RIASSUNTI CORPORATE FINANCE, Sintesi del corso di Finanza Aziendale

Scarica RIASSUNTI CORPORATE FINANCE e più Sintesi del corso in PDF di Finanza Aziendale solo su Docsity! APPLIED CORPORATE FINANCE 1. THE FOUNDATIONS 1.1 THE FIRM: STRUCTURAL SETUP Corporate finance is: • every decision that a business makes has financial implications, and any decision which affects the finances of a business is a corporate finance decision • defined broadly, everything that a business does fits under the The Traditional Accounting Balance Sheet The financial view of the firm (market values ) 1.2 FIRST PRINCIPLES All of corporate finance is built on three principles, which we will call: • the investment principle ® determines where businesses invest their resources; invest in assets and projects that yield a return greater than the minimum acceptable hurdle rate: 1. the hurdle rate should be higher for riskier projects and should reflect the financing mix used—owners’ funds (equity) or borrowed money (debt) 2. returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects • the financing principle ® governs the mix of funding used to fund these investments; choose a financing mix (debt and equity) that maximizes the value of the investments made and match the financing to the nature of the assets being financed • the dividend principle ® answers the question of how much earnings should be reinvested back into the business and how much should be returned to the owners of the business; if there are not enough investments that earn the hurdle rate, return the cash to the owners of the business; in the case of a publicly traded firm, the form of the return—dividends or stock buybacks—will depend on what stockholders prefer. When making investment, financing, and dividend decisions, corporate finance is single-minded about the ultimate objective, which is assumed to be maximizing the value of the business to its owners. These first principles provide the basis from which we will extract the numerous models and theories that comprise modern corporate finance, but they are also commonsense principles. 1.4 SOME FUNDAMENTAL PROPOSITIONS ABOUT CORPORATE FINANCE Corporate finance: • is “common sense” ® the is nothing earth shattering about any of the first principles that govern corporate finance. After all, arguing that: 8 taking investments that make 9% with funds that cost 10% to raise seems to be stating the obvious (the investment decision), as is noting that it is better to find a funding mix which costs 10% instead of 11% (the financing decision) or positing that if most of your investment opportunities generate returns less than your cost of funding, it is best to return the cash to the owners of the business and shrink the business • is focused on maximizing the value of the business that gives corporate finance its focus. As a result of this singular objective, we can: 1. choose the “right” investment decision rule to use, given a menu of such rules 2. determine the “right” mix of debt and equity for a specific business 3. examine the “right” amount of cash that should be returned to the owners of a business and the “right” amount to hold back as a cash balance • is universal ® every business, small or large, public or private, US or emerging market, has to make investment, financing and dividend decisions 1. a publicly traded firm, with its greater access to capital markets and more diversified investor base, may have much lower costs of debt and equity than a private business, but they both should look for the financing mix that minimizes their costs of capital 2. a firm in an emerging market may face greater uncertainty, when assessing new investments, than a firm in a developed market, but both firms should invest only if they believe they can generate higher returns on their investments than they face as their respective (and very different) hurdle rates • if you violate first principles, you will pay a price (no matter who you are..) 1. there are some investors/analysts/managers who convince themselves that the first principles don’t apply to them because of their superior education, standing or past successes, and then proceed to put into place strategies or schemes that violate first principles 2. sooner or later, these strategies will blow up and create huge costs 3. almost every corporate disaster or bubble has its origins in a violation of first principles. 1.3 CORPORATE FINANCIAL DECISIONS, FIRM VALUE, AND EQUITY VALUE The objective in decision-making of the firm is: • to maximize the value of the firm ® in traditional corporate finance • to maximize stockholder wealth (narrower objective) ® when the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price. Maximizing Stock Prices is too “narrow” an objective: • it is not incompatible with meeting employee needs/objectives: 1. employees are often stockholders in many firms 2. firms that maximize stock price generally are profitable firms that can afford to treat employees well • it does not mean that customers are not critical to success ® in most businesses, keeping customers happy is the route to stock price maximization • it does not imply that a company has to be a social outlaw. Capital Asset Pricing Model ® 𝐸(𝑟!) = 𝑟" + 𝛽!(𝑟# − 𝑟") 𝐸(𝑟!) ® required return on common stock 𝑟" ® risk-free rate of return; usually the current rate on Treasury Bill securities 𝛽! ® the beta measures the historical volatility of an individual stock’s return relative to a stock market index; a beta greater than 1 indicates greater volatility (price movements) than the market, while the reverse would be true for a beta less than 1 𝑟# ® return in the market as measured by an appropriate index- 𝑟# − 𝑟" ® premium or excess return of the market versus the risk-free rate (since the market is riskier than Rf, the assumption is that the expected Rm will be greater than Rf) 𝛽!(𝑟# − 𝑟") ® expected return above the risk-free rate for the stock of company j, given the level of risk. The mean–variance framework for assessing risk is focused on measuring risk quantitatively, often with one number—a standard deviation. Behavioral finance scholars present three aspects of risk assessment that are at variance with the mean–variance school’s view of risk: • loss aversion ® individuals are affected far more negatively by a loss than they are helped by an equivalent gain, and that they generally measure losses in dollar terms rather than percentage terms; investors are loss averse rather than risk averse; investments where there is even a small chance of a significant loss in wealth will be viewed as risky, even if they have only a small standard deviation • familiarity bias ® individuals seem to perceive less risk with investments that they are familiar with than with unfamiliar investments; they see less risk in a domestic company with a long provenance than they do in an emerging market firm; this may explain why there is a “home bias” in portfolios, where investors overinvest in investments in their domestic market and underinvest in foreign investments; in an extension of this bias, the risk that individuals perceive in an activity or investment is inversely proportional to the difficulty they face in understanding it • emotional factors ® there is an emotional component to risk that quantitative risk measures cannot capture; this component can have both a: 1. positive affect, where gains accentuate positive affects (happiness and optimism) 2. negative effect, where losses feed into negative affects (worry and anxiety). Investor moods can affect risk perceptions with investments that are viewed as relatively safe in buoyant times becoming risky when investor moods shift. 3.2.2 Rewarded and unrewarded risk Risks can be classified into two categories: • firm-specific risks ® those that are specific to the investment being considered • market risks ® those that apply across most or all investments. The Components of Risk ® when a firm makes an investment, in a new asset or a project, the return on that investment can be affected by several variables, most of which are not under the direct control of the firm. Some of the risk comes directly from the investment, a portion from competition, some from shifts in the industry, some from changes in exchange rates and some from macroeconomic factors. A portion of this risk, however, will be eliminated by the firm itself over the course of multiple investments and another portion by investors as they hold diversified portfolios. The sources of risk are: • project-specific ® an individual project may have higher or lower cash flows than expected, either because the firm misestimated the cash flows for that project or because of factors specific to that project; when firms take a large number of similar projects, it can be argued that much of this risk should be diversified away in the normal course of business • competitive risk ® whereby the earnings and cash flows on a project are affected (positively or negatively) by the actions of competitors; while a good project analysis will build in the expected reactions of competitors into estimates of profit margins and growth, the actual actions taken by competitors may differ from these expectations. In most cases, this component of risk will affect more than one project and is therefore more difficult to diversify away in the normal course of business by the firm • industry-specific risk ® those factors that impact the earnings and cash flows of a specific industry; there are three sources of industry-specific risk: 1. technology risk ® which reflects the effects of technologies that change or evolve in ways different from those expected when a project was originally analyzed 2. legal risk ® which reflects the effect of changing laws and regulations 3. commodity risk ® which reflects the effects of price changes in commodities and services that are used or produced disproportionately by a specific industry; a firm cannot diversify away its industry-specific risk without diversifying across industries, either with new projects or through acquisitions; stockholders in the firm should be able to diversify away industry-specific risk by holding portfolios of stocks from different industries 4. international risk ® a firm faces this type of risk when it generates revenues or has costs outside its domestic market; the earnings and cash flows will be affected by unexpected exchange rate movements or by political developments a) some of this risk may be diversified away by the firm in the normal course of business by investing in projects in different countries whose currencies may not move all in the same direction b) companies can also reduce their exposure to the exchange rate component of this risk by borrowing in the local currency to fund projects c) investors should be able to reduce their exposure to international risk by diversifying globally. To the extent that political risk is correlated across countries, though, it is possible that some of the risk in international expansion may not be diversifiable, to either companies or investors in these companies. • market risk ® macroeconomic factors that affect essentially all companies and all projects, to varying degrees; while expected values of all these variables enter into project analysis, unexpected changes in these variables will affect the values of these investments; neither investors nor firms can diversify away this risk as all risky investments bear some exposure to this risk. Why Diversification Reduces or Eliminates Firm-Specific Risk • risk that affects one of a few firms, can be reduced or even eliminated by investors as they hold more diverse portfolios due to two reasons: 1. each investment in a diversified portfolio is a much smaller percentage of that portfolio ® any risk that increases or reduces the value of only that investment or a small group of investments will have only a small impact on the overall portfolio 2. the effects of firm-specific actions on the prices of individual assets in a portfolio can be either positive or negative for each asset for any period ® in large portfolios, it can be reasonably argued that this risk will average out to be zero and thus not impact the overall value of the portfolio. • risk that affects most of all assets in the market will continue to persist even in large and diversified portfolios. The benefits of diversification can be shown statistically ® standard deviation as the measure of risk in an investment and calculated the standard deviation for an individual stock; when you combine two investments that do not move together in a portfolio, the standard deviation of that portfolio can be lower than the standard deviation of the individual stocks in the portfolio. Example : consider a portfolio of two assets. Asset A has an expected return of 𝜇A and a variance in returns of 𝜎2A, while asset B has an expected return of 𝜇B and a variance in returns of 𝜎2B. The correlation in returns between the two assets, which measures how the assets move together, is 𝜌AB. The expected returns and variance of a two-asset portfolio can be written as a function of these inputs and the proportion of the portfolio going to each asset: 𝜇$%&'"%(!% = 𝑤)𝜇) + (1 − 𝑤))𝜇* 𝜎$%&'"%(!%+ = 𝑤)+𝜎)+ + (1 − 𝑤))+𝜎*+ + 2𝑤)𝑤* 𝜌)*𝜎)𝜎* where wA is the proportion of the portfolio in asset A. The last term in the variance formulation is sometimes written in terms of the covariance in returns between the two assets, which is: 𝜎)* = 𝜌)*𝜎)𝜎* The savings that accrue from diversification are a function of the correlation coefficient. Other things remaining equal, the higher the correlation in returns between the two assets, the smaller are the potential benefits from diversification. The Role of the Marginal Investor ® The marginal investor in a firm is the investor who is most likely to be the buyer or seller on the next trade and to influence the stock price • the marginal investor in a stock has to own a lot of stock and also trade a lot • since trading is required, the largest investor may not be the marginal investor, especially if he or she is a founder/manager of the firm • in all risk and return models in finance, we assume that the marginal investor is well diversified. Identifying the Marginal Investor: • the firm has relatively small institutional holdings but substantial holdings by wealthy individual investors ® the marginal investor is an individual investor with a significant equity holding in the firm; we have to consider how diversified that individual investor’s portfolio is to assess project risk 1. the individual investor is not diversified ® this firm may have to be treated like a private firm, and the cost of equity has to include a premium for all risk, rather than just non-diversifiable risk 2. the individual investor is a wealthy individual with significant stakes in a large number of firms ® a large portion of the risk may be diversifiable • the firm has small institutional holdings and small insider holdings ® its stock is held by large numbers of individual investors with small equity holdings; the marginal investor is an individual investor, with a portfolio that may be only partially diversified • the firm has significant institutional holdings and small insider holdings ® the marginal investor is almost always a diversified, institutional investor • the firm has significant institutional holdings and large insider holdings ® the choice for marginal investor becomes a little more complicated 1. often the large insider is the founder or original owner for the firm, and often, this investor continues to be involved in the top management of firm 2. in most of these cases, the insider owner seldom trades the stock, and his or her wealth is determined by the level of the stock price, which is determined by institutional investors trading the stock ® the institutional investor is the marginal investor in these firms as well. 3.2.3 Measuring Market Risk The Market Portfolio and the risk of an individual asset • the big assumptions ® assuming diversification costs nothing (in terms of transactions costs), and that all assets can be traded, the limit of diversification is to hold a portfolio of every single asset in the economy (in proportion to market value), portfolio called the market portfolio. The consequence: Individual investors will adjust for risk, by adjusting their allocations to this market portfolio and a riskless asset • the essence ® the risk of any asset is the risk that it adds to the market portfolio; statistically, this risk can be measured by how much an asset moves with the market (called the covariance) • the measure ® beta is a standardized measure of this covariance, obtained by dividing the covariance of any asset with the market by the variance of the market; it is a measure of the non-diversifiable risk for any asset Why the CAPM persists ® The CAPM, has survived as the default model for risk in equity valuation and corporate finance; the alternative models that have been presented as better models (APM, Multifactor model..) have made inroads in performance evaluation but not in prospective analysis because: • the alternative models (which are richer) do a much better job than the CAPM in explaining past return, but their effectiveness drops off when it comes to estimating expected future returns (because the models tend to shift and change) • the alternative models are more complicated and require more information than the CAPM • for most companies, the expected returns you get with the alternative models is not different enough to be worth the extra trouble of estimating four additional betas. 3.3 THE RISK IN BORROWING: DEFAULT RISK AND THE COST OF DEBT When an investor lends to an individual or a firm, there is the possibility that the borrower may default on interest and principal payments on the borrowing. This possibility of default is called the default risk • borrowers with higher default risk should pay higher interest rates on their borrowing than those with lower default risk • models of default risk measure the consequences of firm-specific default risk on promised returns • the expected return on a corporate bond is likely to reflect the firm-specific default risk of the firm issuing the bond. The Determinants of Default Risk ® The default risk of a firm is a function of its capacity to generate cash flows from operations and its financial obbligations – including interest and principal payments. It is also a function of the how liquid a firm’s assets are as firms with more liquid assets should have an easier time liquidating them, in a crisis, to meet debt obligations. Consequently, the following propositions relate to default risk: • firms that generate high cash flows relative to their financial obligations have lower default risk than do firms that generate low cash flows relative to obligations. Thus, firms with significant current investments that generate high cash flows will have lower default risk than will firms that do not • the more stable the cash flows, the lower is the default risk in the firm. Firms that operate in predictable and stable businesses will have lower default risk than will otherwise similar firms that operate in cyclical and/or volatile businesses, for the same level of indebtedness • the more liquid a firm’s assets, for any given level of operating cash flows and financial obligations, the less default risk in the firm. 4. RISK MEASUREMENT AND HURDLE RATES IN PRACTICE 4.1 COST OF EQUITY The cost of equity is the rate of return that investors require to invest in the equity of a firm. All of the risk-and-return models described in the previous chapter need a risk-free rate and a risk premium (in the CAPM) or premiums (in the APM and multifactor models). We begin by discussing those common inputs before turning attention to the estimation of risk parameters. 4.1.1 Risk-Free Rate To assess the required return on a risky asset, we generally begin with an asset that is defined as risk-free and use the expected return on that asset as the risk-free rate. The expected returns on risky investments are then measured relative to the risk-free rate, with the risk creating an expected risk premium that is added on to the risk-free rate • requirements for an Asset to be Risk-Free ® we define a risk-free asset as one for which the investor knows the expected returns with certainty. Consequently, for an investment to be risk-free, to have an actual return be equal to the expected return, two conditions have to be met: 1. there has to be no default risk, which generally implies that the security has to be issued by a government. Note, though, that not all governments are default-free, and the presence of government or sovereign default risk can make it very difficult to estimate risk-free rates in some currencies 2. there can be no uncertainty about reinvestment rates, which implies that there are no intermediate cash flows • estimating Risk-Free Rates ® the risk-free rate used to come up with expected returns should be measured consistently with how the cash flows are measured; if the cash flows are nominal, the risk-free rate should be in the same currency in which the cash flows are estimated; it is not where a project or firm is located that determines the choice of a risk-free rate, but the currency in which the cash flows on the project or firm are estimated 1. inputs required to use the CAPM a) current risk-free rate b) expected equity risk premium (the premium expected for investing in risky assets (market portfolio) over the riskless asset) c) beta of the asset being analyzed 2. the choice of risk-free rate a) treasury Bond issued by a government with no default risk (government bonds) b) time horizon ® Zero coupon security (no uncertainty about reinvestment rates) with the same maturity as the cash flow being analyzed c) currency ® the risk-free rate that you use in an analysis should be in the same currency that your cashflows are estimated in 3. Risk-Free Rates: Default-Free Governments ® if you assume that governments are default-free, the simplest measure of a risk-free rate is the interest rate on a market-traded long-term government bond, using the sovereign rating for the government and assuming that any sovereign that is Aaa rated is default-free, although it comes at the cost of having to trust the ratings agencies to be right in their assessments 4. a Real Risk-Free Rate ® under conditions of high and unstable inflation, valuation is often done in real terms. Effectively, this means that cash flows are estimated using real growth rates and without allowing for the growth that comes from price inflation. To be consistent, the discount rates used in these cases have to be real discount rates. To get a real expected rate of return, we need to start with a real risk-free rate. Although default-free government bills and bonds offer returns that are risk-free in nominal terms, they are not risk-free in real terms, because inflation can be volatile. The standard approach of subtracting an expected inflation rate from the nominal interest rate to arrive at a real risk-free rate provides at best only an estimate of the real risk-free rate. An inflation-indexed Treasury security does not offer a guaranteed nominal return to buyers, but instead provides a guaranteed real return 5. if there is no default-free entity a) risk-free rate: governments have default risk ® some governments are perceived as capable of defaulting even on local currency debt and when this is coupled with the fact that they do not borrow long term in the local currency, there are scenarios in which obtaining a risk-free rate in that currency, especially for the long term, becomes more complicated - adjust the local currency government borrowing rate for default risk to get a riskless local currency rate ® if the government does issue long-term bonds in the local currency, you could adjust the government bond rate by the estimated default spread on the bond to arrive at a riskless local currency rate. The default spread on the government bond can be estimated using the local currency sovereign ratings that are available for many countries 𝑟𝑖𝑠𝑘𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 𝑖𝑛 𝑙𝑜𝑐𝑎𝑙 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 = 𝑔𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑙𝑜𝑐𝑎𝑙 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑏𝑜𝑛𝑑 𝑟𝑎𝑡𝑒 − 𝑠𝑜𝑣𝑒𝑟𝑒𝑖𝑔𝑛 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑠𝑝𝑟𝑒𝑎𝑑 𝑤𝑖𝑡ℎ 𝑡ℎ𝑒 𝑠𝑎𝑚𝑒 𝑟𝑎𝑡𝑖𝑛𝑔 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑢𝑛𝑡𝑟𝑦 b) risk-free rate: no local currency government bonds - do the analysis in an alternate currency, where getting the risk-free rate is easier ® choosing to do the analysis in US dollars, the risk-free rate is the US treasury bond rate - do your analysis in real terms, in which case the risk-free rate has to be a real risk-free rate ® the inflation-indexed treasury rate is a measure of a real risk-free rate. Three paths to estimating sovereign default spreads: • sovereign dollar or euro denominated bonds ® the difference between the interest rate on a sovereign US $ bond, issued by the country, and the US treasury bond rate can be used as the sovereign default spread 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑠𝑝𝑟𝑒𝑎𝑑 = 𝑈𝑆 $ 𝑏𝑜𝑛𝑑 𝑜𝑓 𝑎 𝑐𝑜𝑢𝑛𝑡𝑟𝑦 𝑑𝑒𝑛𝑜𝑚𝑖𝑛𝑎𝑡𝑒𝑑 𝑖𝑛 𝑈𝑆 𝑑𝑜𝑙𝑙𝑎𝑟𝑠 − 𝑡𝑟𝑒𝑎𝑠𝑢𝑟𝑦 𝑏𝑜𝑛𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑈𝑆 • CDS spreads ® obtain the default spreads for sovereigns in the CDS market • average spread ® if you know the sovereign rating for a country, you can estimate the default spread based on the rating. 4.1.2 Risk premium The risk premium is the premium that investors demand for investing in an average risk investment, relative to the riskfree rate. As a general proposition, this premium should be: • greater than zero • increase with the risk aversion of the investors in that market • increase with the riskiness of the “average” risk investment. The risk premium in the CAPM measures the extra return that would be demanded by investors for shifting their money from a riskless investment to the market portfolio or risky investments, on average. It should be a function of two variables: • risk aversion of investors ® as investors become more risk averse, they should demand a larger premium for shifting from the riskless asset. Although some of this risk aversion may be inherent, some of it is also a function of economic prosperity (when the economy is doing well, investors tend to be much more willing to take risk) and recent experiences in the market (risk premiums tend to surge after large market drops) • riskiness of the average risk investment ® as the perceived riskiness of the average risk investment increases, so should the premium. This will depend not only on the economic fundamentals of traded firms in a market but also on changing accounting and information disclosure practices. Because each investor in a market is likely to have a different assessment of an acceptable equity risk premium, the premium will be a weighted average of these individual premiums, where the weights will be based on the wealth the investor brings to the market. In the APM and the multifactor models, the risk premiums used for individual factors are similar wealth-weighted averages of the premiums that individual investors would demand for each factor separately. Estimating Risk Premiums in Practice: • survey approach ® survey investors on their desired risk premiums and use the average premium from these surveys; the limitations of this approach are: 1. there are no constraints on reasonability (the survey could produce negative risk premiums or risk premiums of 50%) 2. the survey results are extremely volatile 3. they tend to be short term; even the longest surveys do not go beyond one year • historical premium approach ® assume that the actual premium delivered over long time periods is equal to the expected premium, use historical data; this is the default approach used by most to arrive at the premium to use in the model 1. in most cases, this approach does the following a) defines a time period for the estimation b) calculates average returns on a stock index during the period c) calculates average returns on a riskless security over the period d) calculates the difference between the two averages and uses it as a premium looking forward 2. the limitations of this approach are: a) it assumes that the risk aversion of investors has not changed in a systematic way across time. (The risk aversion may change from year to year, but it reverts back to historical averages) b) it assumes that the riskiness of the “risky” portfolio (stock index) has not changed in a systematic way across time 3. estimation issues ® users of risk-and-return models may have developed a consensus that the historical premium is in fact the best estimate of the risk premium looking forward, but there are surprisingly large differences in the actual premiums used in practice. There are three reasons for the divergence in risk premiums: a) go back as far as you can: time period used ® although there are some who use all of the Ibbotson data which goes back to 1926, there are many using data over shorter time periods, such as fifty, twenty, or even ten years to come up with historical risk premiums. The rationale presented by those who use shorter periods is that the risk aversion of the average investor is likely to change over time and using a shorter and more recent time period provides a more updated estimate. This has to be offset against a cost associated with using shorter time periods, which is the greater estimation error in the risk premium estimate 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑒𝑟𝑟𝑜𝑟 𝑎𝑠𝑠𝑜𝑐𝑖𝑎𝑡𝑒𝑑 𝑤𝑖𝑡ℎ 𝑡ℎ𝑒 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒 = /00:/(!42; <'; ;2.!/'!%0 !0 <'%17 $&!12 =0:#>2& %" ?2/&< %" 6!<'%&!1/( ;/'/ b) be consistent in your use of a risk-free rate: choice of risk-free security ® the historical database reports returns on both Treasury bills and bonds and the risk premium for stocks can be estimated relative to each. Given that short-term rates have been lower than long-term rates in the United States for most of the past seven decades, the risk premium is larger when estimated relative to shorter-term government securities (such as Treasury bills). The risk-free rate chosen in computing the premium has to be consistent with the risk-free rate used to compute expected returns. For the most part, in corporate finance and valuation, the risk-free rate will be a long-term government bond rate and not a short-term rate. Thus the risk premium used should be the premium earned by stocks over Treasury bonds c) use arithmetic premiums for one-year estimates of costs of equity and geometric premiums for estimates of long-term costs of equity: arithmetic and geometric averages ® the final sticking point when it comes to estimating historical premiums relates to how the average returns on stocks and Treasury bonds and bills are computed - the arithmetic average return measures the simple mean of the series of annual returns ® if annual returns are uncorrelated over time and our objective was to estimate the risk premium for the next year, the arithmetic average is the best unbiased estimate of the premium - the geometric average looks at the compounded return à empirical studies seem to indicate that returns on stocks are negatively correlated over time ® the arithmetic average return is likely to overstate the premium à the use of asset-pricing models to get expected returns over long periods suggests that the analysis is more likely to be over multiple years than for just the next year ® the geometric average is better c) estimate returns (including dividends) on stock - 𝑅𝑒𝑡𝑢𝑟𝑛 = (𝑃𝑟𝑖𝑐𝑒B0; − 𝑃𝑟𝑖𝑐𝑒*2G!00!0G + 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠J2&!%;)/𝑃𝑟𝑖𝑐𝑒*2G!00!0G - included dividends only in ex-dividend month d) choose a market index, and estimate returns (inclusive of dividends) on the index for each interval for the period 3. Standard Procedures for Estimating Risk Parameters in the APM and Multifactor Model ® the APM defines risk to be non-diversifiable risk and allows for multiple economic factors in measuring this risk. Although the process of estimation of risk parameters is different for the APM, many of the issues raised relating to the determinants of risk in the CAPM continue to have relevance for the APM a) parameters of the APM are estimated from a factor analysis on historical stock returns, which yields the number of common economic factors determining these returns, the risk premium for each factor, and the factor-specific betas for each firm b) once the factor-specific betas are estimated for each firm, and the factor premiums are measured, the APM can be used to estimate the expected returns on a stock 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑅" +∑ 𝛽,(𝐸?𝑅,@ − 𝑅")K,L8 In a multifactor model, the betas are estimated relative to the specified factors, using historical data for each firm • to estimate the betas from fundamentals ® the beta for a firm may be estimated from a regression, but it is determined by fundamental decisions that the firm has made on what business to be in, how much operating leverage to use in the business, and the degree to which the firm uses financial leverage; determinants of Betas: 1. Industry Effects ® the beta value for a firm depends upon the sensitivity of the demand for its products and services and of its costs to macroeconomic factors that affect the overall market 2. Degree of Operating leverage ® operating leverage refers to the proportion of the total costs of the firm that are fixed. Other things remaining equal, higher operating leverage results in greater earnings variability which in turn results in higher betas 𝐸𝐵𝐼𝑇 𝑉𝑎𝑟𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑀𝑒𝑎𝑠𝑢𝑟𝑒 = %-6/0G2 !0 B*NO %-6/0G2 !0 E2.20:2< 3. Financial leverage ® as firms borrow, they create fixed costs (interest payments) that make their earnings to equity investors more volatile; the beta of equity alone can be written as a function of the unlevered beta and the debt-equity ratio 𝛽P = 𝛽:(1 + (1 − 𝑡) Q B ) where bL is Levered or Equity Beta, bu is Unlevered or Asset Beta, t is Marginal tax rate, D is Market Value of Debt, and E is Market Value of Equity Approaches: a) top-down beta ® for a firm comes from a regression b) bottom up beta ® can be estimated by doing the following: - find out the businesses that a firm operates in - find the unlevered betas of other firms in these businesses - take a weighted (by sales or operating income) average of these unlevered betas - lever up using the firm’s debt/equity ratio. The bottom up beta is a better estimate than the top down beta for the following reasons - the standard error of the beta estimate will be much lower - the betas can reflect the current (and even expected future) mix of businesses that the firm is in rather than the historical mix. Firm betas as weighted averages: the beta of a firm is the weighted average of the betas of its individual projects ↔ the beta of a firm is the weighted average of the betas of its individual division. Adjusting beta for cash: a) the Beta of cash is ZERO (no market risk) b) since the market betas «incorporate» the cash position of the firms, we need to adjust as follows: 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐵𝑒𝑡𝑎 𝑐𝑜𝑟𝑟𝑒𝑐𝑡𝑒𝑑 𝑓𝑜𝑟 𝑐𝑎𝑠ℎ = @0(2.2&2; *2'/ (8F-/<6/T!&# 3/(2) Cost of equity calculation in nominal ® to convert a discount rate in one currency to another, all you need are expected inflation rates in the two currencies (1 + $ 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦) (8VN0"(/'!%0 E/'2/+01%2) (8VN0"(/'!%0 E/'234) − 1 Estimating Betas for Non-Traded Assets (private firms) ® the conventional approaches of estimating betas from regressions do not work for assets that are not traded; there are no stock prices or historical returns that can be used to compute regression betas. There are two ways in which betas can be estimated for non- traded assets a) using comparable firms b) using accounting earnings • to use accounting data ® changes in earnings at a division or a firm, on a quarterly or annual basis, can be regressed against changes in earnings for the market, in the same periods, to arrive at an estimate of a “market beta” to use in the CAPM. The approach has some intuitive appeal, but it suffers from three potential pitfalls: 1. accounting earnings tend to be smoothed out relative to the underlying value of the company, resulting in betas that are “biased down,” especially for risky firms, or “biased up,” for safer firms ® betas are likely to be closer to one for all firms using accounting data 2. earnings can be influenced by accounting choices, such as changes in depreciation or inventory methods, and by allocations of corporate expenses at the division level 3. accounting earnings are measured, at most, once every quarter, and often only once every year, resulting in regressions with few observations and not much power. We could get net income numbers every quarter, which increases the number of observations we have in the regression. We could even estimate accounting betas by division, because the divisional income is reported. We do not attempt to estimate accounting betas for the following reasons: 1. get a sufficient number of observations in our regression, we would need to go back in time at least ten years and perhaps more; the changes that many large companies undergo over time make this a hazardous exercise 2. publicly traded firms smooth out accounting earnings changes even more than private firms do. This will bias the beta estimates downward. Problems with accounting betas are: 1. earnings tend to be smoothed out 2. you will not have very many observations in your regression ® most private firms have financials only once a year. For a firm that has been in existence just a few years, the sample size will be extremely small. 4.1.4 Estimating the cost of equity Having estimated the risk-free rate, the risk premium(s), and the beta(s), we can now estimate the expected return from investing in equity at any firm. In the CAPM, this expected return can be written as: 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑅𝑖𝑠𝑘𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝐵𝑒𝑡𝑎 × 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚, where: • the risk-free rate would be the rate on a long-term government bond • the beta would be either the historical, fundamental, or accounting betas • the risk premium would be either the historical premium or an implied premium. In the APM and multifactor model, the expected return would be written as follows: 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟𝑖𝑠𝑘𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + ∑ 𝛽, × 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚,0,L8 where the risk-free rate is the long-term government bond rate, 𝛽j is the beta relative to factor j, estimated using historical data or fundamentals, and Risk premiumj is the risk premium relative to factor j, estimated using historical data. The expected return on an equity investment in a firm, given its risk, has key implications for both equity investors in the firm and the managers of the firm: • equity investors ® it is the rate they need to make to be compensated for the risk that they have taken on investing in the equity of a firm 1. if after analyzing a stock, they conclude that they cannot make this return, they would not buy it 2. if they decide they can make a higher return, they would make the investment • managers in the firm ® the return that investors need to make to break even on their equity investments becomes the return that they have to try to deliver to keep these investors reasonably satisfied; it becomes the rate that they have to beat in terms of returns on their equity investments in individual projects. In other words, this is the cost of equity to the firm. Implicit in the use of beta as a measure of risk is the assumption that the marginal investor in equity is a well-diversified investor. Although this is a defensible assumption when analyzing publicly traded firms, it becomes much more difficult to sustain for private firms. The owner of a private firm generally has the bulk of his or her wealth invested in the business. Consequently, he or she cares about the total risk in the business rather than just the market risk. Thus, the beta that we have estimated will understate the risk perceived by the owner ® there are 3 solutions to this problem: • assume that the business is run with the near-term objective of sale to a large publicly traded firm ® it is reasonable to use the market beta and cost of equity that comes from it • add a premium to the cost of equity to reflect the higher risk created by the owner’s inability to diversify ® this may help explain the high returns that some venture capitalists demand on their equity investments in fledgling businesses; the magnitude of that premium, though, is generally subjective, although there have been some attempts to use historical data and survey data to make it less so • adjust the beta to reflect total risk rather than market risk ® this adjustment is relatively simple, because the R2 of the regression measures the proportion of the variance that is market risk; dividing the market beta by the square root of the R2 (which yields the correlation coefficient) yields a total beta 𝑇𝑜𝑡𝑎𝑙 𝑏𝑒𝑡𝑎 = W/&72' >2'/ =E <C:/&2; ⇒ 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑟𝑖𝑠𝑘𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝑡𝑜𝑡𝑎𝑙 𝑏𝑒𝑡𝑎(𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚). 4.2 FROM COST OF EQUITY TO COST OF CAPITAL Equity is undoubtedly an important and indispensable ingredient of the financing mix for every business, but it is only one ingredient. Most businesses finance some or much of their operations using debt or some hybrid of equity and debt. The costs of these sources of financing are generally very different from the cost of equity, and the minimum acceptable hurdle rate for a project will reflect their costs as well, in proportion to their use in the financing mix. Intuitively, the cost of capital is the weighted average of the costs of the different components of financing—including debt, equity, and hybrid securities—used by a firm to fund its financial requirements. The cost of capital is a composite cost to the firm of raising financing to fund its projects. In addition to equity, firms can raise capital from debt, which should include: • any interest-bearing liability, whether short term or long term • any lease obligation, whether operating or capital estimating the cost of debt. The Costs of Nonequity Financing ® to estimate the cost of the funding that a firm raises, we have to estimate the costs of all of the nonequity components, which are the cost of debt and the cost of hybrids, such as preferred stock and convertible bonds. The Cost of Debt ® the cost of debt measures the current cost to the firm of borrowing funds to finance projects. In general terms, it is determined by the following variables: • the current level of interest rates ® as market interest rates rise, the cost of debt for all firms will also increase • the default risk of the company ® as the default risk of a firm increases, lenders will charge higher interest rates (a default spread) to compensate for the additional risk • the tax advantage associated with debt ® because interest is tax-deductible, the after-tax cost of debt is a function of the tax rate; the tax benefit that accrues from paying interest makes the after-tax cost of debt lower than the pretax cost; furthermore, this benefit increases as the tax rate increases 𝐴𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 = (𝑅𝑖𝑠𝑘𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑠𝑝𝑟𝑒𝑎𝑑) (1 −𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) Estimating the cost of debt ® 𝐾; = (𝑟𝑖𝑠𝑘𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚)(1 − 𝑡1) • if the firm has bonds outstanding, and the bonds are traded, the yield to maturity on a long-term, straight (no special features) ® bond can be used as the interest rate • if the firm is rated ® use the rating and a typical default spread on bonds with that rating to estimate the cost of debt • if the firm is not rated 1. and it has recently borrowed long term from a bank ® use the interest rate on the borrowing or 2. estimate a synthetic rating for the company, and use the synthetic rating to arrive at a default spread and a cost of debt The cost of debt has to be estimated in the same currency as the cost of equity and the cash flows in the valuation. Estimating the Default Risk and Default Spread of a Firm • the simplest scenario for estimating the cost of debt occurs when a firm has long-term bonds outstanding that are widely traded and have no special features, such as convertibility or first claim on assets, skewing interest rates ® the market price of the bond, in conjunction with its coupon and maturity, can be used to compute a yield we use as the cost of debt; this approach works for firms that have dozens of outstanding bonds that are liquid and trade frequently • many firms have bonds outstanding that do not trade on a regular basis ® because these firms are usually rated, we can estimate their costs of debt by using their ratings and associated default spreads • when there is no rating available to estimate the cost of debt, there are two alternatives: 1. recent borrowing history Many firms that are not rated still borrow money from banks and other financial institutions ® by looking at the most recent borrowings made by a firm, we can get a sense of the types of default spreads being charged and use these spreads to come up with a cost of debt 2. estimate a synthetic rating and default spread ® an alternative is to play the role of a ratings agency and assign a rating to a firm based on its financial ratios; this rating is called a synthetic rating. To make this assessment, we begin with rated firms and examine the financial characteristics shared by firms within each ratings class 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 = 𝐸𝐵𝐼𝑇/𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 By basing the synthetic rating on the interest coverage ratio alone, we run two risks: a) using last year’s operating income as the basis for the rating may yield too low or too high a rating for a firm that had an exceptionally good or bad earnings years ® we can counter that by using the average operating income over a period, say five years, to compute the coverage ratio b) we risk missing the information that is available in the other financial ratios and the qualitative information used by ratings agencies ® the counter to that is to extend the approach to incorporate other ratios: - to develop a score based on multiple ratios, which are usually based on past history on defaulted firms - to relate the level of the score to a bond rating with interest coverage ratios ® in making this extension, though, note that complexity comes at a cost. • The Market Value of Debt ® the market value of debt is usually more difficult to obtain directly because very few firms have all of their debt in the form of bonds outstanding trading in the market; many firms have nontraded debt, such as bank debt, which is specified in book value terms but not market value terms 1. get around the problem, many analysts make the simplifying assumptions that the book value of debt is equal to its market value ® although this is not a bad assumption for mature companies in developed markets, it can be a mistake when interest rates and default spreads are volatile 2. a simple way to convert book value debt into market value debt is to treat the entire debt on the books as a coupon bond, with a coupon set equal to the interest expenses on all of the debt and the maturity set equal to the face-value weighted average maturity of the debt, and to then value this coupon bond at the current cost of debt for the company 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 h 8F 5(57()8& )9 ."-&)'"0+8 1%<' %" ;2>' i + 8 (8V1%<' %" ;2>')'"0+8 . Estimating and Using the Cost of Capital • with the estimates of the costs of the individual components—debt, equity, and preferred stock (if any)—and the market value weights of each of the components, the cost of capital can be computed ® Thus if E, D, and PS are the market values of equity, debt, and preferred stock respectively, the cost of capital can be written as follows: 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑘B B QVBVJA + 𝑘Q Q QVBVJA + 𝑘JA JA QVBVJA • the cost of capital is a measure of the composite cost of raising money that a firm faces ® it will generally be lower than the cost of equity, which is the cost of just equity funding. Choosing a hurdle rate ® either the cost of equity or the cost of capital can be used as a hurdle rate, depending upon whether the returns measured are to equity investors or to all claimholders on the firm (capital): • if returns are measured to equity investors, the appropriate hurdle rate is the cost of equity • if returns are measured to capital (or the firm), the appropriate hurdle rate is the cost of capital. 5. MEASURING RETURN ON INVESTMENTS 5.1 WHAT IS A PROJECT? Investment analysis concerns which projects a company should accept and which it should reject. The conventional project analyzed in capital budgeting has three criteria: • a large upfront cost • cash flows for a specific time period • a salvage value at the end, which captures the value of the assets of the project when the project ends. Although such projects undoubtedly form a significant proportion of investment decisions, especially for manufacturing firms, it would be a mistake to assume that investment analysis stops there. If a project is defined more broadly to include any decision that results in using the scarce resources of a business, then everything from strategic decisions and acquisitions to decisions about which air-conditioning system to use in a building would fall within its reach. Defined broadly then, any of the following decisions would qualify as projects: • major strategic decisions to enter new areas of business or new markets • acquisitions of other firms are projects as well, notwithstanding attempts to create separate sets of rules for them • decisions on new ventures within existing businesses or markets • decisions that may change the way existing ventures and projects are run • decisions on how best to deliver a service that is necessary for the business to run smoothly. Investment decisions can be categorized on a number of different dimensions: • the first relates to how the project affects other projects the firm is considering and analyzing: 1. some projects are independent of other projects, and thus can be analyzed separately, whereas other projects are mutually exclusive (taking one project will mean rejecting other projects) 2. some projects are prerequisites for other projects down the road and others are complementary. In general, projects can be categorized as falling somewhere on the continuum between prerequisites and mutually exclusive: • the second dimension that can be used to classify a project is its ability to generate revenues or reduce costs ® the decision rules that analyze revenue-generating projects attempt to evaluate whether the earnings or cash flows from the projects justify the investment needed to implement them. When it comes to cost-reduction projects, the decision rules examine whether the reduction in costs justifies the upfront investment needed for the projects. 5.2 HURDLE RATES FOR FIRMS VERSUS HURDLE RATES FOR PROJECTS Using the Firm’s Hurdle Rate for Individual Projects • we can use the costs of equity and capital that we have estimated for the firms for these projects only if all investments made by a firm are similar in terms of their risk exposure • if a firm’s investments become more diverse, the firm will no longer be able to use its cost of equity and capital to evaluate these projects ® projects that are riskier have to be assessed using a higher cost of equity and capital than projects that are safer • if a firm chose to use its cost of equity and capital to evaluate projects with different risk profiles, this firm would find itself overinvesting in risky projects and under investing in safe projects. Over time, the firm will become riskier, as its safer businesses find themselves unable to compete with riskier businesses. Cost of Equity for Projects ® in assessing the beta for a project, we will consider three possible scenarios: • single business: project risk similar within business ® all the projects considered by a firm are similar in their exposure to risk; we can use the beta, estimated for the cost of equity, for each project 1. advantage ® it does not require risk estimation prior to every project, providing managers with a fixed benchmark for their project investments 2. disadvantage ® is restricting because it can be usefully applied only to companies that are in one line of business and take on homogeneous projects • multiple businesses with different risk profiles: project risk similar within each business ® a firm is in multiple businesses with different exposures to risk, but projects within each business have the same risk exposure 1. if we make the assumption that projects taken within each business have the same risk profile, we can estimate the cost of equity for each business separately and use that cost of equity for all projects within that business ® riskier businesses will have higher costs of equity than safer businesses, and projects taken by riskier businesses will have to cover these higher costs a) imposing the firm’s cost of equity on all projects in all businesses will lead to overinvesting in risky businesses (because the cost of equity will be set too low) and underinvesting in safe businesses (because the cost of equity will be set too high) 2. estimation of the cost of equity for divisions or business lines ® when the approach requires equity betas, we cannot fall back on the conventional regression approach (in the CAPM) or factor analysis (in the APM) because these approaches require past prices. Instead, we have to use one of: a) bottom-up betas based on other publicly traded firms in the same business b) accounting betas, estimated based on the accounting earnings for the division • project with different risk profiles ® each project considered by a firm has a different exposure to risk; if a project is large in terms of investment needs relative to the firm assessing it and has a very different risk profile from other investments in the firm, it would make sense to assess the cost of equity for the project independently; the only practical way of estimating betas and costs of equity for large, individual projects is the bottom-up beta approach, where you use the betas of publicly traded companies with similar risk profiles. Cost of Debt for Projects ® with individual projects, the assessment of default risk becomes much more difficult, because projects seldom borrow on their own; most firms borrow money for all the projects that they undertake. There are three approaches to estimating the cost of debt for a project: • one based on the argument that because the borrowing is done by the firm rather than by individual projects, the cost of debt for a project should be the cost of debt for the firm considering the project ® this approach makes the most sense when the projects being assessed are small relative to the firm taking them and thus have little or no appreciable effect on the firm’s default risk • to assess at the default risk by looking at other firms that take similar projects, and using the typical cost of debt for these firms ® this approach generally makes sense when the project is large in terms of its capital needs relative to the firm has different cash flow characteristics (both in terms of magnitude and volatility) from other investments taken by the firm • one that applies when a project actually borrows its own funds, with lenders having no recourse against the parent firm, in case the project defaults ® this is unusual, but it can occur when investments have significant tangible assets of their own and the investment is large relative to the firm considering it. In this case, the cost of debt for the project can be assessed using its capacity to generate cash flows relative to its financing obligations. Financing Mix and Cost of Capital for Projects ® to get from the costs of debt and equity to the cost of capital, we have to weight each by their relative proportions in financing. We may borrow money to fund a project, but it is often not clear whether we are using the debt capacity of the project or the firm’s debt capacity. The solution to this problem will again vary depending on the scenario we face: • when estimating the financing mix for smaller projects that do not alter the firm’s overall risk profile drastically, the weights for debt and equity in the cost of capital computation should reflect the firm’s overall debt ratio (either actual or target) ® the fact that an individual project is financed entirely with debt or with equity is no reason to compute a cost of capital with all debt or all equity weights; estimating costs of capital based upon how individual projects are funded will lead you to to over invest in debt-funded projects and under invest in equity-funded ones • when assessing the financing weights of large projects, with risk profiles different from that of the firm, we have to be more cautious ® using the firm’s financing mix to compute the cost of capital for these projects can be misleading, because the project being analyzed may be riskier than the firm as a whole and thus incapable of carrying the firm’s debt ratio; we would argue for the use of a debt ratio that is more reflective of the business the projects is in, rather than the firm’s overall debt ratio • the financing weights for standalone projects that are large enough to issue their own debt should be based on the actual amounts borrowed by the projects ® for firms with such projects, the financing weights can vary from project to projects, as will the cost of debt 5.3 MEASURING RETURNS: THE CHOICES On all of the investment decisions just described, we have to choose between alternative approaches to measuring returns on the investment made ® we will present our argument for return measurement in three steps: • we will contrast accounting earnings and cash flows and argue that cash flows are much better measures of true return on an investment • we will note the differences between total and incremental cash flows and present the case for using incremental cash flows in measuring returns • we will argue that returns that occur earlier in a project life should be weighted more than returns that occur later in a project life and that the return on an investment should be measured using time-weighted returns. 5.3.1 Accounting Earnings versus Cash Flows The first and most basic choice we have to make when it comes to measuring returns is the one between: • the accounting measure of income on a project, measured in accounting statements, using accounting principles and standards. • the cash flow generated by a project, measured as the difference between the cash inflows in each period and the cash outflows. Why Are Accounting Earnings Different from Cash Flows ® accountants have invested substantial time and resources in coming up with ways of measuring the income made by a project. In doing so, they subscribe to some generally accepted accounting principles. Generally accepted accounting principles require the recognition of revenues when the service for which the firm is getting paid has been performed in full or substantially and has received in return either cash or a receivable that is both observable and measurable. For expenses that are directly linked to the production of revenues (like labor and materials), expenses are recognized in the same period in which revenues are recognized. Any expenses that are not directly linked to the production of revenues are recognized in the period in which the firm consumes the services. Although the objective of distributing revenues and expenses fairly across time is worthy, the process of accrual accounting creates an accounting earnings number that can be very different from the cash flow generated by a project in any period. There are three significant factors that account for this difference: • operating versus capital expenditure ® accountants draw a distinction between: 1. expenditures that yield benefits only in the immediate period or periods (such as labor and material for a manufacturing firm) ® operating expenses which are subtracted from revenues in computing the accounting income, whereas the latter are capital expenditures and are not subtracted from revenues in the period that they are made 2. those that yield benefits over multiple periods (such as land, buildings, and long-lived plant) ® the expenditure is spread over multiple periods and deducted as an expense in each period; these expenses are called: a) depreciation ® if the asset is a tangible asset like a building b) amortization ® if the asset is an intangible asset, such as a patent or a trademark. Although the capital expenditures made at the beginning of a project are often the largest part of investment, many projects require capital expenditures during their lifetime ® these capital expenditures will reduce the cash available in each of these periods. • allocated costs ® some of the projected cash flows on an investment will be generated by the firm, whether this investment is accepted or rejected; allocations of fixed expenses, such as general and administrative costs, usually fall into this category; these cash flows are not incremental; allocation is an accounting device created to ensure that every part of a business bears its fair share of costs: 1. costs that are not directly traceable to revenues generated by individual products or divisions are allocated across these units, based on revenues, profits, or assets 2. although the purpose of such allocations may be fairness, their effect on investment analyses has to be viewed in terms of whether they create incremental cash flows 3. an allocated cost that will exist with or without the project being analyzed does not belong in the investment analysis while any increase in administrative or staff costs that can be traced to the project is an incremental cost and belongs in the analysis ® one way to estimate the incremental component of these costs is to break them down on the basis of whether they are fixed or variable and, if variable, what they are a function of; a portion of administrative costs may be related to revenue, and the revenue projections of a new project can be used to estimate the administrative costs to be assigned to it. The Argument for Incremental Cash Flows ® when analyzing investments, it is easy to get tunnel vision and focus on the project or investment at hand, acting as if the objective of the exercise is to maximize the value of the individual investment. There is also the tendency, with perfect hindsight, to require projects to cover all costs that they have generated for the firm, even if such costs will not be recovered by rejecting the project. The objective in investment analysis is to maximize the value of the business or firm taking the investment. Consequently, it is the cash flows that an investment will add on in the future to the business (incremental cash flows). 5.3.3 Time-Weighted versus Nominal Cash Flows Very few projects with long lifetimes generate earnings or cash flows evenly over their lives: • in sectors with huge investments in infrastructure, such as telecommunications, the earnings and cash flows might be negative for an extended period (say, ten to twenty years) before they turn positive • in other sectors, the cash flows peak early and then gradually decrease over time. Whatever the reason for the unevenness of cash flows, a basic question that has to be addressed when measuring returns is whether they should reflect the timing of the earnings or cash flows. We will argue that they should, with earlier earnings and cash flows being weighted more when computing returns than earnings and cash flows later in a project life. Why Cash Flows across Time Are Not Comparable ® there are three reasons why cash flows across time are not comparable, and a cash flow in the future is worth less than a similar cash flow today: • individuals prefer present consumption to future consumption. People would have to be offered more in the future to give up present consumption—this is called the real rate of return ® the greater the real rate of return, the greater the difference in value between a cash flow today and an equal cash flow in the future • when there is inflation, the value of currency decreases over time ® the greater the inflation, the greater the difference in value between a cash flow today and an equal cash flow in the future • any uncertainty (risk) associated with the cash flow in the future reduces the value of the cash flow ® the greater the uncertainty associated with the cash flow, the greater the difference between receiving the cash flow today and receiving an equal amount in the future. This process of moving cash flows through time is: • discounting ® when future cash flows are brought to the present • compounding ® when present cash flows are taken to the future. The process by which future cash flows are adjusted to reflect these factors is called discounting, and the magnitude of these factors is reflected in the discount rate. Thus the present value of a cash flow (CFt) at a point in time t in the future, when the discount rate is r, can be written as follows: 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 = 𝐶𝐹' 8 (8V&)& Note that the second term in the brackets 8 (8V&)& is called the discount factor and effectively weights the cash flow by when it occurs ® the differences in weights across time will depend entirely on the level of the discount rate. Consequently, when discount rates are high, which could be due to high real rates, high inflation, and/or high uncertainty, returns that occur further in the future will be weighted less. The Case for Time-Weighted Returns ® if we accept the arguments that cash flows measure returns more accurately than earnings and that the incremental cash flows more precisely estimate returns than total cash flows, we should logically follow up by using discounted cash flows (time-weighted returns) rather than nominal cash flows for two reasons: • nominal cash flows at different points in time are not comparable and cannot be aggregated to arrive at returns. Discounted cash flows, on the other hand, convert all cash flows on a project to today’s terms and allow us to compute returns more consistently • if the objective in investment analysis is to maximize the value of the business taking the investments, we should be weighting cash flows that occur early more than cash flow that occur later, because investors in the business will also do so. Present Value Mechanics Cash Flow Type Discounting Formula Compounding Formula Simple CF -T* (8V&)* 𝐶𝐹X(1 + 𝑟)0 Annuity 𝐴 8F 5(57+)* & 𝐴 (8V&)*F8 & Growing Annuity 𝐴 8F(57;) * (57+)* &FG Perpetuity 𝐴/𝑟 Growing Perpetuity BD$21'2; -T 02D' ?2/& &FG 5.4 INVESTMENT DECISION RULES What Is an Investment Decision Rule ® when faced with new investments and projects, firms have to decide whether to invest in them or not; there are some characteristics that a good investment decision rule should have: • has to maintain a fair balance between allowing a manager analyzing a project to bring in his or her subjective assessments into the decision and ensuring that different projects are judged consistently ® an investment decision rule that is too mechanical (by not allowing for subjective inputs) or too malleable (where managers can bend the rule to match their biases) is not a good rule • will allow the firm to further the stated objective in corporate finance, which is to maximize the value of the firm ® projects that are acceptable using the decision rule should increase the value of the firm accepting them, whereas projects that do not meet the requirements would destroy value if the firm invested in them • should work across a variety of investments ® investments can be revenue-generating investments or they can be cost-saving investments; some projects have large upfront costs, whereas other projects may have costs spread out across time. A good investment rule will provide an answer on all of these different kinds of investments. Although many firms analyze projects using a number of different investment decision rules, one rule has to dominate. Should there be a risk premium for foreign projects? • the exchange rate risk should be diversifiable risk (and hence should not command a premium) if 1. the company has projects is a large number of countries (or) 2. the investors in the company are globally diversified. • the same diversification argument can also be applied against some political risk, which would mean that it too should not affect the discount rate. However, there are aspects of political risk especially in emerging markets that will be difficult to diversify and may affect the cash flows, by reducing the expected life or cash flows on the project. The key to value is earning excess returns ® there have been attempts to restate this obvious fact in new and different ways. For instance, Economic Value Added (EVA) developed a wide following in the the 1990s: 𝐸𝑉𝐴 = (𝑅𝑂𝐶–𝐶𝑜𝑠𝑡𝑜𝑓𝐶𝑎𝑝𝑖𝑡𝑎𝑙)(𝐵𝑜𝑜𝑘𝑉𝑎𝑙𝑢𝑒𝑜𝑓𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑) Decision rules: • Return on Capital ® the return on capital on a project measures the returns earned by the firm on it is total investment in the project; it is a return to all claimholders in the firm on their collective investment in a project 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 (𝑝𝑟𝑒𝑡𝑎𝑥) = B/&0!0G< >2"%&2 !0'2&2<' /0; '/D2< ).2&/G2 >%%7 ./(:2 %" 1/$!'/( !0.2<'2; !0 $&%,21' 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 (𝑎𝑓𝑡𝑒𝑟𝑡𝑎𝑥) = B/&0!0G< >2"%&2 !0'2&2<' /0; '/D2<(8F'/D &/'2) ).2&/G2 >%%7 ./(:2 %" 1/$!'/( !0.2<'2; !0 $&%,21' Although this calculation is rather straightforward for a one-year project, it becomes more involved for multiyear projects, where both the operating income and the book value of the investment change over time ® in these cases, the return on capital can either be estimated each year and then averaged over time or the average operating income over the life of the project can be used in conjunction with the average investment during the period to estimate the average return on capital. The after-tax return on capital on a project has to be compared to a hurdle rate that is defined consistently ® the return on capital is estimated using the earnings before debt payments and the total capital invested in a project. Consequently, it can be viewed as return to the firm, rather than just to equity investors. Consequently, the cost of capital should be used as the hurdle rate: 1. if the after-tax return on capital > Cost of capital ® Accept the project 2. if the after-tax return on capital < Cost of capital ® Reject the project • Accounting Income-Based Decision Rules ® many of the oldest and most established investment decision rules have been drawn from the accounting statements and, in particular, from accounting measures of income. Some of these rules are based on income to equity investors (net income), and others are based on operating income • Return on Equity ® the return on equity looks at the return to equity investors, using the accounting net income as a measure of this return 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 = Y2' !01%#2 ).2&/G2 >%%7 ./(:2 %" 2C:!'? !0.2<'#20' !0 $&%,21' The return on equity tends to increase over the life of the project, as the book value of equity in the project is depreciated. Just as the appropriate comparison for the return on capital is the cost of capital, the appropriate comparison for the return on equity is the cost of equity, which is the rate of return equity investors demand. Decision rule for ROE measure for independent projects: 1. if the return on equity > Cost of equity ® Accept the project 2. if the return on equity < Cost of equity ® Reject the project The cost of equity should reflect the riskiness of the project being considered and the financial leverage taken on by the firm ® when choosing between mutually exclusive projects of similar risk, the project with the higher return on equity will be viewed as the better project. From Project ROE to Firm ROE ® we can compute return on equity and cost of equity to pass judgment on whether firms are creating value to its equity investors; we can compute the return on equity (net income as a percentage of book equity) and compare to the cost of equity. The return spread is then: 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑒𝑡𝑢𝑟𝑛 𝑆𝑝𝑟𝑒𝑎𝑑 = 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦–𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 1. this measure is particularly useful for financial service firms, where capital, return on capital and cost of capital are difficult measures to nail down 2. for non-financial service firms, it provides a secondary (albeit a more volatile measure of performance). While it usually provides the same general result that the excess return computed from return on capital, there can be cases where the two measures diverge. Assessing Accounting Return Approaches ® in terms of maintaining balance between allowing managers to bring into the analysis their judgments about the project and ensuring consistency between analysis, the accounting returns approach falls short; it fails because it is significantly affected by accounting choices. For instance, changing from straight-line to accelerated depreciation affects both the earnings and the book value over time, thus altering returns. Unless these decisions are taken out of the hands of individual managers assessing projects, there will be no consistency in the way returns are measured on different projects. • investing in projects that earn accounting returns exceeding their hurdle rates will not necessaritly increase the firm value ® the value of a firm is the present value of expected cash flows on the firm over its lifetime 1. because accounting returns are based on earnings rather than cash flows and ignore the time value of money, investing in projects that earn a return greater than the hurdle rates will not necessarily increase firm value 2. some projects that are rejected because their accounting returns fall short of the hurdle rate may have increased firm value ® this problem is compounded by the fact that the returns are based on the book value of investments, rather than the cash invested in the assets. The accounting return works better for projects that have a large upfront investments and generate level income over time ® for projects that do not require a significant initial investment, the return on capital and equity has less meaning • accounting measures of return endure in investment analysis ® although this fact can be partly attributed to the unwillingness of financial managers to abandon familiar measures, it also reflects the simplicity and intuitive appeal of these measures. More importantly, as long as accounting measures of return are used by investors and equity research analysts to assess to overall performance of firms, these same measures of return will be used in project analysis • Cash Flow-Based Decision Rules ® measures of accounting return suffer from all of the problems that we noted with accounting profits; the simplest fix is to replace accounting earnings with cash flows; there are two simple variants: 1. payback ® we examine the number of years it will take to get your money back on an investment; it is a measure of how quickly the cash flows generated by the project cover the initial investment a) the payback can be estimated either for: - all investors in the project ® to estimate the payback for the entire firm, the free cash flows to the firm are added up until they cover the total initial investment - just for the equity investors ® to estimate payback just for the equity investors, the free cash flows to equity are cumulated until they cover the initial equity investment in the project b) Using Payback in Decision Making ® although it is uncommon for firms to make investment decisions based solely on the payback, surveys suggest that some businesses do in fact use payback as their primary decision mechanism; in those situations where payback is used as the primary criterion for accepting or rejecting projects, a maximum acceptable payback period is typically set - projects that payback their initial investment sooner than this maximum are accepted, and projects that do not are rejected - firms are much more likely to employ payback as a secondary investment decision rule and use it either as a constraint in decision making (accept projects that earn a return on capital of at least 15%, as long as the payback is less than ten years) or to choose between projects that score equally well on the primary decision rule (when two mutually exclusive projects have similar returns on equity, choose the one with the lower payback) The discount rates may change for three reasons: à the level of interest rates may change over time, and the term structure may provide some insight on expected rates in the future à the risk characteristics of the project may be expected to change in a predictable way as the project becomes more or less risky over time, resulting in changes in the discount rate à the financing mix on the project may change over time, resulting in changes in both the cost of equity and the cost of capital e) Biases, Limitations, and Caveats ® in spite of its advantages and its linkage to the objective of value maximization, the NPV rule continues to have its detractors, who point out several limitations: - the NPV is stated in absolute rather than relative terms and does not therefore factor in the scale of the projects. Proponents of the NPV rule argue that it is surplus value, over and above the hurdle rate, no matter what the investment - the NPV rule does not control for the life of the project ® when comparing mutually exclusive projects with different lifetimes, the NPV rule is biased toward accepting longer-term projects. 2. Internal Rate of Return (IRR) ® is based on discounted cash flows; unlike the NPV rule, however, it takes into account the project’s scale. It is the discounted cash flow analog to the accounting rates of return. Again, in general terms, the IRR is that discount rate that makes the NPV of a project equal to 0. At the internal rate of return, the NPV of this project is 0. The linkage between the NPV and the IRR is most obvious when the NPV is graphed as a function of the discount rate in a net present value profile a) Using the IRR ® there are analysts who prefer the IRR to the NPV, arguing that you do not need a hurdle rate to use IRR. While this is true for the calculation of the IRR, it is not true when the decision maker has to use the IRR to decide whether to take a project. At that stage in the process, the IRR has to be compared to the discount rate—if the IRR is greater than the discount rate, the project is a good one; alternatively, the project should be rejected. The IRR can be computed in one of two ways: - based on the free cash flows to the firm and the total investment in the project ® in doing so, the IRR has to be compared to the cost of capital; decision rules: à if the IRR > Cost of capital ® Accept the project à if the IRR < Cost of capital ® Reject the project - based on the free cash flows to equity and the equity investment in the project ® if it is estimated with these cash flows, it has to be compared to the cost of equity, which should reflect the riskiness of the project; decision rules: à if the IRR > Cost of equity ® Accept the project à if the IRR < Cost of equity ® Reject the project When choosing between projects of equivalent risk, the project with the higher IRR is viewed as the better project. b) Biases, Limitations, and Caveats ® according to surveys of corporate finance practitioners, the IRR is the most widely used discounted cash flow rule in investment analysis, but it does have some serious limitations: - because the IRR is a scaled measure, it tends to bias decision makers toward smaller projects, which are much more likely to yield high percentage returns, and away from larger ones - there are a number of scenarios in which the IRR cannot be computed or is not meaningful as a decision tool, such as: à when there is no or only a very small initial investment and the investment is spread over time ® the IRR cannot be computed or, if computed, is likely to be meaningless à when there is more than one internal rate of return for a project, and it is not clear which one the decision maker should use. 5.5 PROBABILISTIC APPROACHES TO INVESTMENT ANALYSIS We will examine four approaches for dealing with uncertainty: • sensitivity analysis (simplest) ® we ask what-if questions about key variables and to estimate how much room for error we have on each one 1. key inputs into the analysis, with two objectives in mind: a) to get a sense of how much the value of the project and your decision about investing in the project change as you modify key assumptions b) to get a measure of how much margin for error you have on your estimates 2. sensitivity analysis can be used to analyze how much you can afford to be off in your estimates of revenue growth and margins without altering your decision to accept or reject the investment 3. there are some dangers to sensitivity analysis: a) overdoing what if analyses ® there are often dozens of inputs that go into a project analysis, and we could do sensitivity analyses on each and every one of these inputs. In the process, though, we mix the variables that matter with those that do not and risk obscuring the importance of the former b) losing sight of the objective ® the ultimate objective in asking “What if?” questions is to make better decisions in the face of uncertainty. To help in decision making, sensitivity analysis should be focused on key variables and the findings should be presented in ways that help decision makers better a grip on how outcomes will change as assumptions change c) not considering how variables move together ® in most sensitivity analysis, we change one input at a time, keeping all other inputs at their base case values. While this makes computation simpler, it may be unrealistic, since input variables are often correlated with each other. Thus, assuming that margins will increase while keeping revenue growth fixed or that interest rates will go down while inflation stays high may yield higher net present values for the project, but neither is likely to happen d) double-counting risk ® in any sensitivity analysis, even good projects (with positive NPV and high IRR) will have negative net present values if key variables move adversely. Decision makers who use this as a rationale for rejecting these projects are potentially double-counting risk, since the cash flows were discounted back at a risk-adjusted rate to estimate the base case NPV 4. there are two good uses for sensitivity analysis: a) it can be used as a tie-breaker when firms have to choose between two projects that are roughly equivalent in terms of base case net present value or IRR; the project that is less sensitive to changes in the key variables should be picked b) to use the output from sensitivity analysis to better manage both the operations and the risks of an investment; knowing that the NPV of an investment is sensitive to labor costs may lead to entering into labor contracts that keep these costs under control; the finding that a project’s value fluctuates as exchange rates move may result in the firm using currency options and futures to hedge risk • scenario analysis ® we develop a few possible scenarios, ranging from good to bad outcomes and compute the value of the project under each one; we outline scenarios that are different from the base case, where many or all of the inputs can have different values, and evaluate the project’s value under these scenarios 1. scenario analysis can take one of two forms: a) Best Case/Worst Case ® with risky projects, the actual cash flows can be very different from expectations. At the minimum, we can estimate the cash flows if everything works to perfection—a best- case scenario—and if nothing does—a worse-case scenario - there are two ways in which this analysis can be structured: à each input into the project analysis is set to its best (or worst) possible outcome and the cash flows estimated with those values ® you may set the revenue growth rate and operating margin at the highest possible level while setting the discount rate at its lowest level, and compute the value as the best-case scenario. The problem with this approach is that it may not be feasible à the best possible scenario is defined in terms of what is feasible while allowing for the relationship between the inputs ® we will choose that combination of growth and margin that is feasible and yields the maximum value. While this approach is more realistic, it does require more work to put into practice - there are two ways in which the results from this analysis can help decision makers: à the difference between the best-case and worst-case value can be used as a measure of risk on an asset; the range in value (scaled to size) should be higher for riskier investments à firms that are concerned about the potential spill over effects on their operations of an investment going bad may be able to gauge the danger by looking at the worst-case outcome - a firm that has significant debt obligations may use the worst-case outcome to make a judgment as to whether an investment has the potential to push them into default. In general, though, best- case/worse-case analyses are not very informative b) Multiple Scenario Analysis ® the value of a risky investment can be computed under a number of different scenarios, varying the assumptions about both macro economic and asset-specific variables - it has four critical components: à determination of which factors the scenarios will be built around ® these factors can range from the state of the economy for an automobile firm considering a new plant, to the response of competitors for a consumer product firm introducing a new product, to the behavior of regulatory authorities for a phone company, considering a new phone service à determining the number of scenarios to analyze for each factor ® while more scenarios may be more realistic than fewer, it becomes more difficult to collect information and differentiate between the scenarios in terms of asset cash flows. The question of how many scenarios to consider will depend then on how different the scenarios are and how well the analyst can forecast cash flows under each scenario à estimation of asset cash flows under each scenario ® it is to ease the estimation at this step that we focus on only two or three critical factors and build relatively few scenarios for each factor à assignment of probabilities to each scenario ® for some scenarios, involving macroeconomic factors such as exchange rates, interest rates, and overall economic growth, we can draw on the expertise of services that forecast these variables. For other scenarios, involving either the sector or competitors, we have to draw on our knowledge about the industry - the output from a scenario analysis can be presented as values under each scenario and as an expected value across scenarios (if the probabilities can be estimated in the fourth step) - scenario analysis is best suited for risks that are either discrete or can be categorized into discrete groups. Thus, it is better suited to deal with the risk that a competitor will introduce a product similar to your product than it is to deal with the risk that interest rates may change in future periods • decision trees ® designed for multistage investments, where we evaluate the probabilities of success and failure at each stage and the consequences for the final value; in some projects, risk is not only discrete but is sequential. In other words, for an investment to succeed, it has to pass through a series of tests, with failure at any point potentially translating into a complete loss of value; decision trees allow us to not only consider the risk in stages but also devise the right response to outcomes at each stage. 1. steps in decision tree analysis a) to distinguish between root nodes, decision nodes, event nodes, and end nodes - root node ® represents the start of the decision tree, where a decision maker can be faced with a decision choice or an uncertain outcome; the objective of the exercise is to evaluate what a risky investment is worth at this node - event nodes ® represent the possible outcomes on a risky gamble; whether a drug passes the first stage of the FDA approval process or not is a good example. We have to figure out the possible outcomes and the probabilities of the outcomes occurring, based on the information we have available today - decision nodes ® represent choices that can be made by the decision maker—to expand from a test market to a national market, after a test market’s outcome is known - end nodes ® usually represent the final outcomes of earlier risky outcomes and decisions made in response Note the key elements in the decision tree: - only the event nodes represent uncertain outcomes and have probabilities attached to them - the decision node represents a choice b) divide analysis into risk phases ® the key to developing a decision tree is outlining the phases of risk that you will be exposed to in the future. In some cases, such as the FDA approval process, this will be easy to do since there are only two outcomes—the drug gets approved to move on to the next phase or it does not. In other cases, it will be more difficult. For instance, a test market of a new consumer product can yield hundreds of potential outcomes; here, you will have to create discrete categories for the success of the test market. c) in each phase, estimate the probabilities of the outcomes ® once the phases of risk have been put down and the outcomes at each phase are defined, the probabilities of the outcomes have to be computed. In addition to the obvious requirement that the probabilities across outcomes has to sum up to one, the analyst will also have to consider whether the probabilities of outcomes in one phase can be affected by outcomes in earlier phases d) define decision points ® embedded in the decision tree will be decision points where you will get to determine, based on observing the outcomes at earlier stages, and expectations of what will occur in the future, what your best course of action will be. With the test market example, for instance, you will get to determine, at the end of the test market, whether you want to conduct a second test market, abandon the product, or move directly to a national product introduction. e) compute cash flows/value at end nodes ® estimating what the final cash flow and value outcomes will be at each end node - in some cases, such as abandonment of a test market product, this will be easy to do and will represent the money spent on the test marketing of the product - in other cases, such as a national launch of the same product, this will be more difficult to do since you will have to estimate expected cash flows over the life of the product and discount these cash flows to arrive at value f) folding back the tree ® where the expected values are computed working backwards through the tree - if the node is a chance node, the expected value is computed as the probability-weighted average of all of the possible outcomes - if it is a decision node, the expected value is computed for each branch, and the highest value is chosen (as the optimal decision). The process culminates in an expected value for the asset or investment today An Overall Assessment of Probabilistic Risk Assessment Approaches ® assuming that we decide to use a probabilistic approach to assess risk and could choose between scenario analysis, decision trees, and simulations, which one should we pick? The answer will depend on how you plan to use the output and what types of risk you are facing: 1. selective versus full risk analysis a) in the best-case/worst-case scenario analysis, we look at only three scenarios (the best case, the most likely case, and the worst case) and ignore all other scenarios b) even when we consider multiple scenarios, we will not have a complete assessment of all possible outcomes from risky investments or assets ® the sum of the probabilities can be less than 1 c) with decision trees and simulations, we attempt to consider all possible outcomes: - in decision trees, we try to accomplish this by converting continuous risk into a manageable set of possible outcomes - with simulations, we can use distributions to capture all possible outcomes. The sum of the probabilities of outcomes in decision trees and simulations has to equal 1 ® as a consequence, we can compute expected values across outcomes in the latter, using the probabilities as weights, and these expected values are comparable to the single estimate risk-adjusted values 2. discrete versus continuous risk ® as noted above, scenario analysis and decision trees are generally built around discrete outcomes in risky events whereas simulations are better suited for continuous risks. Focusing on just scenario analysis and decision trees, the latter are better suited for sequential risks, since risk is considered in phases, whereas the former is easier to use when risks occur concurrently. 3. correlation across risks ® if the various risks that an investment is exposed to are correlated, simulations allow for explicitly modeling these correlations (assuming that you can estimate and forecast them). In scenario analysis, we can deal with correlations subjectively by creating scenarios that allow for them; the high (low) interest rate scenario will also include slower (higher) economic growth. Correlated risks are difficult to model in decision trees. Finally, the quality of the information will be a factor in your choice of approach ® since simulations are heavily dependent on being able to assess probability distributions and parameters, they work best in cases where there is substantial historical and cross-sectional data available that can be used to make these assessments. With decision trees, you need estimates of the probabilities of the outcomes at each chance node, making them best suited for risks where these risks can be assessed either using past data or population characteristics. Thus, it should come as no surprise that when confronted with new and unpredictable risks, analysts continue to fall back on scenario analysis, notwithstanding its slapdash and subjective ways of dealing with risk. 6. PROJECT INTERACTIONS, SIDE COSTS, AND SIDE BENEFITS 6.1 MUTUALLY EXCLUSIVE PROJECTS Projects are mutually exclusive when accepting one investment means rejecting others, even though the latter standing alone may pass muster as good investments, have a positive NPV and a high IRR. There are two reasons for the loss of project independence: • the firm may face a capital rationing constraint, where not all good projects can be accepted • projects may be mutually exclusive because they serve the same purpose and choosing one makes the other redundant, such as: 1. when the owner of a commercial building is choosing among a number of different air conditioning 2. when investments provide alternative approaches to the future ® choice between a “high-margin, low- volume” strategy and a “low-margin, high-volume” strategy for a product. 6.2 PROJECT DEPENDENCE FROM CAPITAL RATIONING In the analysis of independent projects, we assumed that investing capital in a good project has no effect on either concurrent or subsequent projects that the firm may consider ® implicitly, we assume that firms with good investment prospects (positive NPV) can raise capital from financial markets, at a fair price, and without paying transaction costs. In reality, however, it is possible that the capital required to finance one project can cause managers to reject other good projects because the firm has limited access to capital ® capital rationing occurs when a firm is unable to invest in some of its projects that earn returns greater than the hurdle rates, positive net present value projects. Firms may face capital rationing constraints because they do not have either the capital or the capacity to raise the capital needed. Reasons for Capital Rationing Constraints ® in theory, there will be no capital rationing constraint as long as the following sequence of events occurs in funding the project: • the firm identifies an attractive investment opportunity • the firm goes to financial markets with a description of the project to seek financing • financial markets believe the firm’s description of the project • the firm issues securities to raise the capital needed to finance the project at fair market prices ® the implicit assumption is that markets are efficient and expectations of future earnings are built into these prices • the cost associated with issuing these securities is minimal. The sequence described depends on a several assumptions, some of which are clearly unrealistic at least for some firms: • project discovery ® the implicit assumption that firms know when they have good projects on hand underestimates the uncertainty and the errors associated with project analysis; in very few cases firms can say with complete certainty that a prospective project will be a good one • credibility ® financial markets tend to be skeptical about announcements made by firms, especially when they contain good news about future projects, and require more substantial proof of the projects’ quality • market efficiency 1. if the market is underpricing securities (stocks, by setting too low a price or debt, by demanding too high an interest rate) ® firms may be reluctant to issue stocks or borrow money to finance even good projects. In particular, the gains from investing in a project for existing stockholders may be overwhelmed by the loss from having to sell securities at or below their estimated true value 2. when securities are overpriced ® there may be a temptation to overinvest, because existing stockholders gain from the very process of issuing equities to new investors • flotation costs ® these are costs associated with raising funds in financial markets, and they can be substantial. If the NPV > flotation costs, it would not make sense to raise these funds and finance the projects. Sources of Capital Rationing • the three primary sources of capital rationing constraints are: 1. a firm’s lack of credibility with financial markets 2. market underpricing of securities 3. flotation costs • researchers have collected data on firms to determine whether they face capital rationing constraints and, if so, to identify the sources of such constraints ® a survey suggests that: 1. some firms face capital rationing constraints as a result of external factors largely beyond their control, such as issuance costs and credibility problems 2. most firms face self-imposed constraints, such as restrictive policies to avoid overextending themselves by investing too much in any period a) managers are reluctant to issue additional equity because they fear that doing so will dilute the control they have over the company • looking at the sources of capital rationing, it seems clear that smaller firms with more limited access to capital markets are more likely to face capital rationing constraints than larger firms. Using similar reasoning, private businesses and emerging market companies are more likely to have limited capital than publicly traded and developed market companies. Project Selection with Capital Rationing ® whatever the reason, many firms face capital rationing constraints, limiting the funds available for investment. When there is a capital rationing constraint, the standard advice of investing in projects with positive NPV breaks down, because we can invest only in a subset of projects. We have to devise ranking systems for good investments that will help us direct the limited capital to where it can generate the biggest payoff • project rankings (NPV and IRR) ® the NPV and the IRR are both time-weighted, cash flow-based measures of return for an investment and generally yield the same conclusion (accept or reject) for an independent, standalone investment. When comparing or ranking multiple projects, however, the two approaches can yield different rankings, because of differences in either the scale or the reinvestment rate assumption • differences in scale 1. the NPV of a project is stated in dollar terms and does not factor in the scale of the project ® rankings based upon the former will rank the biggest projects (with large cash flows) highest 2. the IRR is a percentage rate of return, which is standardized for the scale of the project ® rankings based upon IRR will tilt toward projects that require smaller investments • differences in reinvestment rate assumptions ® although the differences between the NPV rule and the IRR rules owing to scale are fairly obvious, there is a subtler significant difference between them relating to the reinvestment of intermediate cash flows 1. the NPV rule assumes that intermediate cash flows are reinvested 2. the reinvestment rate assumption made by the IRR rule creates more serious consequences the longer the term of the project and the higher the IRR, because it implicitly assumes that the firm has and will continue to have a fountain of projects, yielding returns similar to that earned by the project under consideration. • project rankings: modified rules ® the conventional discounted cash flow rules, NPV or IRR, have limitations when it comes to ranking projects, in the presence of capital rationing 1. the NPV rule is biased toward larger investments and will not result in the best use of limited capital 2. the IRR rule is generally better suited for capital rationed firms, but the assumption that intermediate cash flows get reinvested at the IRR can skew investment choices. We consider 3 modifications to traditional investment rules that yield better choices than the traditional rules: 1. a scaled version of NPV (profitability index) ® the profitability index is the simplest method of including capital rationing in the investment analysis; it is computed by dividing the NPV of the project by the initial investment in the project 𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 = YJ3 %" !0.2<'#20' N0!'!/( !0.2<'#20' 022;2; "%& !0.2<'#20' The profitability index provides a rough measure of the NPV the firm gets for each dollar it invests ® to use it in investment analysis, we first compute it for each investment the firm is considering and, then, pick projects based on the profitability index, starting with the highest values and working down until we reach the capital constraint. When capital is limited and a firm cannot accept every positive NPV project, the profitability index identifies the highest cumulative NPV from the funds available for capital investment. Although the profitability index is intuitively appealing, it has several limitations: a) it assumes that the capital rationing constraint applies to the current period only and does not consider investment requirements in future periods ® a firm may choose projects with a total initial investment that is less than the current period’s capital constraint, but it may expose itself to capital rationing problems in future periods if these projects require outlays in those periods b) the classification of cash flows into an initial investment that occurs now and operating cash inflows that occur in future periods ® if projects have investments spread over multiple periods and operating cash outflows, the profitability index may measure the project’s contribution to value incorrectly c) the profitability index does not guarantee that the total investment will add up to the capital rationing constraint ® if it does not, we have to consider other combinations of projects, which may yield a higher NPV. Although this is feasible for firms with relatively few projects, it becomes increasingly unwieldy as the number of projects increases 2. a modified internal rate of return (MIRR), with more reasonable reinvestment assumptions ® one solution that has been suggested for the reinvestment rate assumption is to assume that intermediate cash flows get reinvested at the hurdle rate (the cost of equity if the cash flows are to equity investors and the cost of capital if they are to the firm) and to calculate the IRR from the initial investment and the terminal value. a) there are many who believe that the MIRR is neither fish nor fowl, because it is a mix of the NPV rule and the IRR rule ® from a practical standpoint, the MIRR becomes a weighted average of the return on an individual project and the hurdle rate the firm uses, with the weights on each depending on the magnitude and timing of the cash flows—the larger and earlier the cash flows on the project, the greater the weight attached to the hurdle rate. Furthermore, the MIRR approach will yield the same choices as the NPV approach for projects of the same scale and lives Opportunity Costs of using Existing Resources ® it becomes more complicated when the resource does have potential future uses; we have to estimate the cash flows forgone on those future uses to estimate the opportunity costs • resource with a current alternative use ® we can estimate the cash flows lost by using the project’s resource 1. the general framework for analyzing opportunity costs begins by asking whether there is any other use for the resource right now a) the resource might be rented out ® the rental revenue lost is the opportunity cost of the resource b) the resource could be sold ® the sales price, net of any tax liability and lost depreciation tax benefits, would be the opportunity cost for the resource c) the resource might be used elsewhere in the firm ® the cost of replacing it is the opportunity cost. Thus, the transfer of experienced employees from established divisions to a new project creates a cost to these divisions, which has to be factored into the decision making 2. decision makers have to decide whether the opportunity cost will be estimated based on the lost rental revenue, the foregone sales price, or the cost of replacing the resource ® it is the highest of the costs (the best alternative forgone) which should be considered as an opportunity cost • resources with no current alternative use ® a resource being considered for use in a project will have no current alternative use, but the business will have to forgo alternative uses in the future. One example would be excess capacity on a machine or a computer. Most firms cannot lease or sell excess capacity but using that capacity now for a new product may cause the businesses to run out of capacity much earlier than they would otherwise. There are two responses analysts have to these resources: 1. they assume that excess capacity is free, because it is not being used currently and cannot be sold off or rented, in most cases 2. they allocate a portion of the book value of the plant or resource to the project. We will argue that neither of these approaches considers the opportunity cost of using excess capacity, because the opportunity cost usually comes from costs that the firm will face in the future as a consequence of using up excess capacity today. By doing so, the firm will run out of the capacity sooner than if it did not take the project. When it does run out of the capacity, it has to take one of the two paths: 1. new capacity will have to be bought or built, in which case, the opportunity cost will be the higher cost in present value terms of expanding earlier rather than later 2. production will have to be cut back on one of the product lines, leading to a loss in cash flows that would have been generated by the lost sales. Again, this choice is not random, because the logical action to take is the one that leads to the lower cost, in present value terms, for the firm. Thus, if it is cheaper to lose sales rather than build new capacity, the opportunity cost for the project being considered should be based on the lost sales. A general framework for pricing excess capacity for purposes of investment analysis asks three questions: 1. if the new project is not taken, when will the firm run out of capacity on the equipment or space that is being evaluated? 2. if the new project is taken, when will the firm run out of capacity on the equipment or space that is being evaluated? Presumably, with the new project using up some of the excess capacity, the firm will run out of capacity sooner than it would have otherwise 3. what will the firm do when it does run out of capacity? The firm has two choices: It can cut back on production of the least profitable product line and make less profits than it would have without a capacity constraint. In this case, the opportunity cost is the present value of the cash flows lost as a consequence. It can buy or build new capacity, in which case, the opportunity cost is the difference in present value between investing earlier rather than later. 6.5 PRODUCT CANNIBALIZATION Product cannibalization refers to the phenomenon whereby a new product introduced by a firm competes with and reduces the sales of the firm’s existing products • it can be argued that this is a negative incremental effect of the new product, and the lost cash flows or profits from the existing products should be treated as costs in analyzing whether to introduce the product ® doing so introduces the possibility that of the new product will be rejected, however. If this happens and a competitor then exploits the opening to introduce a product that fills the niche that the new product would have and, consequently, erodes the sales of the firm’s existing products, the worst of all scenarios is created—the firm loses sales to a competitor rather than to itself • the decision on whether to build in the lost sales created by product cannibalization will depend on the potential for a competitor to introduce a close substitute to the new product being considered ® two extreme possibilities exist: 1. close substitutes will be offered almost instantaneously by competitors ® if the business in which the firm operates is extremely competitive and there are no barriers to entry, it can be assumed that the product cannibalization will occur anyway, and the costs associated with it have no place in an incremental cash flow analysis 2. substitutes cannot be offered ® if a competitor cannot introduce a substitute (because of legal restrictions such as patents, for example) the cash flows lost as a consequence of product cannibalization belong in the investment analysis at least for the period of the patent protection. For example, a pharmaceutical company, which has the only patented drug available to treat ulcers, may hold back on introducing a potentially better, new ulcer drug because of fears of product cannibalization 3. in intermediate cases, there will be some barriers to entry, ensuring that a competitor will either introduce an imperfect substitute, leading to much smaller erosion in existing product sales, or not introduce a substitute for some period of time, leading to a much later erosion in existing product sales ® a compromise solution whereby some of the product cannibalization costs are considered may be appropriate. Note that brand name loyalty is one potential barrier to entry. Firms with stronger brand loyalty should, therefore, factor into their investment analysis more of the cost of lost sales from existing products as a consequence of a new product introduction. 6.6 SIDE BENEFITS FROM PROJECTS A proposed investment may benefit other investments that a firm already has. In assessing this investment, we should, therefore, consider these side benefits • project synergies ® when a project under consideration creates positive benefits (in the form of cash flows) for other projects that a firm may have, project synergies are created 1. sometimes the project synergies are not with existing projects but with other projects being considered contemporaneously ® the best way to analyze the projects is jointly, because examining each separately will lead to a much lower NPV. Thus, a proposal to open a children’s clothing store and an adult clothing store in the same shopping center will have to be treated as a joint investment analysis, and the NPV will have to be calculated for both the stores together. A positive NPV would suggest opening both the stores, whereas a negative NPV would indicate that neither should be opened. • synergy in acquisitions ® synergy is often a motive in acquisitions, but it is used as a way of justifying huge premiums and is seldom analyzed objectively. The framework we developed for valuing synergy in projects can be applied to valuing synergy in acquisitions. The key to the existence of synergy is that the target firm controls a specialized resource that becomes more valuable when combined with the bidding firm’s resources. The specialized resource will vary depending on the merger: 1. horizontal mergers ® occur when two firms in the same line of business merge; the synergy must come from some form of economies of scale, which reduce costs, or from increased market power, which increases profit margins and sales 2. vertical integration ® occurs when a firm acquires a supplier of inputs into its production process or a distributor or retailer for the product it produces; the primary source of synergy in this case comes from more complete control of the chain of production; this benefit has to be weighed against the loss of efficiency from having a captive supplier who does not have any incentive to keep costs low and compete with other suppliers 3. functional integration ® occurs when a firm with strengths in one functional area acquires another firm with strengths in a different functional area; synergy may be gained by exploiting the strengths in these areas. Thus, when a firm with a good distribution network acquires a firm with a promising product line, value is gained by combining these two strengths. The argument is that both the firms will be better off after the merger. Most reasonable observers agree that there is a potential for operating synergy, in one form or the other, in many takeovers. Some disagreement exists, however, over whether synergy can be valued and, if so, how much that value should be 1. one school of thought argues that synergy is too nebulous to be valued and that any systematic attempt to do so requires so many assumptions that it is pointless 2. we disagree. It is true that valuing synergy requires assumptions about future cash flows and growth, but the lack of precision in the process does not mean that an unbiased estimate of value cannot be made. Thus, we maintain that synergy can be valued by answering two fundamental questions: a) what form is the synergy expected to take? The benefits of synergy have to show up in one of the inputs into value, as higher revenues, a healthier operating margin, more investment opportunities, or higher growth in the future. To value synergy, we need to identify which of these inputs will most likely be affected and by how much b) when can the synergy be expected to start affecting cash flows? Even if there are good reasons for believing that synergy exists in a particular merger, it is unlikely that these benefits will accrue instantaneously after the merger is completed. It often takes time to integrate the operations of two firms, and the difficulty of doing so increases with the sizes of the firms. If we have to wait for the higher cash flows that arise as a result of synergy, the value of synergy decreases, and more so if you are exposed to more uncertainty during the waiting period. Once these questions are answered, the value of synergy can be estimated using an extension of investment analysis techniques a) the firms involved in the merger are valued independently by discounting expected cash flows to each firm at the weighted average cost of capital for that firm b) the value of the combined firm, with no synergy, is obtained by adding the values obtained for each firm in the first step c) the effects of synergy are built into expected growth rates and cash flows, and the combined firm is revalued with synergy ® the difference between the value of the combined firm with synergy and the value of the combined firm without synergy provides a value for synergy. How can we reduce the problem of overpayment? a) we need to reform the acquisition process and separate the deal making from the deal analysis: the bankers who stand to profit from deal fees cannot be responsible for providing advice on whether the deal makes sense b) we have to give stockholders a much bigger say in the process ® if the board of directors cannot perform their oversight role, the largest investors in the acquiring company should be allowed representation during the negotiation, and the representative will be given the responsibility of questioning key assumptions and forecasts c) the managers who are most intent on pushing the acquisition through should be given the responsibility of delivering the projected cash flows. 6.7 OPTIONS EMBEDDED IN PROJECTS We examined the process for analyzing a project and deciding whether to accept the project. In particular, we noted that a project should be accepted only if the returns on the project exceed the hurdle rate; in the context of cash flows and discount rates, this translates into projects with positive NPVs. The limitation with traditional investment analysis, which analyzes projects on the basis of expected cash flows and discount rates, is that it fails to consider fully the myriad options that are usually associated with many projects. We will begin by: • describing what an option is why they matter • analyzing three options that are embedded in many capital budgeting projects 1. option to delay a project, especially when the firm has exclusive rights to the project 2. option to expand a project to cover new products or markets sometime in the future 3. option to abandon a project if the cash flows do not measure up to expectations. These are called real options ® the underlying asset is a real asset (a project) rather than a financial asset. Options: Description and Determinants of Value ® an option is an asset that derives its value from another asset, called an underlying asset, and has a cash payoff that is contingent on what happens to the value of the underlying asset • there are two types of options: 1. call option ® you get the right to buy the underlying asset at a fixed price, called a strike price 2. put options ® you get the right to sell the underlying asset at a fixed price. Because you have the right, as the holder of the option, to buy or sell the underlying asset, and not an obligation, you will exercise an option only if it makes sense for you to do so. With a call option, that will occur when the value of the underlying asset is greater than your strike price, whereas with a put, it is when the value is lower • the value of an option ultimately rests of six variables: 1. value 2. volatility 3. expected dividends of the underlying asset 4. strike price 5. life of the option 6. level of interest rates. Without delving into the minutiae of option pricing models, it is still worth noting the differences between valuing conventional assets and projects on the one hand and options on the other: 1. conventional assets can be valued by discounting expected cash flows at a risk-adjusted discount rate, whereas options are valued at a premium over their exercise value; the premium can be attributed to the choice that the holder of the option as to when and whether to exercise 2. increasing risk and uncertainty reduce the value of conventional assets, but they increase the value of options ® this is because the holders of options can never be forced to exercise an option, which protects them against downside risk but preserves upside potential. It is because of these two differences that this section is necessitated: • if an investment has options embedded in it, conventional discounted cash flow value will miss the option premium and understate the value of the investment • the option portion of the investment may benefit as the investment becomes more risky, even as the rest of the investment becomes more valuable. 4. the life of the option is fairly difficult to define, as there is usually no externally imposed exercise period. When valuing the option to expand, the life of the option will be an internal constraint imposed by the firm on itself. For instance, a firm that invests on a small scale in China might impose a constraint that it either will expand within five years or pull out of the market. Why might it do so? There may be considerable costs associated with maintaining the small presence or the firm may have scarce resources that have to be committed elsewhere. As with other real options, there may be a cost to waiting once the expansion option becomes viable. That cost may take the form of cash flows that will be lost on the expansion project if it is not taken or a cost imposed on the firm until it makes its final decision. • Tests for Expansion Option to Have Value ® not all investments have options embedded in them, and not all options, even if they do exist, have value. To assess whether an investment creates valuable options that need to be analyzed and valued, we need to answer three key questions. 1. Is the first investment a prerequisite for the later investment/expansion? If not, how necessary is the first investment for the later investment/expansion? Consider the value of a patent or the value of an undeveloped oil reserve as options. A firm cannot generate patents without investing in research or paying another firm for the patents, and it cannot get rights to an undeveloped oil reserve without bidding on it at a government auction or buying it from another oil company. Clearly, the initial investment here (spending on R&D and bidding at the auction) is required for the firm to have the second investment. Now, consider the Disney investment in a Spanish-language channel, without which presumably it cannot expand into the larger Latin American market. Unlike the patent and undeveloped reserves examples, the initial investment is not a prerequisite for the second, though management might view it as such. The connection gets even weaker and the option value lower, when we look at one firm acquiring another to have the option to be able to enter a large market. Acquiring an Internet service provider to have a foothold in the online retailing market or buying a Chinese brewery to preserve the option to enter the Chinese beer market would be examples of less valuable options. 2. Does the firm have an exclusive right to the later investment/expansion? If not, does the initial investment provide the firm with significant competitive advantages on subsequent investments? The value of the option ultimately derives not from the cash flows generated by the second and subsequent investments but from the excess returns that result from these cash flows. The greater the potential for excess returns on the second investment, the greater the value of the expansion option. The potential for excess returns is closely tied to how much of a competitive advantage the first investment provides the firm when it takes subsequent investments. At one extreme, again, consider investing in R&D to acquire a patent. The patent gives the firm that owns it the exclusive rights to produce that product, and if the market potential is large, the right to the excess returns from the project. At the other extreme, the firm might get no competitive advantages on subsequent investments, in which case, it is questionable whether there can be any excess returns on these investments. In reality, most investments will fall in the continuum between these two extremes, with greater competitive advantages being associated with higher excess returns and larger option values. 3. How sustainable are the competitive advantages? In a competitive marketplace, excess returns attract competitors, and competition drives out excess returns. The more sustainable the compet- itive advantages possessed by a firm, the greater the value of the options embedded in the initial investment. The sustainability of competitive advantages is a function of two forces. The first is the nature of the competition; other things remaining equal, competitive advantages fade much more quickly in sectors where there are aggressive competitors. The second is the nature of the competitive advantage. If the resource controlled by the firm is finite and scarce (as is the case with natural resource reserves), the competitive advantage is likely to be sustainable for longer periods. Alternatively, if the competitive advantage comes from being the first mover in a market or from having technological expertise, it will come under assault far sooner. The most direct way of reflecting this competitive advantage in the value of the option is its life; the life of the option can be set to the period of competitive advantage, and only the excess returns earned over this period counts toward the value of the option. • Practical Considerations ® the practical considerations associated with estimating the value of the option to expand are similar to those associated with valuing the option to delay. In most cases, firms with options to expand have no specific time horizon by which they have to make an expansion decision, making these open- ended options or at best options with arbitrary lives. Even in those cases where a life can be estimated for the option, neither the size nor the potential market for the product may be known, and estimating either can be problematic. To illustrate, consider the Disney expansion example. We adopted a period of 10 years, at the end of which Disney has to decide one way or another on its future expansion in Latin America, but it is entirely possible that this time frame is not specified at the time the store is opened. Furthermore, we have assumed that both the cost and the present value of expansion are known initially. In reality, the firm may not have good estimates for either before starting its Spanish cable channel, because it does not have much information on the underlying market • Intuitive Implications ® the option to expand is implicitly used by firms to rationalize taking projects that may have negative NPV but provide significant opportunities to tap into new markets or sell new products. Although the option pricing approach adds rigor to this argument by estimating the value of this option, it also provides insight into those occasions when it is most valuable. In general, the option to expand is clearly more valuable for more volatile businesses with higher returns on projects (such as biotechnology or technology) than in stable businesses with lower returns (such as housing, chemicals, or automobiles). It can also be argued that R&D provides one immediate application for this methodology. Investing in R&D is justified by noting that it provides the basis for new products for the future. In recent years, however, more firms have stopped accepting this explanation at face value as a rationale for spending on R&D and have started demanding better returns from their investments. Firms that spend considerable amounts of money on R&D or test marketing are often stymied when they try to evaluate these expenses, because the payoffs are often in terms of future projects. At the same time, there is the very real possibility that, after the money has been spent, the products or projects may turn out not to be viable; consequently, the expenditure is treated as a sunk cost. In fact, it can be argued that what emerges from R&D— patents or technological expertise—has the characteristics of a call option. If this is true, the amount spent on the R&D is the cost of the call option, and the patents that might emerge from the research provide the options. Several logical implications emerge from this view of R&D: 1. research expenditures should provide much higher value for firms that are in volatile technologies or businesses, because the higher variance in product or project cash flows creates more valuable call options ® it follows then that R&D at pharmaceutical firms should be redirected to areas where little is known and there is substantial uncertainty and away from areas where there is more stability 2. the value of research and the optimal amount to be spent on research will change over time as the businesses mature. The best example is the pharmaceutical industry: in the 1990s, however, as health care costs started leveling off and the business matured, many of these companies found that they were not getting the same payoffs on research and started cutting back. The Option to Abandon a Project ® the final option to consider here is the option to abandon a project when its cash flows do not measure up to expectations. Generally, the option to abandon a project later will make that project more attractive to investors now. • Describing the Option to Abandon ® to illustrate the option to abandon, assume that you have invested in a project and that V is the remaining value on a project if your continue it to the end of its life. Now, assume that you can abandon the project today and that L is the liquidation or abandonment value for the same project. If the project has a remaining life of n years, the value of continuing the project can be compared to the liquidation (abandonment) value—if it is higher, the project should be continued; if it is lower, the holder of the abandonment option could consider abandoning the project. 1. Payoff from owning an abandonment option = 0 if V > L 2. Payoff from owning an abandonment option = L−V if V ≤ L These payoffs are graphed in Figure 6.12, as a function of the expected stock price. Unlike the prior two cases, the option to abandon takes on the characteristics of a put option. • Intuitive Implications ® the fact that the option to abandon has value provides a rationale for firms to build the flexibility to scale back or terminate projects if they do not measure up to expectations. Firms can do this in a number of ways: 1. to build in the option contractually with those parties that are involved in the project. Thus, contracts with suppliers may be written on an annual basis, rather than long term, and employees may be hired on a temporary basis rather than permanently. The physical plant used for a project may be leased on a short- term basis, rather than bought, and the financial investment may be made in stages rather than as an initial lump sum. Although there is a cost to building in this flexibility, the gains may be much larger, especially in volatile businesses. The option to abandon is particularly valuable for smaller companies investing in large projects, where the investment in the project may represent a significant percentage of the firm’s capital. Assessing Existing or Past investments ® the techniques and principles enunciated apply just as strongly to existing investments; with existing investments, we can try to address one of two questions: • Post –mortem analysis ® look back at existing investments and see if they have created value for the firm 1. the actual cash flows from an investment can be greater than or less than originally forecast for a number of reasons but all these reasons can be categorized into two groups: a) chance ® the nature of risk is that actual outcomes can be different from expectations; even when forecasts are based upon the best of information, they will invariably be wrong in hindsight because of unexpected shifts in both macro (inflation, interest rates, economic growth) and micro (competitors, company) variables b) bias ® if the original forecasts were biased, the actual numbers will be different from expectations; the evidence on capital budgeting is that managers tend to be over-optimistic about cash flows and the bias is worse with over-confident managers 2. while it is impossible to tell on an individual project whether chance or bias is to blame, there is a way to tell across projects and across time a) if chance is the culprit, there should be symmetry in the errors – actuals should be about as likely to beat forecasts as they are to come under forecasts b) if bias is the reason, the errors will tend to be in one direction • what next? ® we can also use the tools of investment analysis to see whether we should keep, expand or abandon existing investments; if: 1. ∑ YT* (8V&)+ 'L0 'LX < 0 ® Liquidate the project 2. ∑ YT* (8V&)+ 'L0 'LX < 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒 ® Terminate the project 3. ∑ YT* (8V&)+ 'L0 'LX < 𝐷𝑖𝑣𝑒𝑠𝑡𝑖𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒 ® Divest the project 4. ∑ YT* (8V&)+ 'L0 'LX > 0 > 𝐷𝑖𝑣𝑒𝑠𝑡𝑖𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒 ® Continue the project. 8. CAPITAL STRUCTURE: THE OPTIMAL FINANCIAL MIX 8.1 OPERATING INCOME APPROACH The Choices in Financing ® there are only two ways in which a business can raise money: • debt ® the essence of debt is that you promise to make fixed payments in the future (interest payments and repaying principal); if you fail to make those payments, you lose control of your business • equity ® with equity, you do get whatever cash flows are left over after you have made debt payments. The Financing Mix Question ® in deciding to raise financing for a business, is there an optimal mix of debt and equity? • if yes, what is the trade off that lets us determine this optimal mix? 1. what are the benefits of using debt instead of equity? 2. what are the costs of using debt instead of equity? • if not, why not? Debt ® recalling the trade off • advantages 1. tax benefit ® interest expenses on debt are tax deducible but cash flows to equity are generally not; implication: the higher the marginal tax rate, the greater the benefits of debt 2. added discipline ® borrowing money may force managers to think about the consequences of the investment decisions a little more carefully and reduce bad investments; implication: as the separation between managers and stockholders increases, the benefits to using debt will go up • disadvantages 1. expected bankruptcy cost ® the expected cost of going bankrupt is a product of the probability of going bankrupt and the cost of going bankrupt; the latter includes both direct and indirect costs; the probability of going bankrupt will be higher in businesses with more volatile earnings and the cost of bankruptcy will also vary across businesses; implications: a) firms with more stable earnings should borrow more, for any given level of earnings b) firm with lower bankruptcy costs should borrow more, for any given level of earnings 2. agency costs ® actions that benefit equity investors may hurt lenders; the greater the potential for this conflict of interest, the greater the cost borne by the borrower (as higher interest rates or more covenants); implication: firms where lenders can monitor/control how their money is being used should be able to borrow more than firms where this is difficult to do 3. loss of flexibility ® using up available debt capacity today will mean that you cannot draw on it in the future; this loss of flexibility can be disastrous if funds are needed and access to capital is shut off; implications: a) firms that can forecast future funding needs better should be able to borrow more b) firms with better access to capital markets should be more willing to borrow more today. This illustration makes the choice of an optimal financing mix seem trivial, and it obscures some real problems that may arise in its application: 1. we typically do not have the benefit of having the entire schedule of costs of financing, before an analysis ® in most cases, the only level of debt about which there is any certainty about the cost of financing is the current level 2. the analysis assumes implicitly that the level of cash flows to the firm is unaffected by the financing mix of the firm and, consequently, by the default risk (or bond rating) for the firm. Although this may be reasonable in some cases, it might not in others. For instance, a firm that manufactures consumer durables (cars, televisions, etc.) might find that its sales and operating income drop if its default risk increases because investors are reluctant to buy its products. We will deal with the computational component of estimating costs of debt, equity, and capital, first, in the standard cost of capital approach and, then, follow up by examining how to bring in changes in expected cash flows into the analysis in the enhanced cost of capital approach. • The Standard Cost of Capital Approach ® in the standard cost of capital approach, we keep the operating income and cash flows fixed, while changing the cost of capital. Not surprisingly, the optimal debt ratio is the one that minimizes the cost of capital 1. Steps in computing cost of capital ® we need three basic inputs to compute the cost of capital—the cost of equity, the after-tax cost of debt, and the weights on debt and equity. The costs of equity and debt change as the debt ratio changes, and the primary challenge of this approach is in estimating each of these inputs a) cost of equity ® we estimated the levered beta as a function of the debt to equity ratio of a firm, the unlevered beta, and the firm’s marginal tax rate: 𝛽(2.2&2; = 𝛽:0(2.2&2; n1 + (1 − 𝑡) Q2>' BC:!'? o If we can estimate the unlevered beta for a firm, we can use it to compute the levered beta of the firm at every debt ratio ® this levered beta can then be used to compute the cost of equity at each debt ratio 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑅𝑖𝑠𝑘𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝛽(2.2&2;(𝑅𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚) b) cost of debt ® it is a function of the firm’s default risk; as firms borrow more, their default risk will increase and so will the cost of debt. If we use bond ratings as the measure of default risk, we can estimate the cost of debt in three steps: - we estimate a firm’s dollar debt and interest expenses at each debt ratio ® as firms increase their debt ratio, both dollar debt and interest expenses will rise - at each debt level, we compute a financial ratio or ratios that measure default risk and use the ratio(s) to estimate a rating for the firm ® as firms borrow more, this rating will decline - a default spread, based on the estimated rating, is added on to the risk-free rate to arrive at the pretax cost of debt. Applying the marginal tax rate to this pretax cost yields an after-tax cost of debt. c) we weight the cost of equity and the cost of debt based on the proportions used of each to estimate the cost of capital ® although we have not explicitly allowed for a preferred stock component in this process, we can have preferred stock as a part of capital. However, we have to keep the preferred stock portion fixed while changing the weights on debt and equity. The debt ratio at which the cost of capital is minimized is the optimal debt ratio. In this approach, the effect of changing the capital structure, on firm value, is isolated, by keeping the operating income fixed and varying only the cost of capital. In practical terms, this requires us to make two assumptions: a) the debt ratio is decreased by raising new equity and retiring debt; conversely, the debt ratio is increased by borrowing money and buying back stock. This process is called recapitalization b) the pretax operating income is assumed to be unaffected by the firm’s financing mix and, by extension, its bond rating ® if the operating income changes with a firm’s default risk, the basic analysis will not change, but minimizing the cost of capital may not be the optimal course of action, because the value of the firm is determined by both the cash flows and the cost of capital. The value of the firm will have to be computed at each debt level, and the optimal debt ratio will be that which maximizes firm value. In calculating the levered beta, we assumed that all market risk is borne by the equity investors; this may be unrealistic especially at higher levels of debt and that the firm will be able to get the full tax benefits of interest expenses even at very high debt ratios. We will also consider an alternative estimate of levered beta that apportions some of the market risk to the debt: 𝛽(2.2&2; = 𝛽: n1 + (1 − 𝑡) Q B o − 𝛽;2>'(1 − 𝑡) Q B The beta of debt can be based on the rating of the bond, estimated by regressing past returns on bonds in each rating class against returns on a market index or backed out of the default spread. The levered betas estimated using this approach will generally be lower than those estimated with the conventional model. We will also examine whether the full benefits of interest expenses will accrue at higher debt ratios ® we face two choices in forecasting costs of debt at different debt ratios: a) to build a model that includes several financial ratios to estimate the synthetic ratings at each debt ratio ® in addition to being more labor and data intensive, the approach will make the ratings process less transparent and more difficult to decipher b) to stick with the simplistic approach of linking the rating to the interest coverage ratio, with the ratio defined as: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 = B/&0!0G< >2"%&2 !0'2&2<' /0; '/D2< !0'2&2<' 2D$20<2< We will stick with the simpler approach for three reasons: - we are not aiming for precision in the cost of debt but an approximation ® given that the more complex approaches also give you approximations, we will tilt in favor of transparency - there is significant correlation not only between the interest coverage ratio and bond ratings but also between the interest coverage ratio and other ratios used in analysis, such as the debt coverage ratios and the funds flow ratios. Thus, we may be adding little by adding other ratios that are correlated with interest coverage ratios, including EBITDA/Fixed Charges, to the mix - the interest coverage ratio changes as a firm changes is financing mix and decreases as the debt ratio increases, a key requirement as we need the cost of debt to change as the debt ratio changes. Note that the interest expenses increase more than proportionately as the debt increases, as the cost of debt rises with the debt ratio ® there are four points to make about these computations: a) at each debt ratio, we compute the dollar value of debt by multiplying the debt ratio by the existing market value of the firm ® in reality, the value of the firm will change as the cost of capital changes and the dollar debt that we need to get to a specified debt ratio, will be different from the values that we have estimated. The reason that we have not tried to incorporate this effect is that it leads more circularity in our computations, as the value at each debt ratio is a function of the savings from the interest expenses at that debt ratio, which in turn, will depend upon the value b) there is a precipitous drop in the bond rating and a concurrent increase in the cost of debt when a firm moves from a 40% debt to ratio to a 50% debt ratio ® this is because the company enters into a dangerous cycle, where a drop in rating feeds into higher interest expenses, which feeds backs into a further drop in rating. We will terms this the “debt ledge” and maintain a safe distance from this ledge in crafting firm’s optimal debt ratio. c) we assume that, at every debt level, all existing debt will be refinanced at the new interest rate that will prevail after the capital structure change ® for instance, a firm’s existing debt, which has a A rating, is assumed to be refinanced at the interest rate corresponding to a B rating when the firm moves to a higher debt ratio. This is done for two reasons: - existing debt holders might have protective puts that enable them to put their bonds back to the firm and receive face value - the refinancing eliminates “wealth expropriation” effects – the effects of stockholders expropriating wealth from existing bondholders when debt is increased and viceversa when debt is reduced. If firms can retain old debt at lower rates while borrowing more and becoming riskier, the lenders of the old debt will lose value. If we lock in current rates on existing d) although it is conventional to leave the marginal tax rate unchanged as the debt ratio is increased, we adjust the tax rate to reflect the potential loss of the tax benefits of debt at higher debt ratios, where the interest expenses exceed the EBIT 𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑇𝑎𝑥 𝐵𝑒𝑛𝑒𝑓𝑖𝑡 = 𝐸𝐵𝐼𝑇 ×𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒 𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒 = W/D!#:# O/D *202"!' N0'2&2<' BD$20<2< This in turn raises the after-tax cost of debt ® the imbalance gets worse at the 80% and 90% debt ratios, leading to lower tax rates and even higher after-tax costs of debt. This is a conservative approach, because losses can be carried forward. Given that this is a permanent shift in leverage, it does make sense to be conservative. We used this tax rate to recompute the levered beta at debt ratios higher than 60%, to reflect the fact that tax savings from interest are depleted. The reason for minimizing the cost of capital is that it maximizes the value of the firm 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠 = BD$21'2; 1/<6 "(%H '% "!&#@"A& '"0+ -%<' %" 1/$!'/(FG , where g is the growth rate in the cash flow to the firm (in perpetuity) 𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇(1 − 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑛𝑜𝑛𝑐𝑎𝑠ℎ 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 The market value of the operating assets (enterprise value) at the time of this analysis was obtained by adding up the estimated market values of debt and equity: 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠 = 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 (𝐸𝑉) = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 − 𝐶𝑎𝑠ℎ 𝑎𝑛𝑑 𝑚𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 If we assume that the market is correctly pricing the firm, we can back out an implied growth rate: 𝐺𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 = T!&# 3/(:2×-%<' %" 1/$!'/(F-T '% "!&# T!&# ./(:2V-T '% "!&# The limitation of this approach is that the growth rate is heavily dependent on both our estimate of the cash flow in the most recent year and the assumption that the firm is in stable growth. In this case, for instance, the implied growth rate that we estimated is too high to be a perpetual growth rate and using it as such exaggerates the effect on firm value. In fact, using any growth rate that exceeds the risk-free rate in perpetuity can be the dangerous. There are two solutions: a) to use a more complete discounted cash flow valuation model, where you allow for higher growth for a period, before settling into perpetual growth ® this option will make your capital structure analysis into a full-fledged valuation exercise and divert attention from the capital structure choice b) to use an alternate approach to estimate the change in firm value ® consider first the change in the cost of capital from 7.81% to 7.16%, a drop of 0.65%. This change in the cost of capital should result in the firm saving on its annual cost of financing its operating assets: 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝑎 𝑓𝑖𝑟𝑚 𝑎𝑡 𝑒𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑑𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜 = $𝑚𝑖𝑙𝑙𝑖𝑜𝑛 × 7.81% = $𝑚𝑖𝑙𝑙𝑖𝑜𝑛8 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝑎 𝑓𝑖𝑟𝑚 𝑎𝑡 𝑜𝑝𝑡𝑖𝑚𝑎𝑙 𝑑𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜 = $𝑚𝑖𝑙𝑙𝑖𝑜𝑛 × 7.16% = $𝑚𝑖𝑙𝑙𝑖𝑜𝑛+ 𝐴𝑛𝑛𝑢𝑙𝑎 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 𝑖𝑛 𝑐𝑜𝑡𝑠 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 = $𝑚𝑖𝑙𝑙𝑖𝑜𝑛8 − $𝑚𝑖𝑙𝑙𝑖𝑜𝑛+ Note that most of these savings are implicit rather than explicit and represent the savings next year ® the present value of these savings over time can now be estimated using the new cost of capital of 7.16% and a perpetual growth rate (capped at the risk-free rate): 𝑃𝑉 𝑜𝑓 𝑆𝑎𝑣𝑖𝑛𝑔𝑠 = )00:/( </.!0G< 02D' ?2/& -%<' %" 1/$!'/(FG 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑎𝑓𝑡𝑒𝑟 𝑟𝑒𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 = 𝐸𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑒𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 + 𝑃𝑉 𝑜𝑓 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 Using this approach, we estimated the enterprise value at different debt ratios ® there are two ways of getting from firm value to the value per share: - because the increase in value accrues entirely to stockholders, we can estimate the increase in value per share by dividing by the total number of shares outstanding: 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = 𝑃𝑉 𝑜𝑓 𝑆𝑎𝑣𝑖𝑛𝑔𝑠/𝑡𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 because the change in cost of capital is being accomplished by borrowing a sum of money, to get from the existing debt to the new debt at the optimal, and buying back shares, it may seem surprising that we are using the shares outstanding before the buyback ® implicit in this computation is the assumption that the increase in firm value will be spread evenly across both the stockholders who sell their stock back to the firm and those who do not, and that is why we term this the “rational” solution, as it leaves investors indifferent between selling back their shares and holding on to them - the alternative approach to arriving at the value per share is to compute the number of shares outstanding after the buyback ® to make this judgment, you will need to assume or know the buyback price 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑎𝑓𝑡𝑒𝑟 𝑏𝑢𝑦𝑏𝑎𝑐𝑘 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 − N01&2/<2 !0 Q2>' A6/&2 $&!12 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑎𝑓𝑡𝑒𝑟 𝑟𝑒𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 = 𝐸𝑉 𝑎𝑓𝑡𝑒𝑟 𝑟𝑒𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 + 𝐶𝑎𝑠ℎ 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑎𝑓𝑡𝑒𝑟 𝑟𝑒𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 = 3/(:2 %" BC:!'? /"'2& &21/$!'/(!4/'!%0 Q2>' %:'<'/0;!0G /"'2& &21/$!'/(!4/'!%0 . 8.2.1 Constrained versions Constrained versions ® The cost of capital approach that we have described is unconstrained, because our only objective is to minimize the cost of capital • there are several reasons why a firm may choose not to view the debt ratio that emerges from this analysis as optimal: 1. the firm’s default risk at the point at which the cost of capital is minimized may be high enough to put the firm’s survival at jeopardy ® stated in terms of bond ratings, the firm may have a below-investment grade rating 2. the optimal debt ratio was computed using the operating income from the most recent financial year ® to the extent that operating income is volatile and can decline, firms may want to curtail their borrowing. In this section, we consider ways we can bring each of these considerations into the cost of capital analysis. • Bond Rating Constraint ® one way of using the cost of capital approach without putting firms into financial jeopardy is to impose a bond rating constraint on the cost of capital analysis. Once this constraint has been imposed, the optimal debt ratio is the one that has the lowest cost of capital, subject to the constraint that the bond rating meets or exceeds a certain level. Although this approach is simple, the rating constraint is essentially subjective and is, therefore, open to manipulation. To make managers more accountable in this regard you should measure the cost of a rating constraint 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑡 = 𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 𝑤𝑖𝑡ℎ𝑜𝑢𝑡 𝐶𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑡𝑠 − 𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 𝑤𝑖𝑡ℎ 𝐶𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑡𝑠 b) we continue to estimate the costs of debt for a private firm using a synthetic bond rating, based on interest coverage ratios, but we will require much higher interest coverage ratios to arrive at the same rating, to reflect the fact that lenders are likely to be more conservative in assessing default risk at small, private firms c) we will use total betas to capture total risk, rather than just market risk, to estimate the cost of equity • Financial Service Firms 1. there are several problems in applying the cost of capital approach to financial service firms, such as banks and insurance companies a) the interest coverage ratio table, which is critical in determining the bond ratings, has to be estimated separately for financial service firms; applying manufacturing company spreads will result in absurdly low ratings for even the safest banks and very low optimal debt ratios. Furthermore, the relationship between interest coverage ratios and ratings tend to be much weaker for financial service firms than it is for manufacturing firms b) measurement problem that arises partly from the difficulty in estimating the debt on a financial service company’s balance sheet. Given the mix of deposits, repurchase agreements, short-term financing, and other liabilities that may appear on a financial service firm’s balance sheet, one solution is to focus only on long-term debt, defined tightly, and to use interest coverage ratios defined using only long-term interest expenses c) financial service firms are regulated and have to meet regulatory capital ratios that are defined in terms of book value. If, in the process of moving to an optimal market value debt ratio, these firms violate the book capital ratios, they could put themselves in jeopardy 2. while we could try to adapt the cost of capital approach to come up with optimal debt ratios for banks and other financial service companies, the results are very sensitive to how we define debt and the relationship we assume between bond ratings and operating income ® an alternative and more effective approach is to use the regulatory capital ratios, usually determined in terms of book equity, as the basis for determining how much equity a financial service firm needs to raise to keep itself as a healthy operating entity. The amount of equity that the bank will have to raise to fund its expansion is computed below: 𝐿𝑜𝑎𝑛𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑎𝑓𝑡𝑒𝑟 𝑒𝑥𝑝𝑎𝑛𝑠𝑖𝑜𝑛 = 𝑒𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑙𝑜𝑎𝑛𝑠 + 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑙𝑜𝑎𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 𝑎𝑓𝑡𝑒𝑟 𝑒𝑥𝑝𝑎𝑛𝑠𝑖𝑜𝑛 = 𝐿𝑜𝑎𝑛𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑎𝑓𝑡𝑒𝑟 𝑒𝑥𝑝𝑎𝑛𝑠𝑖𝑜𝑛 × (1 − 𝐸𝑞𝑢𝑖𝑡𝑦 𝑡𝑜 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝑎𝑡𝑖𝑜 𝑑𝑒𝑠𝑖𝑟𝑒𝑑) 𝑁𝑒𝑤 𝑒𝑞𝑢𝑖𝑡𝑦 𝑛𝑒𝑒𝑑𝑒𝑑 = 𝐸𝑞𝑢𝑖𝑡𝑦 𝑎𝑓𝑒𝑟 𝑒𝑥𝑝𝑎𝑛𝑠𝑖𝑜𝑛 − 𝑒𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑒𝑞𝑢𝑖𝑡𝑦 This incremental equity can come from retained earnings, but if those retained earnings fall short of the new equity needed, the bank will have to issue additional equity 3. As we look at more complex financial service firms that operate in multiple businesses with different risk levels, there are two challenges that we will face in putting this approach into practice: a) Different regulatory capital requirements for different businesses ® when a firm operates in different businesses, the regulatory capital restrictions can vary across businesses. In general, the capital requirements will be higher in riskier businesses and lower in safer businesses. Hence, the equity that a firm has to raise to fund expansion will depend in large part of which businesses are being expanded b) Regulatory versus risk-based capital ratios ® the regulatory capital ratios represent a floor on what a firm has to invest in equity, to keep its operations going and not a ceiling. It is possible that the firm’s own assessment of risk in a business can lead it to hold more equity than required by the regulatory authorities 4. As a final twist, it is worth nothing that banking regulators consider preferred stock as part of equity, when computing regulatory ratios ® in general, there are three strategies that a financial service firm can follow when it comes to the use of leverage: a) The regulatory minimum strategy ® financial service firms try to stay with the bare minimum equity capital, as required by the regulatory ratios - in the most aggressive versions of this strategy, firms exploit loopholes in the regulatory framework to invest in those businesses where regulatory capital ratios are set too low (relative to the risk of these businesses) - upside ® the returns on equity in good times will very high, as the equity capital is kept low - downside ® the risk in the investments ultimately will manifest itself and the absence of equity to cover losses will put the firm’s existence in jeopardy b) The self-regulatory strategy ® the objective for a bank raising equity is not to meet regulatory capital ratios but to ensure that losses from the business can be covered by the existing equity. In effect, financial service firms can assess how much equity they need to hold by evaluating the riskiness of their businesses and the potential for losses. Having done so, they can then check to also make sure that they meet the regulatory requirements for capital - upside ® it forces the firm to both assess risk in its businesses and to make the trade-off between risk and return, when entering new businesses - downside ® it is more data intensive, and errors in assessing risk will affect the firm’s value. c) Combination strategy ® the regulatory capital ratios operate as a floor for established businesses, with the firm adding buffers for safety where needed. In new or evolving businesses, the firm makes its own assessments of risk that may be very different from those made by the regulatory authorities. 5. we would argue that the responsibility for maintaining enough equity has to rest ultimately with the management of the firm and not with the regulatory authorities ® a bank that blames the laxness of regulatory oversight for its failures is not a well-managed bank. 8.2.3 Determinants of Optimal Debt Ratio Determinants of Optimal Debt Ratio ® The preceding analysis highlights some of the determinants of the optimal debt ratio; we can then divide these determinants into firm-specific and macroeconomic factors: • Firm-Specific Factors ® The optimal debt ratios that we compute will vary across firms. There are three firm- specific factors that contribute to these differences: 1. Firm’s tax rate a) in general ® the tax benefits from debt increase as the tax rate goes up b) in relative terms ® firms with higher tax rates will have higher optimal debt ratios than do firms with lower tax rates, other things being equal. It also follows that a firm’s optimal debt ratio will increase as its tax rate increases. - at a 0% tax rate, the optimal debt ratio is zero for all firms ® without the benefits that accrue from taxes, the rationale for using debt disappears - as the tax rate increases, the optimal debt ratios increase for all firms but at different rates ® higher marginal tax rates do make debt more attractive but only to the extent that the firm has the operating income to cover its interest expenses 2. Pretax Returns on the Firm (in Cash Flow Terms) ® The most significant determinant of the optimal debt ratio is a firm’s earnings capacity. In fact, the operating income as a percentage of the market value of the firm (debt plus equity) is usually good indicator of the optimal debt ratio. When this number is high (low), the optimal debt ratio will also be high (low). A firm with higher pretax earnings can sustain much more debt as a proportion of the market value of the firm, because debt payments can be met much more easily from prevailing earnings 3. Variance in Operating Income ® The variance in operating income enters the base case analysis in two ways: a) it plays a role in determining the current beta ® Firms with high (low) variance in operating income tend to have high (low) unlevered betas b) the volatility in operating income can be one of the factors determining bond ratings at different levels of debt ® Ratings drop off much more dramatically for higher variance firms as debt levels are increased. It follows that firms with higher (lower) variance in operating income will have lower (higher) optimal debt ratios. The variance in operating income also plays a role in the constrained analysis, because higher variance firms are much more likely to register significant drops in operating income. Consequently, the decision to increase debt should be made much more cautiously for these firms. • Macroeconomic Factors ® Should macroeconomic conditions affect optimal debt ratios? In purely mechanical terms, the answer is yes. In good economic times, firms will generate higher earnings and be able to service more debt. In recessions, earnings will decline and with it the capacity to service debt. That is why prudent firms borrow based on normalized earnings rather than current earnings. Holding operating income constant, macroeconomic variables can still affect optimal debt ratios. In fact, both the level of risk-free rate and the magnitude of default spreads can affect optimal debt ratios 1. Level of Rates ® as interest rates decline, the conventional wisdom is that debt should become cheaper and more attractive for firms. Though this may seem intuitive, the effect is muted by the fact that lower interest rates also reduce the cost of equity. In fact, changing the risk-free rate has a surprisingly small effect on the optimal debt ratio as long as interest rates move within a normal range. When interest rates exceed normal levels, optimal debt ratios do decline partly because we keep operating income fixed. The higher interest payments at every debt ratio lower bond ratings and affect the capacity of firms to borrow more. 2. Default Spreads ® the default spreads for different ratings classes tend to increase during recessions and decrease during economic booms. Keeping other things constant, as the spreads increase (decrease) optimal debt ratios decrease (increase), for the simple reason that higher spreads penalize firms that borrow more money and have lower ratings. In fact, the default spreads on corporate bonds declined between 2002 and 2007, leading to higher optimal debt ratios for all firms. In 2008, as the economy slowed and the market entered crisis mode, default spreads widened again, leading to lower optimal debt ratios. In 2013, as default spreads return to pre-crisis levels, we are seeing optimal debt ratios also climb back. 8.3 ADJUSTED PRESENT VALUE APPROACH In the adjusted present value (APV) approach, we begin with the value of the firm without debt ® as we add debt to the firm, we consider the net effect on value by considering both the benefits and the costs of borrowing. The value of the levered firm can then be estimated at different levels of the debt, and the debt level that maximizes firm value is the optimal debt ratio • Steps in the APV Approach ® in the APV approach, we assume that the primary benefit of borrowing is a tax benefit and that the most significant cost of borrowing is the added risk of bankruptcy. To estimate the value of the firm with these assumptions, we proceed in three steps: 1. estimating the value of the firm with no leverage ® this can be accomplished by valuing the firm as if it had no debt, by discounting the expected after-tax operating cash flows at the unlevered cost of equity. In the special case where cash flows grow at a constant rate in perpetuity 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚 = 𝐹𝐶𝐹𝐹8/(𝜌: − 𝑔) where FCFF1 is the expected after-tax operating cash flow to the firm in the next period, 𝜌u is the unlevered cost of equity, and g is the expected growth rate. The inputs needed for this are the expected cash flows, growth rates, and the unlevered cost of equity a) we can draw on our earlier analysis and compute the unlevered beta of the firm: 𝛽:0(2.2&2; = _($++"*& 8V(8F')BC This unlevered beta can then be used to arrive at the unlevered cost of equity b) we can take the current market value of the firm as a given and back out the value of the unlevered firm by subtracting out the tax benefits and adding back the expected bankruptcy cost from the existing debt 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚 + 𝑃𝑉 𝑜𝑓 𝑇𝑎𝑥 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐵𝑎𝑛𝑘𝑟𝑢𝑝𝑡𝑒𝑦 𝐶𝑜𝑠𝑡𝑠 2. estimating the present value of the interest tax savings generated by borrowing a given amount of money ® calculation of the expected tax benefit from a given level of debt; this tax benefit is a function of the tax rate of the firm and is discounted at the cost of debt to reflect the riskiness of this cash flow. If the tax savings are viewed as a perpetuity 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑇𝑎𝑥 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 = O/D E/'2×-%<' %" Q2>'×Q2>' -%<' %" Q2>' = 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒 × 𝐷𝑒𝑏𝑡 = 𝑡1𝐷 The tax rate used here is the firm’s marginal tax rate, and it is assumed to stay constant over time. If we anticipate the tax rate changing over time, we can still compute the present value of tax benefits over time, but we cannot use the perpetual growth equation. There are some versions of the APV, where the unlevered cost of equity is used as the discount rate in computing the tax benefits from debt 3. estimate the expected bankruptcy costs as a result of the debt ® evaluate the effect of the given level of debt on the default risk of the firm and on expected bankruptcy costs. In theory, at least, this requires the estimation of the probability of default with the additional debt and the direct and indirect cost of bankruptcy. If 𝜋a is the probability of default after the additional debt and BC is the present value of the bankruptcy cost, the present value of expected bankruptcy cost can be estimated: 𝑃𝑉 𝑜𝑓 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐵𝑎𝑛𝑘𝑟𝑢𝑝𝑡𝑒𝑦 𝐶𝑜𝑠𝑡 = 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝐵𝑢𝑛𝑘𝑟𝑢𝑝𝑡𝑒𝑦 × 𝑃𝑉 𝑜𝑓 𝐵𝑎𝑛𝑘𝑟𝑢𝑝𝑡𝑒𝑦 𝐶𝑜𝑠𝑡 = 𝜋/𝐵𝐶 This step of the APV approach poses the most significant estimation problem, because neither the probability of bankruptcy nor the bankruptcy cost can be estimated directly. There are two ways the probability of bankruptcy can be estimated indirectly: a) to estimate a bond rating, as we did in the cost of capital approach, at each level of debt, and look at past history to estimate the default probabilities for a given rating b) to use a statistical approach, such as a probit, to estimate the probability of default, based on the firm’s observable characteristics, at each level of debt. The bankruptcy cost can be estimated, albeit with considerable error, from studies that have looked at the magnitude of this cost in actual bankruptcies. Studies that have looked at the direct cost of bunlruptcy conclude that they are small relative to firm value. The indirect costs of bankruptcy can be substantial, but the costs vary widely across firms. Shapiro and Titman speculate that the indirect costs could be as large as 25–30% of firm value but provide no direct evidence of the costs. The net effect of adding debt can be calculated by aggregating the costs and the benefits at each level of debt: 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚 = T-TT5 `$FG + 𝑡1𝐷 − 𝜋/𝐵𝐶 We compute the value of the levered firm at different levels of debt. The debt level that maximizes the value of the levered firm is the optimal debt ratio • Benefits and Limitations of the APV Approach 1. advantages a) it separates the effects of debt into different components and allows an analyst to use different discount rates for each component b) we do not assume that the debt ratio stays unchanged forever, which is an implicit assumption in the cost of capital approach c) we have the flexibility to keep the dollar value of debt fixed and to calculate the benefits and costs of the fixed dollar debt • Gradual versus Immediate Change ® Many firms attempt to move to their optimal debt ratios, either gradually over time or immediately. The advantage of an immediate shift to the optimal debt ratio is that the firm immediately receives the benefits of the optimal leverage, which include a lower cost of capital and a higher value. The disadvantage of a sudden change in leverage is that it changes both the way managers make decisions and the environment in which these decisions are made. If the optimal debt ratio has been incorrectly estimated, a sudden change may also increase the risk that the firm has to backtrack and reverse its financing decisions 1. Gradual versus Immediate Change for Underlevered Firms ® for underlevered firms, the decision to increase the debt ratio to the optimal either quickly or gradually is determined by four factors: a) Degree of Confidence in the Optimal Leverage Estimate ® the greater the possible error in the estimate of optimal financial leverage, the more likely the firm will choose to move gradually to the optimal b) Comparability to Industry ® when the optimal debt ratio for a firm differs markedly from that of the industry to which the firm belongs, analysts and ratings agencies might not look favorably on the change, and the firm is much less likely to shift to the optimal quickly c) Likelihood of a Takeover ® factors which may determine the likelihood of a takeover: - empirical studies of the characteristics of target firms in acquisitions have noted that underlevered firms are much more likely to be acquired than are overlevered firms ® the acquisition is financed at least partially by the target firm’s unused debt capacity - firms with excess debt capacity that delay increasing debt run the risk of being taken over ® the greater this risk, the more likely the firm will choose to take on additional debt quickly - the prevalence of antitakeover laws (at the state level) and amendments in the corporate charter designed specifically to prevent hostile acquisitions - the size of the firm ® because raising financing for an is far more difficult for acquiring a $100 billion firm than for a $1 billion firm, larger firms may feel more protected from the threat of hostile takeovers - the extent of holdings by insiders and managers in the company ® insiders and managers with substantial stakes may be able to prevent hostile acquisitions - the stock price performance of the firm ® stockholders in firms where stock prices have dropped significantly over time tend to be much more receptive to the entreaties of hostile acquirers. d) Need for Financial Flexibility ® on occasion, firms may require excess debt capacity to meet unanticipated needs for funds, either to maintain existing projects or to invest in new ones. Firms that need and value this flexibility will be less likely to shift quickly to their optimal debt ratios and use up their excess debt capacity. 2. Gradual versus Immediate Change for Overlevered Firms ® firms that are overlevered also have to decide whether they should shift gradually or immediately to the optimal debt ratios a) the precision of the estimate of the optimal leverage will play a role, with more precise estimates leading to quicker adjustments. So will the comparability to other firms in the sector. When most or all of the firms in a sector become overlevered, firms seem to feel little urgency to reduce their debt ratios, even though they might be struggling to make their payments. In contrast, the pressure to reduce debt is much greater when a firm has a high debt ratio in a sector where most firms have lower debt ratios b) the possibility of default ® too much debt also results in higher interest rates and lower ratings on the debt. Thus, the greater the chance of bankruptcy, the more likely the firm is to move quickly to reduce debt and move to its optimal. How can we assess the probability of default? If firms are rated, their bond ratings offer a noisy but simple measure of default risk. A firm with a below investment grade rating (below BBB) has a significant probability of default. Even if firms are not rated, we can use their synthetic ratings (based on interest coverage ratios) to come to the same conclusion. 9.2.2 Implementing Changes in Financial Mix A firm that decides to change its financing mix has several alternatives: • Ways of Changing the Financing Mix ® there are four basic paths available to a firm that wants to change its financing mix: 1. recapitalization ® to change the current financing mix using new equity to retire debt or new debt to reduce equity; the simplest and often the quickest way to change a firm’s financial mix is to change the way existing investments are financed. Thus, an underlevered firm can increase its debt ratio by borrowing money and buying back stock or replacing equity with debt of equal market value: a) Borrowing money and buying back stock (or paying a large dividend) increases the debt ratio because the borrowing increases the debt, whereas the equity repurchase or dividend payment concurrently reduces the equity; the former accomplishes this by reducing the number of shares outstanding and the latter by lowering the stock price. Many companies have used this approach to increase leverage quickly, largely in response to takeover attempts b) In a debt-for-equity swap, a firm replaces equity with debt of equivalent market value by swapping the two securities. Here again, the simultaneous increase in debt and the decrease in equity causes the debt ratio to increase substantially and quickly. In many cases, firms offer equity investors a combination of cash and debt in lieu of equity. In each of these cases, the firm may be restricted by bond covenants that explicitly prohibit these actions or impose large penalties on the firm. The firm will have to weigh these restrictions against the benefits of the higher leverage and the increased value that flows from it. A recapitalization designed to increase the debt ratio substantially is called a leveraged recapitalization, and many of these recapitalizations are motivated by a desire to prevent a hostile takeover. Though it is far less common, firms that want to lower their debt ratios can adopt a similar strategy. An overlevered firm can: a) attempt to renegotiate debt agreements and try to convince some of the lenders to take an equity stake in the firm in lieu of some or all of their debt in the firm b) try to get lenders to offer more generous terms, including longer maturities and lower interest rates c) issue new equity and use it pay off some of the outstanding debt. The best bargaining chip an over levered firm possesses is the threat of default, because default creates substantial losses for lenders 2. divestiture and use of proceeds ® to sell assets and use the proceeds to pay off debt, if the objective is to reduce the debt ratio, or to buy back stock or pay dividends to reduce equity, if the objective is to increase the debt ratio; firms can also change their debt ratios by selling assets and using the cash they receive from the divestiture to reduce debt or equity a) an underlevered firm can sell some of its assets and use the proceeds to repurchase stock or pay a large dividend. Although this action reduces the equity outstanding at the firm, it will increase the debt ratio of the firm if the firm already has some debt outstanding b) an overlevered firm may choose to sell assets and use the proceeds to retire some of the outstanding debt and reduce its debt ratio. If a firm chooses this path, the choice of which assets to divest is critical. Firms usually want to divest themselves of investments that are earning less than their required returns, but that cannot be the overriding consideration in this decision. The key question is whether there are potential buyers for the asset who are willing to pay fair value or more for it, where the fair value measures how much the asset is worth to the firm, based on its expected cash flows 3. financing new investments ® to use a disproportionately high debt or equity ratio, relative to the firm’s current ratios, to finance new investments over time. The value of the firm increases, but the debt ratio will also change in the process ; firms can also change their debt ratios by financing new investments disproportionately with debt or equity a) if they use a much higher proportion of debt in financing new investments than their current debt ratio, they will increase their debt ratios b) if they use a much higher proportion of equity in financing new investments than their existing equity ratio, they will decrease their debt ratios. There are two key differences between this approach and the previous two: a) because new investments are spread out over time, the debt ratio will adjust gradually over the period b) the process of investing in new assets will increase both the firm value and the dollar debt that goes with any debt ratio 4. changing dividend payout ® to change the proportion of earnings that a firm returns to its stockholders in the form of dividends or by buying back stock, increasing cash returned to stockholders if the intent is to increase the debt ratio and decreasing cash returned if the objective is to reduce the debt ratio; a firm can change its debt ratio over time by changing the proportion of its earnings that it returns to stockholders in each period. Increasing the proportion of earnings paid out in dividends (the dividend payout ratio) or buying back stock each period will increase the debt ratio for two reasons: a) the payment of the dividend or buying back stock will reduce the equity in the firm; holding debt constant, this will increase the debt ratio b) paying out more of the earnings to stockholders increases the need for external financing to fund new investments; if firms fill this need with new debt, the debt ratio will be increased even further. (Decreasing the proportion of earnings returned to stockholders will have the opposite effects.) Firms that choose this route have to recognize that debt ratios will again increase gradually over time. In fact, the value of equity in a firm can be expected to increase each period by the expected price appreciation rate. This rate can be obtained from the cost of equity, after netting out the expected portion of the return that will come from dividends 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑃𝑟𝑖𝑐𝑒 𝐴𝑝𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 • Choosing between the Alternatives ® Given the choice among recapitalizing, divesting, financing new investments, and changing dividend payout, how can a firm choose the right way to change debt ratios? The choice will be determined by three factors: 1. the urgency with which the firm is trying to move to its optimal debt ratio a) recapitalizations and divestitures can be accomplished in a few weeks and can change debt ratios significantly b) financing new investments or changing dividend payout is a long-term strategy to change debt ratios. A firm that needs to change its debt ratio quickly—because it is either under threat of a hostile takeover or faces imminent default—is more likely to use recapitalizations than to finance new investments. 2. the quality of new investments ® we defined a good investment as one that earns a positive NPV and a return greater than its hurdle rate. Firms with good investments will gain more by financing these new investments with new debt if the firm is underlevered or with new equity if the firm is overlevered a) not only will the firm value increase by the value gain we computed, based on the change in the cost of capital, but also the positive NPV of the project will accrue to the firm b) using excess debt capacity or new equity to invest in poor projects is a bad strategy, because the bad projects will destroy value 3. the marketability of existing investments ® two considerations go into marketability: a) whether existing investments earn excess returns ® firms are often more willing to divest themselves of assets that are earning less than the required return b) whether divesting these assets will generate a price high enough to compensate the firm for the cash flows lost by selling them ® ironically, firms often find that their best investments are more likely to meet the second criterion than their worst investments. Although we have presented this choice in stark terms, where firms decide to use one or another of the four alternatives described, a combination of actions may be what is needed to get a firm to its desired debt ratio. This is especially likely when the firm is large and the change in debt ratio is significant. Studies that have looked at firms that have gone through significant increases in debt (in leveraged recapitalization and leveraged buyouts) find, at least on average, that managers are able to cope reasonably well with the demands of debt payments and that operating performance improves after the leverage increase. Note that there are periods when the firm value drops below the debt value, which would suggest that the firm is technically bankrupt in those periods. Firms that weigh this possibility into their financing decision will, therefore, borrow less. Now consider a firm that finances the assets described with debt that matches the assets exactly in terms of cash flows and the debt value rises and falls as the value of the operating assets changes. The next figure provides the firm value, debt value, and equity value for this firm. Because debt value and firm value move together, the possibility of default is eliminated. This, in turn, will allow the firm to carry much more debt, and the added debt should provide tax benefits that make the firm more valuable. Thus, matching liability cash flows to asset cash flows allows firms to have higher optimal debt ratios. 9.3.2 Matching Liabilities to Assets Matching Liabilities to Assets ® The first step every firm should take toward making the right financing choices is to understand how cash flows on its assets vary over time. In this section, we consider five aspects of financing choices and how they are guided by the nature of the cash flows generated by assets: • financing maturity ® the choice among long-term, medium-term, and short-term debt, and this choice will be determined by how long-term asset cash flows are ; firms can issue debt of varying maturities, ranging from very short term to very long term. In making this choice, they should first be guided by how long term the cash flows on their assets are; for instance, firms should not finance assets that generate cash flows over the short term (say, two to three years) using 20-year debt • the choice between fixed and floating rate debt and how this choice will be affected by the way inflation affects the cash flows on the assets financed by the debt 1. Measuring the Cash Flow Lives of Liabilities and Assets a) duration of an asset or liability is a weighted maturity of all the cash flows on that asset or liability, where the weights are based on both the timing and the magnitude of the cash flows. In general, larger and earlier cash flows are weighted more than smaller and later cash flows. A simple measure of duration for a bond, for instance, can be computed as follows: 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝐵𝑜𝑛𝑑 = ;J/;& 8V& = ∑ &×E)$F)*& (57+)& V@×G0(" H02$" (57+)@ &>@ &>5 ∑ E)$F)*& (57+)& VG0(" H02$" (57+)@ &>@ &>5 where N is the maturity of the bond, and t is when each coupon comes due. Holding other factors constant, the duration of a bond will increase with the maturity of the bond and decrease with the coupon rate on the bond. For zero-coupon bonds, the duration is equal to the maturity. This measure of duration can be extended to any asset with expected cash flows. Thus, the duration f a project or asset can be estimated in terms of its operating cash flows: 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑃𝑟𝑜𝑗𝑒𝑐𝑡/𝐴𝑠𝑠𝑒𝑡 = 𝑑𝑃𝑉/𝑑𝑟 = ∑ &×EG& (57+)& V@×I"+J%*02 H02$" (57+)@ &>@ &>5 ∑ EG& (57+)& VI"+J%*02 H02$" (57+)@ &>@ &>5 where CFt is the after-tax operating cash flow on the project in year t and the terminal value is a measure of how much the project is worth at the end of its lifetime of N years. The duration of an asset measures both when, on average, the cash flows on that asset come due and how much the value of the asset changes for a 1% change in interest rates. One limitation of this analysis of duration is that it keeps cash flows fixed while interest rates change. On real projects, however, the cash flows will be adversely affected by the increases in interest rates, and the degree of the effect will vary from business to business—more for cyclical firms (automobiles and housing) and less for noncyclical firms (food processing). Thus, the actual duration of most projects will be higher than the estimates obtained by keeping cash flows constant b) one way of estimating duration without depending on the traditional bond duration measures is to use historical data ® if the duration is, in fact, a measure of how sensitive asset values are to interest rate changes, and a time series of data of asset value and interest rate changes is available, a regression of the former on the latter should yield a measure of duration: 𝛥𝐴𝑠𝑠𝑒𝑡 𝑉𝑎𝑙𝑢𝑒' = 𝑎 + 𝑏 𝛥 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒' In this regression, the coefficient b on interest rate changes should be a measure of the duration of the assets - for firms with publicly traded stocks and bonds, the asset value is the sum of the market values of the enterprise values, obtained by adding net debt to market equity - for a private company or for a public company with a short history, the regression can be run, using changes in operating income as the dependent variable: 𝛥𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒' = 𝑎 + 𝑏 𝛥 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒' , where the coefficient b is a measure of the duration of the assets 2. Duration Matching Strategies ® if the basic idea is to match the duration of a firm’s assets to the duration of its liabilities, it can be accomplished in two ways: a) by matching individual assets and liabilities ® although this approach provides a precise matching of each asset’s characteristics to those of the financing used for it, it has several limitations: - it is expensive to arrange separate financing for each project, given the issuance costs associated with raising funds - ignores interactions and correlations between projects that might make project-specific financing suboptimal for the firm - works only for companies that have very large, independent projects b) by matching the assets of the firm with its collective liabilities ® it is far more straightforward, and often cheaper, to match the duration of a firm’s collective assets to the duration of its collective liabilities. If there is a significant difference, the firm might have to consider changing the duration of its liabilities. It can do so in one of the three ways: - it can finance its new investments with debt of much longer duration - it can repay some of its short-term debt and replace it with long-term debt - it can exchange or swap short-term debt for long-term debt. 3. The Fixed/Floating Rate Choice ® One of the most common choices firms face is whether to make the coupon rate on bonds (and the interest rate on bank loans) a fixed rate or a floating rate, pegged to an index rate (which can be a treasury bill or bond rate or LIBOR). In making this decision, we once again examine the characteristics of the projects being financed with the debt. In particular, we argue that the use of floating rate debt should be more prevalent for firms that are uncertain about the duration of future projects and that have cash flows that move with the inflation rate a) Uncertainty about Future Projects ® The duration of assets and liabilities can be synchronized when assets and projects are well identified, interest rate sensitivity can be estimated, and the appropriate maturity for financing can be ascertained. For some firms, this estimation may be difficult to do. The firm might be changing its business mix by divesting itself of some assets and acquiring new ones or the industry to which the firm belongs might be changing. In such cases, the firm may use short-term or floating rate loans as bridge financing, until it feels more certain about its future investment plans b) Cash Flows and Inflation ® Floating rate loans have interest payments that increase as market interest rates rise and fall as rates fall. If a firm has assets whose earnings increase as interest rates go up and decrease as interest rates go down, it should finance those assets with floating rate loans. The expected inflation rate is a key ingredient determining interest rates. On floating rate loans, this rate will lead to high interest payments in periods when inflation is expected to be high and low interest payments in periods when expected inflation is low. Firms whose earnings increase in periods of high inflation and decrease in periods with low inflation should, therefore, also be more likely to use floating rate loans. A number of factors determine whether a firm’s earnings move with inflation: - the degree of pricing power the firm possesses ® firms that have significant pricing power, either because they produce a unique product or because they are price leaders in their industries, have a much higher chance of being able to increase their earnings as inflation increases. Consequently, these firms should gain more by using floating rate debt. Firms that do not have pricing power are much more likely to be see cash flows decline when inflation is unexpectedly high, and they should be more cautious about using floating rate debt • The Currency Choice ® the currency of in which the debt is to be denominated and link it to the currency in which asset cash flows are generated; many of the points we have made about interest rate risk exposure also apply to currency risk exposure: 1. if any of a firm’s assets or projects generate cash flows denominated in a currency other than its domestic currency, currency risk exists and the firm should consider financing those assets in the foreign currency to reduce the currency risk 2. firms have used more sophisticated variations on traditional bonds to manage foreign exchange risk on investments 3. firms have issued bonds embedded with foreign currency options called indexed currency option notes (ICON), which combine a fixed rate bond with an option on a foreign currency ® this approach is likely to work only for firms that have fairly predictable currency flows, however. For firms that do not have predictable currency flows, currency options or futures may be a cheaper way to manage currency risk, because the currency exposure changes from period to period • The Choice between Straight and Convertible Bonds ® to evaluate when firms should use convertible debt instead of straight rate debt and how this determination should be linked to how much growth there is in asset cash flows; firms vary in terms of how much of their value comes from projects or assets they already own and how much comes from future growth. Firms that derive the bulk of their value from future growth should use different types of financing and design their financing differently than do those that derive most of their value from assets in place. This is so because the current cash flows on high growth firms will generally be low relative to the market value. These cash flows can be expected to grow substantially over time as growth pays off and the firm matures. Accordingly, the financing approach should not create large cash outflows early; it can create substantial cash outflows later, however, reflecting the cash flow patterns of the firm. In addition, the financing should exploit the value that the perception of high growth adds to securities, and it should put relatively few constraints on investment policies 1. straight bonds ® they do not quite fit the bill, because they create large interest payments and do not gain much value from the high growth perceptions; they are likely to include covenants designed to protect the bondholders, which restrict investment and future financing policy 2. convertible bonds ® they create much lower interest payments, impose fewer constraints, and gain value from higher growth perceptions; they might be converted into common stock, but only if the firm is successful. It is, therefore, not uncommon to see young, growth companies use convertible debt (and convertible preferred stock) to fund their operations. In fact, at very young companies, almost all of the value from convertible securities comes from the conversion option (rather than the straight bond or preferred stock portions) • Special Financing Features ® to analyze other features that can be attached to debt and how these features can be used to insulate a firm against specific factors that affect cash flows on assets, either positively or negatively. Every firm is exposed to risk, coming from macroeconomic sources (such as recessions), acts of God (such as the weather), acts of competitors, or technological shifts. If a firm’s exposure to any or all these sources of risk is substantial, it may choose not to borrow, rather than risk default 1. One way firms can partially protect themselves against this default risk is to incorporate special features into bonds or debt, shielding themselves against the most serious risk or risks. Two examples of bonds provide good illustrations: a) some insurance companies have issued bonds where payments can be drastically curtailed if there is a catastrophe that creates substantial liabilities for the companies ® by doing so, they reduce their debt payments in those periods when their overall cash flows are most negative, thereby reducing their likelihood of default b) companies in commodity businesses have issued bonds whose principal and interest payments are tied to the price of the commodity ® because the operating cash flows in these firms are also positively correlated with commodity prices, adding this feature to debt decreases the likelihood of default and allows the firm to use more debt. 2. Market timing, Interest rate illusions and Mismatched Debt ® The argument that we should match the cash flow on debt to the cash flow on assets is based on the premise that managers are not very good at timing markets and/or assessing what types of debt are cheap or expensive. That premise may not be wrong but that does not stop managers from trying to use what they perceive to be “cheap” debt, even if it results in mismatching debt to assets a) playing the term structure ® we presented evidence that managers try to time markets with equity and bond issues, issuing more equity when they feel that their stock is overpriced and less equity when they Trying to describe how we would make financing choices for a firm, we can use two approaches, both should be considered in light of the firm had untapped debt potential that could be used for future projects: • Intuitive Approach ® it begins with an analysis of the characteristics of a typical project and uses it to make recommendations for the firm’s financing • Quantitative Approach 1. it estimates the firm’s sensitivity to changes in a number of macroeconomic variables, using two measures: a) firm value (the market value of debt and equity) b) firm’s operating income 2. Value Sensitivity to Factors: Past Data ® the value of a firm is the obvious choice when it comes to measuring its sensitivity to changes in interest rates, inflation rates, or currency rates, because firm value reflects the effect of these variables on current and future cash flows as well as on discount rates. We begin by collecting past data on enterprise value, operating income, and the macroeconomic variables against which we want to measure its sensitivity. It is possible to choose four broad measures: a) Long-term Treasury bond rate ® because the sensitivity of firm value to changes in interest rates provides a measure of the duration of the projects. It also provides insight into whether the firm should use fixed or floating rate debt; a firm whose operating income increases or decreases with interest rates should consider using floating rate loans b) Real GDP (gross domestic product) ® because the sensitivity of firm value to this variable provides a measure of the cyclicality of the firm c) Exchange rates ® because the sensitivity of firm value to currency movements provides a measure of the exposure to currency rate risk and, thus, helps determine what the currency mix for the debt should be d) Inflation rate ® because the sensitivity of firm value to the inflation rate helps determine whether the interest rate on the debt should be fixed or floating rate debt. Once these data have been collected, we can estimate the sensitivity of firm value to changes in the macroeconomic variables by regressing changes in firm value each year against changes in each of the individual variables. 3. Sensitivity to Changes in Interest Rates ® the duration of a firm’s projects provides useful information for determining the maturity of its debt. Although bond-based duration measures may provide some answers, they will understate the duration of assets or projects if the cash flows on these assets or projects themselves vary with interest rates. Regressing changes in firm value against changes in interest rates over this period 4. Sensitivity to Changes in the Economy (cyclicity) ® one way to answer this question is to measure the sensitivity of firm value to changes in economic growth. Regressing changes in firm value against changes in the real GDP over this period 5. Sensitivity to Changes in the Inflation Rates ® that firms whose values tend to move with inflation should be more likely to issue floating rate debt. Regressing changes in firm value against changes in the inflation rate over this period 6. Sensitivity to Changes in the Dollar ® we can answer the question of how sensitive firm’s value is to changes in currency rates by looking at how the firm’s value changes as a function of changes in currency rates. Regressing changes in firm value against changes in the dollar over this period 7. Cash Flow Sensitivity to Factors: Past Data ® in some cases, it is more reasonable to estimate the sensitivity of operating cash flows directly against changes in interest rates, inflation, and other variables. This is particularly true when we are designing interest payments on debt, because these payments are to be made out of operating income a) regressing changes in operating cash flow against changes in interest rates over this period b) regressing changes in operating cash flow against changes in real GDP over this period c) regressing changes in operating cash flow against changes in inflation over this period d) regressing changes in operating cash flow against changes in the dollar over this period 8. The question of what to do when operating income and firm value have different results can be resolved fairly simply ® for issues relating to the overall design of the debt, the firm value regression should be relied on more; for issues relating to the design of interest payments on the debt, the operating income regression should be used more. Thus, for the duration measure, the regression of firm value on interest rates should generally give a more precise estimate. For the inflation rate sensitivity, because it affects the choice of interest payments (fixed or floating), the operating income regression should be relied on more. 9. Bottom-Up Estimates for Debt Design ® while this type of analysis yields quantitative results, those results should be taken with a grain of salt; they make sense only if the firm has been in its current business for a long time and expects to remain in it for the foreseeable future. In today’s environment, in which firms find their business mixes changing dramatically from period to period as they divest some businesses and acquire new ones, it is unwise to base too many conclusions on a historical analysis. In such cases, we might want to look at the characteristics of the industry in which a firm plans to expand, rather than using past earnings or firm value as a basis for the analysis. Furthermore, the small sample sizes used tend to yield regression estimates that are not statistically significant (as is the case with the duration estimate that we obtained for Disney from the firm value regression) 10. Overall Recommendations ® on the basis of the analyses of firm value and operating income, as well as the sector averages, our recommendations would essentially match those of the intuitive approach, but they would have more depth to because of the additional information we have acquired from the quantitative analysis 11. These conclusions can be used to both design the new debt issues that the firm will be making going forward and to evaluate the existing debt on the firm’s books to see if there is a mismatching of assets and financing in the current firm. 10. DIVIDEND POLICY 10.1 BACKGROUND ON DIVIDEND POLICY In this section, we consider three issues: • how do firms decide how much to pay in dividends, and how do those dividends actually get paid to the stockholders? • two widely used measures of how much a firm pays in dividends, the dividend payout ratio, and the dividend yield • empirical evidence on how companies behave in setting and changing dividends. 10.1.1 The Dividend Process Firms in the United States generally pay dividends every quarter, whereas firms in other countries typically pay dividends on a semi-annual or annual basis • Dividend Payment Time Line ® dividends in publicly traded firms are usually set by the board of directors and paid out to stockholders a few weeks later. There are several key dates between the times the board declares the dividend until the dividend is actually paid 1. dividend declaration date ® the date on which the board of directors declares the dollar dividend that will be paid for that quarter (or period). This date is important because by announcing its intent to increase, decrease, or maintain dividend, the firm conveys information to financial markets. Thus, if the firm changes its dividends, this is the date on which the market reaction to the change is most likely to occur 2. ex-dividend date ® at which time investors must have bought the stock to receive the dividend. Because the dividend is not received by investors buying stock after the ex-dividend date, the stock price will generally fall on that day to reflect that loss. At the close of the business a few days after the ex-dividend date, the company closes its stock transfer books and makes up a list of the shareholders to date on the holder-of- record date. These shareholders will receive the dividends. There should generally be no price effect on this date 3. mailing out the dividend checks on the dividend payment date ® in most cases, the payment date is two to three weeks after the holder-of-record date. Although stockholders may view this as an important day, there should be no price impact on this day either. • Types of Dividends ® there are several ways to classify dividends: 1. dividends can be paid in cash or as additional stock ® stock dividends increase the number of shares outstanding and generally reduce the price per share 2. the dividend can be a regular dividend, which is paid at regular intervals (quarterly, semi-annually, or annually), or a special dividend, which is paid in addition to the regular dividend ® most U.S. firms pay regular dividends every quarter; special dividends are paid at irregular intervals 3. firms sometimes pay dividends that are in excess of the retained earnings they show on their books ® these are called liquidating dividends and are viewed by the Internal Revenue Service as return on capital rather than ordinary income. As a result, they can have different tax consequences for investors • Measures of Dividend Policy ® we generally measure the dividends paid by a firm using one of two measures: 1. dividend yield ® which relates the dividend paid to the price of the stock: 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 = 𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 ∕ 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 The dividend yield is significant because it provides a measure of that component of the total return that comes from dividends, with the balance coming from price appreciation 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝑃𝑟𝑖𝑐𝑒 𝑎𝑝𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 Some investors also use the dividend yield as a measure of risk and as an investment screen, i.e., they invest in stocks with high dividend yields ® studies indicate that stocks with high dividend yields, after adjusting for market performance and risk, earn excess returns 2. dividend payout ratio ® which relates dividends paid to the earnings of the firm. 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 ∕ 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 The payout ratio is used in a number of different settings: a) in valuation as a way of estimating dividends in future periods, because most analysts estimate growth in earnings rather than dividends b) the retention ratio (the proportion of the earnings reinvested in the firm) is useful in estimating future growth in earnings ® firms with high retention ratios (low payout ratios) generally have higher growth rates in earnings than firms with lower retention ratios (higher payout ratios) 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑖𝑜 = 1 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 c) the dividend payout ratio tends to follow the life cycle of the firm, usually starting at zero when the firm is in high growth and gradually increasing as the firm matures and its growth prospects decrease. The payout ratios greater than 100% represent firms that paid out more than their earnings as dividends and also include firms that paid out dividends, even though they reported losses for the year. Finally, we look at how current dividend yields and payout ratios measure up against historical numbers by looking at the average dividend yield and payout ratio for stocks in the S&P 500 from 1960 to 2012. 10.1.2 Empirical Evidence on Dividend Policy We observe several interesting patterns when we look at the dividend policies of firms in the United States in the past fifty years: • dividends tend to follow earnings ® increases in earnings are followed by increases in dividends, and decreases in earnings sometimes by dividend cuts; earnings and dividends are positively correlated over time because dividends are paid out of earnings 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 = T-TTK(8VG) -%<' %" 1/$!'/(FG The existing stockholders will receive a much larger dividend per share, because dividends have been doubled: 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = $8XX #!((!%0 3/(:2 %" <6/&2< %:'<'/0;!0G To estimate the price per share at which the new stock will be issued, note that after the new stock issue of $50 million, the old stockholders in the firm will own only $1,000 million of the total firm value of $1,050 million. 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 𝑓𝑜𝑟 𝑒𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = $1,000 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = 3/(:2 %" '62 "!&# "%& 2D!<'!0G <'%176%(;2&< /"'2& ;!.!;20; $/?#20' 3/(:2 %" <6/&2< %:'<'/0;!0G The price per share is now lower than it was before the dividend increase, but it is exactly offset by the increase in dividends. 𝑉𝑎𝑙𝑢𝑒 𝑎𝑐𝑐𝑟𝑢𝑖𝑛𝑔 𝑡𝑜 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟 = 𝑃𝑟𝑖𝑐𝑒 𝑝𝑟𝑒 𝑠ℎ𝑎𝑟𝑒 + 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 Thus, if the operating cash flows are unaffected by dividend policy, we can show that the firm value will be unaffected by dividend policy and that the average stockholder will be indifferent to dividend policy, because he or she receives the same total value (price + dividends) under any dividend payment • Scenario 2 ® the firm stops paying dividends 1. assume that the firm pays out no dividends and retains the residual $50 million as a cash balance ® the value of the firm to existing stockholders can then be computed as follows: 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 + 𝐶𝑎𝑠ℎ 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 Note that the value per share remains equal no matter how much the firm pays in dividends. When the firm pays less than $50 million in dividends, the cash accrues in the firm and adds to its value ® the increase in the stock price again is offset by the loss of cash flows from dividends. When it pays out more, the price decreases but is exactly offset by the increase in dividends per share. Note, however, that the value per share remains unchanged because we assume that there are no tax differences to investors between receiving dividends and capital gains, that firms can raise new capital with no issuance costs, and that firms do not change their investment policy even when they have excess cash ® these assumptions eliminate the effects on value associated with paying either more in dividends or less. 10.2.3 Implications of Dividend Irrelevance If dividends are irrelevant, firms are spending a great deal of time pondering an issue about which their stockholders are indifferent ® at least two strong implications emerge from this proposition: • stockholders in a firm should be unaffected as its dividend policy changes ® this does not imply that the price per share will be unaffected because larger dividends should result in lower stock prices and more shares outstanding but the total returns generated by stockholders should remain the same • in the long run, there should be no correlation between dividend policy and stock returns. The assumptions needed to arrive at the dividend irrelevance proposition may seem so onerous that many reject it without testing it. That would be a mistake, however, because the argument does contain a valuable message: A firm that has invested in bad projects cannot hope to resurrect its value with stockholders by offering them higher dividends. Conversely, a firm that has a history of making good investments will be forgiven by stockholders, even if it chooses not to pay out what it can afford to in dividends. This may yield some insight into why investors are much more sanguine about cash being accumulated in some companies than in others. 10.3 THE “DIVIDENDS ARE BAD” SCHOOL In the United States, dividends have historically been taxed at much higher rates than capital gains ® based on this tax disadvantage, the second school of thought on dividends argued that dividend payments reduce the returns to stockholders after personal taxes. Stockholders, they posited, would respond by reducing the stock prices of the firms making these payments, relative to firms that do not pay dividends. Consequently, firms would be better off either retaining the money they would have paid out as dividends or repurchasing stock. In 2003, the basis for this argument was largely eliminated when the tax rate on dividends was reduced to match the tax rate on capital gains. 10.3.1 The History of Dividend Taxation The tax treatment of dividends varies widely depending on who receives the dividend ® until 2003 in the United States: • Individual Investors ® were taxed at ordinary tax rates on dividends received while the price appreciation on an investment has been treated as capital gains and taxed at a different and much lower rate 1. history a) 1986 (tax reform act)-2003 ® dividends and capital gains were both taxed at 28%; the tax rate on capital gains was significantly lower than the tax rate on capital gains b) 2003-2012 ® the tax rate on dividends was dropped to 15% to match the tax rate on capital gains, thus nullifying to a large extent the tax disadvantage of dividends c) since 2012 ® the tax rates for both dividends and capital gains increased, they did so in tandem to 20% 2. two points worth making about this chart a) these are the highest marginal tax rates and that most individuals are taxed at lower rates ® some older and poorer investors may pay no taxes on income if it falls below the threshold for taxes b) the capital gains taxes can be higher for some of these individuals than the ordinary tax rate they pay on dividends ® wealthier individuals invested more in stocks than poorer individuals, and it seems fair to conclude that individuals have collectively paid significantly more taxes on the income that they have received in dividends than on capital gains over the past few decades • Institutional Investors ® About two-thirds of all traded equities are held by institutional investors rather than individuals; these institutions include mutual funds, pension funds, and corporations, and dividends get taxed differently in the hands of each 1. corporations ® were sheltered from paying taxes on at least a portion of the dividends they receive 2. pension funds ® were not taxed at all; they are allowed to accumulate both dividends and capital gains without having to pay taxes; there are two reasons for this tax treatment: a) to encourage individuals to save for their retirement and to reward savings b) individuals will be taxed on the pensions they receive from these funds and that taxing pension plans would in effect tax the same income twice 3. mutual funds ® are not directly taxed, but investors in them are taxed for their share of the dividends and capital gains generated by the funds. If high-tax-rate individuals invest in a mutual fund that invests in stocks that pay high dividends, these high dividends will be allocated to the individuals based on their holdings and taxed at their individual tax rates. 10.3.2 Tax Treatment of Dividends in Other Markets Many countries have plans in place to protect investors from the double taxation of dividends ® there are two ways in which they can do this: • corporate tax relief ® to allow corporations to claim a full or partial tax deduction for dividends paid; in some countries, corporations are allowed to claim a partial or full deduction for dividends paid and this brings their treatment into parity with the treatment of the interest paid on debt, which is entitled to a full deduction in most countries 1. why don’t more countries offer tax relief to corporations? There are two factors: a) the presence of foreign investors in the stock who now also share in the tax windfall b) investors in the stock may be tax-exempt or pay no taxes, which effectively reduces the overall taxes paid on dividends to the treasury to zero • individual tax relief ® to give partial or full tax relief to individuals who receive dividends; there are far more countries that offer tax relief to individuals than to corporations. This tax relief can take several forms: 1. tax credit for taxes paid by corporation ® individuals can be allowed to claim the taxes paid by the corporation as a credit when computing their own taxes a) Australia, Finland, Mexico, and New Zealand allow individuals to get a full credit for corporate taxes paid b) Canada, France, the United Kingdom, and Turkey allow for partial tax credits 2. lower tax rate on dividends ® dividends get taxed at a lower rate than other income to reflect the fact that it is paid out of after-tax income. In some countries, the tax rate on dividends is set equal to the capital gains tax rate. In summary, it is far more common for countries to provide tax relief to investors than to corporations. By focusing on individuals, you can direct the tax relief only toward domestic investors and only to those investors who pay taxes in the first place. 10.3.3 Timing of Tax Payments When the 1986 tax reform was signed into law, equalizing tax rates on ordinary income and capital gains: • some believed that all the tax disadvantages of dividends had disappeared • others noted that even with the same tax rates, dividends carried a tax disadvantage because the investor had no choice as to when to report the dividend as income; taxes were due when the firm paid out the dividends • investors retained discretionary power over when to recognize and pay taxes on capital gains, because such taxes were not due until the stock was sold ® this timing option allowed the investor to reduce the tax liability in one of two ways: 1. by taking capital gains in periods of low income or capital losses to offset against the gain, the investor could now reduce the taxes paid 2. deferring a stock sale until an investor’s death could result in tax savings, especially if the investor is not subject to estate taxes. 10.3.4 Assessing Investor Tax Preferences for Dividends The tax rate on dividends can vary widely for different investors—individual, pension fund, mutual fund, or corporation—receiving the dividends and even for the same investor on different investments. It is difficult therefore to look at a company’s investor base and determine their preferences for dividends and capital gains. A simple way to measure the tax disadvantage associated with dividends is to measure the price change on the ex-dividend date and compare it to the actual dividend paid. The stock price on the ex-dividend day should drop to reflect the loss in dividends to those buying the stock after that day. It is not clear, however, whether the price drop will be equal to the dividends if dividends and capital gains are taxed at different rates. To see the relationship between the price drop and the tax rates of the marginal investor: • assume that investors in a firm acquired stock at some point in time at a price P, and that they are approaching an ex-dividend day, in which the dividend is known to be D • assume that each investor in this firm can either sell the stock before the ex-dividend day at a price PB or wait and sell it after the stock goes ex-dividend at a price PA • assume that the tax rate on dividends is to and that the tax rate on capital gains is tcg. The cash flows the investor will receive from selling before the stock goes ex-dividend is 𝐶𝐹* = 𝑃* − (𝑃* − 𝑃)𝑡1G In this case, by selling before the ex-dividend day, the investor receives no dividend. If the sale occurs after the ex-dividend day, the cash flow is: 𝐶𝐹) = 𝑃) − (𝑃) − 𝑃)𝑡1G + 𝐷(1 − 𝑡X) If the cash flow from selling before the ex-dividend day were greater than the cash flow from selling after for all investors, they would all sell before, resulting in a drop in the stock price. Similarly, if the cash flows from selling after the ex-dividend day were greater than the cash flows from selling before for all investors, everyone would sell after, resulting in a price drop after the ex-dividend day. To prevent either scenario, the marginal investors in the stock have to be indifferent between selling before and after the ex-dividend day. This will occur only if the cash flows from selling before are equal to the cash flows from selling after: 𝑃* − (𝑃* − 𝑃)𝑡1G = 𝑃) − (𝑃) − 𝑃)𝑡1G + 𝐷(1 − 𝑡X) This can be simplified to yield the following ex-dividend day equality: 𝑃* − 𝑃) = (1 − 𝑡X)𝐷(1 − 𝑡1G) Thus, a necessary condition for the marginal investor to be indifferent between selling before and after the ex- dividend day is that the price drop on the ex-dividend day must reflect the investor’s tax differential between dividends and capital gains. By turning this equation around, we would argue that by observing a firm’s stock price behavior on the ex-dividend day and relating it to the dividends paid by the firm; we can form some conclusions about the tax disadvantage the firm’s stockholders attach to dividends. In particular: 1. if PB – PA = D ® Marginal investor is between dividends and capital gains 2. if PB – PA < D ® Marginal investor is taxed more heavily on dividends 3. if PB – PA > D ® Marginal investor is taxed more heavily on capital gains. Although there are obvious measurement problems associated with this measure, it does provide some interesting insight into how investors view dividends. The first study of ex-dividend day price behavior by Elton and Gruber in 1970 ® they examined the behavior of stock prices on ex-dividend days for stocks listed on the NYSE between 1966 and 1969. Based on their finding that the price drop was only 78% of the dividends paid, Elton and Gruber concluded that dividends are taxed more heavily than capital gains. They also estimated the price change as a proportion of the dividend paid for firms in different dividend yield classes and reported that price drop is larger, relative to the dividend paid, for firms in the highest dividend yield classes than for firms in lower dividend yield classes. This difference in price drops, they argued, reflected the fact that investors in these firms are in lower tax brackets. Their conclusions were challenged, however, by some who argued justifiably that the investors trading on the stock on ex-dividend days are not the normal investors in the firm; rather, they are short-term, tax-exempt investors interested in capturing the difference between dividends and the price drops. 10.3.5 Implications There is no argument that dividends have historically been treated less favorably than capital gains by the tax authorities in the United States ® the double taxation of dividends, at least at the level of individual investors, should have created a strong disincentive to pay or to increase dividends. Other implications of the tax disadvantage argument include the following: • firms with an investor base composed primarily of individuals typically should have paid lower dividends than do firms with investor bases predominantly made up of tax-exempt institutions • the higher the income level (and hence the tax rates) of the investors holding stock in a firm, the lower the dividend paid out by the firm • as the tax disadvantage associated with dividends increased, the aggregate amount paid in dividends should have decreased. Conversely, if the tax disadvantage associated with dividends decreased, the aggregate amount paid in dividends should have increased. The tax law changes of 2003 changed the terms of this debate, at least for the short term ® by reducing the tax rate on dividends, they made dividends more attractive at least to individual investors than they were prior to the change. We would have expected companies to pay more dividends in response and there is some evidence that companies changed dividend policy in response to the tax law change. high dividends should not have a lower value, because its investors like dividends. This argument assumes that there are enough investors in each dividend clientele to allow firms to be fairly valued, no matter what their dividend policy c) Empirical Evidence on the Clientele Effect ® if there is a strong enough clientele effect, the returns on stocks should not be affected over long periods by the dividend payouts of the underlying firms. If there is a tax disadvantage associated with dividends, the returns on stocks that pay high dividends should be higher than the returns on stocks that pay low dividends to compensate for the tax differences - in their study of the clientele effect, Black and Scholes created twenty-five portfolios of NYSE stocks, classifying firms into five quintiles based on dividend yield, and then subdivided each group into five additional groups based on risk (beta) each year for thirty-five years, from 1931 to 1966 ® when they regressed total returns on these portfolios against the dividend yields, the authors found no statistically significant relationship between them - these findings were contested in a study in 1979 by Litzenberger and Ramaswamy, who used updated dividend yields every month and examined whether the total returns in ex-dividend months were correlated with dividend yields ® they found a strong positive relationship between total returns and dividend yields, supporting the hypothesis that investors are averse to dividends and demand higher returns of high-dividend paying firms. They also estimated that the implied tax differential between capital gains and dividends was approximately 23%. - Miller and Scholes countered by arguing that this finding was contaminated by the stock price effects of dividend increases and decreases - in response, Litzennerger and Ramaswamy removed from the sample all cases in which the dividends were declared and paid in the same month and concluded that the implied tax differential was only 4%, which was not significantly different from zero - in the interest of fairness, we should point out that most studies of the clientele effect have concluded that total returns and dividend yields are positively correlated. Although many of them contend that this is true because the implied tax differential between dividends and capital gains is significantly different from zero, there are alternative explanations for the phenomena. In particular, although one may disagree with Miller and Scholes’s conclusions, their argument—that the higher returns on stocks that pay high dividends might have nothing to do with the tax disadvantages associated with dividends but may instead be a reflection of the price increases associated with unexpected dividend increases—seems reasonable • Dividends Operate as an Information Signal ® changes in dividends allow firms to signal to financial markets how confident they feel about future cash flows; firms that are more confident about their future are therefore more likely to raise dividends; stock prices often increase in response; cutting dividends is viewed by markets as a negative signal about future cash flows, and stock prices often decline in response 1. financial markets examine every action a firm takes for implications for future cash flows and firm value ® when firms announce changes in dividend policy, they are conveying information to markets, whether or not they intend to do so 2. financial markets tend to view announcements made by firms about their future prospects with a great deal of skepticism, because firms routinely make exaggerated claims. At the same time, some firms with good investment prospects are undervalued by markets ® How do such firms convey information credibly to markets? Signaling theory suggests that these firms need to take actions that cannot be easily imitated by firms without good projects a) increasing dividends is viewed as one such action ® by increasing dividends, firms create a cost to themselves, because they commit to paying these dividends in the long run. Their willingness to make this commitment indicates to investors that they believe they have the capacity to generate large, positive cash flows in the long run. This positive signal should therefore lead investors to reevaluate the cash flows and firm values and increase the stock price b) decreasing dividends is a negative signal, largely because firms are reluctant to cut dividends ® when a firm takes this action, markets see it as an indication that this firm is in substantial, long-term financial trouble. Consequently, such actions lead to a drop in stock prices. The empirical evidence concerning price reactions to dividend increases and decreases is consistent, at least on average, with this signaling theory 3. although it is true that firms with good projects may use dividend increases to convey information to financial markets, is it the most efficient way? a) for smaller firms, which have relatively few signals available to them, the answer might be yes b) for larger firms, which have many ways of conveying information to markets, increasing dividends might not be the least expensive or the most effective signal. 4. there is another reason for skepticism ® an equally plausible story can be told about how an increase in dividends sends a negative signal to financial markets. Consider a firm that has never paid dividends in the past but has registered extraordinary growth and high returns on its projects. When this firm first starts paying dividends, its stockholders may consider this an indication that the firm’s projects are neither as plentiful nor as lucrative as they used to be. However, Palepu and Healy found that the initiation of dividends does not signal a decline in earnings growth in a study of 151 firm from 1970 to 1979 5. there is some evidence that markets read less of a story into a dividend change than they used to, perhaps reflecting the growth of other ways to signal good or bad prospects 6. note that the market reactions to both dividend increases and decreases have dropped over time • Dividend Policy Is a Tool fir Changing Financing Mix ® firms can use dividends as a tool for altering their financing mix and moving closer to an optimal debt ratio; dividend policy cannot be analyzed in a vacuum: firms can use dividend policy as a tool to change their debt ratios 1. increasing dividends increases financial leverage over time ® when dividends increase, stockholders sometimes get a bonus in the form of a wealth transfer from lenders to the firm. Lenders would rather have firms accumulate cash than pay it out as dividends. The payment of dividends takes cash out of the firm, and this cash could have been used to cover outstanding interest or principal payments. Not surprisingly, bond prices decline on the announcement of large increases in dividends. It is equity investors who gain from the loss in market value faced by bondholders. Bondholders, of course, try to protect themselves against this loss by restricting how much firms can pay out in dividends 2. decreasing dividends reduces leverage • the commitment to pay dividends can help reduce the conflicts between stockholders and managers by reducing the cash flows available to managers. 10.5 MANAGERIAL INTERESTS AND DIVIDEND POLICY We have considered dividend policy almost entirely from the perspective of equity investors in the firm. In reality, though, managers set dividend policy, and it should come as no surprise that there may be a potential for a conflict of interests between stockholders and managers. 10.5.1 The Source of the Conflict When examining debt policy, we noted that one reason for taking on more debt was to induce managers to be more disciplined in their project choices. Implicit in this free cash flow argument is the assumption that accumulated cash, if left to the discretion of the managers of the firm, would be wasted on poor projects. If this is true, we can argue that forcing a firm to make a commitment to pay dividends provides an alternative way of forcing managers to be disciplined in project choice by reducing the cash that is available for discretionary uses. If this is the reason stockholders want managers to commit to paying larger dividends, firms in which there is a clear separation between ownership and management should pay larger dividends than should firms with substantial insider ownership and involvement in managerial decisions What Do Managers Believe about Dividend Policy? ® Given the pros and cons for paying dividends and the lack of a consensus on the effect of dividends on value, it is worth considering what managers factor in when they make dividend decisions • Baker, Farrely, and Edelman (1985) surveyed managers on their views on dividend policy and reported the level of agreement with a series of statements. It is quite clear from this survey that, rightly or wrongly, managers believe that their dividend payout ratios affect firm value and operate as signals of future prospects. They also operate under the presumption that investors choose firms with dividend policies that match their preferences and that management should be responsive to their needs • In an updated and comprehensive survey of dividend policy published in 2004, Brav, Graham, Harvey, and Michaely conclude that management’s focus is not on the level of dividends but on changes in these dividends. Indicating a shift from views in prior studies, many managers in this survey saw little gain from increasing dividends, even in response to higher earnings and preferred stock buybacks instead. In fact, many managers in companies that paid dividends regret the level of dividends paid by their firms, indicating that they would have set the dividend at a much lower level if they had the choice. In contrast to the survey quoted in the last paragraph, managers also rejected the idea that dividends operate as useful financial signals. From the survey, the authors conclude that the rules of the game for dividends are the following: do not cut dividends, have a dividend policy similar to your peer group, preserve a good credit rating, maintain flexibility, and do not take actions that reduce earnings per share. 11. ANALYZING CASH RETURNED TO STOCKHOLDERS 11.1 CASH RETURNED TO STOCKHOLDERS We considered the decision about how much to pay in dividends and three schools of thought about whether dividend policy affected firm value. Until the middle of the 1980s, dividends remained the primary mechanism for firms to return cash to stockholders. Starting from that period, we have seen firms increasingly turn to buying back their own stock, using either cash on hand or borrowed money, as a mechanism for returning cash to their stockholders. 11.1.1 The Effects of Buying Back Stock The effect of doing a stock buyback on the firm: • the stock buyback requires cash, just as a dividend would, and, thus, has the same effect on the assets of the firm—a reduction in the cash balance • just as a dividend reduces the book value of the equity in the firm, a stock buyback reduces the book value of equity ® both a dividend payment and a stock buyback reduce the overall market value of equity in the firm, but the way they affect the market value is different: 1. the dividend reduces the market price on the ex-dividend day and does not change the number of shares outstanding 2. a stock buyback reduces the number of shares outstanding and is often accompanied by a stock price increase. • unlike a dividend, which returns cash to all stockholders in a firm, a stock buyback returns cash selectively to those stockholders who choose to sell their stock to the firm ® the remaining stockholders get no cash; they gain indirectly from the stock buyback if the stock price increases. The process of repurchasing equity will depend largely on whether the firm intends to repurchase stock in the open market at the prevailing market price or to make a more formal tender offer for its shares ® there are three widely used approaches to buying back equity: • repurchase tender offers ® in a repurchase tender offer, a firm specifies a price at which it will buy back shares, the number of shares it intends to repurchase, and the period of time for which it will keep the offer open and invites stockholders to submit their shares for the repurchase. In many cases, firms retain the flexibility to withdraw the offer if an insufficient number of shares is submitted or to extend the offer beyond the originally specified time period. This approach is used primarily for large equity repurchases • open market repurchases ® in the case of open market repurchases, firms buy shares in the market at the prevailing market price. Although firms do not have to disclose publicly their intent to buy back shares in the market, they do have to comply with SEC requirements to prevent price manipulation or insider trading. Finally, open market purchases can be spread out over much longer time periods than tender offers and are more widely used for smaller repurchases. In terms of flexibility, an open market repurchase affords the firm much more freedom in deciding when to buy back shares and how many shares to repurchase • privately negotiated repurchases ® in privately negotiated repurchases, firms buy back shares from a large stockholder in the company at a negotiated price. This method is not as widely used as the first two and may be used by managers or owners as a way of consolidating control and eliminating a troublesome stockholder. 11.1.2 The Magnitude of Stock Buybacks In recent decade, more firms have used equity repurchases as an alternative to paying dividends. This shift has been much less dramatic outside the United States for a number of reasons: • until 2003, dividends in the United States faced a much higher tax burden, relative to capital gains, than dividends paid in other countries ® many European countries, for instance, allow investors to claim a tax credit on dividends to compensate for taxes paid by the firms paying them. Stock buybacks, therefore, provided a much greater tax benefit to investors in the United States than they did to investors outside the United States by shifting income from dividends to capital gains • stock buybacks were prohibited or tightly constrained in many countries, at least until very recently • a strong reason for the increase in stock buybacks in the United States was pressure from stockholders on managers to pay out idle cash ® this pressure was far less in the weaker corporate governance systems that exist outside the United States. 11.1.3 Reasons for Stock Buybacks Firms that want to return substantial amounts of cash to their stockholders can either pay large special dividends or buy back stock. There are four advantages to the firm in using stock buybacks as an alternative to dividend payments: • unlike regular dividends ® which typically commit the firm to continue payment in future periods, equity repurchases are one-time returns of cash. Consequently, firms with excess cash that are uncertain about their ability to continue generating these cash flows in future periods should repurchase stocks rather than pay dividends (They could also choose to pay special dividends because these do not commit the firm to making similar payments in the future) • the decision to repurchase stock affords a firm much more flexibility to reverse itself and spread the repurchases over a longer period than does a decision to pay an equivalent special dividend ® there is substantial evidence that many firms that announce ambitious stock repurchases do reverse themselves and do not carry the plans through to completion • equity repurchases may provide a way of increasing insider control in firms because they reduce the number of shares outstanding ® if the insiders do not tender their shares back, they will end up holding a larger proportion of the firm and, consequently, having a greater control • equity repurchases may provide firms with a way of supporting their stock prices when the stock is under duress. There are two potential benefits that stockholders might perceive in stock buybacks: 𝐹𝐶𝐹𝐸Y% 02' ;2>' = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − (𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) − 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 • equity investors also have to consider the effect of changes in the levels of debt on their cash flows ® firms can fund some or a significant portion of their reinvestment needs from new debt, generating cash inflows, and repaying the principal on existing debt represents cash outflows. Again, netting the repayment of old debt against the new debt issues provides a measure of the cash flow effects of changes in debt. Allowing for the cash flow effects of net capital expenditures, changes in working capital, and net changes in debt on equity investors, we get a measure of FCFE that is after actual net debt payments: 𝐹𝐶𝐹𝐸)"'2& 02' ;2>' = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − (𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) − 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + (𝑁𝑒𝑤 𝐷𝑒𝑏𝑡 𝐼𝑠𝑠𝑢𝑒𝑑 − 𝐷𝑒𝑏𝑡 𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠) • because firms may choose to add substantially to debt or repay large portions of debt in any given year, causing significant volatility, there is a third version of the FCFE that normalizes the net debt cash flow, by assuming that the reinvestment (in both net capital expenditure and noncash working capital) is funded at a target or standardized debt ratio (𝛿): 𝐹𝐶𝐹𝐸Y%&#/(!42; ;2>' &/'!% = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − (𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙)(1 − 𝛿) Note that the net debt payment item is eliminated because debt repayments are financed with new debt issues to keep the debt ratio fixed ® if the target or optimal debt ratio of the firm is used to forecast the FCFE that will be available in future periods, it is particularly useful to assume that a specified proportion of net capital expenditures and working capital needs will be financed with debt. Alternatively, in examining past periods, we can use the firm’s average or target debt ratio over the period to arrive at approximate free cash flows to equity • Estimating the FCFE at a Financial Service Firm ® estimating FCFE is straightforward for most manufacturing firms because the net capital expenditures, noncash working capital needs, and debt ratio can be obtained from the financial statements. In contrast, the estimation of FCFE is difficult for financial service firms for several reasons: 1. estimating net capital expenditures and noncash working capital for a bank or insurance company is difficult because most of the assets and liabilities are in the form of financial claims 2. it is difficult to define debt for financial service firms, again due to the complexity of their balance sheets. To estimate the FCFE for a bank, we redefine reinvestment as investment in regulatory capital. After all, a financial service firm can grow its business only to the extent that it has the book value of equity to back up that growth and maintain regulatory capital ratios (including any safety buffers that it may have built in). Because any dividends paid deplete equity capital and retained earnings increase that capital, the FCFE for a financial service firm can be written as follows: 𝐹𝐶𝐹𝐸*/07 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑅𝑒𝑔𝑢𝑙𝑎𝑡𝑜𝑟𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐵𝑎𝑠𝑒(𝐵𝑜𝑜𝑘 𝐸𝑞𝑢𝑖𝑡𝑦) This computation obviously becomes more complex if a firm is involved in multiple businesses, with different regulatory capital requirements on each ® to estimate FCFE, we have to estimate growth and capital requirements in each business separately Putting together the pieces, the FCFE (and potential dividends) at a financial service firm will be a function of the following: 1. Growth in asset base ® because the regulatory capital is tied to the size of the asset base, the higher the growth rate in the asset base, the greater will be the investment in regulatory capital; holding all else constant, higher-growth banks and financial service firms should have lower FCFE and dividends than more mature firms 2. Desired capital ratio ® the reinvestment in regulatory capital, for a given growth rate in the asset base, will depend on the equity capital ratio that the firm wants to maintain on that asset base. While regulatory requirements play a key role in determining this ratio, it will also depend on the safety buffer the firm desires to build into its capital. Put more simply, conservative financial service firms will have higher target capital ratios and reinvest more than more aggressive firms, for a given growth rate, leading to lower FCFE for the former 3. Profitability ® ultimately, dividends have to be paid out of net income. Other things remaining equal, the more profits that a firm can generate on a given asset and book equity base, the more it will be able to generate in FCFE. The return on equity, which scales profits to book equity capital, therefore, becomes a key factor in how much a firm can generate in FCFE. Firm that generates higher returns on equity, for a given growth rate and desired capital ratio, will have more cash available to pay out in dividends or to buy back stock. 𝐹𝐶𝐹𝐸(𝑤𝑖𝑡ℎ 𝑛𝑜 𝑑𝑒𝑏𝑡) = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐹𝐶𝐹𝐸(𝑤𝑖𝑡ℎ 𝑎𝑐𝑡𝑢𝑎𝑙 𝑑𝑒𝑏𝑡 𝑖𝑠𝑠𝑢𝑒𝑠) = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + (𝑁𝑒𝑤 𝐷𝑒𝑏𝑡 𝑅𝑎𝑖𝑠𝑒𝑑 − 𝐷𝑒𝑏𝑡 𝑅𝑒𝑝𝑎𝑖𝑑) 𝐹𝐶𝐹𝐸(𝑤𝑖𝑡ℎ 𝑛𝑜𝑟𝑚𝑎𝑙𝑖𝑧𝑒𝑑 𝑑𝑒𝑏𝑡 𝑖𝑠𝑠𝑢𝑒𝑠) = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − (𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙) × (1 − 𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜) • Measuring the Payout Ratio ® the conventional measure of dividend policy—the dividend payout ratio—gives us the value of dividends as a proportion of earnings. In contrast, our approach measures the total cash returned to stockholders as a proportion of FCFE: 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜 = Q!.!;20;< B/&0!0G< 𝐶𝑎𝑠ℎ 𝑡𝑜 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑡𝑜 𝐹𝐶𝐹𝐸 𝑅𝑎𝑡𝑖𝑜 = Q!.!;20;<VBC:!'? E2$:&16/<2< T-TB The ratio of cash returned to stockholders to FCFE shows how much of the cash available to be paid out to stockholders is actually returned to them in the form of dividends and stock buybacks: 1. if this ratio over time is equal or close to 100%, the firm is paying out all that it can to its stockholders 2. if it is significantly less than 100%, the firm is paying out less than it can afford and is using the difference to increase its cash balance or to invest in marketable securities 3. if it is significantly over 100%, the firm is paying out more than it can afford and is either drawing on an existing cash balance or issuing new securities (stocks or bonds) • Why Firms May Not Pay Out What Is Available ® for several reasons, firms often pay out less to stockholders, in the form of dividends and stock buybacks, than they have available in free cash flows to equity; the reasons vary from firm to firm: 1. the managers of a firm may gain by retaining cash rather than paying it out as a dividend ® the desire for empire building makes increasing the size of the firm an objective on its own. Alternatively, management may feel the need to build up a cash cushion to tide them over periods when earnings may dip; in such periods, the cash cushion may help buffer the earnings drop and allow managers to remain in control 2. the firm may be unsure about its future financing needs and may choose to retain some cash to take on unexpected investments or meet unanticipated needs 3. the firm may have volatile earnings and may retain cash to help smooth out dividends over time 4. bondholders may impose restrictions on cash payments to stockholders, which may prevent the firm from returning available cash flows to its stockholders. At the other end of the spectrum, there are firms that pay out more cash than they generate in FCFE though this is a less common phenomenon ® there are several possible reasons: 1. when earnings are volatile and swing from period to period, firms may choose to pay more than their FCFE in down periods and hope to make up for it when earnings recover 2. firms that have historically paid high dividends often are under pressure to maintain those dividends even when earnings drop, for fear of sending a bad signal to the market 3. firms that are underlevered can use a policy of returning more cash to their stockholders as a way of reducing equity and increasing debt ratios • Evidence on Dividends and FCFE ® we can observe the tendency of firms to pay out less to stockholders than they have available in FCFE by examining cash returned to stockholders paid as a percentage of FCFE. Of the roughly 35,000 firms listed globally, about 36% had negative free cash flows to equity and paid out no dividends and bought back no stock, a completely defensible position. About 15% of firms globally had negative free cash flows to equity and returned cash to investors, either in dividends or buybacks, a more tenuous position, though some of these firms may have expect cash flows to improve in the future. We would bunch these firms with the roughly 4% of firms globally that had positive cash flows to equity but returned more than that cash flow to stockholders. About 30% of firms had positive cash flows to equity and chose not to return any cash to investors and accumulated cash, much like just over 10% of the sample that had cash flows to equity and returned less than that amount to stockholders. This last group of firms are cash accumulators. Looking across the regions, Australia, New Zealand, and Canada have the higher proportion of negative cash flow/no cash return companies (almost 70%) in the world, whereas emerging markets have the smallest proportion (about 24%). At the other end of the spectrum, Japan and the United States have the highest proportion of cash accumulating companies, with positive cash flow to equity, returning less or none of the cash to their investors. 11.2.2 Assessing Project Quality We have to consider how good existing and new investments in the firm are; the alternative to returning cash to stockholders is reinvestment • a firm’s investment opportunities influence its dividend policy ® other things remaining equal, a firm with better projects typically has more flexibility in setting dividend policy and defending it against stockholder pressure for higher dividends • how do we define a good project? ® from our earlier assessment of investment decisions, a good project is one that earns at least the hurdle rate, which is the cost of equity if cash flows are estimated on an equity basis or the cost of capital if cash flows are measured on a pre-debt basis 1. we could estimate the expected cash flows on every project available to the firm and calculate the internal rates of return (IRR) or net present value (NPV) of each project to evaluate project quality ® there are several practical problems with this: a) we have to be able to obtain the detailed cash flow estimates and hurdle rates for all available projects, which can be daunting if the firm has dozens or even hundreds of projects b) even if these cash flows are available for existing projects, they will not be available for future projects 2. as an alternative approach to measuring project quality, we can use one or more of the measures we developed to evaluate a firm’s current project portfolio: a) accounting return differentials, where we compare the accounting return on equity to the cost of equity and the accounting return on capital to the cost of capital b) economic value added (EVA), which measures the excess return earned on capital invested in existing investments and can be computed on either an equity or a capital basis 3. using the past project returns as a measure of future project quality can result in errors if a firm is making a transition from one stage in its growth cycle to the next or if it is in the process of restructuring ® in such situations, it is entirely possible that the expected returns on new projects will differ from past project returns. Consequently, it may be worthwhile scrutinizing past returns for trends that may carry over into the future. The average return on equity or capital for a firm will not reveal these trends very well because they are slow to reflect the effects of new projects, especially for large firms. An alternative accounting return measure, which better captures year-to-year shifts, is the marginal return on equity or capital, which is defined as follows (OI is operating income): 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦' = Y2' N01%#2&FY2' N01%#2&?5 *3 %" BC:!'?&?5F*3 %" BC:!'?&?L 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐶𝑎𝑝𝑖𝑡𝑎𝑙' = )"'2&'/D eN&F)"'2&'/D eN&?5 *3 %" -/$!'/(&?5F*3 %" -/$!'/(&?L Although the marginal return on equity (capital) and the average return on equity (capital) will move in the same direction, the marginal returns typically change much more than do the average returns, the difference being a function of the size of the firm ® these marginal returns can be used to compute the quality of the new projects 4. the alternative to using accounting returns to measure the quality of a firm’s projects is to look at how well or badly a firm’s stock has done in financial markets ® the risk-adjusted excess return that we estimated becomes a measure of whether a stock has under- or outperformed the market; a positive excess return would then be viewed as an indication that a firm has done better than expected, whereas a negative excess return would indicate that a firm has done worse than anticipated 5. accounting income and stock returns may vary year to year, not only because of changes in project quality but also because of fluctuations in the business cycles and interest rates ® consequently, the comparisons between returns and hurdle rates should be made over long enough periods, say, 5–10 years, to average out these other effects. • Dealing with Accounting Returns ® accounting rates of return, such as return on equity and capital, are subject to abuse and manipulation. For instance, decisions on how to account for acquisitions (purchase or pooling), choice of depreciation methods (accelerated versus straight line), and whether to expense or capitalize an item (R&D) can all affect reported income and book value. In addition, in any specific year, the return on equity and capital can be biased upward or downward depending on whether the firm had an unusually good or bad year. To estimate a fairer measure of returns on existing projects, we recommend the following: 1. normalize the income before computing returns on equity or capital 2. back out cosmetic earnings effects caused by accounting decisions, such as the one on pooling versus purchase 3. if there are operating expenses designed to create future growth, rather than current income, capitalize those expenses and treat them as part of book value while computing operating income before those expenses 11.2.3 Evaluating Dividend Policy Based on the cash payout and project quality, we consider whether firms should be accumulating more cash or less; once we have measured a firm’s capacity to pay dividends and assessed its project quality, we can decide whether the firm should continue its existing policy of returning cash to stockholders, return more cash, or return less • the assessment will depend on how much of the FCFE is returned to stockholders each period and how good the firm’s project opportunities are ® there are four possible scenarios: 1. a firm has good projects and is paying out more (in dividends and stock buybacks) than its FCFE ® in this case, the firm is losing value in two ways: a) by paying too much in dividends, it creates a cash shortfall that has to be met by issuing more securities b) the cash shortfall often creates capital rationing constraints; as a result, the firm may reject good projects it, otherwise, would have taken 2. a firm has good projects and is paying out less than its FCFE as a dividend ® although it will accumulate cash as a consequence, this firm can legitimately argue that it will have good projects in the future in which it can invest the cash, though investors may wonder why it did not take the projects in the current period 8. Management Responses ® managers in firms that have posted stellar records have a much easier time convincing stockholders of the desirability of withholding cash rather than paying it out. The most convincing argument for retaining funds is that the cash will be used productively in the future and will earn excess returns for the stockholders. Not all stockholders will agree with this view, especially if they feel that future projects will be less attractive than past projects, which might occur if the industry in which the firm operates is maturing 9. Poor Projects and High Payout ® in many ways, the most troublesome combination of circumstances occurs when firms pay out much more in dividends than they can afford and, at the same time, earn disappointing returns on their projects; these firms have problems with both their investment and their dividend policies, and the latter cannot be solved adequately without addressing the former 10. Consequences of High Payout ® when a firm pays out more in dividends than it has available in FCFE, it is creating a cash deficit that has to be funded by: a) drawing on the firm’s cash balance ® if the firm uses its cash reserves, it will reduce equity and raise its debt ratio b) issuing stock to cover the shortfall ® if it issues new equity, it has to cover the ensuing issuance cost c) borrowing money to fund its dividends ® the firm increases its debt while reducing equity and increasing its debt ratio; because the FCFE is after capital expenditures, this firm’s real problem is not that it pays out too much in dividends but that it invests too heavily in bad projects. Cutting back on these projects would, therefore, increase the FCFE and might eliminate the cash shortfall created by paying dividends 11. Stockholder Reaction ® the stockholders of a firm that pays more in dividends than it has available in FCFE face a dilemma: a) they want the firm to reduce its dividends to eliminate the need for additional borrowing or equity issues each year b) the management’s record in picking projects does not evoke much trust that the firm is using funds wisely, and it is likely that the funds saved by not paying the dividends will be used on other poor projects c) it is, therefore, entirely possible, especially if the firm is underleveraged to begin with, that the stockholders will not push for lower dividends but will try to convince managers to improve project choice instead d) it is also possible that they will encourage the firm to eliminate enough poor projects that the FCFE covers the expected dividend payment 12. Management Responses a) managers of firms with poor projects and dividends that exceed FCFE may not think that they have investment problems rather than dividend problems b) they may also disagree that the most efficient way of dealing with these problems is to eliminate some of the capital expenditures c) in general, their views will be the same as managers who have a poor investment track record d) they will claim the period used to analyze project returns was not representative, it was an industry- wide problem that will pass, or the projects have long gestation periods e) it is unlikely that these managers will convince the stockholders of their good intentions on future projects ® consequently, there will be a strong push toward cutbacks in capital expenditures, especially if the firm is borrowing money to finance the dividends and does not have much excess debt capacity 13. Good Projects and High Payout ® the costs of trying to maintain unsustainable dividends are most evident in firms that have a selection of good projects to choose from; the cash that is paid out as dividends could well have been used to invest in some of these projects, leading to a much higher return for stockholders and higher stock prices for the firm 14. Consequences of High Payout a) when a firm pays out more in dividends than it has available in FCFE, it creates a cash shortfall b) if this firm also has good projects available but cannot invest in them because of capital rationing constraints, the firm is paying a hefty price for its dividend policy c) even if the projects are passed up for other reasons, the cash this firm is paying out as dividends would earn much better returns if left to accumulate in the firm d) dividend payments also create a cash deficit that now has to be met by issuing new securities ® issuing new stock carries a potentially large issuance cost, which reduces firm value e) if the firm issues new debt, it might become overleveraged, and this may reduce value 15. Stockholder Reaction ® the best course of action for stockholders is to insist that the firm pay out less in dividends and invest in better projects. If the firm has paid high dividends for an extended period of time and has acquired stockholders who value high dividends even more than they value the firm’s long-term health, reducing dividends may be difficult. Even so, stockholders may be much more amenable to cutting dividends and reinvesting in the firm, if the firm has a ready supply of good projects at hand 16. Management Responses ® the managers of firms that have good projects while paying out too much in dividends have to figure out a way to cut dividends while differentiating themselves from those firms that are cutting dividends due to declining earnings. The initial suspicion with which markets view dividend cuts can be overcome (at least partially) by providing markets with information about project quality at the time of the dividend cut. If the dividends have been paid for a long time, however, the firm may have stockholders who like the high dividends and may not particularly be interested in the projects that the firm has available. If this is the case, the initial reaction to the dividend cut, no matter how carefully packaged, will be negative. However, as disgruntled stockholders sell their holdings, the firm will acquire new stockholders who may be more willing to accept the lower dividend and higher investment policy 17. In Summary ® looking across the four scenarios, it is quite clear that investor assessments of dividend policy and reactions to cash accumulation cannot be separated from evaluations of investment policy. Firms are judged based on their track records, and investors are more likely to trust successful firms with their cash than firms that have a history of poor investments and bad management 11.2.4 Interaction between Dividend policy and Financing Policy We look at the relationship between dividend policy and debt policy; the analysis of dividend policy is further enriched—and complicated—if we bring in the firm’s financing decisions as well; we noted that one of the ways a firm can increase leverage over time is by increasing dividends or repurchasing stock; at the same time, it can decrease leverage by cutting or not paying dividends. Thus, we cannot decide how much a firm should pay in dividends without determining whether it is under- or overlevered and whether or not it intends to close this leverage gap: 1. an underlevered firm may be able to pay more than its FCFE as dividend and may do so intentionally to increase its debt ratio; for instance, an underlevered firm with poor projects and a cash flow surplus has an added incentive to raise dividends and reevaluate investment policy because it will be able to increase its leverage by doing so; in some cases, however, the imperatives of moving to an optimal debt ratio may act as a barrier to carrying out changes in dividend policy 2. an overlevered firm, on the other hand, may have to pay less than its FCFE as dividends because of its desire to reduce leverage; in some of the scenarios already described, leverage can be used to strengthen the suggested recommendations; an overlevered firm with poor projects and a cash flow surplus may find the cash better spent reducing debt rather than paying out dividends. 11.3 A COMPARABLE-FIRM APPROACH TO ANALYZING DIVIDEND POLICY So far, we have examined the dividend policy of a firm by looking at its cash flows and the quality of its investments. There are managers who believe that their dividend policies are judged relative to those of their competitors ® this comparable-firm approach to analyzing dividend policy is often used narrowly, by looking at only firms that are in the same industry group or sector. As we will illustrate, it can be used more broadly, by looking at the determinants of dividend policy across all firms in the market • Using Firms in the Industry ® in the simplest form of this approach, a firm’s dividend yield and payout are compared to those of firms in its industry and accordingly judged to be adequate, excessive, or inadequate. Although comparing a firm to comparable firms on dividend yield and payout may have some intuitive appeal, it can be misleading: 1. it assumes that all firms within the same industry group have the same reinvestment needs ® these assumptions may not be true if firms are in different stages of the life cycle 2. even if the firms are at the same stage in their life cycles, the entire industry may have a dividend policy that is unsustainable or suboptimal 3. it does not consider stock buybacks as an alternative to dividends ® this third criticism can be mitigated when the approach is extended to compare cash returned to stockholders, rather than just dividends. Both the comparisons in this section (to the broad industry average and to a narrower and more detailed subset) should draw attention to the dangers of basing dividend policy based on comparable firms are clear. The “right” amount to pay in dividends will depend heavily on what we define “comparable” to be. If managers are allowed to pick their peer group, it is easy to justify even the most irrational dividend policy • Using the Market ® the alternative to using only comparable firms in the same industry is to study the entire population of firms and try to estimate the variables that cause differences in dividend payout across firms. We outlined some of the determinants of dividend policy and we could try to arrive at more specific measures of each of these determinants. For istance: 1. growth opportunities ® firms with greater growth opportunities should pay out less in dividends than firms without these opportunities; consequently, dividend payout ratios (yields) and expected growth rates in earnings should be negatively correlated with each other 2. risk ® companies that are riskier should be less willing to pay high dividends, partly because their earnings are more volatile 3. financial leverage ® firms with high debt ratios should pay lower dividends because they have already pre- committed their cash flows to make debt payments. Therefore, dividend payout ratios and debt ratios should be negatively correlated with each other. Because there are multiple measures that can be used for each of these variables, we chose specific proxies— analyst estimates of growth in earnings per share over the next five years for growth opportunities (EGR), debt as a percentage of market value of capital (DCAP), and the beta (BETA) as a measure of equity risk. Using data from 2013, we regressed dividend yields and payout ratios against all of these variables and arrived at the following regression equations: 𝑃𝑌𝑇 = 𝑎 − 𝑏(𝐵𝐸𝑇𝐴) − 𝑐(𝐸𝐺𝑅) + 𝑑(𝐷𝐶𝐴𝑃) with an 𝑅+ = 20% 𝑌𝐿𝐷 = 𝑥 − 𝑦(𝐵𝐸𝑇𝐴) − 𝑧(𝐸𝐺𝑅) + 𝑣(𝐷𝐶𝐴𝑃) with an 𝑅+ = 26% The regressions explain about 26% of the differences in dividend yields and 20% of the differences in payout ratios across firms in the United States. The two strongest factors are earnings growth and equity risk, with higher-growth, higher-risk firms paying out less of their earnings as dividends and having lower dividend yields. In addition, firms with higher debt ratios tend to pay out more in dividends, partly because they can afford to. 11.4 MANAGING CHANGES IN DIVIDEND POLICY We noted the tendency on the part of investors to buy stocks with dividend policies that meet their specific needs. Thus, at least before 2003, investors who wanted high current cash flows and did not care much about the tax consequences migrated to firms that paid high dividends; those who wanted price appreciation and were concerned about the tax differential held stock in firms that paid low or no dividends • one consequence of this clientele effect is that changes in dividends, even if entirely justified by the cash flows, may not be well received by stockholders ® in particular, a firm with high dividends that cuts them drastically may find itself facing unhappy stockholders • at the other extreme, a firm with a history of not paying dividends that suddenly institutes a large dividend may also find that its stockholders are not pleased. Is there a way in which firms can announce changes in dividend policy that minimizes the negative fallout that is likely to occur? In this section, we examine dividend changes and the market reaction to them and draw broader lessons for all firms that may plan to make such changes. 11.4.1 Empirical Evidence Firms may cut dividends for several reasons; some clearly have negative implications for future cash flows and the current value of the firm, whereas others have more positive implications. In particular: • the value of firms that cut dividends because of poor earnings and cash flows should drop, whereas the value of firms that cut dividends because of a dramatic improvement in project choice should increase • at the same time, financial markets tend to be skeptical of the latter claims, especially if the firm making the claims reports lower earnings and has a history of poor project returns. Woolridge and Ghosh looked at 408 firms that cut dividends and the actions taken or information provided by these firms in conjunction with the dividend cuts ® they examined three groups of companies: • the first group announced an earnings decline or loss with the dividend cut • the second had made a prior announcement of earnings decline or loss