 –– 6 can be rearranged to solve for 6 can be rearranged to solve for KKaa for an all equity for an all equity firm:firm:

aK

ICROIV

×=[ 20-6]


•• Using the numbers from the continuing example the WACC is:Using the numbers from the continuing example the WACC is:

V

ICROIK a

×=[ 20-7]


20 - 1186

•• On the following slide will show how we can now substitute in On the following slide will show how we can now substitute in component costs for both equity and debt to develop the general component costs for both equity and debt to develop the general equation for WACC (Kequation for WACC (Kaa))

10.16% $3,200

$325.20==×=V

ICROIKa


11

V

D-T)(K

V

SK

V

T)D(KSK

V

ICROIK de

dea +=−+=×=[ 20-8]


20 - 1187

The WACC is simply the weighted average of the component costs.


•• The equation for WACC including common equity, preferred The equation for WACC including common equity, preferred share financing and debt is:share financing and debt is:

1D

-T)(KP

KS

KWACC ++=[ 20-9]


20 - 1188

•• In this case the value of the firm equals the sum of the value In this case the value of the firm equals the sum of the value of stock, preferred and debt:of stock, preferred and debt:

V = S + P + DV = S + P + D

1V

D-T)(K

V

PK

V

SKWACC dpe ++=[ 20-9]

Estimating Market ValuesEstimating Market ValuesMarket Value of EquityMarket Value of Equity

•• The total market value of equity (market The total market value of equity (market capitalization) is the price per share times the capitalization) is the price per share times the number of shares outstanding:number of shares outstanding:


20 - 1189

n 0 ×= PS[ 20-10]

Estimating Market ValuesEstimating Market ValuesMarket Value of Preferred StockMarket Value of Preferred Stock

•• The market price for preferred is simply the annual preferred The market price for preferred is simply the annual preferred dividend divided by the preferred shareholder’s required return.dividend divided by the preferred shareholder’s required return.

0p

p

k

DP =[ 20-11]


20 - 1190

•• The market value of all preferred stock is simply the price per share The market value of all preferred stock is simply the price per share times the number of shares outstanding.times the number of shares outstanding.

p

n 0 ×= PS[ 20-10]

Estimating Market ValuesEstimating Market ValuesMarket Value of BondsMarket Value of Bonds

•• As previously mentioned, the market value of bonds will differ from As previously mentioned, the market value of bonds will differ from their book value only if required rates of return in the market have their book value only if required rates of return in the market have changed since the bonds original issue.changed since the bonds original issue.

•• Knowing the term to maturity, the coupon rate and the bondholder’s Knowing the term to maturity, the coupon rate and the bondholder’s required return we can determine the market value of bonds with required return we can determine the market value of bonds with equation 20 equation 20 -- 12:12:


20 - 1191

equation 20 equation 20 -- 12:12:

1

111

1

nbb

nb

)k(F

k

)k(IB

+×+

+−

×=[ 20-12]

Estimating Market ValuesEstimating Market ValuesMarket Value of BondsMarket Value of Bonds

•• Once you know the market value of the bonds, you multiply their Once you know the market value of the bonds, you multiply their price by the number of bonds outstanding to determine total market price by the number of bonds outstanding to determine total market value.value.


20 - 1192

n ×= bPB[ 20-10]

Market Value WeightsMarket Value WeightsAn ExampleAn Example

Given:Given:–– Market price for common stock = $21.50Market price for common stock = $21.50–– Bonds are trading for 95% of face valueBonds are trading for 95% of face value

•• In order to calculate market value (MV) weights, you will need to In order to calculate market value (MV) weights, you will need to know the total market value of debt, and common stock (and know the total market value of debt, and common stock (and


20 - 1193

know the total market value of debt, and common stock (and know the total market value of debt, and common stock (and preferred stock if the company uses it.)preferred stock if the company uses it.)

•• To calculate total MV you need to know the current price of the To calculate total MV you need to know the current price of the security in each class, as well as the total number of securities security in each class, as well as the total number of securities outstanding:outstanding:

Total Market Capitalization = Price Total Market Capitalization = Price ×× QuantityQuantity

The following balance sheet date, when combined with market price data, will allow you to calculate MV weights.The following balance sheet date, when combined with market price data, will allow you to calculate MV weights.

Market Value WeightsMarket Value WeightsAn ExampleAn Example

XYZ Company LimitedXYZ Company Limited

Balance SheetBalance Sheet

as at January 30, 2xxxas at January 30, 2xxx

ASSETSASSETS LIABILITIES:LIABILITIES:

Current AssetsCurrent Assets $147,000$147,000 Current LiabilitiesCurrent Liabilities $75,250$75,250

Net Fixed AssetsNet Fixed Assets 15,000,25015,000,250 8.5% 2020 Mortgage Bonds8.5% 2020 Mortgage Bonds 4,000,0004,000,000

Common stock (1,000,000 outstanding)Common stock (1,000,000 outstanding) 7,155,0007,155,000


20 - 1194

Retained earningsRetained earnings 3,917,0003,917,000

TOTAL ASSETSTOTAL ASSETS $15,147,250$15,147,250 TOTAL LIABILITIES AND O. EQUITYTOTAL LIABILITIES AND O. EQUITY $15,147,250$15,147,250

Number of common shares outstanding is read from the balance sheet.

Face value of bonds are $1,000, therefore there must be 4,000 bonds outstanding.

Market Value WeightsMarket Value WeightsAn Example Continued…An Example Continued…

Total MV of Equity = Price per share times number of shares = 1M × $21.50 = $21.5M

Total MV of Bonds = Price per bond times number of bonds = $950 × 4,000 = $3,800,000

Market


20 - 1195

Type of Capital

Market price Number

Total Market Value

Market Value

WeightBonds $950.00 4,000 $3,800,000 15.02%Stock $21.50 1,000,000 $21,500,000 84.98%

TOTAL= $25,300,000 100.00%

These weights could now be used to calculate WACC.

Bond ValueBond ValueGeneral FormulaGeneral Formula

)k( n

+−

111

1

•• In the example, you didn’t have to calculate the bond value because you In the example, you didn’t have to calculate the bond value because you were given the fact that it was trading at 95% of par.were given the fact that it was trading at 95% of par.

•• In the event that you do, however, simply use equation 20 In the event that you do, however, simply use equation 20 --12.12.


20 - 1196

)k(

Fk

)k(IB

nbb

nb

+×+

+−

×=1

111

[ 20-12]

Where:I = interest (or coupon ) payments

kb = the bond discount rate (or market rate)n = the term to maturity

F = Face (or par) value of the bond

Estimating the Component CostsEstimating the Component CostsFloatation CostsFloatation Costs

•• Issuing or floatation costs are incurred by a firm when it raises Issuing or floatation costs are incurred by a firm when it raises new capital through the sale of securities in the primary new capital through the sale of securities in the primary market.market.

•• These costs include:These costs include:–– Underwriting discounts paid to the investment dealerUnderwriting discounts paid to the investment dealer–– Direct costs associated with the issue including legal and Direct costs associated with the issue including legal and


20 - 1197

–– Direct costs associated with the issue including legal and Direct costs associated with the issue including legal and accounting costsaccounting costs

•• The result:The result:–– Net proceeds on the sale of each security is less than what the Net proceeds on the sale of each security is less than what the

investor invests, andinvestor invests, and–– The component cost of capital > investor’s required return.The component cost of capital > investor’s required return.

Table 20 4 Table 20 4 –– illustrates average issuing costs for different forms of capital.illustrates average issuing costs for different forms of capital.

Estimating the Component CostsEstimating the Component CostsFloatation Costs and the Marginal Cost of Capital (MCC)Floatation Costs and the Marginal Cost of Capital (MCC)

Commercial paper 0.125%Medium-term notes 1.0%Long-term debt 2.0%

Table 20-4 Average Issuing CostsFloatation costs for

debt securities is lowest because debt is

normally privately placed with large

institutional investors not requiring

underwriting costs and because debt is either


20 - 1198

Equity (large) 5.0%Equity (small) 5.0% - 10.0%Equity (private) 10.0% and up

What issue costs mean is that there is a financing wedge between what the investor pays and what the firm receives, the difference being the money that is lost to these costs. Issue costs are responsib le for

the component cost of capital being greater than th e investor’s required return.

because debt is either issued by high quality

issuers or sits at the top of the priority of

claims list in the case of default.

WACC versus MCCWACC versus MCCFloatation Costs and the Marginal Cost of Capital (MCC)Floatation Costs and the Marginal Cost of Capital (MCC)

•• The Marginal Cost of Capital (MCC) is the weighted average The Marginal Cost of Capital (MCC) is the weighted average cost of the next dollar of financing to be raised.cost of the next dollar of financing to be raised.

•• At low levels of financing the WACC = MCCAt low levels of financing the WACC = MCC•• As a firm raises more and more capital in a given year, it will As a firm raises more and more capital in a given year, it will

exhaust the supply of lower cost sources, and then have to exhaust the supply of lower cost sources, and then have to


20 - 1199

exhaust the supply of lower cost sources, and then have to exhaust the supply of lower cost sources, and then have to access marginally higher cost sources.access marginally higher cost sources.–– Therefore MCC increases with the amount of capital to be Therefore MCC increases with the amount of capital to be

raised.raised.

The following figure illustrates the MCC concept.The following figure illustrates the MCC concept.

(%)

15

The Marginal Cost of Capital MCCThe Marginal Cost of Capital MCC

MCC2= 10.64%

There is only one break in the MCC curve. It occurs at $5,500,000. At this point the firm

has exhausted its internal equity and to raise more equity capital will mean accessing external equity using the services of an

underwriter. %64.10%24.2%4.8

)4%(.6.5)6%(.14100

40)3.1%(8

100

60%14

)1(2

=+=+=

−+=

−+=V

DtK

V

SKMCC de

%44.9%24.2%2.7

)4%(.6.5)6%(.12100

40)3.1%(8

100

60%12

)1(1

=+=+=

−+=

−+=V

DtK

V

SKMCC de


20 - 1200

0 $2,000,000 $4,000,000 $6,000,000 $8,000,000 $10,000,000

Dollars of Capital to be Raised

10

5

MCC1=WACC= 9.44%MCC2= 10.64%

2.24%Each dollar of capital invested is financed 40% by debt. (40% × after-tax cost = 2.24%)

Each dollar of capital invested up to $5.5 million is financed 60% by internal equity (R/E).

(60% × cost of retained earnings = 7.2%)

Each dollar of capital invested beyond $5.5 million

is financed 60% by new equity. (60% × cost of new

equity = 8.4%)

The Component Cost of DebtThe Component Cost of Debt

•• The cost of debt is a function of:The cost of debt is a function of:–– The investor’s required rate of returnThe investor’s required rate of return–– The taxThe tax--deductibility of interest expensedeductibility of interest expense


–– The taxThe tax--deductibility of interest expensedeductibility of interest expense–– The floatation costs incurred to issue new debtThe floatation costs incurred to issue new debt

The Component Cost of DebtThe Component Cost of Debt

•• If you know the debt investor’s required rate of re turn KIf you know the debt investor’s required rate of re turn K dd , the corporate tax rate and the floatation cost , the corporate tax rate and the floatation cost percentage for debt, you can estimate the cost of d ebt in the following manner:percentage for debt, you can estimate the cost of d ebt in the following manner:

•• Assume:Assume:

KKdd = 10% (debt investor’s required return)= 10% (debt investor’s required return)TT = 40% (corporate tax rate)= 40% (corporate tax rate)

ffdd = 3% (floatation cost percentage)= 3% (floatation cost percentage)

The after tax cost of debt is lower than the

investor’s required return because of the


%19.697.0

%6

.03-1

0.4)-(1.010%

f-1

T)-(1Return Required sInvestor' Debt ofCost

d

==×=

×=

return because of the tax shield on interest

expense.

Estimating the Component CostsEstimating the Component CostsDebtDebt

•• Alternatively you can adjust the bond valuation formula for the taxAlternatively you can adjust the bond valuation formula for the tax--deductibility of interest expense and the net proceeds the firm would deductibility of interest expense and the net proceeds the firm would receive on the sale of one bond (after floatation costs) and solve for receive on the sale of one bond (after floatation costs) and solve for the rate (the rate (KKii ) that causes the formula to become and equality:) that causes the formula to become and equality:

Coupon interest times 1 minus corporate tax rate = after tax cost of


20 - 1203

•• KKii = the after= the after--tax and aftertax and after--floatation cost of debt.floatation cost of debt.

1

111

1

)1(n

ii

ni

)K(F

K

)K(TINP

+×+

+−

×−×=[ 20-13]

Net proceeds on the sale of the bond = Selling pric e – floatation cost per bond.

corporate tax rate = after tax cost of interest

Estimating the Component CostsEstimating the Component CostsPreferred SharesPreferred Shares

•• If you know the preferred share If you know the preferred share investor’s required rate of return investor’s required rate of return KKpp , and the floatation cost , and the floatation cost percentage for preferred share percentage for preferred share financing, you can estimate the financing, you can estimate the cost of preferred shares in the cost of preferred shares in the following manner:following manner:

Floatation costs cause

the component cost to be

greater than the investor’s

required return.


following manner:following manner:

•• Assume:Assume:KKpp = 14% (preferred investor’s = 14% (preferred investor’s

required return)required return)F = 5% (floatation cost percentage)F = 5% (floatation cost percentage)

%74.1495.0

%14

.05-1

14%

f-1

Return Required sInvestor' Preferred ofCost

p

===

=

NOTE: Preferred dividends are paid out of after-ta x earnings, therefore there are no taxation effects on the preferred shar e component cost of

capital.

return.

Estimating the Component CostsEstimating the Component CostsPreferred SharesPreferred Shares

•• Alternatively, the component cost of preferred shares Alternatively, the component cost of preferred shares can be found using equation 20 can be found using equation 20 --14, where NP is the 14, where NP is the selling price per preferred share less the floatation costs selling price per preferred share less the floatation costs per share.per share.


20 - 1205

NP

DK p

p =[ 20-14]

Estimating the Component CostsEstimating the Component CostsCommon SharesCommon Shares

•• Estimating the component cost of common stock is the most Estimating the component cost of common stock is the most difficult because:difficult because:–– Promised cash flows are uncertainPromised cash flows are uncertain–– Growth opportunities, their timing and magnitude will influence Growth opportunities, their timing and magnitude will influence

the costthe cost


20 - 1206

the costthe cost–– The riskiness of the stock is influenced by corporate decisions The riskiness of the stock is influenced by corporate decisions

such as the use of leveragesuch as the use of leverage

•• There are numerous alternative approaches that we will There are numerous alternative approaches that we will present to estimate the component cost of equity.present to estimate the component cost of equity.

•• Before doing so, we will first address the effect of leverage on Before doing so, we will first address the effect of leverage on shareholders.shareholders.

LeverageLeverage

•• The increased volatility in operating income over The increased volatility in operating income over time, created by the use of fixed costs in lieu of time, created by the use of fixed costs in lieu of variable costs.variable costs.–– Leverage magnifies profits and losses.Leverage magnifies profits and losses.

•• There are two types:There are two types:


20 - 1207

•• There are two types:There are two types:–– Operating leverageOperating leverage–– Financial leverageFinancial leverage

•• Both types of leverage have the same effect on Both types of leverage have the same effect on shareholders but are accomplished in very shareholders but are accomplished in very different ways, for very different purposes different ways, for very different purposes strategically.strategically.

Leverage Effects on Operating IncomeLeverage Effects on Operating Income

When a firm increases the use of fixed costs it

increases the volatility of operating income.

Normal volatility of operating income

Operating Income


20 - 1208

Years

+

0

-

Operating LeverageOperating LeverageWhat is it? How is it Increased?What is it? How is it Increased?

•• Your textbook defines operating leverage as:Your textbook defines operating leverage as:–– The increased volatility in operating income caused by fixed The increased volatility in operating income caused by fixed

operating costs.operating costs.

•• You should understand that managers do make decisions You should understand that managers do make decisions affecting the cost structure of the firm.affecting the cost structure of the firm.


20 - 1209

affecting the cost structure of the firm.affecting the cost structure of the firm.•• Managers can, and do, decide to invest in assets that give Managers can, and do, decide to invest in assets that give

rise to additional fixed costs and the intent is to reduce rise to additional fixed costs and the intent is to reduce variable costs.variable costs.–– This is commonly accomplished by a firm choosing to become This is commonly accomplished by a firm choosing to become

more capital intensive and less labour intensive, thereby more capital intensive and less labour intensive, thereby increasing operating leverage.increasing operating leverage.

Operating LeverageOperating LeverageAdvantages and DisadvantagesAdvantages and Disadvantages

Advantages:Advantages:–– Magnification of profits to the shareholders if the firm is Magnification of profits to the shareholders if the firm is

profitable.profitable.–– Operating efficiencies (faster production, fewer errors, higher Operating efficiencies (faster production, fewer errors, higher

quality) usually result increasing productivity, reducing quality) usually result increasing productivity, reducing ‘downtime’ etc.‘downtime’ etc.


20 - 1210

‘downtime’ etc.‘downtime’ etc.Disadvantages:Disadvantages:

–– Magnification of losses to the shareholders if the firm does not Magnification of losses to the shareholders if the firm does not earn enough revenue to cover its costs.earn enough revenue to cover its costs.

–– Higher break even pointHigher break even point–– High capital cost of equipment and the illiquidity of such an High capital cost of equipment and the illiquidity of such an

investment make it:investment make it:•• Expensive (more difficult to finance)Expensive (more difficult to finance)•• Potentially exposed to technological obsolescence, etc.Potentially exposed to technological obsolescence, etc.

Financial LeverageFinancial LeverageWhat is it? How is it Increased?What is it? How is it Increased?

•• Your textbook defines financial leverage as:Your textbook defines financial leverage as:–– The increased volatility in operating income caused The increased volatility in operating income caused

by fixed financial costs.by fixed financial costs.

•• Financial leverage can be increased in the firm Financial leverage can be increased in the firm


20 - 1211

•• Financial leverage can be increased in the firm Financial leverage can be increased in the firm by:by:–– Selling bonds or preferred stock (taking on financial Selling bonds or preferred stock (taking on financial

obligations with fixed annual claims on cash flow)obligations with fixed annual claims on cash flow)–– Using the proceeds from the debt to retire equity (if Using the proceeds from the debt to retire equity (if

the lenders don’t prohibit this through the bond the lenders don’t prohibit this through the bond indenture or loan agreement)indenture or loan agreement)

Financial LeverageFinancial LeverageAdvantages and DisadvantagesAdvantages and Disadvantages


profitable.profitable.–– Lower cost of capital at low to moderate levels of financial Lower cost of capital at low to moderate levels of financial

leverage because interest expense is taxleverage because interest expense is tax--deductible.deductible.Disadvantages:Disadvantages:


20 - 1212

Disadvantages:Disadvantages:–– Magnification of losses to the shareholders if the firm does not Magnification of losses to the shareholders if the firm does not

earn enough revenue to cover its costs.earn enough revenue to cover its costs.–– Higher break even point.Higher break even point.–– At higher levels of financial leverage, the low afterAt higher levels of financial leverage, the low after--tax cost of tax cost of

debt is offset by other effects such as:debt is offset by other effects such as:•• Present value of the rising probability of bankruptcy costsPresent value of the rising probability of bankruptcy costs•• Agency costsAgency costs•• Lower operating income (EBIT), etc.Lower operating income (EBIT), etc.

Effects of Operating and Financial LeverageEffects of Operating and Financial LeverageSummarySummary

•• Equity holders bear the added risks associated Equity holders bear the added risks associated with the use of leverage.with the use of leverage.

•• The higher the use of leverage (either operating The higher the use of leverage (either operating or financial) the higher the risk to the or financial) the higher the risk to the


20 - 1213

or financial) the higher the risk to the or financial) the higher the risk to the shareholder.shareholder.

•• Leverage therefore can and does affect Leverage therefore can and does affect shareholders required rate of return, and in turn shareholders required rate of return, and in turn this influences the cost of capital.this influences the cost of capital.

HIGHER LEVERAGE = HIGHER COST OF CAPITALHIGHER LEVERAGE = HIGHER COST OF CAPITAL

The Importance of GrowthThe Importance of Growth

•• To this point we have been valuing stock as a perpetuity:To this point we have been valuing stock as a perpetuity:–– This means that we are assuming the current dividend will be This means that we are assuming the current dividend will be

paid each year in the future into infinity.paid each year in the future into infinity.

•• Table 20 Table 20 –– 8 illustrates the importance of growth opportunities 8 illustrates the importance of growth opportunities to the price of dividend paying stocks on the TSX.to the price of dividend paying stocks on the TSX.


20 - 1214

to the price of dividend paying stocks on the TSX.to the price of dividend paying stocks on the TSX.•• On average, 62.22% of the market value of this sample of On average, 62.22% of the market value of this sample of

firms could be attributed to growth opportunities and the firms could be attributed to growth opportunities and the remaining 37.78% to the present value of the current dividend remaining 37.78% to the present value of the current dividend (perpetuity value)(perpetuity value)

Company Price ($) DPS ($) Dividend Yield (%)

Perpetuity ($)

Growth Value (%)

AGF 25.75 0.283 1.10 5.66 78.0BC Gas 30.60 1.13 3.70 22.60 26.0

Table 20-8 Stock Prices and Growth Prospects

Stock Market Time Horizon

Growth Models and the Cost of Common Growth Models and the Cost of Common EquityEquity

The Importance of Adjusting for GrowthThe Importance of Adjusting for Growth

Current stock price

Perpetuity value of current

dividend


20 - 1215

BC Gas 30.60 1.13 3.70 22.60 26.0CAE 11.50 0.161 1.40 3.22 72.0Dennings 3.50 0.102 2.90 2.04 42.0EL Financial 285 0.570 0.20 11.40 96.0GSW (A) 26.75 0.428 1.60 8.56 68.0Hammersen 14.05 0.197 1.40 3.94 72.0Intrawest 6.95 0.292 4.20 5.84 16.0Jannock 29.60 0.148 0.50 2.96 90.0

Average 1.89 62.22

Source: Booth, Laurence, Table 1 from "What Drives Shareholder Value." Financial Intelligence IV-6, Spring 1999.

% of Current Market Value explained by

growth opportunitie

s.


The Constant Growth ModelThe Constant Growth Model

•• The Gordon model assumes constant growth in the stream of The Gordon model assumes constant growth in the stream of dividends from dividends from t =1t =1 through through ∞∞::

10

gK

DP

−=[ 20-15]


20 - 1216

•• The price of a share (The price of a share (PP0 0 ) today equals the expected dividend ) today equals the expected dividend at at t =1 t =1 dividend b the required shareholder return (dividend b the required shareholder return (K K e e ) minus ) minus the longthe long--run growth rate (run growth rate (g)g) ..

•• This formula can be rearranged to solve for the investor’s This formula can be rearranged to solve for the investor’s required rate of return (required rate of return (K K e e ):):

gK −

Constant Growth ModelConstant Growth ModelThe Cost of Common Equity Using Internal FundsThe Cost of Common Equity Using Internal Funds

•• Investor’s required rate of return consists of two Investor’s required rate of return consists of two components:components:

1.1. Expected dividend yieldExpected dividend yield2.2. Expected longExpected long--run growth rate (g)run growth rate (g)


20 - 1217

–– This is the cost of internal equity (the cost of retained This is the cost of internal equity (the cost of retained earnings where the firm does not need to incur floatation earnings where the firm does not need to incur floatation costs)costs)

0

1 g P

DKe +=[ 20-16]

Constant Growth ModelConstant Growth ModelThe Cost of New EquityThe Cost of New Equity

•• The model can be modified to solve for the cost The model can be modified to solve for the cost of new equity by using NP (net proceeds the firm of new equity by using NP (net proceeds the firm receives for each new share sold after floatation receives for each new share sold after floatation costs)costs)


20 - 1218

1 g NP

DKne +=[ 20-17]

Constant Growth ModelConstant Growth ModelCautionCaution

•• The constant growth model can only be used in The constant growth model can only be used in cases where it is reasonable to assume that the cases where it is reasonable to assume that the growth rate can be sustained in the very long growth rate can be sustained in the very long term.term.


20 - 1219

–– This usually means, using it only for large, mature This usually means, using it only for large, mature ‘blue‘blue--chip’ companies that already pay a significant chip’ companies that already pay a significant dividend.dividend.

•• The Gordon model SHOULD NOT be used on The Gordon model SHOULD NOT be used on smaller, more rapidly growing firms where high smaller, more rapidly growing firms where high current growth rates are experienced, but cannot current growth rates are experienced, but cannot be sustained in the long term. be sustained in the long term.


Growth and ROEGrowth and ROE

•• One way to estimate growth is the sustainable One way to estimate growth is the sustainable growth method:growth method:–– Growth rate is the product of the firm’s retention rate Growth rate is the product of the firm’s retention rate

(b), times the forecast ROE:(b), times the forecast ROE:


20 - 1220

–– This definition of This definition of gg can be used in the Gordon model:can be used in the Gordon model:

ROE bg ×=[ 20-18]



•• Substituting the sustainable growth rate into the Gordon Substituting the sustainable growth rate into the Gordon model:model:

10

ROEbK

DP

×−=[ 20-19]


20 - 1221

•• Now we can recognize that the expected dividend DNow we can recognize that the expected dividend D11 is the is the expected earnings per share (Xexpected earnings per share (X11) times the dividend payout ) times the dividend payout ratio (one minus the retention rate):ratio (one minus the retention rate):

0 ROEbK

Pe ×−

=[ 20-19]



•• This equation shows that the price per share is This equation shows that the price per share is determined by:determined by:–– The firm’s forecast EPSThe firm’s forecast EPS–– Dividend payout (1 Dividend payout (1 –– b)b)–– ROEROE–– Required return by common shareholders (KRequired return by common shareholders (K ))


20 - 1222

–– Required return by common shareholders (KRequired return by common shareholders (Kee))

This equation shows the higher the growth rate, the higher the share price This equation shows the higher the growth rate, the higher the share price because larger future dividends and earnings are forecast.because larger future dividends and earnings are forecast.

)1(1

0 ROEbK

bXP

e ×−−=[ 20-20]



•• Rearranging Equation 20 Rearranging Equation 20 –– 20 by substituting alternative 20 by substituting alternative expressions for expressions for DD11 and and g g ::

111 ROE bP

b)(X g

P

DKe ×+−=+=[ 20-21]


20 - 1223

•• When this equation is used to estimate the cost of equity When this equation is used to estimate the cost of equity capital (internal) for three different growth scenarios (10%, capital (internal) for three different growth scenarios (10%, 12% and 14%) we get some unusual results summarized in 12% and 14%) we get some unusual results summarized in Table 20 Table 20 –– 9:9:

00

ROE bP

gP

Ke ×+=+=[ 20-21]



ROE P0 Expected Dividend

Yield

Sustainable Growth Rate

Ke

Table 20-9 Growth and K e


20 - 1224

Yield

10% $14.29 7% 5% 12%12% $16.67 6% 6% 12%14% $20.00 5% 7% 12%

Stock price rises as expected growth rate rises.

Three different sustainable growth rates.

A lower dividend yield. As prices rise, dividends as a percentage of share

price, fall.

The firm’s retention rate, and thus its dividend pa yout ratio, is reflected in the constant growth DDM as “ b.”

Table 20 – 10 on the next slide gives the share pric e if the retention rate changes under the three sce narios where ROE is 10, 12 and 14%.



b 14.0% 12.0% 10.0%0.40 $18.75 $16.67 $15.000.41 18.85 16.67 14.940.42 18.95 16.67 14.870.43 19.06 16.67 14.810.44 19.18 16.67 14.740.45 19.30 16.67 14.67

Table 20-10 Retention Rates, ROE, and Share Price s

ROE

Retention rate

increases as you

When ROE = 10%, share

price decreases as

the firm


price remains the same as

the firm


price increases as

the firm

The shareholder’s required return is 12%.

When a firm retains more earnings and reinvests

them at a lower rate than


20 - 1225

0.45 19.30 16.67 14.670.46 19.42 16.67 14.590.47 19.56 16.67 14.520.48 19.70 16.67 14.440.49 19.84 16.67 14.370.50 20.00 16.67 14.290.51 20.16 16.67 14.200.52 20.34 16.67 14.120.53 20.52 16.67 14.030.54 20.72 16.67 13.940.55 20.93 16.67 13.850.56 21.15 16.67 13.750.57 21.39 16.67 13.650.58 21.65 16.67 13.550.59 21.93 16.67 13.440.60 22.22 16.67 13.33

s as you go south.

the firm retains more

money.

the firm increases the retention rate.

the firm retains more

money.

them at a lower rate than what shareholders

require, the value of the firm falls.

Clearly, the key to share price growth is to

reinvest earnings at rates greater than the cost of

capital.

Hurdle RateHurdle RateThe Cost of CapitalThe Cost of Capital

•• Table 20 Table 20 --10 tells us that the cost of capital is a 10 tells us that the cost of capital is a hurdle rate.hurdle rate.

•• The HURDLE RATE is the return on an The HURDLE RATE is the return on an investment required to create value; below this investment required to create value; below this


20 - 1226

investment required to create value; below this investment required to create value; below this rate, an investment will destroy value.rate, an investment will destroy value.

Growing Firms Versus Growth FirmsGrowing Firms Versus Growth Firms

Growing FirmsGrowing Firms–– Reinvests in projects that offer rates equal to its cost Reinvests in projects that offer rates equal to its cost

of capital:of capital:

ROE = ROE = KKee


20 - 1227

ROE = ROE = KKee

Growth FirmsGrowth Firms–– Does something that shareholders cannot do Does something that shareholders cannot do ––

reinvest earnings at rates higher than the cost of reinvest earnings at rates higher than the cost of capital.capital.

ROE > ROE > KKee

Growth FirmsGrowth FirmsImportance of the Reinvestment Rate of ReturnImportance of the Reinvestment Rate of Return

Growth FirmsGrowth Firms–– Does something that shareholders cannot do Does something that shareholders cannot do –– reinvest earnings reinvest earnings

at rates higher than the cost of capital.at rates higher than the cost of capital.

ROE > ROE > KKee


20 - 1228

ROE > ROE > KKee

This is the reason earnings yield is not an appropriate estimate of the This is the reason earnings yield is not an appropriate estimate of the firm’s cost of capital.firm’s cost of capital.

What is relevant is NOT whether dividends or earnings are growing, What is relevant is NOT whether dividends or earnings are growing, but rather WHETHER THE FIRM IS INVESTING AT RATES OF but rather WHETHER THE FIRM IS INVESTING AT RATES OF RETURN GREATER THAN THE COST OF CAPITAL.RETURN GREATER THAN THE COST OF CAPITAL.

Of course, this means, the firm should be investing in projects with Of course, this means, the firm should be investing in projects with positive NPVs (IRRs > cost of capital)positive NPVs (IRRs > cost of capital)


MultiMulti--Stage Growth ModelsStage Growth Models

•• MultiMulti--stage DDM is a version of the DDM that stage DDM is a version of the DDM that accounts for different levels of growth in accounts for different levels of growth in earnings and dividends.earnings and dividends.


20 - 1229

earnings and dividends.earnings and dividends.•• There is no limit to the number of growth stages There is no limit to the number of growth stages

one can forecast for a given company, so this is one can forecast for a given company, so this is a very flexible model.a very flexible model.

•• See Chapter 7 for detailed pricing model See Chapter 7 for detailed pricing model description.description.

Simple TwoSimple Two--stage Growth Modelstage Growth ModelMultiMulti--Stage Growth ModelsStage Growth Models

•• Equation 20 Equation 20 –– 22 is a simple, two22 is a simple, two--stage growth model.stage growth model.•• It breaks the stock price into two components:It breaks the stock price into two components:

1.1. PVEO PVEO –– present value of existing opportunities (the value of the firms present value of existing opportunities (the value of the firms current operations assuming no new investment) andcurrent operations assuming no new investment) and

2.2. PVGO PVGO –– present value of growth opportunities present value of growth opportunities –– the net present value the net present value today of the firm’s future investments.today of the firm’s future investments.


20 - 1230

today of the firm’s future investments.today of the firm’s future investments.

)()1(

210

e

e

ee K

KROE

K

Inv

K

BVPSROEP

−+

+×=[ 20-22]

PVEO PVGO

Simple TwoSimple Two--stage Growth Modelstage Growth ModelPVEO and PVGOPVEO and PVGO

)()1(

210

e

e

ee K

KROE

K

Inv

K

BVPSROEP

−+

+×=[ 20-22]


20 - 1231

•• PVGO is discounted back to the present by one year because it PVGO is discounted back to the present by one year because it represents an incremental investment decision today that won’t represents an incremental investment decision today that won’t result in the first cash flow until one year from now.result in the first cash flow until one year from now.

•• PVGO does add a perpetual amount represented by the difference PVGO does add a perpetual amount represented by the difference between ROEbetween ROE22 earned on this added investment and Kearned on this added investment and Kee

PVEO PVGO

Simple TwoSimple Two--stage Growth Modelstage Growth ModelPVGO and ROEPVGO and ROE22

)()1(

210

e

e

ee K

KROE

K

Inv

K

BVPSROEP

−+

+×=[ 20-22]


20 - 1232

IfIf ROEROE22 = K= Kee thenthen the future investment adds the future investment adds nothing to the value of the firmnothing to the value of the firm

IfIf ROEROE22 > K> Kee thenthen the future investment adds the future investment adds value to the firmvalue to the firm

PVGO

Simple TwoSimple Two--stage Growth Model Scenariosstage Growth Model ScenariosPVEO and PVGOPVEO and PVGO

)()1(

210

e

e

ee K

KROE

K

Inv

K

BVPSROEP

−+

+×=[ 20-22]


20 - 1233

Four Scenarios:Four Scenarios:High PVEO and High PVGOHigh PVEO and High PVGO -- StarStarHigh PVEO and Low PVGOHigh PVEO and Low PVGO -- Cash CowCash CowLow PVEO and High PVGOLow PVEO and High PVGO -- TurnaroundTurnaroundLow PVEO and Low PVGOLow PVEO and Low PVGO -- DogDog

(These four scenarios are found in matrix form in Figure 20 (These four scenarios are found in matrix form in Figure 20 --1 )1 )

PVGO

Simple TwoSimple Two--stage Growth Modelstage Growth ModelGrowth Opportunities and Firm TypeGrowth Opportunities and Firm Type

20 - 1 FIGURE


20 - 1234


Star Star –– Growth CompanyGrowth Company–– High PVEO and high PVGOHigh PVEO and high PVGO–– DCF methods of valuation are unreliable due to high growthDCF methods of valuation are unreliable due to high growth

Turnaround Turnaround –– Growth CompanyGrowth Company–– Low PVEO and high PVGOLow PVEO and high PVGO–– Poor PVEO drags down stock price todayPoor PVEO drags down stock price today–– DCF methods of valuation are unreliable due to high growthDCF methods of valuation are unreliable due to high growth


20 - 1235

–– DCF methods of valuation are unreliable due to high growthDCF methods of valuation are unreliable due to high growthCash CowCash Cow

–– High PVEO and low PVGOHigh PVEO and low PVGO–– DCF methods of valuation are reliable due to lack of growth DCF methods of valuation are reliable due to lack of growth –– we are valuing a we are valuing a

perpetuityperpetuityDogDog

–– Low PVEO and low PVGOLow PVEO and low PVGO–– High earnings yield High earnings yield –– forecast to lose value from future investments depressing forecast to lose value from future investments depressing

the current share price.the current share price.

(See Table 20 (See Table 20 --11 for earnings yield and Market11 for earnings yield and Market--toto--book ratios for each type.)book ratios for each type.)


Earnings Yield (%) Market-to-Book

Table 20-11 The Impact of Growth Opportunities on Share Prices


20 - 1236

Star 8.84 2.26

Cash cow 12.00 1.67

Turnaround 2.63 0.76

Dog 114.29 0.02


The Fed ModelThe Fed Model

•• Used by the U.S. central bank to estimate Used by the U.S. central bank to estimate whether the stock market was overwhether the stock market was over-- or underor under--valuedvalued–– Used to decide whether the Central Reserve Bank Used to decide whether the Central Reserve Bank

should send signals to the market to encourage should send signals to the market to encourage


20 - 1237

should send signals to the market to encourage should send signals to the market to encourage ‘reason’ in the market place (to avoid speculative ‘reason’ in the market place (to avoid speculative bubbles and the inevitable price collapse that follows)bubbles and the inevitable price collapse that follows)

Attempting to avoid “irrational exuberance!”Attempting to avoid “irrational exuberance!”

The Fed Model equation is found on the next slide.The Fed Model equation is found on the next slide.



)%)0.1/()( −

=TBond

actual

Fed

actual

KEPSExp

V

V

V[ 20-23]


20 - 1238

TBondFed

Actual value of the U.S. stock a market. (Total market

capitalization).

Estimate of the U.S. stock market value from the Fed

model.

Expected EPS on S&P 500 index divided by yield on long U.S.

Treasury bonds.

Aggregate valuation across the entire market is eas ier because unsystematic risk attached to individual securities is eliminated as a factor for the market as a whole.



•• The Fed’s estimate of market value = Expected EPS on S&P 500 The Fed’s estimate of market value = Expected EPS on S&P 500 divided by Yield on Long U.S. Treasury Bonds minus 1.0%.divided by Yield on Long U.S. Treasury Bonds minus 1.0%.

•• All of this data is continuously, readily available so this estimate of All of this data is continuously, readily available so this estimate of value is easy to produce and to track over time as illustrated in value is easy to produce and to track over time as illustrated in Figure 20 Figure 20 –– 2 on the following slide:2 on the following slide:


20 - 1239

)%)0.1(

)(

−=

TBondFed K

EPSExp V[ 20-24]

Aggregate valuation across the entire market is eas ier because unsystematic risk attached to individual securities is eliminated as a factor for the market as a whole.

The Fed ModelThe Fed ModelFed’s Stock Valuation ModelFed’s Stock Valuation Model

20 - 2 FIGURE


20 - 1240



•• If the Fed Model is rearranged it can show when the If the Fed Model is rearranged it can show when the market is fairly valued:market is fairly valued:

X


20 - 1241

% .-K P

XTBond

S&P

01500

=[ 20-25]



•• When the earnings yield on the S&P 500 (market) is equal to the When the earnings yield on the S&P 500 (market) is equal to the longlong--term Treasury Bond yield minus 1.0 percent, the market is fairly term Treasury Bond yield minus 1.0 percent, the market is fairly valued.valued.

•• The earnings yield is the appropriate discount rate for the noThe earnings yield is the appropriate discount rate for the no--growth growth case. (perpetuities), whereas we would expect the market as a case. (perpetuities), whereas we would expect the market as a whole to grow at the nominal GDP growth rate.whole to grow at the nominal GDP growth rate.


20 - 1242

whole to grow at the nominal GDP growth rate.whole to grow at the nominal GDP growth rate.

•• Required return on the market as a whole = Long Treasury Yield + Required return on the market as a whole = Long Treasury Yield + 4.0% risk premium. (5% nominal GDP 4.0% risk premium. (5% nominal GDP –– 1%).1%).

% .-K P

XTBond

S&P

01500

=[ 20-25]



•• Required return on the market as a whole = Long Treasury Yield + 4.0% Required return on the market as a whole = Long Treasury Yield + 4.0% risk premium. (5% nominal GDP risk premium. (5% nominal GDP –– 1%).1%).

% .-K P

XTBond 01=[ 20-25]


20 - 1243

The required rate of return on the market as a whole can serve as a The required rate of return on the market as a whole can serve as a useful benchmark for financial managers as they attempt to estimate useful benchmark for financial managers as they attempt to estimate

their own firm’s cost of capital.their own firm’s cost of capital.

P TBondS&P 500

RiskRisk--Based Models and the Cost of Common Based Models and the Cost of Common EquityEquity

Using the CAPM to Estimate the Cost of Common EquityUsing the CAPM to Estimate the Cost of Common Equity

•• CAPM can be used to estimate the required return by CAPM can be used to estimate the required return by common shareholders.common shareholders.

•• It can be used in situations where DCF methods will It can be used in situations where DCF methods will perform poorly (growth firms)perform poorly (growth firms)


20 - 1244

•• CAPM estimate is a ‘market determined’ estimate CAPM estimate is a ‘market determined’ estimate because:because:–– The RF (riskThe RF (risk--free) rate is the benchmark return and is measured free) rate is the benchmark return and is measured

directly, today as the yield on 91directly, today as the yield on 91--day Tday T--billsbills–– The market premium for risk (MRP) is taken from current market The market premium for risk (MRP) is taken from current market

estimates of the overall return in the market place less RF (ERestimates of the overall return in the market place less RF (ERMM––RF)RF)



•• As a singleAs a single--factor model, we estimate the common shareholder’s required factor model, we estimate the common shareholder’s required return based on an estimate of the systematic risk of the firm (measured by return based on an estimate of the systematic risk of the firm (measured by the firm’s beta coefficient)the firm’s beta coefficient)


20 - 1245

•• Where:Where:KKee = investor’s required rate of return= investor’s required rate of returnββee = the stock’s beta coefficient= the stock’s beta coefficientRRff = the risk= the risk--free rate of returnfree rate of returnMRPMRP = the market risk premium (ER= the market risk premium (ERM M -- RRff ))

MRPRK eFe β×+=[ 20-26]


Estimating the Market Risk PremiumEstimating the Market Risk Premium

•• RRff is ‘observable’ (yield on 91is ‘observable’ (yield on 91--day Tday T--bills)bills)•• Getting an estimate of the market risk premium is one of the more Getting an estimate of the market risk premium is one of the more

MRPRK eFe β×+=[ 20-26]


20 - 1246

•• Getting an estimate of the market risk premium is one of the more Getting an estimate of the market risk premium is one of the more difficult challenges in using this model.difficult challenges in using this model.–– We really need a ‘forward’ looking of MRP or a ‘forward’ looking We really need a ‘forward’ looking of MRP or a ‘forward’ looking

estimate of the ERestimate of the ERMM

•• One approach is to use an estimate of the current, expected MRP One approach is to use an estimate of the current, expected MRP by examining a longby examining a long--run average that prevailed in the past.run average that prevailed in the past.

•• Table 20 Table 20 --12 illustrates the % returns on S&P/TSX Composite 12 illustrates the % returns on S&P/TSX Composite annually for the first five years of this century.annually for the first five years of this century.



Returns

2000 7.5072%

2001 -12.572%

Table 20-12 Returns on the S&P/TSX Composite Inde x Investors are unlikely to expect negative returns

on the stock market. If they

did, no one would hold

It would be better to use average realized returns over an entire

business/market cycle.


20 - 1247

2001 -12.572%

2002 -12.438%

2003 26.725%

2004 14.480%

2005 24.127%

would hold shares!

Who would have guessed before

hand, there would be two consecutive

years of aggregate market

losses?

Such is the reality of

investing since none of us are

clairvoyant.



Annual Arithmetic

Average (%)


Standard Deviation of

Annual

Table 20-13 Average Investment Returns and Standa rd Deviations (1938 to 2005)

Long-run average rates of return are more reliable.


20 - 1248

Average (%) Mean (%) Annual Returns (%)

Government of Canada Treasury Bills 5.20 5.11 4.32Government of Canada Bonds 6.62 6.24 9.32Canadian Stocks 11.79 10.60 16.22U.S. Stocks 13.15 11.76 17.54

Source: Data from Canadian Institute of Actuaries

Average risk premium of Canadian stocks over bonds was 5.17%

The consensus is that the Canadian MRP over the lon g-term bond yield (an observable yield) is between 4.0 and 5.5%.



Financial Forecasts Average Annual Percent Return

Bank of Canada Overnight Rate 4.50

Cash: 3-Month T-bills 4.40

Income: Scotia Universe Bond Index 5.60

Table 20-14 Long-Run Financial Projections


20 - 1249

Income: Scotia Universe Bond Index 5.60

Canadian Equities: S&P/TSX Composite Index 7.30

U.S. Equities: S&P 500 Index 7.80

International Non-U.S. Equities: MSCI EAFE Index 7.50

Source: TD Economics

An estimate of ER M is very important.

TD Economics recently generated the above estimates of ‘forward’ looking rates.

The Scotia Universe Bond Index is a long-term bond index that contains Canada’s and corporate bonds with default risk. Nevertheless, o n a risk-adjusted basis, the TD forecast for

MRP is consistent with an arithmetic risk premium o f 4.3%


Estimating BetasEstimating Betas

•• After obtaining estimates of the two important After obtaining estimates of the two important market rates (Rmarket rates (Rff and MRP), an estimate for the and MRP), an estimate for the company beta is required.company beta is required.


20 - 1250

company beta is required.company beta is required.

•• Figure 20 Figure 20 --3 illustrates that estimated betas for 3 illustrates that estimated betas for major submajor sub--indexes of the S&P/TSX have varied indexes of the S&P/TSX have varied widely over time:widely over time:


Estimated Betas for Sub Indexes of the S&P/TSX Composite IndexEstimated Betas for Sub Indexes of the S&P/TSX Composite Index

20 - 3 FIGURE


20 - 1251


Estimated Betas for Sub Indexes of the S&P/TSX Composite IndexEstimated Betas for Sub Indexes of the S&P/TSX Composite Index

•• Actual data for Figure 20 Actual data for Figure 20 --3 is presented in Table 20 3 is presented in Table 20 --15 on 15 on the following slide:the following slide:

•• You should note:You should note:–– IT sub index shows rapidly increasing betasIT sub index shows rapidly increasing betas–– Other sub index betas show constand or decreasing trends.Other sub index betas show constand or decreasing trends.

•• Reasons:Reasons:


20 - 1252

•• Reasons:Reasons:–– The weighted average of all betas = 1.0 (by definition they are The weighted average of all betas = 1.0 (by definition they are

the market)the market)–– If one sub index is changing…that change alone affects all If one sub index is changing…that change alone affects all

others in the opposite direction.others in the opposite direction.•• What Happened in the 1995 What Happened in the 1995 –– 2005 decade?2005 decade?

–– The internet bubble of the late 1990s resulted in rapid growth in The internet bubble of the late 1990s resulted in rapid growth in the IT sector till it burst in the early 2000s.the IT sector till it burst in the early 2000s.


Estimating BetasEstimating Betas

Energy Materials Industrials ConsDisc ConsStap Health Fin IT Telco Utilities

1995 0.93 1.41 1.19 0.82 0.68 0.36 0.92 1.25 0.53 0.67

1996 0.93 1.28 1.10 0.83 0.66 0.39 1.02 1.36 0.61 0.65

1997 0.98 1.33 0.97 0.82 0.62 0.60 0.93 1.56 0.62 0.53

Table 20-15 S&P/TSX Sub Index Beta Estimates

IT Bubble


20 - 1253

1998 0.85 1.12 0.94 0.80 0.60 1.02 1.11 1.40 0.92 0.55

1999 0.91 1.04 0.78 0.73 0.43 1.00 1.00 1.55 1.11 0.30

2000 0.67 0.74 0.73 0.69 0.23 1.10 0.79 1.78 0.92 0.14

2001 0.50 0.60 0.82 0.68 0.10 0.98 0.67 2.12 0.94 -0.03

2002 0.43 0.57 0.86 0.73 0.11 0.99 0.67 2.27 0.92 -0.06

2003 0.27 0.42 0.91 0.74 -0.04 0.85 0.39 2.75 0.82 -0.26

2004 0.17 0.42 1.04 0.81 -0.02 0.84 0.41 2.89 0.55 -0.14

2005 0.48 0.78 1.12 0.84 0.14 0.74 0.58 2.71 0.71 -0.01

Source: Data from Financial Post Corporate Analyzer Database


Nortel Stock PriceNortel Stock Price

•• Nortel’s stock price reflects the IT bubble and Nortel’s stock price reflects the IT bubble and crash.crash.


20 - 1254

(See Figure 20 (See Figure 20 --4 on the following slide for Nortel Stock Price history)4 on the following slide for Nortel Stock Price history)


Nortel Stock PriceNortel Stock Price

20 - 4 FIGURE


20 - 1255


IT Bubble effect on Betas of Other Companies Outside the SectorIT Bubble effect on Betas of Other Companies Outside the Sector

•• The bubble in IT stocks has driven down the betas in other The bubble in IT stocks has driven down the betas in other sectors.sectors.

•• This is demonstrated in Rothman’s beta over the 1966 This is demonstrated in Rothman’s beta over the 1966 –– 2004 2004 period.period.


20 - 1256

period.period.•• Remember, Rothman’s is a stable company and it’s beta Remember, Rothman’s is a stable company and it’s beta

should be expected to remain constant.should be expected to remain constant.

(See Figure 20 (See Figure 20 --5 on the following slide for Rothman’s beta history)5 on the following slide for Rothman’s beta history)


Rothman’s Beta EstimatesRothman’s Beta Estimates

20 - 5 FIGURE


20 - 1257


Adjusting Beta Estimates and Establishing a RangeAdjusting Beta Estimates and Establishing a Range

•• When betas are measured over the period of a When betas are measured over the period of a sector bubble or crash, it is necessary to adjust sector bubble or crash, it is necessary to adjust the beta estimates of firms in other sectors.the beta estimates of firms in other sectors.

•• Take the industry grouping as a major input, Take the industry grouping as a major input,


20 - 1258

•• Take the industry grouping as a major input, Take the industry grouping as a major input, plus the individual company beta estimate.plus the individual company beta estimate.–– Using current MRP and Using current MRP and RRf f Develop estimates of KDevelop estimates of Kee

using the range of Company betas prior to the bubble using the range of Company betas prior to the bubble or crashor crash


Using CAPM to Estimate KUsing CAPM to Estimate Knene

•• We can scale our estimate of the equity holder’s We can scale our estimate of the equity holder’s required return when accessing new equity and required return when accessing new equity and incurring floatation costs.incurring floatation costs.


20 - 1259

incurring floatation costs.incurring floatation costs.

NP PKK ene /0×=[ 20-27]

The Investment Opportunity ScheduleThe Investment Opportunity Schedule

•• The IOS is the ranking of a firm’s investment The IOS is the ranking of a firm’s investment opportunities from highest to lowest profitability opportunities from highest to lowest profitability according to expected IRR.according to expected IRR.

•• When superimposed on the MCC curve, the firm is able When superimposed on the MCC curve, the firm is able


20 - 1260

•• When superimposed on the MCC curve, the firm is able When superimposed on the MCC curve, the firm is able to identify projects that will increase the value of the firm.to identify projects that will increase the value of the firm.

•• A stylized version of this for Rothmans is found in Figure A stylized version of this for Rothmans is found in Figure 20 20 –– 6.6.

Cost of Capital and InvestmentCost of Capital and InvestmentRothman’s Inc.’s IOS Schedule, 2006Rothman’s Inc.’s IOS Schedule, 2006

20 - 6 FIGURE

Rate of Return

OPTIMAL INVESTMENT

IOS

Projects expected to increase the value of the

firm.

The break in the MCC at $177,607 million

indicates that the firm has a surplus of

internally-generated funds…more than enough to fund the $11,976 of capital

investments.Projects


20 - 1261

$11,976 Million

WACC


$177,607 Million

investments.rejected.

Investment Opportunity ScheduleInvestment Opportunity ScheduleA Detailed ExampleA Detailed Example

•• In practice, the IOS is a detailed list, rank In practice, the IOS is a detailed list, rank ordered from highest IRR to lowest of the ordered from highest IRR to lowest of the investment project proposals for one year.investment project proposals for one year.


20 - 1262

investment project proposals for one year.investment project proposals for one year.•• As you can see on the following slides:As you can see on the following slides:

–– The width of the columns indicate the capital The width of the columns indicate the capital investment each project requires, andinvestment each project requires, and

–– The height of the columns indicates the forecast IRR The height of the columns indicates the forecast IRR for the projectfor the project

Investment Opportunity ScheduleInvestment Opportunity ScheduleA Detailed Example …A Detailed Example …

•• In any one year, a firm may consider a number of capital projects.In any one year, a firm may consider a number of capital projects.

•• The greater the number of projects undertaken, the more money The greater the number of projects undertaken, the more money that the firm will have to raise in order to finance them.that the firm will have to raise in order to finance them.


20 - 1263

•• There is a limit to the amount of money that can be raised in any There is a limit to the amount of money that can be raised in any one year (ie. the capital markets are finite … ie. there is a limit to the one year (ie. the capital markets are finite … ie. there is a limit to the number of investors and their investment dollars that will consider number of investors and their investment dollars that will consider investing in any prospect in any given year.) …hence it is important investing in any prospect in any given year.) …hence it is important that the capital budgeting analysis be extended to take this fact into that the capital budgeting analysis be extended to take this fact into account.account.


•• This Investment opportunity schedule is the prioritized list of This Investment opportunity schedule is the prioritized list of capital projects, listed by IRR (internal rate of return) from capital projects, listed by IRR (internal rate of return) from highest to lowest.highest to lowest.

•• At the same time, the cumulative investment required is listed.At the same time, the cumulative investment required is listed.


20 - 1264

Example:Example:Consider a firm that has six different capital investment proposals this Consider a firm that has six different capital investment proposals this year. Each project has it’s own IRR and capital cost. year. Each project has it’s own IRR and capital cost.

(see the next slide)(see the next slide)


Example:Example:Consider a firm that has six different capital investment Consider a firm that has six different capital investment proposals this year. Each project has it’s own IRR and capital proposals this year. Each project has it’s own IRR and capital cost. Each project has the same risk as the firm as a whole.cost. Each project has the same risk as the firm as a whole.

Project A can be eliminated at this point because it


20 - 1265


Annual ATCF Benefits

Useful Life NPV IRR

A $1,500,000 $290,000 7 -$88,159 8.19%B $2,300,000 $529,000 6 $3,933 10.06%C $3,750,000 $940,000 6 $343,945 13.07%D $180,000 $40,000 7 $14,737 12.45%E $985,000 $318,540 5 $222,517 18.50%F $2,154,000 $421,500 8 $94,671 11.20%

point because it has a negative

NPV.


Example:Example:The first step in developing an IOS is to order the projects The first step in developing an IOS is to order the projects from highest IRR to lowest, and then to calculate the from highest IRR to lowest, and then to calculate the cumulative capital cost of the projects.cumulative capital cost of the projects.


20 - 1266


Cumulative Cost of the Projects IRR

E $985,000 $985,000 18.50%C $3,750,000 $4,735,000 13.07%D $180,000 $4,915,000 12.45%F $2,154,000 $7,069,000 11.20%B $2,300,000 $9,369,000 10.06%A $1,500,000 $10,869,000 8.19%

Investment Opportunity ScheduleInvestment Opportunity ScheduleA Detailed Example Continued …A Detailed Example Continued …

Example:Example:It was clear at the start that project A was unacceptable…it had a It was clear at the start that project A was unacceptable…it had a negative NPV.negative NPV.

The remaining projects certainly meet the first investment screen (they The remaining projects certainly meet the first investment screen (they


20 - 1267

The remaining projects certainly meet the first investment screen (they The remaining projects certainly meet the first investment screen (they have positive NPV’s … that is, they offer rates of return in excess of have positive NPV’s … that is, they offer rates of return in excess of the firm’s WACC).the firm’s WACC).

Now we can prepare a graphical representation of the IOS by plotting Now we can prepare a graphical representation of the IOS by plotting the projects’ IRR against the cumulative dollars of capital to be raised.the projects’ IRR against the cumulative dollars of capital to be raised.

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)A Detailed Example Continued …A Detailed Example Continued …

IRR

(%)

15

EIRR = 18.5%

CIRR = 13.07% F B

DIRR = 12.45%

The height of each cylinder is equal to the project’s IRR; the width is equal to the initial investment for the project.

The upper surface of the columns is

the IOS


20 - 1268

0 $2,000,000 $4,000,000 $6,000,000 $8,000,000 $10,000,000


10

5

FIRR = 11.2%

BIRR = 10.06%

Investment Opportunity Schedule (IOS)Investment Opportunity Schedule (IOS)A Detailed Example Continued …A Detailed Example Continued …

IRR

(%)

15

EIRR = 18.5%

CIRR = 13.07%

DIRR = 12.45%

IOS


20 - 1269

0 $2,000,000 $4,000,000 $6,000,000 $8,000,000 $10,000,000


10

5

FIRR = 11.2%

BIRR = 10.06%

MCC Superimposed on the IOSMCC Superimposed on the IOSA Detailed Example Continued …A Detailed Example Continued …

IRR

(%)

15

EIRR = 18.5%

CIRR = 13.07%

DIRR = 12.45%

MCC2= 10.64%

The break in the MCC is caused by the exhaustion of low cost

retained earnings and the need to finance project F through external offering of equity, incurring floatation costs.

IRRB < MCC2so this

project is rejected. It

will not increase the value of the

firm.


20 - 1270

0 $2,000,000 $4,000,000 $6,000,000 $8,000,000 $10,000,000


10

5

FIRR = 11.2%

BIRR = 10.06%

MCC1=WACC= 9.44%

MCC2= 10.64%

The Break In the IOSThe Break In the IOSA Detailed Example Continued …A Detailed Example Continued …

•• The break in the IOS curve (the amount of capital investment that The break in the IOS curve (the amount of capital investment that exhausts retained earnings) can be estimated as:exhausts retained earnings) can be estimated as:

Structure Capital in the UpMakesEquity that Percentage

Investmentfor Available Earnings Retained of $ MCCin Break =


•• Assuming the firm has $3.3 million in internal capital to invest and Assuming the firm has $3.3 million in internal capital to invest and equity represents 60% of the firm’s capital structure the break point equity represents 60% of the firm’s capital structure the break point occurs at:occurs at:

$5,500,000 60%

$3,300,000 MCCin Break ==

MCC and IOSMCC and IOS

•• The foregoing is consistent with economic theory The foregoing is consistent with economic theory that states a firm will operate where “marginal that states a firm will operate where “marginal cost equals marginal revenue.”cost equals marginal revenue.”


20 - 1272

•• Now the rationale for this must be clear. The Now the rationale for this must be clear. The value of the firm will fall if it undertakes projects value of the firm will fall if it undertakes projects that offer a rate of return that is less than the that offer a rate of return that is less than the marginal cost of capital used to finance them.marginal cost of capital used to finance them.

Divisional Costs of CapitalDivisional Costs of Capital

•• An overall cost of capital developed for a highly diversified An overall cost of capital developed for a highly diversified conglomerate may not be appropriate for decisions made within conglomerate may not be appropriate for decisions made within specific divisions of the company.specific divisions of the company.

•• HighHigh--risk divisions (with high return possibilities) would have a risk divisions (with high return possibilities) would have a disproportionate share of their investment proposals accepted if they disproportionate share of their investment proposals accepted if they use an overall WACC.use an overall WACC.


20 - 1273

use an overall WACC.use an overall WACC.

•• The solution to this is to develop riskThe solution to this is to develop risk--adjusted discount rates that adjusted discount rates that reflect the unique risk characteristics of each division.reflect the unique risk characteristics of each division.

•• Developing these estimates can sometimes be accomplished by Developing these estimates can sometimes be accomplished by looking at other firms in that industry that are not highly diversified in looking at other firms in that industry that are not highly diversified in their operations… this is called the pure play approach.their operations… this is called the pure play approach.


In this chapter you have learned:In this chapter you have learned:–– How types of equity differ in their degree of “equityness” and How types of equity differ in their degree of “equityness” and

therefore have different costs of capitaltherefore have different costs of capital–– WACC is the market value weighted average of the afterWACC is the market value weighted average of the after--tax tax

costs of all securities used to finance the firm.costs of all securities used to finance the firm.–– If a firm earns more than its WACC, the value of the firm will If a firm earns more than its WACC, the value of the firm will

rise.rise.


20 - 1274

rise.rise.–– Common shareholders are residual claimants hence they hold Common shareholders are residual claimants hence they hold

the riskiest securities issued by the firm.the riskiest securities issued by the firm.–– The most difficult estimate in WACC is the cost of common The most difficult estimate in WACC is the cost of common

equity.equity.–– DCF approaches to estimating the cost of equity is particularly DCF approaches to estimating the cost of equity is particularly

prone to errors for high growth firms.prone to errors for high growth firms.–– CAPM can be used to minimize estimation errors, however, CAPM can be used to minimize estimation errors, however,

estimation of beta can be affected by recent stock market estimation of beta can be affected by recent stock market performance.performance.

Appendix 1Appendix 1Steep Hill Mines 1Steep Hill Mines 1

An Exercise in Cost of CapitalAn Exercise in Cost of Capital

Steep Hill Mines # 1Steep Hill Mines # 1The QuestionThe Question

Steep Hill Mines Ltd. shares are publicly traded on the Toronto Steep Hill Mines Ltd. shares are publicly traded on the Toronto Stock Exchange. The shares currently trade at a price of $30.00 per Stock Exchange. The shares currently trade at a price of $30.00 per share. Security analysts that follow the stock have estimated it's beta share. Security analysts that follow the stock have estimated it's beta coefficient to be 0.9. Steep Hill paid a dividend on its common stock coefficient to be 0.9. Steep Hill paid a dividend on its common stock last year that totaled $1.50 per share. Dividends have been growing at last year that totaled $1.50 per share. Dividends have been growing at a 4% compound rate for the past six years and the expectation is that a 4% compound rate for the past six years and the expectation is that this growth can continue into the foreseeable future.this growth can continue into the foreseeable future.


20 - 1276

Steep Hill also has it's longSteep Hill also has it's long--term bonds trading on public markets. term bonds trading on public markets. The bonds are currently trading at a discount from their par value of The bonds are currently trading at a discount from their par value of 96.54%. These 5.75% bonds have ten years left until they mature.96.54%. These 5.75% bonds have ten years left until they mature.

Steep Hill Mines Ltd. has an important capital project to consider. Steep Hill Mines Ltd. has an important capital project to consider. Project A is expected to produce annual cash flows after tax of Project A is expected to produce annual cash flows after tax of $100,000 for the next eight years. It is considered to be of similar risk $100,000 for the next eight years. It is considered to be of similar risk to the risk of the firm itself. It will cost Steep Hill $400,000 this year to to the risk of the firm itself. It will cost Steep Hill $400,000 this year to get this project up and running.get this project up and running.

Steep Hill Mines # 1Steep Hill Mines # 1The Question …The Question …

Cathy Jones, Steep Hill's manager of finance has collected current Cathy Jones, Steep Hill's manager of finance has collected current data from the firm's underwriters.data from the firm's underwriters.

–– Government of Canada 91Government of Canada 91--day Treasury bills are currently yielding 4.25%. day Treasury bills are currently yielding 4.25%. –– The expected return on the TSE 300 composite index is forecast to be 10% in The expected return on the TSE 300 composite index is forecast to be 10% in

the next yearthe next year–– New equity capital could be raised by the firm at the current market price, but New equity capital could be raised by the firm at the current market price, but


20 - 1277

–– New equity capital could be raised by the firm at the current market price, but New equity capital could be raised by the firm at the current market price, but floatation costs would amount of 4% of the value of the issue. floatation costs would amount of 4% of the value of the issue.

–– New bonds could be sold into the market, but the floatation cost percentage New bonds could be sold into the market, but the floatation cost percentage would be 6%. would be 6%.

–– The firm faces a corporate tax rate of 40%. The firm faces a corporate tax rate of 40%. –– The company will seek to sustain the current capital structure based on existing The company will seek to sustain the current capital structure based on existing

market value weights. market value weights. –– If the firm goes ahead with the capital project, it will have to seek external If the firm goes ahead with the capital project, it will have to seek external

financing since there is no internal cash flow available for reinvestment.financing since there is no internal cash flow available for reinvestment.

The firm's most recent financial statements are found below:The firm's most recent financial statements are found below:

Steep Hill Mines # 1Steep Hill Mines # 1The Question …The Question …

Steep Hill Mines Ltd.Steep Hill Mines Ltd.Balance SheetBalance Sheet

As at December 31, 20XXAs at December 31, 20XXIn $ '000sIn $ '000s

Assets:Assets: Liabilities:Liabilities:CashCash 100100 AccrualsAccruals 3030Accounts ReceivableAccounts Receivable 220220 Accounts PayableAccounts Payable 312312InventoriesInventories 450450 ________


20 - 1278

Total Current AssetsTotal Current Assets 770770 Total Current LiabilitiesTotal Current Liabilities 342342Gross Fixed AssetsGross Fixed Assets 4,0004,000 5.75% bonds5.75% bonds 1,0001,000Accumulated DepreciationAccumulated Depreciation 1,5001,500 Common stock Common stock

(100,000 outstanding)(100,000 outstanding) 1,0001,000Net Fixed AssetsNet Fixed Assets 2,5002,500 Retained earningsRetained earnings 928928TOTAL ASSETSTOTAL ASSETS 3,2703,270 TOTAL CLAIMSTOTAL CLAIMS 3,2703,270

Required:Required:Find the WACC using book value weights, market value weights and target capital structure Find the WACC using book value weights, market value weights and target capital structure

weights. Using the target capital structure weights, is the proposed project viable?weights. Using the target capital structure weights, is the proposed project viable?

Steep Hill Mines # 1Steep Hill Mines # 1The Solution The Solution –– The Equity Investor’s Required ReturnThe Equity Investor’s Required Return

Investor's Required Return on Equity Capital:Investor's Required Return on Equity Capital:DDM Approach:DDM Approach:

%2.904.052.004.30$

56.1$04.

30$

)04.1(50.1$)1(

0

0 =+=+=+=++= gP

gDKS


CAPM Approach:CAPM Approach:

%425.9%175.5%25.4

%]25.4%10[9.0%25.4][

=+=−+=−+=

S

MsS

K

RFERBRFK

Steep Hill Mines # 1Steep Hill Mines # 1The Solution The Solution –– The Cost of EquityThe Cost of Equity

Investor's Required Return on Equity CapitalInvestor's Required Return on Equity CapitalThe average of our two estimates for the cost of retained earnings The average of our two estimates for the cost of retained earnings is: (9.2 + 9.425)/2 = is: (9.2 + 9.425)/2 = 9.3%9.3%

This is the returns our current shareholders are demanding on our This is the returns our current shareholders are demanding on our stock.stock.


stock.stock.

If we raise external capital, we will incur floatation costs If we raise external capital, we will incur floatation costs (underwriter's fees, legal costs, etc.) This represents 4%.(underwriter's fees, legal costs, etc.) This represents 4%.

%7.996.%3.9

.4-1

%3.9

f-1

Return Required InvestorsEquity New ofCost

===

=

Steep Hill Mines # 1Steep Hill Mines # 1The SolutionThe Solution

Investor's Required Return on DebtInvestor's Required Return on Debt

1

111

1

+×+

+−

×= )k(

Fk

)k(IB

nbb

nb[ 20-12]


%22.62%11.3k

%11.3k

1

111

1

$28.75$965.40

1

b

b

20

20

=×==

+×+

+−

=

+

lysemiannual

)k(F

k

)k(

)k(k

bb

b

bb

Steep Hill Mines # 1Steep Hill Mines # 1The Solution The Solution –– The Cost of DebtThe Cost of Debt

Since interest on debt is tax deductible to the fir m, the afterSince interest on debt is tax deductible to the fir m, the after--tax and tax and after floatation cost of debt is:after floatation cost of debt is:

%97.306.1

)4.1%(22.6

1

)1%(22.6 =−

−=−

−=f

TKd


Where:Where:T = T = 40%40%f =f = 6%6%

%97.306.11

=−

=−

=f

Kd

Market Value Weights:Market Value Weights:Market values are always found by Market values are always found by multiplying the number of outstanding multiplying the number of outstanding securities times their price per unit.securities times their price per unit.

Steep Hill Mines # 1Steep Hill Mines # 1The Solution The Solution –– Determining Market Value WeightsDetermining Market Value Weights


20 - 1283

securities times their price per unit.securities times their price per unit.

Market Value of LT Debt = 1,000 bonds outstanding times $965.40 =Market Value of LT Debt = 1,000 bonds outstanding times $965.40 = $965,400$965,400Market Value of Equity = 100,000 times $30.00 =Market Value of Equity = 100,000 times $30.00 = 3,00 0,0003,000,000TOTAL MARKET VALUE OF THE FIRM =TOTAL MARKET VALUE OF THE FIRM = 3,965,4003,965,400

Market Value Weight of LT Debt = $965,400/$3,965,4 00 = 24.35%Market Value Weight of LT Debt = $965,400/$3,965,4 00 = 24.35%Market Value Weight of Equity = (1 Market Value Weight of Equity = (1 -- .2435) = 75.65 %.2435) = 75.65%

The Cost of Capital Using Market Value The Cost of Capital Using Market Value Weights:Weights:

Steep Hill Mines # 1Steep Hill Mines # 1The Solution The Solution –– Market Value WACCMarket Value WACC

Source of Market Value

Specific Marginal Weighted


20 - 1284

Capital Weight Cost CostL. T. Debt 24.4% 3.97% 0.97%Preferred 0.0% 0.00% 0.00%Common 75.7% 9.70% 7.34%

WACC = 8.30%

Viability of the Capital ProjectViability of the Capital Project

Since the project has similar risk characteristics to the firm as Since the project has similar risk characteristics to the firm as a whole, we do not have to calculate a riska whole, we do not have to calculate a risk--adjust discount adjust discount rate…instead, we can just use the firm's WACC.rate…instead, we can just use the firm's WACC.

Steep Hill Mines # 1Steep Hill Mines # 1The SolutionThe Solution


20 - 1285

Since the market value capital structure weights wi ll be used Since the market value capital structure weights wi ll be used by the firm in the long run, let's use that as the WACC, and by the firm in the long run, let's use that as the WACC, and discount the prospective afterdiscount the prospective after--tax cash flows on t his project tax cash flows on this project back to the present and compare that with the cost of the back to the present and compare that with the cost of the project to see if there is a positive NPV.project to see if there is a positive NPV.

Steep Hill Mines # 1Steep Hill Mines # 1The Solution The Solution –– Project NPVProject NPV

000,400$)VIFA$100,000(P

)1(

...)1()1()1(

01

033

22

11

−=

−+

=

−++

++

++

=

=∑

CFk

CF

CFk

CF

k

CF

k

CFNPV

t

n

it

[ 13-1] Using Equation 13 -1 for NPV, and

substituting in the annual cash flow

benefits of $100,000 after-tax, initial cost, useful life of 8 years,

and WACC of 8.3% we find the project offers


20 - 1286

178,168$

000,400$178,568$

000,400$).681788$100,000(5

000,400$083.

(1.083)1

-1$100,000

000,400$)VIFA$100,000(P

000,400$)VIFA$100,000(P

8

8.3%k8,n

WACCk8,n

=−=

−=

−=

−=−=

==

==

NPV

find the project offers a positive NPV.

CHAPTER 21CHAPTER 21Capital Structure DecisionsCapital Structure DecisionsCapital Structure DecisionsCapital Structure Decisions


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• Financial LeverageFinancial Leverage•• Determining Capital StructureDetermining Capital Structure•• M&M Irrelevance TheoremM&M Irrelevance Theorem

www.bookfiesta4u.com ContentsCHAPTER 21 – Capital Structure Decisions

21 - 1289

•• Impact of TaxesImpact of Taxes•• Financial Distress, Bankruptcy and Agency CostsFinancial Distress, Bankruptcy and Agency Costs•• Other Factors affecting Capital StructureOther Factors affecting Capital Structure•• Capital Structure in PracticeCapital Structure in Practice•• Summary and ConclusionsSummary and Conclusions

–– Concept Review QuestionsConcept Review Questions–– Appendix 1 Appendix 1 –– Thunder Bay Industries Thunder Bay Industries –– Indifference AnalysisIndifference Analysis


1.1. How business risk and financial risk affect a firm’s ROE and EPSHow business risk and financial risk affect a firm’s ROE and EPS2.2. How indifference analysis may be used to compare financing alternatives How indifference analysis may be used to compare financing alternatives

based on expected EBIT levelsbased on expected EBIT levels3.3. Modigliani and Miller’s irrelevance, argument, as well as the key assumptions Modigliani and Miller’s irrelevance, argument, as well as the key assumptions

upon which it is basedupon which it is based4.4. How the introduction of corporate taxes affects M&M’s irrelevance argumentHow the introduction of corporate taxes affects M&M’s irrelevance argument


21 - 1290

4.4. How the introduction of corporate taxes affects M&M’s irrelevance argumentHow the introduction of corporate taxes affects M&M’s irrelevance argument5.5. How financial distress and bankruptcy costs lead to the static tradeHow financial distress and bankruptcy costs lead to the static trade--off theory off theory

of capital structureof capital structure6.6. How information asymmetry problems and agency problems may lead firms to How information asymmetry problems and agency problems may lead firms to

follow a pecking order approach to financingfollow a pecking order approach to financing7.7. How other factors such as firm size, profitability and growth, asset tangibility, How other factors such as firm size, profitability and growth, asset tangibility,

and market conditions can affect a firm’s capital structure.and market conditions can affect a firm’s capital structure.


•• Agency costsAgency costs•• BankruptcyBankruptcy•• Business riskBusiness risk•• Cash flowCash flow--toto--debt ratiodebt ratio•• Corporate debt tax shieldCorporate debt tax shield•• Direct costs of bankruptcyDirect costs of bankruptcy

•• Financial riskFinancial risk•• Fixed burden coverage ratioFixed burden coverage ratio•• Homemade leverageHomemade leverage•• Indifference pointIndifference point•• Indirect costs of bankruptcyIndirect costs of bankruptcy•• Invested capitalInvested capital


21 - 1291

•• Direct costs of bankruptcyDirect costs of bankruptcy•• EPS indifference pointEPS indifference point•• Financial breakFinancial break--even pointseven points•• Financial distressFinancial distress•• Financial leverageFinancial leverage•• Financial leverage risk Financial leverage risk

premiumpremium

•• Invested capitalInvested capital•• M&M equity cost equationM&M equity cost equation•• Modigliani and MillerModigliani and Miller•• Pecking orderPecking order•• Profit planning chartsProfit planning charts•• Return on equity (ROE)Return on equity (ROE)•• Return on invested capitalReturn on invested capital•• Risk value of moneyRisk value of money•• Static tradeoffStatic tradeoff

The Focus of this ChapterThe Focus of this Chapter

•• You know:You know:–– It is the responsibility of the financial manager to maximize It is the responsibility of the financial manager to maximize

shareholder wealth.shareholder wealth.–– The afterThe after--tax cost of debt is significantly lower than the cost of tax cost of debt is significantly lower than the cost of

equity primarily because of the taxequity primarily because of the tax--deductibility of interest deductibility of interest expense…therefore, using debt has a cost advantage over expense…therefore, using debt has a cost advantage over


21 - 1292

expense…therefore, using debt has a cost advantage over expense…therefore, using debt has a cost advantage over equity.equity.

–– The lower the cost of capital, the greater the value of the firm.The lower the cost of capital, the greater the value of the firm.–– This chapter addresses the question:This chapter addresses the question:

Does the relative mix of financing used by a firm affect its value? If so, how and why and are what are the other impacts that capital structure can have on the firm?

In this Chapter You Will LearnIn this Chapter You Will Learn

1.1. The optimal (target) capital structure is the one that The optimal (target) capital structure is the one that maximizes the value of the firm and minimizes the cost of maximizes the value of the firm and minimizes the cost of capital.capital.

2.2. How lenders seek to protect themselves from excessive use How lenders seek to protect themselves from excessive use of corporate leverage through the use of protective of corporate leverage through the use of protective


21 - 1293

of corporate leverage through the use of protective of corporate leverage through the use of protective covenants.covenants.

3.3. The tax advantage to debt is offset at higher levels of The tax advantage to debt is offset at higher levels of financial leverage by costs associated with financial distress financial leverage by costs associated with financial distress and bankruptcy.and bankruptcy.

4.4. Firms depart from the target capital structure in practice Firms depart from the target capital structure in practice because of financing preferences and capital market because of financing preferences and capital market conditions.conditions.

LeverageLeverageWhat is it?What is it?

•• The increased volatility in operating income over The increased volatility in operating income over time, created by the use of fixed costs in lieu of time, created by the use of fixed costs in lieu of variable costs.variable costs.–– Leverage magnifies profits and losses.Leverage magnifies profits and losses.

•• There are two types:There are two types:


21 - 1294

•• There are two types:There are two types:–– Operating leverageOperating leverage–– Financial leverageFinancial leverage

•• Both types of leverage have the same effect on Both types of leverage have the same effect on shareholders but are accomplished in very shareholders but are accomplished in very different ways, for very different purposes different ways, for very different purposes strategically.strategically.

Leverage Effects on Operating IncomeLeverage Effects on Operating Income

When a firm increases the use of fixed costs it

increases the volatility of operating income.

Normal volatility of operating income

Operating Income


21 - 1295

Years

+

0

-

Operating LeverageOperating LeverageWhat is it? How is it Increased?What is it? How is it Increased?

•• Operating leverage is:Operating leverage is:–– The increased volatility in operating income caused by fixed The increased volatility in operating income caused by fixed

operating costs.operating costs.

•• You should understand that managers do make decisions You should understand that managers do make decisions affecting the cost structure of the firm.affecting the cost structure of the firm.


21 - 1296

affecting the cost structure of the firm.affecting the cost structure of the firm.•• Managers can, and do, decide to invest in assets that give Managers can, and do, decide to invest in assets that give

rise to additional fixed costs and the intent is to reduce rise to additional fixed costs and the intent is to reduce variable costs.variable costs.–– This is commonly accomplished by a firm choosing to become This is commonly accomplished by a firm choosing to become

more capital intensive and less labour intensive, thereby more capital intensive and less labour intensive, thereby increasing operating leverage.increasing operating leverage.

Operating LeverageOperating LeverageAdvantages and DisadvantagesAdvantages and Disadvantages


profitable.profitable.–– Operating efficiencies (faster production, fewer errors, higher Operating efficiencies (faster production, fewer errors, higher

quality) usually result increasing productivity, reducing quality) usually result increasing productivity, reducing ‘downtime’ etc.‘downtime’ etc.


21 - 1297

‘downtime’ etc.‘downtime’ etc.Disadvantages:Disadvantages:

–– Magnification of losses to the shareholders if the firm does not Magnification of losses to the shareholders if the firm does not earn enough revenue to cover its costs.earn enough revenue to cover its costs.

–– Higher break even pointHigher break even point–– High capital cost of equipment and the illiquidity of such an High capital cost of equipment and the illiquidity of such an

investment make it:investment make it:•• Expensive (more difficult to finance)Expensive (more difficult to finance)•• Potentially exposed to technological obsolescence, etc.Potentially exposed to technological obsolescence, etc.

Financial LeverageFinancial LeverageWhat is it? How is it Increased?What is it? How is it Increased?

•• Your textbook defines financial leverage as:Your textbook defines financial leverage as:–– The increased volatility in operating income caused The increased volatility in operating income caused

by the corporate use of sources of capital that carry by the corporate use of sources of capital that carry fixed financial costs.fixed financial costs.

•• Financial leverage can be increased in the firm Financial leverage can be increased in the firm


21 - 1298

•• Financial leverage can be increased in the firm Financial leverage can be increased in the firm by:by:–– Selling bonds or preferred stock (taking on financial Selling bonds or preferred stock (taking on financial

obligations with fixed annual claims on cash flow)obligations with fixed annual claims on cash flow)–– Using the proceeds from the debt to retire equity (if Using the proceeds from the debt to retire equity (if

the lenders don’t prohibit this through the bond the lenders don’t prohibit this through the bond indenture or loan agreement)indenture or loan agreement)

Financial LeverageFinancial LeverageAdvantages and DisadvantagesAdvantages and Disadvantages


profitable.profitable.–– Lower cost of capital at low to moderate levels of financial Lower cost of capital at low to moderate levels of financial

leverage because interest expense is taxleverage because interest expense is tax--deductible.deductible.Disadvantages:Disadvantages:


21 - 1299

Disadvantages:Disadvantages:–– Magnification of losses to the shareholders if the firm does not Magnification of losses to the shareholders if the firm does not

earn enough revenue to cover its costs.earn enough revenue to cover its costs.–– Higher break even point.Higher break even point.–– At higher levels of financial leverage, the low afterAt higher levels of financial leverage, the low after--tax cost of tax cost of

debt is offset by other effects such as:debt is offset by other effects such as:•• Present value of the rising probability of bankruptcy costsPresent value of the rising probability of bankruptcy costs•• Agency costsAgency costs•• Lower operating income (EBIT), etc.Lower operating income (EBIT), etc.

Effects of Operating and Financial LeverageEffects of Operating and Financial LeverageSummarySummary

•• Equity holders bear the added risks associated with the use of Equity holders bear the added risks associated with the use of leverage.leverage.

•• The higher the use of leverage (either operating or financial) the The higher the use of leverage (either operating or financial) the higher the risk to the shareholder.higher the risk to the shareholder.


21 - 1300

•• Leverage therefore can and does affect shareholders required rate Leverage therefore can and does affect shareholders required rate of return, and in turn this influences the cost of capital.of return, and in turn this influences the cost of capital.

HIGHER LEVERAGE = HIGHER COST OF CAPITALHIGHER LEVERAGE = HIGHER COST OF CAPITAL

Business RiskBusiness Risk

•• All firms experience variability in sales and operating (fixed All firms experience variability in sales and operating (fixed and variable) operating costs over time.and variable) operating costs over time.–– Some firms operate in a highly volatile industry (for example oil Some firms operate in a highly volatile industry (for example oil

and gas) and we would say the firm has a high degree of and gas) and we would say the firm has a high degree of business risk.business risk.


21 - 1301

business risk.business risk.–– Other firms operate in a very stable industry where revenues and Other firms operate in a very stable industry where revenues and

expenses don’t change much from year to year throughout the expenses don’t change much from year to year throughout the business cycle; these firms have low business risk.business cycle; these firms have low business risk.

•• Business risk is the variability of a firm’s operating income Business risk is the variability of a firm’s operating income caused by operational risk.caused by operational risk.–– Business risk is measured by the standard deviation of EBIT.Business risk is measured by the standard deviation of EBIT.

Financial LeverageFinancial LeverageRisk and LeverageRisk and Leverage

•• Lenders to the firm insulate themselves from risk through Lenders to the firm insulate themselves from risk through financial contracting:financial contracting:

•• Lending money through a formal, legallyLending money through a formal, legally--binding contract.binding contract.•• Demanding a fixed rate of return on the money they lend to the Demanding a fixed rate of return on the money they lend to the

firm, infirm, in--keeping with their required return on monies borrowed.keeping with their required return on monies borrowed.


21 - 1302

firm, infirm, in--keeping with their required return on monies borrowed.keeping with their required return on monies borrowed.•• Demanding other promises that will protect the lender’s interests Demanding other promises that will protect the lender’s interests

over the life of the loan/investment.over the life of the loan/investment.•• Demanding a high priority in the priority of claims list in the event Demanding a high priority in the priority of claims list in the event

of corporate dissolution/bankruptcy.of corporate dissolution/bankruptcy.

•• Shareholders bear the risk associated with business risk, Shareholders bear the risk associated with business risk, and the added risks associated with the use of leverage and the added risks associated with the use of leverage because they are residual claimants of the firm.because they are residual claimants of the firm.

Return on Investment (ROI)Return on Investment (ROI)Financial LeverageFinancial Leverage

Return on Investment (ROI)Return on Investment (ROI)–– is the return on all the capital provided by investors; EBIT is the return on all the capital provided by investors; EBIT

minus taxes divided by invested capital.minus taxes divided by invested capital.–– Invested Capital (IC) is a firm’s capital structure consisting of Invested Capital (IC) is a firm’s capital structure consisting of

shareholders’ equity and shortshareholders’ equity and short-- and longand long--term debt.term debt.


21 - 1303

)1(

BSE

TEBITROI

+−=[ 21-2]

But we know the claims on the numerator

(operating income after taxes) are very

different, and so too are the risks each provider of capital is exposed.

Return on Equity (ROE)Return on Equity (ROE)Financial LeverageFinancial Leverage

ROE ROE –– is the return earned by equity holders on is the return earned by equity holders on their investment in the companytheir investment in the company–– ROE = net income divided by shareholders’ equity.ROE = net income divided by shareholders’ equity.


21 - 1304

)1)((

SE

TBREBITROE D −−=[ 21-1]

ROI versus ROEROI versus ROEFinancial LeverageFinancial Leverage

•• If the firm is completely financed by equity: If the firm is completely financed by equity: ROE = ROI.ROE = ROI.

•• Let us examine the effects of sales volatility on Let us examine the effects of sales volatility on ROI and ROE given different levels of financial ROI and ROE given different levels of financial


21 - 1305

ROI and ROE given different levels of financial ROI and ROE given different levels of financial leverage.leverage.


•• Using this base income statement:Using this base income statement:

Sales $1,000Variable costs 300

Table 21-1 Example Income Statement


21 - 1306

•• The following three slides show three different financing strategies and the The following three slides show three different financing strategies and the impacts on ROE, ROI, EPS for breakimpacts on ROE, ROI, EPS for break--even, normal, and high sales levels:even, normal, and high sales levels:

Variable costs 300Fixed costs 158EBIT $542Interest 42Taxable Income $500Tax (40%) 200Net Income $300

Financial LeverageFinancial LeverageIncome Statement Income Statement –– No Financial LeverageNo Financial Leverage

-77.5% 100.0% 140.0%

Sales $225 $1,000 $1,400Variable costs 68 300 420Fixed costs 158 158 158EBIT -$1 $542 $822



21 - 1307

Interest 0 0 0Taxable Income -$1 $542 $822Tax (40%) 0 217 329Net Income -$0 $325 $493

Invested capital = $1,700 100.0%Debtholders' investment = $0 0.0%Shareholders' Equity = $1,700 100.0%

ROI = 0.0% 19.1% 29.0%ROE = 0.0% 19.1% 29.0%EPS (1,700 shares) = $0.00 $0.19 $0.29

This assumes a 0.0 debt/equity ratio

ROE = ROI because no use of debt financing.

Financial LeverageFinancial LeverageIncome Statement Income Statement –– Base CaseBase Case

-71.5% 100.0% 140.0%

Sales $285 $1,000 $1,400Variable costs 86 300 420Fixed costs 158 158 158EBIT $42 $542 $822



21 - 1308

Interest 42 42 42Taxable Income -$0 $500 $780Tax (40%) 0 200 312Net Income -$0 $300 $468

Invested capital = $1,700 100.0%Debtholders' investment = $700 41.2%Shareholders' Equity = $1,000 58.8%

ROI = 1.5% 19.1% 29.0%ROE = -0.1% 42.9% 66.9%EPS (1000 shares) = $0.00 $0.30 $0.47

This assumes a 0.70 debt/equity ratio

ROE is levered compared to ROI because of the moderate

use of debt financing.

Financial LeverageFinancial LeverageIncome Statement with High Financial LeverageIncome Statement with High Financial Leverage

-65.4% 100.0% 140.0%

Sales $346 $1,000 $1,400Variable costs 104 300 420Fixed costs 158 158 158EBIT $84 $542 $822



21 - 1309

Interest 84 $84 $84Taxable Income $0 $458 $738Tax (40%) 0.08 183.2 295.2Net Income $0 $275 $443

Invested capital = $1,700 100.0%Debtholders' investment = $1,400 82.4%Shareholders' Equity = $300 17.6%

ROI = 3.0% 19.1% 29.0%ROE = 0.0% 91.6% 147.6%EPS (300 shares) = $0.00 $0.92 $1.48

ROE is more volatile than ROI because of the high use

of financial leverage.


•• Consider the equation for ROE:Consider the equation for ROE:

)1)(( TBREBIT −−

EBIT – Interest expense = EBTEBT times (1 – T) = Net Income


21 - 1310

)1)((

SE

TBREBITROE D −−=[ 21-1]

The equation reduce to net income divided by BV of shareholders’ equity.


•• Equation 21 Equation 21 –– 2 is the definition of ROI:2 is the definition of ROI:

)1( TEBIT

ROI−=[ 21-2]


21 - 1311

•• If we reIf we re--express EBIT (1express EBIT (1--T) in the ROE equation, T) in the ROE equation, we get:we get:

BSE

ROI+

=[ 21-2]


•• This is the financial leverage equation:This is the financial leverage equation:

)1((B

TRROIROIROE D −−+=[ 21-3]


21 - 1312

•• ROI measures the return that the firm earns from ROI measures the return that the firm earns from operations, but DOES NOT explicitly considered operations, but DOES NOT explicitly considered how the firm is financed.how the firm is financed.

)1((SE

TRROIROIROE D −−+=[ 21-3]


•• If we rearrange Equation 21 If we rearrange Equation 21 –– 3, grouping like terms involving 3, grouping like terms involving ROI we get:ROI we get:

)1()1(SE

BTR

SE

BROIROE D −−++=[ 21-4]


21 - 1313

•• The second term is fixed.The second term is fixed.•• The first term depends on the firm’s uncertain ROI.The first term depends on the firm’s uncertain ROI.•• This means we can graph ROE against ROI as a straight line.This means we can graph ROE against ROI as a straight line.

See Figure 21 See Figure 21 --1 on the following slide.1 on the following slide.

SESE


21 - 1 FIGURE

ROE

80

60All Equity

D/E =0.70Slope of the

all equity line is = 1.0.

In this case

D/E = 0.70.

Slope of the line > 1.0.


21 - 1314

40

20

ROI

-20

-40

-60

All Equity

-16 -12 -8 -4 0 4 8 12 16 20 24 28 32 36 40

In this case ROI = ROE.Above the intercept with the

horizontal axis, ROE

>ROI.

Financial Break-even points where ROE = 0Indifference point where

ROEs for different financing strategies are equal.


Financial BreakFinancial Break--even point:even point:–– Points at which a firm’s ROE is zero.Points at which a firm’s ROE is zero.

Indifference Point:Indifference Point:


21 - 1315

Indifference Point:Indifference Point:–– Points at which two financing strategies provide the Points at which two financing strategies provide the

same ROE. same ROE.

Financial LeverageFinancial LeverageThe Rules of Financial LeverageThe Rules of Financial Leverage

•• For valueFor value--maximizing firms, the use of debt increases maximizing firms, the use of debt increases the expected ROE so shareholders expect to be better the expected ROE so shareholders expect to be better off by using debt financing, rather than equity financing.off by using debt financing, rather than equity financing.

•• Financing with debt increases the variability of the firm’s Financing with debt increases the variability of the firm’s ROE, which usually increases the risk to the common ROE, which usually increases the risk to the common


21 - 1316

ROE, which usually increases the risk to the common ROE, which usually increases the risk to the common shareholders.shareholders.

•• Financing with debt increases the likelihood of the firm Financing with debt increases the likelihood of the firm running into financial distress and possibly even running into financial distress and possibly even bankruptcy.bankruptcy.


70% D/E Ratio 100% EquityROI (%)

Table 21-2 Varying ROI Values

ROE (%)


21 - 1317

ROI (%)10 14.48 1030 48.48 30

Range 34 20

ROE (%)

ROI reflects the business risk of the firm.

ROE =ROI in the all equity firm.

ROE increases as the firm finances with more debt.


70% D/E Ratio 100% EquityROI (%)

Table 21-3 Wider Variation ROI Values

ROE (%)


21 - 1318

ROI (%)-10 -19.52 -1040 65.48 40

Range 85 50

ROE (%)

Wider variation in ROI means magnified ROE over a s till wider range than ROI.

Financial Leverage Financial Leverage Investing Using LeverageInvesting Using Leverage

•• Figure 21Figure 21--2 illustrates the monthly returns from 2 illustrates the monthly returns from investing in the S&P/TSX Composite Index investing in the S&P/TSX Composite Index using two different financing strategies:using two different financing strategies:

1.1. Investing in the index (all equity)Investing in the index (all equity)2.2. Investing in the index with 80% borrowed on margin.Investing in the index with 80% borrowed on margin.


21 - 1319

2.2. Investing in the index with 80% borrowed on margin.Investing in the index with 80% borrowed on margin.

•• The added volatility of gains and losses over The added volatility of gains and losses over time is clearly evident.time is clearly evident.

•• These principles of leverage apply to These principles of leverage apply to corporations as well as householdscorporations as well as households


Financial Leverage Financial Leverage Investing Using LeverageInvesting Using Leverage

21 - 2 FIGURE


21 - 1320

Financial LeverageFinancial LeverageIndifference AnalysisIndifference Analysis

•• Is a profit planning technique used to forecast Is a profit planning technique used to forecast the EPSthe EPS--EBIT relationships under different EBIT relationships under different financing scenarios.financing scenarios.

•• The indifference point is where:The indifference point is where:


21 - 1321

•• The indifference point is where:The indifference point is where:

EPSEPS(Financing strategy 1)(Financing strategy 1)=EPS=EPS(Financing strategy 2)(Financing strategy 2)

Financial Leverage Financial Leverage Indifference AnalysisIndifference Analysis

•• The formula for EPS, given EBIT, interest on debt (RThe formula for EPS, given EBIT, interest on debt (RDDB), the corporate tax B), the corporate tax rate (T), and the number of common shares outstanding (#):rate (T), and the number of common shares outstanding (#):

)1)(( TBREBIT −−


21 - 1322

•• We can rearrange the definition of EPS and show how it varies with EBIT:We can rearrange the definition of EPS and show how it varies with EBIT:

#

)1)(( TBREBITEPS D −−=[ 21-5]

Financial Leverage Financial Leverage Indifference AnalysisIndifference Analysis

•• EPS is a simple linear function of EBIT:EPS is a simple linear function of EBIT:

)1()1( TEBITTBR

EPS D −+−−=[ 21-6]


21 - 1323

•• This is illustrated in the EPSThis is illustrated in the EPS--EBIT graph in EBIT graph in Figure 21 Figure 21 –– 3 found on the following slide:3 found on the following slide:

##

EPS D +=[ 21-6]

Financial Leverage Financial Leverage EPSEPS--EBIT (Profit Planning) ChartsEBIT (Profit Planning) Charts

21 - 3 FIGURE

0.8

0.6

0.4

Indifference point.


21 - 1324

0.4

0.2

0

-0.2

-0.4

-0.6 EPS 0% D/E EPS 70% D/E

-567-397-312-227 -142 57 28 113 198 283 368 453 538 623 708 793 878 963 1048 1133

The horizontal intercept of the 70% D/E line is greater by the added interest expense that must be

covered before producing earnings available for common shareholders.

Financial Leverage Financial Leverage EPSEPS--EBIT (Profit Planning) ChartsEBIT (Profit Planning) Charts

•• The slope of the lines are a function of the The slope of the lines are a function of the number of common shares outstanding (dilution number of common shares outstanding (dilution of EPS).of EPS).–– The all equity line will have a lower slope because The all equity line will have a lower slope because

every dollar of net income is divided by more common every dollar of net income is divided by more common


21 - 1325

every dollar of net income is divided by more common every dollar of net income is divided by more common shares.shares.

•• The horizontal intercept is greater for the debt The horizontal intercept is greater for the debt financing line because the firm must cover its financing line because the firm must cover its interest expense before earnings begin to interest expense before earnings begin to accrue to the benefit of shareholders.accrue to the benefit of shareholders.

Determining Capital StructureDetermining Capital Structure

•• Table 21 Table 21 –– 4 demonstrates the 1990 results of a 4 demonstrates the 1990 results of a Conference Board survey of 119 U.S. Conference Board survey of 119 U.S. companies to determine their capital structure.companies to determine their capital structure.

•• External sources of information include:External sources of information include:


21 - 1326

•• External sources of information include:External sources of information include:–– (#2) checking with their advisors, and(#2) checking with their advisors, and–– (#5) examining other firms in the industry.(#5) examining other firms in the industry.

•• The three primary sources of information are:The three primary sources of information are:–– (#4) impact on profits(#4) impact on profits–– (#3) risk(#3) risk–– (#1) analysis of cash flows(#1) analysis of cash flows


1. Analysis of cash flows 23.0%2. Consultations 18.3%3. Risk considerations 16.5%

Table 21-4 Determinants of Capital Structure


21 - 1327

3. Risk considerations 16.5%4. Impact on profits 14.0%5. Industry comparisons 12.0%6. Other 3.4%Source: Data f rom Conference Board, 1990

Primary sources include:• Analysis of cash flows

• Risk consideration• Impact on profits

Determining Capital StructureDetermining Capital StructureUseful RatiosUseful Ratios

•• Stock ratios (balance sheet ratios) that are Stock ratios (balance sheet ratios) that are helpful include:helpful include:–– Total debt to total assetsTotal debt to total assets–– Debt to equity ratioDebt to equity ratio


21 - 1328

•• Flow ratios make use of information taken from Flow ratios make use of information taken from the income statement and when combined with the income statement and when combined with balance sheet data help to determine the ability balance sheet data help to determine the ability of the firm to service its debt.of the firm to service its debt.


•• Fixed Burden Coverage Ratio:Fixed Burden Coverage Ratio:

EBITDA

CoverageBurdenFixed−++

=[ 21-7]


21 - 1329

–– An expanded interest coverage ratio that looks at a An expanded interest coverage ratio that looks at a broader measure of both income and the broader measure of both income and the expenditures associated with debt.expenditures associated with debt.

)1/()Pref.Div.( TSFI

CoverageBurdenFixed−++

=[ 21-7]


•• CashCash--flowflow--toto--debt ratio (CFTD)debt ratio (CFTD)

EBITDA

CFTD =[ 21-8]


21 - 1330

–– A direct measure of the cash flow over a period that is A direct measure of the cash flow over a period that is available to cover a firm’s stock of outstanding debt.available to cover a firm’s stock of outstanding debt.

Debt

CFTD =[ 21-8]


IG Non-IG

Coverage 4.01 1.45Leverage (%) 46.2 67.4Cash flow-to-debt (%) 18.3 8.10

Table 21-5 Moody's Average Credit RatiosInvestment grade (IG) companies

have at least a BBB bond rating.


21 - 1331

Cash flow-to-debt (%) 18.3 8.10Liquidity (%) 3.66 4.45Profit margin (%) 6.26 1.39Return on assets (%) 8.41 6.92Sales stability 7.14 5.60Total assets ($ billion) 6.31 1.19Altman Z score 2.17 1.62

Source: Data from M oody's Investo r Services, "The Distribution o f Common Financial Ratios by Rating and

Industry fo r North A merican Non-Financial Corpo rations," December 2004.

Altman Z score is a weighted average of

several key ratios and is a useful predictor of a

firm’s probability of bankruptcy.

Determining Capital StructureDetermining Capital StructureAltman Z ScoreAltman Z Score

•• Altman’s prediction of bankruptcy equation:Altman’s prediction of bankruptcy equation:

999060334121 54321 X.X.X.X.X.Z ++++=[ 21-9]


21 - 1332

•• Where:Where:XX11 = working capital divided by total assets= working capital divided by total assetsXX22 = retained earnings divided by total assets= retained earnings divided by total assetsXX33 = EBIT divided by total assets= EBIT divided by total assetsXX44 = market values of total equity divided by non= market values of total equity divided by non--equity book liabilitiesequity book liabilitiesXX55 = sales divided by total assets= sales divided by total assets

The Modigliani and Miller Irrelevance The Modigliani and Miller Irrelevance TheoremTheorem

Capital Structure DecisionsCapital Structure Decisions

The Modigliani and Miller (M&M) The Modigliani and Miller (M&M) Irrelevance TheoremIrrelevance Theorem

M&M and Firm ValueM&M and Firm Value

•• The theorem that concludes (under some The theorem that concludes (under some simplifying assumptions) that the value of the simplifying assumptions) that the value of the firm should not be affected by the manner in firm should not be affected by the manner in which it is financed.which it is financed.


21 - 1334

which it is financed.which it is financed.–– How the firm is financed is irrelevant.How the firm is financed is irrelevant.

(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremAssumptionsAssumptions

Assumptions about the Real World:Assumptions about the Real World:•• Markets are perfect in the sense that there are no Markets are perfect in the sense that there are no

transactions costs or asymmetric information problemstransactions costs or asymmetric information problems•• No taxesNo taxes


21 - 1335

•• There is no risk of costly bankruptcy or associated financial There is no risk of costly bankruptcy or associated financial distressdistress

Modeling Assumptions:Modeling Assumptions:•• There exist two firms in the same “risk class” with different There exist two firms in the same “risk class” with different

levels of debtlevels of debt•• The earnings of both firms are perpetuitiesThe earnings of both firms are perpetuities

(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremArbitrage ArgumentArbitrage Argument

Arbitrage is a powerful economic force in capital Arbitrage is a powerful economic force in capital markets.markets.

Where two identical assets trade at different prices, Where two identical assets trade at different prices, market traders will spot the opportunity to earn market traders will spot the opportunity to earn riskless profits.riskless profits.


21 - 1336

riskless profits.riskless profits.•• Traders will sell the overvalued asset and buy the Traders will sell the overvalued asset and buy the

undervalued asset.undervalued asset.•• This activity will cause the price of the overvalued asset to This activity will cause the price of the overvalued asset to

fall, and the price of the undervalued asset to rise until the fall, and the price of the undervalued asset to rise until the two are priced the same.two are priced the same.

•• The traders will earn abnormal profits from these trades until The traders will earn abnormal profits from these trades until the prices of the two securities move into equilibrium.the prices of the two securities move into equilibrium.

Table 21 Table 21 –– 6 illustrates the two different positions and the equal payoffs6 illustrates the two different positions and the equal payoffs

(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremArbitrage ArgumentArbitrage Argument

Market participants who find levered investments Market participants who find levered investments trading for a greater value, can trading for a greater value, can undo the leverageundo the leverage and and earn abnormal profits.earn abnormal profits.

Arbitrage will force assets with equal payoffs to trade for Arbitrage will force assets with equal payoffs to trade for


21 - 1337

Arbitrage will force assets with equal payoffs to trade for Arbitrage will force assets with equal payoffs to trade for the same price.the same price.

Table 21 Table 21 –– 6 illustrates the two different positions and the equal payoffs6 illustrates the two different positions and the equal payoffs

(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremM&M and Firm ValueM&M and Firm Value

Portfolios (Actions) Cost Payoff

Portfolio A: αVU α EBIT

Buy α of unlevered firm

Table 21-6 M&M Arbitrage Table I

Net payoffs


21 - 1338

Portfolio B:

Buy α of levered firm's equity αSL α(EBIT αKD D )

Buy α of levered firm's debt αD αKD D

Total portfolio α(SL + D) α EBIT

Net payoffs are equal

Portfolio A and B must be priced equally despite th eir different financial structures because the payoffs are equal.

(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremM&M and Firm ValueM&M and Firm Value

Where payoffs are identical for two different asset s, both should be priced the same.

LLU VDSV =+=[ 21-10]


21 - 1339

The value of the levered firm (VL) is equal to the value of its debt plus the value of its equity (SL + D) and this must equal the value of the unlevered firm (VU).

Debt cannot destroy value.

LLU VDSV =+=[ 21-10]

(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremPersonal Leverage and Corporate LeveragePersonal Leverage and Corporate Leverage


Portfolio C: αSL α(EBIT - KD D )


Table 21-7 M&M Arbitrage Table II


21 - 1340


Portfolio D:

Buy α of levered firm 's equity αVU α EBIT

Buy α of levered firm 's debt αD - αKD D

Total portfolio α(VU - D) α(EBIT - KD D )

(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremHomemade LeverageHomemade Leverage

•• Homemade leverage is the creation of the same Homemade leverage is the creation of the same effect of a firm’s financial leverage through the effect of a firm’s financial leverage through the use of personal leverage.use of personal leverage.

•• This means that individuals can:This means that individuals can:


21 - 1341

•• This means that individuals can:This means that individuals can:–– Buy an unlevered firm, and through the use of Buy an unlevered firm, and through the use of

personal debt, replicate corporate leverage, orpersonal debt, replicate corporate leverage, or–– Buy a levered firm, and undo its effects.Buy a levered firm, and undo its effects.

(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremM&M and The Cost of CapitalM&M and The Cost of Capital

•• M&M made a modeling assumption (to simplify the calculations and M&M made a modeling assumption (to simplify the calculations and focus analysis on the leverage issue) that the firm’s earnings focus analysis on the leverage issue) that the firm’s earnings represent a represent a perpetuityperpetuity::


21 - 1342

K

D)(EBIT-KS

e

DL =[ 21-11]


•• The cost of equity capital is simply the earnings yield and is The cost of equity capital is simply the earnings yield and is estimated as follows:estimated as follows:


21 - 1343

S

D)(EBIT-KK

L

De =[ 21-12]


•• Since the value of the firm is unchanged by leverage, we can define Since the value of the firm is unchanged by leverage, we can define the unlevered value (the unlevered value (VVUU) by discounting the firm’s expected EBIT by ) by discounting the firm’s expected EBIT by it unlevered equity cost (it unlevered equity cost (KKUU):):


21 - 1344

VDSV

EBITV LL

UU =+==[ 21-13]

(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremM&M Equity Cost EquationM&M Equity Cost Equation

•• To determine who equity cost varies with the debtTo determine who equity cost varies with the debt--equity ratio, we equity ratio, we solve for EBIT, and substitute it for EBIT in the leveraged equity cost solve for EBIT, and substitute it for EBIT in the leveraged equity cost equation:equation:

/)( SDKKKK LDUue −+=[ 21-14]


21 - 1345

•• If the firm has no debt, the equity investor requires KIf the firm has no debt, the equity investor requires KUU (cost of (cost of unlevered equity).unlevered equity).

•• KKUU depends on depends on business riskbusiness risk of the firm.of the firm.•• As the firm uses debt, the equity cost increases due to the As the firm uses debt, the equity cost increases due to the financial financial

leverage risk premiumleverage risk premium..

/)( SDKKKK LDUue −+=[ 21-14]


•• In a world without taxes, the WACC (KIn a world without taxes, the WACC (KUU) is simply the weighted ) is simply the weighted average of the cost of debt and the cost of equity:average of the cost of debt and the cost of equity:

D

KS

KK DEU +=[ 21-15]


21 - 1346

•• Figure 21 Figure 21 –– 4 illustrates M&M without corporate taxes (the 4 illustrates M&M without corporate taxes (the irrelevance model) where the cost of equity (irrelevance model) where the cost of equity (KKEE) rises in a prescribed ) rises in a prescribed manner to offset the lower cost of debt (manner to offset the lower cost of debt (KKDD) producing WACC that ) producing WACC that remains unchanged by the use of financial leverage.remains unchanged by the use of financial leverage.

V

KV

KK DEU +=[ 21-15]


20 - 4 FIGURE

Equity Cost KE%


21 - 1347

Debt-Equity Ratio

Debt Cost KD

WACC


•• If WACC remains the same regardless of the financial If WACC remains the same regardless of the financial strategy used by the firm:strategy used by the firm:–– VVLL = V= VUU

–– Financial strategy is irrelevantFinancial strategy is irrelevant


21 - 1348

•• As the use of debt financing is increased, the cost of equity As the use of debt financing is increased, the cost of equity will rise…so even if EPS is increased through the use of debt will rise…so even if EPS is increased through the use of debt financing, that benefit is offset by a higher discount rate.financing, that benefit is offset by a higher discount rate.

•• From a shareholder wealth perspective, under the M&M From a shareholder wealth perspective, under the M&M assumptions, financing strategy is irrelevant.assumptions, financing strategy is irrelevant.

The Impact of TaxesThe Impact of TaxesIntroducing Corporate TaxesIntroducing Corporate Taxes

•• The value of firms drop in the presence of corporate taxes.The value of firms drop in the presence of corporate taxes.•• The higher the tax rate, the lower the value of the firm.The higher the tax rate, the lower the value of the firm.


21 - 1349

)1(

K

TEBITV

UU

−=[ 21-16]

The Impact of TaxesThe Impact of TaxesCorporate Tax Effect on Levered EquityCorporate Tax Effect on Levered Equity


Portfolio E: αSL α(EBIT - KD D )(1-T)


Table 21-8 M&M with Taxes


21 - 1350


Portfolio D:

Buy α of levered firm's equity αVU α EBIT(1-T)

Buy α of levered firm's debt αD(1-T) - αKD D

Total portfolio α(VU - D)(1-T) α(EBIT - KD D )(1-T)


•• To avoid arbitrage the value of the firm must equal: To avoid arbitrage the value of the firm must equal: VVUU –– D(1D(1--t) = St) = SLL

VVLL = S= SLL + D, therefore:+ D, therefore:

Corporate Debt


21 - 1351

The value of the firm with leverage is the value without leverage plus the The value of the firm with leverage is the value without leverage plus the corporate debt tax shield from debt financing.corporate debt tax shield from debt financing.

DT VV UL +=[ 21-17]

Tax Shield


•• The total claims of corporate taxes, debt holders, The total claims of corporate taxes, debt holders, and equity holders are borne by the preand equity holders are borne by the pre--tax cash tax cash flow produced by the firm.flow produced by the firm.

•• If the firm uses more debt, and interest on that If the firm uses more debt, and interest on that


21 - 1352

•• If the firm uses more debt, and interest on that If the firm uses more debt, and interest on that debt is taxdebt is tax--deductible, this produces a greater deductible, this produces a greater tax shield, reducing the government share of the tax shield, reducing the government share of the value of the private enterprise, the WACC must value of the private enterprise, the WACC must go down.go down.–– Here we assume a zeroHere we assume a zero--sum game (that value is not sum game (that value is not

destroyed through the use of financial leverage)destroyed through the use of financial leverage)

The Impact of TaxesThe Impact of TaxesFirm Value with Corporate TaxesFirm Value with Corporate Taxes

EquityDebt

21 - 5 FIGURE


21 - 1353

Taxes


•• The tax The tax ––corrected value of Equation 21corrected value of Equation 21--14 is:14 is:

/)1)(( SDTKKKK LDUUe −−+=[ 21-18]


21 - 1354

•• Both the interest cost and the financial leverage riskBoth the interest cost and the financial leverage risk--premium on the equity premium on the equity cost are reduced by (1cost are reduced by (1-- T)T)

•• As the use of debt increases, WACC decreases, and therefore the value of As the use of debt increases, WACC decreases, and therefore the value of the firm in a world with corporate taxes should increase the firm in a world with corporate taxes should increase


The Impact of TaxesThe Impact of TaxesM&M with Corporate TaxesM&M with Corporate Taxes

21 - 6 FIGURE

Equity Cost KE%


21 - 1355

Debt-Equity Ratio

Debt Cost KD(1-T)

WACC

The Impact of TaxesThe Impact of TaxesWACC with Corporate TaxesWACC with Corporate Taxes

•• WACC declines continuously with the use of debt financing.WACC declines continuously with the use of debt financing.•• WACC equation corrected for the taxWACC equation corrected for the tax--deductibility of interest deductibility of interest

expense is:expense is:


21 - 1356

)1( TKV

DK

V

SWACC De −+=[ 21-19]

The Impact of TaxesThe Impact of TaxesTaxTax--Extended M&M Equity Cost EquationExtended M&M Equity Cost Equation

•• The ‘beta’ version of Equation 21 The ‘beta’ version of Equation 21 –– 18 allows us to adjust for the systematic 18 allows us to adjust for the systematic risk of the firm:risk of the firm:

)/)1(1( SDTMRPRFK LUe −−×+= β[ 21-20]


21 - 1357

•• Equity cost without any debt is the riskEquity cost without any debt is the risk--free rate plus the market risk free rate plus the market risk premium (MRP) times the unlevered beta coefficient.premium (MRP) times the unlevered beta coefficient.

•• This equation allows us to unlever betas to get the unlevered equity cost.This equation allows us to unlever betas to get the unlevered equity cost.•• There is one important flaw in this equation There is one important flaw in this equation –– it is assumed that 100% debt it is assumed that 100% debt

financing is optimal.financing is optimal.•• To address that issue, we must relax M&M’s assumptions regarding risk of To address that issue, we must relax M&M’s assumptions regarding risk of

financial distress or bankruptcy.financial distress or bankruptcy.

BankruptcyBankruptcyIntroductionIntroduction

•• Bankruptcy is a state of insolvency that occurs Bankruptcy is a state of insolvency that occurs when a firm commits an act of bankruptcy, such when a firm commits an act of bankruptcy, such as nonas non--payment of interest, and creditors payment of interest, and creditors enforce their legal rights to recoup money, or enforce their legal rights to recoup money, or


21 - 1358

enforce their legal rights to recoup money, or enforce their legal rights to recoup money, or when a firm voluntarily declares bankruptcy in when a firm voluntarily declares bankruptcy in an effort to be protected while reorganizing to an effort to be protected while reorganizing to become solvent again.become solvent again.

ReorganizationReorganization

•• Firms can be reorganized under:Firms can be reorganized under:–– Companies Creditors Arrangements Act (CCAA)Companies Creditors Arrangements Act (CCAA)

•• Used by larger more complex firms with debt > $5mUsed by larger more complex firms with debt > $5m•• Flexible Flexible –– allowing the firm to pursue agreements with allowing the firm to pursue agreements with

creditors/employees, to raise new financingcreditors/employees, to raise new financing


21 - 1359

creditors/employees, to raise new financingcreditors/employees, to raise new financing•• Trustee is appointed by the court and there is a stayTrustee is appointed by the court and there is a stay--ofof--

proceedingsproceedings

–– Bankruptcy Insolvency Act (BIA)Bankruptcy Insolvency Act (BIA)•• Limited scope to prevent creditors from seizing assetsLimited scope to prevent creditors from seizing assets•• No DIP financingNo DIP financing•• No provision to impose a settlement on all creditorsNo provision to impose a settlement on all creditors

Costs of BankruptcyCosts of BankruptcyDirect CostsDirect Costs

Direct Costs:Direct Costs:–– Costs incurred as a direct result of bankruptcy Costs incurred as a direct result of bankruptcy

including:including:•• Liquidation of assetsLiquidation of assets


21 - 1360

•• Liquidation of assetsLiquidation of assets•• Loss of tax losses (potential tax shield benefits)Loss of tax losses (potential tax shield benefits)•• Legal and accounting costsLegal and accounting costs

Costs of BankruptcyCosts of BankruptcyIndirect CostsIndirect Costs

Indirect Costs:Indirect Costs:–– Financial distress costs are losses to a firm prior to declaration of Financial distress costs are losses to a firm prior to declaration of

bankruptcy including:bankruptcy including:•• Agency costsAgency costs•• Increasing costs of doing business:Increasing costs of doing business:

–– Creditors tightening trade credit termsCreditors tightening trade credit terms–– Lending increasing risk premiums and increasing monitoring Lending increasing risk premiums and increasing monitoring


21 - 1361

–– Lending increasing risk premiums and increasing monitoring Lending increasing risk premiums and increasing monitoring surveillancesurveillance

–– loss of key staff and increases in recruitment and retention costsloss of key staff and increases in recruitment and retention costs–– Distracted management focused on financing and not on management Distracted management focused on financing and not on management

of business operations.of business operations.•• Reduced sales revenue:Reduced sales revenue:

–– Management is distracted by financial issuesManagement is distracted by financial issues–– Customers may become wary and look for other suppliersCustomers may become wary and look for other suppliers

(Figure 21 (Figure 21 –– 8 illustrates the rising value of distress costs with increasing debt)8 illustrates the rising value of distress costs with increasing debt)

Static TradeoffStatic TradeoffFirm Value and Financial Distress CostsFirm Value and Financial Distress Costs

21 - 8 FIGURE

VU + DT

Value


21 - 1362

Distress Costs

Debt Ratio

Costs of BankruptcyCosts of BankruptcyAgency CostsAgency Costs

Agency Costs:Agency Costs:–– It is possible for shareholders (and Board of Directors) to act in their It is possible for shareholders (and Board of Directors) to act in their

own best interests at the expense of debt holders.own best interests at the expense of debt holders.–– When under financial stress sometimes:When under financial stress sometimes:

•• Preferential treatment of creditors.Preferential treatment of creditors.•• Assets may be dissipated to related but solvent companies.Assets may be dissipated to related but solvent companies.•• Moral hazard (where management may take extraordinary risks that will be Moral hazard (where management may take extraordinary risks that will be


21 - 1363

•• Moral hazard (where management may take extraordinary risks that will be Moral hazard (where management may take extraordinary risks that will be ultimately borne by the debt holders, not the equity holders) (asymmetric ultimately borne by the debt holders, not the equity holders) (asymmetric payoff of an option)payoff of an option)

–– Being aware of these risks, lenders take action to protect their interests Being aware of these risks, lenders take action to protect their interests including:including:

•• Moratorium on further debt.Moratorium on further debt.•• Increases in rates on adjustableIncreases in rates on adjustable--rate debt.rate debt.•• Demands for additional surveillance of financial performance.Demands for additional surveillance of financial performance.•• Take the firm to court to enforce rights.Take the firm to court to enforce rights.

(Figure 21 (Figure 21 –– 7 illustrates the shareholder’s one year call option value on the underlying firm)7 illustrates the shareholder’s one year call option value on the underlying firm)

Financial Distress, Bankruptcy, and Financial Distress, Bankruptcy, and Agency CostsAgency Costs

The Firm Value as a Call Option for ShareholdersThe Firm Value as a Call Option for Shareholders

21 - 7 FIGURE

No limited liability

Equity Payoff


21 - 1364

Underlying Firm Value

$50 million debt0

Costs of BankruptcyCosts of BankruptcySummarySummary

Costs of Bankruptcy are very high.Costs of Bankruptcy are very high.Probability of Bankruptcy and Financial Distress Probability of Bankruptcy and Financial Distress

costs rise exponentially as the use of debt costs rise exponentially as the use of debt


21 - 1365

costs rise exponentially as the use of debt costs rise exponentially as the use of debt increases.increases.

These costs rob value from both shareholders and These costs rob value from both shareholders and potentially debt holders.potentially debt holders.

Costs of BankruptcyCosts of BankruptcyStatic Tradeoff ModelStatic Tradeoff Model

Figure 21 Figure 21 –– 9 illustrates the impact of bankruptcy and financial 9 illustrates the impact of bankruptcy and financial distress costs on M&M with corporate taxes.distress costs on M&M with corporate taxes.–– Cost of equity rises throughout as more debt is added.Cost of equity rises throughout as more debt is added.–– The cost of debt rises at higher levels of debt.The cost of debt rises at higher levels of debt.


21 - 1366

–– The cost of debt rises at higher levels of debt.The cost of debt rises at higher levels of debt.–– WACC falls initially because the benefits of the taxWACC falls initially because the benefits of the tax--deductibility deductibility

of interest expense outof interest expense out--weigh the marginal increases in weigh the marginal increases in component costs, however, at higher levels of debt, the taxcomponent costs, however, at higher levels of debt, the tax--advantage of debt is offset and the value of the firm falls when advantage of debt is offset and the value of the firm falls when WACC starts to rise. WACC starts to rise.

Static Tradeoff ModelStatic Tradeoff Model21 - 9 FIGURE

WACC

Ke

Cost (%)

KD


21 - 1367

D/E*

Debt-to-equity

Firm Value

Other Factors Affecting Capital StructureOther Factors Affecting Capital StructurePecking OrderPecking Order

•• Static Trade off model ignores two issues:Static Trade off model ignores two issues:1.1. Information asymmetry problemsInformation asymmetry problems2.2. Agency problemsAgency problems

•• These factors are likely responsible for what These factors are likely responsible for what


21 - 1368

•• These factors are likely responsible for what These factors are likely responsible for what Myers and Donaldson call the Myers and Donaldson call the pecking orderpecking order..

•• The pecking order is the order in which firms The pecking order is the order in which firms prefer to raise financing prefer to raise financing

1.1. starting with internal cash flow, starting with internal cash flow, 2.2. debt and debt and 3.3. finally issuing common equity.finally issuing common equity.

Capital Structure in PracticeCapital Structure in Practice

•• Factors favouring corporate ability and Factors favouring corporate ability and willingness to issue debt:willingness to issue debt:–– Profitability (so the firm can use the tax shield benefit Profitability (so the firm can use the tax shield benefit

of interestof interest--deductibility).deductibility).–– Unencumbered tangible assets to be used as Unencumbered tangible assets to be used as


21 - 1369

–– Unencumbered tangible assets to be used as Unencumbered tangible assets to be used as collateral for secured debt.collateral for secured debt.

–– Stable business operations over time.Stable business operations over time.–– Corporate size.Corporate size.–– Growth rate of the firm.Growth rate of the firm.–– Capital market conditionsCapital market conditions


In this chapter you have learned:In this chapter you have learned:–– The three effects of leverage: expected ROE tends to increase, The three effects of leverage: expected ROE tends to increase,

the variability of the ROE increases, and the risk of financial the variability of the ROE increases, and the risk of financial distress increases.distress increases.

–– The major determinants of the firm’s capital structure decision The major determinants of the firm’s capital structure decision are its impact on profits, risk and cash flows.are its impact on profits, risk and cash flows.

–– Impacts can be assessed by profit planning charts, financial Impacts can be assessed by profit planning charts, financial


21 - 1370

–– Impacts can be assessed by profit planning charts, financial Impacts can be assessed by profit planning charts, financial breakbreak--even analysis and use of standard ratioseven analysis and use of standard ratios

–– Debt creates value because interest on debt is taxDebt creates value because interest on debt is tax--deductibledeductible–– The tax incentive to use debt is offset by the resulting financial The tax incentive to use debt is offset by the resulting financial

distress and bankruptcy costsdistress and bankruptcy costs–– In a dynamic world, firms depart from the static tradeIn a dynamic world, firms depart from the static trade--off optimal off optimal

debt ratio over time, then refinance to bring it back in line with debt ratio over time, then refinance to bring it back in line with the target debt ratio.the target debt ratio.

–– Actual capital structures are constantly changing as firms take Actual capital structures are constantly changing as firms take advantage of market conditions.advantage of market conditions.

Appendix 1Appendix 1Thunder Bay IndustriesThunder Bay Industries

Exercise in Indifference AnalysisExercise in Indifference Analysis

Thunder Bay IndustriesThunder Bay IndustriesThe ProblemThe Problem

Thunder Bay Industries has experienced rapid growth in sales revenue over the past four years. The Thunder Bay Industries has experienced rapid growth in sales revenue over the past four years. The company is now operating at 100% of capacity and must expand in order to meet the demand for its new company is now operating at 100% of capacity and must expand in order to meet the demand for its new line of video games. line of video games.

The current financial statements for Thunder Bay Industries are as follows:The current financial statements for Thunder Bay Industries are as follows:

Thunder Bay IndustriesThunder Bay IndustriesBalance SheetBalance Sheet

as at December 31, 20xxas at December 31, 20xx


21 - 1372

as at December 31, 20xxas at December 31, 20xx($ '000s Cdn.)($ '000s Cdn.)

Assets:Assets: Liabilities and Owner's Equity:Liabilities and Owner's Equity:CashCash 1,0001,000 Accounts payableAccounts payable 550550Accounts receivableAccounts receivable 2,1002,100 AccrualsAccruals 249249InventoriesInventories 2,7662,766 Other current liabilitiesOther current liabilities 11Net Fixed AssetsNet Fixed Assets 16,24416,244 8% bonds maturing in 10 years8% bonds maturing in 10 years 5,0005,000

______________ Common stock (100,000 outstanding)Common stock (100,000 outstanding) 1,0001,000Retained earningsRetained earnings 15,31015,310

Total AssetsTotal Assets $22,110$22,110 Total Liabilities and Owner's EquityTotal Liabilities and Owner's Equity $22,110$22,110

The most recent income statement is found on the following slide:The most recent income statement is found on the following slide:


Thunder Bay IndustriesThunder Bay IndustriesIncome StatementIncome Statement

for the year ended December 31, 20xxfor the year ended December 31, 20xx($ '000s Cdn)($ '000s Cdn)

SalesSales $25,002$25,002Cost of Goods SoldCost of Goods Sold 18,25218,252Gross Margin on SalesGross Margin on Sales $ 6,750$ 6,750


21 - 1373

Gross Margin on SalesGross Margin on Sales $ 6,750$ 6,750Administrative and Selling ExpensesAdministrative and Selling Expenses 4,0004,000Earnings before Interest Expense and TaxesEarnings before Interest Expense and Taxes 2,7502,750Interest expenseInterest expense 400400Earnings before taxEarnings before tax $ 2,350$ 2,350TaxesTaxes 1,0111,011Net IncomeNet Income $1,339$1,339

If the firm does not expand, it sales growth will stall at the current $25m level or If the firm does not expand, it sales growth will stall at the current $25m level or less. If the company undertakes the planned expansion management has less. If the company undertakes the planned expansion management has identified a probability distribution for possible EBIT levels:identified a probability distribution for possible EBIT levels:


If the firm does not expand, it sales growth will stall at the current $25m level or less. If the If the firm does not expand, it sales growth will stall at the current $25m level or less. If the company undertakes the planned expansion management has identified a probability company undertakes the planned expansion management has identified a probability distribution for possible EBIT levels:distribution for possible EBIT levels:

Possible EBITPossible EBIT ProbabilityProbability$2,200$2,200 .1.1$2,700$2,700 .4.4$3,200$3,200 .4.4


21 - 1374

$3,200$3,200 .4.4$3.700$3.700 .1.1

The planned expansion will require Thunder Bay Industries to raise $10,000,000 in new The planned expansion will require Thunder Bay Industries to raise $10,000,000 in new capital. If raised in the form of bonds, the bonds would carry a 6.5% coupon rate. New capital. If raised in the form of bonds, the bonds would carry a 6.5% coupon rate. New common stock could be sold for $250.00 per share.common stock could be sold for $250.00 per share.

Find the EBIT/EPS indifference point. What is the probability that EBIT will be greater than Find the EBIT/EPS indifference point. What is the probability that EBIT will be greater than the indifference point? Which method of financing is most likely to maximize earnings per the indifference point? Which method of financing is most likely to maximize earnings per share? What method of financing do you recommend? Why? Discuss the limitations of share? What method of financing do you recommend? Why? Discuss the limitations of indifference analysis. Prepare a properly labeled diagram of the EBIT/EPS analysis.indifference analysis. Prepare a properly labeled diagram of the EBIT/EPS analysis.

Thunder Bay IndustriesThunder Bay IndustriesThe SolutionThe Solution

You can first determine the expected EBIT for next year and using that, determine the You can first determine the expected EBIT for next year and using that, determine the standard deviation of that EBIT. These calculations will be useful later when we try to standard deviation of that EBIT. These calculations will be useful later when we try to determine the probability that EBIT will be less than, or greater than the indifference determine the probability that EBIT will be less than, or greater than the indifference point.point.

Possible EBIT Probability W td EBIT$2,200,000 10.0% $220,000

www.bookfiesta4u.com ContentsCHAPTER 21 – Capital Structure Decisions 21 - 1375

2,700,000 40.0% 1,080,0003,200,000 40.0% 1,280,0003,700,000 10.0% 370,000

Expected EBIT = $2,950,000

110,403$

11.403

500,162

56250000,25000,2556250

)750(1.)250(4.)250(4.)750(1. 2222

===

+++=

++−+−=EBITσ

Thunder Bay IndustriesThunder Bay IndustriesThe Solution …The Solution …

Next set up equations for EPS for each alternative source of Next set up equations for EPS for each alternative source of financing, equate them, substitute in known values and solve financing, equate them, substitute in known values and solve for the common EBIT.for the common EBIT.

)1)((

21

1

+−−=

nn

TBREBITEPS D

common


000,675,2$

000,100

)43.1)(000,650000,400(

000,40000,100

)43.1)(000,400(

)1)(()1)((

)1)((

1

21

21

1

1

21

21

=

−−−=+

−−

−−−=+

−−=

−−−=

EBIT

EBITEBIT

n

TBRBREBIT

nn

TBREBIT

EPSEPS

n

TBRBREBITEPS

DDD

debtcommon

DDdebt


Our prediction for EPS at EBIT=$2,675,000 for the common share Our prediction for EPS at EBIT=$2,675,000 for the common share

financing alternative is:financing alternative is:

26.9$)43.1)(000,050,1$000,675,2($

26.9$000,140

)43.1)(000,400$000,675,2($

=−−=

=−−=ecommonshar

EPS

EPS


21 - 1377

26.9$000,100

)43.1)(000,050,1$000,675,2($ =−−=DebtEPS


The probability than EBIT will favour common stock financing (ie. be The probability than EBIT will favour common stock financing (ie. be less than the indifference point) is:less than the indifference point) is:

σµ−= X

z 110,403

000,950,2000,675,2 −=z


Where:Where:zz = the number of standard deviations away from the mean= the number of standard deviations away from the meanXX = the point of interest= the point of interestαα= the standard deviation of the probability distribution= the standard deviation of the probability distribution

µµ = the mean of the probability distribution= the mean of the probability distribution

σ=z

6822.0−=


The negative sign indicates that the point of interest (X) or (indifference point) The negative sign indicates that the point of interest (X) or (indifference point) lies on the leftlies on the left--hand side of the mean. It lies .6822 of 1 standard deviation away hand side of the mean. It lies .6822 of 1 standard deviation away from the mean.from the mean.

Going to the table for Values of the Standard Normal Distribution Function we Going to the table for Values of the Standard Normal Distribution Function we find the area under the curve between the point of interest and the mean of the find the area under the curve between the point of interest and the mean of the distribution to be:distribution to be:

6822.0

110,403

000,950,2000,675,2

−=

−=z


distribution to be:distribution to be:.2517 or 25.27%.2517 or 25.27%

Therefore, the probability that EBIT will exceed the indifference point (favouring Therefore, the probability that EBIT will exceed the indifference point (favouring debt financing) is 75.17% The probability that EBIT will be below the debt financing) is 75.17% The probability that EBIT will be below the indifference point (favouring equity financing is (1indifference point (favouring equity financing is (1-- .7517) 24.83%..7517) 24.83%.

(These normal distribution is plotted on the following chart.)(These normal distribution is plotted on the following chart.)


6822.0

110,403

000,950,2000,675,2

−=

−=z

Area = .2517

Area = .5


(These relationships are now plotted on the following indifference chart.)(These relationships are now plotted on the following indifference chart.)

µ=$2,950,000X=$2,675,000


Area = Area = .5

EPS

Equity Financing

DebtFinancing

$9.26


(This chart illustrates that debt financing is forecast to produce higher EPS than the equity (This chart illustrates that debt financing is forecast to produce higher EPS than the equity alternative.)alternative.)

µ=$2,950,000X=$2,675,000

Area = .2517

Area = .5

$400,000 $1,050,000

CHAPTER 22CHAPTER 22Dividend PolicyDividend PolicyDividend PolicyDividend Policy


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• Mechanics of Dividend PaymentsMechanics of Dividend Payments•• Cash Dividend PaymentsCash Dividend Payments•• M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance Theorem

www.bookfiesta4u.com ContentsCHAPTER 22 – Dividend Policy

22 - 1384

•• The “Bird in the Hand” ArgumentThe “Bird in the Hand” Argument•• Dividend Policy in PracticeDividend Policy in Practice•• Relaxing the M&M AssumptionsRelaxing the M&M Assumptions•• Stock Dividends and Stock SplitsStock Dividends and Stock Splits•• Share RepurchasesShare Repurchases•• Summary and ConclusionsSummary and Conclusions



You should understand the following:You should understand the following:•• The mechanics of dividend payments and why they are different The mechanics of dividend payments and why they are different

from interest paymentsfrom interest payments•• The difference between a stock split and a stock dividendThe difference between a stock split and a stock dividend•• Under what assumptions a dividend payment is irrelevant and what Under what assumptions a dividend payment is irrelevant and what


22 - 1385

a homemade dividend isa homemade dividend is•• Why dividend payments generally reflect the business risk of the Why dividend payments generally reflect the business risk of the

firmfirm•• How transactions costs, taxes and information problems give value How transactions costs, taxes and information problems give value

to corporate dividend policiesto corporate dividend policies•• How stock dividends and stock splits differHow stock dividends and stock splits differ•• How a share repurchase program can substitute for a dividend How a share repurchase program can substitute for a dividend

payout policy.payout policy.


•• Agency theoryAgency theory•• Bird in the hand argumentBird in the hand argument•• Cash cowCash cow•• Declaration dateDeclaration date•• Dividend reinvestment plansDividend reinvestment plans

•• Free cash flowFree cash flow•• Holder of recordHolder of record•• Homemade dividendsHomemade dividends•• Income strippingIncome stripping•• Odd lotsOdd lots•• Residual theory of dividendsResidual theory of dividends


22 - 1386

•• Dividend reinvestment plansDividend reinvestment plans•• Dividend yieldDividend yield•• Equity market capitalizationEquity market capitalization•• ExEx--dividend datedividend date

•• Residual theory of dividendsResidual theory of dividends•• Special dividendSpecial dividend•• Split sharesSplit shares•• Stock dividendStock dividend•• Stock splitStock split•• Tax clientelesTax clienteles

Dividend PolicyDividend PolicyWhat is It?What is It?

•• Dividend policyDividend policy refers to the explicit or implicit refers to the explicit or implicit decision of the Board of Directors regarding the decision of the Board of Directors regarding the amount of residual earnings (past or present) amount of residual earnings (past or present) that should be distributed to the shareholders of that should be distributed to the shareholders of


22 - 1387

that should be distributed to the shareholders of that should be distributed to the shareholders of the corporationthe corporation–– This decision is considered a This decision is considered a financing decisionfinancing decision

because the profits of the corporation are an because the profits of the corporation are an important source of financing available to the firmimportant source of financing available to the firm

Types of DividendsTypes of Dividends

•• Dividends are a permanent distribution of residual Dividends are a permanent distribution of residual earnings/property of the corporation to its ownersearnings/property of the corporation to its owners

•• Dividends can be in the form of:Dividends can be in the form of:–– CashCash


22 - 1388

–– CashCash–– Additional shares of stock (stock dividend)Additional shares of stock (stock dividend)–– PropertyProperty

•• If a firm is dissolved, at the end of the process, a final If a firm is dissolved, at the end of the process, a final dividend of any residual amount is made to the shareholders dividend of any residual amount is made to the shareholders –– this is known as a this is known as a liquidating dividendliquidating dividend..

–– In the absence of dividends, corporate earnings accrue to the In the absence of dividends, corporate earnings accrue to the benefit of shareholders as retained earnings and are benefit of shareholders as retained earnings and are automatically reinvested in the firmautomatically reinvested in the firm

–– When a cash dividend is declared, those funds leave the firm When a cash dividend is declared, those funds leave the firm permanently and irreversiblypermanently and irreversibly

–– Distribution of earnings as dividends may starve the company of Distribution of earnings as dividends may starve the company of

Dividends a Financing DecisionDividends a Financing Decision


22 - 1389

–– Distribution of earnings as dividends may starve the company of Distribution of earnings as dividends may starve the company of funds required for growth and expansion, and this may cause the funds required for growth and expansion, and this may cause the firm to seek additional external capitalfirm to seek additional external capital

Corporate Profits After TaxRetained Earnings

Dividends

Dividends versus Interest ObligationsDividends versus Interest Obligations

InterestInterest•• Interest is a payment to lenders for the use of their funds for a given Interest is a payment to lenders for the use of their funds for a given

period of time period of time •• Timely payment of the required amount of interest is a legal obligationTimely payment of the required amount of interest is a legal obligation•• Failure to pay interest (and fulfill other contractual commitments under Failure to pay interest (and fulfill other contractual commitments under

the bond indenture or loan contract) is an act of bankruptcy and the the bond indenture or loan contract) is an act of bankruptcy and the lender has recourse through the courts to seek remedieslender has recourse through the courts to seek remedies


22 - 1390

lender has recourse through the courts to seek remedieslender has recourse through the courts to seek remedies•• Secured lenders (bondholders) have the first claim on the firm’s assets Secured lenders (bondholders) have the first claim on the firm’s assets

in the case of dissolution or in the case of bankruptcyin the case of dissolution or in the case of bankruptcyDividendsDividends•• A dividend is a discretionary payment made to shareholdersA dividend is a discretionary payment made to shareholders•• The decision to distribute dividends is solely the responsibility of the The decision to distribute dividends is solely the responsibility of the

board of directorsboard of directors•• Shareholders are residual claimants of the firm (they have the last, and Shareholders are residual claimants of the firm (they have the last, and

residual claim on assets on dissolution and on profits after all other residual claim on assets on dissolution and on profits after all other claims have been fully satisfied)claims have been fully satisfied)

Dividend PaymentsDividend PaymentsMechanics of Cash Dividend PaymentsMechanics of Cash Dividend Payments

Declaration DateDeclaration Date–– The date on which the Board of Directors meet and The date on which the Board of Directors meet and

declare the dividend. In their resolution the Board will declare the dividend. In their resolution the Board will set the set the date of recorddate of record, the , the date of paymentdate of payment and the and the amount of the dividendamount of the dividend for each share class.for each share class.


22 - 1391

amount of the dividendamount of the dividend for each share class.for each share class.–– When CARRIED, this resolution makes the dividend a When CARRIED, this resolution makes the dividend a

current liability for the firm.current liability for the firm.Date of RecordDate of Record

–– The date on which the shareholders register is closed The date on which the shareholders register is closed after the trading day and all those who are listed will after the trading day and all those who are listed will receive the dividend.receive the dividend.

Dividend PaymentsDividend PaymentsMechanics of Cash Dividend PaymentsMechanics of Cash Dividend Payments

Ex dividend DateEx dividend Date–– The date that the value of the firm’s common shares will The date that the value of the firm’s common shares will

reflect the dividend payment (i.e.. fall in value)reflect the dividend payment (i.e.. fall in value)–– ‘Ex’ means without.‘Ex’ means without.–– At the start of trading on the exAt the start of trading on the ex--dividend date, the share dividend date, the share

price will normally open for trading at the previous days price will normally open for trading at the previous days


22 - 1392

price will normally open for trading at the previous days price will normally open for trading at the previous days close, less the value of the dividend per share. This close, less the value of the dividend per share. This reflects the fact that purchasers of the stock on the exreflects the fact that purchasers of the stock on the ex--dividend date and beyond WILL NOT receive the declared dividend date and beyond WILL NOT receive the declared dividend.dividend.

Date of PaymentDate of Payment–– The date the cheques for the dividend are mailed out to The date the cheques for the dividend are mailed out to

the shareholders.the shareholders.

Declaration Date

Date ofRecord

Date ofPayment

2 business days prior to the Date of Record

Dividend Declaration Time LineDividend Declaration Time Line


22 - 1393

Ex Dividend Date is determined by the Date of Record.

The market value of the sharesdrops by the value of the dividend

per share on market opening…comparedto the previous day’s close.

The Board Meetsand passes the

motion to createthe dividend

Changes in the Settlement CycleChanges in the Settlement Cycle•• In June 1995 the settlement cycle for all nonIn June 1995 the settlement cycle for all non--moneymoney--market Canadian and market Canadian and

U.S. securities was reduced from five business days (T + 5) to U.S. securities was reduced from five business days (T + 5) to three three business daysbusiness days (T + 3).(T + 3).

•• The rationale for the change stems from the 1987 stock market crash when The rationale for the change stems from the 1987 stock market crash when it was realized that a securities market failure could result in a credit it was realized that a securities market failure could result in a credit market failure. The gridlock created in 1990 by the bankruptcy of Drexel market failure. The gridlock created in 1990 by the bankruptcy of Drexel

Trade Settlement and the Ex Dividend Trade Settlement and the Ex Dividend DateDate


22 - 1394

market failure. The gridlock created in 1990 by the bankruptcy of Drexel market failure. The gridlock created in 1990 by the bankruptcy of Drexel Burnham Lambert, a large U.S. broker, increased the need to minimize the Burnham Lambert, a large U.S. broker, increased the need to minimize the risks involved in the clearing and settlement of securities.risks involved in the clearing and settlement of securities.

•• The shortened settlement cycle requires that the payment of funds and the The shortened settlement cycle requires that the payment of funds and the delivery of securities take place on the delivery of securities take place on the third business daythird business day after the trade after the trade date. This will reduce credit, market and liquidity risks by decreasing postdate. This will reduce credit, market and liquidity risks by decreasing post--trade settlement exposure.trade settlement exposure.

Ex Dividend DateEx Dividend Date•• The date is not chosen by the board of directors, rather it is determined as The date is not chosen by the board of directors, rather it is determined as

a result of the exchanges settlement practices and is a function of the date a result of the exchanges settlement practices and is a function of the date of record.of record.

Dividend PolicyDividend PolicyDividends, Shareholders and the Board of DirectorsDividends, Shareholders and the Board of Directors

•• There is no legal obligation for firms to pay dividends to There is no legal obligation for firms to pay dividends to common shareholderscommon shareholders

•• Shareholders cannot force a Board of Directors to declare a Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with the BOD’s right to dividend, and courts will not interfere with the BOD’s right to make the dividend decision because:make the dividend decision because:


22 - 1395

make the dividend decision because:make the dividend decision because:–– Board members are jointly and severally liable for any damages Board members are jointly and severally liable for any damages

they may causethey may cause–– Board members are constrained by legal rules affecting Board members are constrained by legal rules affecting

dividends including:dividends including:•• Not paying dividends out of capitalNot paying dividends out of capital•• Not paying dividends when that decision could cause the firm to Not paying dividends when that decision could cause the firm to

become insolventbecome insolvent•• Not paying dividends in contravention of contractual commitments Not paying dividends in contravention of contractual commitments

(such as debt covenant agreements)(such as debt covenant agreements)

Dividend PaymentsDividend PaymentsDividend Reinvestment Plans (DRIPs)Dividend Reinvestment Plans (DRIPs)

•• DRIPs involve shareholders deciding to use the cash DRIPs involve shareholders deciding to use the cash dividend proceeds to buy more shares of the firmdividend proceeds to buy more shares of the firm–– DRIPs will buy as many shares as the cash dividend allows with DRIPs will buy as many shares as the cash dividend allows with

the residual deposited as cashthe residual deposited as cash–– Leads to shareholders owning odd lots (less than 100 shares) Leads to shareholders owning odd lots (less than 100 shares)


22 - 1396

–– Leads to shareholders owning odd lots (less than 100 shares) Leads to shareholders owning odd lots (less than 100 shares)

•• Firms are able to raise additional common stock capital Firms are able to raise additional common stock capital continuously at no cost and fosters an oncontinuously at no cost and fosters an on--going going relationship with shareholdersrelationship with shareholders

Dividend PaymentsDividend PaymentsStock DividendsStock Dividends

•• Stock dividends simply amount to distribution of Stock dividends simply amount to distribution of additional shares to existing shareholdersadditional shares to existing shareholders

•• They represent nothing more than recapitalization of They represent nothing more than recapitalization of earnings of the company. (that is, the amount of the earnings of the company. (that is, the amount of the stock dividend is transferred from the R/E account to the stock dividend is transferred from the R/E account to the


22 - 1397

stock dividend is transferred from the R/E account to the stock dividend is transferred from the R/E account to the common share account.common share account.

•• Because of the Because of the capital impairment rule capital impairment rule stock dividends stock dividends reduce the firm’s ability to pay dividends in the future.reduce the firm’s ability to pay dividends in the future.

Dividend PaymentsDividend PaymentsStock DividendsStock Dividends

ImplicationsImplications–– reduction in the R/E accountreduction in the R/E account–– reduced capacity to pay future dividendsreduced capacity to pay future dividends–– proportionate share ownership remains unchangedproportionate share ownership remains unchanged–– shareholder’s wealth (theoretically) is unaffectedshareholder’s wealth (theoretically) is unaffected

Effect on the CompanyEffect on the Company–– conserves cashconserves cash


22 - 1398

–– conserves cashconserves cash–– serves to lower the market value of firm’s stock modestlyserves to lower the market value of firm’s stock modestly–– promotes wider distribution of shares to the extent that current owners promotes wider distribution of shares to the extent that current owners

divest themselves of shares...because they have moredivest themselves of shares...because they have more–– adjusts the capital accountsadjusts the capital accounts–– dilutes EPSdilutes EPS

Effect on ShareholdersEffect on Shareholders–– proportion of ownership remains unchangedproportion of ownership remains unchanged–– total value of holdings remains unchangedtotal value of holdings remains unchanged–– if former DPS is maintained, this really represents an increased dividend if former DPS is maintained, this really represents an increased dividend

payoutpayout

Dividend PaymentsDividend PaymentsStock Dividend ExampleStock Dividend Example

ABC CompanyABC CompanyEquity AccountsEquity Accounts

as at February xx, 20x9as at February xx, 20x9Common stock (215,000)Common stock (215,000) $5,000,000$5,000,000Retained earningsRetained earnings 20,000,00020,000,000Net WorthNet Worth $25,000,000$25,000,000

•• The company, on March 1, 20x9 declares a 10 percent stock dividend when The company, on March 1, 20x9 declares a 10 percent stock dividend when


22 - 1399

•• The company, on March 1, 20x9 declares a 10 percent stock dividend when The company, on March 1, 20x9 declares a 10 percent stock dividend when the current market price for the stock is $40.00 per sharethe current market price for the stock is $40.00 per share

•• This stock dividend will increase the number of shares outstanding by 10 This stock dividend will increase the number of shares outstanding by 10 percent. This will mean issuing 21,500 shares. The value of the shares is:percent. This will mean issuing 21,500 shares. The value of the shares is:

$40.00 (21,500) = $860,000$40.00 (21,500) = $860,000

•• This stock dividend will result in $860,000 being transferred from the This stock dividend will result in $860,000 being transferred from the retained earnings account to the common stock account:retained earnings account to the common stock account:

Dividend PaymentsDividend PaymentsStock Dividend ExampleStock Dividend Example

After the stock dividend:After the stock dividend:

ABC CompanyABC CompanyEquity AccountsEquity Accounts

as at March 1, 20x9as at March 1, 20x9

Common stock (236,500)Common stock (236,500) $5,860,000$5,860,000Retained earningsRetained earnings 19,140,00019,140,000


22 - 1400

Retained earningsRetained earnings 19,140,00019,140,000Net worthNet worth $25,000,000$25,000,000

The market price of the stock will be affected by the stock dividend:The market price of the stock will be affected by the stock dividend:

New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36

The individual shareholder’s wealth will remain unchanged.The individual shareholder’s wealth will remain unchanged.

Dividend PaymentsDividend PaymentsStock SplitsStock Splits

•• Although there is no theoretical proof, there is some who Although there is no theoretical proof, there is some who believe that an optimal price range exists for a company’s believe that an optimal price range exists for a company’s common shares.common shares.

•• It is generally felt that there is greater demand for shares of It is generally felt that there is greater demand for shares of companies that are traded in the $40 companies that are traded in the $40 -- $80 dollar range.$80 dollar range.

•• The purpose of a stock split is to decrease share price.The purpose of a stock split is to decrease share price.


22 - 1401

•• The purpose of a stock split is to decrease share price.The purpose of a stock split is to decrease share price.•• The result is:The result is:

–– increase in the number of share outstandingincrease in the number of share outstanding–– theoretically, no change in shareholder wealththeoretically, no change in shareholder wealth

•• Reasons for use:Reasons for use:–– better share price trading rangebetter share price trading range–– psychological appeal (signalling affect)psychological appeal (signalling affect)

Dividend PaymentsDividend PaymentsStock Split ExampleStock Split Example

The Board of Directors of XYZ Company is considering using a stock split to The Board of Directors of XYZ Company is considering using a stock split to put its shares into a better trading range. They are confident that the firm’s put its shares into a better trading range. They are confident that the firm’s stock price will continue to rise given the firm’s outstanding financial stock price will continue to rise given the firm’s outstanding financial performance. Currently, the company’s shares are trading for $150 and the performance. Currently, the company’s shares are trading for $150 and the company’s shareholders equity accounts are as follows:company’s shareholders equity accounts are as follows:

Commons shares (100,000 outstanding)Commons shares (100,000 outstanding) $1,500,000$1,500,000


22 - 1402

Commons shares (100,000 outstanding)Commons shares (100,000 outstanding) $1,500,000$1,500,000

Retained earningsRetained earnings 15,000,00015,000,000Net WorthNet Worth $16,500,000$16,500,000

A 2 for 1 Stock Split:A 2 for 1 Stock Split:New Share Price = PNew Share Price = P00[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00

The firm’s equity accounts:The firm’s equity accounts:Commons shares (200,000 outstanding)Commons shares (200,000 outstanding) $1,500,000$1,500,000

Retained earningsRetained earnings 15,000,00015,000,000Net WorthNet Worth $16,500,000$16,500,000

Dividend PaymentsDividend PaymentsFurther Stock Split ExamplesFurther Stock Split Examples

A 4 for 3 Stock Split:A 4 for 3 Stock Split:New Share Price = PNew Share Price = P00[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50

The firm’s equity accounts:The firm’s equity accounts:Commons shares (133,333 outstanding)Commons shares (133,333 outstanding) $1,500,000$1,500,000Retained earningsRetained earnings 15,000,00015,000,000Net WorthNet Worth $16,500,000$16,500,000


22 - 1403

A 3 for 4 Reverse Stock Split:A 3 for 4 Reverse Stock Split:New Share Price = PNew Share Price = P00[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00

The firm’s equity accounts:The firm’s equity accounts:Commons shares (75,000 outstanding)Commons shares (75,000 outstanding) $1,500,000$1,500,000Retained earningsRetained earnings 15,000,00015,000,000Net WorthNet Worth $16,500,000$16,500,000

Clearly the Board can use stock splits and reverse stock splits to place the Clearly the Board can use stock splits and reverse stock splits to place the firm’s stock in a particular trading range.firm’s stock in a particular trading range.

Dividend PaymentsDividend PaymentsStock Split EffectsStock Split Effects

•• Shareholders wealth should remain unaffected:Shareholders wealth should remain unaffected:

Original Holdings: (100 shares @ $150/share) = $15,000Original Holdings: (100 shares @ $150/share) = $15,000

After a 4 for 1 split: (400 shares @ $37.50/share) = $15,000After a 4 for 1 split: (400 shares @ $37.50/share) = $15,000


22 - 1404

•• The above will hold true if there is no psychological The above will hold true if there is no psychological appeal to the stock splitappeal to the stock split

•• There is some evidence that the share price of There is some evidence that the share price of companies which split stock is more bouyant because of companies which split stock is more bouyant because of a positive signal being transferred to the market by this a positive signal being transferred to the market by this action.action.

Stock Dividends versus Stock SplitsStock Dividends versus Stock Splits

Stock Dividends Stock Splits

••lowers stock price slightlylowers stock price slightly ••large drop in stock pricelarge drop in stock price

••little psychological appeallittle psychological appeal ••much stronger potential much stronger potential signalling effectsignalling effect

••recapitalization of earningsrecapitalization of earnings ••no recapitalizationno recapitalization

www.bookfiesta4u.com ContentsCHAPTER 22 – Dividend Policy 22 - 1405

••recapitalization of earningsrecapitalization of earnings ••no recapitalizationno recapitalization

••no change in proportional no change in proportional ownershipownership

••samesame

••odd lots createdodd lots created ••odd lots rareodd lots rare

••theoretically, no value to the theoretically, no value to the investorinvestor

••samesame

Cash Dividend PaymentsCash Dividend PaymentsThe Macro PerspectiveThe Macro Perspective

•• Figure 22Figure 22--2 illustrates:2 illustrates:–– Aggregate afterAggregate after--tax profits run at approximately 6% of tax profits run at approximately 6% of

GDP but are highly variableGDP but are highly variable–– Aggregate dividends are relatively stable when Aggregate dividends are relatively stable when


22 - 1406

–– Aggregate dividends are relatively stable when Aggregate dividends are relatively stable when compared to aftercompared to after--tax profits.tax profits.

•• They are sustained in the face of drops in profit during They are sustained in the face of drops in profit during recessionsrecessions

•• They are held reasonably constant in the face of peaks They are held reasonably constant in the face of peaks in aggregate profits.in aggregate profits.

Cash Dividend PaymentsCash Dividend PaymentsAggregate Dividends and ProfitsAggregate Dividends and Profits

FIGURE 22-2


22 - 1407

Cash Dividend PaymentsCash Dividend PaymentsThe Macro PerspectiveThe Macro Perspective

•• Figure 22Figure 22--3 illustrates:3 illustrates:–– Aggregate Dividend payouts further illustrates the Aggregate Dividend payouts further illustrates the

effects of relatively stable dividend payouts in the face effects of relatively stable dividend payouts in the face of profit volatility:of profit volatility:


22 - 1408

of profit volatility:of profit volatility:•• The normal aggregate dividend payout rate is about 40% of The normal aggregate dividend payout rate is about 40% of

afterafter--tax profittax profit•• When profits drop and dividends are held constant, payout When profits drop and dividends are held constant, payout

rates rise to 100%rates rise to 100%

(See Figure 22 (See Figure 22 -- 2 on the following slide)2 on the following slide)

Cash Dividend PaymentsCash Dividend PaymentsAggregate Dividend PayoutsAggregate Dividend Payouts

FIGURE 22-3


22 - 1409

Cash Dividend PaymentsCash Dividend PaymentsThe Macro Perspective The Macro Perspective -- QuestionQuestion

•• Why are dividends smoothed and not matched Why are dividends smoothed and not matched to profits?to profits?


22 - 1410

Cash Dividend PaymentsCash Dividend PaymentsThe Micro PerspectiveThe Micro Perspective

•• Table 22 Table 22 --1 contains dividend yields for selected 1 contains dividend yields for selected companies.companies.–– The companies chosen here illustrate the dramatic The companies chosen here illustrate the dramatic

differences between companies:differences between companies:


22 - 1411

differences between companies:differences between companies:•• Some pay no dividendsSome pay no dividends•• Some pay consistent cash dividends representing substantial Some pay consistent cash dividends representing substantial

yields on current shares pricesyields on current shares prices–– The highest yields are found in the case of Income Trusts and The highest yields are found in the case of Income Trusts and

large stable ‘bluelarge stable ‘blue--chip’ financials and utilitieschip’ financials and utilities

Cash Dividend PaymentsCash Dividend PaymentsDividend YieldsDividend Yields

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Average% % % % % % % % % %

BCE 4.69 3.42 2.52 1.41 1.07 3.15 3.99 4.08 4.29 4.44 3.31

Table 22-1 S&P/TSX 60 Index Dividend Yields


22 - 1412

BCE 4.69 3.42 2.52 1.41 1.07 3.15 3.99 4.08 4.29 4.44 3.31Celestica Inc. 0 0 0 0 0 0 0 0 0 0 0.00CIBC 3.67 3.07 2.85 3.37 3.17 2.9 3.48 3.28 3.31 3.57 3.27Cott Corporation 0.23 0.53 0.54 0 0 0 0 0 0 0 0.13Kinross Gold Corporation 0 0 0 0 0 0 0 0 0 0 0.00TransAlta Corporation 6.22 5.16 4.52 5.35 5.59 4.06 4.92 5.73 5.88 4.51 5.19Yellow Pages Income Fund 7.34 7.09 7.22

Modigliani and Miller’s Dividend Irrelevance Modigliani and Miller’s Dividend Irrelevance TheoremTheorem

The value of M&M’s Dividend Irrelevance The value of M&M’s Dividend Irrelevance argument is that in the end, it shows where argument is that in the end, it shows where value can be created with dividend policy and value can be created with dividend policy and why.why.


22 - 1413

why.why.

M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremM&M, Dividends, and Firm ValueM&M, Dividends, and Firm Value

Start with the singleStart with the single--period DDM:period DDM:

+


22 - 1414

1

110 )K(

PDP

e++=[ 22-1]


•• Multiply by the number of shares outstanding Multiply by the number of shares outstanding ((mm) to convert the single stock price model to a ) to convert the single stock price model to a model to value the whole firm:model to value the whole firm:


22 - 1415

1

)( 1100 )K(

PDmVmP

e++==[ 22-2]

M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremAssumptionsAssumptions

•• No TaxesNo Taxes•• Perfect capital marketsPerfect capital markets

–– large number of individual buyers and sellerslarge number of individual buyers and sellers


22 - 1416

–– costless informationcostless information–– no transaction costsno transaction costs

•• All firms maximize valueAll firms maximize value•• There is no debtThere is no debt


•• Without debt, sources and uses of funds identity (sources = Without debt, sources and uses of funds identity (sources = uses) can be expressed as:uses) can be expressed as:

1111 mDInPX +=+[ 22-3]


22 - 1417

•• Where:Where:�� XX represents cash flow from operationsrepresents cash flow from operations�� II represents investmentrepresents investment�� X X –– I I is free cash flowis free cash flow�� mDmD11 is dividend to current shareholders at time 1 is dividend to current shareholders at time 1

1111 mDInPX +=+[ 22-3]


•• Solving for dividends paid out (Solving for dividends paid out (mDmD11 ):):

1111 InPXmD −+=


22 - 1418

1111 InPXmD −+=


•• If a firm pays out dividends that exceeds its free cash flow (X If a firm pays out dividends that exceeds its free cash flow (X ––I), then it must issue new common shares to pay for these I), then it must issue new common shares to pay for these dividends.dividends.

•• Substituting into Equation 22 Substituting into Equation 22 –– 2 we get:2 we get:

])[(X VPnmI =++−


22 - 1419

•• The value of the firm is the value of the next period’s free The value of the firm is the value of the next period’s free cash flow (cash flow (XX11 ––II11) plus the next period’s equity market value…) plus the next period’s equity market value…

)1(

])[(X 11110 K

VPnmIV

+=++−=[ 22-4]


•• The firm value is determined as the present value of the free The firm value is determined as the present value of the free cash flows to the equity holders:cash flows to the equity holders:

)1(0 ∑ +

−=α

ttt

K

IXV[ 22-5]

Value has nothing to do with dividends


22 - 1420

•• The dividend is equal to the free cash flow each period, and The dividend is equal to the free cash flow each period, and dividends are therefore a residual after the firm has taken dividends are therefore a residual after the firm has taken care of all of its investment requirements care of all of its investment requirements –– this is the this is the Residual Residual Theory of DividendsTheory of Dividends

)1(1

0 ∑= +

=t

tKV

M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremResidual Theory of DividendsResidual Theory of Dividends

The The Residual Theory of DividendsResidual Theory of Dividends suggests that suggests that logically, each year, management should:logically, each year, management should:–– Identify free cash flow generated in the previous Identify free cash flow generated in the previous

periodperiod–– Identify investment projects that have positive NPVsIdentify investment projects that have positive NPVs


22 - 1421

–– Identify investment projects that have positive NPVsIdentify investment projects that have positive NPVs–– Invest in all positive NPV projectsInvest in all positive NPV projects

•• If free cash flow is insufficient, then raise external capital If free cash flow is insufficient, then raise external capital –– in in this case no dividend is paidthis case no dividend is paid

•• If free cash flow exceeds investment requirements, the If free cash flow exceeds investment requirements, the residual amount is distributed in the form of cash dividends.residual amount is distributed in the form of cash dividends.

M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremResidual Theory of Dividends Residual Theory of Dividends -- ImplicationImplication

The implication of the The implication of the Residual Theory of DividendsResidual Theory of Dividends are:are:

Investment decisions are independent of the firm’s dividend Investment decisions are independent of the firm’s dividend policypolicy•• No firm would pass on a positive NPV project because of the lack No firm would pass on a positive NPV project because of the lack

of funds, because, by definition the incremental cost of those of funds, because, by definition the incremental cost of those


22 - 1422

of funds, because, by definition the incremental cost of those of funds, because, by definition the incremental cost of those funds is less than the IRR of the project, so the value of the firm is funds is less than the IRR of the project, so the value of the firm is maximized only if the project is undertaken.maximized only if the project is undertaken.

•• If the firm can’t make good use of free cash flow (ie. It has no If the firm can’t make good use of free cash flow (ie. It has no projects with IRRs > cost of capital) then those funds should be projects with IRRs > cost of capital) then those funds should be distributed back to shareholders in the form of dividends for them distributed back to shareholders in the form of dividends for them to invest on their own.to invest on their own.

•• The firm should operate where Marginal Cost equals Marginal The firm should operate where Marginal Cost equals Marginal Revenue as seen in Figure 22 Revenue as seen in Figure 22 –– 4 on the following slide:4 on the following slide:

M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremInternal Funds, Investment, and DividendsInternal Funds, Investment, and Dividends

22 - 4 FIGURE

Rate of Return

OPTIMAL INVESTMENT

IOS

MC=MR


22 - 1423

$11,976 Million

WACC


$177,607 Million

M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance TheoremHomemade DividendsHomemade Dividends

•• Shareholders can buy or sell shares in an Shareholders can buy or sell shares in an underlying company to create their own cash underlying company to create their own cash flow pattern.flow pattern.–– They don’t need management declare a cash They don’t need management declare a cash


22 - 1424

–– They don’t need management declare a cash They don’t need management declare a cash dividend, they can create their own.dividend, they can create their own.

Conclusion: under the assumptions of M&M’s model, Conclusion: under the assumptions of M&M’s model, the investor is indifferent to the firm’s dividend policy.the investor is indifferent to the firm’s dividend policy.

The “BirdThe “Bird--inin--thethe--Hand” ArgumentHand” ArgumentM&M’s Assumptions RelaxedM&M’s Assumptions Relaxed

•• Risk is a real world factor.Risk is a real world factor.•• Firm’s that reinvest free cash flow, put that Firm’s that reinvest free cash flow, put that

money at risk money at risk –– there is no certainty of there is no certainty of investment outcome investment outcome –– those forfeit dividends those forfeit dividends


22 - 1425

investment outcome investment outcome –– those forfeit dividends those forfeit dividends that are reinvested…could be lost!that are reinvested…could be lost!

•• Remember the twoRemember the two--stage DDM?stage DDM?


•• Remember the twoRemember the two--stage DDM?stage DDM?

)ROE

()K(1

Inv 2

e

1

e

e

e K

K

K

BVPSROEP

−+

+×=[ 22-6]


22 - 1426

–– The first term is the present value of existing opportunities The first term is the present value of existing opportunities (PVEO)(PVEO)

–– The second term is the present value of growth opportunities The second term is the present value of growth opportunities (PVGO)(PVGO)

–– These forecast returns face risks of new market entrants to These forecast returns face risks of new market entrants to compete for the excess profits forecast in emerging opportunities compete for the excess profits forecast in emerging opportunities making PVGO extremely vulnerable.making PVGO extremely vulnerable.

)K(1 e ee KK +


•• Myron Gordon suggests that dividends are more stable than Myron Gordon suggests that dividends are more stable than capital gains and are therefore more highly valued by capital gains and are therefore more highly valued by investors.investors.

•• This implies that investors perceive nonThis implies that investors perceive non--dividend paying firms dividend paying firms


22 - 1427

•• This implies that investors perceive nonThis implies that investors perceive non--dividend paying firms dividend paying firms to be riskier and apply a higher discount rate to value them to be riskier and apply a higher discount rate to value them causing the share price to fall.causing the share price to fall.

•• The difference between the M&M and Gordon arguments are The difference between the M&M and Gordon arguments are illustrated in Figure 22 illustrated in Figure 22 -- 5 on the following slide:5 on the following slide:–– M&M argue that dividends and capital gains are perfect M&M argue that dividends and capital gains are perfect

substitutessubstitutes

The “BirdThe “Bird--inin--thethe--Hand” ArgumentHand” ArgumentM&M versus Gordon’s Bird in the Hand TheoryM&M versus Gordon’s Bird in the Hand Theory

0

1

P

D

22 - 5 FIGURE

OPTIMAL INVESTMENT


22 - 1428

GordonM&M

0

01

P

PP −

The “BirdThe “Bird--inin--thethe--Hand” ArgumentHand” ArgumentM&M versus Gordon’s Bird in the Hand TheoryM&M versus Gordon’s Bird in the Hand Theory

Conclusions:Conclusions:–– Firms cannot change underlying operational Firms cannot change underlying operational

characteristics by changing the dividendcharacteristics by changing the dividend


22 - 1429

–– The dividend should reflect the firm’s operations The dividend should reflect the firm’s operations through the residual value of dividendsthrough the residual value of dividends

Dividend Policy in PracticeDividend Policy in Practice

•• Firms smooth their dividendsFirms smooth their dividends–– Firms tend to hold dividends constant, even in the Firms tend to hold dividends constant, even in the

face of increasing afterface of increasing after--tax profittax profit–– Firms are very reluctant to cut dividendsFirms are very reluctant to cut dividends


22 - 1430

–– Firms are very reluctant to cut dividendsFirms are very reluctant to cut dividends

Dividend Policy in PracticeDividend Policy in PracticeLintner’s Work on Dividend AdjustmentLintner’s Work on Dividend Adjustment

•• John Lintner suggested a partial adjustment John Lintner suggested a partial adjustment model to explain the smoothing of dividend model to explain the smoothing of dividend behaviour illustrating that firms slowly change behaviour illustrating that firms slowly change dividends as they move toward a new target dividends as they move toward a new target level:level:


22 - 1431

level:level:

1 ) -Dβ(D∆D t-*tt =[ 22-7]


•• The target dividend The target dividend DDtt** Lintner suggested is a function of the Lintner suggested is a function of the

firm’s optimal payout rate of the firm’s underlying earnings (firm’s optimal payout rate of the firm’s underlying earnings (EEtt) ) leading to the following equation:leading to the following equation:

)1( cEDbaD +−+=[ 22-8]


22 - 1432

•• The coefficient on lagged dividends was estimated at 0.70 The coefficient on lagged dividends was estimated at 0.70 indicating an adjustment speed (indicating an adjustment speed (bb) coefficent of 0.30. ) coefficent of 0.30.

•• The coefficient on current earnings (The coefficient on current earnings (cc) was estimated at 0.15) was estimated at 0.15

)1( 11 cEDbaD t-t +−+=[ 22-8]


ImplicationsImplications–– The speed of dividend adjustment is only about 30 The speed of dividend adjustment is only about 30

percentpercent–– Firms are very reluctant to fully adjustFirms are very reluctant to fully adjust–– Firms do not follow a policy of paying a constant Firms do not follow a policy of paying a constant


22 - 1433

–– Firms do not follow a policy of paying a constant Firms do not follow a policy of paying a constant proportion of earnings out as dividendsproportion of earnings out as dividends

Dividend policy in practice does not follow M&M’s Dividend policy in practice does not follow M&M’s irrelevance arguments because the real world does irrelevance arguments because the real world does

not match the assumptions used.not match the assumptions used.

Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsWelcome to the Real World!Welcome to the Real World!

Transactions CostsTransactions Costs–– Underwriting costs are very high, providing a strong Underwriting costs are very high, providing a strong

incentive for firms to finance growth out of free cash incentive for firms to finance growth out of free cash flowflow

–– Facing these high underwriting costs firms:Facing these high underwriting costs firms:


22 - 1434

–– Facing these high underwriting costs firms:Facing these high underwriting costs firms:•• With high growth rates have little incentive to pay dividendsWith high growth rates have little incentive to pay dividends•• With volatile earnings conserve cash from year to year to With volatile earnings conserve cash from year to year to

finance projects and therefore pay very conservative finance projects and therefore pay very conservative dividendsdividends


Dividends and SignallingDividends and Signalling–– Under conditions of information asymmetry, shareholders and Under conditions of information asymmetry, shareholders and

the investing public watch for management signals (actions) the investing public watch for management signals (actions) about what management knows.about what management knows.

–– Management is therefore very cautious about dividend Management is therefore very cautious about dividend changes…they don’t want to create high expectations (this is the changes…they don’t want to create high expectations (this is the


22 - 1435

changes…they don’t want to create high expectations (this is the changes…they don’t want to create high expectations (this is the reason for extra or special dividends) that will lead to reason for extra or special dividends) that will lead to disappointment, and they don’t want to have investors over react disappointment, and they don’t want to have investors over react to negative earnings surprises (the sticky dividend phenomenon)to negative earnings surprises (the sticky dividend phenomenon)

(The Signalling Model is explained in Figure 22 (The Signalling Model is explained in Figure 22 –– 6 found on the next slide.)6 found on the next slide.)

Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsThe Signalling ModelThe Signalling Model

22 - 6 FIGURE

et

$

et*

dt*


22 - 1436

1 2 3 Time

t

dt


Agency TheoryAgency Theory–– Investors are wary of senior management so they seek to put Investors are wary of senior management so they seek to put

controls in place.controls in place.–– There is a fear that managers may waste corporate resources by There is a fear that managers may waste corporate resources by

overover--investing in low or poor NPV projects.investing in low or poor NPV projects.–– Gordon Donaldson argued this is the reason for the pecking Gordon Donaldson argued this is the reason for the pecking


22 - 1437

–– Gordon Donaldson argued this is the reason for the pecking Gordon Donaldson argued this is the reason for the pecking order managements tend to use when raising capitalorder managements tend to use when raising capital

•• Shareholders would prefer to receive a dividend and then have Shareholders would prefer to receive a dividend and then have management file a prospectus, justifying investment in projects and management file a prospectus, justifying investment in projects and the need to raise the capital that was just distributed as a dividend.the need to raise the capital that was just distributed as a dividend.

•• Shareholders are prepared to pay those additional underwriting Shareholders are prepared to pay those additional underwriting costs as an agency cost incurred to monitor and assess costs as an agency cost incurred to monitor and assess management.management.


Taxes and the Clientele EffectTaxes and the Clientele Effect–– Table 22 Table 22 --3 (on the following slide) illustrates that different 3 (on the following slide) illustrates that different

classes of investors face different tax bracketsclasses of investors face different tax brackets–– Preference for dividends versus capital gains income depends Preference for dividends versus capital gains income depends

on the province of residence and taxable income level leading to on the province of residence and taxable income level leading to tax clienteles.tax clienteles.


22 - 1438

tax clienteles.tax clienteles.•• High income earners tend to prefer capital gains (there is an High income earners tend to prefer capital gains (there is an

additional tax incentive for such individuals in that they can choose additional tax incentive for such individuals in that they can choose the timing of the sale of their investment…remember only ‘realized’ the timing of the sale of their investment…remember only ‘realized’ capital gains are subject to taxcapital gains are subject to tax

•• Low income earners tend to prefer dividendsLow income earners tend to prefer dividends

Conclusion Conclusion –– firm’s should not change dividend policy drastically firm’s should not change dividend policy drastically since it upsets the existing ownership base.since it upsets the existing ownership base.

Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsTaxesTaxes

Income Level $25,000 $50,000 $75,000 $100,000

British Columbia Dividends 2.52 6.19 15.69 20.04Capital gains 12.45 15.58 18.85 20.35

Alberta Dividends 3.63 8.03 13.83 13.83

Table 22-3 Individual Tax Rates (% ) on Dividends and Capital Gains


22 - 1439

Alberta Dividends 3.63 8.03 13.83 13.83Capital gains 12.63 16.00 18.00 18.00

Ontario Dividends 0.00 8.24 20.74 20.74Capital gains 10.65 15.58 21.71 21.71

Quebec Dividends 5.95 15.42 26.06 26.06Capital gains 14.37 19.19 22.86 22.86

Nova Scotia Dividends 0.00 8.75 17.05 19.06Capital gains 12.02 18.48 21.34 22.63

Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsRepackaging DividendRepackaging Dividend--Paying SecuritiesPaying Securities

•• Tax clienteles help to explain the financial Tax clienteles help to explain the financial engineering whereby different parts of the return engineering whereby different parts of the return by the firm are stripped, repackaged and sold to by the firm are stripped, repackaged and sold to different investors as illustrated in Figure 22 different investors as illustrated in Figure 22 –– 7. 7.


22 - 1440

different investors as illustrated in Figure 22 different investors as illustrated in Figure 22 –– 7. 7. (See the following slide)(See the following slide)

•• Split shares are shares sold as the dividends Split shares are shares sold as the dividends and capital gains parts.and capital gains parts.

Relaxing the M&M AssumptionsRelaxing the M&M AssumptionsMYW’s B Corporation SharesMYW’s B Corporation Shares

22 - 7 FIGURE

www.bookfiesta4u.com ContentsCHAPTER 22 – Dividend Policy 22 - 1441

MYW $143 million$330 million

$454 million

Share RepurchasesShare Repurchases

•• Simply another form of payout policy.Simply another form of payout policy.•• An alternative to cash dividend where the An alternative to cash dividend where the

objective is to increase the price per share objective is to increase the price per share rather than paying a dividend.rather than paying a dividend.


22 - 1442

rather than paying a dividend.rather than paying a dividend.•• Since there are rules against improper Since there are rules against improper

accumulation of funds, firms adopt a policy of accumulation of funds, firms adopt a policy of large infrequent share repurchase programs.large infrequent share repurchase programs.

•• allowed under the OBCA and CBCAallowed under the OBCA and CBCA•• reasons for use:reasons for use:

–– Offsetting the exercise of executive stock optionsOffsetting the exercise of executive stock options–– Leveraged recapitalizationsLeveraged recapitalizations

Share RepurchasesShare Repurchases


22 - 1443

–– Leveraged recapitalizationsLeveraged recapitalizations–– Information or signalling effectsInformation or signalling effects–– Repurchase dissident sharesRepurchase dissident shares–– Removing cash without generating expectations for future Removing cash without generating expectations for future

distributionsdistributions–– Take the firm private.Take the firm private.

•• they are usually done on an irregular basis, so a shareholder they are usually done on an irregular basis, so a shareholder cannot depend on income from this source.cannot depend on income from this source.

•• if regular repurchases are made, there is a good chance that if regular repurchases are made, there is a good chance that Revenue Canada will rule that the repurchases were simply a tax Revenue Canada will rule that the repurchases were simply a tax

Disadvantages of Share RepurchasesDisadvantages of Share Repurchases


22 - 1444

Revenue Canada will rule that the repurchases were simply a tax Revenue Canada will rule that the repurchases were simply a tax avoidance scheme (to avoid tax on dividends) and will assess tax avoidance scheme (to avoid tax on dividends) and will assess tax

•• there may be some agency problems there may be some agency problems -- if managers have inside if managers have inside information, they are purchasing from shareholders at a price less information, they are purchasing from shareholders at a price less than the intrinsic value of the shares.than the intrinsic value of the shares.

•• tender offer:tender offer:–– this is a formal offer to purchase a given number of shares at a this is a formal offer to purchase a given number of shares at a

given price over current market price.given price over current market price.

•• open market purchase:open market purchase:–– the purchase of shares through an investment dealer like any the purchase of shares through an investment dealer like any

Methods of Share RepurchasesMethods of Share Repurchases


22 - 1445

–– the purchase of shares through an investment dealer like any the purchase of shares through an investment dealer like any other investorother investor

–– this is not designed for large block purchases.this is not designed for large block purchases.

•• private negotiation with major shareholdersprivate negotiation with major shareholders

In any repurchase program, the securities commission requires In any repurchase program, the securities commission requires disclosure of the event as well as all other material information disclosure of the event as well as all other material information through a prospectus.through a prospectus.

•• called treasury stock (U.S.)called treasury stock (U.S.)•• nonnon--voting (U.S.)voting (U.S.)•• may not receive dividends (U.S.)may not receive dividends (U.S.)

Repurchased SharesRepurchased Shares


22 - 1446

•• if not retired, can be resold (U.S.)if not retired, can be resold (U.S.)•• unlike the U.S., repurchases in Canada do not unlike the U.S., repurchases in Canada do not

involve shares that can be placed into treasury involve shares that can be placed into treasury stock stock -- they are canceledthey are canceled

Current EPSCurrent EPS= [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00= [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00

Current P/E ratioCurrent P/E ratio= $20 / $4 = 5X= $20 / $4 = 5X

Repurchase ExampleRepurchase Example


22 - 1447

EPS after repurchase of 100,000 sharesEPS after repurchase of 100,000 shares== $4.4 m / 1.0 = $4.40 $4.4 m / 1.0 = $4.40

Expected market price after repurchase:Expected market price after repurchase:= [p/e][EPS= [p/e][EPSnewnew] = [5][$4.40] = $22.00 per share] = [5][$4.40] = $22.00 per share

•• EPS should increase following the repurchase if EPS should increase following the repurchase if earnings afterearnings after--tax remains the sametax remains the same

•• a higher market price per outstanding share of a higher market price per outstanding share of

Effects of A Share RepurchaseEffects of A Share Repurchase


22 - 1448

•• a higher market price per outstanding share of a higher market price per outstanding share of common stock should resultcommon stock should result

•• stockholders not selling their shares back to the stockholders not selling their shares back to the firm will enjoy a capital gain if the repurchase firm will enjoy a capital gain if the repurchase increases the stock price.increases the stock price.

•• signal positive information about the firm’s future cash flowssignal positive information about the firm’s future cash flows•• used to effect a largeused to effect a large--scale change in the firm’s capital scale change in the firm’s capital

structurestructure•• increase investor’s return without creating an expectation of increase investor’s return without creating an expectation of

higher future cash dividendshigher future cash dividends

Advantages of Share RepurchasesAdvantages of Share Repurchases


22 - 1449

higher future cash dividendshigher future cash dividends•• reduce future cash dividend requirements or increase cash reduce future cash dividend requirements or increase cash

dividends per share on the remaining shares, without creating a dividends per share on the remaining shares, without creating a continuing incremental cash draincontinuing incremental cash drain

•• capital gains treated more favourably than cash dividends for capital gains treated more favourably than cash dividends for tax purposes.tax purposes.

•• signal negative information about the firm’s signal negative information about the firm’s future growth and investment opportunitiesfuture growth and investment opportunities

•• the provincial securities commission may raise the provincial securities commission may raise

Disadvantages of Share RepurchasesDisadvantages of Share Repurchases


22 - 1450

•• the provincial securities commission may raise the provincial securities commission may raise questions about the intentionquestions about the intention

•• share repurchase may not qualify the investor share repurchase may not qualify the investor for a capital gainfor a capital gain

•• Is this legal? is it possible to do?Is this legal? is it possible to do?•• YesYes

–– the firm must have the ability and capacity to borrowthe firm must have the ability and capacity to borrow–– the firm must have sufficient retained earnings to allow it the firm must have sufficient retained earnings to allow it

to pay the dividend to pay the dividend

Borrowing to Pay DividendsBorrowing to Pay Dividends


22 - 1451

to pay the dividend to pay the dividend –– the firm must have sufficient cash on hand to pay the the firm must have sufficient cash on hand to pay the

cash dividendcash dividend–– the firm must NOT have agreed to any limitations on the the firm must NOT have agreed to any limitations on the

payment of dividends under the bond indenture.payment of dividends under the bond indenture.

•• Why?Why?–– A possible answer is to signal to the market that the A possible answer is to signal to the market that the

board is confident about the firm’s ability to sustain cash board is confident about the firm’s ability to sustain cash dividends into the future.dividends into the future.

Assets : Liabilities :

Cash 10 Long-term Debt 0Fixed Assets 140 Common Stock 50

Retained Earnings 100

Total Assets $150 Total Claims $150

Before Borrowing:0% Debt

Borrowing to Pay DividendsBorrowing to Pay DividendsAn ExampleAn Example


22 - 1452

After Borrowing…before cash dividend :Assets : Liabilities :


Retained Earnings 100


25% Debt

Assets : Liabilities :

Cash 60 Current liabilities 50Fixed Assets 140 Long-term Debt 50

Common Shares 50Retained earnings 50


After Dividend Declaration…before date of payment.

50% Debt

Borrowing to Pay DividendsBorrowing to Pay DividendsAn Example …An Example …


22 - 1453


After Cash Dividend payment of $50Assets : Liabilities :


Retained earnings 50


33% Debt

•• The foregoing example illustrates:The foregoing example illustrates:–– it is possible for a firm with ‘borrowing capacity’ to borrow funds to it is possible for a firm with ‘borrowing capacity’ to borrow funds to

pay cash dividends.pay cash dividends.–– this is not possible if the lenders insist on restrictive covenants that this is not possible if the lenders insist on restrictive covenants that

limit or prevent this from occurring.limit or prevent this from occurring.–– the cash for the dividend must be present in the cash account.the cash for the dividend must be present in the cash account.

Borrowing to Pay DividendsBorrowing to Pay DividendsAn ExampleAn Example


22 - 1454

–– the cash for the dividend must be present in the cash account.the cash for the dividend must be present in the cash account.–– payment of dividends reduces both the cash account on the asset payment of dividends reduces both the cash account on the asset

side of the balance sheet as well as the retained earnings account side of the balance sheet as well as the retained earnings account on the ‘claims’ side of the balance sheet.on the ‘claims’ side of the balance sheet.

–– in the absence of restrictions, it is possible to transfer wealth from in the absence of restrictions, it is possible to transfer wealth from the bondholders to the stockholders. the bondholders to the stockholders. (Bondholders in this example (Bondholders in this example may have thought their firm would have only a 25% debt ratio….after the may have thought their firm would have only a 25% debt ratio….after the dividend the debt ratio rose to 33% and the equity cusion dropped from dividend the debt ratio rose to 33% and the equity cusion dropped from 75% to 66%.)75% to 66%.)


In this chapter you have learned:In this chapter you have learned:–– About the different types of dividends including, regular and About the different types of dividends including, regular and

special cash dividends, stock dividends, stock splits as well as special cash dividends, stock dividends, stock splits as well as share repurchases.share repurchases.

–– M&M’s dividend irrelevance argument and the real world factors M&M’s dividend irrelevance argument and the real world factors


22 - 1455

–– M&M’s dividend irrelevance argument and the real world factors M&M’s dividend irrelevance argument and the real world factors such as transactions costs, taxes, clientele effects and such as transactions costs, taxes, clientele effects and signalling tend to favour realsignalling tend to favour real--world dividend relevanceworld dividend relevance

–– Tax motives and other reasons explain why firms might want to Tax motives and other reasons explain why firms might want to repurchase their shares.repurchase their shares.

CHAPTER 23CHAPTER 23Working Capital Working Capital Working Capital Working Capital

Management: General IssuesManagement: General Issues


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• An integrated approach to working capital An integrated approach to working capital

managementmanagement

www.bookfiesta4u.com ContentsCHAPTER 23 – Working Capital Management –

General Issues

23 - 1458

managementmanagement•• Analyzing cash inflows and outflowsAnalyzing cash inflows and outflows•• Working capital managementWorking capital management•• Summary and ConclusionsSummary and Conclusions



You should understand:You should understand:•• Why the management of net working capital is critical for the Why the management of net working capital is critical for the

survival of the firmsurvival of the firm•• How managing receivables, inventory, and payables is related in How managing receivables, inventory, and payables is related in


General Issues

23 - 1459

an integrated approach to net working capital managementan integrated approach to net working capital management•• How the financing and current asset investment decisions interact How the financing and current asset investment decisions interact

to determine a company’s overall working capital positionto determine a company’s overall working capital position•• How some key financial ratios can be used to analyze a firm’s net How some key financial ratios can be used to analyze a firm’s net

working capital policiesworking capital policies


•• BreakBreak--even sales growtheven sales growth•• Cash budgetCash budget•• Cash conversion cycleCash conversion cycle•• Credit policyCredit policy

•• Net working capitalNet working capital•• Operating cycleOperating cycle•• Payment policyPayment policy•• Trade creditTrade credit•• Working capital Working capital


General Issues

23 - 1460

•• Credit policyCredit policy•• Inventory policyInventory policy

•• Working capital Working capital managementmanagement

Working Capital ManagementWorking Capital Management

•• The way in which a firm manages both its The way in which a firm manages both its current assets and its current liabilities.current assets and its current liabilities.


General Issues

23 - 1461

Good Working Capital ManagementGood Working Capital Management

•• Characterized by:Characterized by:1.1. The maintenance of optimal cash balancesThe maintenance of optimal cash balances2.2. The investment of any excess liquid funds in marketable The investment of any excess liquid funds in marketable

securities that provide the best return possible, considering any securities that provide the best return possible, considering any liquidity or defaultliquidity or default--risk constraintsrisk constraints


General Issues

23 - 1462

liquidity or defaultliquidity or default--risk constraintsrisk constraints3.3. Proper management of accounts receivableProper management of accounts receivable4.4. An efficient inventory management systemAn efficient inventory management system5.5. Maintaining an appropriate level of shortMaintaining an appropriate level of short--term financing, in the term financing, in the

least expensive and most flexible manner possible.least expensive and most flexible manner possible.

Working Capital ManagementWorking Capital ManagementImportance of Cash Flow ManagementImportance of Cash Flow Management

•• Management of the firm’s cash flow is one of Management of the firm’s cash flow is one of the greatest challenges facing the financial the greatest challenges facing the financial manager:manager:–– Exhaustion of liquid resources can leave the firm Exhaustion of liquid resources can leave the firm


General Issues

23 - 1463

–– Exhaustion of liquid resources can leave the firm Exhaustion of liquid resources can leave the firm unable to pay it’s maturing obligations as they come unable to pay it’s maturing obligations as they come due (a state of technical insolvency…an Act of due (a state of technical insolvency…an Act of Bankruptcy)Bankruptcy)

Working Capital ManagementWorking Capital ManagementExhaustion of Liquid ResourcesExhaustion of Liquid Resources

•• Firms can ‘run out’ of liquid financial resources in a number Firms can ‘run out’ of liquid financial resources in a number of ways:of ways:–– Rapid growth in production and sales, can cause the firm to Rapid growth in production and sales, can cause the firm to

use up all of its cash pursuing growth, leaving it invested in use up all of its cash pursuing growth, leaving it invested in illiquid assets such as inventories, accounts receivable and net illiquid assets such as inventories, accounts receivable and net fixed assets.fixed assets.


General Issues

23 - 1464

fixed assets.fixed assets.•• The surprising thing about this state is that the firm may be highly The surprising thing about this state is that the firm may be highly

profitable in an accounting sense, but be on the verge of profitable in an accounting sense, but be on the verge of bankruptcy as it pursues uncontrolled growth in sales.bankruptcy as it pursues uncontrolled growth in sales.

–– Continuing to produce inventory in the face of falling sales Continuing to produce inventory in the face of falling sales revenue.revenue.

–– Selling products/services for less than their variable cost to Selling products/services for less than their variable cost to produce.produce.

An Integrated Approach to Net Working Capital An Integrated Approach to Net Working Capital ManagementManagement

The Cash BudgetThe Cash Budget

•• The monthly cash budget is a management tool used to forecast the The monthly cash budget is a management tool used to forecast the timing, magnitude and duration of both cash surpluses as well as timing, magnitude and duration of both cash surpluses as well as deficits.deficits.

$ 1 2 3 4 5 6

Table 23-2 ABC's Six-Month Cash Budget


General Issues

23 - 1465

$ 1 2 3 4 5 6Sales 1,000 1,500 2,000 2,500 3,000 3,500

Cash inflow 1,000 1,000 1,500 2,000 2,500 3,000

Cash outflow

Current sales 750 1,125 1,500 1,875 2,250 2,625

Inventory 0 375 375 375 375 375

Operating cash 250 -500 -375 -250 -125 0

Start cash 1,000 1,250 750 375 125 0

End cash 1,250 750 375 125 0 0

Required cash 200 300 400 500 600 700

Surplus/deficit 1,050 450 -25 -375 -600 -700

An Integrated Approach to Net Working An Integrated Approach to Net Working Capital ManagementCapital Management

•• Knowledge of the cash flow cycle of a firm gives the manager Knowledge of the cash flow cycle of a firm gives the manager an awareness of the dynamics involved in working capital an awareness of the dynamics involved in working capital management.management.

•• The cash flow cycle helps the manager visualize the impact of The cash flow cycle helps the manager visualize the impact of


General Issues

23 - 1466

•• The cash flow cycle helps the manager visualize the impact of The cash flow cycle helps the manager visualize the impact of changes in variables on the cash account:changes in variables on the cash account:–– How increasing sales requires additional investment in inventoryHow increasing sales requires additional investment in inventory–– How increasing accounts receivable reduces cashHow increasing accounts receivable reduces cash–– How delaying payables preserves cashHow delaying payables preserves cash–– How speeding collections on A/R improves the cash positionHow speeding collections on A/R improves the cash position

Cash and Net Working CapitalCash and Net Working Capital

•• The cash flow cycle The cash flow cycle –– where cash comes from…how it is where cash comes from…how it is used to finance the operations of the firm…and how it is used to finance the operations of the firm…and how it is recovered and how it grows over time is a cruciallyrecovered and how it grows over time is a crucially--important important part of understanding how a business functions.part of understanding how a business functions.


General Issues

23 - 1467

part of understanding how a business functions.part of understanding how a business functions.

Cash and Net Working CapitalCash and Net Working CapitalActivities that Increase CashActivities that Increase Cash

•• Increasing longIncreasing long--term debtterm debt•• Increasing equityIncreasing equity•• Increasing current liabilitiesIncreasing current liabilities•• Decreasing current assets other than cashDecreasing current assets other than cash


General Issues

23 - 1468

•• Decreasing current assets other than cashDecreasing current assets other than cash•• Decreasing fixed assetsDecreasing fixed assets

Cash and Net Working CapitalCash and Net Working CapitalActivities that Decrease CashActivities that Decrease Cash

•• Decreasing longDecreasing long--term debtterm debt•• Decreasing equityDecreasing equity•• Decreasing current liabilitiesDecreasing current liabilities•• Increasing current assets other than cashIncreasing current assets other than cash


General Issues

23 - 1469

•• Increasing current assets other than cashIncreasing current assets other than cash•• Increasing fixed assetsIncreasing fixed assets•• Paying dividendsPaying dividends

Example of Exhaustion of the Liquid Example of Exhaustion of the Liquid Resources of a New FirmResources of a New Firm

A simple example of a $1.0 million equity investment in a business levering additional

financial resources and the need to finance the growth of the business leaving it exhausted of

cash resources.

7 steps to technical insolvency for an otherwise pr ofitable firm.

This ExerciseThis Exercise

•• This exercise reinforces the classic working This exercise reinforces the classic working capital problem illustrated in the text.capital problem illustrated in the text.

•• Demonstrates:Demonstrates:–– How cash is utilized over time in the firm.How cash is utilized over time in the firm.


General Issues

23 - 1471

–– How cash is utilized over time in the firm.How cash is utilized over time in the firm.–– How investment in assets such as accounts How investment in assets such as accounts

receivable and inventory deplete cash resources.receivable and inventory deplete cash resources.–– How the delays in receipt of cash from sales can How the delays in receipt of cash from sales can

leave a firm without cash, despite overall profitability.leave a firm without cash, despite overall profitability.

Cash Flow CycleCash Flow CycleStartStart

The entrepreneur opens a current account in the name

of the business.Step 1


General Issues

23 - 1472

Cash Account

Balance = $0

Cash Flow CycleCash Flow CycleInitial Equity InvestmentInitial Equity Investment

The entrepreneur invests $1,000,000 in equity. Step 2


General Issues

23 - 1473

Cash Account

Balance = $1,000,000

Owner/Shareholders invest and receive

common stock

= $1,000,000

Balance Sheet

Cash $1m Common Stock $1 m

_____________________________________

T. Assets $1m T. Claims $1m

Cash Flow CycleCash Flow CyclePurchase of $500,000 Fixed AssetsPurchase of $500,000 Fixed Assets

Fixed Assets

The firm purchases fixed assets. Step 3


General Issues

23 - 1474

Balance Sheet

Cash $0.5F. Assets 0.5 Common Stock $1 m___________________________________T. Assets $1m T. Claims $1m

Cash Account

Balance = $500,000


common stock

= $1,000,000

Cash Flow CycleCash Flow CycleBuy $300,000 of inventory on trade creditBuy $300,000 of inventory on trade credit

Fixed Assets

The firm purchases $300,000 inventory

from suppliers.Step 4


General Issues

23 - 1475

Balance Sheet

Cash $0.5 A/P $0.3Inventory 0.3

F. Assets 0.5 Common Stock $1 m_____________________________________T. Assets $1.3m T. Claims $1.3m

Cash Account

Balance = $500,000


common stock

= $1,000,000

Inventory

Cash Flow CycleCash Flow CycleFurther WorkFurther Work--inin--process plus finished goodsprocess plus finished goods

Fixed Assets

Work-in-process inventory

Labour/utilities

Depreciation

Finished goods inventory

Value is added to inventory through

labour ($300,000) and equipment ($100,000).

Step 5


General Issues

23 - 1476

Balance Sheet

Cash $0.5 A/P $0.3Inventory 0.7 Accruals 0.3

F. Assets 0.4 Common Stock $1 m_____________________________________T. Assets $1.6m T. Claims $1.6m

Cash Account

Balance = $500,000


common stock

= $1,000,000

Inventory

Cash Flow CycleCash Flow CyclePayment of initial A/P and AccrualsPayment of initial A/P and Accruals

Fixed Assets


Labour/utilities

Depreciation


Suppliers of initial inventory are paid

($0.3m). Labour costs ($0.2m in accruals) are paid – resulting in a $0

cash balance.

Step 6

$200,000 paid


General Issues

23 - 1477

Balance Sheet

Cash $0.0 A/P $0.0Inventory 0.7 Accruals 0.1F. Assets 0.4 Common Stock $1 m_____________________________________

T. Assets $1.0m T. Claims $1.1m

Cash Account

Balance = $0


common stock

= $1,000,000

Inventory

$300,000 paid

Cash Flow CycleCash Flow CycleGoods sold on A/R for a profitGoods sold on A/R for a profit

Fixed Assets


Labour/utilities

Depreciation


Sold $400,000 of F.G. Inventory for

$500,000

Sale of inventory occurs. Accounts receivable

created. Cash = $0. There are 30 days till A/R

collected.

Step 7


General Issues

23 - 1478

Balance Sheet

Cash $0.0 A/P $0.0A/R 0.5

Inventory 0.3 Accruals 0.1F. Assets 0.4 Common Stock $1 m

R/E 0.1____________________________________

T. Assets $1.2m T. Claims $1.2m

Cash Account

Balance = $0


common stock

= $1,000,000

Inventory

Summary of the ExerciseSummary of the Exercise

•• This firm is left at the stage where it is waiting to This firm is left at the stage where it is waiting to collect on accounts receivable, but should be collect on accounts receivable, but should be ordering more inventory and converting that ordering more inventory and converting that inventory into saleable products.inventory into saleable products.

•• The firm could move forward if it had additional The firm could move forward if it had additional


General Issues

23 - 1479

•• The firm could move forward if it had additional The firm could move forward if it had additional financing:financing:–– Sale of additional shares to investorsSale of additional shares to investors–– Borrow funds Borrow funds –– Delay payment of wages to employees until collection Delay payment of wages to employees until collection

of accounts receivableof accounts receivable–– Collect on accounts receivable.Collect on accounts receivable.

The Cash BudgetThe Cash BudgetSampleSample

$ 1 2 3 4 5 6 7 8 9 10 11 12

Sales 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000 6,500

Cash inflow 1,000 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000

Cash outflow

Current sales 750 1,125 1,500 1,875 2,250 2,625 3,000 3,375 3,750 4,125 4,500 4,875

Table 23-3 ABC's 12-Month Cash Budget


General Issues

23 - 1480

Inventory 0 375 375 375 375 375 375 375 375 375 375 375

Operating cash 250 -500 -375 -250 -125 0 0 250 375 500 625 750

Start cash 1,000 1,250 750 375 125 0 0 125 375 750 1,250 1,875

End cash 1,250 750 375 125 0 0 0 375 750 1,250 1,875 2,625

Required cash 200 300 400 500 600 700 700 900 1,000 1,100 1,200 1,300

Surplus/deficit 1,050 450 -25 -375 -600 -700 -700 -525 -250 150 675 1,325

The Cash BudgetThe Cash BudgetPurposePurpose

•• The cash budget is a planning tool used to The cash budget is a planning tool used to forecast cash inflows and outflows (usually each forecast cash inflows and outflows (usually each month) out into the future.month) out into the future.

•• The purpose of the cash budget is to forecast The purpose of the cash budget is to forecast


General Issues

23 - 1481

•• The purpose of the cash budget is to forecast The purpose of the cash budget is to forecast the timing, magnitude and duration of cash flow the timing, magnitude and duration of cash flow surpluses and deficits.surpluses and deficits.

•• The cumulative impact of the cash The cumulative impact of the cash inflows/outflows will be forecast through the cash inflows/outflows will be forecast through the cash budget.budget.

Forecast Cash BalancesForecast Cash BalancesTimingTiming

$ CashPredicting when forecast deficits start and end

allow the manager to communicate with the bank and eventually becomes a control-mechanism for

the bank when monitoring the evolving financial condition of the firm.


General Issues

23 - 1482

Jan Feb Mar Apr May Jun Jul Aug

Forecast Cash BalancesForecast Cash BalancesMagnitudeMagnitude

$ Cash


General Issues

23 - 1483


How much the firm is

likely to need to borrow to

cover a projected

deficit.

Forecast Cash BalancesForecast Cash BalancesDurationDuration

$ Cash The length of time that the projected cash deficit will last is useful in choosing the

right financing solution, but is also an important control mechanism for

monitoring after the fact.


General Issues

23 - 1484


The Cash BudgetThe Cash BudgetUseUse

•• The Cash Budget:The Cash Budget:–– Allows management to change plans before they are Allows management to change plans before they are

implemented to produce a more favourable cash implemented to produce a more favourable cash resultresult


General Issues

23 - 1485

resultresult–– Allows management to choose the most correct Allows management to choose the most correct

investment option in the case of forecast surplusesinvestment option in the case of forecast surpluses–– Allows management to arrange the most appropriate Allows management to arrange the most appropriate

financing solution in the case of forecast deficits.financing solution in the case of forecast deficits.

Cash BudgetsCash BudgetsDealing with Forecast SurplusesDealing with Forecast Surpluses

•• Knowing the timing, magnitude and duration of cash surpluses allows Knowing the timing, magnitude and duration of cash surpluses allows management to choose the most appropriate management response:management to choose the most appropriate management response:

–– Small Amount of Surplus available for a short period of time (ie. less than Small Amount of Surplus available for a short period of time (ie. less than $100,000)$100,000)

•• Keep in current accountKeep in current account


General Issues23 - 1486

–– Small Sum available for a long period time Small Sum available for a long period time •• Consider dispersing as cash dividendsConsider dispersing as cash dividends•• Potentially retire debtPotentially retire debt

–– Large Sum available for a short period of time 30 Large Sum available for a short period of time 30 –– 90 days (ie. greater than 90 days (ie. greater than $100,00)$100,00)

•• Invest in money market securities such as TInvest in money market securities such as T--billsbills

–– Large Sum available for a long period timeLarge Sum available for a long period time•• Consider dispersing excess funds as cash dividendsConsider dispersing excess funds as cash dividends•• Alternatively invest in longerAlternatively invest in longer--time, higher yielding investmentstime, higher yielding investments

Cash BudgetsCash BudgetsDealing with Forecast DeficitsDealing with Forecast Deficits

•• Knowing the timing, magnitude and duration of cash deficits allows Knowing the timing, magnitude and duration of cash deficits allows management to choose the most appropriate management response:management to choose the most appropriate management response:

–– Small deficit persisting for a short period of time (ie. less than $100,000)Small deficit persisting for a short period of time (ie. less than $100,000)•• Delay purchases, speed collections and try to synchronize cash flows to eliminate Delay purchases, speed collections and try to synchronize cash flows to eliminate

or minimize, oror minimize, or•• Negotiate an operating line of credit with the financial institutionNegotiate an operating line of credit with the financial institution



•• Negotiate an operating line of credit with the financial institutionNegotiate an operating line of credit with the financial institution

–– Small deficit available for a long period time Small deficit available for a long period time •• Explore more permanent solutions to the underExplore more permanent solutions to the under--fundingfunding

–– Large deficit forecast to last a short period of time 30 Large deficit forecast to last a short period of time 30 –– 90 days (ie. greater 90 days (ie. greater than $100,00)than $100,00)

•• Operating line of credit, orOperating line of credit, or•• Seek longer term permanent capital solutions if large cash flow deficits are likely to Seek longer term permanent capital solutions if large cash flow deficits are likely to

reoccur.reoccur.

–– Large Sum available for a long period timeLarge Sum available for a long period time•• Seek permanent capital increases in the form of debt, equity or combination.Seek permanent capital increases in the form of debt, equity or combination.

•• Analysis of the impact of sales growth on the firm’s cash position Analysis of the impact of sales growth on the firm’s cash position can be done using Equation 23 can be done using Equation 23 --1:1:

Analyzing Cash Inflows and OutflowsAnalyzing Cash Inflows and OutflowsCash Changes and Sales GrowthCash Changes and Sales Growth

)]21(1[1 g-bSCash t +=∆ −[ 23-1]

The sensitivity of cash to sales growth

will be strongly related to the firm’s

inventory and


General Issues

23 - 1488

•• Where:Where:gg = monthly sales growth= monthly sales growthbb = the cash production cost and (1 = the cash production cost and (1 –– bb ) = unit contribution margin, and) = unit contribution margin, andSStt--11 = Sales at time minus 1= Sales at time minus 1

•• When this relationship is graphed we get a straight line.When this relationship is graphed we get a straight line.

inventory and accounts receivable

policies.

Analyzing Cash Inflows and OutflowsAnalyzing Cash Inflows and OutflowsCredit, Inventory and PayablesCredit, Inventory and Payables

•• We can create a formula to explore the sensitivity of the firm’s We can create a formula to explore the sensitivity of the firm’s cash position with respect to the firms credit, inventory and cash position with respect to the firms credit, inventory and payables policies.payables policies.

•• Let:Let:


General Issues

23 - 1489

•• Let:Let:αα = = the firm’s credit policy as the percentage of sales collected the firm’s credit policy as the percentage of sales collected

this monththis month1 1 –– αα = the balance of sales collected in the month following sales= the balance of sales collected in the month following salesββ = the proportion of this month’s production costs paid in this = the proportion of this month’s production costs paid in this

monthmonth

1 1 -- ββ= = the proportion of production costs paid next month.the proportion of production costs paid next month.ΓΓ = perecentage of the firm’s monthly sales tied up in inventory= perecentage of the firm’s monthly sales tied up in inventory


•• Equation 23 Equation 23 --2 shows that the change in cash each month depends 2 shows that the change in cash each month depends on:on:–– Credit policy Credit policy –– how much sales revenue is collected in the month of salehow much sales revenue is collected in the month of sale–– Inventory management practicesInventory management practices–– Trade credit Trade credit –– how much of current production is paid this month versus how much of current production is paid this month versus

next month:next month:


General Issues

23 - 1490

next month:next month:

()1()1( 1111 )SSbγSb-bβbSSCash ttttt −−− −−−−−+=∆ βαα[ 23-2]


•• We can simplify Equation 23 We can simplify Equation 23 --2 by including the sales growth rate 2 by including the sales growth rate and removing the different sales levels:and removing the different sales levels:

Cash∆


General Issues

23 - 1491

11

γ)]g-b(β[-b)(S

Cash

t

++=∆

−

α[ 23-3]

We can now graph the change in cash against the sales growth rate:

Analyzing Cash Inflows and OutflowsAnalyzing Cash Inflows and OutflowsChange in Cash and Sales GrowthChange in Cash and Sales Growth

23 - 1 FIGURE

Cash Sb-1

(1-b) gb ))(( γβα +−

The slope of this line is determined by the firm’s

credit, inventory and


General Issues

23 - 1492

g

“Break-even” Sales Growth Rate

(1-b) gb ))(( γβα +− inventory and payables

policies and practices.


23 - 1 FIGURE

Cash Sb-1

(1-b) gb ))(( γβα +−

A lower slope for this line will reduce the firm’s

cash sensitivity to


General Issues

23 - 1493

g


(1-b) gb ))(( γβα +− sensitivity to changes in

sales.


A lower slope can be

achieved by:• Collecting on

A/R more quickly

23 - 1 FIGURE

Cash Sb-1

(1-b) gb ))(( γβα +−


General Issues

23 - 1494

quickly• Delaying

payments on A/P longer

• Increasing the inventory turnover rate. g


(1-b) gb ))(( γβα +−


•• We can solve for the monthly sales growth rate where the firm can grow We can solve for the monthly sales growth rate where the firm can grow without needing or generating cash:without needing or generating cash:

])([

1

αγβ −+−=

b

bg[ 23-4]


General Issues

23 - 1495

•• The firm can grow faster if:The firm can grow faster if:–– It has a higher gross margin (It has a higher gross margin (1 1 –– bb))–– Lower production costs (Lower production costs (bb))–– Collects is receivables more quickly (higher Collects is receivables more quickly (higher αα))–– Pays its bills more slowly (lower Pays its bills more slowly (lower ββ))–– Has less inventory (lower Has less inventory (lower γγ))

])([ αγβ −+b

Use of Ratios in Working Capital Use of Ratios in Working Capital ManagementManagement

•• Ratios are commonly used to assess or to Ratios are commonly used to assess or to summarize a firm’s working capital summarize a firm’s working capital management.management.


General Issues

23 - 1496

management.management.•• The focus of such an assessment is:The focus of such an assessment is:

–– Liquidity managementLiquidity management–– The firm’s efficiency in asset utilizationThe firm’s efficiency in asset utilization–– Current liability managementCurrent liability management

Working Capital ManagementWorking Capital ManagementLiquidity RatiosLiquidity Ratios

•• Ratios used to assess the firm’s liquidity include the current and quick Ratios used to assess the firm’s liquidity include the current and quick ratios:ratios:

)(

)(

CLsliabilitieCurrent

CAassetsCurrentratioCurrent =[ 23-5]


General Issues

23 - 1497

•• Excessive liquidity will reduce ROI and ROE. It can also mean the firm is Excessive liquidity will reduce ROI and ROE. It can also mean the firm is too lenient in terms of credit policy, or may have excessive inventories that too lenient in terms of credit policy, or may have excessive inventories that may be subject to technological obsolescence.may be subject to technological obsolescence.

)()(sec)(

CL

ARreceivableaccountsMSuritiesMarketableCCashratioQuick

++=[ 23-6]

Working Capital ManagementWorking Capital ManagementWorking Capital RatiosWorking Capital Ratios

•• Changes in these ratios can indicate growing problems with credit Changes in these ratios can indicate growing problems with credit policy and/or a need to improve collections efforts.policy and/or a need to improve collections efforts.

[ 23-7] T)turnover(RsReceivable

AR

Sales=


General Issues

23 - 1498

•• The shorter the collection period, the lower the cash sensitivity to The shorter the collection period, the lower the cash sensitivity to changes in sales.changes in sales.

[ 23-7]

365

)()period(ACP collectionAverage

RTADSsalesdailyAverage

AR ==[ 23-8]


•• CGS is not likely to be comparable across different firms, so alternative is to CGS is not likely to be comparable across different firms, so alternative is to use Sales in the numerator as illustrated in Equation 23 use Sales in the numerator as illustrated in Equation 23 -- 10.10.

)(

T)Turnover(IInventory Inventory

CGSsoldgoodsofCost=[ 23-9]


General Issues

23 - 1499

•• The higher the inventory turnover, the lower the sensitivity of cash to The higher the inventory turnover, the lower the sensitivity of cash to changes in sales.changes in sales.


Sales=[ 23-10]


•• Dividing 364 days by inventory turnover (IT) gives ADSI:Dividing 364 days by inventory turnover (IT) gives ADSI:


Sales=[ 23-10]


General Issues

23 - 1500

•• The higher IT the lower ADSI showing more efficient inventory The higher IT the lower ADSI showing more efficient inventory management and a reduced sensitivity of cash to changes in sales.management and a reduced sensitivity of cash to changes in sales.

365

ADSI)inventory(in sales days AverageITADS

Inventory ==[ 23-11]


•• On the liability side of the balance payable management ratios include:On the liability side of the balance payable management ratios include:

PT) turnover(PayablespayableAccounts

Sales=[ 23-12]


General Issues

23 - 1501

•• PT shows how many times a year a firm pays off its suppliers on average.PT shows how many times a year a firm pays off its suppliers on average.•• ADSP shows how long a firm defers payments to its suppliers.ADSP shows how long a firm defers payments to its suppliers.

365

DSP)payables(Ain sales of days AveragePTADS

payableAccounts ==[ 23-13]

Operating Cycle (OC)Operating Cycle (OC)

–– Operating cycle is the time period Operating cycle is the time period between the acquisition of between the acquisition of

inventory and when cash is inventory and when cash is collected from receivables.collected from receivables.


General Issues

23 - 1502

collected from receivables.collected from receivables.

Working Capital ManagementWorking Capital ManagementOperating and Cash Conversion CyclesOperating and Cash Conversion Cycles

•• Operating Cycle is defined by Equation 23 Operating Cycle is defined by Equation 23 --14:14:

ACPADSIOC +=[ 23-14]


General Issues

23 - 1503

•• Operating cycle is a function of average days sales in inventory and Operating cycle is a function of average days sales in inventory and the average collection period.the average collection period.

ACPADSIOC +=

Cash Conversion Cycle (CCC)Cash Conversion Cycle (CCC)

•• Cash cycle is the time between cash Cash cycle is the time between cash disbursement and cash collection.disbursement and cash collection.

•• An estimate of the average time between An estimate of the average time between when a firm pays cash for its inventory when a firm pays cash for its inventory


General Issues

23 - 1504

when a firm pays cash for its inventory when a firm pays cash for its inventory purchases and when it receives cash for its purchases and when it receives cash for its sales; the average number of days of sales sales; the average number of days of sales that firm must finance outside the use of that firm must finance outside the use of trade credt.trade credt.

Working Capital ManagementWorking Capital ManagementOperating and Cash Conversion CyclesOperating and Cash Conversion Cycles

•• The Cash Conversion Cycle is defined by Equation 23 The Cash Conversion Cycle is defined by Equation 23 –– 15:15:

ADSP-OCCCC=[ 23-15]


General Issues

23 - 1505

•• The estimated time between when a firm pays cash for inventory The estimated time between when a firm pays cash for inventory purchases and when it receives cash from sales.purchases and when it receives cash from sales.

ADSP-OCCCC=

Cash Conversion Cycle (CCC)Cash Conversion Cycle (CCC)Operating and Cash Conversion CyclesOperating and Cash Conversion Cycles

Cash Conversion CycleCash Conversion Cycle == Inventory conversion period +Inventory conversion period +Receivables conversion period Receivables conversion period --Payables deferral periodPayables deferral period


General Issues

23 - 1506

Management of the cash cycle can make an important difference in the Management of the cash cycle can make an important difference in the amount of financing required, assets employed to generate a given amount of financing required, assets employed to generate a given level of sales...and therefore, can affect ROA and ROE.level of sales...and therefore, can affect ROA and ROE.

Cash Flow Time LineCash Flow Time LineOperating and Cash Conversion CyclesOperating and Cash Conversion Cycles

Inventory period

Inventory sold

Cash received

Inventory purchased

Accounts receivable period


General Issues

23 - 1507

Inventory period Accounts receivable period

Operating cycle (OC)

Cash Conversion Cycle (CCC)

Cash paid for inventory

Accounts payable periodTime

Importance of Cash FlowImportance of Cash Flow

•• Planning to have cash available to pay bills of the business as they Planning to have cash available to pay bills of the business as they become due is a critical aspect of business survival…it is a become due is a critical aspect of business survival…it is a management skill.management skill.

•• Understanding the cash flow cycle of a firm can help you manage Understanding the cash flow cycle of a firm can help you manage those elements that are critical to ensuring you can pay your bills.those elements that are critical to ensuring you can pay your bills.


General Issues

23 - 1508

those elements that are critical to ensuring you can pay your bills.those elements that are critical to ensuring you can pay your bills.•• Cash flow forecasting through a cash budget provides important Cash flow forecasting through a cash budget provides important

information to you and to your potential funding partners about your information to you and to your potential funding partners about your operating financial needs and most particularly, the operating financial needs and most particularly, the timingtiming and and magnitudemagnitude of any projected cash deficits or surpluses.of any projected cash deficits or surpluses.

The Cash BudgetThe Cash Budget

•• The purpose of the cash budget is to forecast The purpose of the cash budget is to forecast the timing and magnitude of expected cash the timing and magnitude of expected cash deficits and surpluses so that, before the fact, deficits and surpluses so that, before the fact, you (the manager) can arrange appropriate you (the manager) can arrange appropriate financing or plan an appropriate investment financing or plan an appropriate investment


General Issues

23 - 1509

financing or plan an appropriate investment financing or plan an appropriate investment strategy.strategy.

ShortShort--term Creditterm Credit

•• shortshort--term loans can be secured much more quickly than longterm loans can be secured much more quickly than long--term creditterm credit•• shortshort--term credit is generally more flexibleterm credit is generally more flexible

–– low flotation costslow flotation costs–– generally no prepayment penaltiesgenerally no prepayment penalties–– fewer restrictive covenantsfewer restrictive covenants


General Issues

23 - 1510

–– fewer restrictive covenantsfewer restrictive covenants

•• with an upward sloping yield curve with an upward sloping yield curve -- shortshort--term credit is normally less expensive term credit is normally less expensive than longthan long--term debtterm debt

•• shortshort--term credit may be more risky than longterm credit may be more risky than long--term debt:term debt:–– interest rate risk exposureinterest rate risk exposure–– renegotiation riskrenegotiation risk

Sources of ShortSources of Short--term Financingterm Financing

•• AccrualsAccruals–– spontaneous source of financingspontaneous source of financing–– no explicit cost to these sourcesno explicit cost to these sources–– examples:examples:


General Issues

23 - 1511

•• accrued wagesaccrued wages•• accrued taxesaccrued taxes


•• Accounts Payable / Trade CreditAccounts Payable / Trade Credit–– there may be no explicit cost (eg. Net 30)there may be no explicit cost (eg. Net 30)–– if there is a discount for early payment, then if there is a discount for early payment, then


General Issues

23 - 1512

–– if there is a discount for early payment, then if there is a discount for early payment, then there is an implicit cost for not taking the there is an implicit cost for not taking the discount.discount.

–– discounts lost discounts lost -- an expense on the income an expense on the income statement can reduce net income more than statement can reduce net income more than taking a loan in order to take the discount.taking a loan in order to take the discount.

Approximate Cost of A/PApproximate Cost of A/P

Approximate percentage cost = Approximate percentage cost = [Discount percentage/(100 [Discount percentage/(100 -- Discount percentage)] Discount percentage)] [365/(Days credit is outstanding [365/(Days credit is outstanding -- Discount period)]Discount period)]

EAR = (1 + periodic interest rate)EAR = (1 + periodic interest rate)(number of times/year such an activity can occur) (number of times/year such an activity can occur) -- 11


General Issues

23 - 1513

Example: assume (2/10 net 30)Example: assume (2/10 net 30)Approximate percentage cost = (2/98)(365/20) = 37.2%Approximate percentage cost = (2/98)(365/20) = 37.2%EAR = (1 + .0204082)EAR = (1 + .0204082)18.2518.25 -- 1 = 1.4458539 1 = 1.4458539 -- 1 = 44.6% 1 = 44.6%

(This, of course, assumes that the company pays on the 30th day. The (This, of course, assumes that the company pays on the 30th day. The costs will change if the firm pays later or earlier.) costs will change if the firm pays later or earlier.)


•• Bank LoansBank Loans–– types:types:

•• operating loans operating loans •• line of creditline of credit•• revolving credit agreementrevolving credit agreement


General Issues

23 - 1514

•• revolving credit agreementrevolving credit agreement

–– costs:costs:

Effective rateEffective ratesimplesimple = interest/amount received = $800/$10,000 = 8%= interest/amount received = $800/$10,000 = 8%

Costs of Bank LoansCosts of Bank Loans

Discount InterestDiscount Interest

Interest is deducted in advance, reducing the principal amount available to to Interest is deducted in advance, reducing the principal amount available to to borrower.borrower.

Effective ratediscount = interest/amount received


General Issues

23 - 1515

Effective ratediscount = interest/amount received = interest/(Face value - interest)

= $800/($10,000 - $800) = 8.7%

orEffective ratediscount = 8%/(1-.08) = 8%/(.92) = 8.7%

Cost of Bank LoansCost of Bank Loans

Compensating BalancesCompensating Balances

Reduce the the amount of the loan available to the borrower and effectively Reduce the the amount of the loan available to the borrower and effectively increase the cost of the loan.increase the cost of the loan.

Effective rateEffective rate = Nominal Rate(%)/ (1.0 = Nominal Rate(%)/ (1.0 -- CB stated as a fraction)CB stated as a fraction)


General Issues

23 - 1516

Effective rateEffective ratesimple/CBsimple/CB = Nominal Rate(%)/ (1.0 = Nominal Rate(%)/ (1.0 -- CB stated as a fraction)CB stated as a fraction)= 8%/(1.0 = 8%/(1.0 -- 0.10)0.10)= 8%/.9= 8%/.9= 8.9%= 8.9%

Commercial PaperCommercial Paper

•• shortshort--term unsecured promissory note issued term unsecured promissory note issued only by the most creditonly by the most credit--worthy of corporate worthy of corporate issuersissuers

•• byby--passes banks and allows the firm direct passes banks and allows the firm direct


General Issues

23 - 1517

•• byby--passes banks and allows the firm direct passes banks and allows the firm direct access to the money marketaccess to the money market

•• is a negotiable security that does not carry a is a negotiable security that does not carry a stated rate of interest, rather, it trades at a stated rate of interest, rather, it trades at a discount from par value.discount from par value.

Banker’s AcceptancesBanker’s Acceptances

•• an alternative to commercial paper for smaller an alternative to commercial paper for smaller firms that don’t have the creditfirms that don’t have the credit--worthiness to worthiness to secure commercial paper financing.secure commercial paper financing.

•• a money market instrumenta money market instrument


General Issues

23 - 1518

•• a money market instrumenta money market instrument•• the bank “accepts” the promissory note by the bank “accepts” the promissory note by

stamping it “accepted”....the note therefore is stamping it “accepted”....the note therefore is secured by the Bank’s promise to pay.secured by the Bank’s promise to pay.

Pledging of A/RPledging of A/R

•• lender has claims against the receivables as well lender has claims against the receivables as well as recourse to the borrower.as recourse to the borrower.

•• the risk of default on the receivable stays with the risk of default on the receivable stays with the borrower.the borrower.


General Issues

23 - 1519

the borrower.the borrower.•• the buyer of the goods does not know that the the buyer of the goods does not know that the

receivables have been pledged as collateral for receivables have been pledged as collateral for a loan.a loan.

Factoring (Selling) A/RFactoring (Selling) A/R•• legally binding agreement between the seller of the goods and the financial institution.legally binding agreement between the seller of the goods and the financial institution.•• the factoring institution receives a credit approval slip...the institution does a credit check...if the factoring institution receives a credit approval slip...the institution does a credit check...if

approved, shipment is made and the buyer is instructed to make payment directly to the approved, shipment is made and the buyer is instructed to make payment directly to the factoring company.factoring company.

•• the factor the factor -- credit check credit check -- lendslends -- bears risk bears risk -- in the process of performing these functions, in the process of performing these functions, the firm that sells its receivables to a factor, eliminates the need for an accounts receivable the firm that sells its receivables to a factor, eliminates the need for an accounts receivable department and receives a net amount of cash immediately following the sale...these funds department and receives a net amount of cash immediately following the sale...these funds are advanced by the factor.are advanced by the factor.


General Issues

23 - 1520

are advanced by the factor.are advanced by the factor.•• the factor is compensated for its services and protects its interests by charging interest, the factor is compensated for its services and protects its interests by charging interest,

charging a commission and maintaining a holdcharging a commission and maintaining a hold--back(reserve) in the case of disputes back(reserve) in the case of disputes between buyer and seller over damaged goods, returns, etc.between buyer and seller over damaged goods, returns, etc.

•• once this arrangement is in place once this arrangement is in place -- the financing is the financing is spontaneous.spontaneous.

Inventory FinancingInventory Financing

•• Blanket Liens Blanket Liens -- gives the lending institution a lien against all of the gives the lending institution a lien against all of the borrower’s inventories.borrower’s inventories.

•• Trust Receipts Trust Receipts -- issued for specific items of inventory. The lending issued for specific items of inventory. The lending institution sends someone to the borrower’s premises to periodically institution sends someone to the borrower’s premises to periodically check that the numbers are correctly listed.check that the numbers are correctly listed.


General Issues

23 - 1521

check that the numbers are correctly listed.check that the numbers are correctly listed.•• Warehouse ReceiptsWarehouse Receipts -- either an independent third party warehouses the either an independent third party warehouses the

goods, or the goods are secured in a separate location on the goods, or the goods are secured in a separate location on the borrower’s property. Warehouse financing involves:borrower’s property. Warehouse financing involves:

•• public notificationpublic notification•• physical control of the inventoryphysical control of the inventory•• supervision by a custodiansupervision by a custodian

-- used to finance the seasonal buildup of inventory.used to finance the seasonal buildup of inventory.-- ensures proper warehousing practices...and inventory control.ensures proper warehousing practices...and inventory control.-- because of the foregoing, inventory becomes more acceptable as collateral.because of the foregoing, inventory becomes more acceptable as collateral.

Balance Sheet Accounts over timeBalance Sheet Accounts over time

100

120

www.bookfiesta4u.com ContentsCHAPTER 23 – Working Capital Management – General Iss ues 23 - 1522

0

20

40

60

80

Ja Fe Ma Ap Ma Jn Ju Au Se Oc No De

CashInventories

Selecting the Fiscal Year EndSelecting the Fiscal Year End

•• tax considerationstax considerations–– for smaller, owner/managed enterprises, there are greater taxfor smaller, owner/managed enterprises, there are greater tax--planning planning

opportunities if the corporate fiscal year end is set sometime after the calendar opportunities if the corporate fiscal year end is set sometime after the calendar year endyear end

–– the firm’s financial positionthe firm’s financial position–– firms will look most healthy if the fiscal year end is set sometime after firms will look most healthy if the fiscal year end is set sometime after

the seasonal sales peak....long enough afterward to see receivables the seasonal sales peak....long enough afterward to see receivables


General Issues

23 - 1523

the seasonal sales peak....long enough afterward to see receivables the seasonal sales peak....long enough afterward to see receivables collected.collected.

–– auditors preferencesauditors preferences–– auditors are busy around the calendar year end...with firms and auditors are busy around the calendar year end...with firms and

individuals that have selected Dec 31 as their year end.individuals that have selected Dec 31 as their year end.–– auditors are busy from February through May with income taxauditors are busy from February through May with income tax

Key TopicsKey Topics

•• Reasons for holding CashReasons for holding Cash•• Advantages of holding CashAdvantages of holding Cash•• Cash BudgetsCash Budgets•• Cash Management TechniquesCash Management Techniques•• Marketable Securities ManagementMarketable Securities Management


General Issues

23 - 1524

•• Marketable Securities ManagementMarketable Securities Management•• Criteria for selecting marketable securitiesCriteria for selecting marketable securities•• Balancing Cash and Marketable Security HoldingsBalancing Cash and Marketable Security Holdings

Reasons for Holding CashReasons for Holding Cash

•• transactionstransactions•• compensation to banks for providing services compensation to banks for providing services

and loansand loans•• precautionary balances/speculative balances vs. precautionary balances/speculative balances vs.


General Issues

23 - 1525

•• precautionary balances/speculative balances vs. precautionary balances/speculative balances vs. reserve borrowing capacity.reserve borrowing capacity.

Advantages of Holding CashAdvantages of Holding Cash

•• take advantage of trade discountstake advantage of trade discounts•• maintain adequate liquidity...and therefore a maintain adequate liquidity...and therefore a

strong credit ratingstrong credit rating•• take advantage of special offers and unexpected take advantage of special offers and unexpected


General Issues

23 - 1526

•• take advantage of special offers and unexpected take advantage of special offers and unexpected opportunitiesopportunities

•• have sufficient liquid resources in times of have sufficient liquid resources in times of emergencyemergency

Marketable SecuritiesMarketable Securities

•• holding M/Sholding M/S–– conservative working capital management strategyconservative working capital management strategy–– finance seasonal/cyclical needsfinance seasonal/cyclical needs–– build funds for a major investment/acquisition/cash outflowbuild funds for a major investment/acquisition/cash outflow–– productive precautionary balanceproductive precautionary balance


General Issues

23 - 1527

•• criteria used to select M/Scriteria used to select M/S–– default riskdefault risk–– interest rate riskinterest rate risk–– purchasing power riskpurchasing power risk–– liquidity or marketability riskliquidity or marketability risk–– overall rate of returnoverall rate of return

In summary you have …In summary you have …

•• gained an understanding the management of shortgained an understanding the management of short--term financeterm finance•• learned that shortlearned that short--term cash flow management involves the term cash flow management involves the

minimizing of costs while ensuring there are adequate liquid minimizing of costs while ensuring there are adequate liquid resources available to meet the anticipated needsresources available to meet the anticipated needs



resources available to meet the anticipated needsresources available to meet the anticipated needs•• learned that in the real world, the firm must keep additional learned that in the real world, the firm must keep additional

working capital resources as a buffer against unexpected needs working capital resources as a buffer against unexpected needs and opportunitiesand opportunities

•• learned how to prepare a cash budget and how to use it.learned how to prepare a cash budget and how to use it.


In this chapter you have learned:In this chapter you have learned:–– The importance of effective working capital management The importance of effective working capital management

and the classic cash flow challenges faced by growing and the classic cash flow challenges faced by growing firms.firms.

–– That an integrative approach to working capital That an integrative approach to working capital


General Issues

23 - 1529

–– That an integrative approach to working capital That an integrative approach to working capital management reveals the relationships and management reveals the relationships and interdependency among working capital accountsinterdependency among working capital accounts

–– How to generate and use cash budgetsHow to generate and use cash budgets–– How to use some common ratios to assess a firm’s overall How to use some common ratios to assess a firm’s overall

approach to working capital management.approach to working capital management.

CHAPTER 24CHAPTER 24

Working Capital Management: Working Capital Management: Working Capital Management: Working Capital Management: Current Assets and Current Current Assets and Current

LiabilitiesLiabilities


•• Learning ObjectivesLearning Objectives•• Important TermsImportant Terms•• Cash ManagementCash Management

–– Reasons for Holding CashReasons for Holding Cash–– Determining the Optimal Cash BalanceDetermining the Optimal Cash Balance–– Cash Management TechniquesCash Management Techniques

•• Accounts Receivable ManagementAccounts Receivable Management


Current Assets and Current Liabilities

24 - 1532

•• Accounts Receivable ManagementAccounts Receivable Management–– The Credit DecisionThe Credit Decision–– Credit PoliciesCredit Policies–– The Collection ProcessThe Collection Process

•• Inventory ManagementInventory Management–– Inventory Management ApproachesInventory Management Approaches–– Evaluating Inventory ManagementEvaluating Inventory Management

•• ShortShort--Term Financing ConsiderationsTerm Financing Considerations•• Summary and ConclusionsSummary and Conclusions



You should understand the following:You should understand the following:•• How to manage individual asset items, such as cash, receivables, How to manage individual asset items, such as cash, receivables,

and inventoryand inventory•• The nature of the major sources of shortThe nature of the major sources of short--term financing, such as term financing, such as



24 - 1533

trade credit, bank loans, factoring arrangements, and money trade credit, bank loans, factoring arrangements, and money market securitiesmarket securities

•• The fact that in evaluating current asset and current liability The fact that in evaluating current asset and current liability decisions, the final decision rests on the standard problem of decisions, the final decision rests on the standard problem of trading off expected benefits and potential coststrading off expected benefits and potential costs


•• ABC approachABC approach•• CapacityCapacity•• CharacterCharacter•• ConditionsConditions•• Credit analysisCredit analysis

•• Materials requirement planningMaterials requirement planning•• Open accountOpen account•• Optimal cash balanceOptimal cash balance•• Precautionary motivePrecautionary motive•• PrepaymentsPrepayments•• SecuritizationSecuritization



24 - 1534

•• Credit enhancementsCredit enhancements•• Economic Order QuantityEconomic Order Quantity•• Factoring arrangementsFactoring arrangements•• Finance motiveFinance motive•• FloatFloat•• JustJust--inin--time inventory time inventory

systemssystems

•• Special purpose vehiclesSpecial purpose vehicles•• Speculative motiveSpeculative motive•• Terms of creditTerms of credit•• Transactions motiveTransactions motive

Cash and Marketable SecuritiesCash and Marketable SecuritiesReasons for Holding CashReasons for Holding Cash

1.1. Transactions motiveTransactions motive2.2. Precautionary motivePrecautionary motive3.3. Finance motiveFinance motive4.4. Speculative motiveSpeculative motive


Current Assets and Current Liabilities24 - 1535

4.4. Speculative motiveSpeculative motive

Cash and Marketable SecuritiesCash and Marketable SecuritiesDetermining the Optimal Cash BalanceDetermining the Optimal Cash Balance

•• The optimal cash balance is the amount of cash The optimal cash balance is the amount of cash that balances the risks of illiquidity against the that balances the risks of illiquidity against the sacrifice in expected return that is associated sacrifice in expected return that is associated with maintaining cash.with maintaining cash.



24 - 1536

with maintaining cash.with maintaining cash.–– Differs substantially across firmsDiffers substantially across firms

•• Firms with predictable cash flows will have lower optimal Firms with predictable cash flows will have lower optimal cash balance requirementcash balance requirement

•• Firms with excess borrowing capacity (unused line of credit Firms with excess borrowing capacity (unused line of credit for example) can hold less cash.for example) can hold less cash.

Cash and Marketable SecuritiesCash and Marketable SecuritiesCash Management TechniquesCash Management Techniques

•• Cash flow synchronization can free up cash (and lower the Cash flow synchronization can free up cash (and lower the amount of capital a firm requires)amount of capital a firm requires)

•• This is done by:This is done by:–– Speeding up cash inflows:Speeding up cash inflows:

•• Bill clients earlier each monthBill clients earlier each month



24 - 1537

•• Bill clients earlier each monthBill clients earlier each month•• Increase cash sales through incentivesIncrease cash sales through incentives•• Encourage customers to pay using electronic payments systems Encourage customers to pay using electronic payments systems

such as direct deposit, automatic debit, debit card, rather than such as direct deposit, automatic debit, debit card, rather than cheque.cheque.

–– Delaying outflows:Delaying outflows:•• Arrange with suppliers for more liberal trade credit terms (net 40 Arrange with suppliers for more liberal trade credit terms (net 40

rather than net 30 for example)rather than net 30 for example)•• Paying employees once a month rather than twice.Paying employees once a month rather than twice.

Cash ManagementsCash ManagementsFloatFloat

•• Float is the time that elapses between the time the paying Float is the time that elapses between the time the paying firm initiates payment, and the time the funds are available firm initiates payment, and the time the funds are available for use by the receiving firm.for use by the receiving firm.

•• It has three major sources:It has three major sources:1.1. The time it takes the cheque to reach the firm after it is mailed by The time it takes the cheque to reach the firm after it is mailed by

the customer.the customer.



24 - 1538

the customer.the customer.2.2. The time it takes the receiving firm to process the cheque and The time it takes the receiving firm to process the cheque and

deposit in an account, anddeposit in an account, and3.3. The time it takes the cheque to clear through the banking system The time it takes the cheque to clear through the banking system

so that the funds are available to the firm.so that the funds are available to the firm.•• Float has been reduced or eliminated through:Float has been reduced or eliminated through:

–– Debit cardsDebit cards–– Preauthorized paymentsPreauthorized payments–– Electronic funds transfer (EFT) and electronic data interchange Electronic funds transfer (EFT) and electronic data interchange

(EDI) systems.(EDI) systems.

Accounts ReceivableAccounts Receivable

1.1. The decision to extend credit to customers has significant The decision to extend credit to customers has significant cash flow and credit risk implications for the firm.cash flow and credit risk implications for the firm.

•• Firms often don’t have a choice, if the availability of credit is an Firms often don’t have a choice, if the availability of credit is an important factor in the customer’s purchase decision process (if important factor in the customer’s purchase decision process (if competitors offer credit, then the firm must at least match those competitors offer credit, then the firm must at least match those credit terms, and then choose to compete on another basis.)credit terms, and then choose to compete on another basis.)



24 - 1539

credit terms, and then choose to compete on another basis.)credit terms, and then choose to compete on another basis.)

2.2. The second decision (once the firm has decided to extend The second decision (once the firm has decided to extend credit) is to determine which customers will be granted credit) is to determine which customers will be granted credit.credit.

3.3. The credit terms must be established.The credit terms must be established.4.4. The collection process must be decided.The collection process must be decided.

Accounts ReceivableAccounts ReceivableThe Credit DecisionThe Credit Decision

•• The decision to extend credit is determined:The decision to extend credit is determined:–– Nature of the product sold,Nature of the product sold,–– The industryThe industry–– Practices of competitors.Practices of competitors.



24 - 1540

–– Practices of competitors.Practices of competitors.

Accounts ReceivableAccounts ReceivableCredit AnalysisCredit Analysis

•• The process designed to assess the risk of nonThe process designed to assess the risk of non--payment by payment by potential customers, which involves collecting information potential customers, which involves collecting information about potential customers with respect to their credit history, about potential customers with respect to their credit history, their ability to make payments as reflected in their expected their ability to make payments as reflected in their expected cash flows, and their overall financial stability.cash flows, and their overall financial stability.



24 - 1541

cash flows, and their overall financial stability.cash flows, and their overall financial stability.•• From the firm’s point of view:From the firm’s point of view:

–– Often willing to extend credit on terms better than a bank Often willing to extend credit on terms better than a bank because:because:

•• The potential for the firm developing a good customer into the The potential for the firm developing a good customer into the future, andfuture, and

•• Losses are limited to production costs in the case of default.Losses are limited to production costs in the case of default.

Accounts ReceivableAccounts ReceivableCredit AnalysisCredit Analysis

Variables that are weighed in the credit analysis Variables that are weighed in the credit analysis process:process:

–– Capacity Capacity –– the customer’s ability to paythe customer’s ability to pay



24 - 1542

–– Capacity Capacity –– the customer’s ability to paythe customer’s ability to pay–– Character Character –– the customer’s willingness to paythe customer’s willingness to pay–– Collateral Collateral –– the security that could be seized to satisfy the security that could be seized to satisfy

paymentpayment–– Conditions Conditions –– the state of the economy.the state of the economy.

Accounts ReceivableAccounts ReceivableCredit PoliciesCredit Policies

•• The firm must choose what terms of credit to The firm must choose what terms of credit to offer its customers.offer its customers.

•• Terms of credit include:Terms of credit include:–– The due dateThe due date–– The discount amount (if any)The discount amount (if any)



24 - 1543

–– The discount amount (if any)The discount amount (if any)

•• Options include:Options include:–– Cash on delivery (COD)Cash on delivery (COD)–– Cash before delivery (CBD)Cash before delivery (CBD)–– Net 30, net 40 Net 30, net 40 -- no incentive for early paymentno incentive for early payment–– 2/10 net 30 2/10 net 30 -- a 2% discount for early paymenta 2% discount for early payment

Accounts ReceivableAccounts ReceivableChange in Credit Policy AnalysisChange in Credit Policy Analysis

•• When extending more lenient credit terms the firm hopes to increase When extending more lenient credit terms the firm hopes to increase revenues through the sale of more units, and perhaps even charge revenues through the sale of more units, and perhaps even charge higher prices.higher prices.

•• These benefits are offset by financing costs and the increased risk These benefits are offset by financing costs and the increased risk of nonof non--payment.payment.



24 - 1544

of nonof non--payment.payment.•• Evaluation of these decisions can use an NPV framework:Evaluation of these decisions can use an NPV framework:

CF - CFs) PV(FutureNPV 0=[ 24-1]

Accounts ReceivableAccounts ReceivableThe Collection ProcessThe Collection Process

•• The firm must monitor outstanding A/R by customer and by The firm must monitor outstanding A/R by customer and by category.category.

•• The firm must then determine what action it will take when The firm must then determine what action it will take when late payments occur.late payments occur.–– Charge interest on outstanding balancesCharge interest on outstanding balances–– Notify customer of arrears (email, mail, telephone)Notify customer of arrears (email, mail, telephone)



24 - 1545

–– Notify customer of arrears (email, mail, telephone)Notify customer of arrears (email, mail, telephone)•• Actions on unpaid amounts:Actions on unpaid amounts:

–– Allow no further purchases on creditAllow no further purchases on credit–– Choose from a number of additional options to collect:Choose from a number of additional options to collect:

1.1. Take legal actionTake legal action2.2. Sell receivable to a collection agencySell receivable to a collection agency3.3. Write off the debt as uncollectable.Write off the debt as uncollectable.

Accounts ReceivableAccounts ReceivableFactoringFactoring

It may not be costIt may not be cost--effective for a firm to manage effective for a firm to manage the collection process itself.the collection process itself.

Factoring arrangements are the sale of a firm’s Factoring arrangements are the sale of a firm’s



24 - 1546

Factoring arrangements are the sale of a firm’s Factoring arrangements are the sale of a firm’s receivables, at a discount, to a financial receivables, at a discount, to a financial company called a factor, which specializes in company called a factor, which specializes in collections, or the outcollections, or the out--sourcing of the sourcing of the collections to a factor.collections to a factor.

Evaluating Receivables ManagementEvaluating Receivables Management

•• Use of productivity ratios introduced in Chapter 4 Use of productivity ratios introduced in Chapter 4 can give a tool for evaluating the firm’s ability to can give a tool for evaluating the firm’s ability to manage its accounts receivable.manage its accounts receivable.



24 - 1547

Evaluating Receivables ManagementEvaluating Receivables ManagementReceivables TurnoverReceivables Turnover

•• Measures the sales generated by every dollar of Measures the sales generated by every dollar of receivables.receivables.



24 - 1548

Receivable Accounts

Sales

turnover sReceivable

=

=

RT

AR

S[4- 16]

Evaluating Receivables ManagementEvaluating Receivables ManagementAverage Collection PeriodAverage Collection Period

•• Estimates the number of days it takes a firm to collect on its Estimates the number of days it takes a firm to collect on its accounts receivable.accounts receivable.

ARTurnover sReceivable

365 Period Collection Average ==ADS

AR[4- 17]



24 - 1549

•• If ACP is 40 days, and the firm’s credit policy is net 30, If ACP is 40 days, and the firm’s credit policy is net 30, clearly, customers are not paying in keeping with the firm’s clearly, customers are not paying in keeping with the firm’s policy, and there may be concerns about the quality of the policy, and there may be concerns about the quality of the firm’s customers, and what might happen if economic firm’s customers, and what might happen if economic conditions deteriorate.conditions deteriorate.

turnoversReceivable

AR =ACP

InventoryInventory

•• The level of inventory a firm holds is a trade off between The level of inventory a firm holds is a trade off between benefits and costs:benefits and costs:

Benefits of Holding Inventory:Benefits of Holding Inventory:•• Take advantage of largeTake advantage of large--volume discountsvolume discounts•• Reduce the probability of production disruptions because of lack of Reduce the probability of production disruptions because of lack of



24 - 1550

•• Reduce the probability of production disruptions because of lack of Reduce the probability of production disruptions because of lack of inventoryinventory

•• Minimize lost sales because of stockMinimize lost sales because of stock--outsouts

Costs of Holding Inventory:Costs of Holding Inventory:•• Financing costs associated with inventory investmentFinancing costs associated with inventory investment•• Storage, handling, insurance, spoilage and obsolescence costs.Storage, handling, insurance, spoilage and obsolescence costs.

InventoryInventoryInventory Management ApproachesInventory Management Approaches

•• ABC ApproachABC Approach•• Economic Order Quantity (EOQ) ModelEconomic Order Quantity (EOQ) Model•• Materials Requirement Planning (MRP)Materials Requirement Planning (MRP)



24 - 1551

•• JustJust--inin--time (JIT) Inventory systems.time (JIT) Inventory systems.

InventoryInventoryEvaluating Inventory ManagementEvaluating Inventory Management

•• Use of financial ratios can give some indication Use of financial ratios can give some indication of the effectiveness of a firm’s inventory of the effectiveness of a firm’s inventory management.management.

•• Ratios, however, do not measure shortage Ratios, however, do not measure shortage



24 - 1552

•• Ratios, however, do not measure shortage Ratios, however, do not measure shortage costs, financing costs, etc.costs, financing costs, etc.

•• These ratios include:These ratios include:–– Inventory turnoverInventory turnover–– Average day’s sales in inventory.Average day’s sales in inventory.


•• Estimates the number of times, ending inventory was ‘turned Estimates the number of times, ending inventory was ‘turned over’ (sold) in the year.over’ (sold) in the year.


CGS=[4- 18]



24 - 1553

•• A ratio that involves both ‘stock’ and ‘flow’ valuesA ratio that involves both ‘stock’ and ‘flow’ values•• Is strongly a function of ending inventory value…managers Is strongly a function of ending inventory value…managers

often try to improve this ratio as they approach year end often try to improve this ratio as they approach year end through inventory reduction strategies (cash and carry through inventory reduction strategies (cash and carry sales/inventory clearance, etc.) sales/inventory clearance, etc.)

INV


•• When Cost of Goods Sold is not available, it may be When Cost of Goods Sold is not available, it may be necessary to estimate inventory turnover using sales.necessary to estimate inventory turnover using sales.


Sales=[4- 19]



24 - 1554

•• Use of the sales figure is less valid than Cost of Goods Sold Use of the sales figure is less valid than Cost of Goods Sold because Cost of Goods Sold is based on inventoried cost, but because Cost of Goods Sold is based on inventoried cost, but Sales includes a profit margin on top of inventoried cost.Sales includes a profit margin on top of inventoried cost.


=

Productivity RatiosProductivity RatiosAverage Days Sales in Inventory (ADSI)Average Days Sales in Inventory (ADSI)

•• Estimates the number of days of sales tied up in Estimates the number of days of sales tied up in inventory (based on ending inventory values)inventory (based on ending inventory values)



24 - 1555

turnoverInventory

ADS

INV

365

(ADSI)inventory in sales days Average

=

= [4- 20]

ShortShort--Term Financing ConsiderationsTerm Financing Considerations

•• Investment in current assets tend to rise and fall Investment in current assets tend to rise and fall with the volume of activity.with the volume of activity.

•• Accruals and accounts payable (trade credit) are Accruals and accounts payable (trade credit) are ‘spontaneous’ liabilities.‘spontaneous’ liabilities.



24 - 1556

‘spontaneous’ liabilities.‘spontaneous’ liabilities.•• Other sources of financing must be ‘negotiated’ Other sources of financing must be ‘negotiated’

and before using the firm must evaluate the cost and before using the firm must evaluate the cost effectiveness of alternative financing effectiveness of alternative financing mechanisms.mechanisms.

ShortShort--Term Financing ConsiderationsTerm Financing Considerations

To estimate the annual effective rate of return or cost (k) of any To estimate the annual effective rate of return or cost (k) of any financing alternative:financing alternative:



24 - 1557

1cos

1 365 - )ricePurchase p

tfinancing n-Day(k /n+=[ 24-2]

ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsTrade CreditTrade Credit

•• Often a very important source of shortOften a very important source of short--term financing.term financing.•• Offers a number of advantages:Offers a number of advantages:

–– Readily availableReadily available–– ConvenientConvenient–– FlexibleFlexible



24 - 1558

–– FlexibleFlexible–– Usually does not entail any restrictive covenants or pledges of Usually does not entail any restrictive covenants or pledges of

security.security.

•• There is no explicit cost associated with credit terms such as:There is no explicit cost associated with credit terms such as:–– Net 30Net 30–– Net 40Net 40

ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsTrade CreditTrade Credit

•• There is usually a high implicit cost to a firm that forgoes discounts There is usually a high implicit cost to a firm that forgoes discounts on early payment such as:on early payment such as:–– 2/10 Net 302/10 Net 30

Example: assume (2/10 net 30)Example: assume (2/10 net 30)



24 - 1559

Example: assume (2/10 net 30)Example: assume (2/10 net 30)Approximate percentage cost = (2/98)(365/20) = 37.2%Approximate percentage cost = (2/98)(365/20) = 37.2%

The firm is being charged 2% for the use of funds from day 10 to The firm is being charged 2% for the use of funds from day 10 to day 30 (20 days).day 30 (20 days).

ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsBank Loans and Factor ArrangementsBank Loans and Factor Arrangements

Options include:Options include:–– Operating loans / lines of creditOperating loans / lines of credit

•• Secured by accounts receivable and inventory to a maximum Secured by accounts receivable and inventory to a maximum percent of those assetspercent of those assets



24 - 1560

percent of those assetspercent of those assets•• Interest only paymentsInterest only payments•• Balance can be retired at the firm’s discretionBalance can be retired at the firm’s discretion

–– Factor arrangementsFactor arrangements

ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsMoney Market InstrumentsMoney Market Instruments

•• Large firms with high credit ratings may be able to byLarge firms with high credit ratings may be able to by--pass financial institutions and borrow directly from the pass financial institutions and borrow directly from the money market.money market.

•• Two forms of money market instruments:Two forms of money market instruments:–– Commercial paper Commercial paper



24 - 1561

–– Commercial paper Commercial paper –– Bankers’ acceptancesBankers’ acceptances

•• The firm pays a stamping fee, and is able to borrow based on their The firm pays a stamping fee, and is able to borrow based on their bank’s credit rating.bank’s credit rating.

•• Money market securities:Money market securities:–– Sold at a discount from face valueSold at a discount from face value–– Maturities at time of issue of 30, 60, 90 daysMaturities at time of issue of 30, 60, 90 days–– Face amounts of $100,000 or more.Face amounts of $100,000 or more.

ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsMoney Market InstrumentsMoney Market Instruments

•• The annualized yield on a money market instrument:The annualized yield on a money market instrument:



24 - 1562

365

yield annual eApproximatturityDays to mapriceMarket

Discount ×=[ 24-3]

ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsSecuritizationsSecuritizations

•• Special purpose vehicles (SPVs) are conduits for packaging Special purpose vehicles (SPVs) are conduits for packaging portfolios of receivables and selling them to investors in the portfolios of receivables and selling them to investors in the money market; a recent innovation in financing trade credit.money market; a recent innovation in financing trade credit.

•• Credit enhancements are actions taken to reduce credit risk, Credit enhancements are actions taken to reduce credit risk, such as requiring collateral, insurance or other agreements.such as requiring collateral, insurance or other agreements.

•• AssetAsset--backed commercial paper (ABCP) is an example.backed commercial paper (ABCP) is an example.



24 - 1563

•• AssetAsset--backed commercial paper (ABCP) is an example.backed commercial paper (ABCP) is an example.–– The subThe sub--prime mortgage problems in the U.S. has exposed the prime mortgage problems in the U.S. has exposed the

problems with ABCP where investors have become concerned problems with ABCP where investors have become concerned about the underlying asset values (packages of receivables) and about the underlying asset values (packages of receivables) and the market is actively repricing these money market instrumentsthe market is actively repricing these money market instruments

–– In some cases the market has disappeared for some of these In some cases the market has disappeared for some of these money market instruments.money market instruments.


In this chapter you have learned:In this chapter you have learned:–– That the optimal level of investment in cash, That the optimal level of investment in cash,

receivables and inventory occurs when the receivables and inventory occurs when the benefits balance the costsbenefits balance the costs



24 - 1564

benefits balance the costsbenefits balance the costs–– The advantages, the disadvantages and The advantages, the disadvantages and

associated effective annual costs of the most associated effective annual costs of the most common shortcommon short--term financing options available to term financing options available to companies.companies.

THANK YOUTHANK YOU

www.bookfiesta4u.comwww.bookfiesta4u.com

www.bookfiesta4u.com Contents

www.bookfiesta4u.comwww.bookfiesta4u.comLets Celebrate KnowledgeLets Celebrate Knowledge

introduction to corporate finance (1565 slides, 24 chapters presentation)

Economy & Finance