Theory of Corporate Finance
Theory of Corporate Finance FIN 332
Cal State Fullerton
Popular in Course
Popular in Finance
This 117 page Class Notes was uploaded by Mr. April Weber on Wednesday September 30, 2015. The Class Notes belongs to FIN 332 at California State University - Fullerton taught by Staff in Fall. Since its upload, it has received 23 views. For similar materials see /class/217018/fin-332-california-state-university-fullerton in Finance at California State University - Fullerton.
Reviews for Theory of Corporate Finance
Report this Material
What is Karma?
Karma is the currency of StudySoup.
You can buy or earn more Karma at anytime and redeem it for class notes, study guides, flashcards, and more!
Date Created: 09/30/15
Chapter 14 Financial Planning and Forecasting Pro Forma Financial Statements ANSWERS T0 ENDOFCHAPTER QUESTIONS l4l a Fquot O The operating plan provides detailed implementation guidance designed to accomplish corporate objectives It details who is responsible for what particular function and when speci c tasks are to be accomplished The nancial plan details the nancial aspects of the corporation s operating plan In addition to an analysis of the rm s current nancial condition the nancial plan normally includes a sales forecast the capital budget the cash budget pro forma nancial statements and the external nancing plan A sales forecast is merely the forecast of unit and dollar sales for some future period Of course a lot of work is required to produce a good sales forecast Generally sales forecasts are based on the recent trend in sales plus forecasts of the economic prospects for the nation industry region and so forth The sales forecast is critical to good nancial planning A pro forma nancial statement shows how an actual statement would look if certain assumptions are realized With the percent of sales forecasting method many items on the income statement and balance sheets are assumed to increase proportionally with sales As sales increase these items that are tied to sales also increase and the values of these items for a particular year are estimated as percentages of the forecasted sales for that year Funds are spontaneously generated if a liability account increases spontaneously automatically as sales increase An increase in a liability account is a source of funds thus funds have been generated Two examples of spontaneous liability accounts are accounts payable and accrued wages Note that notes payable although a current liability account is not a spontaneous source of funds since an increase in notes payable requires a speci c action between the rm and a creditor Answers and Solutions 14 1 d Additional funds needed AFN are those funds required from external sources to increase the firm s assets to support a sales increase A sales increase will normally require an increase in assets However some of this increase is usually offset by a spontaneous increase in liabilities as well as by earnings retained in the rm Those funds that are required but not generated internally must be obtained from external sources Although most firms forecasts of capital requirements are made b constructing pro forma income statements and balance sheets the AFN formula is sometimes used to forecast financial requirements It is written as follows Additional Required Spontaneous Increase in funds increase increase in retained needed in assets liabilities earnings AFN ASJAS LSJAS M31 1 d Capital intensity is the dollar amount of assets required to produce a dollar of sales The capital intensity ratio is the reciprocal of the total assets turnover ratio Lumpy assets are those assets that cannot be acquired smoothly but require large discrete additions For example an electric utility that is operating at full capacity cannot add a small amount of generating capacity at least not economically Accounts payable accrued wages and accrued taxes increase spontaneously and proportionately with sales Retained earnings increase but not proportionately The equation gives good forecasts of financial requirements if the ratios A S and L S as well as M and d are stable Otherwise another forecasting technique should be used 142 143 145 a b c d It reduces spontaneous funds however it may eventually increase retained earnings Answers and Solutions 14 2 SOLUTIONS TO ENDOF CHAPTER PROBLEMS 14 1 AFN As0As LsoAs MSl1 d w 1000000 w 1000000 00560000001 07 5000000 5000000 061000000 011000000 30000003 600000 100000 90000 410000 142 AFN w 1000000 7 011000000 7 30000003 5000000 081000000 100000 90000 800000 190000 610000 The capital intensity ratio is measured as A9780 This rm s capital intensity ratio is higher than that of the rm in Problem 141 therefore this rm is more capital intensiveit would require a large increase in total assets to support the increase in sa es 14 3 AFN 061000000 011000000 00560000001 0 600000 100000 300000 200000 Under this scenario the company would have a higher level of retained earnings which would reduce the amount of additional funds needed Answers and Solutions 14 3 144 2004 2000000 A2004 1500000 CL2004 500000 NP2004 200000 Afzoo4 200000 Accrualszoo4 100000 PM 5 d 60 A So 075 AFN As0As LsoAs MSl1 d w 2000000 075AS 015AS 002s1 06AS 002s1 06s1 so 002s1 06s1 2000000 002s1 0681 1200000 00231 1200000 05881 206896552 sl 075AS AS 005Sl1 06 Sales can increase by 206896552 2000000 6896552 without additional funds being needed 14 5 a AFN ASAS7LSAS7M8117d 1225 70 175 70 105 42006 1344 million 350 350 350 Answers and Solutions 14 4 Upton Computers Pro Forma Balance Sheet December 31 2005 Millions of Dollars Forecast Pro Forma Basis after 2004 2005 Sales Additions Pro Forma Financing Financing Cash 35 00100 420 420 Receivables 260 07430 3120 3120 Inventories 580 01660 6960 6960 Total current assets 875 10500 10500 Net xed assets 350 0100 4200 4200 Total assets 1225 14700 14700 Accounts payable 90 00257 1080 1080 Notes payable 180 1800 1344 3144 Accruals 85 00243 1020 1020 Total current liabilities 355 3900 5244 Mortgage loan 60 600 600 Common stock 150 1500 1500 Retained earnings 660 756quotlt 7356 7356 Total liab and equity 1225 13356 14700 AFN M PM 105350 3 Payout 42105 40 Nl 350 X 12 X 003 126 Addition to RE NI DIV 126 04126 06126 756 Answers and Solutions 14 5 146 a Stevens Textiles Pro Forma Income Statement December 31 2005 Thousands of Dollars Forecast Pro Forma 2004 Basis 2005 Sales 36000 115 X Saleso4 41400 Operating costs 32440 09011 gtlt Sales05 37 306 EBIT 3560 4094 Interest 460 010 X Debt04 560 EBT 3100 3534 Taxes 40 1 240 1 414 Net income 1 860 2 120 Dividends 45 837 954 Addition to RE 1023 1166 Stevens Textiles Pro Forma Balance Sheet December 31 2005 Thousands of Dollars Forecast Pro Forma Basis after 2004 2005 Sales Additions Pro Forma Financing Financing Cash 10800 00300 1242 1242 Accts receivable 6480 01883 7452 7452 Inventories 9000 02005 10350 10350 Total curr assets 16560 19044 19044 Fixed assets 12600 03500 14490 14490 Total assets 29160 33534 33534 Accounts payable 4320 01200 4968 4968 Accruals 2880 00800 3312 3312 Notes payable 2100 2 100 2128 w Total current liabilities 9300 10380 12508 Longterm debt 3500 3500 3500 Total debt 12800 13880 16008 Common stock 3500 3500 3500 Retained earnings 12860 1166 14026 14026 Total liabilities and equity 29160 31406 33534 AFN 2 128 From income statement Answers and Solutions 14 6 147 8 amp b Garlington Technologies Inc Pro Forma Income Statement December 31 2005 Forecast 2004 Basis Additions 2005 Sales 3600000 110 gtlt Salesm 3960000 Operating costs 3 279 720 0911 X Salesos 3 607 692 EBIT 320280 352308 Interest 18 280 013 X Debtm 20 280 EBT 302000 332028 Taxes 40 120 800 132 811 Net income 181 200 199 217 Dividends 108000 103 X 2004 Dividends 112000 Addition to RE 73200 87217 Garlington Technologies Inc Pro Forma Balance Statement December 31 2005 Forecast a51s o AFN With AFN 2004 2005 Sales Additions 2005 Effects 2005 Cash 180000 005 198000 198000 Receivables 360000 010 396000 396000 Inventories 720 000 020 792 000 792 000 Total current assets 1260000 1386000 1386000 Fixed assets 1 440 000 040 1 584 000 1 584 000 Total assets 2 700 000 2 970 000 2 970 000 Accounts payable 360000 010 396000 396000 Notes payable 156000 156000 128783 284783 Accruals 180 000 005 198 000 198 000 Total current liabilities 696000 750000 878783 Common stock 1800000 1800000 1800000 Retained earnings 204 000 87217 291 217 291 217 Total liab and equity 2 700 000 2 841 217 2 970 000 AFN M Cumulative AFN M See income statement Answers and Solutions 14 7 Total liabilities Accounts Longterm Common Retained 148 a and equity Payable debt stock earnings 1200000 375000 Longterm debt 425000 295000 Longterm debt 105000 Total debt Accounts payable Longterm debt 375000 105000 480000 Alternatively Total Total debt liabilities Common stock Retained earnings and equit 1200000 425000 295000 480000 b AssetsSales A VS 12000002 00000 48 L Sales 3750002500000 15 2002 Sales 1252500000 3125000 AFN ASAS LSAS MSl1 d New common stock 048625000 015625000 006312500006 75000 300000 93750 112500 75000 18750 Alternatively using the percentage of sales method Forecast Basis Additions New 2004 2005 Sales Financin RE Pro Forma Total assets 1 200 000 048 1 500 000 Current liabilities 375000 015 468750 Longterm debt 105 000 105 000 Total debt 480 000 573 750 Common stock 425000 75000 500000 Retained earnings 295 000 112500 407 500 Total common equity 720 000 907 500 Total liabilities and equity 1 200 000 1 481 250 AFN Longterm debt 18 750 Given in problem that rm will sell new common stock 75000 MPM 6 Payout 40 NIzoos 2500000 X 125 X 006 187500 Addition to RE NI X 1 Payout 187500 X 06 112500 Answers and Solutions 14 8 149 Cash 10000 X 2 20000 Accounts receivable 20000 X 2 40000 Inventories 20000 X 2 40000 Net xed assets 50000 00 50000 Total assets 1 00000 1 50000 Accounts payable 5000 X 2 10000 Notes payable 15000 15000 36000 51000 Accruals 5000 X 2 1 0000 Longterm debt 40000 40000 Common stock 10000 10000 Retained ea1nings 25000 40 29000 Total liabilities and equity 1 00000 1 14000 AFN 36000 Capacity sales Sales05 100005 2000 Target FMS ratio 5002000 025 Target FA 0252000 500 Required FA Since the rm currently has 500 of xed assets no new xed assets will be required Addition to RE MSl1 Payout ratio 005200004 40 Answers and Solutions 14 9 SOLUTION TO SPREADSHEET PROBLEM 1410 The detailed solution for the spreadsheet problem is available both on the instructor s resource CD ROM in the le Solution to FM11 Ch 14 10 Build a Modelxls and on the instructor s side of the web site httpb139ighamswleamingc0m Answers and Solutions 14 10 MINI CASE Betty Simmons the new nancial manager of Southeast Chemicals SEC a Georgia producer of specialized chemicals for use in fruit orchards must prepare a financial forecast for 2005 SEC s 2004 sales were 2 billion and the marketing department is forecasting a 25 percent increase for 2005 Simmons thinks the company was operating at full capacity in 2004 but she is not sure about this The 2004 financial statements plus some other data are shown below Assume that you were recently hired as Simmons assistant and your first major task is to help her develop the forecast She asked you to begin by answering the following set of questions Financial Statements And Other Data On SEC Millions Of Dollars A 2004 Balance Sheet of of sales m Cash amp Securities 20 1 Accounts Payable And Accruals 100 5 Accounts Receivable 240 12 Notes Payable 100 Inventory 240 12 Total Current Liabilities 200 Total Current Assets 500 LongTerm Debt 100 Net Fixed Assets 500 25 Common Stock 500 Retained Earnings 200 Total Assets 1 000 Total Liabilities And Equity 1 000 B 2004 Income Statement of m Sales 200000 Cost Of Goods Sold COGS 120000 60 Sales General And Administrative Costs 70000 35 Earnings Before Interest And Taxes 10000 Interest 1000 Earnings Before Taxes 9000 Taxes 40 3600 Net Income 5400 Dividends 40 2160 Addition To Retained Earnings 3240 Mini Case 14 11 C Key Ratios Sec Indust Pro t Margin 270 400 Return On Equity 771 1560 Days Sales Outstanding 365 Days 4380 Days 3200 Days Inventory Turnover 833 X 1 100gtlt Fixed Assets Turnover 4 00 500 DebtAssets 3000 3600 Times Interest Earned 1000gtlt 940gtlt Current Ratio 2 50 300 Return On Invested Capital NOPATOperating Capital 667 1400 I a Describe three ways that pro forma statements are used in nancial planning Answer Three important uses 1 forecast the amount of external nancing that will be required 2 evaluate the impact that changes in the operating plan have on the value of the rm 3 set appropriate targets for compensation plans b Explain the steps in nancial forecasting Answer 1 forecast sales 2 project the assets needed to support sales 3 project internally generated funds 4 project outside funds needed 5 decide how to raise funds and 6 see effects of plan on ratios and stock price c Assume 1 that SEC was operating at full capacity in 2004 with respect to all assets 2 that all assets must grow prop01tionally with sales 3 that accounts payable and accruals will also grow in proportion to sales and 4 that the 2003 pro t margin and dividend payout will be maintained Under these conditions what will the company s nancial requirements be for the coming year Use the AFN equation to answer this question Answer SEC will need 1845 million Here is the AFN equation AFN ASOAS L Zsoms MSlRR A Sog30 L Sog30 MsO1 g1 payout 100020000252000 10020000252000 00270200012506 250 25 405 1845 million Mini Case 14 12 d How would changes in these items affect the AFN 1 sales increase 2 the dividend payout ratio increases 3 the pro t margin increases 4 the capital intensity ratio increases and 5 SEC begins paying its suppliers sooner Consider each item separately and hold all other things constant Answer 1 If sales increase more assets are required which increases the AFN 2 If the payout ratio were reduced then more earnings would be retained and this would reduce the need for external nancing or AFN Note that if the rm is pro table and has any payout ratio less than 100 percent it will have some retained earnings so if the growth rate were zero AFN would be negative ie the rm would have surplus funds As the growth rate rose above zero these surplus funds would be used to nance growth At some point ie at some growth rate the surplus AFN would be exactly used up This growth rate where AFN 0 is called the sustainable growth rate and it is the maximum growth rate which can be nanced without outside funds holding the debt ratio and other ratios constant 3 If the pro t margin goes up then both total and retained earnings will increase and this will reduce the amount of AFN 4 The capital intensity ratio is de ned as the ratio of required assets to total sales or a s0 Put another way it represents the dollars of assets required per dollar of sales The higher the capital intensity ratio the more new money will be required to support an additional dollar of sales Thus the higher the capital intensity ratio the greater the AFN other things held constant 5 If SEC begins paying sooner this reduces spontaneous liabilities leading to a higher AFN e Brie y explain how to forecast nancial statements using the percent of sales approach Be sure to explain how to forecast interest expenses Answer Project sales based on forecasted growth rate in sales Forecast some items as a percent of the forecasted sales such as costs cash accounts receivable inventories net xed assets accounts payable and accruals Choose other items according to the company s nancial policy debt dividend policy which determines retained earnings common stock Given the previous assumptions and choices we can estimate the required assets to support sales and the speci ed sources of nancing The additional funds needed AFN is required assets minus speci ed sources of nancing If AFN is positive then you must secure additional nancing If AFN is negative then you have more nancing than is needed and you can pay off debt buy back stock or buy shortterm investments Mini Case 14 13 Interest expense is actually based on the daily balance of debt during the year There are three ways to approximate interest expense You can base it on 1 debt at end of year 2 debt at beginning of year or 3 average of beginning and ending debt Basing interest expense on debt at end of year will overestimate interest expense if debt is added throughout the year instead of all on January 1 It also causes circularity called nancial feedback more debt causes more interest which reduces net income which reduces retained earnings which causes more debt etc Basing interest expense on debt at beginning of year will underestimate interest expense if debt is added throughout the year instead of all on December 31 But it doesn t cause problem of circularity Basing interest expense on average of beginning and ending debt will accurately estimate the interest payments if debt is added smoothly throughout the year But it has the problem of circularity A solution that balances accuracy and complexity is to base interest expense on beginning debt but use a slightly higher interest rate This is easy to implement and is reasonably accurate See FM 1 1 ch 14 mini case feedbackxls for an example basing interest expense on average debt Mini Case 14 14 139 Now estimate the 2005 nancial requirements using the percent of sales approach Assume 1 that each type of asset as well as payables accruals and xed and variable costs will be the same percent of sales in 2005 as in 2004 2 that the payout ratio is held constant at 40 percent 3 that external funds needed are financed 50 percent by notes payable and 50 percent by long term debt no new common stock will be issued 4 that all debt carries an interest rate of 10 percent and 5 interest expenses should be based on the balance of debt at the beginning of the year Answer See the completed worksheet The problem is not dif cult to do by hand but we used a spreadsheet model for the exibility such a model provides Income Statement In Millions Of Dollars Actual Forecast 2004 Forecast Basis 2005 Sales 20000 Growth 125 25000 COGS 12000 Of Sales 6000 15000 SGA Expenses 7000 Of Sales 3500 8750 EBIT 1000 1250 Less Interest 100Interest Rate X Debt04 200 EBT 900 1050 Taxes 40 360 420 Net Income 540 630 Dividends 216 252 Add To Retained Earnings 324 378 Mini Case 14 15 Balance Sheet In Millions Of Dollars Assets Cash Accounts Receivable Inventories Total Current Assets Net Plant And Equipment Total Assets Liabilities And Equity Accounts Payable amp Accruals Notes Payable Total Current Liabilities LongTerm Bonds Total Liabilities Common Stock Retained Earnings Total Common Equity Total Liabilities And Equity Required Assets Speci ed Sources Of Financing Additional Funds Needed AFN Mini Case 14 16 2005 2005 Forecast Forecast Without With Forecast 2004 Basis AFN AFN AFN 0 200 Of Sales 100 250 250 2400 Of Sales 1200 3000 3000 2400 Of Sales 1200 3000 3000 5000 6250 6250 5000 Of Sales 2500 6250 6250 10000 12500 12500 1000 Of Sales 500 1250 1250 1000 CarryOver 1000 936 1936 2000 2250 3186 1000 CarryOver 1000 936 1936 3000 3250 5122 5000 CarryOver 5000 5000 RE02 2000 DRE03 2378 2378 7000 7378 7378 10000 10628 12500 12500 10628 18720 Why does the percent of sales approach produce a somewhat different AFN than the equation approach Which method provides the more accurate forecast Answer The difference occurs because the AFN equation method assumes that the pro t margin remains constant while the forecasted balance sheet method permits the pro t margin to vary The balance sheet method is somewhat more accurate but in this case the difference is not very large The real advantage of the balance sheet method is that it can be used when everything does not increase proportionately with sales In addition forecasters generally want to see the resulting ratios and the balance sheet method is necessary to develop the ratios In practice the only time we have ever seen the AFN equation used is to provide 1 a quick and dirty forecast prior to developing the balance sheet forecast and 2 a rough check on the balance sheet forecast Mini Case 14 17 h Calculate SEC39s forecasted ratios and compare them with the company39s 2004 ratios and with the industry averages Calculate SEC s forecasted free cash ow and return on invested capital ROIC Answer Actual Forecast Key Ratios 2004 2005 Indust Pro t Margin 270 252 400 ROE 771 854 1560 DSO 4380 4380 3200 Inventory Turnover 833 833 1100 Fixed Asset Turnover 400 400 500 DebtAssets 3000 4098 3600 TIE 1000 625 940 Current Ratio 250 196 300 Free 7 Operating Gross Investment in Cash Flow Cash Flow Operating Capital NOPAT Net Investment In Operating Capital FCF NOPAT Operating Capitalzoos Operating Capita12004 1251 04 625 125 625 500 100 500 75 1125 900 75 225 150 Note Operating Capital Net Operating Working Capital Net Fixed Assets ROIC NOPAT Capital 75 1125 0067 667 Mini Case 14 18 Based on comparisons between SEC39s days sales outstanding DSO and inventory turnover ratios with the industry average gures does it appear that SEC is operating ef ciently with respect to its inventory and accounts receivable Suppose SEC was able to bring these ratios into line with the industry averages and reduce its SGAsales ratio to 33 What effect would this have on its AFN and its nancial ratios What effect would this have on free cash ow and ROIC Answer The DSO and inventory turnover ratio indicate that SEC has excessive inventories and receivables The effect of improvements here would reduce asset requirements and AFN See the results below based on the spreadsheet FM 1 1 ch 14 mini casexls Inputs Before After DSO 4320 3201 Accounts ReceivableSales 120 877 Inventory Turnover 833 1100 Inventory Sales 120 909 SGNSales 350 330 Outputs AFN 1872 157 FCF 1500 335 ROIC 67 108 ROE 85 123 j Suppose you now learn that SEC s 2004 receivables and inventories were in line with required levels given the rm s credit and inventory policies but that excess capacity existed with regard to xed assets Speci cally xed assets were operated at only 75 percent of capacity J 1 What level of sales could have existed in 2004 with the available xed assets 2 000 Answer Full Capaclty Sales Acmal sales 2667 of capac1ty at wh1ch 075 xed assets were operated Since the rm started with excess xed asset capacity it will not have to add as much xed assets during 2004 as was originally forecasted J 2 How would the existence of excess capacity in xed assets affect the additional funds needed during 2005 Mini Case 14 19 Answer We had previously found an AFN of 1845 using the balance sheet method The xed assets increase was 025500 125 Therefore the funds needed will decline by 125 k The relationship between sales and the various types of assets is important in nancial forecasting The percent of sales approach under the assumption that each asset item grows at the same rate as sales leads to an AFN forecast that is reasonably close to the forecast using the AFN equation Explain how each of the following factors would affect the accuracy of nancial forecasts based on the AFN equation 1 economies of scale in the use of assets and 2 lumpy assets Answer 1 Economies of scale in the use of assets mean that the asset item in question must increase less than proportionately with sales hence it will grow less rapidly than sales Cash and inventory are common examples with possible relationship to sales as shown below Cash 0 Sales Inventories Base Stock 0 Sales Mini Case 14 20 In ve nto ries Sales O 2 Lumpy assets would cause the relationship between assets and sales to look as shown below This situation is common with xed assets Fix ed assets 0 Sales Mini Case 14 21 Chapter 15 Corporate Valuation ValueBased Management and Corporate Governance ANSWERS T0 ENDOFCHAPTER QUESTIONS 151 Fquot O a Assetsinplace also known as operating assets include the land buildings machines and inventory that the rm uses in its operations to produce its products and services Growth options are not tangible They include items such as RampD and customer relationships Financial or nonoperating assets include investments in marketable securities and noncontrolling interests in the stock of other companies Operating current assets are the current assets used to support operations such as cash accounts receivable and inventory It does not include shortterm investments Operating current liabilities are the current liabilities that are a natural consequence of the firm s operations such as accounts payable and accruals It does not include notes payable or any other shortterm debt that charges interest Net operating working capital is operating current assets minus operating current liabilities Operating capital is sum of net operating working capital and operating longterm assets such as net plant and equipment Operating capital also is equal to the net amount of capital raised from investors This is the amount of interestbearing debt plus preferred stock plus common equity minus shortterm investments NOPAT is the amount of net income a company would generate if it had no debt and held no nancial assets NOPAT is a better measure of the performance of a company s operations because debt lowers income In order to get a true re ection of a company s operating performance one would want to take out debt to get a clearer picture of the situation Free cash ow is the cash ow actually available for distribution to investors after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operations It is the most important measure of cash ows because it shows the exact amount available to all investors The value of operations is the present value of all the future free cash ows that are expected from current assetsinplace and the expected growth of assetsinplace when discounted at the weighted average cost of capital 00 FCFt V tt39 0 OW me E 1 WACCt The terminal or horizon value is the value of operations at the end of the explicit forecast period It is equal to the present value of all free cash ows beyond the forecast period discounted back to the end of the forecast period at the weighted average cost of capital V FCFNH FCFN 1 g OWHWN WACC g WACC g 39 The corporate valuation model defines the total value of a company as the value of operations plus the value of nonoperating assets plus the value of growth options Answers and Solutions 15 1 15 4 3 1 Valuebased management is the systematic application of the corporate value model to a com any s decisions The four value drivers are the growth rate in sales g operating pro tability OPNOPAT Sales capital requirements CRCapitalSales and the weighted average cost of capital WACC Return on Invested Capital ROIC is NOPAT divided by the amount of capital that is available at the beginning of the year D Managerial entrenchment occurs when a company has such a weak board of directors and has such strong antitakeover provisions in its corporate charter that senior managers feel there is very little chance that they will be removed Nonpecuniary bene ts are perks that are not actual cash payments such as lavish of ces memberships at country clubs corporate jets and excessively large staffs quot1 Targeted share repurchases also known as greenmail occur when a company buys back stock from a potential acquiror at a higher than fairmarket price In return the potential acquiror agrees not to attempt to take over the company Shareholder rights provisions also known as poison pills allow existing shareholders in a company to purchase additional shares of stock at a lower than market value if a potential acquiror purchases a controlling stake in the company A restricted voting rights provision automatically deprives a shareholder of voting rights if the shareholder owns more than a speci ed amount of stock A stock option allows its owner to purchase a share of stock at a xed price called the exercise price no matter what the actual price of the stock is Stock options always have an expiration date after which they cannot be exercised A restricted stock grant allows an employee to buy shares of stock at a large discount from the current stock price but the employee is restricted from selling the stock for a speci ed number of years An Employee Stock Ownership Plan often called an ESOP is a type of retirement plan in which employees own stock in the company W The rst step is to nd the value of operations by discounting all expected future free cash ows at the weighted average cost of capital The second step is to nd the total corporate value by summing the value of operations the value of nonoperating assets and the value of growth options The third step is to nd the value of equity by subtracting the value of debt and preferred stock from the total value of the corporation The last step is to divide the value of equity by the number of shares of common stock A company can be pro table and yet have an ROIC that is less than the WACC if the company has large capital requirements If ROIC is less than the WACC then the company is not earning enough on its capital to satisfy its investors Growth adds even more capital that is not satisfying investors hence growth decreases value Entrenched managers consume to many perquisites such as lavish of ces excessive staffs country club memberships and corporate jets They also invest in projects or acquisitions that make the rm larger even if they don t make the rm more valuable Stock options in compensation plans usually are issued with an exercise price equal to the current stock price As long as the stock price increases the option will become valuable even if the stock price doesn t increase as much as investors expect Answers and Solutions 15 2 SOLUTIONS TO ENDOF CHAPTER PROBLEMS 15 1 NOPAT EBIT1 T 1001 04 60 Net operating WC04 27 80 106 52 28 213 80 133 Operating capita104 133 265 398 Net operating WC05 28 84 112 56 28 224 84 140 Operating capita105 140 281 421 FCF NOPAT Net investment in operating capital 10006 421 398 370 152 Value of operations V0p PV of expected future free cash ow Vop FCF1g 400000105 6000000 WACC g 012 005 108000 153 a VOpz 2700000 b 0 1 2 3 N WACC 12 g 8 1 1 1 1 o o o 1 80000 100000 108000 7142857 7971939 2 152 42347 2 303 57143 Answers and Solutions 15 3 154 a vp 7 w 771333 3 0137007 b 0 1 2 4 N WACC13 g7 20 30 40 1770 4 l 2349 lt v 771333 52210 lt 75333 527 89 c Total valuet0 52789 100 53789 Value of common equity 53789 100 43789 Price per share 4379 155 The growth rate in FCF from 2006 to 2007 is g750007075570750 7 006 70755 106 v 7 7 15000 Op at 2006 011 006 156 v0 200000000 W 009 010 P 0098 005 200000000 40000000 160000000 MVA 160000000 200000000 40000000 157 Capltalzoog SaleSzoos 129000000 300 000 0001 005 043 v 129000000 4 0067 0098 Opatzoog 0098 005 1005 129000000 65625000000020 129000000130375000 259375000 158 Total corporate value Value of operations marketable securities 756 77 833 million Value of equity Total corporate value 7 debt 7 Preferred stock 833 7 151 190 76 416 million 159 Total corporate value Value of operations marketable securities 651 47 698 million Value of equity Total corporate value 7 debt 7 Preferred stock 698 7 65 131 33 469 million Price per share 469 10 4690 Answers and Solutions 15 4 1510 a NOPATzoos 1086104 6516 NOWC2005 56 562 1124 7 112 281 1349 million Capita12005 1349 3975 5324 million FConos NOPAT 7 Investment in Capital 6516 7 5324 5022 6516 302 3496 million b HV2005 7 3496106011006 7 741152 million 0 Vop at 12312004 3496 7411521011 69920 million 3 1 Total corporate value 69920 499 74910 million e Value ofequity 74910 7 699 1408 350 5034 million Price per share 5034 10 5034 Answers and Solutions 15 5 SOLUTION TO SPREADSHEET PROBLEM 1511 The detailed solution for the problem is available both on the instructor s resource CD ROM in the le Solution for FM Ch 15 11 Build a Modelxls and on the instructor s side of the web site httpb139ighamswleamingc0m Answers and Solutions 15 6 MINI CASE You have been hired as a consultant to Kulpa Fishing Supplies KFS a company that is seeking to increase its value KFS has asked you to estimate the value of two privately held companies that KFS is considering acquiring But rst the senior management of KFS would like for you to explain how to value companies that don t pay any dividends You have structured your presentation around the following questions a List the three types of assets that companies own Answer Assetsinplace growth options and nonoperating or nancial assets b What are assets in place How can their value be estimated Answer Assetsinplace are tangible such as buildings machines inventory Usually they are expected to grow They generate free cash ows The PV of their expected future free cash ows discounted at the WACC is the value of operations c What are growth options How can their value be estimated Answer Growth options are not tangible They include RampD such as at drug companies and genetic engineering companies and building customer relationships such as at amazonc0m Growth options are valued using option pricing techniques in Chapter 17 d What are nonoperating assets How can their value be estimated Answer Nonoperating assets are marketable securities and ownership of noncontrolling interest in another company The value of nonoperating assets usually is very close to gure that is reported on balance sheets e What is the total value of a corporation Who has claims on this value Answer Total corporate value is sum of value of operations value of nonoperating assets and value of growth options No examples in this chapter have a growth option this is deferred until chapter 17 Debt holders have rst claim Preferred stockholders have the next claim Any remaining value belongs to stockholders Mini Case 15 7 f 1 The rst acquisition target is a privately held company in a mature industry The company currently has free cash ow of 20 million Its WACC is 10 and it is expected to grow at a constant rate of 5 The company has marketable securities of 100 million It is nanced with 200 million of debt 50 million of preferred stock and 210 million of book equity What is its value of operations Answer FCFO 1 g VOP WACC g 20 1 005 VOp g 420 0 10 005 f 2 What is its total corporate value What is its value of equity Answer Total Corporate Value VOP MKT SEC 420 100 520 million Value Of Equity Total Debt Pref 520 200 50 270 million f 3 What is its MVA MVA total corporate value total book value Answer MVA total corporate value of rm minus total book value of rm total book value of rm book value of equity book value of debt book value of preferred stock MVA 520 210 200 50 60 million Mini Case 15 8 g 1 The second acquisition target is a privately held company in a growing industry The target has recently borrowed 40 million to f39mance its expansion it has no other debt or preferred stock It pays no dividends and currently has no marketable securities KFS expects the company to produce free cash ows of 5 million in one year 10 million in two years and 20 million in three years After three years free cash ow will grow at a rate of 6 Its WACC is 10 and it currently has 10 million shares of stock What is its horizon value ie its value of operations at year three What is its current value of operations ie at time zero Answer 0 re 10 1 2 3 g 6 4 N 1 1 1 1 1 o o o 1 5 10 20 4545 i 8 264 lt 15026 7 7 20 1006 398 197 V P3 7 530 7 0107006 416942 Value Of Operations g 2 What is its value of equity on a price per share basis Answer Value of equity value of operations debt 41694 40 37694 million price per share 3769410 3769 h KFS is also interested in applying value based management to its own divisions Explain what value based management is Answer VBM is the systematic application of the corporate valuation model to all corporate decisions and strategic initiatives The objective of VBM is to increase market value added MVA Mini Case 15 9 What are the four value drivers How does each of them affect value Answer MVA is determined by four drivers sales growth operating pro tability OPNOPATsales capital requirements CRoperating capital sales and the weighted average cost of capital MVA will improve if WACC is reduced operating pro tability OP increases or the capital requirement CR decreases See the next question for an explanation of the impact of growth j What is return on invested capital ROIC Why is the spread between ROIC and WACC so important Answer ROIC is the return on the capital that is in place at the beginning of the period NOPATHI ROIC t1 Capitalt If the spread between the expected return ROICM and the required return WACC is positive then MVA is positive and growth makes MVA larger The opposite is true if the spread is negative KFS has two divisions Both have current sales of 1000 current expected growth of 5 and a WACC 0f 10 Division A has high pro tability OP6 but high capital requirements CR78 Division B has low pro tability OP4 but low capital requirements CR27 What is the MVA of each division based on the current growth of 5 What is the MVA of each division if growth is 6 Answer MVAtWOP WACC CR g 1g WACC Division A Division B OP 6 6 4 4 CR 78 78 27 27 Growth 5 6 5 6 MVA 3000 3600 3000 3850 Mini Case 15 10 1 What is the ROIC of each division for 5 growth and for 6 growth How is this related to MVA Answer Division A Division B Capitalo 780 780 270 270 Growth 5 6 5 6 Salesl 1050 1060 1050 1060 Nopatl 63 636 42 424 Roicl 81 82 156 157 Mva 3000 3600 3000 3850 The expected ROIC of division A is less than the WACC so the division should postpone growth efforts until it improves ROIC by reducing capital requirements e g reducing inventory andor improving pro tability The expected ROIC of division b is greater than the WACC so the division should continue with its growth plans m The managers at KFS have heard that corporate governance can affect shareholder value List for them the three mechanisms of corporate governance Answer The three mechanisms are provisions in the charter that affect takeovers composition of the board of directors and compensation plans 11 Why is entrenched management potentially harmful to shareholders Answer Entrenchment occurs when there is little chance that poorly performing managers will be replaced There are two causes antitakeover provisions in the charter and a weak board of directors Management consumes perks lavish of ces corporate jets excessively large staffs memberships at country clubs Management accepts projects or acquisitions to make rm larger even if MVA goes down This is because salary and prestige are highly correlated with size 0 List three provisions in the corporate charter that affect takeovers Answer These include targeted share repurchases ie greenmail shareholder rights provisions ie poison pills and restricted voting rights plans Mini Case 15 11 p Explain the difference between insiders and outsiders on the board of directors What are interlocking boards Answer Weak boards have many insiders ie those who also have another position in the company compared with outsiders Interlocking boards are weaker CEO of company A sits on board of company B CEO ofB sits on board of A q What is a stock option in a compensation plan Answer Gives owner of option the right to buy a share of the company s stock at a speci ed price called the exercise price even if the actual stock price is higher Usually can t exercise the option for several years called the vesting period Can t exercise the option after a certain number of years called the expiration or maturity date Mini Case 15 12 Chapter 18 Distributions to Shareholders Dividends and Repurchases ANSWERS T0 ENDOFCHAPTER QUESTIONS 181 a Fquot 3 1 The optimal distribution policy is one that strikes a balance between dividend yield and capital gains so that the firm s stock price is maximized The dividend irrelevance theory holds that dividend policy has no effect on either the price of a firm s stock or its cost of capital The principal proponents of this View are Merton Miller and Franco Modigliani MM They prove their position in a theoretical sense but only under strict assumptions some of which are clearly not true in the real world The birdinthehand theory assumes that investors value a dollar of dividends more highly than a dollar of expected capital gains because the dividend yield component DlPO is less risky than the g component in the total expected return equation rs DlPO g The tax preference theory proposes that investors prefer capital gains over dividends because capital gains taxes can be deferred into the future but taxes on dividends must be paid as the dividends are received The information content of dividends is a theory which holds that investors regard dividend changes as signals of management forecasts Thus when dividends are raised this is Viewed by investors as recognition by man agement of future earnings increases Therefore if a firm s stock price increases with a dividend increase the reason may not be investor preference for dividends but expectations of higher future earnings Conversely a dividend reduction may signal that management is forecasting poor earnings in the future The clientele effect is the attraction of companies with specific dividend policies to those investors whose needs are best served by those policies Thus companies with high dividends will have a clientele of investors with low marginal tax rates and strong desires for current income Similarly companies with low dividends will attract a clientele with little need for current income and who often have high marginal tax rates The residual distribution model states that firms should make distributions only when more earnings are available than needed to support the optimal capital budget An extra dividend is a dividend paid in addition to the regular dividend when earnings permit Firms with volatile earnings may have a low regular dividend that can be maintained even in lowpro t or high capital investment years and then supplement it with an extra dividend when excess funds are available Answers and Solutions 18 1 The declaration date is the date on which a rm s directors issue a statement declaring a dividend If a company lists the stockholder as an owner on the holderof record date then the stockholder receives the dividend The eXdividend date is the date when the right to the dividend leaves the stock This date was established by stockbrokers to avoid confusion and is 2 business days prior to the holder of record date If the stock sale is made prior to the eXdividend date the dividend is paid to the buyer D If the stock is bought on or after the eXdividend date the dividend is paid to the seller The date on which a rm actually mails dividend checks is known as the payment date quot1 Dividend reinvestment plans allow stockholders to automatically purchase shares of common stock of the paying corporation in lieu of receiving cash dividends There are two types of plansone involves only stock that is already outstanding while the other involves newly issued stock In the rst type the dividends of all participants are pooled and the stock is purchased on the open market Participants bene t from lower transaction costs In the second type the company issues new shares to the participants Thus the company issues stock in lieu of the cash dividend In a stock split current shareholders are given some number or fraction of shares for each stock owned Thus in a 3for1 split each shareholder would receive 3 new shares in exchange for each old share thereby tripling the number of shares outstanding Stock splits usually occur when the stock price is outside of the optimal trading range Stock dividends also increase the number of shares outstanding but at a slower rate than splits In a stock dividend current shareholders receive additional shares on some proportional basis Thus a holder of 100 shares would receive 5 additional shares at no cost if a 5 percent stock dividend were declared Stock repurchases occur when a rm repurchases its own stock These shares of stock are then referred to as treasury stock The higher EPS on the now decreased number of shares outstanding will cause the price of the stock to rise and thus capital gains are substituted for cash dividends 9 Answers and Solutions 18 2 182 183 184 E Fquot O D quot1 9 The difference is largely one of accounting From the stockholders point of view an increase in the personal income tax rate would make it more desirable for a rm to retain and reinvest earnings Consequently an increase in personal tax rates should lower the aggregate payout ratio If the depreciation allowances were raised cash ows would increase With higher cash ows payout ratios would tend to increase On the other hand the change in taxallowed depreciation charges would increase rates of return on investment other things being equal and this might stimulate investment and consequently reduce payout ratios On balance it is likely that aggregate payout ratios would rise and this has in fact been the case If interest rates were to increase the increase would make retained earnings a relatively attractive way of nancing new investment Consequently the payout ratio might be expected to decline On the other hand higher interest rates would cause rd rs and rm s MCCs to risethat would mean that fewer projects would qualify for capital budgeting and the residual would increase other things constant hence the payout ratio might increase A permanent increase in pro ts would probably lead to an increase in dividends but not necessarily to an increase in the payout ratio Ifthe aggregate pro t increase were a cyclical increase that could be expected to be followed by a decline then the payout ratio might fall because rms do not generally raise dividends in response to a short run pro t increase If investment opportunities for rms declined while cash in ows remained relatively constant an increase would be expected in the payout ratio Dividends are currently paid out of aftertax dollars and interest charges from before tax dollars Permission for rms to deduct dividends as they do interest charges would make dividends less costly to pay than before and would thus tend to increase the payout ratio This change would make capital gains less attractive and would lead to an increase in the payout ratio In the case of a split the rm simply increases the number of shares and simultaneously reduces the par or stated value per share In the case of a stock dividend there must be a transfer from retained earnings to capital stock For most rms a 100 percent stock dividend and a 2for1 split accomplish exactly the same thing hence investors may choose either one a The residual distribution policy is based on the premise that since new common stock is more costly than retained ea1nings a rm should use all the retained earnings it can to satisfy its common equity requirement Thus the distribution under this policy is a function of the rm s investment opportunities Yes A more shallow plot implies that changes from the optimal capital structure have little effect on the rm s cost of capital hence value In this situation dividend policy is less critical than if the plot were Vshaped Answers and Solutions 18 3 185 a True When investors sell their stock they are subject to capital gains taxes Fquot True If a company s stock splits 2 for l and you own 100 shares then after the split you will own 200 shares True Dividend reinvestment plans that involve newly issued stock will increase the amount of equity capital available to the rm 0 3 1 False The taX code through the taX deductibility of interest encourages rms to use debt and thus pay interest to investors rather than dividends which are not taX deductible In addition due to a lower capital gains taX rate than the highest personal taX rate the taX code encourages investors in high taX brackets to prefer rms who retain earnings rather than those that pay large dividends True If a company s clientele prefers large dividends the rm is unlikely to adopt a residual dividend policy A residual dividend policy could mean low or zero dividends in some years which would upset the company s developed clientele D quot1 False If a rm follows a residual dividend policy all else constant its dividend payout will tend to decline whenever the rm s investment opportunities improve SOLUTIONS TO ENDOFCHAPTER PROBLEMS 181 70 Debt 30 Equity Capital Budget 3000000 NI 2000000 PO Equity retained 033000000 900000 NI 2000000 Additions 900 000 Eamings Remaining 1 100 000 Payout w 55 2000000 182 Po 90 Split 3 for 2 New P0 90 P 7 60 0 New 32 Answers and Solutions 18 4 183 Retained earnings Net income 1 Payout ratio 5000000055 2750000 External equity needed Total equity required New investment1 Debt ratio 10000000060 6000000 New external equity needed 6000000 2750000 3250000 The company requires 0401200000 480000 of equity nancing If the company follows a residual dividend policy it will retain 480000 for its capital budget and pay out the 120000 residual to its shareholders as a dividend The payout ratio would therefore be 120000600000 020 20 185 Equity nancing 12000000060 7200000 187 Dividends Net income Equity nancing 15000000 7200000 7800000 Dividend payout ratio DividendsNet income 780000015000000 52 DPS after split 075 Equivalent presplit dividend 0755 375 New equivalent dividend Last year s dividendl09 375 Last year s dividendl09 Last year s dividend 375109 344 Capital budget should be 10 million We know that 50 of the 10 million should be equity Therefore the company should pay dividends of Dividends Net income needed equit 7287500 5000000 2287500 Payout ratio 22875007287500 03139 3139 Answers and Solutions 18 5 188 a 1 2005 Dividends 1102004 Dividends 1103600000 3960000 2 2004 Payout 360000010800000 033 33 2005 Dividends 0332004 Net income 03314400000 4800000 Note If the payout ratio is rounded off to 33 2005 dividends are then calculated as 4752000 3 Equity nancing 8400000060 5040000 2005 Dividends Net income Equity nancing 14400000 5040000 9360000 All of the equity nancing is done with retained earnings as long as they are available 4 The regular dividends would be 10 above the 2004 dividends Regular dividends 1103600000 3960000 The residual policy calls for dividends of 9360000 Therefore the extra dividend which would be stated as such would be Extra dividend 9360000 3960000 5400000 An even better use of the surplus funds might be a stock repurchase b Policy 4 based on the regular dividend with an extra seems most logical Implemented properly it would lead to the correct capital budget and the correct nancing of that budget and it would give correct signals to investors Answers and Solutions 18 6 189 E Fquot O Q D quot1 Capital Budget 10000000 Capital structure 60 equity 40 debt Retained Earnings Needed 10000000 06 6000000 According to the residual dividend model only 2 million is available for dividends NI Retained earnings needed for cap projects Residual dividend 8000000 6000000 2000000 DPS 20000001000000 200 Payout ratio 20000008000000 25 Retained Earnings Available 8000000 300 1000000 Retained Earnings Available 8000000 3000000 Retained Earnings Available 5000000 No If the company maintains its 300 DPS only 5 million of retained ea1nings will be available for capital projects However if the rm is to maintain its current capital structure 6 million of equity is required This would necessitate the company having to issue 1 million of new common stock Capital Budget 10 million Dividends 3 million NI 8 million Capital Structure RE Available 8000000 3000000 5000000 Percentage of Cap Budget Financed with RE W 50 10000000 Percentage of Cap Budget Financed with Debt W 50 10000000 Dividends 3 million Capital Budget 10 million 60 equity 40 debt NI 8 million Equity Needed 1000000006 6000000 RE Available 8000000 3001000000 8000000 3000000 5000000 EXtemal New Equity Needed 6000000 5000000 1 5 Answers and Solutions 18 7 g Dividends 3 million NI 8 million Capital structure 60 equity 40 debt RE Available 8000000 3000000 5000000 We re forcing the RE Available Required Equity to nd the new capital budget Required Equity Capital Budget Target Equity Ratio 5000000 Capital Budget06 Capital Budget 8333333 Therefore if Buena Terra cuts its capital budget from 10 million to 833 million it can maintain its 300 DPS its current capital structure and still follow the residual dividend policy h The rm can do one of four things 1 Cut dividends 2 Change capital structure that is use more debt 3 Cut its capital budget 4 Issue new common stock Realize that each of these actions is not without consequences to the company s cost of capital stock price or both Answers and Solutions 18 8 SPREADSHEET PROBLEM 1810 The detailed solution for the problem is available both on the instructor s resource CD ROM fin the le Solutionfor FM Ch 18PJOBuz39ld aModelxls and on the instructor s side 0 the web site httpb139ighamswleamingc0m Answers and Solutions 18 9 MINI CASE Southeastern Steel Company SSC was formed 5 years ago to exploit a new continuous casting process SSC s founders Donald Brown and Margo Valencia had been employed in the research department of a major integrated steel company but when that company decided against using the new process which Brown and Valencia had developed they decided to strike out on their own One advantage of the new process was that it required relatively little capital in comparison with the typical steel company so Brown and Valencia have been able to avoid issuing new stock and thus they own all of the shares However SSC has now reached the stage where outside equity capital is necessary if the firm is to achieve its growth targets yet still maintain its target capital structure of 60 percent equity and 40 percent debt Therefore Brown and Valencia have decided to take the company public Until now Brown and Valencia have paid themselves reasonable salaries but routinely reinvested all after tax earnings in the firm so dividend policy has not been an issue However before talking with potential outside investors they must decide on a dividend policy Assume that you were recently hired by Arthur Adamson amp Company AA a national consulting firm which has been asked to help SSC prepare for its public offering Martha Millon the senior AA consultant in your group has asked you to make a presentation to Brown and Valencia in which you review the theory of dividend policy and discuss the following questions a 1 What is meant by the term distribution policy Answer Distribution policy is de ned as the rm s policy with regard to l the level of distributions 2 the form of distributions dividends or stock repurchases and 3 the stability of distributions a 2 The terms irrelevance bird in the hand and tax preference have been used to describe three major theories regarding the way dividend payouts affect a firm s value Explain what these terms mean and brie y describe each theory Mini Case 18 10 Answer Dividend irrelevance refers to the theory that investors are indifferent between dividends and capital gains making dividend policy irrelevant with regard to its effect on the value of the rm Birdin thehand refers to the theory that a dollar of dividends in the hand is preferred by investors to a dollar retained in the business in which case dividend policy would affect a f1rm s value The dividend irrelevance theory was proposed by MM but they had to make some very restrictive assumptions to prove it zero taxes no otation or transactions costs MM argued that paying out a dollar per share of dividends reduces the growth rate in earnings and dividends because new stock will have to be sold to replace the capital paid out as dividends Under their assumptions a dollar of dividends will reduce the stock price by exactly 1 Therefore according to MM stockholders should be indifferent between dividends and capital gains The birdinthehand theory is identified with Myron Gordon and John Lintner who argued that investors perceive a dollar of dividends in the hand to be less risky than a dollar of potential future capital gains in the bush hence stockholders prefer a If the birdinthehand theory is true then investors would regard a firm with a high payout ratio as being dollar of actual dividends to a dollar of retained earnings less risky than one with a low payout ratio all other things equal hence firms with high payout ratios would have higher values than those with low payout ratios MM opposed the GordonLintner theory arguing that a f1rm s risk is dependent only on the riskiness of its cash ows from assets and its capital structure not by how its earnings are distributed to investors The taX preference theory recognizes that there are two taxrelated reasons for 1 taxes are not paid on capital gains until the stock is sold 2 if a stock is held by believing that investors might prefer a low dividend payout to a high payout someone until he or she dies no capital gains taX is due at allthe beneficiaries who receive the stock can use the stock s value on the death day as their cost basis and thus escape the capital gains tax Mini Case 18 11 What do the three theories indicate regarding the actions management should take with respect to dividend payout Answer If the dividend irrelevance theory is correct then dividend payout is of no consequence and the rm may pursue any dividend payout If the birdinthehand theory is correct the rm should set a high payout if it is to maximize its stock price If the tax preference theory is correct the rm should set a low payout if it is to maximize its stock price Therefore the theories are in total con ict with one another What results have empirical studies of the dividend theories produced How does all this affect what we can tell managers about dividend payouts Answer Unfortunately empirical tests of the theories have been inconclusive because rms don t differ just with respect to payout so we cannot tell managers whether investors prefer dividends or capital gains Even though we cannot determine what the optimal dividend policy is managers can use the types of analyses discussed in this chapter to help develop a rational and reasonable if not completely optimal dividend policy Discuss 1 the information content or signaling hypothesis 2 the clientele effect and 3 their effects on distribution policy Answer 1 Different groups or clienteles of stockholders prefer different dividend payout policies For example many retirees pension funds and university endowment funds are in a low or zero tax bracket and they have a need for current cash income Therefore this group of stockholders might prefer high payout stocks These investors could of course sell some of their stock but this would be inconvenient transactions costs would be incurred and the sale might have to be made in a down market Conversely investors in their peak earnings years who are in high tax brackets and who have no need for current cash income should prefer low payout stocks Mini Case 18 12 2 E Clienteles do exist but the real question is whether there are more members of one clientele than another which would affect what a change in its dividend policy would do to the demand for the firm s stock There are also costs taxes and brokerage to stockholders who would be forced to switch from one stock to another if a firm changes its policy Therefore we cannot say whether a policy change to appeal to one particular clientele or another would lower or raise a firm s cost of equity MM argued that one clientele is as good as another so in their view the existence of clienteles does not imply that one dividend policy is better than another Still no one has offered convincing proof that firms can disregard clientele effects We know that stockholder shifts will occur if policy is changed and since such shifts result in transaction costs and capital gains taxes policy changes should not be taken lightly Further dividend policy should be changed slowly rather than abruptly in order to give stockholders time to adjust It has long been recognized that the announcement of a dividend increase often results in an increase in the stock price while an announcement of a dividend cut typically causes the stock price to fall One could argue that this observation supports the premise that investors prefer dividends to capital gains However MM argued that dividend announcements are signals through which management Information asymmetries eXistmanagers know more about their firms prospects than do investors Further managers tend conveys information to investors to raise dividends only when they believe that future earnings can comfortably support a higher dividend level and they cut dividends only as a last resort Therefore 1 a largerthannormal dividend increase signals that management believes the future is bright 2 a smallerthaneXpected increase or a dividend cut is a negative signal and 3 if dividends are increased by a normal amount this is a neutral signal Mini Case 18 13 c 1 Assume that SSC has an 800000 capital budget planned for the coming year You have determined that its present capital structure 60 percent equity and 40 percent debt is optimal and its net income is forecasted at 600000 Use the residual distribution model approach to determine SSC s total dollar distribution Assume for now that the distribution is in the form of a dividend Then explain what would happen if net income were forecasted at 400000 or at 800000 Answer We make the following points a Fquot 0 3 1 Given the optimal capital budget and the target capital structure we must now determine the amount of equity needed to nance the projects Of the 800000 required for the capital budget 06800000 480000 must be raised as equity and 04800000 320000 must be raised as debt if we are to maintain the optimal capital structure Debt 320000 40 Equity 480 000 800 000 04 If a residual eXiststhat is if net income exceeds the amount of equity the company needsthen it should distribute the residual amount out as either dividends or stock repurchases For now we assume all payouts are in the form of dividends Since 600000 of earnings is available and only 480000 is needed the residual is 600000 480000 120000 so this is the amount which should be paid out as dividends 120000600000 020 20 Thus the payout ratio would be If only 400000 of earnings were available the theoretical break point would occur at BP 40000006 666667 investment opportunity set and marginal cost of capital was still at 800000 the Assuming the intersection of the rm would still need 480000 of equity It should then retain a11 of its earnings and also sell 80000 of new stock The residual policy would call for a zero payment If 800000 of earnings was available the dividend would be increased to 800000 480000 320000800000 40 320000 and the payout ratio would rise to Mini Case 18 14 e Equot Answer In general terms how would a change in investment opportunities affect the payout ratio under the residual payment policy A change in investment opportunities would lead to an increase if investment opportunities were good or a decrease if investment opportunities were not good in the amount of equity needed hence in the residual dividend payout Answer What are the advantages and disadvantages of the residual policy Hint don t neglect signaling and clientele effects The primary advantage of the residual policy is that under it the rm makes maximum use of lower cost retained earnings thus minimizing otation costs and hence the cost of capital Also whatever negative signals are associated with stock issues would be avoided However if it were applied exactly the residual model would result in dividend payments which uctuated signi cantly from year to year as capital requirements and internal cash ows uctuated This would 1 send investors con icting signals over time regarding the rm s future prospects and 2 since no speci c clientele would be attracted to the rm it would be an orphan These signaling and clientele effects would lead to a higher required return on equity which would more than offset the effects of lower otation costs Because of these factors few if any publicly owned rms follow the residual model on a yeartoyear basis Even though the residual approach is not used to set the annual dividend it is used when rms establish their longrun dividend policy If normalized cost of capital and investment opportunity conditions suggest that in a normal year the company should pay out about 60 percent of its earnings this fact will be noted and used to help determine the longrun policy Answer What are stock repurchases Discuss the advantages and disadvantages of a firm s repurchasing its own shares A rm may distribute cash to stockholders by repurchasing its own stock rather than paying out cash dividends Stock repurchases can be used 1 somewhat routinely as an alternative to regular dividends 2 to dispose of excess nonrecurring cash that came from asset sales or from temporarily high earnings and 3 in connection with a capital structure change in which debt is sold and the proceeds are used to buy back and retire shares Mini Case 18 15 Advantages of repurchases l A repurchase announcement may be viewed as a positive signal that management believes the shares are undervalued Stockholders have a choiceif they want cash they can tender their shares receive the cash and pay the taxes or they can keep their shares and avoid taxes On the other hand one must accept a cash dividend and pay taxes on it If the company raises the dividend to dispose of excess cash this higher dividend must be maintained to avoid adverse stock price reactions A stock repurchase on the other hand does not obligate management to future repurchases Repurchased stock called treasu stock can be used later in mergers when employees exercise stock options when convertible bonds are converted and when warrants are exercised Treasury stock can also be resold in the open market if the rm needs cash Repurchases can remove a large block of stock that is overhanging the market and keeping the price per share down Repurchases can be varied from year to year without giving off adverse signals while dividends may not Repurchases can be used to produce largescale changes in capital structure Disadvantages of repurchases l A repurchase could lower the stock s price if it is taken as a signal that the rm has relatively few good investment opportunities On the other hand though a repurchase can signal stockholders that managers are not engaged in empire building where they invest funds in lowretum projects If the IRS establishes that the repurchase was primarily to avoid taxes on dividends then penalties could be imposed Such actions have been brought against closely held firms but to our knowledge charges have never been brought against publicly held firms Selling shareholders may not be fully informed about the repurchase hence they may make an uninformed decision and may later sue the company To avoid this firms generally announce repurchase programs in advance Mini Case 18 16 4 The rm may bid the stock price up and end up paying too high a price for the shares In this situation the selling shareholders would gain at the expense of the remaining shareholders This could occur if a tender offer were made and the price was set too high or if the repurchase was made in the open market and buying pressure drove the price above its equilibrium level Describe the series of steps that most firms take in setting dividend policy in practice Answer Firms establish dividend policy within the framework of their overall nancial plans The steps in setting policy are listed below 1 N E 4 The rm forecasts its annual capital budgets and its annual sales along with its working capital needs for a relatively longterm planning horizon often 5 years The target capital structure presumably the one which minimizes the WACC while retaining suf cient reserve borrowing capacity to provide nancing exibility will also be established With its capital structure and investment requirements in mind the rm can estimate the approximate amount of debt and equity nancing required during each year over the planning horizon A longterm target payout ratio is then determined based on the residual model concept Because of otation costs and potential negative signaling the rm will not want to issue common stock unless this is absolutely necessary At the same time due to the clientele effect the rm will move cautiously from its past dividend policy if a new policy appears to be warranted and it will move toward any new policy gradually rather than in one giant step Mini Case 18 17 5 An actual dollar dividend say 2 per year will be decided upon The size of this dividend will re ect l the longrun target payout ratio and 2 the probability that the dividend once set will have to be lowered or worse yet omitted If there is a great deal of uncertainty about cash ows and capital needs then a relatively low initial dollar dividend will be set for this will minimize the probability that the rm will have to either reduce the dividend or sell new common stock The rm will run its corporate planning model so that management can see what is likely to happen with different initial dividends and projected growth rates under different economic scenarios 139 What are stock dividends and stock splits What are the advantages and disadvantages of stock dividends and stock splits Answer When it uses a stock dividend a rm issues new shares in lieu of paying a cash dividend For example in a 5 percent stock dividend the holder of 100 shares would receive an additional 5 shares In a stock split the number of shares outstanding is increased or decreased in a reverse split in an action unrelated to a dividend payment For example in a 2for1 split the number of shares outstanding is doubled A 100 stock dividend and a 2for1 stock split would produce the same effect but there would be differences in the accounting treatments of the two actions Both stock dividends and stock splits increase the number of shares outstanding and in effect cut the pie into more but smaller pieces If the dividend or split does not occur at the same time as some other event which would alter perceptions about future cash ows such as an announcement of higher ea1nings then one would expect the price of the stock to adjust such that each investor s wealth remains unchanged For example a 2for1 split of a stock selling for 50 would result in the stock price being cut in half to 25 It is hard to come up with a convincing rationale for small stock dividends like 5 percent or 10 percent No economic value is being created or distributed yet stockholders have to bear the administrative costs of the distribution Further it is inconvenient to own an odd number of shares as may result after a small stock dividend Thus most companies today avoid small stock dividends On the other hand there is a good reason for stock splits or large stock dividends Speci cally there is a widespread belief that an optimal price range exists for stocks The argument goes as follows if a stock sells for about 2080 then it can be purchased in round lots hence at reduced commissions by most investors A higher price would put round lots out of the price range of many small investors while a Mini Case 18 18 stock price lower than about 20 would convey the image of a stock that is doing poorly Thus most rms try to keep their stock prices within the 20 to 80 range If the company prospers it will split its stock occasionally to hold the price down Also companies that are doing poorly occasionally use reverse splits to raise their price Many companies do operate outside the 20 to 80 range but most stay within it Another factor that may in uence stock splits and dividends is the belief that they signal management s belief that the future is bright If a firm s management would be inclined to split the stock or pay a stock dividend only if it anticipated improvements in earnings and dividends then a splitdividend action could provide a positive signal and thus boost the stock price However if earnings and cash dividends did not subsequently rise the price of the stock would fall back to its old level or even lower because managers would lose credibility Interestingly one of the most astute investors of the 20th century Warren Buffett Berkshire currently sells for over 34000 per share and its performance over the years has been absolutely spectacular It may be that Berkshire s market value would be higher if it chairman of BerkshireHathaway has never split his firm s stock had a 4251 stock split or it may be that the conventional wisdom is wrong g Answer What is a dividend reinvestment plan drip and how does it work Under a dividend 39 plan DRIP 39 39 391 automatically reinvesting their dividends in shares of the firm s common stock In an have the option of open market purchase plan a trustee pools all the dividends to be reinvested and then 1 brokerage costs are reduced by the volume purchases 2 the drip is a convenient way buys shares on the open market Shareholders use the drip for three reasons to invest excess funds and 3 the company generally pays all administrative costs associated with the operation In a new stock plan the firm issues new stock to the DRIP members in lieu of cash dividends No fees are charged and many companies even offer the stock at a 5 percent discount from the market price on the dividend date on the grounds that the firm avoids otation costs that would otherwise be incurred Only firms that need new equity capital use new stock plans while firms with no need for new stock use an open market purchase plan Mini Case 18 19 Chapter 6 Bonds and Their Valuation ANSWERS T0 ENDOFCHAPTER QUESTIONS 61 a Fquot O A bond is a promissory note issued by a business or a governmental unit Treasury bonds sometimes referred to as government bonds are issued by the Federal government and are not exposed to default risk Corporate bonds are issued by corporations and are exposed to default risk Different corporate bonds have different levels of default risk depending on the issuing company39s characteristics and on the terms of the specific bond Municipal bonds are issued by state and local governments The interest earned on most municipal bonds is exempt from federal taxes and also from state taxes if the holder is a resident of the issuing state Foreign bonds are issued by foreign governments or foreign corporations These bonds are not only exposed to default risk but are also exposed to an additional risk if the bonds are denominated in a currency other than that of the investor39s home currency The par value is the nominal or face value of a stock or bond The par value of a bond generally represents the amount of money that the firm borrows and promises to repay at some future date The par value ofa bond is often 1000 but can be 5000 or more The maturity date is the date when the bonds par value is repaid to the bondholder Maturity dates generally range from 10 to 40 years from the time of issue A call provision may be written into a bond contract giving the issuer the right to redeem the bonds under specific conditions prior to the normal maturity date A bond s coupon or coupon payment is the dollar amount of interest paid to each bondholder on the interest payment dates The coupon is so named because bonds used to have dated coupons attached to them which investors could tear off and redeem on the interest payment dates The coupon interest rate is the stated rate of interest on a bond In some cases a bond s coupon payment may vary over time These bonds are called oating rate bonds Floating rate debt is popular with investors because the market value of the debt is stabilized It is advantageous to corporations because firms can issue longterm debt without committing themselves to paying a historically high interest rate for the entire life of the loan Zero coupon bonds pay no coupons at all but are offered at a substantial discount below their par values and hence provide capital appreciation rather than interest income In general any bond originally offered at a price significantly below its par value is called an original issue discount bond OID Answers and Solutions 6 1 3 1 Most bonds contain a call provision which gives the issuing corporation the right to call the bonds for redemption The call provision generally states that if the bonds are called the company must pay the bondholders an amount greater than the par value a call premium Redeemable bonds give investors the right to sell the bonds back to the corporation at a price that is usually close to the par value If interest rates rise investors can redeem the bonds and reinvest at the higher rates A sinking fund provision facilitates the orderly retirement of a bond issue This can be achieved in one of two ways The company can call in for redemption at par value a certain percentage of bonds each year The company may buy the required amount of bonds on the open market Convertible bonds are securities that are convertible into shares of common stock at a fixed price at the option of the bondholder Bonds issued with warrants are similar to convertibles Warrants are options which permit the holder to buy stock for a stated price thereby providing a capital gain if the stock price rises Income bonds pay interest only if the interest is earned These securities cannot bankrupt a company but from an investor s standpoint they are riskier than quotregularquot bonds The interest rate of an indexed or purchasing power bond is based on an in ation index such as the consumer price index CPI so the interest paid rises automatically when the in ation rate rises thus protecting the bondholders against in ation D quot1 Bond prices and interest rates are inversely related that is they tend to move in the opposite direction from one another A fixedrate bond will sell at par when its coupon interest rate is equal to the going rate of interest rd When the going rate of interest is above the coupon rate a fixedrate bond will sell at a quotdiscountquot below its par value If current interest rates are below the coupon rate a fixedrate bond will sell at a quotpremiumquot above its par value g The current yield on a bond is the annual coupon payment divided by the current market price YTM or yield to maturity is the rate of interest earned on a bond if it is held to maturity Yield to call YTC is the rate of interest earned on a bond if it is called If current interest rates are well below an outstanding callable bond s coupon rate the YTC may be a more relevant estimate of expected return than the YTM since the bond is likely to be called Pquot The shorter the maturity of the bond the greater the risk of a decrease in interest rates The risk of a decline in income due to a drop in interest rates is called reinvestment rate risk Interest rates uctuate over time and people or rms who invest in bonds are exposed to risk from changing interest rates or interest rate risk The longer the maturity of the bond the greater the exposure to interest rate risk Interest rate risk relates to the value of the bonds in a portfolio while reinvestment rate risk relates to the income the portfolio produces No fixedrate bond can be considered totally riskless Bond portfolio managers try to balance these two risks but some risk always exists in any bond Another important risk associated with bonds is default risk If the issuer defaults investors receive less than the promised Answers and Solutions 6 2 return on the bond Default risk is in uenced by both the nancial strength of the issuer and the terms of the bond contract especially whether collateral has been pledged to secure the bond The greater the default risk the higher the bonds yield to maturity Corporations can in uence the default risk of their bonds by changing the type of bonds they issue Under a mortgage bond the corporation pledges certain assets as security for the bond All such bonds are written subject to an indenture which is a legal document that spells out in detail the rights of both the bondholders and the corporation A debenture is an unsecured bond and as such it provides no lien against specific property as security for the obligation Debenture holders are therefore general creditors whose claims are protected by property not otherwise pledged Subordinated debentures have claims on assets in the event of bankruptcy only after senior debt as named in the subordinated debt s indenture has been paid off Subordinated debentures may be subordinated to designated notes payable or to all other debt j A development bond is a taxexempt bond sold by state and local governments whose proceeds are made available to corporations for specific uses deemed by Congress to be in the public interest Municipalities can insure their bonds in which an insurance company guarantees to pay the coupon and principal payments should the issuer default This reduces the risk to investors who are willing to accept a lower coupon rate for an insured bond issue visavis an uninsured issue Bond issues are normally assigned quality ratings by major rating agencies such as Moody39s Investors Service and Standard amp Poor s Corporation These ratings re ect the probability that a bond will go into default Aaa Moody s and AAA SampP are the highest ratings Rating assignments are based on qualitative and quantitative factors including the firm39s debtassets ratio current ratio and coverage ratios Because a bond s rating is an indicator of its default risk the rating has a direct measurable in uence on the bonds interest rate and the firm s cost of debt capital Junk bonds are highrisk highyield bonds issued to finance leveraged buyouts mergers or troubled companies Most bonds are purchased by institutional investors rather than individuals and many institutions are restricted to investment grade bonds securities with ratings of Baa BBB or above 62 False Shortterm bond prices are less sensitive than longterm bond prices to interest rate changes because funds invested in shortterm bonds can be reinvested at the new interest rate sooner than funds tied up in longterm bonds Answers and Solutions 6 3 63 The price of the bond will fall and its YTM will rise if interest rates rise If the bond still has a long term to maturity its YTM will re ect longterm rates Of course the bonds price will be less affected by a change in interest rates if it has been outstanding a long time and matures shortly While this is true it should be noted that the YTM will increase only for buyers who purchase the bond after the change in interest rates and not for buyers who purchased previous to the change If the bond is purchased and held to maturity the bondholder s YTM will not change regardless of what happens to interest rates 64 If interest rates decline signi cantly the values of callable bonds will not rise by as much as those of bonds without the call provision It is likely that the bonds would be called by the issuer before maturity so that the issuer can take advantage of the new lower rates 65 From the corporation s viewpoint one important factor in establishing a sinking fund is that its own bonds generally have a higher yield than do government bonds hence the company saves more interest by retiring its own bonds than it could earn by buying government bonds This factor causes firms to favor the second procedure Investors also would prefer the annual retirement procedure if they thought that interest rates were more likely to rise than to fall but they would prefer the government bond purchases program if they thought rates were likely to fall In addition bondholders recognize that under the government bond purchase scheme each bondholder would be entitled to a given amount of cash from the liquidation of the sinking fund if the firm should go into default whereas under the annual retirement plan some of the holders would receive a cash benefit while others would benefit only indirectly from the fact that there would be fewer bonds outstanding On balance investors seem to have little reason for choosing one method over the other while the annual retirement method is clearly more beneficial to the firm The consequence has been a pronounced trend toward annual retirement and away from the accumulation scheme Answers and Solutions 6 4 64 SOLUTIONS TO ENDOF CHAPTER PROBLEMS With your nancial calculator enter the following N 10 I YTM 9 PMT 008 gtlt1000 80 FV 1000 PV VB PV 93582 Alternatively vB 80Pv1FA910 1000Pv1F910 801 11091 009 100011091 8064177 100004224 51342 42240 93582 With your nancial calculator enter the following N 12 PV 850 PMT 010 X 1000 100 FV 1000 I YTM YTM 1248 With your nancial calculator enter the following to nd YTM N 10 X 2 20 PV 1100 PMT 0082 gtlt1000 40 FV 1000 I YTM YTM 331 X 2 662 With your nancial calculator enter the following to nd YTC N 5 X 2 10 PV 1100 PMT 0082 gtlt1000 40 FV 1050 I YTC YTC 324 X 2 649 With your nancial calculator enter the following to nd the current value of the bonds so you can then calculate their current yield N 7 I YTM 8 PMT 009 gtlt1000 90 FV 1000PV VB PV 105206 Current yield 90105206 855 Alternatively vB 90PVIFA877 1000Pv1F87 901 11087008 100011087 9052064 100005835 46858 58350 105208 Current yield 90105208 855 Answers and Solutions 6 5 65 66 The problem asks you to nd the price of a bond given the following facts N 16 I 852 425 PMT 45 FV 1000 With a nancial calculator solve for PV 102860 a Fquot vB PMTPVIFAin FVPv1Fm PMT1 11i i FV11iquot 1 5 Bond L vB 100103797 100004810 151897 Bond 8 vB 100 100009524 104764 2 8 Bond L vB 10085595 100003152 117115 Bond 8 vB 100 100009259 101849 3 12 Bond L vB 10068109 100001827 86379 Bond 8 vB 100 100008929 98219 Calculator solutions 1 5 Bond L Input N 15 I 5 PMT 100 FV 1000 PV PV 151898 Bond S Change N 1 PV PV 104762 2 8 Bond L From Bond S inputs change N 15 and I 8 PV PV 117119 Bond S ChangeN 1 PV PV101852 3 12 Bond L From Bond S inputs change N 15 and I 12 PV PV 86378 Bond S Change N 1 PV PV 98214 Think about a bond that matures in one month Its present value is in uenced primarily by the maturity value which will be received in only one month Even if interest rates double the price of the bond will still be close to 1000 A oneyear bond s value would uctuate more than the onemonth bond s value because of the difference in the timing of receipts However its value would still be fairly close to 1000 even if interest rates doubled A longterm bond paying semiannual coupons on the other hand will be dominated by distant receipts receipts which are multiplied by 11 rd2t and if rd increases these multipliers will decrease significantly Another way to view this problem is from an opportunity point of view A one month bond can be reinvested at the new rate very quickly and hence the opportunity to invest at this new rate is not lost however the longterm bond locks in subnormal returns for a long period of time Answers and Solutions 6 6 N INT M Ham mm PMT1 11rdquotrdFV11rdquot M 1000 INT 0091000 90 a VB 829 901 11rd4rd 100011rd4 The YTM can be found by trialanderror If the YTM was 9 percent the bond value would be its maturity value Since the bond sells at a discount the YTM must be greater than 9 percent Let s try 10 percent At 10 VB 28529 68300 96829 96829 gt 82900 therefore the bonds YTM is greater than 10 percent Try 15 percent At 15 VB 25695 57180 82875 Therefore the bonds YTM is approximately 15 percent N 1104 901 11rd4rd 100011rd4 The bond is selling at a premium therefore the YTM must be below 9 percent Try 6 percent At 6 VB 31186 79210 110396 Therefore when the bond is selling for 1104 its YTM is approximately 6 percent Calculator solution 1 Input N 4 PV 829 PMT 90 FV 1000 I I 1499 2 Change PV 1104 I I 600 b Yes At a price of 829 the yield to maturity 15 percent is greater than your required rate of return of 12 percent If your required rate of return were 12 percent you should be willing to buy the bond at any price below 90888 Answers and Solutions 6 7 68 1000 1401 11rd6rd 109011rd6 Try 18 percent PV18 14034976 109003704 48966 40374 89340 18 percent is too high Try 15 percent PV15 14037845 109004323 52983 47121 100104 15 percent is slightly low The rate of return is approximately 1503 percent found with a calculator using the following inputs N 6 PV 1000 PMT 140 FV 1090 I Solve for I 1503 O 2 Using a nancial calculator input the following N 20 PV 1100 PMT 60 FV 1000 and solve for I 51849 However this is a periodic rate The nominal annual rate 518492 103699 E 1037 Fquot The current yield 1201100 1091 c YTM Current Yield Capital Gains Loss Yield 1037 1091 Capital Loss Yield 054 Capital Loss Yield Q Using a financial calculator input the following N 8 PV 1100 PMT 60 FV 1060 and solve forI 50748 However this is a periodic rate The nominal annual rate 507482 101495 E 1015 Answers and Solutions 6 8 610 The problem asks you to solve for the YTM given the following facts N 5 PMT 80 and FV 1000 In order to solve for I we need PV However you are also given that the current yield is equal to 821 Given this information we can find PV Current yield Annual interestCurrent price 00821 80PV PV 8000821 97442 Now solve for the YTM with a financial calculator N 5 PV 97442 PMT 80 and FV 1000 Solve for I YTM 865 The problem asks you to solve for the current yield given the following facts N 14 I 1058832 52942 PV 1020 and FV 1000 In order to solve for the current yield we need to find PMT With a financial calculator we find PMT 5500 However because the bond is a semiannual coupon bond this amount needs to be multiplied by 2 to obtain the annual interest payment 55002 11000 Finally find the current yield as follows Current yield Annual interestCurrent Price 1 10 1020 1078 The bond is selling at a large premium which means that its coupon rate is much higher than the going rate of interest Therefore the bond is likely to be calledit is more likely to be called than to remain outstanding until it matures Thus it will probably provide a return equal to the YTC rather than the YTM So there is no point in calculating the YTMjust calculate the YTC Enter these values N 10 PV 135354 PMT 70 FV 1050 and then solve for I The periodic rate is 324 percent so the nominal YTC is 2 X 324 647 This would be close to the going rate and it is about what the firm would have to pay on new bonds Answers and Solutions 6 9 613 a The bonds now have an 8year or a 16semiannual period maturity and their value is calculated as follows i 50 1000 t110339 10316 62806 62320 125126 50125611 100006232 Calculator solution Input N 16 I 3 PMT 50 FV 1000 PV PV 125122 Fquot VB 50101059 100003936 50530 39360 89890 Calculator solution Change inputs from Part a to I 6 PV PV 89894 c The price of the bond will decline toward 1000 hitting 1000 plus accrued interest at the maturity date 8 years 16 sixmonth periods hence 614 Answers and Solutions 6 10 615 Bond Value Time Path 1100 Bond C 1000 900 Bond Z 800 700 7 1 Years 0 1 2 3 4 Answers and Solutions 6 11 SOLUTION TO SPREADSHEET PROBLEM 616 The detailed solution for the problem is available both on the instructor s resource CD ROM in the le Solution for FM11 Ch 06 P16 Build a Modelxls and on the instructor s side of the book s web site httpb139ighamswleamingc0m Answers and Solutions 6 12 MINI CASE Sam Strother and Shawna Tibbs are vice presidents of Mutual of Seattle Insurance Company and co directors of the company39s pension fund management division A major new client the Northwestern Municipal Alliance has requested that Mutual of Seattle present an investment seminar to the mayors of the represented cities and Strother and Tibbs who will make the actual presentation have asked you to help them by answering the following questions Because the Boeing Company operates in one of the league39s cities you are to work Boeing into the presentation a What are the key features of a bond Answer LA 4 V39 Par or face value We generally assume a 1000 par value but par can be anything and often 5000 or more is used With registered bonds which is what are issued today if you bought 50000 worth that amount would appear on the certi cate Coupon rate The dollar coupon is the quotrentquot on the money borrowed which is generally the par value of the bond The coupon rate is the annual interest payment divided by the par value and it is generally set at the value of r on the day the bond is issued Maturity This is the number of years until the bond matures and the issuer must repay the loan return the par value Issue date This is the date the bonds were issued Default risk is inherent in all bonds except treasury bondswi11 the issuer have the cash to make the promised payments Bonds are rated from AAA to D and the lower the rating the riskier the bond the higher its default risk premium and consequently the higher its required rate of return r Mini Case 6 13 b What are call provisions and sinking fund provisions Do these provisions make bonds more or less risky Answer A call provision is a provision in a bond contract that gives the issuing corporation the right to redeem the bonds under speci ed terms prior to the normal maturity date The call provision generally states that the company must pay the bondholders an amount greater than the par value if they are called The additional sum which is called a call premium is typically set equal to one year s interest if the bonds are called during the first year and the premium declines at a constant rate of INTn each year thereafter A sinking fund provision is a provision in a bond contract that requires the issuer to retire a portion of the bond issue each year A sinking fund provision facilitates the orderly retirement of the bond issue The call privilege is valuable to the firm but potentially detrimental to the investor especially if the bonds were issued in a period when interest rates were cyclically high Therefore bonds with a call provision are riskier than those without a call provision Accordingly the interest rate on a new issue of callable bonds will exceed that on a new issue of noncallable bonds Although sinking funds are designed to protect bondholders by ensuring that an issue is retired in an orderly fashion it must be recognized that sinking funds will at times work to the detriment of bondholders On balance however bonds that provide for a sinking fund are regarded as being safer than those without such a provision so at the time they are issued sinking fund bonds have lower coupon rates than otherwise similar bonds without sinking funds Mini Case 6 14 c How is the value of any asset whose value is based on expected future cash ows determined Answer 0 1 2 3 n 1 1 1 1 o o o 1 CF1 CF CF3 CFn PV CFl 1 PV CF2 The value of an asset is merely the present value of its expected future cash ows n VALUEPV CFI CFZ CF3 CFquot Z e 1r1 1r2 1r3 1rquot Haw If the cash ows have widely varying risk or if the yield curve is not horizontal which signi es that interest rates are expected to change over the life of the cash ows it would be logical for each period s cash ow to have a different discount rate However it is very difficult to make such adjustments hence it is common practice to use a single discount rate for all cash ows The discount rate is the opportunity cost of capital that is it is the rate of return that could be obtained on alternative investments of similar risk Thus the discount rate depends primarily on factors discussed back in chapter 1 rirlPLPMRPDRP Mini Case 6 15 Answer How is the value of a bond determined What is the value of a 10 year 1000 par value bond with a 10 percent annual coupon if its required rate of return is 10 percent A bond has a speci c cash ow pattern consisting of a stream of constant interest payments plus the return of par at maturity The annual coupon payment is the cash ow pmt coupon rate gtlt par value 011000 100 For a 10year 10 percent annual coupon bond the bonds value is found as follows 0 10 1 2 3 9 10 1 1 1 1 o o o 1 1 100 100 100 100 100 9091 H 1000 3855 38554 1 00000 Expressed as an equation we have 100 100 1000 1r1 1r10 1r10 9091 3855 38554 1000 01 V3 100PVIFA10710 1000PV1F1010 100 1 11110010 1000 1101010 The bond consists of a 10year 10 annuity of 100 per year plus a 1000 lump sum payment at t 10 PV Annuity 61446 PV Maturity Value 38554 Value Of Bond 1 00000 The mathematics of bond valuation is programmed into nancial calculators which do the operation in one step so the easy way to solve bond valuation problems is with a nancial calculator Input 11 10 rd i 10 PMT 100 and FV 1000 and then press PV to nd the bonds value 1000 Then change 11 from 10 to 1 and press PV to get the value of the 1year bond which is also 1000 Mini Case 6 16 e 1 What would be the value of the bond described in paIt d if just after it had been issued the expected in ation rate rose by 3 percentage points causing investors to require a 13 percent return Would we now have a discount or a premium bond Answer with a nancial calculator just change the value of r i from 10 to 13 and press the PV button to determine the value of the bond 10year 83721 Using the formulas we would have at r 13 percent VB10YR 100PVIFA13710 1000PVIF13710 100 1 110131 013 1000 110131 54262 29459 83721 In a situation like this where the required rate of return r rises above the coupon rate the bonds39 values fall below par so they sell at a discount What would happen to the bonds39 value if in ation fell and rd declined to 7 percent Would we now have a premium or a discount bond Answer In the second situation where r falls to 7 percent the price of the bond rises above par Just change r from 13 t0 7 We see that the 10year bond s value rises to 121071 With tables we have VB10YR 100PVIFA7710 1000PVIF7710 100 1 110071 007 1000 110071 70236 50835 121071 Thus when the required rate of return falls below the coupon rate the bonds value rises above par or to a premium Further the longer the maturity the greater the price effect of any given interest rate change Mini Case 6 17 e 3 What would happen to the value of the 10 year bond over time if the required rate of return remained at 13 percent or if it remained at 7 percent Hint with a fmancial calculator enter PMT I FV and N and then change override n to see what happens to the PV as the bond approaches maturity Answer Assuming that interest rates remain at the new levels either 7 or 13 we could nd the bonds value as time passes and as the maturity date approaches If we then plotted the data we would nd the situation shown below Bond Value rd 7 o Years remaining to Maturity At maturity the value of any bond must equal its par value plus accrued interest Therefore if interest rates hence the required rate of return remain constant over time then a bond39s value must move toward its par value as the maturity date approaches so the value of a premium bond decreases to 1000 and the value of a discount bond increases to 1000 barring default Mini Case 6 18 f 1 What is the yield to maturity on a 10 year 9 percent annual coupon 1000 par value bond that sells for 88700 That sells for 113420 What does the fact that a bond sells at a discount or at a premium tell you about the relationship between rd and the bond39s coupon rate Answer The yield to maturity YTM is that discount rate which equates the present value of a bond s cash ows to its price In other words it is the promised rate of return on the bond Note that the expected rate of return is less than the YTM if some probability of default exists On a time line we have the following situation when the bond sells for 887 0 1 9 10 1 1 1 1 90 90 90 13v1 H 1000 r 13v1 PVM SUM PV E We want to nd r in this equation INT INT M 1 r1 1rN 1rN39 VBPV We know n 10 PV 887 pmt 90 and FV 1000 so we have an equation with one unknown r We can solve for r by entering the known data into a nancial calculator and then pressing the I r button The YTM is found to be 1091 Alternatively we could use present value interest factors 887 90PV1FA10 1000PV1F10 90 1 11r10r 1000 11r10 We would substitute for various interest rates in a trialanderror manner until we found the rate that produces the equality This is tiresome and the procedure will not give an exact answer unless the YTM is a whole number Consequently in the real world everyone uses financial calculators We can tell from the bonds price even before we begin the calculations that the YTM must be above the 9 coupon rate We know this because the bond is selling at a discount and discount bonds always have r gt coupon rate Mini Case 6 19 If the bond were priced at 113420 then it would be selling at a premium In that case it must have a YTM that is below the 9 percent coupon rate because all premium bonds must have coupons which exceed the going interest rate Going through the same procedures as beforeplugging the appropriate values into a nancial calculator and then pressing the r I button we nd that at a price of 113420 r YTM 708 f 2 What are the total return the current yield and the capital gains yield for the discount bond Assume the bond is held to maturity and the company does not default on the bond Answer The current yield is de ned as follows Current Yield W Current price of the bond The capital gains yield is de ned as follows Capital gains yield Expected ghange in bond price I Beg1nn1ng of year pr1ce The total expected return is the sum of the current yield and the expected capital gains yield Expected Expected Expected capital Total Return 7 current yield gains yield The term yield to maturity or YTM is often used in discussing bonds It is simply the expected total return assuming no default risk so I expected total return expected YTM Recall also that securities have required returns r which depend on a number of factors Required return r rquot IP LP MRP DRP We know that 1 security markets are normally in equilibrium and 2 that for equilibrium to exist the expected return i YTM as seen by the marginal investor must be equal to the required return r If that equality does not hold then buying and selling will occur until it does hold and equilibrium is established Therefore for the marginal investor YTMr Mini Case 6 20 For our 9 coupon 10year bond selling at a price of 887 with a YTM of 1091 the current yield is Current yield 01015 1015 887 Knowing the current yield and the total return we can nd the capital gains yield YTM current yield capital gains yield And Capital gains yield YTM current yield 1091 1015 076 The capital gains yield calculation can be checked by asking this question quotWhat is the expected value of the bond 1 year from now assuming that interest rates remain at current levelsquot This is the same as asking quotWhat is the value of a 9year 9 percent annual coupon bond if its YTM its required rate of return is 1091 percentquot The answer using the bond valuation function of a calculator is 89387 With this data we can now calculate the bonds capital gains yield as follows Capital Gains Yield VBl VB0 VB0 89387 887887 00077 077 This agrees with our earlier calculation except for rounding When the bond is selling for 113420 and providing a total return of r YTM 708 we have this situation Current Yield 90113420 794 Capital Gains Yield 708 794 086 The bond provides a current yield that exceeds the total return but a purchaser would incur a small capital loss each year and this loss would exactly offset the excess current yield and force the total return to equal the required rate Mini Case 6 21 g What is interest rate or price risk Which bond has more interest rate risk an annual payment l year bond or a 10 year bond Why Answer Interest rate risk which is often just called price risk is the risk that a bond will lose value as the result of an increase in interest rates Earlier we developed the following values for a 10 percent annual coupon bond Maturity L lYear Change 10Year Change 5 1048 4 8 1386 386 10 1000 39 0 1000 251 15 956 39 749 A 5 percentage point increase in r causes the value of the 1year bond to decline by only 48 percent but the 10year bond declines in value by more than 38 percent Thus the 10year bond has more interest rate price risk Bond Value Interest Rate Price Risk for 10 Percent Coupon Bonds with Different Maturities 1900 I wpnr I 4 I 5 E 7 9 9 10 11 5 The graph above shows the relationship between bond values and interest rates for a 10 percent annual coupon bond with different maturities The longer the maturity the greater the change in value for a given change in interest rates rd 12 13 14 1 Interest Rate Mini Case 6 22 What is reinvestment rate risk Which has more reinvestment rate risk a 1 year bond 01 a 10 year bond Answer Investment rate risk is de ned as the risk that cash ows interest plus principal repayments will have to be reinvested in the future at rates lower than today39s rate To illustrate suppose you just won the lottery and now have 500000 You plan to invest the money and then live on the income from your investments Suppose you buy a lyear bond with a YTM of 10 percent Your income will be 50000 during the rst year Then after 1 year you will receive your 500000 when the bond matures and you will then have to reinvest this amount If rates have fallen to 3 percent then your income will fall from 50000 to 15000 On the other hand had you bought 30year bonds that yielded 10 your income would have remained constant at 50000 per year Clearly buying bonds that have short maturities carries reinvestment rate risk Note that long maturity bonds also have reinvestment rate risk but the risk applies only to the coupon payments and not to the principal amount Since the coupon payments are signi cantly less than the principal amount the reinvestment rate risk on a longterm bond is signi cantly less than on a short term bond Mini Case 6 23 How does the equation for valuing a bond change if semiannual payments are made Find the value of a 10 year semiannual payment 10 percent coupon bond if nominal rd 13 Answer In reality Virtually all bonds issued in the US have semiannual coupons and are valued using the setup shown below 1 2 N YEARS 0 1 2 3 4 2N 1 2N SA PERIODS 1 1 1 1 1 o o o 1 1 INT2 INT2 INT2 INT2 INT2 INT2 M PV1lt PVN PVM V7301 sum of PVs We would use this equation to nd the bonds value 2 INT 2 M VB t 2N 39 1 1rd2 1rd2 The payment stream consists of an annuity of 2n payments plus a lump sum equal to the maturity value To nd the value of the 10year semiannual payment bond semiannual interest annual coupon2 1002 50 and n 2 years to maturity 210 20 To nd the value ofthe bond with a nancial calculator enter n 20 rd2 I 5 pmt 50 FV 1000 and then press PV to determine the value of the bond Its value is 1000 You could then change r I to see what happens to the bonds value as r changes and plot the valuesthe graph would look like the one we developed earlier For example if r rose to 13 we would input I 65 rather than 5 and nd the 10year bond s value to be 83472 Ifr fell to 7 then input I 35 and press PV to nd the bonds new value 121319 We would nd the values with a nancial calculator but they could also be found with formulas Thus V10YEAR 50PVIFA5YZO 1000PVIF5720 50 1 11005200065 1000 1100520 50124622 1000037689 62311 37689 100000 Mini Case 6 24 At a 13 percent required return VIOYEAR 50PVIFA6520 1000PVIF5520 50 1 110065200065 1000 11006520 83472 At a 7 percent required return VIOYEAR 50PVIFA3520 1000PVIF3520 50 1 1100352 0035 1000 1100352 121319 j Suppose you could buy for 1000 either a 10 percent 10 year annual payment bond or a 10 percent 10 year semiannual payment bond They are equally risky Which would you prefer If 1000 is the proper price for the semiannual bond what is the equilibrium price for the annual payment bond Answer The semiannual payment bond would be better Its EAR would be 010 2 17 11025 11 EAR17rN m J 1 m An EAR of 1025 is clearly better than one of 100 which is what the annual payment bond offers You and everyone else would prefer it If the going rate of interest on semiannual bonds is rN0m 10 with an EAR of 1025 then it would not be appropriate to nd the value of the annual payment bond using a 10 EAR If the annual payment bond were traded in the market its value would be found using 1025 because investors would insist on getting the same EAR on the two bonds because their risk is the same Therefore you could find the value of the annual payment bond using 1025 with your calculator It would be 98480 versus 1000 for the semiannual payment bond Note that if the annual payment bond were selling for 98480 in the market its EAR would be 1025 This value can be found by entering n 10 PV 98480 pmt 100 and FV 1000 into a financial calculator and then pressing the r I button to find the answer 1025 With this rate and the 98480 price the annual and semiannual payment bonds would be in equilibriuminvestors would get the same rate of return on either bond so there would not be a tendency to sell one and buy the other as there would be if they were both priced at 1000 Mini Case 6 25 Suppose a 10 year 10 percent semiannual coupon bond with a par value of 1000 is currently selling for 113590 producing a nominal yield to maturity of 8 percent However the bond can be called after 5 years for a price of 1050 What is the bond39s nominal yield to call Y T C I k k 1 Answer If the bond were called bondholders would receive 1050 at the end of year 5 Thus the time line would look like this 0 l 2 3 4 5 1 1 1 1 1 1 50 50 50 50 50 50 50 50 50 50 1 105 PV1 PV4 PVsc PVSCP 1 13590 sum ofPVs The easiest way to nd the YTC on this bond is to input values into your calculator r1 10 PV 113590 pmt 50 and FV 1050 which is the par value plus a call premium of 50 and then press the r I button to nd I 3765 However this is the 6month rate so we would nd the nominal rate on the bond as follows rNom 23765 75301 E 75 This 75 is the rate brokers would quote if you asked about buying the bond You could also calculate the EAR on the bond EAR 1037652 1 7672 Usually people in the bond business just talk about nominal rates which is OK so long as a11 the bonds being compared are on a semiannual payment basis When you start making comparisons among investments with different payment patterns though it is important to convert to EARS Mini Case 6 26 F N If you bought this bond do you think you would be more likely to earn the YTM or the YTC Why Answer Since the coupon rate is 10 versus YTC rd 753 it would pay the company to call the bond get rid of the obligation to pay 100 per year in interest and sell replacement bonds whose interest would be only 7530 per year Therefore if interest rates remain at the current level until the call date the bond will surely be called so investors should expect to earn 753 In general investors should expect to earn the YTC on premium bonds but to earn the YTM on par and discount bonds Bond brokers publish lists of the bonds they have for sale they quote YTM or YTC depending on whether the bond sells at a premium or a discount Boeing39s bonds were issued with a yield to maturity of 75 percent Does the yield to maturity represent the promised or expected return on the bond Answer The yield to maturity is the rate of return earned on a bond if it is held to maturity It can be viewed as the bonds promised rate of return which is the return that investors will receive if all the promised payments are made The yield to maturity equals the expected rate of return only if 1 the probability of default is zero and 2 the bond cannot be called For bonds where there is some default risk or where the bond may be called there is some probability that the promised payments to maturity will not be received in which case the promised yield to maturity will differ from the expected return Boeing39s bonds were rated AA by SampP Would you consider these bonds investment grade or junk bonds Answer The Boeing bonds would be investment grade bonds TripleA doubleA singleA and tripleB bonds are considered investment grade DoubleB and lowerrated bonds are considered speculative or junk bonds because they have a significant probability of going into default Many financial institutions are prohibited from buying junk bonds Mini Case 6 27 11 What factors determine a company39s bond rating Answer Bond ratings are based on both qualitative and quantitative factors some of which are listed below 1 LA Financial performancedetermined by ratios such as the debt TIE FCC and current ratios Provisions in the bond contract A Secured vs Unsecured debt B Senior vs Subordinated debt C Guarantee provisions D Sinking fund provisions E Debt maturity Other factors A Earnings stability B Regulatory environment C Potential product liability D Accounting policy Mini Case 6 28 Answer If this lm were to default on the bonds would the company be immediately liquidated Would the bondholders be assured of receiving all of their promised payments When a business becomes insolvent it does not have enough cash to meet scheduled interest and principal payments A decision must then be made whether to dissolve the rm through liguidation or to permit it to reorganize and thus stay alive The decision to force a rm to liquidate or to permit it to reorganize depends on whether the value of the reorganized rm is likely to be greater than the value of the rm s assets if they were sold off piecemeal In a reorganization a committee of unsecured creditors is appointed by the court to negotiate with management on the terms of a potential reorganization The reorganization plan may call for a restructuring of the rm s debt in which case the interest rate may be reduced the term to maturity lengthened or some of the debt may be exchanged for equity The point of the restructuring is to reduce the nancial charges to a level that the rm s cash ows can support If the rm is deemed to be too far gone to be saved it will be liquidated and the priority of claims would be as follows Secured creditors Trustee s costs Expenses incurred after bankruptcy was led Wages due workers up to a limit of 2000 per worker Claims for unpaid contributions to employee bene t plans Unsecured claims for customer deposits up to 900 per customer Federal state and local taxes Unfunded pension plan liabilities General unsecured creditors Preferred stockholders up to the par value of their stock Common stockholders if anything is left Qwewwe HH B95090 If the rm s assets are worth more alive than dead the company would be reorganized Its bondholders however would expect to take a hit Thus they would not expect to receive all their promised payments If the rm is deemed to be too far gone to be saved it would be liquidated Mini Case 6 29 Chapter 3 Financial Statements Cash Flow and Taxes ANSWERS TO ENDOFCHAPTER QUESTIONS E Fquot 0 3 1 The annual report is a report issued annually by a corporation to its stockholders It contains basic nancial statements as well as management s opinion of the past year s operations and the rm s future prospects A rm s balance sheet is a statement of the rm s nancial position at a speci c point in time It speci cally lists the rm s assets on the lefthand side of the balance sheet while the righthand side shows its liabilities and equity or the claims against these assets An income statement is a statement summarizing the rm s revenues and expenses over an accounting period Net sales are shown at the top of each statement after which various costs including income taxes are subtracted to obtain the net income available to common stockholders The bottom of the statement reports earnings and dividends per share Common Stockholders Equity Net Worth is the capital supplied by common stockholderscapital stock paidin capital retained earnings and occasionally certain reserves Paidin capital is the difference between the stock s par value and what stockholders paid when they bought newly issued shares Retained earnings is the portion of the rm s earnings that have been saved rather than paid out as dividends The statement of retained earnings shows how much of the rm s earnings were retained in the business rather than paid out in dividends Note that retained earnings represents a claim against assets not assets per se Firms retain earnings primarily to expand the business not to accumulate cash in a bank account The statement of cash ows reports the impact of a rm s operating investing and nancing activities on cash ows over an accounting period Depreciation is a noncash charge against tangible assets such as buildings or machines It is taken for the purpose of showing an asset s estimated dollar cost of the capital equipment used up in the production process Amortization is a noncash charge against intangible assets such as goodwill EBITDA is earnings before interest taxes depreciation and amortization Answers and Solutions 3 1 D Operating current assets are the current assets used to support operations such as cash accounts receivable and inventory It does not include shortterm investments Operating current liabilities are the current liabilities that are a natural consequence of the rm s operations such as accounts payable and accruals It does not include notes payable or any other shortterm debt that charges interest Net operating working capital is operating current assets minus operating current liabilities Total net operating capital is sum of net operating working capital and operating longterm assets such as net plant and equipment Operating capital also is equal to the net amount of capital raised from investors This is the amount of interestbearing debt plus preferred stock plus common equity minus shortterm investments quot1 Accounting pro t is a rm s net income as reported on its income statement Net cash ow as opposed to accounting net income is the sum of net income plus non cash adjustments NOPAT net operating pro t after taxes is the amount of pro t a company would generate if it had no debt and no nancial assets Free cash ow is the cash ow actually available for distribution to investors after the company has made all investments in xed assets and working capital necessary to sustain ongoing operations Market value added is the difference between the market value of the rm ie the sum of the market value of common equity the market value of debt and the market value of preferred stock and the book value of the rm s common equity debt and preferred stock If the book values of debt and preferred stock are equal to their market values then MVA is also equal to the difference between the market value of equity and the amount of equity capital that investors supplied Economic value added represents the residual income that remains after the cost of all capital including equity capital has been deducted W Pquot A progressive tax means the higher one s income the larger the percentage paid in taxes Taxable income is de ned as gross income less a set of exemptions and deductions which are spelled out in the instructions to the tax forms individuals must le Marginal tax rate is de ned as the tax rate on the last unit of income Average tax rate is calculated by taking the total amount of tax paid divided by taxable 1ncome Capital gain loss is the pro t loss from the sale of a capital asset for more less than its purchase price Ordinary corporate operating losses can be carried backward for 2 years or forward for 20 years to offset taxable income in a given year j Improper accumulation is the retention of earnings by a business for the purpose of enabling stockholders to avoid personal income taxes on dividends An S corporation is a small corporation which under Subchapter S of the Internal Revenue Code elects to be taxed as a proprietorship or a partnership yet retains limited liability and other bene ts of the corporate form of organization Answers and Solutions 3 2 The four nancial statements contained in most annual reports are the balance sheet income statement statement of retained earnings and statement of cash ows No because the 20 million of retained earnings would probably not be held as cash The retained earnings gure represents the reinvestment of earnings by the rm Consequently the 20 million would be an investment in all of the rm s assets Operating capital is the amount of interest bearing debt preferred stock and common equity used to acquire the company s net operating assets Without this capital a rm cannot exist as there is no source of funds with which to nance operations NOPAT is the amount of net income a company would generate if it had no debt and held no nancial assets NOPAT is a better measure of the performance of a company s operations because debt lowers income In order to get a true re ection of a company s operating performance one would want to take out debt to get a clearer picture of the situation Free cash ow is the cash ow actually available for distribution to investors after the company has made all the investments in xed assets and working capital necessary to sustain ongoing operations It is the most important measure of cash ows because it shows the exact amount available to all investors If the business were organized as a partnership or a proprietorship its income could be taken out by the owners without being subject to double taxation Also if you expected to have losses for a few years while the company was getting started if you were not incorporated and if you had outside income the business losses could be used to offset your other income and reduce your total tax bill These factors would lead you to not incorporate the business An alternative would be to organize as an S Corporation if requirements are met Answers and Solutions 3 3 SOLUTIONS TO ENDOF CHAPTER PROBLEMS 31 Corporate yield 9 T 355 AT yield 91 T 90645 576 32 Corporate bond yields 8 Municipal bond yields 6 Equivalent pretax yield 7 Yield on muni on taxable bond 1 7 T 8 6 1 T 008 7 008T 006 7 008T 7002 T 25 32 Income 365000 Less Interest deduction 50000 Plus Dividends receiveda 4 500 Taxable income 319 500 aFor a corporation 70 of dividends received are excluded from taxes therefore taxable dividends are calculated as 150001 070 4500 Tax 22250 319500 100000039 22250 85605 107855 Aftertax income Taxable income 319500 Taxes 107855 Plus Nontaxable dividends receivedb 10 500 Net income 222 145 bNontaxable dividends are calculated as 15000 x 07 10500 The company s marginal tax rate is 39 percent The company s average tax rate is 107855319500 3376 Answers and Solutions 3 4 3 4 a Tax 3400000 10500000 10000000035 3575000 b Tax 1000000035 350000 c Tax 1000000030035 105000 AT yield on FLA bond 5 AT yield on ATampT bond 75 Taxes 75 75035 4875 Check Invest 10000 75 750 interest Pay 35 tax so AT income 7501 T 750065 48750 AT rate ofretum 4875010000 4 875 AT yield on ATampT preferred stock AT yield 6 Taxes 6 036035 6 063 537 Therefore invest in ATampT preferred stock We could make this a harder problem by asking for the tax rate that would cause the company to prefer the Florida bond or the ATampT bond EBIT 750000 DEP 200000 100 Equity T 40 NINCFOCF First determine net income by setting up an income statement EBIT 750000 Interest 0 EBT 750000 Taxes 40 300 000 N1 450 000 NCF N1 DEP 450000 200000 650000 Answers and Solutions 3 5 37 a Income Statement Sales revenues 12000000 Costs except depreciation 9000000 Depreciation 1 500 000 EBT 1500000 Taxes 40 600 000 Net income 900000 Add back depreciation 1 500 000 Net cash ow 2 400 000 b If depreciation doubled taxable income would fall to zero and taxes would be zero Thus net income would decrease to zero but net cash ow would rise to 3000000 Menendez would save 600000 in taxes thus increasing its cash ow ACF TADepreciation 041500000 600000 c If depreciation were halved taxable income would rise to 2250000 and taxes to 900000 Therefore net income would rise to 1350000 but net cash ow would fall to 2100000 d You should prefer to have higher depreciation charges and higher cash ows Net cash ows are the funds that are available to the owners to withdraw from the firm and therefore cash ows should be more important to them than net income Answers and Solutions 3 6 E 0 3 1 D NOPAT EBIT1 Tax rate 15000000006 90000000 NOWC03 Operating CA 7 operating CL 360000000 90000000 60000000 210000000 NOWC04 372000000 180000000 192000000 Net plant and equipment working capital 250000000 210000000 460000000 N t t39 Operating cap1ta103 6 Opera mg 300000000 192000000 492000000 Operating capital 04 FCF NOPAT Net investment in operating capital 90000000 492000000 460000000 58000000 The large increase in dividends for 2004 can most likely be attributed to a large increase in free cash ow from 2003 to 2004 since FCF represents the amount of cash available to be paid out to stockholders after the company has made all investments in xed assets and working capital necessary to sustain the business Answers and Solutions 3 7 Prior Years 2002 2003 150000 150000 150 000 150 000 Pro t earned Carryback credit Adjusted pro t 0 0 Tax previously paid 40 60 000 60 000 Tax refund Taxes previously paid 60000 60000 Total check from Us Treasury 60000 60000 120000 Future Years 2005 2006 2007 2008 2009 Estimated pro t 150000 150000 150000 150000 150000 Carryforward credit 150 000 150 000 50 000 0 0 Adjusted pro t 0 0 100000 150000 150000 Tax at 40 0 0 40 000 60 000 60 000 Answers and Solutions 3 8 SOLUTION TO SPREADSHEET PROBLEM 313 The detailed solution for the spreadsheet problem is available both on the instructor s resource CD ROM in the le Solution for FM11 Ch 03 P13 Build a ModeLxls and on the instructor s side of the book s web site httpb139ighamswleamingc0m Answers and Solutions 3 9 MINI CASE Donna Jamison a recent graduate of the University of Tennessee with four years of banking experience was recently brought in as assistant to the chairman of the board of Computron Industries a manufacturer of electronic calculators The company doubled its plant capacity opened new sales of ces outside its home territory and launched an expensive advertising campaign Computron s results were not satisfactory to put it mildly Its board of directors which consisted of its president and vice president plus its major stockholders who were all local business people was most upset when directors learned how the expansion was going Suppliers were being paid late and were unhappy and the bank was complaining about the deteriorating situation and threatening to cut off credit As a result Al Watkins Computron s president was informed that changes would have to be made and quickly or he would be red Also at the board s insistence Donna Jamison was brought in and given the job of assistant to Fred Campo a retired banker who was Computron s chairman and largest stockholder Campo agreed to give up a few of his gol ng days and to help nurse the company back to health with Jamison s help Jamison began by gathering nancial statements and other data Assume that you are Jamison s assistant and you must help her answer the following questions for Campo Mini Case 3 10 Balance Sheets Assets 2003 2004 Cash 9000 7282 Shortterm investments 48600 20000 Accounts receivable 351200 632160 Inventories 715200 1287360 total current assets 1124000 1946802 Gross xed assets 491000 1202950 Less accumulated J J 39 quot 146200 263160 net xed assets 344800 939790 Total assets 1468800 2886592 Liabilities and eguit 2003 2004 Accounts payable 145600 324000 Notes payable 200000 720000 Accruals 136000 284960 total current liabilities 481600 1328960 Longterm debt 323432 1000000 Common stock 100000 shares 460000 460000 Retained earnings 203768 97632 total equity 663768 557632 Total liabilities and equity 1468800 2886592 Mini Case 3 11 Income Statements 2003 2004 Sales 3432000 5834400 Cost of goods sold 2864000 4980000 Other expenses 340000 720000 Depreciation 18900 116960 total operating costs 3222900 5816960 EBIT 209100 17440 Interest expense 62500 176000 EBT 146600 158560 Taxes 40 58640 63424 Net income 87960 195136 Other data 2002 2003 Stock price 850 600 Shares outstanding 100000 100000 EPS 0880 0951 DPS 0220 0110 Statement of retained earnings 2004 Balance ofretained earnings 12312003 203768 add net income 2004 95136 less dividend paid 2004 11000 Balance of retained earnings 12312004 97632 Mini Case 3 12 Statement of Cash Flows Operating activities Net income 95136 Adjustments noncash adjustments depreciation 116960 changes in working capital change in accounts receivable 280960 change in inventories 572160 change in accounts payable 178400 change in accruals 148960 Net cash provided by operating activities 503936 Longterm investing activities Cash used to acquire xed assets 711950 Financing activities change in short term investments 28600 change in notes payable 520000 change in longterm debt 676568 change in common stock payment of cash dividends 1 11000 Net cash provided by nancing activities 1214168 Snmmar Net change in cash 1718 Cash at beginning of year 9000 Cash at end of year 7282 a What effect did the expansion have on sales and net income What effect did the expansion have on the asset side of the balance sheet What effect did it have on liabilities and equity Answer Sales increased by over by over 24 million but net income fell by over 190000 Assets almost doubled Debt and funds provided by suppliers increased but retained earnings fell due to the year s loss Mini Case 3 13 b What do you conclude from the statement of cash ows Answer Net CF from operations 503936 because of negative net income and increases in working capital The rm spent 711950 on FA The rm borrowed heavily and sold some shortterm investments to meet its cash requirements Even after borrowing the cash account fell by 1718 Answer What is free cash ow Why is it important What are the ve uses of FCF FCF is the amount of cash available from operations for distribution to all investors including stockholders and debtholders after making the necessary investments to support operations A company s value depends upon the amount of FCF it can generate 1 Pay interest on debt 2 Pay back principal on debt 3 Pay dividends 4 Buy back stock 5 Buy nonoperating assets e g marketable securities investments in other companies etc What are operating current assets What are operating current liabilities How much net operating working capital and total net operating capital does Computron have Answer Operating current assets are the CA needed to support operations OP CA include cash inventory receivables OP CA exclude shortterm investments because these are not a part of operations Operating current liabilities are the CL resulting as a normal part of operations OP CL include accounts payable and accruals OP CA exclude notes payable because this is a source of nancing not a part of operations NOWC operating CA 7 operating CL NOWC04 7282 632160 1287360 324000 284960 1317842 NOWC03 793800 NOWC net xed assets Total operating working capital Operating capital in 2004 1317842 939790 2257632 Operating capital in 2003 1138600 Mini Case 3 14 e What are Computron s net operating pro t after taxes NOPAT and free cash ow FCF ANSWER NOPAT EBIT1 TAX RATE NOPAT04 174401 04 10464 NOPAT03 125460 FCF NOPAT NET INVESTMENT IN CAPITAL 10464 2257632 1138600 10464 1119032 1108568 139 Calculate Computron s return on invested capital Computron has a 10 cost of capital W ACC Do you think Computron s growth added value ANSWER ROIC NOPAT TOTAL NET OPERATING CAPITAL ROIC04 10464 2257632 0 7 05 A ROIC03 110 The ROIC of 05 is less than the WACC of 10 Investors did not get the return they require Note high growth usually causes negative FCF due to investment in capital but that s ok if ROIC gt WACC For example home depot has high growth negative FCF but a high ROIC g Jamison also has asked you to estimate Computron39s EVA She estimates that the after tax cost of capital was 10 percent in both years ANSWER EVA NOPAT WACCCAPITAL EVA04 10464 012257632 10464 225763 215299 EVA03 125460 0101138600 125460 113860 11600 Mini Case 3 15 h What happened to Computron39s market value added MVA Answer MVA market value of the rm book value of the rm Market value shares of stockp1ice per share value of debt Book value total common equity value of debt If the market value of debt is close to the book value of debt then MVA is market value of equity minus book value of equity Assume market value of debt equals book value of debt Market value of equity 2003 100000600 600000 Book value of equity 2003 557632 MVA03 600000 557632 42368 MVAoz 850000 663768 186232 i Assume that a corporation has 100000 of taxable income from operations plus 5000 of interest income and 10000 of dividend income What is the company s tax liability Answer Calculation of the company s tax liability Taxable operating income 100000 Taxable interest income 5000 Taxable dividend income 03 X 10000 3 000 Total taxable income 108 000 Tax 22250 108000 100000039 25370 taxable dividend income dividends exclusion 10000 0710000 3000 Mini Case 3 16 Assume that you are in the 27 percent marginal tax bracket and that you have 5000 to invest You have narrowed your investment choices down to California bonds with a yield of 7 percent or equally risky Exxon bonds with a yield of 10 percent Which one should you choose and why At what marginal tax rate would you be indifferent to the choice between California and Exxon bonds Answer Aftertax return income at t 27 Exxon 0105000 0105000027 365 California 0075000 0 350 Alternatively calculate aftertax yields AT yieldxxon 1001 t 101 027 73 AT yieldCam 70 At what marginal tax rate would you be indifferent 70 1001 t Solve for t 70 100 100t 100t 3 t 30 Mini Case 3 17 Chapter 16 Capital Structure Decisions The Basics ANSWERS T0 ENDOFCHAPTER QUESTIONS 161 a Fquot 0 Capital structure is the manner in which a rm s assets are nanced that is the right hand side of the balance sheet Capital structure is normally expressed as the percentage of each type of capital used by the rmdebt preferred stock and common equity Business risk is the risk inherent in the operations of the rm prior to the nancing decision Thus business risk is the uncertainty inherent in a total risk sense future operating income or earnings before interest and taxes EBIT Business risk is caused by many factors Two of the most important are sales variability and operating leverage Financial risk is the risk added by the use of debt nancing Debt nancing increases the variability of earnings before taxes but after interest thus along with business risk it contributes to the uncertainty of net income and earnings per share Business risk plus nancial risk equals total corporate risk Operating leverage is the extent to which xed costs are used in a rm s operations If a high percentage of a rm s total costs are xed costs then the rm is said to have a high degree of operating leverage Operating leverage is a measure of one element of business risk but does not include the second major element sales variability Financial leverage is the extent to which xedincome securities debt and preferred stock are used in a rm s capital structure If a high percentage of a rm s capital structure is in the form of debt and preferred stock then the rm is said to have a high degree of nancial leverage The breakeven point is that level of unit sales at which costs equal revenues Breakeven analysis may be performed with or without the inclusion of nancial costs If nancial costs are not included breakeven occurs when EBIT equals zero If nancial costs are included breakeven occurs when EBT equals zero Reserve borrowing capacity exists when a rm uses less debt under normal conditions than called for by the tradeoff theory This allows the rm some exibility to use debt in the future when additional capital is needed Business risk refers to the uncertainty inherent in projections of future ROEU Firms with relatively high non nancial xed costs are said to have a high degree of operating leverage Operating leverage affects EBIT and through EBIT EPS Financial leverage has no effect on EBITit only affects EPS given EBIT Answers and Solutions 16 1 165 166 167 If sales tend to uctuate widely then cash ows and the ability to service xed charges will also vary Such a rm is said to have high business risk Consequently there is a relatively large risk that the rm will be unable to meet its xed charges and interest payments are xed charges As a result rms in unstable industries tend to use less debt than those whose sales are subject to only moderate uctuations Public utilities place greater emphasis on longterm debt because they have more stable sales and pro ts as well as more xed assets Also utilities have xed assets which can be pledged as collateral Further trade rms use retained earnings to a greater extent probably because these rms are generally smaller and hence have less access to capital markets Public utilities have lower retained earnings because they have high dividend payout ratios and a set of stockholders who want dividends EBIT depends on sales and operating costs Interest is deducted from EBIT At high debt levels rms lose business employees worry and operations are not continuous because of nancing dif culties Thus nancial leverage can in uence sales and costs and hence EBIT if excessive leverage is used The tax bene ts from debt increase linearly which causes a continuous increase in the rm s value and stock price However nancial distress costs get higher and higher as more and more debt is employed and these costs eventually offset and begin to outweigh the bene ts of debt Answers and Solutions 16 2 161 SOLUTIONS TO ENDOF CHAPTER PROBLEMS a Here are the steps involved 1 Determine the variable cost per unit at present V Pro t PQ FC VQ 500000 10000050 2000000 V50 50V 2500000 V 50000 2 Determine the new pro t level if the change is made New pro t P2Q2 FCz V2Q2 9500070 2500000 50000 1000070 1350000 3 Determine the incremental pro t Pro t 1350000 500000 850000 4 Estimate the approximate rate of return on new investment ROI Pro tInvestment 8500004000000 2125 Since the ROI exceeds the 15 percent cost of capital this analysis suggests that the rm should go ahead with the change Answers and Solutions 16 3 b If we measure operating leverage by the ratio of xed costs to total costs at the expected output then the change would increase operating leverage Old FC 2 000 000 4444 FC VQ 2000000 2500000 New FC2 7 2500000 47 17 FC2 V2Q2 T 2500000 2800000 The change would also increase the breakeven point Old QBE i w 40 units P V 100000 50000 New QBE w 4545 units 95000 40000 However one could measure operating leverage in other ways say by degree of operating leverage QP V 5050000 7 5 0 QP V F 5050000 2000000 39 39 Old DOL New The new DOL at the expected sales level of 70 is 7095000 40000 2 85 7055000 2500000 39 39 The problem here is that we have changed both output and sales price so the DOLs are not really comparable 0 It is impossible to state unequivocally whether the new situation would have more or less business risk than the old one We would need information on both the sales probability distribution and the uncertainty about variable input cost in order to make this determination However since a higher breakeven point other things held constant is more risky the change in breakeven pointsand also the higher percentage of xed costssuggests that the new situation is more risky Answers and Solutions 16 4 162 163 a Expected ROE for Firm C ROEC 01 50 0250 04150 02250 01350 150 Note The distribution of ROEC is symmetrical Thus the answer to this problem could have been obtained by simple inspection Standard deviation of ROE for Firm C 01 50 1502 0250 1502 04150 1502 02250 1502 01350 1502 6c 01 202 02 102 0402 02102 01202 402002040 120 110 According to the standard deviations of ROE Firm A is the least risky while C is the most risky However this analysis does not take into account portfolio effectsnif C s ROE goes up when most other companies ROEs decline that is its beta is negative its apparent riskiness would be reduced Firm A s 6R0 ng 55 Therefore Firm A uses no nancial leverage and has no nancial risk Firm B and Firm C have 6R0 gt 63151 and hence both use leverage Firm C uses the most leverage because it has the highest 6R0 ng measure of nancial risk However Firm C s stockholders also have the highest expected ROE Original value of the rm D 0 V D S 0 15200000 3000000 Original cost of capital WACC wd rd1T wers 0 1010 10 With nancial leverage wd30 WACC wd rd1T wers 0371040 0711 896 Because growth is zero the value of the company is Answers and Solutions 16 5 V FCF Z EBIT1 T Z 5000001 040 3a348 14i286n WACC WACC 00896 Increasing the nancial leverage by adding 900000 of debt results in an increase in the rm s value from 3000000 to 3348214286 Fquot Using its target capital structure of 30 debt the company must have debt of D wd V 0303348214286 1004464286 Therefore its debt value of equity is S V 7 D 2343750 Alternatively S lwdV 073348214286 2343750 The new price per share P is P 7 s D 7 D0no 7 2343750 1004464286 7 0200000 7 16741 O The number of shares repurchased X is X D 7 D0P 100446428616741 60000256 m 60000 The number of remaining shares n is n 200000 7 60000 140000 Initial position EPS 500000 7 01040 200000 150 With nancial leverage EPS 500000 7 00710044642861040 140000 500000 7 7031251040 140000 2578125140000 1842 Thus by adding debt the rm increased its EPS by 0342 Answers and Solutions 16 6 164 d 30 debt TIE H I 703125 Probability TIE 010 142 020 284 040 711 020 1138 010 1564 The interest payment is not covered when TIE lt 10 The probability of this occurring is 010 or 10 percent a Present situation 50 debt WACC wd rd1T wers 05101015 0514 1125 FCF EBIT1 T 13241 015 100 million WACC WACC 01125 V 70 percent debt WACC wd rd1T wers 07121015 0316 1194 FCF EBIT1 T Z 13241 015 94255 million WACC WACC 01194 V 30 percent debt WACC wd rd1T wers 0381015 0713 1114 FCF EBIT1 T Z 13241 015 101023 million WACC WACC 01114 V Answers and Solutions 165 a BEA s unlevered beta is bUbL1 1TDS10110402080 7 0870 b bL 7 bU 1 1TDS At 40 percent debt bL 7 087 1 064060 7 1218 rs 7 6 12184 7 10872 c WACC wd rd1T wers 049104 0610872 8683 FCF EBIT1 T Z 149331 04 V 103188 million WACC WACC 008683 166 TaX rate 40 rRF 50 131 I M I Rl From data given in the problem and table we can develop the following table A A rd rd1 T rs beta Notes 3 These beta estimates were calculated using the Hamada equation b bU117 TDE These rs estimates were calculated using the CAPM rs rRF rM 7 rRFb C These WACC estimates were calculated with the following equation WACC wdrd1 7 T wcrs The rm s optimal capital structure is that capital structure which minimizes the rm s WACC Elliott s WACC is minimized at a capital structure consisting of 40 debt and 60 equity At that capital structure the rm s WACC is 1145 Answers and Solutions 16 8 SOLUTION TO SPREADSHEET PROBLEM 167 The detailed solution for the problem is available both on the instructor s resource CD ROM in the le Solution for FM11 Ch 16 P7 Build a M0delxls and on the instructor s side of the web site httpb139ighamswleamingc0m Answers and Solutions 16 9 MINI CASE Assume you have just been hired as business manager of PizzaPalace a pizza restaurant located adjacent to campus The company39s EBIT was 500000 last year and since the university39s enrollment is capped EBIT is expected to remain constant in real terms over time Since no expansion capital will be required PizzaPalace plans to pay out all earnings as dividends The management group owns about 50 percent of the stock and the stock is traded in the over the counter market The rm is currently nanced with all equity it has 100000 shares outstanding and P0 25 per share When you took your MBA Corporate Finance course your instructor stated that most rms39 owners would be nancially better off if the rms used some debt When you suggested this to your new boss he encouraged you to pursue the idea As a rst step assume that you obtained from the rm39s investment banker the following estimated costs of debt for the rm at different capital structures Financed With Debt Rd 0 20 80 30 85 40 100 50 120 If the company were to recapitalize debt would be issued and the funds received would be used to repurchase stock PizzaPalace is in the 40 percent state plus federal corporate tax bracket its beta is 10 the risk free rate is 6 percent and the market risk premium is 6 percent a Provide a brief overview of capital structure effects Be sure to identify the ways in which capital structure can affect the weighted average cost of capital and free cash ows Answer The basic de nitions are 1 V Value Of Firm 2 FCF Free Cash Flow 3 WACC Weighted Average Cost Of Capital 4 Rs And Rd are costs of stock and debt 5 We And Wd are percentages of the rm that are nanced with stock and debt The impact of capital structure on value depends upon the effect of debt on WACC and0r FCF Mini Case 16 10 Debt holders have a prior claim on cash ows relative to stockholders Debt holders xed claim increases risk of stockholders residual claim so the cost of stock rs goes up Firm s can deduct interest expenses This reduces the taxes paid frees up more cash for payments to investors and reduces aftertax cost of debt Debt increases the risk of bankruptcy causing pretaX cost of debt rd to increase Adding debt increase the percent of rm nanced with lowcost debt wd and decreases the percent nanced with highcost equity we The net effect on WACC is uncertain since some of these effects tend to increase WACC and some tend to decrease WACC Additional debt can affect FCF The additional debt increases the probability of bankruptcy The direct costs of nancial distress are legal fees re sales etc The indirect costs are lost customers reductions in productivity of managers and line workers reductions in credit ie accounts payable offered by suppliers Indirect costs cause NOPAT to go down due to lost customers and drop in productivity and causes the investment in capital to go up due to increases in net operating working capital accounts payable goes up as suppliers tighten credit Additional debt can affect the behavior of managers It can cause reductions in agency costs because debt precommits or bonds free cash ow for use in making interest payments Thus managers are less likely to waste FCF on perquisites or nonvalue adding acquisitions But it can cause increases in other agency costs Debt can make managers too risk averse causing underinvestment in risky but positive NPV projects There are also effects due to asymmetric information and signaling Managers know the rm s future prospects better than investors Thus managers would not issue additional equity if they thought the current stock price was less than the true value of the stock given their inside information Hence investors often perceive an additional issuance of stock as a negative signal and the stock price falls b 1 What is business risk What factors in uence a rm39s business risk Answer Businsess risk is uncertainty about EBIT Factors that in uence business risk include uncertainty about demand unit sales uncertainty about output prices uncertainty about input costs product and other types of liability degree of operating leverage DOL Mini Case 16 11 b 2 what is operating leverage and how does it affect a firm39s business risk Show the operating break even point if a company has xed costs of 200 a sales price of 15 and variables costs of 10 Answer Operating leverage is the change in EBIT caused by a change in quantity sold The higher the proportion of xed costs within a rm s overall cost structure the greater the operating leverage Higher operating leverage leads to more business risk because a small sales decline causes a larger EBIT decline Q is quantity sold F is xed cost V is variable cost TC is total cost and P is price per unit Operating Breakeven QBE QBE F P V Example F200 P15 AND V10 QBE 200 15 7 10 40 c Now to develop an example which can be presented to PizzaPalace s management to illustrate the effects of financial leverage consider two hypothetical firms firm U which uses no debt financing and firm L which uses 10000 of 12 percent debt Both firms have 20000 in assets a 40 percent tax rate and an expected EBIT of 3000 1 Construct partial income statements which start with EBIT for the two firms Answer Here are the fully completed statements Firm U Firm L Assets 20000 20000 Equity 20000 10000 EBIT 3000 3000 INT 12 0 l 200 EBT 3000 1800 Taxes 40 l 200 720 N1 1 800 1 080 Mini Case 16 12 c 2 Now calculate roe for both firms Answer Firm U Firm L BEP 150 150 ROI 90 114 ROE 90 108 TIE oo 25x c 3 What does this example illustrate about the impact of fmancial leverage on ROEquot Answer Conclusions from the analysis The firm s basic earning power BEP EBITtotal assets is unaffected by nancial leverage Firm L has the higher expected ROI because of the tax savings effect 0 ROIU 90 o ROIL 114 Firm L has the higher expected roe o ROEU 90 o ROEL 108 Therefore the use of financial leverage has increased the expected profitability to shareholders The higher roe results in part from the tax savings and also because the stock is riskier if the rm uses debt At the expected level of EBIT ROEL gt ROEU The use of debt will increase roe only if ROA exceeds the aftertax cost of debt Here ROA unleveraged roe 90 gt rd1 t 1206 72 so the use of debt raises roe 0 Finally note that the TIE ratio is huge undefined or infinitely large if no debt is used but it is relatively low if 50 percent debt is used The expected tie would be larger than 25x if less debt were used but smaller if leverage were increased Mini Case 16 13 d Explain the difference between nancial risk and business risk Answer Business risk increases the uncertainty in future EBIT It depends on business factors such as competition operating leverage etc Financial risk is the additional business risk concentrated on common stockholders when nancial leverage is used It depends on the amount of debt and preferred stock financing e Now consider the fact that EBIT is not known with certainty but rather has the following probability distribution Economic State Probability EBIT Bad 025 2000 Average 050 3000 Good 025 4000 Redo the part A analysis for firms U and L but add basic earning power BEP return on investment ROI de ned as net income interestdebt equity and the times interest earned TIE ratio to the outcome measures Find the values for each rm in each state of the economy and then calculate the expected values Finally calculate the standard deviation and coefficient of variation of ROE What does this example illustrate about the impact of debt nancing on risk and return Answer Here are the pro forma income statements Firm U Firm L Bad A g Good Bad Avg Good Prob 025 050 025 025 050 025 EBIT 2000 3000 4000 2000 3000 4000 Interest 0 0 0 1 200 1 200 1 200 EBT 2000 3000 4000 800 1800 2800 Taxes 40 800 1 200 1 600 320 720 1 120 I 1 200 1 800 2 400 480 1 080 1 680 BEP 100 150 200 10 0 150 200 ROIC 60 90 120 60 90 120 ROE 60 90 120 48 108 168 TIE oo oo oo 17gtlt 25gtlt 33gtlt EBEP 150 150 EROIC 90 90 EROE 90 108 GROIC 212 212 GROE 212 424 Mini Case 16 14 This example illustrates that nancial leverage can increase the expected return to stockholders But at the same time it increases their risk 0 Firm L has a wider range of ROEs and a higher standard deviation of ROE indicating that its higher expected return is accompanied by higher risk To be precise 6ROE Unleveraged 2120A and GROE Leveraged 424 Thus in a standalone risk sense rm L is twice as risky as rm Uits business risk is 212 percent but its standalone risk is 424 percent so its nancial risk is 424 212 212 139 What does capital structure theory attempt to do What lessons can be learned from capital structure theory Be sure to address the MM models Answer MM theory begins with the assumption of zero taxes MM prove under a very restrictive set of assumptions that a rm s value is unaffected by its nancing mix VL Vu Therefore capital structure is irrelevant Any increase in roe resulting from nancial leverage is exactly offset by the increase in risk ie rs so WACC is constant MM theory later includes corporate taxes Corporate tax laws favor debt nancing over equity nancing With corporate taxes the bene ts of nancial leverage exceed the risks because more EBIT goes to investors and less to taxes when leverage is used MM show that VL VU TD If T40 then every dollar of debt adds 40 cents of extra value to rm Miller later included personal taxes Personal taxes lessen the advantage of corporate debt Corporate taxes favor debt nancing since corporations can deduct interest expenses but personal taxes favor equity nancing since no gain is reported until stock is sold and longterm gains are taxed at a lower rate Miller s conclusions with personal taxes are that the use of debt nancing remains advantageous but bene ts are less than under only corporate taxes Firms should still use 100 debt Note however miller argued that in equilibrium the tax rates of marginal investors would adjust until there was no advantage to debt MM theory ignores bankruptcy nancial distress costs which increase as more leverage is used At low leverage levels tax bene ts outweigh bankruptcy costs At high levels bankruptcy costs outweigh tax bene ts An optimal capital structure exists that balances these costs and bene ts This is the tradeoff theory Mini Case 16 15 MM assumed that investors and managers have the same information But managers often have better information Thus they would sell stock if stock is overvalued and sell bonds if stock is undervalued Investors understand this so view new stock sales as a negative signal This is signaling theory One agency problem is that managers can use corporate funds for nonvalue maximizing purposes The use of financial leverage bonds free cash ow and forces discipline on managers to avoid perks and nonvalue adding acquisitions A second agency problem is the potential for underinvestmen Debt increases risk of financial distress Therefore managers may avoid risky projects even if they have positive NPVs g With the above points in mind now consider the optimal capital structure for PizzaPalace g 1 For each capital structure under consideration calculate the levered beta the cost of equity and the WACC Answer MM theory implies that beta changes with leverage EU is the beta of a firm when it has no debt the unlevered beta Hamada s equation provides the beta of a levered firm BL BU 1 1 TDS For example to find the cost of equity for wd 20 we first use Hamada s equation to find beta BL BU 1 1 TDS 10 1 104 2080 115 Then use CAPM to find the cost of equity Rs RRF BL RPM 6 115 6 129 We can repeat this for the capital structures under consideration WD DS BL Rs 0 000 1000 1200 20 025 1150 1290 30 043 1257 1354 40 067 1400 1440 50 100 1600 1560 Mini Case 16 16 Next nd the WACC For example the WACC for wd 20 is WACC wd 1T rd we rs WACC 02 1 7 04 8 08 129 WACC 1128 Then repeat this for all capital structures under consideration wd rd rS WACC 0 00 1200 1200 20 80 1290 1128 30 85 1354 1101 40 100 1440 1104 50 120 1560 1140 g 2 Now calculate the corporate value the value of the debt that will be issued and the resulting market value of equity Answer For example the corporate value for wd 20 is V FCF WACCG G0 so investment in capital is zero so FCF NOPAT EBIT lT In this example NOPAT 5000001040 300000 Using these values V 300000 01128 2659574 Repeating this for all capital structures gives the following table wd WACC Corp Value 0 1200 2500000 20 1128 2659574 30 1101 2724796 40 1104 2717391 50 1140 2631579 As this shows value is maximized at a capital structure with 30 debt Mini Case 16 17 g 3 Calculate the resulting price per share the number of shares repurchased and the remaining shares Answer First nd the dollar value of debt and equity For example for wd 20 the dollar value of debt is d wd V 02 2659574 531915 We can then nd the dollar value of equity S V 7 D S 2659574 531915 2127659 We repeat this process for all the capital structures wd Debt D Stock Value S 0 0 2500000 20 531915 2127660 30 817439 1907357 40 1086957 1630435 50 1315789 1315789 Note these are rounded see FM11 Ch 16 mini casexls for full calculations Notice that the value of the equity declines as more debt is issued because debt is used to repurchase stock But the total wealth of shareholders is the value of stock after the recap plus the cash received in repurchase and this total goes up it is equal to corporate value on earlier slide The rm issues debt which changes its WACC which changes value The rm then uses debt proceeds to repurchase stock The stock price changes after debt is issued but does not change during actual repurchase or arbitrage is possible The stock price after debt is issued but before stock is repurchased re ects shareholder wealth which is the sum of the stock and the cash paid in repurchase For example to nd the stock price for wd 20 let D0 and N0 denote debt and outstanding shares before the recap D D0 is equal to cash that will be used to repurchase stock S D D0 is the wealth of shareholders after the debt is issued but immediately before the repurchase We can express the stock price per share prior to the repurchase P for wd 20 as P s D 7 D0010 P 2127660 531915 7 0 100000 P 26596 per share Mini Case 16 18 The number of shares repurchased is repurchased D D0 P rep 531915 7 0 26596 20000 The number of remaining shares after the repurchase is remaining N S P N 2127660 26596 80000 We can apply this same procedure to all the capital structures under consideration Shares Shares Wd P Repurch Remaining 0 2500 0 100000 20 2660 20000 80000 30 2725 30000 70000 40 2717 40000 60000 50 2632 50000 50000 h Considering only the capital structures under analysis what is PizzaPalace39s optimal capital structure Answer The optimal capital structure is for wd 30 This gives the highest corporate value the lowest WACC and the highest stock price per share But notice that wd 40 is very similar to the optimal solution in other words the optimal range is pretty at i What other factors should managers consider when setting the target capital structure Answer Managers should also consider the debt ratios of other rms in the industry pro forma coverage ratios at different capital structures under different economic scenarios lender and rating agency attitudes ie the impact on bond ratings reserve borrowing capacity the effects on control ie does the capital structure make it easier of harder for an outsider to take over the firm the firm s types of assets ie are they tangible and hence suitable as collateral and the firm s projected taX rates Mini Case 16 19
Are you sure you want to buy this material for
You're already Subscribed!
Looks like you've already subscribed to StudySoup, you won't need to purchase another subscription to get this material. To access this material simply click 'View Full Document'