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(cid:1) Self-Test 3
Suppose you could achieve full diversification in a portfolio constructed from stocks
with an average beta of .5. If the standard deviation of the market is 20 percent per year,
what is the standard deviation of the portfolio return?
414 SECTION FOUR
FIGURE 4.9
(a) The slope of the fitted line
shows that investors in the
Windsor II mutual fund bore
market risk slightly below
that of the S&P 500
portfolio. Windsor II’s beta
was .87. This was the average
beta of the individual
common stocks held by the
fund. They also bore some
unique risk, however; note
the scatter of Windsor II’s
returns above and below the
fitted line.
(b) The Vanguard 500
Portfolio is a fully diversified
index fund designed to track
the performance of the
market. Note the fund’s beta
(1.0) and the absence of
unique risk. The fund’s
returns lie almost precisely
on the fitted line relating its
returns to those of the S&P
500 portfolio.
Windsor II return,
percent
20
(cid:2)20
(cid:2)15
(cid:2)10
(cid:2)5
10
0
(cid:2)10
(cid:2)20
Index 500 return,
percent
20
(cid:2)20
(cid:2)15
(cid:2)10
(cid:2)5
10
0
(cid:2)10
(cid:2)20
(a)
(b)
5
10
15
20
Market return,
percent
5
10
15
20
Market return,
percent
Risk and Return
Earlier we looked at past returns on selected investments. The least risky investment
was U.S. Treasury bills. Since the return on Treasury bills is fixed, it is unaffected by
what happens to the market. Thus the beta of Treasury bills is zero. The most risky in-
vestment that we considered was the market portfolio of common stocks. This has av-
erage market risk: its beta is 1.0.
Wise investors don’t run risks just for fun. They are playing with real money and
therefore require a higher return from the market portfolio than from Treasury bills. The
difference between the return on the market and the interest rate on bills is termed the
market risk premium. Over the past 73 years the average market risk premium has
been just over 9 percent a year. Of course, there is plenty of scope for argument as to
whether the past 73 years constitute a typical period, but we will just assume here that
9 percent is the normal risk premium, that is, the additional return that an investor could
reasonably expect from investing in the stock market rather than Treasury bills.
MARKET RISK
PREMIUM Risk premium
of market portfolio.
Difference between market
return and return on risk-free
Treasury bills.
Risk, Return, and Capital Budgeting 415
In Figure 4.10a we plotted the risk and expected return from Treasury bills and the
market portfolio. You can see that Treasury bills have a beta of zero and a risk-free re-
turn; we’ll assume that return is 5 percent. The market portfolio has a beta of 1.0 and
an assumed expected return of 14 percent.3
Now, given these two benchmarks, what expected rate of return should an investor
require from a stock or portfolio with a beta of .5? Halfway between, of course. Thus
in Figure 4.10b we drew a straight line through the Treasury bill return and the expected
market return and marked with an X the expected return for a beta of .5, that is, 9.5
percent. This includes a risk premium of 4.5 percent above the Treasury bill return of 5
percent.
You can calculate this return as follows: start with the difference between the ex-
pected market return rm and the Treasury bill rate rf. This is the expected market risk
premium.
FIGURE 4.10
(a) Here we begin the plot of
expected rate of return
against beta. The first
benchmarks are Treasury
bills (beta = 0) and the
market portfolio (beta = 1.0).
We assume a Treasury bill
rate of 5 percent and a
market return of 14 percent.
The market risk premium is
14 – 5 = 9 percent.
(b) A portfolio split evenly
between Treasury bills and
the market will have beta =
.5 and an expected return of
9.5 percent (point X). A
portfolio invested 80 percent
in the market and 20 percent
in Treasury bills has beta =
.8 and an expected rate of
return of 12.2 percent (point
Y). Note that the expected
rate of return on any
portfolio mixing Treasury
bills and the market lies on a
straight line. The risk | Brealey |
premium is proportional to
the portfolio beta.
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14
5
0
9% (cid:1) market
risk premium
Treasury bills
14
12.2
9.5
5
0
Market
portfolio
1.0
Beta
(a)
Market
portfolio
Y
X
.5
.8
1.0
Beta
(b)
3 On past evidence the risk premium on the market is 9 percent. With a 5 percent Treasury bill rate, the ex-
pected market return would be 5 + 9 = 14 percent.
416 SECTION FOUR
Market risk premium = rm – rf = 14% – 5% = 9%
Beta measures risk relative to the market. Therefore, the expected risk premium on
any asset equals beta times the market risk premium:
Risk premium on any asset = r – rf = β(rm – rf)
With a beta of .5 and a market risk premium of 9 percent,
Risk premium = β(rm – rf) = .5 × 9 = 4.5%
The total expected rate of return is the sum of the risk-free rate and the risk premium:
Expected return = risk-free rate + risk premium
r =
=
rf
5%
+ β(rm – rf)
+ 4.5% = 9.5%
You could have calculated the expected rate of return in one step from this formula:
Expected return = r = rf + β(rm – rf)
= 5% + (.5 × 9%) = 9.5%
Theory of the
CAPITAL ASSET
PRICING MODEL
(CAPM)
relationship between risk and
return which states that the
expected risk premium on
any security equals its beta
times the market risk
premium.
This formula states the basic risk–return relationship called the capital asset pricing
model, or CAPM. The CAPM has a simple interpretation:
The expected rates of return demanded by investors depend on two things:
(1) compensation for the time value of money (the risk-free rate rf), and (2) a
risk premium, which depends on beta and the market risk premium.
Note that the expected rate of return on an asset with β = 1 is just the market return.
With a risk-free rate of 5 percent and market risk premium of 9 percent,
r = rf + β(rm – rf)
= 5% + (1 × 9%) = 14%
(cid:1) Self-Test 4
What are the risk premium and expected rate of return on a stock with β = 1.5? Assume
a Treasury bill rate of 6 percent and a market risk premium of 9 percent.
WHY THE CAPM WORKS
The CAPM assumes that the stock market is dominated by well-diversified investors
who are concerned only with market risk. That makes sense in a stock market where
trading is dominated by large institutions and even small fry can diversify at very low
cost.
(cid:1) EXAMPLE 3
How Would You Invest $1 Million?
Have you ever daydreamed about receiving a $1 million check, no strings attached, from
an unknown benefactor? Let’s daydream about how you would invest it.
We have two good candidates: Treasury bills, which offer an absolutely safe return,
and the market portfolio (possibly via the Vanguard index fund discussed earlier in this
Risk, Return, and Capital Budgeting 417
material). The market has generated superior returns on average, but those returns have
fluctuated a lot. (Look back to Figure 3.15.) So your investment policy is going to de-
pend on your tolerance for risk.
If you’re a cautious soul, you may invest only part of your money in the market port-
folio and lend the remainder to the government by buying Treasury bills. Suppose that
you invest 80 percent of your money in the market portfolio and lend out the other 20
percent to the government by buying U.S. Treasury bills. Then the beta of your portfo-
lio will be a mixture of the beta of the market (β
market = 1.0) and the beta of the T-bills
(β
T-bills = 0):
Beta of portfolio = ( proportion × beta of) + (proportion × beta of)
market
T-bills
in market
market)
β = (.8 × β
= (.8 × 1.0)
in T-bills
T-bills)
+ (.2 × β
+ (.2 × 0) = .80
The fraction of funds that you invest in the market also affects your return. If you in-
vest your entire million in the market portfolio, you earn the full market risk premium.
But if you invest only 80 percent of your money in the market, you earn only 80 per-
cent of the risk premium.
risk premium = (proportion in × risk premium) + ( proportion in × market risk)
on T-bills
premium
market
T-bills
Expected
on portfolio
= (.2 × 0) + (.8 × expected market risk premium)
= .8 × expected market risk premium
= .8 × 9 = 7.2%
The expected return on your portfolio is equal to the risk-free interest rate plus the
| Brealey |
expected risk premium:
Expected portfolio return = rportfolio = 5 + 7.2 = 12.2%
In Figure 4.10b we show the beta and expected return on this portfolio by the letter Y.
THE SECURITY MARKET LINE
SECURITY MARKET
LINE
between expected return and
beta.
Relationship
Example 3 illustrates a general point: by investing some proportion of your money in
the market portfolio and lending (or borrowing)4 the balance, you can obtain any com-
bination of risk and expected return along the sloping line in Figure 4.11. This line is
generally known as the security market line.
4 Notice that the security market line extends above the market return at β = 1. How would you generate a
portfolio with, say, β = 2? It’s easy, but it’s risky. Suppose you borrow $1 million and invest the loan plus $1
million in the market portfolio. That gives you $2 million invested and a $1 million liability. Your portfolio
now has a beta of 2.0:
Beta of portfolio = (proportion in market × beta of market) + (proportion in loan × beta of loan)
β = (2 × β
market) + (–1 × β
loan)
= (2 × 1.0) + (–1 × 0) = 2
Notice that the proportion in the loan is negative because you are borrowing, not lending money.
By the way, borrowing from a bank or stockbroker would not be difficult or unduly expensive as long as
you put up your $2 million stock portfolio as security for the loan.
Can you calculate the risk premium and the expected rate of return on this borrow-and-invest strategy?
418 SECTION FOUR
FIGURE 4.11
The security market line
shows how expected rate of
return depends on beta.
According to the capital
asset pricing model, expected
rates of return for all
securities and all portfolios
lie on this line.
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rm
rf
0
Security market line
Beta
1.0
(cid:1) Self-Test 5
How would you construct a portfolio with a beta of .25? What is the expected return to
this strategy? Assume Treasury bills yield 6 percent and the market risk premium is 9
percent.
The security market line describes the expected returns and risks from
investing different fractions of your funds in the market. It also sets a
standard for other investments. Investors will be willing to hold other
investments only if they offer equally good prospects. Thus the required risk
premium for any investment is given by the security market line:
Risk premium on investment = beta × expected market risk premium
Look back to Figure 4.10b, which asserts that an individual common stock with β =
.5 must offer a 9.5 percent expected rate of return when Treasury bills yield 5 percent
and the market risk premium is 9 percent. You can now see why this has to be so. If that
stock offered a lower rate of return, nobody would buy even a little of it—they could get
9.5 percent just by investing 50-50 in Treasury bills and the market. And if nobody wants
to hold the stock, its price has to drop. A lower price means a better buy for investors,
that is, a higher rate of return. The price will fall until the stock’s expected rate of return
is pushed up to 9.5 percent. At that price and expected return the CAPM holds.
If, on the other hand, our stock offered more than 9.5 percent, diversified investors
would want to buy more of it. That would push the price up and the expected return
down to the levels predicted by the CAPM.
This reasoning holds for stocks with any beta. That’s why the CAPM makes sense,
and why the expected risk premium on an investment should be proportional to its beta.
(cid:1) Self-Test 6
Suppose you invest $400,000 in Treasury bills and $600,000 in the market portfolio.
What is the return on your portfolio if bills yield 6 percent and the expected return on
the market is 15 percent? What does the return on this portfolio imply for the expected
return on individual stocks with betas of .6?
Risk, Return, and Capital Budgeting 419
HOW WELL DOES THE CAPM WORK?
The basic idea behind the capital asset pricing model is that investors expect a reward
for both waiting and worrying. The greater the worry, the greater the expected return.
If you invest in a risk-free Treasury bill, you just receive the rate of interest. That’s the | Brealey |
reward for waiting. When you invest in risky stocks, you can expect an extra return or
risk premium for worrying. The capital asset pricing model states that this risk premium
is equal to the stock’s beta times the market risk premium. Therefore,
Expected return on stock = risk-free interest rate + (beta × market risk premium)
r = rf + β(rm – rf)
How well does the CAPM work in practice? Do the returns on stocks with betas of
.5 on average lie halfway between the return on the market portfolio and the interest rate
on Treasury bills? Unfortunately, the evidence is conflicting. Let’s look back to the ac-
tual returns earned by investors in low-beta stocks and in high-beta stocks.
Imagine that in 1931 ten investors gathered in a Wall Street bar to discuss their port-
folios. Each agreed to follow a different strategy. Investor 1 opted to buy each year the
10 percent of New York Stock Exchange stocks with the lowest betas; investor 2 chose
the 10 percent with the next-lowest betas; and so on, up to investor 10, who agreed to
buy the stocks with the highest betas. They also agreed that they would return 60 years
later to compare results, and so they parted with much cordiality and good wishes.
In 1991 the same 10 investors, now much older and wealthier, met again in the same
bar. Figure 4.12 shows how they fared. Investor 1’s portfolio turned out to be much less
risky than the market; its beta was only .49. However, investor 1 also realized the low-
est return, 9 percent above the risk-free rate of interest. At the other extreme, the beta
of investor 10’s portfolio was 1.52, about three times that of investor 1’s portfolio. But
investor 10 was rewarded with the highest return, averaging 17 percent above the inter-
est rate. So over this 60-year period returns did indeed increase with beta.
As you can see from Figure 4.12, the market portfolio over the same 60-year period
provides an average return of 14 percent above the interest rate5 and (of course) had a
,
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1
9
9
1
–
1
3
9
1
30
25
20
15
10
5
0
Security market line
Investor 1
M
Market portfolio
Investor 10
.2
.4
.6
.8
1.0
1.2
1.4
1.6
Portfolio beta
Source: F. Black, “Beta and Return,” Journal of Portfolio Management 20:8–18 (Fall 1993). © 1993. Used
by permission of Institutional Investor, Inc.
5 In Figure 4.12 the stocks in the “market portfolio” are weighted equally. Since the stocks of small firms have
provided higher average returns than those of large firms, the risk premium on an equally weighted index is
higher than on a value-weighted index. This is one reason for the difference between the 14 percent market
risk premium in Figure 4.2 and the 9.4 percent premium reported in Table 3.9.
FIGURE 4.12
The capital asset pricing
model states that the
expected risk premium from
any investment should lie on
the security market line. The
dots show the actual average
risk premiums from portfolios
with different betas. The
high-beta portfolios
generated higher average
returns, just as predicted by
the CAPM. But the high-beta
portfolios plotted below the
security market line, and four
of the five low-beta portfolios
plotted above. A line fitted to
the 10 portfolio returns
would be flatter than the
market line.
420 SECTION FOUR
beta of 1.0. The CAPM predicts that the risk premium should lie on the upward-
sloping security market line in Figure 4.12. Since the market provided a risk premium
of 14 percent, investor 1’s portfolio, with a beta of .49, should have provided a risk pre-
mium of a shade under 7 percent and investor 10’s portfolio, with a beta of 1.52, should
have given a premium of a shade over 21 percent. You can see that while high-beta
stocks performed better than low-beta stocks, the difference was not as great as the
CAPM predicts.
Figure 4.12 provides broad support for the CAPM, though it suggests that the line
relating return to beta has been too flat. But recent years have been less kind to the
CAPM. For example, if the 10 friends had invested their cash in 1966 rather than 1931, | Brealey |
there would have been very little relation between their portfolio returns and beta. Does
this imply that there has been a fundamental change in the relation between risk and re-
turn in the last 30 years or did high-beta stocks just happen to perform worse during
these years than investors expected? It is hard to be sure.
There is little doubt that the CAPM is too simple to capture everything that is going
on in the stock market. For example, it appears that stocks of small companies or stocks
with low price-earnings ratios have offered higher rates of return than the CAPM pre-
dicts. This has prompted headlines like “Is Beta Dead?” in the business press.6 It is not
the first time that beta has been declared dead, but the CAPM is still being used. Only
strong theories can have more than one funeral.
The CAPM is not the only model of risk and return. It has several brothers and sis-
ters as well as second cousins. However, the CAPM captures in a simple way two fun-
damental ideas. First, almost everyone agrees that investors require some extra return
for taking on risk. Second, investors appear to be concerned principally with the mar-
ket risk that they cannot eliminate by diversification. That is why financial managers
rely on the capital asset pricing model as a good rule of thumb.
USING THE CAPM TO ESTIMATE
EXPECTED RETURNS
To calculate the returns that investors are expecting from particular stocks, we need
three numbers—the risk-free interest rate, the expected market risk premium, and beta.
In mid-1999, the interest rate on Treasury bills was about 4.8 percent. Assume that the
market risk premium is about 9 percent. Finally, look back to Table 4.9, where we gave
you betas of several stocks. Table 4.10 puts these numbers together to give an estimate
of the expected return from each stock. Let’s take Exxon as an example:
Expected return on Exxon = risk-free interest rate + (beta × expected market)
risk premium
r = 4.8% + (.61 × 9%)
= 10.3%
You can also use the capital asset pricing model to find the discount rate for a new
capital investment. For example, suppose you are asked to analyze a proposal by Merck
to expand its operations. At what rate should you discount the forecast cash flows? Ac-
cording to Table 4.10 investors are looking for a return of 13.1 percent from investments
with the risk of Merck stock. That is the opportunity cost of capital for Merck’s expan-
sion project.
In practice, choosing a discount rate is seldom this easy. (After all, you can’t expect
6 A. Wallace, “Is Beta Dead?” Institutional Investor 14 (July 1980), pp. 22–30.
TABLE 4.10
Expected rates of return
Stock
Expected Return, %
Risk, Return, and Capital Budgeting 421
Biogen
Compaq
Delta Airlines
Exxon
Ford Motor Co.
MCI WorldCom
Merck
Microsoft
PepsiCo
Xerox
14.4
15.1
12.5
10.3
13.5
16.5
13.1
16.8
16.8
15.6
Note: Expected return = r = rf + β(rm – rf) = 4.8% + (β × 9%).
to become a captain of finance simply by plugging numbers into a formula.) For ex-
ample, you must learn how to estimate the return demanded by the company’s investors
when the company has issued both equity and debt securities.7 We will come to such re-
finements later.
(cid:1) EXAMPLE 4
Comparing Project Returns and the
Opportunity Cost of Capital
You have forecast the cash flows on a project and calculated that its internal rate of re-
turn is 15.0 percent. Suppose that Treasury bills offer a return of 5 percent and the ex-
pected market risk premium is 9 percent. Should you go ahead with the project?
To answer this question you need to figure out the opportunity cost of capital r. This
depends on the project’s beta. For example, if the project is a sure thing, the beta is zero
and the cost of capital equals the interest rate on Treasury bills:
r = 5 + (0 × 9) = 5%
If your project offers a return of 15.0 percent when the cost of capital is 5 percent, you
should obviously go ahead.8
Sure-fire projects rarely occur outside finance texts. So let’s think about the cost of
capital if the project has the same risk as the market portfolio. In this case beta is 1.0 | Brealey |
and the cost of capital is the expected return on the market:
r = 5 + (1.0 × 9) = 14%
The project appears less attractive than before but still worth doing.
But what if the project has even higher risk? Suppose, for example, that it has a beta
of 1.5. What is the cost of capital in this case? To find the answer, we plug a beta of 1.5
into our formula for r:
7 We could ignore this complication in the case of Merck, because Merck is financed almost entirely by com-
mon stock. Therefore, the risk of its assets equals the risk of its stock. But most companies issue a mix of debt
and common stock.
8 Earlier we described some special cases where you should prefer projects that offer a lower internal rate of
return than the cost of capital. We assume here that your project is a “normal” one, and that you prefer high
IRRs to low ones.
422 SECTION FOUR
FIGURE 4.13
The expected return of this
project is less than the
expected return one could
earn on stock market
investments with the same
market risk (beta). Therefore,
the project’s expected
return–risk combination lies
below the security market
line, and the project should
be rejected.
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18.5
15
14
5
0
Project
Security market line
1.0
1.5
Beta
r = 5 + (1.5 × 9) = 18.5%
A project this risky would need a return of at least 18.5 percent to justify going ahead.
The 15 percent project should be rejected.
This rejection occurs because, as Figure 4.13 shows, the project’s expected rate of re-
turn plots below the security market line. The project offers a lower return than investors
can get elsewhere, so it is a negative-NPV investment.
The security market line provides a standard for project acceptance. If the
project’s return lies above the security market line, then the return is higher
than investors could expect to get by investing their funds in the capital
market and therefore is an attractive investment opportunity.
(cid:1) Self-Test 7
Suppose that Merck’s expansion project is forecast to produce cash flows of $50 mil-
lion a year for each of 10 years. What is its present value? Use data from Table 4.10.
What would the present value be if the beta of the investment were .7?
COMPANY COST OF
CAPITAL Expected rate
of return demanded by
investors in a company,
determined by the average
risk of the company’s assets
and operations.
Capital Budgeting and Project Risk
COMPANY VERSUS PROJECT RISK
Long before the development of modern theories linking risk and return, smart finan-
cial managers adjusted for risk in capital budgeting. They realized intuitively that, other
things equal, risky projects are less desirable than safe ones and must provide higher
rates of return.
Many companies estimate the rate of return required by investors in their securities
and use this company cost of capital to discount the cash flows on all new projects.
Risk, Return, and Capital Budgeting 423
Since investors require a higher rate of return from a risky company, risky firms will
have a higher company cost of capital and will set a higher discount rate for their new
investment opportunities. For example, we showed in Table 4.9 that on past evidence
Merck has a beta of .92 and the corresponding expected rate of return (see Table 4.10)
is about 13 percent. According to the company cost of capital rule, Merck should use a
13 percent cost of capital to calculate project NPVs.
This is a step in the right direction, but we must take care when the firm has issued
securities other than equity. Moreover, this approach can get a firm in trouble if its new
projects do not have the same risk as its existing business. Merck’s beta reflects in-
vestors’ estimate of the risk of the pharmaceutical business and its company cost of cap-
ital is the return that investors require for taking on this risk. If Merck is considering an
expansion of its regular business, it makes sense to discount the forecast cash flows by
the company cost of capital. But suppose that Merck is wondering whether to branch
out into production of computer hardware. Its beta tells us nothing about the project | Brealey |
cost of capital. That depends on the risk of the hardware business and the return that
shareholders require from investing in such a business.
The project cost of capital depends on the use to which that capital is put.
Therefore, it depends on the risk of the project and not on the risk of the
company. If a company invests in a low-risk project, it should discount the
cash flows at a correspondingly low cost of capital. If it invests in a high-risk
project, those cash flows should be discounted at a high cost of capital.
PROJECT COST OF
CAPITAL Minimum
acceptable expected rate of
return on a project given its
risk.
SEE BOX
The nearby box discusses how companies decide on the discount rate. It notes, for
example, that Siemens, a German industrial giant, uses 16 different discount rates, de-
pending on the riskiness of each line of its business.
(cid:1) Self-Test 8
The company cost of capital for Merck is about 13 percent (see Table 4.10); for Com-
paq Computer it is about 15 percent. What would be the more reasonable discount rate
for Merck to use for its proposed computer hardware division? Why?
DETERMINANTS OF PROJECT RISK
We have seen that the company cost of capital is the correct discount rate for projects
that have the same risk as the company’s existing business, but not for those projects
that are safer or riskier than the company’s average. How do we know whether a proj-
ect is unusually risky? Estimating project risk is never going to be an exact science, but
here are two things to bear in mind.
First, we saw earlier that operating leverage increases the risk of a project. When a
large fraction of your costs is fixed, any change in revenues can have a dramatic effect
on earnings. Therefore, projects that involve high fixed costs tend to have higher betas.
Second, many people intuitively associate risk with the variability of earnings. But
much of this variability reflects diversifiable risk. Lone prospectors in search of gold
look forward to extremely uncertain future earnings, but whether they strike it rich is
not likely to depend on the performance of the rest of the economy. These investments
have a high standard deviation but a low beta.
FINANCE IN ACTION
How High a Hurdle?
It did raise some eyebrows at first. Two months ago,
when Aegon, a Dutch life insurer known for taking care
of its shareholders, bought Transamerica, a San Fran-
cisco– based insurer, Aegon said it was expecting a re-
turn of only 9% from the deal, well below the 11% “ hur-
dle rate” it once proclaimed as its benchmark. Had this
darling of the stock market betrayed its devoted in-
vestors for the sake of an eye-catching deal?
Not at all. Years of falling interest rates and rising eq-
uity valuations have shrunk the cost of capital for firms
such as Aegon. So companies that regularly adjust the
hurdle rates they use to evaluate potential investment
projects and acquisitions are not cheating their share-
holders. Far from it: they are doing their investors a
service. Unfortunately, such firms are rare in Europe. “ I
don’t know many companies at all who lowered their
hurdle rates in line with interest rates, so they’re all un-
derinvesting,” says Greg Milano, a partner at Stern
Stewart, a consultancy that helps companies estimate
their cost of capital.
This has a huge impact on corporate strategy. Com-
panies generally make their investment decisions by
discounting the net cash flows a project is estimated to
generate to their present value. If the net present value
is positive, the project should make shareholders better
off.
Generally speaking, says Paul Gibbs, an analyst at
J.P. Morgan, an American bank, finance directors in
America often review their hurdle rates; in continental
Europe they do so sometimes, and in Britain, rarely. As
a result, the Confederation of British Industry, a big-
business lobby, worries about underinvestment, and of-
ficials at the Bank of England grumble about firms’ re-
luctance to lower hurdles. This reluctance seems | Brealey |
surprising, since companies with high hurdle rates will
tend to lose out in bidding for business assets or firms.
The hurdle rate should reflect not only interest rates but
also the riskiness of each individual project. For in-
stance, Siemens, a German industrial giant, last year
started assigning a different hurdle rate to each of its 16
businesses, ranging from household appliances to
medical equipment and semiconductors. The hurdle
rates—
from 8% to 11%— are based on the volatility of
shares in rival companies in the relevant industry, and
are under constant review.
Source: “How High a Hurdle?” The Economist, May 8, 1999, p. 82.
© 1999 The Economist Newspaper Group, Inc. Reprinted with per-
mission. Further reproduction prohibited. www.economist.com.
What matters is the strength of the relationship between the firm’s earnings
and the aggregate earnings of all firms. Thus cyclical businesses, whose
revenues and earnings are strongly dependent on the state of the economy,
tend to have high betas and a high cost of capital. By contrast, businesses that
produce essentials, such as food, beer, and cosmetics, are less affected by the
state of the economy. They tend to have low betas and a low cost of capital.
DON’T ADD FUDGE FACTORS
TO DISCOUNT RATES
Risk to an investor arises because an investment adds to the spread of possible portfo-
lio returns. To a diversified investor, risk is predominantly market risk. But in everyday
usage risk simply means “bad outcome.” People think of the “risks” of a project as the
things that can go wrong. For example,
• A geologist looking for oil worries about the risk of a dry hole.
• A pharmaceutical manufacturer worries about the risk that a new drug which re-
verses balding may not be approved by the Food and Drug Administration.
• The owner of a hotel in a politically unstable part of the world worries about the po-
litical risk of expropriation.
424
Risk, Return, and Capital Budgeting 425
Managers sometimes add fudge factors to discount rates to account for worries such
as these.
This sort of adjustment makes us nervous. First, the bad outcomes we cited appear
to reflect diversifiable risks which would not affect the expected rate of return de-
manded by investors. Second, the need for an adjustment in the discount rate usually
arises because managers fail to give bad outcomes their due weight in cash-flow fore-
casts. They then try to offset that mistake by adding a fudge factor to the discount rate.
For example, if a manager is worried about the possibility of a bad outcome such as a
dry hole in oil exploration, he or she may reduce the value of the project by using a
higher discount rate. This approach is unsound, however. Instead, the possibility of the
dry hole should be included in the calculation of the expected cash flows to be derived
from the well. Suppose that there is a 50 percent chance of a dry hole and a 50 percent
chance that the well will produce oil worth $20 million. Then the expected cash flow is
not $20 million but (.5 × 0) + (.5 × 20) = $10 million. You should discount the $10 mil-
lion expected cash flow at the opportunity cost of capital: it does not make sense to dis-
count the $20 million using a fudged discount rate.
Expected cash-flow forecasts should already reflect the probabilities of all
possible outcomes, good and bad. If the cash-flow forecasts are prepared
properly, the discount rate should reflect only the market risk of the project.
It should not have to be fudged to offset errors or biases in the cash-flow
forecast.
Summary
How can you measure and interpret the market risk, or beta, of a security?
The contribution of a security to the risk of a diversified portfolio depends on its market
risk. But not all securities are equally affected by fluctuations in the market. The sensitivity
of a stock to market movement is known as beta. Stocks with a beta greater than 1.0 are
particularly sensitive to market fluctuations. Those with a beta of less than 1.0 are not so | Brealey |
sensitive to such movements. The average beta of all stocks is 1.0.
What is the relationship between the market risk of a security and the rate of re-
turn that investors demand of that security?
The extra return that investors require for taking risk is known as the risk premium. The
market risk premium—that is, the risk premium on the market portfolio—averaged
almost 9.4 percent between 1926 and 1998. The capital asset pricing model states that the
expected risk premium of an investment should be proportional to both its beta and the
market risk premium. The expected rate of return from any investment is equal to the risk-
free interest rate plus the risk premium, so the CAPM boils down to
r = rf + β(rm – rf)
The security market line is the graphical representation of the CAPM equation. The
security market line relates the expected return investors demand of a security to the beta.
How can a manager calculate the opportunity cost of capital for a project?
The opportunity cost of capital is the return that investors give up by investing in the project
rather than in securities of equivalent risk. Financial managers use the capital asset pricing
426 SECTION FOUR
Related Web
Links
Key Terms
Quiz
model to estimate the opportunity cost of capital. The company cost of capital is the
expected rate of return demanded by investors in a company, determined by the average risk
of the company’s assets and operations.
The opportunity cost of capital depends on the use to which the capital is put. Therefore,
required rates of return are determined by the risk of the project, not by the risk of the
firm’s existing business. The project cost of capital is the minimum acceptable expected
rate of return on a project given its risk.
Your cash-flow forecasts should already factor in the chances of pleasant and unpleasant
surprises. Potential bad outcomes should be reflected in the discount rate only to the extent
that they affect beta.
www.stanford.edu/~wfsharpe/ws/wksheets.htm William Sharpe’s site contains “portfolio opti-
mizers,” spreadsheets that can be used to construct efficiently diversified portfolios
www.riskmetrics.com RiskMetrics® Group maintains this site, which uses modern portfolio
theory to help manage risk; some of the content at this site, including educational and demon-
stration materials, is free.
www.riskview.com A nice site with historical risk and return data as well as software to manage
and measure portfolio risk
www.finance.yahoo.com You can find stock betas as well as other risk measures and company
profiles here
market portfolio
beta
market risk premium
capital asset pricing model (CAPM)
security market line
company cost of capital
project cost of capital
1.
Risk and Return. True or false? Explain or qualify as necessary.
a. Investors demand higher expected rates of return on stocks with more variable rates of
return.
b. The capital asset pricing model predicts that a security with a beta of zero will provide
an expected return of zero.
c. An investor who puts $10,000 in Treasury bills and $20,000 in the market portfolio will
have a portfolio beta of 2.0.
d. Investors demand higher expected rates of return from stocks with returns that are highly
exposed to macroeconomic changes.
e. Investors demand higher expected rates of return from stocks with returns that are very
sensitive to fluctuations in the stock market.
2. Diversifiable Risk. In light of what you’ve learned about market versus diversifiable
(unique) risks, explain why an insurance company has no problem in selling life insurance
to individuals but is reluctant to issue policies insuring against flood damage to residents of
coastal areas. Why don’t the insurance companies simply charge coastal residents a premium
that reflects the actuarial probability of damage from hurricanes and other storms?
3. Unique vs. Market Risk. Figure 4.14 plots monthly rates of return from 1993 to 1999 for
the Snake Oil mutual fund. Was this fund well-diversified? Explain.
4. Risk and Return. Suppose that the risk premium on stocks and other securities did in fact
| Brealey |
Risk, Return, and Capital Budgeting 427
FIGURE 4.14
Monthly rates of return for
the Snake Oil mutual fund
and the Standard & Poor’s
Composite Index. See
problem 3.
Snake Oil return,
percent
5
4
3
2
1
Practice
Problems
(cid:2)3
(cid:2)2
(cid:2)1
1
2
3
Market return,
percent
0
(cid:2)1
(cid:2)2
(cid:2)3
(cid:2)4
(cid:2)5
rise with total risk (that is, the variability of returns) rather than just market risk. Explain
how investors could exploit the situation to create portfolios with high expected rates of re-
turn but low levels of risk.
5. CAPM and Hurdle Rates. A project under consideration has an internal rate of return of
14 percent and a beta of .6. The risk-free rate is 5 percent and the expected rate of return on
the market portfolio is 14 percent.
a. Should the project be accepted?
b. Should the project be accepted if its beta is 1.6?
c. Why does your answer change?
6. CAPM and Valuation. You are considering acquiring a firm that you believe can generate
expected cash flows of $10,000 a year forever. However, you recognize that those cash flows
are uncertain.
a. Suppose you believe that the beta of the firm is .4. How much is the firm worth if the
risk-free rate is 5 percent and the expected rate of return on the market portfolio is 15 per-
cent?
b. By how much will you overvalue the firm if its beta is actually .6?
7. CAPM and Expected Return. If the risk-free rate is 6 percent and the expected rate of re-
turn on the market portfolio is 14 percent, is a security with a beta of 1.25 and an expected
rate of return of 16 percent overpriced or underpriced?
8. Using Beta. Investors expect the market rate of return this year to be 14 percent. A stock
with a beta of .8 has an expected rate of return of 12 percent. If the market return this year
turns out to be 10 percent, what is your best guess as to the rate of return on the stock?
9. Unique vs. Market Risk. Figure 4.15 shows plots of monthly rates of return on three stocks
versus the stock market index. The beta and standard deviation of each stock is given beside
its plot.
a. Which stock is riskiest to a diversified investor?
b. Which stock is riskiest to an undiversified investor who puts all her funds in one of these
stocks?
428 SECTION FOUR
FIGURE 4.15
These plots show monthly
rates of return for (a) Exxon,
(b) Polaroid, (c) Nike, and
the market portfolio. See
problem 9.
(a)
t
n
e
c
r
e
p
,
n
r
u
t
e
r
n
o
x
x
E
25
20
15
10
5
0
(cid:2)5
(cid:2)10
(cid:2)15
(cid:2)20
(cid:2)25
(cid:2)10
25
20
15
10
5
0
(cid:3)5
(cid:3)10
(cid:3)15
(cid:3)20
(cid:3)25
(cid:3)10
(b)
t
n
e
c
r
e
p
,
n
r
u
t
e
r
d
o
r
a
o
P
l
i
Beta (cid:2) .61
Standard deviation (cid:2) 16%
(cid:2)8
(cid:2)6
(cid:2)4
(cid:2)2
0
2
4
6
8
10
Market return, percent
Beta (cid:2) .53
Standard deviation (cid:2) 22%
(cid:3)8
(cid:3)6
(cid:3)4
(cid:3)2
0
2
4
6
8
10
Market return, percent
c. Consider a portfolio with equal investments in each stock. What would this portfolio’s
beta have been?
d. Consider a well-diversified portfolio made up of stocks with the same beta as Exxon.
What are the beta and standard deviation of this portfolio’s return? The standard devia-
tion of the market portfolio’s return is 20 percent.
e. What is the expected rate of return on each stock? Use the capital asset pricing model
with a market risk premium of 8 percent. The risk-free rate of interest is 4 percent.
10. Calculating Beta. Following are several months’ rates of return for Tumblehome Canoe
Company. Prepare a plot like Figure 4.7. What is Tumblehome’s beta?
Risk, Return, and Capital Budgeting 429
FIGURE 4.15
(Continued)
(c)
t
n
e
c
r
e
p
,
n
r
u
t
e
r
e
k
N
i
25
20
15
10
5
0
(cid:2)5
(cid:2)10
(cid:2)15
(cid:2)20
Beta (cid:2) 1.20
Standard deviation (cid:2) 31%
(cid:2)25
(cid:3)10
(cid:2)8
(cid:2)6
(cid:2)4
(cid:2)2
0
2
4
6
8
10
Market return, percent
Month
Market Return, % Tumblehome Return, %
1
2
3
4
5
6
7
8
9
10
0
0
–1
–1
+1
+1
+2
+2
–2
–2
+1
–1
–2.5
–0.5
+2
+1
+4
+2
–2
–4
11. Expected Returns. Consider the following two scenarios for the economy, and the returns
in each scenario for the market portfolio, an aggressive stock A, and a defensive stock D.
Rate of Return
Scenario
Market
Aggressive Stock A
Defensive Stock D
Bust
Boom
–8%
32
–10%
38
–6%
24
a. Find the beta of each stock. In what way is stock D defensive? | Brealey |
b. If each scenario is equally likely, find the expected rate of return on the market portfolio
and on each stock.
c. If the T-bill rate is 4 percent, what does the CAPM say about the fair expected rate of re-
turn on the two stocks?
d. Which stock seems to be a better buy based on your answers to (a) through (c)?
12. CAPM and Cost of Capital. Draw the security market line when the Treasury bill rate is
10 percent and the market risk premium is 8 percent. What are the project costs of capital
for new ventures with betas of .75 and 1.75? Which of the following capital investments
have positive NPVs?
430 SECTION FOUR
Project
Beta
Internal Rate of Return, %
P
Q
R
S
T
1.0
0
2.0
0.4
1.6
20
10
25
16
25
13. CAPM and Valuation. You are a consultant to a firm evaluating an expansion of its current
business. The cash-flow forecasts (in millions of dollars) for the project are:
Years
0
1–10
Cash Flow
–100
+ 15
Based on the behavior of the firm’s stock, you believe that the beta of the firm is 1.4. As-
suming that the rate of return available on risk-free investments is 5 percent and that the ex-
pected rate of return on the market portfolio is 15 percent, what is the net present value of
the project?
14. CAPM and Cost of Capital. Reconsider the project in the preceding problem. What is the
project IRR? What is the cost of capital for the project? Does the accept–reject decision
using IRR agree with the decision using NPV?
15. CAPM and Valuation. A share of stock with a beta of .75 now sells for $50. Investors ex-
pect the stock to pay a year-end dividend of $2. The T-bill rate is 4 percent, and the market
risk premium is 8 percent. If the stock is perceived to be fairly priced today, what must be
investors’ expectation of the price of the stock at the end of the year?
16. CAPM and Expected Return. Reconsider the stock in the preceding problem. Suppose in-
vestors actually believe the stock will sell for $54 at year-end. Is the stock a good or bad
buy? What will investors do? At what point will the stock reach an “equilibrium” at which
it again is perceived as fairly priced?
17. Portfolio Risk and Return. Suppose that the S&P 500, with a beta of 1.0, has an expected
return of 13 percent and T-bills provide a risk-free return of 5 percent.
a. What would be the expected return and beta of portfolios constructed from these two as-
sets with weights in the S&P 500 of (i) 0; (ii) .25; (iii) .5; (iv) .75; (v) 1.0?
b. Based on your answer to (a), what is the trade-off between risk and return, that is, how
does expected return vary with beta?
c. What does your answer to (b) have to do with the security market line relationship?
18. Portfolio Risk and Return. Suppose that the S&P 500, with a beta of 1.0, has an expected
return of 15 percent and T-bills provide a risk-free return of 5 percent.
a. How would you construct a portfolio from these two assets with an expected return of 12
percent?
b. How would you construct a portfolio from these two assets with a beta of .4?
c. Show that the risk premiums of the portfolios in (a) and (b) are proportional to their
betas.
19. CAPM and Valuation. You are considering the purchase of real estate which will provide
perpetual income that should average $50,000 per year. How much will you pay for the prop-
erty if you believe its market risk is the same as the market portfolio’s? The T-bill rate is 5
percent, and the expected market return is 12.5 percent.
20. Risk and Return. According to the CAPM, would the expected rate of return on a security
with a beta less than zero be more or less than the risk-free interest rate? Why would in-
Risk, Return, and Capital Budgeting 431
vestors be willing to invest in such a security? Hint: Look back to the auto and gold exam-
ple.
21. CAPM and Expected Return. The following table shows betas for several companies. Cal-
culate each stock’s expected rate of return using the CAPM. Assume the risk-free rate of in-
terest is 5 percent. Use a 9 percent risk premium for the market portfolio.
Company
Bristol-Myers Squibb | Brealey |
General Mills
McGraw-Hill
Amazon.com
Beta
1.13
0.70
0.92
2.48
22. CAPM and Expected Return. Stock A has a beta of .5 and investors expect it to return 5
percent. Stock B has a beta of 1.5 and investors expect it to return 13 percent. Use the CAPM
to find the market risk premium and the expected rate of return on the market.
23. CAPM and Expected Return. If the expected rate of return on the market portfolio is 14
percent and T-bills yield 6 percent, what must be the beta of a stock that investors expect to
return 10 percent?
24. Project Cost of Capital. Suppose General Mills is considering a new investment in the
common stock of a publishing company. Which of the betas shown in the table in problem
21 is most relevant in determining the required rate of return for this venture? Explain why
the expected return to General Mills stock is not the appropriate required return.
25. Risk and Return. True or false? Explain or qualify as necessary.
a. The expected rate of return on an investment with a beta of 2 is twice as high as the ex-
pected rate of return of the market portfolio.
b. The contribution of a stock to the risk of a diversified portfolio depends on the market
risk of the stock.
c. If a stock’s expected rate of return plots below the security market line, it is underpriced.
d. A diversified portfolio with a beta of 2 is twice as volatile as the market portfolio.
e. An undiversified portfolio with a beta of 2 is twice as volatile as the market portfolio.
26. CAPM and Expected Return. A mutual fund manager expects her portfolio to earn a rate
of return of 12 percent this year. The beta of her portfolio is .8. If the rate of return available
on risk-free assets is 5 percent and you expect the rate of return on the market portfolio to
be 15 percent, should you invest in this mutual fund?
27. Required Rate of Return. Reconsider the mutual fund manager in the previous problem.
Explain how you would use a stock index mutual fund and a risk-free position in Treasury
bills (or a money market mutual fund) to create a portfolio with the same risk as the
manager’s but with a higher expected rate of return. What is the rate of return on that port-
folio?
28. Required Rate of Return. In view of your answer to the preceding problem, explain why a
mutual fund must be able to provide an expected rate of return in excess of that predicted
by the security market line for investors to consider the fund an attractive investment op-
portunity.
29. CAPM. We Do Bankruptcies is a law firm that specializes in providing advice to firms in
financial distress. It prospers in recessions when other firms are struggling. Consequently,
its beta is negative, –.2.
a. If the interest rate on Treasury bills is 5 percent and the expected return on the market
portfolio is 15 percent, what is the expected return on the shares of the law firm accord-
ing to the CAPM?
432 SECTION FOUR
Challenge
Problem
Solutions to
Self-Test
Questions
FIGURE 4.16
Each point shows the
performance of Anchovy
Queen stock when the market
is up or down by 1 percent.
On average, Anchovy Queen
stock follows the market; it
has a beta of 1.0.
b. Suppose you invested 90 percent of your wealth in the market portfolio and the remain-
der of your wealth in the shares in the law firm. What would be the beta of your port-
folio?
30. Leverage and Portfolio Risk. Footnote 4 in the material asks you to consider a borrow-and-
invest strategy in which you use $1 million of your own money and borrow another $1 mil-
lion to invest $2 million in a market index fund. If the risk-free interest rate is 4 percent and
the expected rate of return on the market index fund is 12 percent, what is the risk premium
and expected rate of return on the borrow-and-invest strategy? Why is the risk of this strat-
egy twice that of simply investing your $1 million in the market index fund?
1 See Figure 4.16. Anchovy Queen’s beta is 1.0.
2 A portfolio’s beta is just a weighted average of the betas of the securities in the portfolio.
In this case the weights are equal, since an equal amount is assumed invested in each of the | Brealey |
stocks in Table 4.9. The average beta of these stocks is (1.07 + 1.14 + .88 + .61 + .97 + 1.30
+ .92 + 1.33 + 1.33 + 1.20)/10 = 1.07.
3 The standard deviation of a fully diversified portfolio’s return is proportional to its beta. The
standard deviation in this case is .5 × 20 = 10 percent.
4 r = rf + β(rm – rf)
= 6 + (1.5 × 9) = 19.5%
5 Put 25 percent of your money in the market portfolio and the rest in Treasury bills. The
portfolio’s beta is .25 and its expected return is
rportfolio = (.75 × 6) + (.25 × 15) = 8.25%
6 rportfolio = (.4 × 6) + (.6 × 15) = 11.4%
This portfolio’s beta is .6, since $600,000, which is 60 percent of the investment, is in the
market portfolio. Investors in a stock with a beta of .6 would not buy it unless it also
offered a rate of return of 11.4 percent and would rush to buy if it offered more. The stock
price would adjust until the stock’s expected rate of return was 11.4 percent.
Anchovy Queen return,
percent
2
1.5
1
.5
0
(cid:2).4
(cid:2).2
(cid:2)1.0
(cid:2).8
(cid:2).6
.2
.4
.6
.8
1.0
Market return,
percent
(cid:2).5
(cid:2)1
(cid:2)1.5
(cid:2)2
Risk, Return, and Capital Budgeting 433
7 Present value = $50 million × 10-year annuity factor at 13.1%
= $270.23 million
If β = .7, then the cost of capital falls to
r = 4.8% + (.7 × 9%) = 11.1%
and the value of the 10-year annuity increases to $293.23 million.
8 Merck should use Compaq’s cost of capital. Merck’s company cost of capital tells us what
expected rate of return investors demand from the pharmaceutical business. This is not the
appropriate project cost of capital for Merck’s venture into computer hardware.
THE COST OF CAPITAL
Geothermal’s Cost of Capital
Calculating the Weighted-Average Cost of Capital
Calculating Company Cost of Capital as a Weighted Average
Market versus Book Weights
Taxes and the Weighted-Average Cost of Capital
What If There Are Three (or More) Sources of Financing?
Wrapping Up Geothermal
Checking Our Logic
Measuring Capital Structure
Calculating Required Rates of Return
The Expected Return on Bonds
The Expected Return on Common Stock
The Expected Return on Preferred Stock
Big Oil’s Weighted-Average Cost of Capital
Real Oil Company WACCs
Interpreting the Weighted-Average Cost of Capital
When You Can and Can’t Use WACC
Some Common Mistakes
How Changing Capital Structure Affects Expected Returns
What Happens When the Corporate Tax Rate Is Not Zero
Flotation Costs and the Cost of Capital
Summary
Jo Ann Cox needs to calculate the required rate of return on this geothermal plant.
How should she do it?
© Cameramann International, Ltd.
435
Y
ou learned how to use the capital asset pricing model to estimate the ex-
pected return on a company’s common stock. If the firm is financed
wholly by common stock, then the stockholders own all the firm’s assets
and are entitled to all the cash flows. In this case, the expected return required
by investors in the common stock equals the company cost of capital.1
Most companies, however, are financed by a mixture of securities, including com-
mon stock, bonds, and often preferred stock or other securities. Each of these securities
has different risks and therefore investors in them look for different rates of return. In
these circumstances, the company cost of capital is no longer the same as the expected
return on the common stock. It depends on the expected return from all the securities
that the company has issued. It also depends on taxes, because interest payments made
by a corporation are tax-deductible expenses.
Therefore, the company cost of capital is usually calculated as a weighted average of
the after-tax interest cost of debt financing and the “cost of equity,” that is, the expected
rate of return on the firm’s common stock. The weights are the fractions of debt and eq-
uity in the firm’s capital structure. Managers refer to the firm’s weighted-average cost
of capital, or WACC (rhymes with “quack”).
Managers use the weighted-average cost of capital to evaluate average-risk capital
investment projects. “Average risk” means that the project’s risk matches the risk of the
| Brealey |
firm’s existing assets and operations. This material explains how the weighted-average
cost of capital is calculated in practice.
After studying this material you should be able to
(cid:1) Calculate a firm’s capital structure.
(cid:1) Estimate the required rates of return on the securities issued by the firm.
(cid:1) Calculate the weighted-average cost of capital.
(cid:1) Understand when the weighted-average cost of capital is—or isn’t—the appropriate
discount rate for a new project.
Managers calculating WACC can get bogged down in formulas. We want you to un-
derstand why WACC works, not just how to calculate it. Let’s start with “Why?” We’ll
listen in as a young financial manager struggles to recall the rationale for project dis-
count rates.
Geothermal’s Cost of Capital
Jo Ann Cox, a recent graduate of a prestigious eastern business school, poured a third
cup of black coffee and tried again to remember what she once knew about project hur-
436
1 Investors will invest in the firm’s securities only if they offer the same expected return as that of other
equally risky securities. When securities are properly priced, the return that investors can expect from their
investments is therefore also the return that they require.
The Cost of Capital 437
dle rates. Why hadn’t she paid more attention in Finance 101? Why had she sold her fi-
nance text the day after passing the finance final?
Costas Thermopolis, her boss and CEO of Geothermal Corporation, had told her to
prepare a financial evaluation of a proposed expansion of Geothermal’s production. She
was to report at 9:00 Monday morning. Thermopolis, whose background was geo-
physics, not finance, not only expected a numerical analysis; he expected her to explain
it to him.
Thermopolis had founded Geothermal in 1993 to produce electricity from geother-
mal energy trapped deep under Nevada. The company had pioneered this business and
had been able to obtain perpetual production rights for a large tract on favorable terms
from the United States government. When the 1999 oil shock drove up energy prices
worldwide, Geothermal became an exceptionally profitable company. It was currently
reporting a rate of return on book assets of 25 percent per year.
Now, in 2001, production rights were no longer cheap. The proposed expansion
would cost $30 million and should generate a perpetual after-tax cash flow of $4.5 mil-
lion annually. The projected rate of return was 4.5/30 = .15, or 15 percent, much less
than the profitability of Geothermal’s existing assets. However, once the new project
was up and running, it would be no riskier than Geothermal’s existing business.
Jo Ann realized that 15 percent was not necessarily a bad return—though of course
25 percent would have been better. Fifteen percent might still exceed Geothermal’s cost
of capital, that is, exceed the expected rate of return that outside investors would de-
mand to invest money in the project. If the cost of capital was less than the 15 percent
expected return, expansion would be a good deal and would generate net value for Ge-
othermal and its stockholders.
Jo Ann remembered how to calculate the cost of capital for companies which used
only common stock financing. Briefly she sketched the argument.
“I need the expected rate of return investors would require from Geothermal’s real
assets—the wells, pumps, generators, etc. That rate of return depends on the assets’ risk.
However, the assets aren’t traded in the stock market, so I can’t observe how risky they
have been. I can only observe the risk of Geothermal’s common stock.
“But if Geothermal issues only stock—no debt—then owning the stock means own-
ing the assets, and the expected return demanded by investors in the stock must also be
the cost of capital for the assets.” She jotted down the following identities:
Value of business = value of stock
Risk of business = risk of stock
Rate of return on business = rate of return on stock
Investors’ required return from business = investors’ required return from stock
| Brealey |
Unfortunately, Geothermal had borrowed a substantial amount of money; its stock-
holders did not have unencumbered ownership of Geothermal’s assets. The expansion
project would also justify some extra debt finance. Jo Ann realized that she would have
to look at Geothermal’s capital structure—its mix of debt and equity financing—and
consider the required rates of return of debt as well as equity investors.
Geothermal had issued 22.65 million shares, now trading at $20 each. Thus share-
holders valued Geothermal’s equity at $20 × 22.65 million = $453 million. In addition,
the company had issued bonds with a market value of $194 million. The market value
of the company’s debt and equity was therefore $194 + 453 = $647 million. Debt was
194/647 = .3, or 30 percent of the total.
“Geothermal’s worth more to investors than either its debt or its equity,” Jo Ann
438 SECTION FOUR
mused. “But I ought to be able to find the overall value of Geothermal’s business by
adding up the debt and equity.” She sketched a rough balance sheet:
Assets
Liabilities and Shareholders’ Equity
Market value of assets = value
of Geothermal’s existing business
Total value
$647
$647
Market value of debt
Market value of equity
Total value
$194
$453
$647
(30%)
(70%)
(100%)
“Holy Toledo, I’ve got it!” Jo Ann exclaimed. “If I bought all the securities issued by
Geothermal, debt as well as equity, I’d own the entire business. That means. . . .” She
jotted again:
Value of business =
value of portfolio of all the firm’s
debt and equity securities
Risk of business = risk of portfolio
Rate of return on business = rate of return on portfolio
Investors’ required return on business
investors’ required return on
(company cost of capital) portfolio
=
“All I have to do is calculate the expected rate of return on a portfolio of all the firm’s
securities. That’s easy. The debt’s yielding 8 percent, and Fred, that nerdy banker, says
that equity investors want 14 percent. Suppose he’s right. The portfolio would contain
30 percent debt and 70 percent equity, so. . . .”
Portfolio return = (.3 × 8%) + (.7 × 14%) = 12.2%
It was all coming back to her now. The company cost of capital is just a weighted av-
erage of returns on debt and equity, with weights depending on relative market values
of the two securities.
“But there’s one more thing. Interest is tax-deductible. If Geothermal pays $1 of in-
terest, taxable income is reduced by $1, and the firm’s tax bill drops by 35 cents (as-
suming a 35 percent tax rate). The net cost is only 65 cents. So the cost of debt is not 8
percent, but .65 × 8 = 5.2 percent.
“Now I can finally calculate the weighted-average cost of capital:
WACC = (.3 × 5.2%) + (.7 × 14%) = 11.4%
“Looks like the expansion’s a good deal. Fifteen’s better than 11.4. But I sure need a
break.”
Calculating the Weighted-Average
Cost of Capital
Jo Ann’s conclusions were important. It should be obvious by now that the choice of the
discount rate can be crucial, especially when the project involves large capital expendi-
tures or is long-lived. The nearby box describes how a major investment in a power sta-
tion—an investment with both a large capital expenditure and very long life—turned on
the choice of the discount rate.
Think again what the company cost of capital is, and what it is used for. We define
FINANCE IN ACTION
Choosing the Discount Rate
Shortly before the British government began to sell off
the electricity industry to private investors, controversy
erupted over the industry’s proposal to build a 1,200-
megawatt nuclear power station known as Hinkley
Point C. The government argued that a nuclear station
would both diversify the sources of electricity genera-
tion and reduce sulfur dioxide and carbon dioxide emis-
sions. Protesters emphasized the dangers of nuclear
accidents and attacked the proposal as “ bizarre, dated
and irrelevant.”
At the public inquiry held to consider the proposal,
opponents produced some powerful evidence that the
nuclear station was also a very high cost option. Their
principal witness, Professor Elroy Dimson, argued that | Brealey |
the government-owned power company had employed
an unrealistically low figure for the opportunity cost of
capital. Had the government-owned industry used a
more plausible figure, the cost of building and operating
the nuclear station would have been higher than that of
a comparable station based on fossil fuels.
The reason why the choice of discount rate was so
important was that nuclear stations are expensive to
build but cheap to operate. If capital is cheap (i.e., the
discount rate is low), then the high up-front cost is less
serious. But if the cost of capital is high, then the high
initial cost of nuclear stations made them uneconomic.
Evidence produced at the inquiry suggested that the
construction cost of a nuclear station was £1,527 mil-
lion (or about $2.3 billion), while the cost of a compara-
ble nonnuclear station was only £895 million. However,
power stations last about 40 years and, once built, nu-
clear stations cost much less to operate than nonnu-
clear stations. If operated at 75 percent of theoretical
capacity, the running costs of the nuclear station would
be about £63 million a year, compared with running
costs of £168 million a year for the nonnuclear station.
The following table shows the cost advantage of the
nuclear power station at different (real) discount rates.
At a 5 percent discount rate, which was the figure used
by the government, the present value of the costs of the
nuclear option was nearly £1 billion lower than that of a
station based on fossil fuels. But with a discount rate of
16 percent, which was the figure favored by Professor
Dimson, the position was almost exactly reversed, so
that the government could save nearly £1 billion by re-
fusing the power company permission to build Hinkley
Point C and relying instead on new fossil-fuel power
stations.
Eight years after the inquiry, the proposal to con-
struct Hinkley Point C continues to gather dust, and
British Energy, the privatized electric utility, has de-
clared that it has no plans to build a new nuclear power
station in the near future.
Present value of the cost advantage to a nuclear rather than
a fossil-fuel station (figures in billions of pounds)
Real Discount
Rate
Present Value of the Cost
Advantage of the Nuclear Station
5%
8
10
12
14
16
18
0.9
0.2
–0.1
–0.4
–0.7
–0.9
–1.2
Technical Notes:
1. Present values are measured at the date that the power station
comes into operation.
2. The above table assumes for simplicity that construction costs for
nuclear stations are spread evenly over the 8 years before the station
comes into operation, while the costs for fossil-fuel stations are as-
sumed to be spread evenly over the 4 years before operation. As a re-
sult the present value of the costs of the two stations may differ
slightly from the more precise estimates produced by Professor Dim-
son.
Source: Adapted with permission from Energy Economics, July 1989,
E. Dimson, “The Discount Rate for a Power Station,” 1989, Elsevier
Science Ltd., Oxford, England.
it as the opportunity cost of capital for the firm’s existing assets; we use it to value new
assets that have the same risk as the old ones. The weighted-average cost of capital is a
way of estimating the company cost of capital; it also incorporates an adjustment for the
taxes a company saves when it borrows.
439
440 SECTION FOUR
CALCULATING COMPANY COST OF CAPITAL
AS A WEIGHTED AVERAGE
Calculating the company cost of capital is straightforward, though not always easy,
when only common stock is outstanding. For example, a financial manager could esti-
mate beta and calculate shareholders’ required rate of return using the capital asset pric-
ing model (CAPM). This would be the expected rate of return investors require on the
company’s existing assets and operations and also the expected return they will require
on new investments that do not change the company’s market risk.
But most companies issue debt as well as equity.
The company cost of capital is a weighted average of the returns demanded by | Brealey |
debt and equity investors. The weighted average is the expected rate of return
investors would demand on a portfolio of all the firm’s outstanding securities.
Let’s review Jo Ann Cox’s calculations for Geothermal. To avoid complications,
we’ll ignore taxes for the next two or three pages. The total market value of Geother-
mal, which we denote as V, is the sum of the values of the outstanding debt D and the
equity E. Thus firm value is V = D + E = $194 million + $453 million = $647 million.
Debt accounts for 30 percent of the value and equity accounts for the remaining 70
percent. If you held all the shares and all the debt, your investment in Geothermal
would be V = $647 million. Between them, the debt and equity holders own all the
firm’s assets. So V is also the value of these assets—the value of Geothermal’s existing
business.
Suppose that Geothermal’s equity investors require a 14 percent rate of return on
their investment in the stock. What rate of return must a new project provide in order
that all investors—both debtholders and stockholders—earn a fair rate of return? The
debtholders require a rate of return of rdebt = 8 percent. So each year the firm will need
× D = .08 × $194 million = $15.52 million. The shareholders, who
to pay interest of rdebt
have invested in a riskier security, require a return of requity = 14 percent on their
investment of $453 million. Thus in order to keep shareholders happy, the company
× E = .14 × $453 million = $63.42 million. To satisfy
needs additional income of requity
both the debtholders and the shareholders, Geothermal needs to earn $15.52 million +
$63.42 million = $78.94 million. This is equivalent to earning a return of rassets =
78.94/647 = .122, or 12.2 percent.
Figure 4.17 illustrates the reasoning behind our calculations. The figure shows the
amount of income needed to satisfy the debt and equity investors. Notice that debthold-
ers account for 30 percent of Geothermal’s capital structure but receive less than 30 per-
cent of its expected income. On the other hand, they bear less than a 30 percent share
of risk, since they have first cut at the company’s income, and also first claim on its as-
sets if the company gets in trouble. Shareholders expect a return of more than 70 per-
cent of Geothermal’s income because they bear correspondingly more risk.
However, if you buy all Geothermal’s debt and equity, you own its assets lock, stock,
and barrel. You receive all the income and bear all the risks. The expected rate of return
you’d require on this portfolio of securities is the same return you’d require from unen-
cumbered ownership of the business. This rate of return—12.2 percent, ignoring
taxes—is therefore the company cost of capital and the required rate of return from an
equal-risk expansion of the business.
The bottom line (still ignoring taxes) is
Company cost of capital = weighted average of debt and equity returns
The Cost of Capital 441
FIGURE 4.17
Geothermal’s debtholders
account for 30 percent of the
company’s capital structure,
but they get a smaller share
of income because their
return is guaranteed by the
company. Geothermal’s
stockholders bear more risk
and receive, on average,
greater return. Of course if
you buy all the debt and all
the equity, you get all the
income.
Share of capital structure
Share of income
Debt
$194 (30%)
Debt
$15.5
(19.7%)
Equity
$453 (70%)
Equity
$63.4 (80.3%)
Total (cid:2) $647 (100%)
Total (cid:2) $78.9 (100%)
× D) and the equity
The underlying algebra is simple. Debtholders need income of (rdebt
× D) +
investors need income of (requity
× E). The amount of their combined existing investment in the company is V. So
(requity
to calculate the return that is needed on the assets, we simply divide the income by the
investment:
× E). The total income that is needed is (rdebt
rassets =
=
total income
value of investment
(D (cid:1) rdebt) + (E (cid:1) requity)
V
For Geothermal,
= ( D (cid:1) rdebt) + ( E (cid:1) requity)
V
V
| Brealey |
(cid:1) Self-Test 1
rassets = (.30 × 8%) + (.70 × 14%) = 12.2%
This figure is the expected return demanded by investors in the firm’s assets.
Hot Rocks Corp., one of Geothermal’s competitors, has issued long-term bonds with a
market value of $50 million and an expected return of 9.0 percent. It has 4 million
shares outstanding trading for $10 each. At this price the shares offer an expected re-
turn of 17 percent. What is the weighted-average cost of capital for Hot Rocks’s assets
and operations? Assume Hot Rocks pays no taxes.
MARKET VERSUS BOOK WEIGHTS
The company cost of capital is the expected rate of return that investors demand from
the company’s assets and operations.
The cost of capital must be based on what investors are actually willing to
pay for the company’s outstanding securities—that is, based on the securities’
market values.
442 SECTION FOUR
Market values usually differ from the values recorded by accountants in the com-
pany’s books. The book value of Geothermal’s equity reflects money raised in the past
from shareholders or reinvested by the firm on their behalf. If investors recognize Ge-
othermal’s excellent prospects, the market value of equity may be much higher than
book, and the debt ratio will be lower when measured in terms of market values rather
than book values.
Financial managers use book debt-to-value ratios for various other purposes, and
sometimes they unthinkingly look to the book ratios when calculating weights for the
company cost of capital. That’s a mistake, because the company cost of capital meas-
ures what investors want from the company, and it depends on how they value the com-
pany’s securities. That value depends on future profits and cash flows, not on account-
ing history. Book values, while useful for many other purposes, only measure net
cumulative historical outlays; they don’t generally measure market values accurately.
(cid:1) Self-Test 2
Here is a book balance sheet for Duane S. Burg Associates. Figures are in millions.
Assets
Assets (book value)
Liabilities and Shareholders’ Equity
$75
$75
Debt
Equity
$25
50
$75
Unfortunately, the company has fallen on hard times. The 6 million shares are trading
for only $4 apiece, and the market value of its debt securities is 20 percent below the
face (book) value. Because of the company’s large cumulative losses, it will pay no
taxes on future income.
Suppose shareholders now demand a 20 percent expected rate of return. The bonds
are now yielding 14 percent. What is the weighted-average cost of capital?
TAXES AND THE WEIGHTED-AVERAGE
COST OF CAPITAL
Thus far in this section our examples have ignored taxes. Taxes are important because
interest payments are deducted from income before tax is calculated. Therefore, the cost
to the company of an interest payment is reduced by the amount of this tax saving.
The interest rate on Geothermal’s debt is rdebt = 8 percent. However, with a corporate
tax rate of Tc = .35, the government bears 35 percent of the cost of the interest payments.
The government doesn’t send the firm a check for this amount, but the income tax that
the firm pays is reduced by 35 percent of its interest expense.
Therefore, Geothermal’s after-tax cost of debt is only 100 – 35 = 65 percent of the 8
percent pretax cost:
After-tax cost of debt = pretax cost (cid:1) (1 – tax rate)
(cid:1) (1 – Tc)
= rdebt
= 8% × (1 – .35) = 5.2%
We can now adjust our calculation of Geothermal’s cost of capital to recognize the
tax saving associated with interest payments:
Company cost of capital, after-tax = (.3 × 5.2%) + (.7 × 14%) = 11.4%
(cid:1) Self-Test 3
WEIGHTED-AVERAGE
COST OF CAPITAL
(WACC)
Expected rate of
return on a portfolio of all the
firm’s securities, adjusted for
tax savings due to interest
payments.
(cid:1) Self-Test 4
The Cost of Capital 443
Criss-cross Industries has earnings before interest and taxes (EBIT) of $10 million. In-
terest payments are $2 million and the corporate tax rate is 35 percent. Construct a sim-
ple income statement to show that the debt interest reduces the taxes the firm owes to | Brealey |
the government. How much more tax would Criss-cross pay if it were financed solely
by equity?
Now we’re back to the weighted-average cost of capital, or WACC. The general
formula is
WACC = [ D (cid:1) (1 – Tc)rdebt]+( E (cid:1) requity)
V
V
Calculate WACC for Hot Rocks (Self-Test 1) and Burg Associates (Self-Test 2) assum-
ing the companies face a 35 percent corporate income tax rate.
WHAT IF THERE ARE THREE (OR MORE)
SOURCES OF FINANCING?
We have simplified our discussion of the cost of capital by assuming the firm has only
two classes of securities: debt and equity. Even if the firm has issued other classes of
securities, our general approach to calculating WACC remains unchanged. You simply
calculate the weighted-average after-tax return of each security type.
For example, suppose the firm also has outstanding preferred stock. Preferred stock
has some of the characteristics of both common stock and fixed-income securities. Like
bonds, preferred stock promises to pay a given, usually level, stream of dividends. Un-
like bonds, however, there is no maturity date for the preferred stock. The promised div-
idends constitute a perpetuity as long as the firm stays in business. Moreover, a failure
to come up with the cash to pay the dividends does not push the firm into bankruptcy.
Instead, dividends owed simply cumulate; the common stockholders do not receive div-
idends until the accumulated preferred dividends have been paid. Finally, unlike inter-
est payments, preferred stock dividends are not considered tax-deductible expenses.
How would we calculate WACC for a firm with preferred stock as well as common
stock and bonds outstanding? Using P to denote preferred stock, we simply generalize
the formula for WACC as follows:
WACC = [ D (cid:1) (1 – Tc)rdebt]+ (P (cid:1) rpreferred) + ( E (cid:1) requity)
V
V
V
Let’s try an example to make this concrete.
(cid:1) EXAMPLE 1
Weighted-Average Cost of Capital for Executive Fruit
Unlike Geothermal, Executive Fruit has issued three types of securities—debt, pre-
ferred stock, and common stock. The debtholders require a return of 6 percent, the pre-
ferred stockholders require an expected return of 12 percent, and the common stock-
holders require 18 percent. The debt is valued at $4 million (D = 4), the preferred stock
444 SECTION FOUR
at $2 million (P = 2), and the common stock at $6 million (E = 6). The corporate tax
rate is 35 percent. What is Executive’s weighted-average cost of capital?
Don’t be put off by the third security, preferred stock. We simply work through the
following three steps.
Step 1. Calculate the value of each security as a proportion of the firm’s value. Firm
value is V = D + P + E = 4 + 2 + 6 = $12 million. So D/V = 4/12 = .33; P/V = 2/12
= .17; and E/V = 6/12 = .5.
Step 2. Determine the required rate of return on each security. We have already given
you the answers: rdebt = 6%, rpreferred = 12%, and requity = 18%.2
Step 3. Calculate a weighted average of the cost of the after-tax return on debt and the
return on the preferred and common stock:
Weighted-average
cost of capital
= [ D × (1 – Tc)rdebt] + (P × rpreferred) = (E × requity)
V
V
V
= [.33 × (1 – .35) 6%] + (.17 × 12%) + (.5 × 18%)
= 12.3%
WRAPPING UP GEOTHERMAL
We now turn one last time to Jo Ann Cox and Geothermal’s proposed expansion. We
want to make sure that she—and you—know how to use the weighted-average cost of
capital.
Remember that the proposed expansion cost $30 million and should generate a per-
petual cash flow of $4.5 million per year. A simple cash-flow worksheet might look like
this:3
Revenue
– Operating expenses
= Pretax operating cash flow
– Tax at 35%
After-tax cash flow
$10.00 million
– 3.08
6.92
– 2.42
$ 4.50 million
Note that these cash flows do not include the tax benefits of using debt.
Geothermal’s managers and engineers forecast revenues, costs, and taxes as if the
project was to be all-equity financed. The interest tax shields generated by the project’s
actual debt financing are not forgotten, however. They are accounted for by using the | Brealey |
after-tax cost of debt in the weighted-average cost of capital.
Project net present value is calculated by discounting the cash flow (which is a per-
petuity) at Geothermal’s 11.4 percent weighted-average cost of capital:
NPV = –30 +
4.5
.114
= +$9.5 million
Expansion will thus add $9.5 million to the net wealth of Geothermal’s owners.
2 Financial managers often use “equity” to refer to common stock, even though a firm’s equity strictly includes
both common and preferred stock. We continue to use requity to refer specifically to the expected return on the
common stock.
3 For this example we ignore depreciation, a noncash but tax-deductible expense. (If the project were really
perpetual, why depreciate?)
The Cost of Capital 445
CHECKING OUR LOGIC
Any project offering a rate of return more than 11.4 percent will have a positive NPV,
assuming that the project has the same risk and financing as Geothermal’s business. A
project offering exactly 11.4 percent would be just break-even; it would generate just
enough cash to satisfy both debtholders and stockholders.
Let’s check that out. Suppose the proposed expansion had revenues of only $8.34
million and after-tax cash flows of $3.42 million:
Revenue
– Operating costs
= Pretax operating cash flow
– Tax at 35%
After-tax cash flow
$8.34 million
– 3.08
5.26
– 1.84
$3.42 million
With an investment of $30 million, the internal rate of return on this perpetuity is ex-
actly 11.4 percent:
NPV is exactly zero:
Rate of return =
3.42
30
= .114, or 11.4%
NPV = –30 +
3.42
.114
= 0
When we calculated Geothermal’s weighted-average cost of capital, we recognized
that the company’s debt ratio was 30 percent. When Geothermal’s analysts use the
weighted-average cost of capital to evaluate the new project, they are assuming that the
$30 million additional investment would support the issue of additional debt equal to
30 percent of the investment, or $9 million. The remaining $21 million is provided by
the shareholders.
The following table shows how the cash flows would be shared between the
debtholders and shareholders. We start with the pretax operating cash flow of $5.26 mil-
lion:
Cash flow before tax and interest
– Interest payment (.08 × $9 million)
= Pretax cash flow
– Tax at 35%
Cash flow after tax
$5.26 million
–
.72
4.54
– 1.59
$2.95 million
Project cash flows before tax and interest are forecast to be $5.26 million. Out of this
figure, Geothermal needs to pay interest of 8 percent of $9 million, which comes to $.72
million. This leaves a pretax cash flow of $4.54 million, on which the company must
pay tax. Taxes equal .35 × 4.54 = $1.59 million. Shareholders are left with $2.95 mil-
lion, just enough to give them the 14 percent return that they need on their $21 million
investment. (Note that 2.95/21 = .14, or 14 percent.) Therefore, everything checks out.
If a project has zero NPV when the expected cash flows are discounted at the
weighted-average cost of capital, then the project’s cash flows are just
sufficient to give debtholders and shareholders the returns they require.
446 SECTION FOUR
Measuring Capital Structure
We have explained the formula for calculating the weighted-average cost of capital. We
will now look at some of the practical problems in applying that formula. Suppose that
the financial manager of Big Oil has asked you to estimate the firm’s weighted-average
cost of capital. Your first step is to work out Big Oil’s capital structure. But where do
you get the data?
Financial managers usually start with the company’s accounts, which show
the book value of debt and equity, whereas the weighted-average cost of capital
formula calls for their market values. A little work and a dash of judgment are
needed to go from one to the other.
Table 4.11 shows the debt and equity issued by Big Oil. The firm has borrowed $200
million from banks and has issued a further $200 million of long-term bonds. These
bonds have a coupon rate of 8 percent and mature at the end of 12 years. Finally, there
are 100 million shares of common stock outstanding, each with a par value of $1.00. | Brealey |
But the accounts also recognize that Big Oil has in past years plowed back into the firm
$300 million of retained earnings. The total book value of the equity shown in the ac-
counts is $100 million + $300 million = $400 million.
The figures shown in Table 4.11 are taken from Big Oil’s annual accounts and are
therefore book values. Sometimes the differences between book values and market val-
ues are negligible. For example, consider the $200 million that Big Oil owes the bank.
The interest rate on bank loans is usually linked to the general level of interest rates.
Thus if interest rates rise, the rate charged on Big Oil’s loan also rises to maintain the
loan’s value. As long as Big Oil is reasonably sure to repay the loan, the loan is worth
close to $200 million. Most financial managers most of the time are willing to accept
the book value of bank debt as a fair approximation of its market value.
What about Big Oil’s long-term bonds? Since the bonds were originally issued, long-
term interest rates have risen to 9 percent.4 We can calculate the value today of each
bond as follows.5 There are 12 coupon payments of .08 × 200 = $16 million, and then
repayment of face value 12 years out. Thus the final cash payment to the bondholders
is $216 million. All the bond’s cash flows are discounted back at the current interest rate
of 9 percent.
PV =
16
1.09
+
16
(1.09)2
+
16
(1.09)3
+ . . . +
216
(1.09)12
= $185.7
TABLE 4.11
The book value of Big Oil’s
debt and equity (dollar
figures in millions)
Bank debt
Long-term bonds (12-year maturity, 8% coupon)
Common stock (100 million shares, par value $1)
Retained earnings
Total
$200
200
100
300
$800
25.0%
25.0
12.5
37.5
100.0%
4 If Big Oil’s bonds are traded, you can simply look up their price. But many bonds are not regularly traded,
and in such cases you need to infer their price by calculating the bond’s value using the rate of interest of-
fered by similar bonds.
5 We assume that coupon payments are annual. Most bonds in the United States actually pay interest twice a
year.
TABLE 4.12
The market values of Big
Oil’s debt and equity (dollar
figures in millions)
Bank debt
Long-term bonds
Total debt
Common stock, 100 million shares at $12
Total
$ 200.0
185.7
385.7
1,200.0
$1,585.7
12.6%
11.7
24.3
75.7
100.0%
The Cost of Capital 447
Therefore, the bonds are worth only $185.7 million, 92.8 percent of their face value.
If you used the book value of Big Oil’s long-term debt rather than its market value,
you would be a little bit off in your calculation of the weighted-average cost of capital,
but probably not seriously so.
The really big errors are likely to arise if you use the book value of equity rather than
its market value. The $400 million book value of Big Oil’s equity measures the total
amount of cash that the firm has raised from shareholders in the past or has retained and
invested on their behalf. But perhaps Big Oil has been able to find projects that were
worth more than they originally cost or perhaps the value of the assets has increased
with inflation. Perhaps investors see great future investment opportunities for the com-
pany. All these considerations determine what investors are willing to pay for Big Oil’s
common stock.
In September 2001 Big Oil stock was $12 a share. Thus the total market value of the
stock was
Number of shares × share price = 100 million × $12 = $1,200 million
In Table 4.12 we show the market value of Big Oil’s debt and equity. You can see that
debt accounts for 24.3 percent of company value (D/V = .243) and equity accounts for
75.7 percent (E/V = .757). These are the proportions to use when calculating the
weighted-average cost of capital. Notice that if you looked only at the book values
shown in the company accounts, you would mistakenly conclude that debt and equity
each accounted for 50 percent of value.
(cid:1) Self-Test 5
Here is the capital structure shown in Executive Fruit’s book balance sheet:
Debt
Preferred stock
Common stock
Total
$4.1 million
2.2
2.8
$9.1 million
45 %
24.2
30.8
100 %
Explain why the percentage weights given above should not be used in calculating Ex- | Brealey |
ecutive Fruit’s WACC.
Calculating Required Rates of Return
To calculate Big Oil’s weighted-average cost of capital, you also need the rate of return
that investors require from each security.
448 SECTION FOUR
THE EXPECTED RETURN ON BONDS
We know that Big Oil’s bonds offer a yield to maturity of 9 percent. As long as the com-
pany does not go belly-up, that is the rate of return investors can expect to earn from
holding Big Oil’s bonds. If there is any chance that the firm may be unable to repay the
debt, however, the yield to maturity of 9 percent represents the most favorable outcome
and the expected return is lower than 9 percent.
For most large and healthy firms, the probability of bankruptcy is sufficiently low that
financial managers are content to take the promised yield to maturity on the bonds as a
measure of the expected return. But beware of assuming that the yield offered on the
bonds of Fly-by-Night Corporation is the return that investors could expect to receive.
THE EXPECTED RETURN ON COMMON STOCK
Estimates Based on the Capital Asset Pricing Model.
Earlier we showed you how
to use the capital asset pricing model to estimate the expected rate of return on common
stock. The capital asset pricing model tells us that investors demand a higher rate of re-
turn from stocks with high betas. The formula is
Expected return
on stock
=
risk-free
interest rate
+ ( stock’s × expected market)
risk premium
beta
(cid:1) Self-Test 6
Financial managers and economists measure the risk-free rate of interest by the yield
on Treasury bills. To measure the expected market risk premium, they usually look back
at capital market history, which suggests that investors have received an extra 8 to 9 per-
cent a year from investing in common stocks rather than Treasury bills. Yet wise finan-
cial managers use this evidence with considerable humility, for who is to say whether
investors in the past received more or less than they expected, or whether investors
today require a higher or lower reward for risk than their parents did?
Let’s suppose Big Oil’s common stock beta is estimated at .85, the risk-free interest
rate of rf is 6 percent, and the expected market risk premium (rm – rf) is 9 percent. Then
the CAPM would put Big Oil’s cost of equity at
Cost of equity = requity = rf + β(rm – rf)
= 6% + .85(9%) = 13.65%
Of course no one can estimate expected rates of return to two decimal places, so we’ll
just round to 13.5 percent.
Jo Ann Cox decides to check whether Fred, the nerdy banker, was correct in claiming
that Geothermal’s cost of equity is 14 percent. She estimates Geothermal’s beta at 1.20.
The risk-free interest rate in 2001 is 6 percent, and the long-run average market risk pre-
mium is 9 percent. What is the expected rate of return on Geothermal’s common stock,
assuming of course that the CAPM is true? Recalculate Geothermal’s weighted-average
cost of capital.
Dividend Discount Model Cost of Equity Estimates. Whenever you are given an
estimate of the expected return on a common stock, always look for ways to check
whether it is reasonable. One check on the estimates provided by the CAPM can be ob-
tained from the dividend discount model (DDM). Earlier we showed you how to use the
constant-growth DDM formula to estimate the return that investors expect from differ-
ent common stocks. Remember the formula: if dividends are expected to grow indefi-
nitely at a constant rate g, then the price of the stock is equal to:
The Cost of Capital 449
P0 =
DIV1
requity – g
where P0 is the current stock price, DIV1 is the forecast dividend at the end of the year,
and requity is the expected return from the stock. We can rearrange this formula to pro-
vide an estimate of requity:
requity =
DIV1 + g
P0
In other words, the expected return on equity is equal to the dividend yield (DIV1/P0)
plus the expected perpetual growth rate in dividends (g).
This constant-growth dividend discount model is widely used in estimating expected
rates of return on common stocks of public utilities. Utility stocks have a fairly stable | Brealey |
growth pattern and are therefore tailor-made for the constant-growth formula.
Remember that the constant-growth formula will get you into trouble if you
apply it to firms with very high current rates of growth. Such growth cannot
be sustained indefinitely.
Using the formula in these circumstances will lead to an overestimate of the expected
return.
Beware of False Precision. Do not expect estimates of the cost of equity to be pre-
cise. In practice you can’t know whether the capital asset pricing model fully explains
expected returns or whether the assumptions of the dividend discount model hold ex-
actly. Even if your formulas were right, the required inputs would be noisy and subject
to error. Thus a financial analyst who can confidently locate the cost of equity in a band
of two or three percentage points is doing pretty well. In this endeavor it is perfectly OK
to conclude that the cost of equity is, say, “about 15 percent” or “somewhere between
14 and 16 percent.”6
Sometimes accuracy can be improved by estimating the cost of equity or WACC for
an industry or a group of comparable companies. This cuts down the “noise” that
plagues single-company estimates. Suppose, for example, that Jo Ann Cox is able to
identify three companies with investments and operations similar to Geothermal’s. The
average WACC for these three companies would be a valuable check on her estimate of
WACC for Geothermal alone.
Or suppose that Geothermal is contemplating investment in oil refining. For
this venture Geothermal’s existing WACC is probably not right; it needs a discount rate
reflecting the risks of the refining business. It could therefore try to estimate WACC
for a sample of oil refining companies. If too few “pure-play” refining companies were
available—most oil companies invest in production and marketing as well as refining—
an industry WACC for a sample of large oil companies could be a useful check
or benchmark. (We report estimates of oil industry WACCs at the end of the next
section.)
THE EXPECTED RETURN ON PREFERRED STOCK
Preferred stock that pays a fixed annual dividend can be valued from the perpetuity for-
mula:
6 The calculations have been done to one or two decimal places only to avoid confusion from rounding.
450 SECTION FOUR
Price of preferred =
dividend
rpreferred
where rpreferred is the appropriate discount rate for the preferred stock. Therefore, we
can infer the required rate of return on preferred stock by rearranging the valuation
formula to
rpreferred =
dividend
price of preferred
For example, if a share of preferred stock sells for $20 and pays a dividend of $2 per
share, the expected return on preferred stock is rpreferred = $2/$20 = 10 percent, which is
simply the dividend yield.
Big Oil’s Weighted-Average
Cost of Capital
Now that you have worked out Big Oil’s capital structure and estimated the expected re-
turn on its securities, you need only simple arithmetic to calculate the weighted-average
cost of capital. Table 4.13 summarizes the necessary data. Now all you need to do is
plug the data in Table 4.13 into the weighted-average cost of capital formula:
WACC = [ D × (1 – Tc)rdebt] + ( E × requity)
V
= [.243 × (1 – .35) 9%] + (.757 × 13.5%) = 11.6%
V
Suppose that Big Oil needed to evaluate a project with the same risk as its existing busi-
ness that would also support a 24.3 percent debt ratio. The 11.6 percent weighted-
average cost of capital is the appropriate discount rate for the cash flows.
REAL OIL COMPANY WACCs
Big Oil is entirely hypothetical—and not even very big compared to actual oil compa-
nies. Figure 4.18 shows estimated average costs of equity (requity) and WACCs for a sam-
ple of 10 to 12 large oil companies from 1965 to 1997. The latest estimates seem to fall
below 10 percent, less than our hypothetical figure for Big Oil.
The WACC estimates in Figure 4.18 decline steadily since the early 1980s. Some of
that decline can be attributed to a decline in interest rates over the 1980s and early | Brealey |
1990s. We have included a plot of the risk-free rate (rf) in Figure 4.18 as a reference
point. However, the spread between the WACC estimates and these interest rates has
also narrowed, suggesting that investors viewed the oil business as less risky in the early
1990s than a decade earlier.
TABLE 4.13
Data needed to calculate Big
Oil’s weighted-average cost
of capital (dollar figures in
millions)
Security Type
Capital Structure
Required Rate of Return
Debt
Common stock
Total
D = $ 385.7
E = $1,200.0
V = $1,585.7
D/V = .243
E/V = .757
rdebt = .09, or 9%
requity = .135, or 13.5%
Note: Corporate tax rate = Tc = .35.
FIGURE 4.18
The middle line represents
average weighted-average
costs of capital for a sample
of large oil companies.
Average costs of equity (for
the same sample) and the
risk-free rate of interest are
also plotted for comparison.
The Cost of Capital 451
30
t 25
n
e
c
r
e
p
20
Weighted-average
cost of capital
Cost of equity capital
,
n
r
u
t
e
r
f
o
s
e
t
a
r
d
e
r
i
u
q
e
R
15
10
5
0
Treasury rate
1965
’70
’75
’80
’85
’90
’95
Year
Remember, the WACCs shown in Figure 4.18 are industry averages and therefore
cover a wide range of activities. The large oil companies sampled are involved in some
risky activities, such as exploration, and some relatively safe activities, such as fran-
chising retail gas stations. The industry average will not be right for everything the in-
dustry does.
Interpreting the Weighted-Average
Cost of Capital
WHEN YOU CAN AND CAN’T USE WACC
Earlier discussed the company cost of capital, but at that stage we did not know how to
measure the company cost of capital when the firm has issued different types of secu-
rities or how to adjust for the tax-deductibility of interest payments. The weighted-av-
erage cost of capital formula solves those problems.
The weighted-average cost of capital is the rate of return that the firm must
expect to earn on its average-risk investments in order to provide a fair
expected return to all its security holders. We use it to value new assets that
have the same risk as the old ones and that support the same ratio of debt.
Strictly speaking, the weighted-average cost of capital is an appropriate
discount rate only for a project that is a carbon copy of the firm’s existing
business. But often it is used as a companywide benchmark discount rate;
the benchmark is adjusted upward for unusually risky projects and
downward for unusually safe ones.
There is a good musical analogy here. Most of us, lacking perfect pitch, need a well-
defined reference point, like middle C, before we can sing on key. But anyone who
can carry a tune gets relative pitches right. Businesspeople have good intuition about
452 SECTION FOUR
relative risks, at least in industries they are used to, but not about absolute risk or re-
quired rates of return. Therefore, they set a company- or industrywide cost of capital as
a benchmark. This is not the right hurdle rate for everything the company does, but
judgmental adjustments can be made for more risky or less risky ventures.
SOME COMMON MISTAKES
One danger with the weighted-average formula is that it tempts people to make logical
errors. Think back to your estimate of the cost of capital for Big Oil:
WACC = [ D × (1 – Tc)rdebt] + ( E × requity)
V
V
= [.243 × (1 – .35) 9%] + (.757 × 13.5%) = 11.6%
Now you might be tempted to say to yourself, “Aha! Big Oil has a good credit rating. It
could easily push up its debt ratio to 50 percent. If the interest rate is 9 percent and the
required return on equity is 13.5 percent, the weighted-average cost of capital would be
WACC = [.50 × (1 – .35) 9%] + (.50 × 13.5%) = 9.7%
At a discount rate of 9.7 percent, we can justify a lot more investment.”
That reasoning will get you into trouble. First, if Big Oil increased its borrowing, the
lenders would almost certainly demand a higher rate of interest on the debt. Second, as
the borrowing increased, the risk of the common stock would also increase and there-
fore the stockholders would demand a higher return.
There are actually two costs of debt finance. The explicit cost of debt is the | Brealey |
rate of interest that bondholders demand. But there is also an implicit cost,
because borrowing increases the required return to equity.
When you jumped to the conclusion that Big Oil could lower its weighted-average cost
of capital to 9.7 percent by borrowing more, you were recognizing only the explicit cost
of debt and not the implicit cost.
(cid:1) Self-Test 7
Jo Ann Cox’s boss has pointed out that Geothermal proposes to finance its expansion
entirely by borrowing at an interest rate of 8 percent. He argues that this is therefore the
appropriate discount rate for the project’s cash flows. Is he right?
HOW CHANGING CAPITAL STRUCTURE
AFFECTS EXPECTED RETURNS
We will illustrate how changes in capital structure affect expected returns by focusing
on the simplest possible case, where the corporate tax rate Tc is zero.
Think back to our earlier example of Geothermal. Geothermal, you may remember,
has the following market-value balance sheet:
Assets
Liabilities and Shareholders’ Equity
Assets = value of Geothermal’s
$647
Debt
$194
(30%)
existing business
Total value
$647
Equity
Value
$453
$647
(70%)
(100%)
The Cost of Capital 453
Geothermal’s debtholders require a return of 8 percent and the shareholders require a
return of 14 percent. Since we assume here that Geothermal pays no corporate tax, its
weighted-average cost of capital is simply the expected return on the firm’s assets:
WACC = rassets = (.3 × 8%) + (.7 × 14%) = 12.2%
This is the return you would expect if you held all Geothermal’s securities and therefore
owned all its assets.
Now think what will happen if Geothermal borrows an additional $97 million and
uses the cash to buy back and retire $97 million of its common stock. The revised mar-
ket-value balance sheet is
Assets
Liabilities and Shareholders’ Equity
Assets = value of Geothermal’s
$647
Debt
$291
(45%)
existing business
Total value
$647
Equity
Value
356
$647
(55%)
(100%)
If there are no corporate taxes, the change in capital structure does not affect the total
cash that Geothermal pays out to its security holders and it does not affect the risk of
those cash flows. Therefore, if investors require a return of 12.2 percent on the total
package of debt and equity before the financing, they must require the same 12.2
percent return on the package afterward. The weighted-average cost of capital is there-
fore unaffected by the change in the capital structure.
Although the required return on the package of the debt and equity is unaffected, the
change in capital structure does affect the required return on the individual securities.
Since the company has more debt than before, the debt is riskier and debtholders are
likely to demand a higher return. Increasing the amount of debt also makes the equity
riskier and increases the return that shareholders require.
WHAT HAPPENS WHEN THE CORPORATE
TAX RATE IS NOT ZERO
We have shown that when there are no corporate taxes the weighted-average cost of cap-
ital is unaffected by a change in capital structure. Unfortunately, taxes can complicate
the picture.7 For the moment, just remember
• The weighted-average cost of capital is the right discount rate for average-
risk capital investment projects.
• The weighted-average cost of capital is the return the company needs to
•
earn after tax in order to satisfy all its security holders.
If the firm increases its debt ratio, both the debt and the equity will
become more risky. The debtholders and equity holders require a higher
return to compensate for the increased risk.
7 There’s nothing wrong with our formulas and examples, provided that the tax deductibility of interest pay-
ments doesn’t change the aggregate risk of the debt and equity investors. However, if the tax savings from
deducting interest are treated as safe cash flows, the formulas get more complicated. If you really want to dive
into the tax-adjusted formulas showing how WACC changes with capital structure, we suggest later
in R. A. Brealey and S. C. Myers, Principles of Corporate Finance, 6th ed. (New York: Irwin/McGraw-Hill,
2000).
| Brealey |
454 SECTION FOUR
Flotation Costs and the Cost of Capital
To raise the necessary cash for a new project, the firm may need to issue stocks, bonds,
or other securities. The costs of issuing these securities to the public can easily amount
to 5 percent of funds raised. For example, a firm issuing $100 million in new equity
may net only $95 million after incurring the costs of the issue.
Flotation costs involve real money. A new project is less attractive if the firm must
spend large sums on issuing new securities. To illustrate, consider a project that will
cost $900,000 to install and is expected to generate a level perpetual cash-flow stream
of $90,000 a year. At a required rate of return of 10 percent, the project is just barely
viable, with an NPV of zero: –$900,000 + $90,000/.10 = 0.
Now suppose that the firm needs to raise equity to pay for the project, and that
flotation costs are 10 percent of funds raised. To raise $900,000, the firm actually
must sell $1 million of equity. Since the installed project will be worth only $90,000/.10
= $900,000, NPV including flotation costs is actually –$1 million + $900,000 =
–$100,000.
In our example, we recognized flotation costs as one of the incremental costs of un-
dertaking the project. But instead of recognizing these costs explicitly, some companies
attempt to cope with flotation costs by increasing the cost of capital used to discount
project cash flows. By using a higher discount rate, project present value is reduced.
This procedure is flawed on practical as well as theoretical grounds. First, on a
purely practical level, it is far easier to account for flotation costs as a negative cash
flow than to search for an adjustment to the discount rate that will give the right NPV.
Finding the necessary adjustment is easy only when cash flows are level or will grow
indefinitely at a constant trend rate. This is almost never the case in practice, however.
Of course, there always exists some discount rate that will give the right measure of the
project’s NPV, but this rate could no longer be interpreted as the rate of return available
in the capital market for investments with the same risk as the project.
The cost of capital depends only on interest rates, taxes, and the risk of the
project. Flotation costs should be treated as incremental (negative) cash flows;
they do not increase the required rate of return.
Summary
Why do firms compute weighted-average costs of capital?
They need a standard discount rate for average-risk projects. An “average-risk” project is
one that has the same risk as the firm’s existing assets and operations.
What about projects that are not average?
The weighted-average cost of capital can still be used as a benchmark. The benchmark is
adjusted up for unusually risky projects and down for unusually safe ones.
How do firms compute weighted-average costs of capital?
Here’s the WACC formula one more time:
The Cost of Capital 455
WACC = rdebt
× (1 – Tc) × D/V + requity
× E/V
The WACC is the expected rate of return on the portfolio of debt and equity securities
issued by the firm. The required rate of return on each security is weighted by its proportion
of the firm’s total market value (not book value). Since interest payments reduce the firm’s
× (1 – Tc).
income tax bill, the required rate of return on debt is measured after tax, as rdebt
This WACC formula is usually written assuming the firm’s capital structure includes just
two classes of securities, debt and equity. If there is another class, say preferred stock, the
formula expands to include it. In other words, we would estimate rpreferred, the rate of return
demanded by preferred stockholders, determine P/V, the fraction of market value accounted
× P/V to the equation. Of course the weights in the WACC
for by preferred, and add rpreferred
formula always add up to 1.0. In this case D/V + P/V + E/V = 1.0.
How are the costs of debt and equity calculated?
The cost of debt (rdebt) is the market interest rate demanded by bondholders. In other words, | Brealey |
it is the rate that the company would pay on new debt issued to finance its investment
projects. The cost of preferred (rpreferred) is just the preferred dividend divided by the market
price of a preferred share.
The tricky part is estimating the cost of equity (requity), the expected rate of return on the
firm’s shares. Financial managers use the capital asset pricing model to estimate expected
return. But for mature, steady-growth companies, it can also make sense to use the constant-
growth dividend discount model. Remember, estimates of expected return are less reliable
for a single firm’s stock than for a sample of comparable-risk firms. Therefore, some
managers also consider WACCs calculated for industries.
What happens when capital structure changes?
The rates of return on debt and equity will change. For example, increasing the debt ratio
will increase the risk borne by both debt and equity investors and cause them to demand
higher returns. However, this does not necessarily mean that the overall WACC will
increase, because more weight is put on the cost of debt, which is less than the cost of
equity. In fact, if we ignore taxes, the overall cost of capital will stay constant as the
fractions of debt and equity change.
Should WACC be adjusted for the costs of issuing securities to finance a project?
No. If acceptance of a project would require the firm to issue securities, the flotation costs
of the issue should be added to the investment required for the project. This reduces project
NPV dollar for dollar. There is no need to adjust WACC.
Related Web
Links
www.geocities.com/WallStreet/Market/1839/irates.html Incorporating risk premiums into the
cost of capital
www.financeadvisor.com/coc.htm Another approach to calculating cost of capital
Key Terms
Quiz
capital structure
weighted-average cost of capital (WACC)
1. Cost of Debt. Micro Spinoffs, Inc., issued 20-year debt a year ago at par value with a coupon
rate of 9 percent, paid annually. Today, the debt is selling at $1,050. If the firm’s tax bracket
is 35 percent, what is its after-tax cost of debt?
456 SECTION FOUR
Practice
Problems
2. Cost of Preferred Stock. Micro Spinoffs also has preferred stock outstanding. The stock
pays a dividend of $4 per share, and the stock sells for $40. What is the cost of preferred
stock?
3. Calculating WACC. Suppose Micro Spinoffs’s cost of equity is 12.5 percent. What is its
WACC if equity is 50 percent, preferred stock is 20 percent, and debt is 30 percent of total
capital?
4. Cost of Equity. Reliable Electric is a regulated public utility, and it is expected to provide
steady growth of dividends of 5 percent per year for the indefinite future. Its last dividend
was $5 per share; the stock sold for $60 per share just after the dividend was paid. What is
the company’s cost of equity?
5. Calculating WACC. Reactive Industries has the following capital structure. Its corporate tax
rate is 35 percent. What is its WACC?
Security
Market Value
Required Rate of Return
Debt
Preferred stock
Common stock
$20 million
$10 million
$50 million
8%
10%
15%
6. Company versus Project Discount Rates. Geothermal’s WACC is 11.4 percent. Executive
Fruit’s WACC is 12.3 percent. Now Executive Fruit is considering an investment in geother-
mal power production. Should it discount project cash flows at 12.3 percent? Why or why
not?
7. Flotation Costs. A project costs $10 million and has NPV of $+2.5 million. The NPV is
computed by discounting at a WACC of 15 percent. Unfortunately, the $10 million invest-
ment will have to be raised by a stock issue. The issue would incur flotation costs of $1.2
million. Should the project be undertaken?
8. WACC. The common stock of Buildwell Conservation & Construction, Inc., has a beta of
.80. The Treasury bill rate is 4 percent and the market risk premium is estimated at 8 per-
cent. BCCI’s capital structure is 30 percent debt paying a 5 percent interest rate, and 70 per-
cent equity. What is BCCI’s cost of equity capital? Its WACC? Buildwell pays no taxes.
9. WACC and NPV. BCCI (see the previous problem) is evaluating a project with an internal | Brealey |
rate of return of 12 percent. Should it accept the project? If the project will generate a cash
flow of $100,000 a year for 7 years, what is the most BCCI should be willing to pay to ini-
tiate the project?
10. Calculating WACC. Find the WACC of William Tell Computers. The total book value of the
firm’s equity is $10 million; book value per share is $20. The stock sells for a price of $30
per share, and the cost of equity is 15 percent. The firm’s bonds have a par value of $5 mil-
lion and sell at a price of 110 percent of par. The yield to maturity on the bonds is 9 percent,
and the firm’s tax rate is 40 percent.
11. WACC. Nodebt, Inc., is a firm with all-equity financing. Its equity beta is .80. The Treasury
bill rate is 5 percent and the market risk premium is expected to be 10 percent. What is
Nodebt’s asset beta? What is Nodebt’s weighted-average cost of capital? The firm is exempt
from paying taxes.
12. Cost of Capital. A financial analyst at Dawn Chemical notes that the firm’s total interest
payments this year were $10 million while total debt outstanding was $80 million, and he
concludes that the cost of debt was 12.5 percent. What is wrong with this conclusion?
13. Cost of Equity. Bunkhouse Electronics is a recently incorporated firm that makes electronic
entertainment systems. Its earnings and dividends have been growing at a rate of 30 percent,
The Cost of Capital 457
and the current dividend yield is 2 percent. Its beta is 1.2, the market risk premium is 8 per-
cent, and the risk-free rate is 4 percent.
a. Calculate two estimates of the firm’s cost of equity.
b. Which estimate seems more reasonable to you? Why?
14. Cost of Debt. Olympic Sports has two issues of debt outstanding. One is a 9 percent coupon
bond with a face value of $20 million, a maturity of 10 years, and a yield to maturity of 10
percent. The coupons are paid annually. The other bond issue has a maturity of 15 years, with
coupons also paid annually, and a coupon rate of 10 percent. The face value of the issue
is $25 million, and the issue sells for 92.8 percent of par value. The firm’s tax rate is 35
percent.
a. What is the before-tax cost of debt for Olympic?
b. What is Olympic’s after-tax cost of debt?
15. Capital Structure. Examine the following book-value balance sheet for University Prod-
ucts, Inc. What is the capital structure of the firm based on market values? The preferred
stock currently sells for $15 per share and the common stock for $20 per share. There are
one million common shares outstanding.
BOOK VALUE BALANCE SHEET
(all values in millions)
Assets
Liabilities and Net Worth
Cash and short-term securities
$ 1
Bonds, coupon = 8%, paid
$10.0
Accounts receivable
Inventories
Plant and equipment
Total
annually (maturity = 10 years,
current yield to maturity = 9%)
Preferred stock (par value $20
per share)
Common stock (par value $.10)
Additional paid in stockholders’
capital
Retained earnings
Total
2.0
.1
9.9
10.0
$32.0
3
7
21
$32
16. Calculating WACC. Turn back to University Products’s balance sheet from the previous
problem. If the preferred stock pays a dividend of $2 per share, the beta of the stock is .8,
the market risk premium is 10 percent, the risk-free rate is 6 percent, and the firm’s tax rate
is 40 percent, what is University’s weighted-average cost of capital?
17. Project Discount Rate. University Products is evaluating a new venture into home com-
puter systems (see problems 15 and 16). The internal rate of return on the new venture
is estimated at 13.4 percent. WACCs of firms in the personal computer industry tend to
average around 14 percent. Should the new project be pursued? Will University Products
make the correct decision if it discounts cash flows on the proposed venture at the firm’s
WACC?
18. Cost of Capital. The total market value of Okefenokee Real Estate Company is $6 million,
and the total value of its debt is $4 million. The treasurer estimates that the beta of the stock
currently is 1.5 and that the expected risk premium on the market is 10 percent. The Trea- | Brealey |
sury bill rate is 4 percent.
a. What is the required rate of return on Okefenokee stock?
b. What is the beta of the company’s existing portfolio of assets? The debt is perceived to
be virtually risk-free.
458 SECTION FOUR
Challenge
Problems
Solutions to
Self-Test
Questions
c. Estimate the weighted-average cost of capital assuming a tax rate of 40 percent.
d. Estimate the discount rate for an expansion of the company’s present business.
e. Suppose the company wants to diversify into the manufacture of rose-colored glasses.
The beta of optical manufacturers with no debt outstanding is 1.2. What is the required
rate of return on Okefenokee’s new venture?
19. Changes in Capital Structure. Look again at our calculation of Big Oil’s WACC. Suppose
Big Oil is excused from paying taxes. How would its WACC change? Now suppose Big Oil
makes a large stock issue and uses the proceeds to pay off all its debt. How would the cost
of equity change?
20. Changes in Capital Structure. Refer again to problem 19. Suppose Big Oil starts from the
financing mix in Table 4.13, and then borrows an additional $200 million from the bank. It
then pays out a special $200 million dividend, leaving its assets and operations unchanged.
What happens to Big Oil’s WACC, still assuming it pays no taxes? What happens to the cost
of equity?
21. WACC and Taxes. “The after-tax cost of debt is lower when the firm’s tax rate is higher;
therefore, the WACC falls when the tax rate rises. Thus, with a lower discount rate, the firm
must be worth more if its tax rate is higher.” Explain why this argument is wrong.
22. Cost of Capital. An analyst at Dawn Chemical notes that its cost of debt is far below that
of equity. He concludes that it is important for the firm to maintain the ability to increase its
borrowing because if it cannot borrow, it will be forced to use more expensive equity to fi-
nance some projects. This might lead it to reject some projects that would have seemed at-
tractive if evaluated at the lower cost of debt. Comment on this reasoning.
1 Hot Rocks’s 4 million common shares are worth $40 million. Its market value balance sheet
is:
Assets
Assets
$90
Value
$90
Liabilities and Shareholders’ Equity
Debt
Equity
Value
$50
40
$90
(56%)
(44%)
WACC = (.56 × 9%) + (.44 × 17%) = 12.5%
We use Hot Rocks’s pretax return on debt because the company pays no taxes.
2 Burg’s 6 million shares are now worth only 6 million × $4 = $24 million. The debt is sell-
ing for 80 percent of book, or $20 million. The market value balance sheet is:
Assets
Assets
$44
Value
$44
Liabilities and Shareholders’ Equity
Debt
Equity
Value
$20
24
$44
(45%)
(55%)
WACC = (.45 × 14%) + (.55 × 20%) = 17.3%
Note that this question ignores taxes.
The Cost of Capital 459
3 Compare the two income statements, one for Criss-cross Industries and the other for a firm
with identical EBIT but no debt in its capital structure. (All figures in millions.)
Criss-cross
Firm with No Debt
EBIT
Interest expense
Taxable income
Taxes owed
Net income
Total income accruing to debt & equity holders
$10.0
2.0
8.0
2.8
5.2
7.2
$10.0
0.0
10.0
3.5
6.5
6.5
Notice that Criss-cross pays $.7 million less in taxes than its debt-free counterpart. Ac-
cordingly, the total income available to debt plus equity holders is $.7 million higher.
4 For Hot Rocks,
WACC = [.56 × 9 × (1 – .35)] + (.44 × 17) = 10.76%
For Burg Associates,
WACC = [.45 × 14 × (1 – .35)] + (.55 × 20) = 15.1%
5 WACC measures the expected rate of return demanded by debt and equity investors in the
firm (plus a tax adjustment capturing the tax-deductibility of interest payments). Thus the
calculation must be based on what investors are actually paying for the firm’s debt and eq-
uity securities. In other words, it must be based on market values.
6 From the CAPM:
requity = rf + β
equity (rm – rf)
= 6% + 1.20(9%) = 16.8%
WACC = .3(1 – .35) 8% + .7(16.8%) = 13.3%
7 Jo Ann’s boss is wrong. The ability to borrow at 8 percent does not mean that the cost of
capital is 8 percent. This analysis ignores the side effects of the borrowing, for example, that
at the higher indebtedness of the firm the equity will be riskier, and therefore the equity- | Brealey |
holders will demand a higher rate of return on their investment.
MINICASE
Bernice Mountaindog was glad to be back at Sea Shore Salt.
Employees were treated well. When she had asked a year ago for
a leave of absence to complete her degree in finance, top man-
agement promptly agreed. When she returned with an honors de-
gree, she was promoted from administrative assistant (she had
been secretary to Joe-Bob Brinepool, the president) to treasury
analyst.
Bernice thought the company’s prospects were good. Sure,
table salt was a mature business, but Sea Shore Salt had grown
steadily at the expense of its less well-known competitors. The
company’s brand name was an important advantage, despite the
difficulty most customers had in pronouncing it rapidly.
went smoothly. Then Mr. Brinepool’s cost of capital memo as-
signed her to explain Sea Shore Salt’s weighted-average cost of
capital to other managers. The memo came as a surprise to Ber-
nice, so she stayed late to prepare for the questions that would
surely come the next day.
Bernice first examined Sea Shore Salt’s most recent balance
sheet, summarized in Table 4.14. Then she jotted down the fol-
lowing additional points:
• The company’s bank charged interest at current market rates,
and the long-term debt had just been issued. Book and market
values could not differ by much.
Bernice started work on January 2, 2000. The first two weeks
• But the preferred stock had been issued 35 years ago, when
460 SECTION FOUR
TABLE 4.14
Sea Shore Salt’s balance
sheet, taken from the
company’s 1999 balance
sheet (figures in millions)
Assets
Working capital
Plant and equipment
Other assets
Total
$200
360
40
$600
Liabilities and Net Worth
Bank loan
Long-term debt
Preferred stock
Common stock, including retained earnings
Total
$120
80
100
300
$600
Notes:
1. At year-end 1999, Sea Shore Salt had 10 million common shares outstanding.
2. The company had also issued 1 million preferred shares with book value of $100 per share. Each share
receives an annual dividend of $6.00.
interest rates were much lower. The preferred stock was now
trading for only $70 per share.
• The common stock traded for $40 per share. Next year’s earn-
ings per share would be about $4.00 and dividends per share
probably $2.00. Sea Shore Salt had traditionally paid out 50
percent of earnings as dividends and plowed back the rest.
• Earnings and dividends had grown steadily at 6 to 7 percent
per year, in line with the company’s sustainable growth rate:
Sustainable
growth rate
× plowback
ratio
=
return
on equity
= 4.00/30 × .5
= .067, or 6.7%
• Sea Shore Salt’s beta had averaged about .5, which made
sense, Bernice thought, for a stable, steady-growth business.
She made a quick cost of equity calculation using the capital
asset pricing model (CAPM). With current interest rates of
about 7 percent, and a market risk premium of 8 percent,
CAPM cost of equity = rE = rf + β(rm – rf)
= 7% + .5(8%) = 11%
This cost of equity was significantly less than the 16 percent
decreed in Mr. Brinepool’s memo. Bernice scanned her notes ap-
prehensively. What if Mr. Brinepool’s cost of equity was wrong?
Was there some other way to estimate the cost of equity as a
check on the CAPM calculation? Could there be other errors in
his calculations?
Bernice resolved to complete her analysis that night. If neces-
sary, she would try to speak with Mr. Brinepool when he arrived
at his office the next morning. Her job was not just finding the
right number. She also had to figure out how to explain it all to
Mr. Brinepool.
The Cost of Capital 461
Sea Shore Salt Company
Spring Vacation Beach, Florida
CONFIDENTIAL MEMORANDUM
DATE:
TO:
FROM:
SUBJECT:
January 15, 2000
S.S.S. Management
Joe-Bob Brinepool, President
Cost of Capital
This memo states and clarifies our company’s long-standing policy regarding hurdle rates
for capital investment decisions. There have been many recent questions, and some evident
confusion, on this matter.
Sea Shore Salt evaluates replacement and expansion investments by discounted cash flow. | Brealey |
The discount or hurdle rate is the company’s after-tax weighted-average cost of capital.
The weighted-average cost of capital is simply a blend of the rates of return expected by
investors in our company. These investors include banks, bond holders, and preferred
stock investors in addition to common stockholders. Of course many of you are, or soon
will be, stockholders of our company.
The following table summarizes the composition of Sea Shore Salt’s financing.
Amount (in millions)
Percent of Total
Rate of Return
Bank loan
Bond issue
Preferred stock
Common stock
$120
80
100
300
$600
20%
13.3
16.7
50
100%
8%
7.75
6
16
The rates of return on the bank loan and bond issue are of course just the interest rates
we pay. However, interest is tax-deductible, so the after-tax interest rates are lower
than shown above. For example, the after-tax cost of our bank financing, given our 35%
tax rate, is 8(1 – .35) = 5.2%.
The rate of return on preferred stock is 6%. Sea Shore Salt pays a $6 dividend on each
$100 preferred share.
Our target rate of return on equity has been 16% for many years. I know that some
newcomers think this target is too high for the safe and mature salt business. But we
must all aspire to superior profitability.
Once this background is absorbed, the calculation of Sea Shore Salt’s weighted-average
cost of capital (WACC) is elementary:
WACC = 8(1 – .35)(.2) + 7.75(1 – .35)(.133) + 6(.167) + 16(.50) = 10.7%
The official corporate hurdle rate is therefore 10.7%.
If you have further questions about these calculations, please direct them to our new
Treasury Analyst, Ms. Bernice Mountaindog. It is a pleasure to have Bernice back at Sea
Shore Salt after a year’s leave of absence to complete her degree in finance.
Section 5
Project Analysis
An Overview of Corporate Financing
How Corporations Issue Securities
PROJECT ANALYSIS
The Option to Expand
Abandonment Options
Flexible Production Facilities
Investment Timing Options
Summary
How Firms Organize the
Investment Process
Stage 1: The Capital Budget
Stage 2: Project Authorizations
Problems and Some Solutions
Some “What-If” Questions
Sensitivity Analysis
Scenario Analysis
Break-Even Analysis
Accounting Break-Even Analysis
NPV Break-Even Analysis
Operating Leverage
Flexibility in Capital
Budgeting
Decision Trees
“But Mr. Mitterand, have you thought of sensitivity analysis?”
Prime Minister Margaret Thatcher and President Francois Mitterand meet to sign the treaty
leading to construction of a railway tunnel under the English Channel between England and
France.
AP/Wide World Photos
465
I
t helps to use discounted cash-flow techniques to value new projects but
good investment decisions also require good data. Therefore, we start
this material by thinking about how firms organize the capital budgeting
operation to get the kind of information they need. In addition, we look at
how they try to ensure that everyone involved works together toward a common goal.
Project evaluation should never be a mechanical exercise in which the financial man-
ager takes a set of cash-flow forecasts and cranks out a net present value. Cash-flow es-
timates are just that—estimates. Financial managers need to look behind the forecasts
to try to understand what makes the project tick and what could go wrong with it. A
number of techniques have been developed to help managers identify the key assump-
tions in their analysis. These techniques involve asking a number of “what-if ” ques-
tions. What if your market share turns out to be higher or lower than you forecast? What
if interest rates rise during the life of the project? In the second part of this material we
show how managers use the techniques of sensitivity analysis, scenario analysis, and
break-even analysis to help answer these what-if questions.
Books about capital budgeting sometimes create the impression that once the man-
ager has made an investment decision, there is nothing to do but sit back and watch the
cash flows develop. But since cash flows rarely proceed as anticipated, companies con-
stantly need to modify their operations. If cash flows are better than anticipated, the
| Brealey |
project may be expanded; if they are worse, it may be scaled back or abandoned alto-
gether. In the third section of this material we describe how good managers take account
of these options when they analyze a project and why they are willing to pay money
today to build in future flexibility.
After studying this material you should be able to
(cid:1) Appreciate the practical problems of capital budgeting in large corporations.
(cid:1) Use sensitivity, scenario, and break-even analysis to see how project profitability
would be affected by an error in your forecasts and understand why an overestimate
of sales is more serious for projects with high operating leverage.
(cid:1) Recognize the importance of managerial flexibility in capital budgeting.
How Firms Organize
the Investment Process
For most sizable firms, investments are evaluated in two separate stages.
466
ACAPITAL BUDGET
List of planned investment
projects.
Project Analysis 467
STAGE 1: THE CAPITAL BUDGET
Once a year, the head office generally asks each of its divisions and plants to provide a
list of the investments that they would like to make.1 These are gathered together into a
proposed capital budget.
This budget is then reviewed and pruned by senior management and staff specializ-
ing in planning and financial analysis. Usually there are negotiations between the firm’s
senior management and its divisional management, and there may also be special analy-
ses of major outlays or ventures into new areas. Once the budget has been approved, it
generally remains the basis for planning over the ensuing year.
Many investment proposals bubble up from the bottom of the organization. But
sometimes the ideas are likely to come from higher up. For example, the managers of
plants A and B cannot be expected to see the potential benefits of closing their plants
and consolidating production at a new plant C. We expect divisional management to
propose plant C. Similarly, divisions 1 and 2 may not be eager to give up their own data
processing operations to a large central computer. That proposal would come from sen-
ior management.
Senior management’s concern is to see that the capital budget matches the firm’s
strategic plans. It needs to ensure that the firm is concentrating its efforts in areas where
it has a real competitive advantage. As part of this effort, management must also iden-
tify declining businesses that should be sold or allowed to run down.
The firm’s capital investment choices should reflect both “bottom-up” and “top-
down” processes—capital budgeting and strategic planning, respectively. The two
processes should complement each other. Plant and division managers, who do most of
the work in bottom-up capital budgeting, may not see the forest for the trees. Strategic
planners may have a mistaken view of the forest because they do not look at the trees.
STAGE 2: PROJECT AUTHORIZATIONS
The annual budget is important because it allows everybody to exchange ideas before
attitudes have hardened and personal commitments have been made. However, the fact
that your pet project has been included in the annual budget doesn’t mean you have per-
mission to go ahead with it. At a later stage you will need to draw up a detailed proposal
describing particulars of the project, engineering analyses, cash-flow forecasts, and
present value calculations. If your project is large, this proposal may have to pass a
number of hurdles before it is finally approved.
The type of backup information that you need to provide depends on the project cat-
egory. For example, some firms use a fourfold breakdown:
1. Outlays required by law or company policy, for example, for pollution control equip-
ment. These outlays do not need to be justified on financial grounds. The main issue
is whether requirements are satisfied at the lowest possible cost. The decision is
therefore likely to hinge on engineering analyses of alternative technologies.
2. Maintenance or cost reduction, such as machine replacement. Engineering analysis | Brealey |
is also important in machine replacement, but new machines have to pay their own
way.
3. Capacity expansion in existing businesses. Projects in this category are less straight-
1 Large firms may be divided into several divisions. For example, International Paper has divisions that spe-
cialize in printing paper, packaging, specialty products, and forest products. Each of these divisions may be
responsible for a number of plants.
468 SECTION FIVE
forward; these decisions may hinge on forecasts of demand, possible shifts in tech-
nology, and the reactions of competitors.
4. Investment for new products. Projects in this category are most likely to depend on
strategic decisions. The first projects in a new area may not have positive NPVs if
considered in isolation, but they may give the firm a valuable option to undertake
follow-up projects. More about this later.
PROBLEMS AND SOME SOLUTIONS
Valuing capital investment opportunities is hard enough when you can do the entire job
yourself. In most firms, however, capital budgeting is a cooperative effort, and this
brings with it some challenges.
Ensuring that Forecasts Are Consistent.
Inconsistent assumptions often creep into
investment proposals. For example, suppose that the manager of the furniture division
is bullish (optimistic) on housing starts but the manager of the appliance division is
bearish (pessimistic). This inconsistency makes the projects proposed by the furniture
division look more attractive than those of the appliance division.
To ensure consistency, many firms begin the capital budgeting process by establish-
ing forecasts of economic indicators, such as inflation and the growth in national in-
come, as well as forecasts of particular items that are important to the firm’s business,
such as housing starts or the price of raw materials. These forecasts can then be used as
the basis for all project analyses.
Eliminating Conflicts of Interest. Earlier we pointed out that while managers want
to do a good job, they are also concerned about their own futures. If the interests of
managers conflict with those of stockholders, the result is likely to be poor investment
decisions. For example, new plant managers naturally want to demonstrate good per-
formance right away. To this end, they might propose quick-payback projects even if
NPV is sacrificed. Unfortunately, many firms measure performance and reward man-
agers in ways that encourage such behavior. If the firm always demands quick results,
it is unlikely that plant managers will concentrate only on NPV.
Reducing Forecast Bias. Someone who is keen to get a project proposal accepted is
also likely to look on the bright side when forecasting the project’s cash flows. Such
overoptimism is a common feature in financial forecasts. For example, think of large
public expenditure proposals. How often have you heard of a new missile, dam, or high-
way that actually cost less than was originally forecast? Think back to the Eurotunnel
project. The final cost of the project was about 50 percent higher than initial forecasts.
It is probably impossible to ever eliminate bias completely, but if senior management is
aware of why bias occurs, it is at least partway to solving the problem.
Project sponsors are likely to overstate their case deliberately only if the head office
encourages them to do so. For example, if middle managers believe that success de-
pends on having the largest division rather than the most profitable one, they will pro-
pose large expansion projects that they do not believe have the largest possible net pres-
ent value. Or if divisions must compete for limited resources, they will try to outbid
each other for those resources. The fault in such cases is top management’s—if lower
level managers are not rewarded based on net present value and contribution to firm
value, it should not be surprising that they focus their efforts elsewhere.
Other problems stem from sponsors’ eagerness to obtain approval for their favorite
Project Analysis 469
| Brealey |
projects. As the proposal travels up the organization, alliances are formed. Thus once a
division has screened its own plants’ proposals, the plants in that division unite in com-
peting against outsiders. The result is that the head office may receive several thousand
investment proposals each year, all essentially sales documents presented by united
fronts and designed to persuade. The forecasts have been doctored to ensure that NPV
appears positive.
Since it is difficult for senior management to evaluate each specific assumption in
an investment proposal, capital investment decisions are effectively decentralized what-
ever the rules say. Some firms accept this; others rely on head office staff to check cap-
ital investment proposals.
Sorting the Wheat from the Chaff. Senior managers are continually bombarded
with requests for funds for capital expenditures. All these requests are supported with
detailed analyses showing that the projects have positive NPVs. How then can managers
ensure that only worthwhile projects make the grade? One response of senior managers
to this problem of poor information is to impose rigid expenditure limits on individual
plants or divisions. These limits force the subunits to choose among projects. The firm
ends up using capital rationing not because capital is unobtainable but as a way of de-
centralizing decisions.2
Senior managers might also ask some searching questions about why the project has
a positive NPV. After all, if the project is so attractive, why hasn’t someone already un-
dertaken it? Will others copy your idea if it is so profitable? Positive NPVs are plausi-
ble only if your company has some competitive advantage.
Such an advantage can arise in several ways. You may be smart or lucky enough to
be the first to the market with a new or improved product for which customers will pay
premium prices. Your competitors eventually will enter the market and squeeze out ex-
cess profits, but it may take them several years to do so. Or you may have a proprietary
technology or production cost advantage that competitors cannot easily match. You may
have a contractual advantage such as the distributorship for a particular region. Or your
advantage may be as simple as a good reputation and an established customer list.
Analyzing competitive advantage can also help ferret out projects that incorrectly
appear to have a negative NPV. If you are the lowest cost producer of a profitable prod-
uct in a growing market, then you should invest to expand along with the market. If your
calculations show a negative NPV for such an expansion, then you probably have made
a mistake.
Some “What-If” Questions
SENSITIVITY ANALYSIS
Uncertainty means that more things can happen than will happen. Therefore, whenever
managers are given a cash-flow forecast, they try to determine what else might happen
and the implications of those possible events. This is called sensitivity analysis.
Put yourself in the well-heeled shoes of the financial manager of the Finefodder su-
permarket chain. Finefodder is considering opening a new superstore in Gravenstein
2 We discussed capital rationing earlier.
SENSITIVITY
ANALYSIS Analysis of
the effects on project
profitability of changes in
sales, costs, and so on.
470 SECTION FIVE
TABLE 5.1
Cash-flow forecasts for
Finefodder’s new superstore
FIXED COSTS Costs
that do not depend on the
level of output.
VARIABLE COSTS
Costs that change as the
level of output changes.
Investment
–$5,400,000
Year 0
Years 1–12
1. Sales
2. Variable costs
3. Fixed costs
4. Depreciation
5. Pretax profit (1 – 2 – 3 – 4)
6. Taxes (at 40%)
7. Profit after tax
8. Cash flow from operations (4 + 7)
$16,000,000
13,000,000
2,000,000
450,000
550,000
220,000
330,000
780,000
Net cash flow
–$5,400,000
$
780,000
and your staff members have prepared the figures shown in Table 5.1. The figures are
fairly typical for a new supermarket, except that to keep the example simple we have
assumed no inflation. We have also assumed that the entire investment can be depreci-
ated straight-line for tax purposes, we have neglected the working capital requirement, | Brealey |
and we have ignored the fact that at the end of the 12 years you could sell off the land
and buildings.
As an experienced financial manager, you recognize immediately that these cash
flows constitute an annuity and therefore you calculate present value by multiplying the
$780,000 cash flow by the 12-year annuity factor. If the cost of capital is 8 percent,
present value is
PV = $780,000 × 12-year annuity factor
= $780,000 × 7.536 = $5.878 million
Subtract the initial investment of $5.4 million and you obtain a net present value of
$478,000:
NPV = PV – investment
= $5.878 million – $5.4 million = $478,000
Before you agree to accept the project, however, you want to delve behind these fore-
casts and identify the key variables that will determine whether the project succeeds or
fails.
Some of the costs of running a supermarket are fixed. For example, regardless of the
level of output, you still have to heat and light the store and pay the store manager.
These fixed costs are forecast to be $2 million per year.
Other costs vary with the level of sales. In particular, the lower the sales, the less
food you need to buy. Also, if sales are lower than forecast, you can operate a lower
number of checkouts and reduce the staff needed to restock the shelves. The new su-
perstore’s variable costs are estimated at 81.25 percent of sales. Thus variable costs =
.8125 × $16 million = $13 million.
The initial investment of $5.4 million will be depreciated on a straight-line basis over
the 12-year period, resulting in annual depreciation of $450,000. Profits are taxed at a
rate of 40 percent.
These seem to be the important things you need to know, but look out for things that
may have been forgotten. Perhaps there will be delays in obtaining planning permission,
Project Analysis 471
TABLE 5.2
Sensitivity analysis for superstore project
Range
NPV
Variable
Pessimistic
Expected
Optimistic
Pessimistic
Expected
Optimistic
Investment
Sales
Variable cost as
percent of sales
Fixed cost
6,200,000
14,000,000
5,400,000
16,000,000
5,000,000
18,000,000
–121,000
–1,218,000
+478,000
+478,000
+778,000
+2,174,000
83
2,100,000
81.25
2,000,000
80
1,900,000
–788,000
+26,000
+478,000
+478,000
+1,382,000
+930,000
or perhaps you will need to undertake costly landscaping. The greatest dangers often lie
in these unknown unknowns, or “unk-unks,” as scientists call them.
Having found no unk-unks (no doubt you’ll find them later), you look at how NPV
may be affected if you have made a wrong forecast of sales, costs, and so on. To do this,
you first obtain optimistic and pessimistic estimates for the underlying variables. These
are set out in the left-hand columns of Table 5.2.
Next you see what happens to NPV under the optimistic or pessimistic forecasts for
each of these variables. You recalculate project NPV under these various forecasts to de-
termine which variables are most critical to NPV.
(cid:1) EXAMPLE 1
Sensitivity Analysis
The right-hand side of Table 5.2 shows the project’s net present value if the variables are
set one at a time to their optimistic and pessimistic values. For example, if fixed costs
are $1.9 million rather than the forecast $2.0 million, annual cash flows are increased
by (1 – tax rate) × ($2.0 million – $1.9 million) = .6 × $100,000 = $60,000. If the cash
flow increases by $60,000 a year for 12 years, then the project’s present value increases
by $60,000 times the 12-year annuity factor, or $60,000 × 7.536 = $452,000. Therefore,
NPV increases from the expected value of $478,000 to $478,000 + $452,000 =
$930,000, as shown in the bottom right corner of the table. The other entries in the three
columns on the right in Table 5.2 similarly show how the NPV of the project changes
when each input is changed.
Your project is by no means a sure thing. The principal uncertainties appear to be
sales and variable costs. For example, if sales are only $14 million rather than the fore-
cast $16 million (and all other forecasts are unchanged), then the project has an NPV
of –$1.218 million. If variable costs are 83 percent of sales (and all other forecasts are | Brealey |
unchanged), then the project has an NPV of –$788,000.
(cid:1) Self-Test 1
Recalculate cash flow as in Table 5.1 if variable costs are 83 percent of sales. Confirm
that NPV will be –$788,000.
Value of Information. Now that you know the project could be thrown badly off
course by a poor estimate of sales, you might like to see whether it is possible to resolve
472 SECTION FIVE
some of this uncertainty. Perhaps your worry is that the store will fail to attract suffi-
cient shoppers from neighboring towns. In that case, additional survey data and more
careful analysis of travel times may be worthwhile.
On the other hand, there is less value to gathering additional information about
fixed costs. Because the project is marginally profitable even under pessimistic assump-
tions about fixed costs, you are unlikely to be in trouble if you have misestimated that
variable.
Limits to Sensitivity Analysis. Your analysis of the forecasts for Finefodder’s new
superstore is known as a sensitivity analysis. Sensitivity analysis expresses cash flows
in terms of unknown variables and then calculates the consequences of misestimating
those variables. It forces the manager to identify the underlying factors, indicates where
additional information would be most useful, and helps to expose confused or inappro-
priate forecasts.
Of course, there is no law stating which variables you should consider in your sen-
sitivity analysis. For example, you may wish to look separately at labor costs and the
costs of the goods sold. Or, if you are concerned about a possible change in the corpo-
rate tax rate, you may wish to look at the effect of such a change on the project’s NPV.
One drawback to sensitivity analysis is that it gives somewhat ambiguous results. For
example, what exactly does optimistic or pessimistic mean? One department may be in-
terpreting the terms in a different way from another. Ten years from now, after hundreds
of projects, hindsight may show that one department’s pessimistic limit was exceeded
twice as often as the other’s; but hindsight won’t help you now while you’re making the
investment decision.
Another problem with sensitivity analysis is that the underlying variables are likely
to be interrelated. For example, if sales exceed expectations, demand will likely be
stronger than you anticipated and your profit margins will be wider. Or, if wages are
higher than your forecast, both variable costs and fixed costs are likely to be at the upper
end of your range.
Because of these connections, you cannot push one-at-a-time sensitivity analysis too
far. It is impossible to obtain expected, optimistic, and pessimistic values for total proj-
ect cash flows from the information in Table 5.2. Still, it does give a sense of which vari-
ables should be most closely monitored.
SCENARIO ANALYSIS
SCENARIO ANALYSIS
Project analysis given a
particular combination of
assumptions.
When variables are interrelated, managers often find it helpful to look at how their proj-
ect would fare under different scenarios. Scenario analysis allows them to look at dif-
ferent but consistent combinations of variables. Forecasters generally prefer to give an
estimate of revenues or costs under a particular scenario rather than giving some ab-
solute optimistic or pessimistic value.
(cid:1) EXAMPLE 2
Scenario Analysis
You are worried that Stop and Scoff may decide to build a new store in nearby Salome.
That would reduce sales in your Gravenstein store by 15 percent and you might be
forced into a price war to keep the remaining business. Prices might be reduced to the
point that variable costs equal 82 percent of revenue. Table 5.3 shows that under this
TABLE 5.3
Scenario analysis, NPV of
Finefodder’s Gravenstein
superstore with scenario of
new competing store in
nearby Salome
Project Analysis 473
Cash Flows Years 1–12
Base Case
Competing Store Scenarioa
1. Sales
2. Variable costs
3. Fixed costs
4. Depreciation
5. Pretax profit (1 – 2 – 3 – 4)
6. Taxes (40%)
7. Profit after tax | Brealey |
8. Cash flow from operations (4 + 7)
Present value of cash flows
NPV
$16,000,000
13,000,000
2,000,000
450,000
550,000
220,000
330,000
780,000
5,878,000
478,000
$13,600,000
11,152,000
2,000,000
450,000
–2,000
–800
–1,200
448,800
3,382,000
–2,018,000
a Assumptions: Competing store causes (1) a 15 percent reduction in sales, and (2) variable costs to
increase to 82 percent of sales.
scenario of lower sales and smaller margins your new venture would no longer be
worthwhile.
SIMULATION
ANALYSIS Estimation of
the probabilities of different
possible outcomes, e.g.,
from an investment project.
An extension of scenario analysis is called simulation analysis. Here, instead of
specifying a relatively small number of scenarios, a computer generates several hundred
or thousand possible combinations of variables according to probability distributions
specified by the analyst. Each combination of variables corresponds to one scenario.
Project NPV and other outcomes of interest can be calculated for each combination of
variables, and the entire probability distribution of outcomes can be constructed from
the simulation results.
(cid:1) Self-Test 2
What is the basic difference between sensitivity analysis and scenario analysis?
BREAK-EVEN
ANALYSIS Analysis of
the level of sales at which the
company breaks even.
Break-Even Analysis
When we undertake a sensitivity analysis of a project or when we look at alternative
scenarios, we are asking how serious it would be if we have misestimated sales or costs.
Managers sometimes prefer to rephrase this question and ask how far off the estimates
could be before the project begins to lose money. This exercise is known as break-even
analysis.
For many projects, the make-or-break variable is sales volume. Therefore, managers
most often focus on the break-even level of sales. However, you might also look at other
variables, for example, at how high costs could be before the project goes into the red.
As it turns out, “losing money” can be defined in more than one way. Most often,
the break-even condition is defined in terms of accounting profits. More properly, how-
ever, it should be defined in terms of net present value. We will start with accounting
474 SECTION FIVE
break-even, show that it can lead you astray, and then show how NPV break-even can
be used as an alternative.
ACCOUNTING BREAK-EVEN ANALYSIS
The accounting break-even point is the level of sales at which profits are zero or, equiv-
alently, at which total revenues equal total costs. As we have seen, some costs are fixed
regardless of the level of output. Other costs vary with the level of output.
When you first analyzed the superstore project, you came up with the following es-
timates:
Sales
Variable cost
Fixed costs
Depreciation
$16 million
13 million
2 million
0.45 million
Notice that variable costs are 81.25 percent of sales. So, for each additional dollar of
sales, costs increase by only $.8125. We can easily determine how much business
the superstore needs to attract to avoid losses. If the store sells nothing, the income
statement will show fixed costs of $2 million and depreciation of $450,000. Thus
there will be a loss of $2.45 million. Each dollar of sales reduces this loss by $1.00 –
$.8125 = $.1875. Therefore, to cover fixed costs plus depreciation, you need sales of
2.45 million/.1875 = $13.067 million. At this sales level, the firm will break even. More
generally,
Break-even level of revenues =
fixed costs
including depreciation
additional profit
from each additional dollar of sales
Table 5.4 shows how the income statement looks with only $13.067 million of sales.
Figure 5.1 shows how the break-even point is determined. The 45-degree line shows
accounting revenues. The cost line shows how costs vary with sales. If the store
doesn’t sell a cent, it still incurs fixed costs and depreciation amounting to $2.45 mil-
lion. Each extra dollar of sales adds $.8125 to these costs. When sales are $13.067 mil-
lion, the two lines cross, indicating that costs equal revenues. For lower sales, revenues | Brealey |
are less than costs and the project is in the red; for higher sales, revenues exceed costs
and the project moves into the black.
Is a project that breaks even in accounting terms an acceptable investment? If you
TABLE 5.4
Income statement, break-even
sales volume
Item
$ Thousands
Revenues
Variable costs
Fixed costs
Depreciation
Pretax profit
Taxes
Profit after tax
13,067
10,617
2,000
450
0
0
0
(81.25 percent of sales)
FIGURE 5.1
Accounting break-even
analysis
n
o
i
l
l
i
m
$
,
e
u
n
e
v
e
r
d
n
a
s
t
s
o
C
13.067
2.45
Project Analysis 475
Revenue
Total costs
Variable costs
13.067
Fixed costs
Costs exceed revenue
Revenue exceeds costs
Sales revenue, $ million
are not sure about the answer, here’s a possibly easier question. Would you be happy
about an investment in a stock that after 5 years gave you a total rate of return of zero?
We hope not. You might break even on such a stock but a zero return does not com-
pensate you for the time value of money or the risk that you have taken.
A project that simply breaks even on an accounting basis gives you your
money back but does not cover the opportunity cost of the capital tied up in
the project. A project that breaks even in accounting terms will surely have a
negative NPV.
Let’s check this with the superstore project. Suppose that in each year the store has
sales of $13.067 million—just enough to break even on an accounting basis. What
would be the cash flow from operations?
Cash flow from operations = profit after tax + depreciation
= 0 + $450,000 = $450,000
The initial investment is $5.4 million. In each of the next 12 years, the firm receives a
cash flow of $450,000. So the firm gets its money back:
Total cash flow from operations = initial investment
12 × $450,000 = $5.4 million
But revenues are not sufficient to repay the opportunity cost of that $5.4 million in-
vestment. NPV is negative.
NPV BREAK-EVEN ANALYSIS
Instead of asking how bad sales can get before the project makes an accounting loss, it
is more useful to focus on the point at which NPV switches from positive to negative.
The cash flows of the project in each year will depend on sales as follows:
476 SECTION FIVE
1. Variable costs
2. Fixed costs
3. Depreciation
4. Pretax profit
5. Tax (at 40%)
6. Profit after tax
7. Cash flow (3 + 6)
81.25 percent of sales
$2 million
$450,000
(.1875 × sales) – $2.45 million
.40 × (.1875 × sales – $2.45 million)
.60 × (.1875 × sales – $2.45 million)
$450,000 + .60 × (.1875 × sales – $2.45 million)
= .1125 × sales – $1.02 million
This cash flow will last for 12 years. So to find its present value we multiply by the
12-year annuity factor. With a discount rate of 8 percent, the present value of $1 a year
for each of 12 years is $7.536. Thus the present value of the cash flows is
PV (cash flows) = 7.536 × (.1125 × sales – $1.02 million)
The project breaks even in present value terms (that is, has a zero NPV) if the pres-
ent value of these cash flows is equal to the initial $5.4 million investment. Therefore,
break-even occurs when
PV (cash flows) = investment
7.536 × (.1125 × sales – $1.02 million) = $5.4 million
–$7.69 million + .8478 × sales = $5.4 million
sales =
5.4 + 7.69
.8478
= $15.4 million
This implies that the store needs sales of $15.4 million a year for the investment to have
a zero NPV. This is more than 18 percent higher than the point at which the project has
zero profit.
Figure 5.2 is a plot of the present value of the inflows and outflows from the super-
store as a function of annual sales. The two lines cross when sales are $15.4 million.
This is the point at which the project has zero NPV. As long as sales are greater than
this, the present value of the inflows exceeds the present value of the outflows and the
project has a positive NPV.
FIGURE 5.2
NPV break-even analysis
s
r
a
l
l
o
d
f
o
s
n
o
i
l
l
i
m
,
s
e
u
a
v
l
j
t
c
e
o
r
P
5.4
0
(cid:1)7.69
PV of
project
cash flows
Investment
Sales
revenue,
millions
of
dollars
15.4
NPV is negative
NPV is positive
(cid:1) Self-Test 3
What would be the NPV break-even level of sales if the capital investment was only $5
million?
Project Analysis 477
(cid:1) EXAMPLE 3
| Brealey |
Break-Even Analysis
We have said that projects that break even on an accounting basis are really making a
loss—they are losing the opportunity cost of their investment. Here is a dramatic ex-
ample. Lophead Aviation is contemplating investment in a new passenger aircraft, code-
named the Trinova. Lophead’s financial staff has gathered together the following esti-
mates:
1. The cost of developing the Trinova is forecast at $900 million, and this investment
can be depreciated in 6 equal annual amounts.
2. Production of the plane is expected to take place at a steady annual rate over the fol-
lowing 6 years.
3. The average price of the Trinova is expected to be $15.5 million.
4. Fixed costs are forecast at $175 million a year.
5. Variable costs are forecast at $8.5 million a plane.
6. The tax rate is 50 percent.
7. The cost of capital is 10 percent.
How many aircraft does Lophead need to sell to break even in accounting terms?
And how many does it need to sell to break even on the basis of NPV? (Notice that the
break-even point is defined here in terms of number of aircraft, rather than revenue. But
since revenue is proportional to planes sold, these two break-even concepts are inter-
changeable.)
To answer the first question we set out the profits from the Trinova program in rows
1 to 7 of Table 5.5 (ignore row 8 for a moment).
In accounting terms the venture breaks even when pretax profit (and therefore net
profit) is zero. In this case
(7 × planes sold) – 325 = 0
Planes sold =
325
7
= 46
TABLE 5.5
Forecast profitability for
production of the Trinova
airliner (figures in millions
of dollars)
Investment
1. Sales
2. Variable costs
3. Fixed costs
4. Depreciation
5. Pretax profit (1 – 2 – 3 – 4)
6. Taxes (at 50%)
7. Net profit (5 – 6)
8. Net cash flow (4 + 7)
Year 0
$900
Years 1–6
15.5 × planes sold
8.5 × planes sold
175
900/6 = 150
(7 × planes sold) – 325
(3.5 × planes sold) – 162.5
(3.5 × planes sold) – 162.5
(3.5 × planes sold) – 12.5
–$900
478 SECTION FIVE
Thus Lophead needs to sell about 46 planes a year, or a total of about 280 planes over
the 6 years to show a profit.
Notice that we obtain the same result if we attack the problem in terms of the break-
even level of revenue. The variable cost of each plane is $8.5 million, which is 54.8 per-
cent of the $15.5 million price. Therefore, each dollar of sales increases pretax profits
by $1 – $.548 = $.452. So
Break-even revenue =
fixed costs including depreciation
additional profit from each additional dollar of sales
=
$325 million
.452
= $719 million
Since each plane cost $15.5 million, this revenue level implies sales of 719/15.5 = 46
planes per year.
Now let us look at what sales are needed before the project has a zero NPV. Devel-
opment of the Trinova costs $900 million. For each of the next 6 years the company ex-
pects a cash flow of $3.5 million × planes sold – $12.5 million (see row 8 of Table 5.5).
If the cost of capital is 10 percent, the 6-year annuity factor is 4.355. So
NPV = –900 + 4.355(3.5 × planes sold – 12.5)
= 15.24 × planes sold – 954.44
If the project has a zero NPV,
0 = 15.24 planes sold – 954.44
planes sold = 63
Thus Lophead can recover its initial investment with sales of 46 planes a year (about
280 in total), but it needs to sell 63 a year (or about 375 in total) to earn a return on this
investment equal to the opportunity cost of capital.
Our example may seem fanciful but it is based loosely on reality. In 1971 Lockheed
was in the middle of a major program to bring out the L-1011 TriStar airliner. This pro-
gram was to bring Lockheed to the brink of failure and it tipped Rolls-Royce (supplier
of the TriStar engine) over the brink. In giving evidence to Congress, Lockheed argued
that the TriStar program was commercially attractive and that sales would eventually ex-
ceed the break-even point of about 200 aircraft. But in calculating this break-even point
Lockheed appears to have ignored the opportunity cost of the huge capital investment
in the project. Lockheed probably needed to sell about 500 aircraft to reach a zero net
present value.3
| Brealey |
(cid:1) Self-Test 4
What is the basic difference between sensitivity analysis and break-even analysis?
OPERATING LEVERAGE
A project’s break-even point depends on both its fixed costs, which do not vary with
sales, and the profit on each extra sale. Managers often face a trade-off between these
3 The true break-even point for the TriStar program is estimated in U. E. Reinhardt, “Break-Even Analysis for
Lockheed’s TriStar: An Application of Financial Theory,” Journal of Finance 28 (September 1973), pp.
821–838.
Project Analysis 479
variables. For example, we typically think of rental expenses as fixed costs. But super-
market companies sometimes rent stores with contingent rent agreements. This means
that the amount of rent the company pays is tied to the level of sales from the store. Rent
rises and falls along with sales. The store thus replaces a fixed cost with a variable cost
that rises along with sales. Because a greater proportion of the company’s expenses will
fall when its sales fall, its break-even point is reduced.
Of course, a high proportion of fixed costs is not all bad. The firm whose costs are
largely fixed fares poorly when demand is low, but it may make a killing during a boom.
Let us illustrate.
Finefodder has a policy of hiring long-term employees who will not be laid off ex-
cept in the most dire circumstances. For all intents and purposes, these salaries are fixed
costs. Its rival, Stop and Scoff, has a much smaller permanent labor force and uses ex-
pensive temporary help whenever demand for its product requires extra staff. A greater
proportion of its labor expenses are therefore variable costs.
Suppose that if Finefodder adopted its rival’s policy, fixed costs in its new superstore
would fall from $2 million to $1.56 million but variable costs would rise from 81.25 to
84 percent of sales. Table 5.6 shows that with the normal level of sales, the two policies
fare equally. In a slump a store that relies on temporary labor does better since its costs
fall along with revenue. In a boom the reverse is true and the store with the higher pro-
portion of fixed costs has the advantage.
If Finefodder follows its normal policy of hiring long-term employees, each extra
dollar of sales results in a change of $1.00 – $.8125 = $.1875 in pretax profits. If it uses
temporary labor, an extra dollar of sales leads to a change of only $1.00 – $.84 = $.16
in profits. As a result, a store with high fixed costs is said to have high operating lever-
age. High operating leverage magnifies the effect on profits of a fluctuation in sales.
We can measure a business’s operating leverage by asking how much profits change
for each 1 percent change in sales. The degree of operating leverage, often abbreviated
as DOL, is this measure.
DOL =
percentage change in profits
percentage change in sales
For example, Table 5.6 shows that as the store moves from normal conditions to boom,
sales increase from $16 million to $19 million, a rise of 18.75 percent. For the policy
with high fixed costs, profits increase from $550,000 to $1,112,000, a rise of 102.2 per-
cent. Therefore,
DOL =
102.2
18.75
= 5.45
The percentage change in sales is magnified more than fivefold in terms of the per-
centage impact on profits.
High Fixed Costs
High Variable Costs
Slump
Normal
Boom
Slump
Normal
Boom
Sales
– Variable costs
– Fixed costs
– Depreciation
= Pretax profit
13,000
10,563
2,000
450
–13
16,000
13,000
2,000
450
550
19,000
15,438
2,000
450
1,112
13,000
10,920
1,560
450
70
16,000
13,440
1,560
450
550
19,000
15,960
1,560
450
1,030
OPERATING LEVERAGE
Degree to which costs are
fixed.
DEGREE OF
OPERATING LEVERAGE
(DOL)
change in profits given a 1
percent change in sales.
Percentage
TABLE 5.6
A store with high operating
leverage performs relatively
badly in a slump but
flourishes in a boom (figures
in thousands of dollars)
480 SECTION FIVE
Now look at the operating leverage of the store if it uses the policy with low fixed
costs but high variable costs. As the store moves from normal times to boom, profits in-
crease from $550,000 to $1,030,000, a rise of 87.3 percent. Therefore,
DOL =
87.3
18.75
= 4.65
| Brealey |
Because some costs remain fixed, a change in sales continues to have a magnified ef-
fect on profits but the degree of operating leverage is lower.
In fact, one can show that degree of operating leverage depends on fixed charges (in-
cluding depreciation) in the following manner:4
DOL = 1 +
fixed costs
profits
This relationship makes it clear that operating leverage increases with fixed costs.
(cid:1) EXAMPLE 4
Operating Leverage
Suppose the firm adopts the high-fixed-cost policy. Then fixed costs including depre-
ciation will be 2.00 + .45 = $2.45 million. Since the store produces profits of $.55 mil-
lion at a normal level of sales, DOL should be
DOL = 1 +
fixed costs
profits
= 1 +
2.00 + .45
.55
= 5.45
This value matches the one we obtained by comparing the actual percentage changes in
sales and profits.
You can see from this example that the risk of a project is affected by the
degree of operating leverage. If a large proportion of costs is fixed, a shortfall
in sales has a magnified effect on profits.
We will have more to say about risk later.
(cid:1) Self-Test 5
Suppose that sales increase by 10 percent from the values in the normal scenario. Com-
pute the percentage change in pretax profits from the normal level for both policies in
Table 5.6. Compare your answers to the values predicted by the DOL formula.
4 This formula for DOL can be derived as follows. If sales increase by 1 percent, then variable costs also
should increase by 1 percent, and profits will increase by .01 × (sales – variable costs) = .01 × (profits + fixed
costs). Now recall the definition of DOL:
DOL =
percentage change in profits
percentage change in sales
=
change in profits/level of profits
.01
= 100 × change in profits
level of profits
= 100 × .01 × (profits + fixed costs)
level of profits
= 1 +
fixed costs
profits
Project Analysis 481
Flexibility in Capital Budgeting
Sensitivity analysis and break-even analysis help managers understand why a venture
might fail. Once you know this you can decide whether it is worth investing more time
and effort in trying to resolve the uncertainty.
Of course it is impossible to clear up all doubts about the future. Therefore, man-
agers also try to build flexibility into the project and they value more highly a project
that allows them to mitigate the effect of unpleasant surprises and to capitalize on
pleasant ones.
DECISION TREES
The scientists of MacCaugh have developed a diet whiskey and the firm is ready to go
ahead with pilot production and test marketing. The preliminary phase will take a year
and cost $200,000. Management feels that there is only a 50-50 chance that the pilot
production and market tests will be successful. If they are, then MacCaugh will build a
$2 million plant which will generate an expected annual cash flow in perpetuity of
$480,000 a year after taxes. Given an opportunity cost of capital of 12 percent, project
NPV in this case will be –$2 million + $480,000/.12 = $2 million. If the tests are not
successful, MacCaugh will discontinue the project and the cost of the pilot production
will be wasted. How can MacCaugh decide whether to spend the money on the pilot
program?
Notice that the only decision MacCaugh needs to make now is whether to go ahead
with the preliminary phase. Depending on how that works out, it may choose to go
ahead with full-scale production.
When faced with projects like this that involve sequential decisions, it is often help-
ful to draw a decision tree, as in Figure 5.3. You can think of the problem as a game be-
tween MacCaugh and fate. The square represents a decision point for MacCaugh and
the circle represents a decision point for fate. MacCaugh starts the play at the left-hand
box. If MacCaugh decides to test, then fate will cast the enchanted dice and decide the
result of the tests. Given the test results, the firm faces a second decision: Should it in-
vest $2 million and start full-scale production?
Success
Pursue project
NPV (cid:1) $2 million
Test (invest
$200,000)
Failure
Stop project | Brealey |
NPV (cid:1) 0
Don’t test
NPV (cid:1) 0
DECISION TREE
Diagram of sequential
decisions and possible
outcomes.
FIGURE 5.3
Decision tree
482 SECTION FIVE
The second-stage decision is obvious: Invest if the tests indicate that NPV is posi-
tive, and stop if they indicate that NPV would be negative. Now the firm can easily de-
cide between paying for the test program or stopping immediately. The net present value
of stopping is zero, so the first-stage decision boils down to a simple problem: Should
MacCaugh invest $200,000 now to obtain a 50 percent chance of a project with an NPV
of $2 million a year later? If payoffs of zero and $2 million are equally likely, the ex-
pected payoff is (.5 × 0) + (.5 × 2 million) = $1 million. Thus the pilot project offers an
expected payoff of $1 million on an investment of $200,000. At any reasonable cost of
capital this is a good deal.
THE OPTION TO EXPAND
Notice that MacCaugh’s expenditure on the pilot program buys a valuable managerial
option. The firm has the option to produce the new product depending on the outcome
of the tests. If the pilot program turns up disappointing results, the firm can walk away
from the project without incurring additional costs.
The option to walk away once the results are revealed introduces a valuable
asymmetry. Good outcomes can be exploited, while bad outcomes can be
limited by canceling the project.
MacCaugh was not obliged to have a pilot program. Instead, it could have gone di-
rectly into full-scale whiskey production. After all, if diet whiskey is a success, the
sooner MacCaugh can clean up the market the better. But it is possible that the product
will not take off; in that case the expenditure on the pilot operation may help the firm
avoid a costly mistake. When it proposed a pilot project, MacCaugh’s management was
simply following the fundamental rule of swimmers: If you know the water temperature
(and depth), dive in; if you don’t, try putting a toe in first.
Here is another example of an apparently unprofitable investment that has value be-
cause of the flexibility it gives to make further follow-on investments. Some of the
world’s largest oil reserves are found in the tar sands of Athabasca, Canada. Unfortu-
nately, the cost of extracting oil from the sands is substantially higher than the current
market price and almost certainly higher than most people’s estimate of the likely price
in the future. Yet oil companies have been prepared to pay considerable sums for these
tracts of barren land. Why?
The answer is that ownership of these tracts gives the companies an option. They are
not obliged to extract the oil. If oil prices remain below the cost of extraction, the
Athabasca sands will remain undeveloped. But if prices do rise above the cost of ex-
traction, those land purchases could prove very profitable.
Notice that the option to develop the tar sands is valuable because the future price of
oil is uncertain. If we knew that oil prices would remain at their current level, nobody
would pay a cent for the tar sands. It is the possibility that oil prices may fluctuate
sharply above or below their present level that gives the option value.5
As a general rule, flexibility is most valuable when the future is most
uncertain. The ability to change course as events develop and new
information becomes available is most valuable when it is hard to predict
with confidence what the best action ultimately will turn out to be.
5 Oil prices sometimes move very sharply. They roughly halved between the beginning of 1997 and the end
of 1998. By early 2000, they had almost trebled.
Project Analysis 483
You can probably think of many other investments that take on added value because
of the further opportunities that they may open up. For example, when designing a fac-
tory, it may make sense to provide for the possibility in the future of an additional pro-
duction line; when building a four-lane highway, it may pay to build six-lane bridges so
that the road can be converted later to six lanes if traffic volume turns out to be higher | Brealey |
than expected.
ABANDONMENT OPTIONS
If the option to expand has value, what about the option to bail out? Projects don’t just
go on until the equipment disintegrates. The decision to terminate a project is usually
taken by management, not by nature. Once the project is no longer profitable, the com-
pany will cut its losses and exercise its option to abandon the project.
Some assets are easier to bail out of than others. Tangible assets are usually easier to
sell than intangible ones. It helps to have active secondhand markets, which really exist
only for standardized, widely used items. Real estate, airplanes, trucks, and certain ma-
chine tools are likely to be relatively easy to sell. On the other hand, the knowledge ac-
cumulated by a drug company’s research and development program is a specialized in-
tangible asset and probably would not have significant abandonment value. Some
assets, such as old mattresses, even have negative abandonment value; you have to pay
to get rid of them. It is very costly to decommission nuclear power plants or to reclaim
land that has been strip-mined. Managers recognize the option to abandon when they
make the initial investment.
(cid:1) EXAMPLE 5
Abandonment Option
Suppose that the Wigeon Company must choose between two technologies for the man-
ufacture of a new product, a Wankel engine outboard motor:
1. Technology A uses custom-designed machinery to produce the complex shapes re-
quired for Wankel engines at low cost. But if the Wankel engine doesn’t sell, this
equipment will be worthless.
2. Technology B uses standard machine tools. Labor costs are much higher, but the
tools can easily be sold if the motor doesn’t sell.
Technology A looks better in an NPV analysis of the new product, because it was de-
signed to have the lowest possible cost at the planned production volume. Yet you can
sense the advantage of technology B’s flexibility if you are unsure whether the new out-
board will sink or swim in the marketplace.
When you are unsure about the success of a venture, you may wish to choose
a flexible technology with a good resale market to preserve the option to
abandon the project at low cost.
(cid:1) Self-Test 6
Consider a firm operating a copper mine that incurs both variable and fixed costs of
production. Suppose the mine can be shut down temporarily if copper prices fall below
484 SECTION FIVE
the variable cost of mining copper. Why is this a valuable operating option? How does
it increase the NPV of the mine to the operator?
FLEXIBLE PRODUCTION FACILITIES
Companies try to avoid becoming dependent on a single source of raw materials, build-
ing flexibility into their production facilities whenever possible. For example, at current
prices gas-fired industrial boilers are cheaper to operate than oil-fired ones. Yet most
companies prefer to buy boilers that can use either oil or natural gas, even though these
dual-fired boilers cost more than a gas-fired boiler.6 The reason is obvious. If gas prices
rise relative to oil prices, the dual-fired boiler gives the company a valuable option to
switch to low-cost oil. In effect the company has the option to exchange one asset (an
oil-fired boiler) for another (a gas-fired boiler).
If the firm is uncertain about the future demand for its products, it may also build in
the option to vary the output mix. For example, in recent years automobile manufac-
turers have made major investments in flexible production facilities that allow them to
change their output rapidly in response to consumer demand.
INVESTMENT TIMING OPTIONS
Suppose that you have a project that might be a big winner or a big loser. The project’s
upside potential outweighs its downside potential, and it has a positive NPV if under-
taken today. However, the project is not “now-or-never.” Should you invest right away
or wait? It’s hard to say. If the project truly is a winner, waiting means loss or deferral
of its early cash flows. But if it turns out to be a loser, it may pay to wait and get a bet-
ter fix on the likely demand.
| Brealey |
You can think of any project proposal as giving you the option to invest today. You
don’t have to exercise that option immediately. Instead you need to weigh the value of
the cash flows lost by delaying against the possibility that you will pick up some valu-
able information.
Think again of those tar sands in Athabasca. Suppose that the price of oil rises to 10
cents a barrel above your cost of production. You can extract the oil profitably at this
price, and the required investment has a small positive NPV if the price stays where it
is. But it still might be worth delaying production. After all, if the price plummets, you
will by waiting avoid a costly mistake. If it rises further, however, you can invest and
make a killing.
We repeat, it is because the future is so uncertain that managers value flexibility. Ide-
ally, a project will give the firm an option to expand if things go well and to bail out or
switch production if they don’t. In addition, it may pay the firm to postpone the project.
Some managers treat capital investment decisions as black boxes; they are handed
cash-flow forecasts and they churn out present values without looking inside the black
box. But successful firms ask not only what could be wrong with the forecasts but
whether there are opportunities to respond to surprises. In other words, they recognize
the value of flexibility.
(cid:1) Self-Test 7
Investments in new products or production capacity often include an option to expand.
What are the other major types of options encountered in capital investment decisions?
6 See N. Kulatilaka, “The Value of Flexibility: The Case of a Dual-Fuel Industrial Steam Boiler,” Financial
Management 22 (Autumn 1993), pp. 271–280.
Project Analysis 485
Summary
What are some of the practical problems of capital budgeting in large corporations?
For most large corporations there are two stages in the investment process: the preparation
of the capital budget, which is a list of planned investments, and the authorization process
for individual projects. This process is usually a cooperative effort.
Investment projects should never be selected through a purely mechanical process.
Managers need to ask why a project should have a positive NPV. A positive NPV is
plausible only if the company has some competitive advantage that prevents its rivals from
stealing most of the gains.
How are sensitivity, scenario, and break-even analysis used to see the effect of an
error in forecasts on project profitability? Why is an overestimate of sales more se-
rious for projects with high operating leverage?
Good managers realize that the forecasts behind NPV calculations are imperfect. Therefore,
they explore the consequences of a poor forecast and check whether it is worth doing some
more homework. They use the following principal tools to answer these what-if questions:
• Sensitivity analysis, where one variable at a time is changed.
• Scenario analysis, where the manager looks at the project under alternative scenarios.
• Simulation analysis, an extension of scenario analysis in which a computer generates
hundreds or thousands of possible combinations of variables.
• Break-even analysis, where the focus is on how far sales could fall before the project
begins to lose money. Often the phrase “lose money” is defined in terms of accounting
losses, but it makes more sense to define it as “failing to cover the opportunity cost of
capital”—in other words, as a negative NPV.
• Operating leverage, the degree to which costs are fixed. A project’s break-even point
will be affected by the extent to which costs can be reduced as sales decline. If the
project has mostly fixed costs, it is said to have high operating leverage. High operating
leverage implies that profits are more sensitive to changes in sales.
Why is managerial flexibility important in capital budgeting?
Some projects may take on added value because they give the firm the option to bail out if
things go wrong or to capitalize on success by expanding. We showed how decision trees | Brealey |
may be used to analyze such flexibility.
Related Web
Links
Key Terms
www.windpower.dk/tour/econ/econ.htm Evaluation of a sample energy-saving project
www.palisade.com Software for Monte Carlo analysis
capital budget
sensitivity analysis
fixed costs
variable costs
scenario analysis
simulation analysis
break-even analysis
operating leverage
degree of operating
leverage (DOL)
decision tree
Quiz
1. Fixed and Variable Costs. In a slow year, Wimpy’s Burgers will produce 1 million ham-
burgers at a total cost of $1.75 million. In a good year, it can produce 2 million hamburgers
at a total cost of $2.25 million. What are the fixed and variable costs of hamburger produc-
tion?
486 SECTION FIVE
Practice
Problems
2. Average Cost. Reconsider Wimpy’s Burgers from problem 1.
a. What is the average cost per burger when the firm produces 1 million hamburgers?
b. What is average cost when the firm produces 2 million hamburgers?
c. Why is average cost lower when more burgers are produced?
3. Sensitivity Analysis. A project currently generates sales of $10 million, variable costs equal
to 50 percent of sales, and fixed costs of $2 million. The firm’s tax rate is 35 percent. What
are the effects of the following changes on after-tax profits and cash flow?
a. Sales increase from $10 million to $11 million.
b. Variable costs increase to 60 percent of sales.
4. Sensitivity Analysis. The project in the preceding problem will last for 10 years. The dis-
count rate is 12 percent.
a. What is the effect on project NPV of each of the changes considered in the problem?
b. If project NPV under the base-case scenario is $2 million, how much can fixed costs in-
crease before NPV turns negative?
c. How much can fixed costs increase before accounting profits turn negative?
5. Sensitivity Analysis. Emperor’s Clothes Fashions can invest $5 million in a new plant for
producing invisible makeup. The plant has an expected life of 5 years, and expected sales are
6 million jars of makeup a year. Fixed costs are $2 million a year, and variable costs are $1
per jar. The product will be priced at $2 per jar. The plant will be depreciated straight-line
over 5 years to a salvage value of zero. The opportunity cost of capital is 12 percent, and the
tax rate is 40 percent.
a. What is project NPV under these base-case assumptions?
b. What is NPV if variable costs turn out to be $1.20 per jar?
c. What is NPV if fixed costs turn out to be $1.5 million per year?
d. At what price per jar would project NPV equal zero?
6. Scenario Analysis. The most likely outcomes for a particular project are estimated as
follows:
Unit price:
Variable cost:
Fixed cost:
Expected sales:
$50
$30
$300,000
30,000 units per year
However, you recognize that some of these estimates are subject to error. Suppose that each
variable may turn out to be either 10 percent higher or 10 percent lower than the initial esti-
mate. The project will last for 10 years and requires an initial investment of $1 million,
which will be depreciated straight-line over the project life to a final value of zero. The
firm’s tax rate is 35 percent and the required rate of return is 14 percent. What is project
NPV in the “best-case scenario,” that is, assuming all variables take on the best possible
value? What about the worst-case scenario?
7. Scenario Analysis. Reconsider the best- and worst-case scenarios in the previous problem.
Do the best- and worst-case outcomes when each variable is treated independently seem to
be reasonable scenarios in terms of the combinations of variables? For example, if price is
higher than predicted, is it more or less likely that cost is higher than predicted? What other
relationships may exist among the variables?
8. Break-Even. The following estimates have been prepared for a project under consideration:
Project Analysis 487
Fixed costs:
Depreciation:
Price:
Accounting break-even:
$20,000
$10,000
$2
60,000 units
What must be the variable cost per unit?
9. Break-Even. Dime a Dozen Diamonds makes synthetic diamonds by treating carbon. Each | Brealey |
diamond can be sold for $100. The materials cost for a standard diamond is $30. The fixed
costs incurred each year for factory upkeep and administrative expenses are $200,000. The
machinery costs $1 million and is depreciated straight-line over 10 years to a salvage value
of zero.
a. What is the accounting break-even level of sales in terms of number of diamonds sold?
b. What is the NPV break-even level of sales assuming a tax rate of 35 percent, a 10-year
project life, and a discount rate of 12 percent?
10. Break-Even. Turn back to problem 9.
a. Would the accounting break-even point in the first year of operation increase or decrease
if the machinery were depreciated over a 5-year period?
b. Would the NPV break-even point increase or decrease if the machinery were depreciated
over a 5-year period?
11. Break-Even. You are evaluating a project that will require an investment of $10 million that
will be depreciated over a period of 7 years. You are concerned that the corporate tax rate
will increase during the life of the project. Would such an increase affect the accounting
break-even point? Would it affect the NPV break-even point?
12. Break-Even. Define the cash-flow break-even point as the sales volume (in dollars) at which
cash flow equals zero. Is the cash-flow break-even level of sales higher or lower than the
zero-profit break-even point?
13. Break-Even and NPV. If a project operates at cash-flow break-even (see problem 12) for its
entire life, what must be true of the project’s NPV?
14. Break-Even. Modern Artifacts can produce keepsakes that will be sold for $80 each. Non-
depreciation fixed costs are $1,000 per year and variable costs are $60 per unit.
a. If the project requires an initial investment of $3,000 and is expected to last for 5 years
and the firm pays no taxes, what are the accounting and NPV break-even levels of sales?
The initial investment will be depreciated straight-line over 5 years to a final value of
zero, and the discount rate is 10 percent.
b. How do your answers change if the firm’s tax rate is 40 percent?
15. Break-Even. A financial analyst has computed both accounting and NPV break-even sales
levels for a project under consideration using straight-line depreciation over a 6-year period.
The project manager wants to know what will happen to these estimates if the firm uses
MACRS depreciation instead. The capital investment will be in a 5-year recovery period
class under MACRS rules (see Table 7.4). The firm is in a 35 percent tax bracket.
a. What (qualitatively) will happen to the accounting break-even level of sales in the first
years of the project?
b. What (qualitatively) will happen to NPV break-even level of sales?
c. If you were advising the analyst, would the answer to (a) or (b) be important to you?
Specifically, would you say that the switch to MACRS makes the project more or less at-
tractive?
488 SECTION FIVE
16. Break-Even. Reconsider Finefodder’s new superstore. Suppose that by investing an addi-
tional $600,000 initially in more efficient checkout equipment, Finefodder could reduce
variable costs to 80 percent of sales.
a. Using the base-case assumptions (Table 5.1), find the NPV of this alternative scheme.
Hint: Remember to focus on the incremental cash flows from the project.
b. At what level of sales will accounting profits be unchanged if the firm invests in the new
equipment? Assume the equipment receives the same 12-year straight-line depreciation
treatment as in the original example. Hint: Focus on the project’s incremental effects on
fixed and variable costs.
c. What is the NPV break-even point?
17. Break-Even and NPV. If the superstore project (see the previous problem) operates at ac-
counting break-even, will net present value be positive or negative?
18. Operating Leverage. You estimate that your cattle farm will generate $1 million of profits
on sales of $4 million under normal economic conditions, and that the degree of operating
leverage is 7.5. What will profits be if sales turn out to be $3.5 million? What if they are | Brealey |
$4.5 million?
19. Operating Leverage.
a. What is the degree of operating leverage of Modern Artifacts (in problem 14) when sales
are $8,000?
b. What is the degree of operating leverage when sales are $10,000?
c. Why is operating leverage different at these two levels of sales?
20. Operating Leverage. What is the lowest possible value for the degree of operating leverage
for a profitable firm? Show with a numerical example that if Modern Artifacts (see problem
14a) has zero fixed costs, then DOL = 1 and in fact sales and profits are directly propor-
tional so that a 1 percent change in sales results in a 1 percent change in profits.
21. Operating Leverage. A project has fixed costs of $1,000 per year, depreciation charges of
$500 a year, revenue of $6,000 a year, and variable costs equal to two-thirds of revenues.
a. If sales increase by 5 percent, what will be the increase in pretax profits?
b. What is the degree of operating leverage of this project?
c. Confirm that the percentage change in profits equals DOL times the percentage change
in sales.
22. Project Options. Your midrange guess as to the amount of oil in a prospective field is 10
million barrels, but in fact there is a 50 percent chance that the amount of oil is 15 million
barrels, and a 50 percent chance of 5 million barrels. If the actual amount of oil is 15 mil-
lion barrels, the present value of the cash flows from drilling will be $8 million. If the
amount is only 5 million barrels, the present value will be only $2 million. It costs $3
million to drill the well. Suppose that a seismic test that costs $100,000 can verify the
amount of oil under the ground. Is it worth paying for the test? Use a decision tree to justify
your answer.
23. Project Options. A silver mine can yield 10,000 ounces of copper at a variable cost of $8
per ounce. The fixed costs of operating the mine are $10,000 per year. In half the years, sil-
ver can be sold for $12 per ounce; in the other years, silver can be sold for only $6 per ounce.
Ignore taxes.
a. What is the average cash flow you will receive from the mine if it is always kept in op-
eration and the silver always is sold in the year it is mined?
b. Now suppose you can shut down the mine in years of low silver prices. What happens to
the average cash flow from the mine?
Challenge
Problems
Solutions to
Self-Test
Questions
Project Analysis 489
24. Project Options. An auto plant that costs $100 million to build can produce a new line of
cars that will produce cash flows with a present value of $140 million if the line is success-
ful, but only $50 million if it is unsuccessful. You believe that the probability of success is
only about 50 percent.
a. Would you build the plant?
b. Suppose that the plant can be sold for $90 million to another automaker if the auto line
is not successful. Now would you build the plant?
c. Illustrate the option to abandon in (b) using a decision tree.
25. Production Options. Explain why options to expand or contract production are most valu-
able when forecasts about future business conditions are most uncertain.
26. Abandonment Option. Hit or Miss Sports is introducing a new product this year. If its see-
at-night soccer balls are a hit, the firm expects to be able to sell 50,000 units a year at a price
of $60 each. If the new product is a bust, only 30,000 units can be sold at a price of $55. The
variable cost of each ball is $30, and fixed costs are zero. The cost of the manufacturing
equipment is $6 million, and the project life is estimated at 10 years. The firm will use
straight-line depreciation over the 10-year life of the project. The firm’s tax rate is 35 per-
cent and the discount rate is 12 percent.
a. If each outcome is equally likely, what is expected NPV? Will the firm accept the proj-
ect?
b. Suppose now that the firm can abandon the project and sell off the manufacturing equip-
ment for $5.4 million if demand for the balls turns out to be weak. The firm will make
the decision to continue or abandon after the first year of sales. Does the option to aban- | Brealey |
don change the firm’s decision to accept the project?
27. Expansion Option. Now suppose that Hit or Miss Sports from the previous problem can ex-
pand production if the project is successful. By paying its workers overtime, it can increase
production by 20,000 units; the variable cost of each ball will be higher, however, equal to
$35 per unit. By how much does this option to expand production increase the NPV of the
project?
1 Cash flow forecasts for Finefodder’s new superstore:
Investment
–5,400,000
Year 0
Years 1–12
1. Sales
2. Variable costs
3. Fixed costs
4. Depreciation
5. Pretax profit (1 – 2 – 3 – 4)
6. Taxes (at 40%)
7. Profit after tax
8. Cash flow from operations (4 + 7)
Net cash flow
–5,400,000
16,000,000
13,280,000
2,000,000
450,000
270,000
108,000
162,000
612,000
612,000
NPV = –$5.4 million + (7.536 × $612,000) = –$788,000
2 Both calculate how NPV depends on input assumptions. Sensitivity analysis changes inputs
one at a time, whereas scenario analysis changes several variables at once. The changes
should add up to a consistent scenario for the project as a whole.
490 SECTION FIVE
3 With the lower initial investment, depreciation is also lower; it now equals $417,000 per
year. Cash flow is now as follows:
1. Variable costs
2. Fixed costs
3. Depreciation
4. Pretax profit
5. Tax (at 40%)
6. Profit after tax
7. Cash flow (3 + 6)
81.25 percent of sales
$2 million
$417,000
(.1875 × sales) – $2.417 million
.4 × (.1875 × sales – $2.417 million)
.6 × (.1875 × sales – $2.417 million)
.6 × (.1875 × sales – $2.417 million) + $417,000
= .1125 × sales – $1.033 million
Break-even occurs when
PV (cash inflows) = investment
7.536 × (.1125 × sales – $1.033 million) = $5.0 million
and sales = $15.08 million.
4 Break-even analysis finds the level of sales or revenue at which NPV = 0. Sensitivity analy-
sis changes these and other input variables to optimistic and pessimistic values and recalcu-
lates NPV.
5 Reworking Table 8.6 for the normal level of sales and 10 percent higher sales gives the fol-
lowing:
High Fixed Costs
High Variable Costs
Normal
10% Higher Sales
Normal
10% Higher Sales
Sales
– Variable costs
– Fixed costs
– Depreciation
= Pretax profit
16,000
13,000
2,000
450
550
17,600
14,300
2,000
450
850
16,000
13,440
1,560
450
550
17,600
14,784
1,560
450
806
For the high-fixed-cost policy, profits increase by 54.5 percent, from $550,000 to $850,000.
For the low-fixed-cost policy, profits increase by 46.5 percent. In both cases the percentage
increase in profits equals DOL times the percentage increase in sales. This illustrates that
DOL measures the sensitivity of profits to changes in sales.
6 The option to shut down is valuable because the mine operator can avoid incurring losses
when copper prices are low. If the shut-down option were not available, cash flow in the low-
price periods would be negative. With the option, the worst cash flow is zero. By allowing
managers to respond to market conditions, the option makes the worst-case cash flow bet-
ter than it would be otherwise. The average cash flow (that is, averaging over all possible
scenarios) therefore must improve, which increases project NPV.
7 Abandonment options, options due to flexible production facilities, investment timing op-
tions.
Project Analysis 491
MINICASE
Maxine Peru, the CEO of Peru Resources, hardly noticed the
plate of savory quenelles de brochet and the glass of Corton
Charlemagne ’94 on the table before her. She was absorbed by
the engineering report handed to her just as she entered the exec-
utive dining room.
The report described a proposed new mine on the North Ridge
of Mt. Zircon. A vein of transcendental zirconium ore had been
discovered there on land owned by Ms. Peru’s company. Test bor-
ings indicated sufficient reserves to produce 340 tons per year of
transcendental zirconium over a 7-year period.
The vein probably also contained hydrated zircon gemstones.
The amount and quality of these zircons were hard to predict,
since they tended to occur in “pockets.” The new mine might
come across one, two, or dozens of pockets. The mining engineer | Brealey |
guessed that 150 pounds per year might be found. The current
price for high-quality hydrated zircon gemstones was $3,300 per
pound.
Peru Resources was a family-owned business with total assets
of $45 million, including cash reserves of $4 million. The outlay
required for the new mine would be a major commitment. Fortu-
nately, Peru Resources was conservatively financed, and Ms. Peru
believed that the company could borrow up to $9 million at an in-
terest rate of about 8 percent.
The mine’s operating costs were projected at $900,000 per
year, including $400,000 of fixed costs and $500,000 of variable
costs. Ms. Peru thought these forecasts were accurate. The big
question marks seemed to be the initial cost of the mine and the
selling price of transcendental zirconium.
Opening the mine, and providing the necessary machinery
and ore-crunching facilities, was supposed to cost $10 million,
but cost overruns of 10 percent or 15 percent were common in the
mining business. In addition, new environmental regulations, if
enacted, could increase the cost of the mine by $1.5 million.
There was a cheaper design for the mine, which would reduce
its cost by $1.7 million and eliminate much of the uncertainty
about cost overruns. Unfortunately, this design would require
much higher fixed operating costs. Fixed costs would increase to
$850,000 per year at planned production levels.
The current price of transcendental zirconium was $10,000
per ton, but there was no consensus about future prices.1 Some
experts were projecting rapid price increases to as much as
$14,000 per ton. On the other hand, there were pessimists saying
that prices could be as low as $7,500 per ton. Ms. Peru did not
have strong views either way: her best guess was that price would
just increase with inflation at about 3.5 percent per year. (Mine
operating costs would also increase with inflation.)
Ms. Peru had wide experience in the mining business, and she
knew that investors in similar projects usually wanted a fore-
casted nominal rate of return of at least 14 percent.
You have been asked to assist Ms. Peru in evaluating this proj-
ect. Lay out the base-case NPV analysis and undertake sensitiv-
ity, scenario, or break-even analyses as appropriate. Assume that
Peru Resources pays tax at a 35 percent rate. For simplicity, also
assume that the investment in the mine could be depreciated for
tax purposes straight-line over 7 years.
What forecasts or scenarios should worry Ms. Peru the most?
Where would additional information be most helpful? Is there a
case for delaying construction of the new mine?
1 There were no traded forward or futures contracts on transcendental zir-
conium.
AN OVERVIEW OF
CORPORATE FINANCING
Common Stock
Book Value versus Market Value
Dividends
Stockholders’ Rights
Voting Procedures
Classes of Stock
Corporate Governance in the United States and Elsewhere
Preferred Stock
Corporate Debt
Debt Comes in Many Forms
Innovation in the Debt Market
Convertible Securities
Patterns of Corporate Financing
Do Firms Rely Too Heavily on Internal Funds?
External Sources of Capital
Summary
There are more than 57 different kinds of security that a company can issue.
Scott Goodwin Photography
493
T
his material begins our analysis of long-term financing decisions. In later
material this will involve a careful look at some classic finance prob-
lems, such as how much firms should borrow and what dividends they
should pay their shareholders. But before getting down to specifics, we will
provide a brief overview of types of long-term finance.
It is customary to classify sources of finance as debt or equity. When the firm bor-
rows, it promises to repay the debt with interest. If it doesn’t keep its promise, the
debtholders may force the firm into bankruptcy. However, no such commitments are
made to the equityholders. They are entitled to whatever is left over after the debthold-
ers have been paid off. For this reason, equity is called a residual claim on the firm.
| Brealey |
However, a simple division of sources of finance into debt and equity would miss the
enormous variety of financing instruments that companies use today. For example,
Table 5.7 shows the many long-term securities issued by H. J. Heinz. Yet H. J. Heinz has
not come close to exhausting the menu of possible securities.
This material introduces you to the principal families of securities and explains how
they are used by corporations. We also draw attention to some of the interesting aspects
of firms issuing these securities.
After studying this material you should be able to
(cid:1) Describe the major classes of securities issued by firms to raise capital.
(cid:1) Summarize recent trends in the use made by firms of different sources of finance.
Common Stock
Most major corporations are far too large to be owned by one investor. For example,
you would need to lay your hands on over $17 billion if you wanted to own the whole
H. J. Heinz Company.
Heinz is owned by about 61,000 different investors, each of whom holds a number
of shares of common stock. These investors are therefore known as shareholders or
stockholders. Altogether Heinz has outstanding 358 million shares of common stock.
Thus if you were to buy one Heinz share, you would own 1/358,000,000, or about
.00000028 percent of the company. Of course, a large pension fund might hold many
thousands of Heinz shares.
The 358 million shares held by investors are not the only shares that have been is-
sued by Heinz. The company has also issued a further 72 million shares, which it later
bought back from investors. These shares are held in the company’s treasury and are
known as treasury stock. The shares held by investors are said to be issued and out-
standing shares. By contrast, the 72 million treasury shares are said to be issued but
not outstanding.
If Heinz wishes to raise more money, it can sell more shares. However, there is a
limit to the number that it can issue without getting the approval of the current share-
TREASURY STOCK
Stock that has been
repurchased by the company
and held in its treasury.
ISSUED SHARES
Shares that have been issued
by the company.
OUTSTANDING
SHARES Shares that
have been issued by the
company and are held by
investors.
494
TABLE 5.7
Large firms use many
different kinds of securities.
Look at the variety of
securities issued by H. J.
Heinz
AUTHORIZED SHARE
CAPITAL Maximum
number of shares that the
company is permitted to
issue, as specified in the
firm’s articles of
incorporation.
PAR VALUE Value of
security shown on certificate.
ADDITIONAL PAID-IN
CAPITAL Difference
between issue price and par
value of stock. Also called
capital surplus.
TABLE 5.8
Book value of common
stockholders’ equity of H. J.
Heinz Company, April 28,
1999 (figures in millions)
An Overview of Corporate Financing 495
Equity
Common stock
Preferred stock
Debt
Commercial paper
Senior unsecured notes
Revenue bonds
Promissory notes
Eurodollar bonds
Sterling notes
Italian lira notes
Australian dollar notes
Bank loans
holders. The maximum number of shares that can be issued is known as the authorized
share capital—for Heinz, this is 600 million shares. Since Heinz has already issued
431 million shares, it can issue 169 million more without shareholders’ approval.
Table 5.8 shows how the investment by Heinz’s common stockholders is recorded in
the company’s books. The price at which each share is recorded is known as its par
value. In Heinz’s case each share has a par value of $.25. Thus the total par value of the
issued shares is 431 million shares × $.25 per share = $108 million. Par value has little
economic significance.1
The price at which new shares are sold to investors almost always exceeds par value.
The difference is entered into the company’s accounts as additional paid-in capital, or
capital surplus. For example, if Heinz sold an additional 100,000 shares at $50 a share,
the par value of the common stock would increase by 100,000 × $.25 = $25,000 and ad-
ditional paid-in capital would increase by 100,000 × ($50 – $.25) = $4,975,000. You can | Brealey |
see from this example that the funds raised from the stock issue are divided between par
value and additional paid-in capital. Since the choice of par value in the first place was
immaterial, so is the allocation between par value and additional paid-in capital.
Common shares ($.25 par value per share)
Additional paid-in capital
Retained earnings
Treasury shares at cost
Net common equity
$108
278
3,853
(2,435)
1,803
Note:
Authorized shares
Issued shares, of which
Outstanding shares
Treasury shares
431
358
72
1 Because some states do not allow companies to sell new shares below par value, par value is generally set
at a low figure. Some companies even issue shares with no par value, in which case the stock is listed in the
accounts at an arbitrarily determined figure.
496 SECTION FIVE
RETAINED EARNINGS
Earnings not paid out as
dividends.
Besides buying new stock, shareholders also indirectly contribute new capital to the
firm whenever profits that could be paid out as dividends are instead plowed back into
the company. Table 5.8 shows that the cumulative amount of such retained earnings is
$3,853.
Heinz’s books also show the amount that the company has spent in the past on re-
purchasing its own stock. The repurchase of the 72 million shares cost Heinz $2,435
million. This is money that has in effect been returned to shareholders.
The sum of the par value, additional paid-in capital, and retained earnings, less re-
purchased stock, is known as the net common equity of the firm. It equals the total
amount contributed directly by shareholders when the firm issued new stock and indi-
rectly when it plowed back part of its earnings.
(cid:1) Self-Test 1
Generic Products has had one stock issue in which it sold 100,000 shares to the public
at $15 per share. Can you fill in the following table?
Common shares ($1.00 par value per share)
Additional paid-in capital
Retained earnings
Net common equity
________
________
________
$4,500,000
BOOK VALUE VERSUS MARKET VALUE
We discussed the distinction between book and market value earlier, but it bears
repeating.
Book value is a backward-looking measure. It tells us how much capital the
firm has raised from shareholders in the past. It does not measure the value
that investors place on those shares today. The market value of the firm is
forward-looking; it depends on the future dividends that shareholders expect
to receive.
Heinz’s common equity has a book value of $1,803 million. With 358 million shares
outstanding, this translates to a book value of $1,803/358 = $5.04 per share. But in April
1999 Heinz shares were priced at about $49 each. So the total market value of the com-
mon stock was 358 million shares × $49 per share = $17.5 billion, nearly 10 times the
book value.
Market value is usually greater than book value. This is partly because inflation has
driven the value of many assets above what they originally cost. Also, firms raise capi-
tal to invest in projects with present values that exceed initial cost. These positive-NPV
projects made the shareholders better off. So we would expect the market value of the
firm to be higher than the amount of money put up by the shareholders.
However, sometimes projects do go awry and companies fall on hard times. In this
case, market value can fall below book value.
An Overview of Corporate Financing 497
(cid:1) Self-Test 2
No-name News can be established by investing $10 million in a printing press. The
newspaper is expected to generate a cash flow of $2 million a year for 20 years. If the
cost of capital is 10 percent, is the firm’s market or book value greater? What if the cost
of capital is 20 percent?
DIVIDENDS
Shareholders hope to receive a series of dividends on their investment. However, the
company is not obliged to pay any dividend and the decision is up to the board of di-
rectors.
Because dividends are discretionary, they are not considered to be a business ex-
pense. Therefore, companies are not allowed to deduct dividend payments when they
calculate their taxable income.
| Brealey |
STOCKHOLDERS’ RIGHTS
Stockholders have the ultimate control of the company’s affairs. Occasionally compa-
nies need shareholder approval before they can take certain actions. For example, they
need approval to increase the authorized capital or to merge with another company.
On most other matters, shareholder control boils down to the right to vote on
appointments to the board of directors.
The board usually consists of the company’s top management as well as outside di-
rectors, who are not employed by the firm. In principle, the board is elected as an agent
of the shareholders. It appoints and oversees the management of the firm and meets to
vote on such matters as new share issues. Most of the time the board will go along with
the management, but in crisis situations it can be very independent. For example, when
the management of RJR Nabisco announced that it wanted to take over the company,
the outside directors stepped in to make sure that the company was sold to the highest
bidder.
VOTING PROCEDURES
MAJORITY VOTING
Voting system in which each
director is voted on
separately.
CUMULATIVE VOTING
Voting system in which all the
votes one shareholder is
allowed to cast can be cast
for one candidate for the
board of directors.
In most companies stockholders elect directors by a system of majority voting. In this
case each director is voted on separately and stockholders can cast one vote for each
share they own. In some companies directors are elected by cumulative voting. The di-
rectors are then voted on jointly and the stockholders can, if they choose, cast all their
votes for just one candidate. For example, suppose there are five directors to be elected
and you own 100 shares. You therefore have a total of 5 × 100 = 500 votes. Under ma-
jority voting you can cast a maximum of 100 votes for any one candidate. With a cu-
mulative voting system you can cast all 500 votes for your favorite candidate. Cumula-
tive voting makes it easier for a minority group of the stockholders to elect a director to
represent their interests. That is why minority groups devote so much effort to cam-
paigning for cumulative voting.
On many issues a simple majority of the votes cast is enough to carry the day, but
there are some decisions that require a “supermajority” of, say, 75 percent of those
498 SECTION FIVE
PROXY CONTEST
Takeover attempt in which
outsiders compete with
management for
shareholders’ votes.
eligible to vote. For example, a supermajority vote is sometimes needed to approve a
merger. This requirement makes it difficult for the firm to be taken over and therefore
helps to protect the incumbent management.
Shareholders can either vote in person or appoint a proxy to vote. The issues on
which they are asked to vote are rarely contested, particularly in the case of large, pub-
licly traded firms. Occasionally, however, there are proxy contests in which outsiders
compete with the firm’s existing management and directors for control of the corpora-
tion. But the odds are stacked against the outsiders, for the insiders can get the firm to
pay all the costs of presenting their case and obtaining votes.
CLASSES OF STOCK
Most companies issue just one class of common stock. Sometimes, however, a firm may
have two or more classes outstanding, which differ in their right to vote or receive div-
idends. Suppose that a firm needs fresh capital but its present stockholders do not want
to give up control of the firm. The existing shares could be labeled class A, and then
class B shares could be issued to outside investors. The class B shares could have lim-
ited voting rights, although they would probably sell for less as a result.
CORPORATE GOVERNANCE IN THE
UNITED STATES AND ELSEWHERE
Heinz’s shareholders own the company but they don’t manage it. Management is dele-
gated to a team of professional managers. Each shareholder owns only a small fraction
of Heinz’s shares and can exert little influence on the way the company is run. If share-
holders do not like the policies the management team pursues, they can try to vote in | Brealey |
another board of directors who will bring about a change in policy. But such attempts
are rarely successful, and the shareholders’ simplest solution is to sell the shares.
The separation between ownership and management in major United States corpo-
rations creates a potential conflict between shareholders (the principals who own the
company) and managers (their agents who make the decisions). We noted earlier sev-
eral mechanisms that have evolved to mitigate this conflict:
• Shareholders elect a board of directors, which then appoints the managers, oversees
them, and on occasion fires them.
• Managers’ remuneration is tied to their performance.
• Poorly performing companies are taken over and the management is replaced by a
new team.
These principles of corporate governance do not apply worldwide. The United
States, Canada, Britain, Australia, and other English-speaking countries all have
broadly similar systems, but other countries do not. In Japan industrial and financial
companies are often linked together in a group, called a keiretsu. For example, the Mit-
subishi keiretsu contains 29 core companies, including two banks, two insurance com-
panies, an automobile manufacturer, a steel producer, and a cement company. Members
of the keiretsu are tied together in several ways. First, managers may sit on the boards
of directors of other group companies, and a “president’s council” of chief executives
meets regularly. Second, each company in the group holds shares in many of the other
companies. And third, companies generally borrow from the keiretsu’s bank or from
elsewhere within the group. These links may have several advantages. Companies can
obtain funds from other members of the group without the need to reveal confidential
An Overview of Corporate Financing 499
information to the public, and if a member of the group runs into financial heavy
weather, its problems can be worked out with other members of the group rather than
in the bankruptcy court.
The more stable and concentrated shareholder base of large Japanese corporations
may make it easier for them to resist pressures for short-term performance and allow
them to focus on securing long-term advantage. But the Japanese system of corporate
governance also has its disadvantages, for the lack of market discipline may promote a
too-cozy life and allow lagging or inefficient Japanese corporations to put off painful
surgery.
Keiretsus are found only in Japan. But large companies in continental Europe are
linked in some similar ways. For example, banks and other companies often own or con-
trol large blocks of shares and can push hard for changes in the management or strat-
egy of poorly performing firms. (Banks in the United States are prohibited from large
or permanent holdings of the stock of nonfinancial corporations.) Thus oversight and
control are entrusted largely to banks and other corporations. Hostile takeovers of
poorly performing companies are rare in Germany and virtually impossible in Japan.
For large corporations, separation of ownership and control is seen the world
over. In the United States, control of large public companies is exercised
through the board of directors and pressure from the stock market. In other
countries the stock market is less important, and control shifts to major
stockholders, typically banks and other companies.
Preferred Stock
Usually when investors talk about equity or stock, they are referring to common stock.
But Heinz has also issued $200,000 of preferred stock, and this too is part of the com-
pany’s equity. The sum of Heinz’s common equity and preferred stock is known as its
net worth.
For most companies preferred stock is much less important than common stock.
However, it can be a useful method of financing in mergers and certain other special sit-
uations.
Like debt, preferred stock promises a series of fixed payments to the investor and
with relatively rare exceptions preferred dividends are paid in full and on time. Never- | Brealey |
theless, preferred stock is legally an equity security. This is because payment of a pre-
ferred dividend is almost invariably within the discretion of the directors. The only ob-
ligation is that no dividends can be paid on the common stock until the preferred
dividend has been paid.2 If the company goes out of business, the preferred stockhold-
ers get in the queue after the debtholders but before the common stockholders.
Preferred stock rarely confers full voting privileges. This is an advantage to firms
that want to raise new money without sharing control of the firm with the new share-
holders. However, if there is any matter that affects their place in the queue, preferred
stockholders usually get to vote on it. Most issues also provide the holder with some
voting power if the preferred dividend is skipped.
Companies cannot deduct preferred dividends when they calculate taxable income.
2 These days this obligation is usually cumulative. In other words, before the common stockholders get a cent,
the firm must pay any preferred dividends that have been missed in the past.
PREFERRED STOCK
Stock that takes priority over
common stock in regard to
dividends.
NET WORTH Book value
of common stockholders’
equity plus preferred stock.
500 SECTION FIVE
FLOATING-RATE
PREFERRED Preferred
stock paying dividends that
vary with short-term interest
rates.
(cid:1) Self-Test 3
Like common stock dividends, preferred dividends are paid from after-tax income. For
most industrial firms this is a serious deterrent to issuing preferred. However, regulated
public utilities can take tax payments into account when they negotiate with regulators
the rates they charge customers. So they can effectively pass the tax disadvantage of
preferred on to the consumer. A large fraction of the dollar value of new offerings of or-
dinary preferred stock consists of issues by utilities.
Preferred stock does have one tax advantage. If one corporation buys another’s
stock, only 30 percent of the dividends it receives is taxed. This rule applies to dividends
on both common and preferred stock, but it is most important for preferred, for which
returns are dominated by dividends rather than capital gains.
Suppose that your firm has surplus cash to invest. If it buys a bond, the interest will
be taxed at the company’s tax rate of 35 percent. If it buys a preferred share, it owns an
asset like a bond (the preferred dividends can be viewed as “interest”), but the effective
tax rate is only 30 percent of 35 percent, .30 × .35 = .105, or 10.5 percent. It is no sur-
prise that most preferred shares are held by corporations.
If you invest your firm’s spare cash in a preferred stock, you will want to make sure
that when it is time to sell the stock, it won’t have plummeted in value. One problem
with garden-variety preferred stock that pays a fixed dividend is that the preferreds’
market prices go up and down as interest rates change (because present values fall when
rates rise). So one ingenious banker thought up a wrinkle: Why not link the dividend on
the preferred stock to interest rates so that it goes up when interest rates rise and vice
versa? The result is known as floating-rate preferred. If you own floating-rate pre-
ferred, you know that any change in interest rates will be counterbalanced by a change
in the dividend payment, so the value of your investment is protected.
A company in a 35 percent tax bracket can buy a bond yielding 10 percent or a pre-
ferred stock of the same firm that is priced to yield 8 percent. Which will provide the
higher after-tax yield? What if the purchaser is a private individual in a 35 percent tax
bracket?
Corporate Debt
When they borrow money, companies promise to make regular interest payments and
to repay the principal (that is, the original amount borrowed).
However, corporations have limited liability. By this we mean that the promise
to repay the debt is not always kept. If the company gets into deep water, the
company has the right to default on the debt and to hand over the company’s | Brealey |
assets to the lenders.
Clearly it will choose bankruptcy only if the value of the assets is less than the amount
of the debt. In practice, when companies go bankrupt, this handover of assets is far from
straightforward. For example, when the furniture company Wickes went into bank-
ruptcy, there were 250,000 creditors all jostling for a better place in the queue. Sorting
out these problems is left to the bankruptcy court.
Because lenders are not regarded as owners of the firm, they don’t normally have any
An Overview of Corporate Financing 501
voting power. Also, the company’s payments of interest are regarded as a cost and are
therefore deducted from taxable income. Thus interest is paid out of before-tax income,
whereas dividends on common and preferred stock are paid out of after-tax income.
This means that the government provides a tax subsidy on the use of debt, which it does
not provide on stock.
DEBT COMES IN MANY FORMS
Some orderly scheme of classification is essential to cope with the almost endless va-
riety of debt issues. We will walk you through the major distinguishing characteristics.
Interest Rate. The interest payment, or coupon, on most long-term loans is fixed at
the time of issue. If a $1,000 bond is issued with a coupon of 10 percent, the firm con-
tinues to pay $100 a year regardless of how interest rates change. As we pointed out-
earlier, you sometimes encounter zero-coupon bonds. In this case the firm does not
make a regular interest payment. It just makes a single payment at maturity. Obviously,
investors pay less for zero-coupon bonds.
Most loans from a bank and some long-term loans carry a floating interest rate. For
example, your firm may be offered a loan at “1 percent over prime.” The prime rate is
the benchmark interest rate charged by banks to large customers with good to excellent
credit. (But the largest and most creditworthy corporations can, and do, borrow at less
than prime.) The prime rate is adjusted up and down with the general level of interest
rates. When the prime rate changes, the interest on your floating-rate loan also changes.
Floating-rate loans are not always tied to the prime rate. Often they are tied to the
rate at which international banks lend to one another. This is known as the London In-
terbank Offered Rate, or LIBOR.
Would you expect the price of a 10-year floating-rate bond to be more or less sensitive
to changes in interest rates than the price of a 10-year maturity fixed-rate bond?
Maturity. Funded debt is any debt repayable more than 1 year from the date of issue.
Debt due in less than a year is termed unfunded and is carried on the balance sheet as
a current liability. Unfunded debt is often described as short-term debt and funded debt
is described as long-term, although it is clearly artificial to call a 364-day debt short-
term and a 366-day debt long-term (except in leap years).
There are corporate bonds of nearly every conceivable maturity. For example, Walt
Disney Co. has issued bonds with a 100-year maturity. Some British banks have issued
perpetuities—that is, bonds which may survive forever. At the other extreme we find
firms borrowing literally overnight.
Repayment Provisions. Long-term loans are commonly repaid in a steady regular
way, perhaps after an initial grace period. For bonds that are publicly traded, this is done
by means of a sinking fund. Each year the firm puts aside a sum of cash into a sinking
fund that is then used to buy back the bonds. When there is a sinking fund, investors are
prepared to lend at a lower rate of interest. They know that they are more likely to be
repaid if the company sets aside some cash each year than if the entire loan has to be
repaid on one specified day.
Firms issuing debt to the public sometimes reserve the right to call the debt—that is,
PRIME RATE
Benchmark interest rate
charged by banks.
(cid:1) Self-Test 4
FUNDED DEBT Debt
with more than 1 year
remaining to maturity.
SINKING FUND Fund
established to retire debt
before maturity.
| Brealey |
502 SECTION FIVE
CALLABLE BOND
Bond that may be
repurchased by firm before
maturity at specified call
price.
(cid:1) Self-Test 5
SUBORDINATED DEBT
Debt that may be repaid in
bankruptcy only after senior
debt is paid.
SECURED DEBT Debt
that has first claim on
specified collateral in the
event of default.
issuers of callable bonds may buy back the bonds before the final maturity date. The
price at which the firm can call the bonds is set at the time that the bonds are issued.
This option to call the bond is attractive to the issuer. If interest rates decline and
bond prices rise, the issuer may repay the bonds at the specified call price and borrow
the money back at a lower rate of interest.3
The call provision comes at the expense of bondholders, for it limits investors’ cap-
ital gain potential. If interest rates fall and bond prices rise, holders of callable bonds
may find their bonds bought back by the firm for the call price.
Suppose Heinz is considering two issues of 20-year maturity coupon bonds; one issue
will be callable, the other not. For a given coupon rate, will the callable or noncallable
bond sell at the higher price? If the bonds are both to be sold to the public at par value,
which bond must have the higher coupon rate?
Seniority. Some debts are subordinated. In the event of default the subordinated
lender gets in line behind the firm’s general creditors. The subordinated lender holds a
junior claim and is paid only after all senior creditors are satisfied.
When you lend money to a firm, you can assume that you hold a senior claim unless
the debt agreement says otherwise. However, this does not always put you at the front
of the line, for the firm may have set aside some of its assets specifically for the pro-
tection of other lenders. That brings us to our next classification.
Security. When you borrow to buy your home, the savings and loan company will
take out a mortgage on the house. The mortgage acts as security for the loan. If you de-
fault on the loan payments, the S&L can seize your home.
When companies borrow, they also may set aside certain assets as security for the
loan. These assets are termed collateral and the debt is said to be secured. In the event
of default, the secured lender has first claim on the collateral; unsecured lenders have a
general claim on the rest of the firm’s assets but only a junior claim on the collateral.
Default Risk. Seniority and security do not guarantee payment. A debt can be senior
and secured but still as risky as a dizzy tightrope walker—it depends on the value and
the risk of the firm’s assets. Earlier, we showed how the safety of most corporate bonds
can be judged from bond ratings provided by Moody’s and Standard & Poor’s. Bonds
that are rated “triple-A” seldom default. At the other extreme, many speculative-grade
(or “junk”) bonds may be teetering on the brink.
As you would expect, investors demand a high return from low-rated bonds. We saw
evidence of this in Section 3, where Figure 3.9 showed yields on default-free U.S. Trea-
sury bonds as well as on corporate bonds in various rating classes. The lower-rated
bonds did in fact offer higher promised yields to maturity.
Country and Currency. These days capital markets know few national boundaries
and many large firms in the United States borrow abroad. For example, an American
company may choose to finance a new plant in Switzerland by borrowing Swiss francs
from a Swiss bank, or it may expand its Dutch operation by issuing a bond in Holland.
3 Sometimes callable bonds specify a period during which the firm is not allowed to call the bond if the pur-
pose is simply to issue another bond at a lower interest rate.
An Overview of Corporate Financing 503
Also many foreign companies come to the United States to borrow dollars, which are
then used to finance their operations throughout the world.
In addition to these national capital markets, there is also an international capital
market centered mainly in London. There are some 500 banks in London from over 70 | Brealey |
different countries; they include such giants as Citicorp, Union Bank of Switzerland,
Deutsche Bank, Bank of Tokyo–Mitsubishi, Banque Nationale de Paris, and Barclays
Bank. One reason they are there is to collect deposits in the major currencies. For ex-
ample, suppose an Arab sheikh has just received payment in dollars for a large sale of
oil to the United States. Rather than depositing the check in the United States, he may
choose to open a dollar account with a bank in London. Dollars held in a bank outside
the United States came to be known as eurodollars. Similarly, yen held outside Japan
were termed euroyen, and so on). When the new European currency was named the
euro, the term eurodollars became confusing. Doubtless in time bankers will dream up
a new name for dollars held outside the United States; until they do, we’ll just call them
international dollars.
The London bank branch that is holding the sheikh’s dollar deposit may temporarily
lend those dollars to a company, in the same way that a bank in the United States may
relend dollars that have been deposited with it. Thus a company can either borrow dol-
lars from a bank in the United States or borrow dollars from a bank in London.4
If a firm wants to make an issue of long-term bonds, it can choose to do so in the
United States. Alternatively, it can sell the bonds to investors in several countries. These
bonds have traditionally been known as eurobonds, but international bonds may be a
less misleading term. The payments on these bonds may be fixed in dollars, euros, or
any other major currency. Companies usually sell these bonds to the London branches
of the major international banks, which then resell them to investors throughout the
world.
Public versus Private Placements. Publicly issued bonds are sold to anyone who
wishes to buy and, once they have been issued, they can be freely traded in the securi-
ties markets. In a private placement, the issue is sold directly to a small number of
banks, insurance companies, or other investment institutions. Privately placed bonds
cannot be resold to individuals in the United States but only to other qualified institu-
tional investors. However, there is increasingly active trading among these investors.
We will have more to say about the difference between public issues and private
placements later.
Protective Covenants. When investors lend to a company, they know that they might
not get their money back. But they expect that the company will use their money well
and not take unreasonable risks. To help ensure this, lenders usually impose a number
of conditions, or protective covenants, on companies that borrow from them. An hon-
est firm is willing to accept these conditions because it knows that they enable the firm
to borrow at a reasonable rate of interest.
Companies that borrow in moderation are less likely to get into difficulties than
those that are up to the gunwales in debt. So lenders usually restrict the amount of extra
debt that the firm can issue. Lenders are also eager to prevent others from pushing
ahead of them in the queue if trouble occurs. So they will not allow the company to cre-
ate new debt that is senior to them or to put aside assets for other lenders.
4 Because the Federal Reserve requires banks in the United States to keep interest-free reserves, there is in ef-
fect a tax on dollar deposits in the United States. Overseas dollar deposits are free of this tax and therefore
banks can afford to charge the borrower slightly lower interest rates.
EURODOLLARS Dollars
held on deposit in a bank
outside the United States.
EUROBOND Bond that is
marketed internationally.
PRIVATE PLACEMENT
Sale of securities to a limited
number of investors without
a public offering.
PROTECTIVE
COVENANT Restriction
on a firm to protect
bondholders.
504 SECTION FIVE
SEE BOX
(cid:1) Self-Test 6
LEASE Long-term rental
agreement.
Another possible hazard for lenders is that the company will pay a bumper dividend | Brealey |
to the shareholders, leaving no cash for the debtholders. Therefore, lenders sometimes
limit the size of the dividends that can be paid.
The story of Marriott in the nearby box shows what can happen when bondholders
are not sufficiently careful about the conditions they impose. In the wake of the large
losses suffered by Marriott bondholders, several observers predicted that investors
would demand more restrictive bond covenants in future transactions.
In 1988 RJR Nabisco, the food and tobacco giant, had $5 billion of A-rated debt out-
standing. In that year the company was taken over, and $19 billion of debt was issued
and used to buy back equity. The debt ratio skyrocketed, and the debt was downgraded
to a BB rating. The holders of the previously issued debt were furious, and one filed a
lawsuit claiming that RJR had violated an implicit obligation not to undertake major fi-
nancing changes at the expense of existing bondholders. Why did these bondholders be-
lieve they had been harmed by the massive issue of new debt? What type of explicit re-
striction would you have wanted if you had been one of the original bondholders?
A Debt by Any Other Name. The word debt sounds straightforward, but companies
enter into a number of financial arrangements that look suspiciously like debt yet are
treated differently in the accounts. Some of these obligations are easily identifiable. For
example, accounts payable are simply obligations to pay for goods that have already
been delivered and are therefore like a short-term debt.
Other arrangements are not so easy to spot. For example, instead of borrowing
money to buy equipment, many companies lease or rent it on a long-term basis. In this
case the firm promises to make a series of payments to the lessor (the owner of the
equipment). This is just like the obligation to make payments on an outstanding loan.
What if the firm can’t make the payments? The lessor can then take back the equipment,
which is precisely what would happen if the firm had borrowed money from the lessor,
using the equipment as collateral for the loan.
(cid:1) EXAMPLE 1
The Terms of Heinz’s Bond Issue
Now that you are familiar with some of the jargon, you might like to look at an exam-
ple of a bond issue. Table 5.9 is a summary of the terms of a bond issue by Heinz taken
from Moody’s Industrial Manual. We have added some explanatory notes.
INNOVATION IN THE DEBT MARKET
We have discussed domestic bonds and eurobonds, fixed-rate and floating-rate loans,
secured and unsecured loans, senior and junior loans, and much more. You might think
that this gives you all the choice you need. Yet almost every day companies and their
advisers dream up a new type of debt. Here are some examples of unusual bonds.
Indexed Bonds. We saw in earlier how the United States government has issued
bonds whose payments rise in line with inflation. Occasionally borrowers have linked
the payments on their bonds to the price of a particular commodity. For example, Mex-
An Overview of Corporate Financing 505
TABLE 5.9
Heinz’s bond issue
Comment
1. A debenture is an unsecured bond.
2. Coupon is 6.375 percent. Thus each bond makes an
annual interest payment of .06375 × $1,000 = $63.75.
Description of Bond
H. J. Heinz Company 6.375% debentures, due 2028
3. Moody’s bond rating is A, the third-highest quality
Rating—A
rating.
4. Heinz is authorized to issue (and has outstanding) $250
AUTH.
$250,000,000: outstg. $250,000,000.
million of the bonds.
5. The bond was issued in July 1998 and is to be repaid in
DATED July 10, 1998. DUE July 15, 2028.
July 2028.
6. Interest is payable at 6-month intervals on January and
INTEREST J&J 15.
July 15.
7. A trustee is appointed to look after the bondholders’
TRUSTEE First National Bank of Chicago.
interest.
8. The bonds are registered. The registrar keeps a record of
DENOMINATION Fully registered. $1,000 and integral
who owns the bonds.
9. The bond can be held in multiples of $1,000.
10. Unlike some bond issues, the Heinz issue does not give | Brealey |
the company an option to call (i.e., repurchase) the
bonds before maturity at specified prices. Also Heinz
does not set aside money each year in a sinking fund
that is then used to redeem the bonds.
11. The bonds are not secured, that is, no assets have been
set aside to protect the bondholders in the event of
default.
12. However, if Heinz sets aside assets to protect any other
bondholders, the debenture will also be secured on these
assets.This is termed a negative pledge clause.
13. The bonds were sold at a price of 99.549 percent of face
value. After deducting the payment to the underwriters
the company received $986.74 per bond. The bonds
could be bought from the listed underwriters.
multiples thereof. Transferable and exchangable without
service charge.
EARLY REDEMPTION The debentures are not
redeemable prior to maturity.
SECURITY Not secured. Ranks equally with all other
unsecured and unsubordinated indebtedness of the
Company. Company or any affiliate will not create as
security for any indebtedness for borrowed money, any
mortgage, pledge, security interest, or lien on any stock
or any indebtedness of any affiliate . . . without
effectively providing that the debentures shall be secured
equally and ratably with such indebtedness, unless such
secured debt would not exceed 10% of Consolidated Net
Assets.
OFFERED $250,000,000 at 99.549 plus accrued interest
(proceeds to Company 98.674) thru Goldman, Sachs &
Co., J. P. Morgan & Co., Warburg Dillon Read LLC.
ico, which is a large oil producer, has issued billions of dollars worth of bonds that pro-
vide an extra payoff if oil prices rise. Mexico reasons that oil-linked bonds reduce its
risk. If the price of oil is high, it can afford the higher payments on the bond. If oil prices
are low, its interest payments will also be lower. The Swiss insurance company Win-
terthur has also issued an unusual bond with varying interest payments. The payments
on the bonds are reduced if there is a hailstorm in Switzerland which damages at least
6,000 cars that have been insured by Winterthur.5 The bondholders receive a higher in-
terest rate but take on some of the company’s risk.
5 The Winterthur bond is an example of a catastrophe (or CAT) bond. Its payments are linked to the occur-
rence of a natural catastrophe. CAT bonds are discussed in M. S. Cantor, J. B. Cole, and R. L. Sandor, “In-
surance Derivatives: A New Asset Class for the Capital Markets and a New Hedging Tool for the Insurance
Industry,” Journal of Applied Corporate Finance 10 (Fall 1997), pp. 69–83.
FINANCE IN ACTION
Marriott Plan Enrages Holders of Its Bonds
Marriott Corp. has infuriated bond investors with a re-
structuring plan that may be a new way for companies
to pull the rug out from under bondholders.
Prices of Marriott’s existing bonds have plunged as
much as 30% in the past two days in the wake of the
hotel and food-services company’s announcement that
it plans to separate into two companies, one burdened
with virtually all of Marriott’s debt.
On Monday, Marriott said that it will divide its opera-
tions into two separate businesses. One, Marriott Inter-
national Inc., is a healthy company that will manage
Marriott’s vast hotel chain; it will get most of the old
company’s revenue, a larger share of the cash flow and
will be nearly debt-free.
The second business, called Host Marriott Corp., is
a debt-laden company that will own Marriott hotels
along with other real estate and retain essentially all of
the old Marriott’s $3 billion of debt.
The announcement stunned and infuriated bond-
holders, who watched nervously as the value of their
Marriott bonds tumbled and as Moody’s Investors Ser-
vice Inc. downgraded the bond to the junk-bond cate-
gory
from
investment-grade.
Price Plunge
In trading, Marriott’s 10% bonds that mature in 2012,
which Marriott sold to investors just six months ago,
were quoted yesterday at about 80 cents on the dollar,
down from 110 Friday. The price decline translates into
a stunning loss of $300 for a bond with a $1,000 face
amount.
| Brealey |
Marriott officials concede that the company’s spinoff
plan penalizes bondholders. However, the company
notes that, like all public corporations, its fiduciary duty
is to stockholders, not bondholders. Indeed, Marriott’s
stock jumped 12% Monday. (It fell a bit yesterday.)
Bond investors and analysts worry that if the Marriott
spinoff goes through, other companies will soon follow
suit by separating debt-laden units from the rest of
the company. “ Any company that fears it has underper-
forming divisions that are dragging down its stock price
is a possible candidate” for such a restructuring, says
Dorothy K. Lee, an assistant vice president at Moody’s.
If the trend heats up, investors said, the Marriott re-
structuring could be the worst news for corporate
Inc.’s managers
bondholders since RJR Nabisco
shocked investors in 1987 by announcing they were
taking the company private in a record $25 billion lever-
aged buy-out. The move, which loaded RJR with debt
and tanked the value of RJR bonds, triggered a deep
slump in prices of many investment-grade corporate
bonds as investors backed away from the market.
Strong Covenants May Re-Emerge
Some analysts say the move by Marriott may trigger the
re-emergence of strong covenants, or written protec-
tions, in future corporate bond issues to protect bond-
holders against such restructurings as the one being
engineered by Marriott. In the wake of the RJR buy-out,
many investors demanded stronger covenants in new
corporate bond issues.
Some investors blame themselves for not demand-
ing stronger covenants. “ It’s our own fault,” said Robert
Hickey, a bond fund manager at Van Kampen Merritt. In
their rush to buy bonds in an effort to lock in yields,
many investors have allowed companies to sell bonds
with covenants that have been “ slim to none,” Mr.
Hickey said.
Source: Reprinted by permission of The Wall Street Journal, © 1992
Dow Jones & Company, Inc. All Rights Reserved Worldwide.
Asset-Backed Bonds. The rock star David Bowie earns royalties from a number of
successful albums such as The Rise and Fall of Ziggy Stardust and Diamond Dogs. But
instead of waiting to receive these royalties, Bowie decided that he would prefer the
money upfront. The solution was to issue $55 million of 10-year bonds and to set aside
the future royalty payments from the singer’s albums to make the payments on these
bonds. Such bonds are known as asset-backed securities; the borrower sets aside a
group of assets and the income from these assets is then used to service the debt. The
Bowie bonds are an unusual example of an asset-backed security, but billions of dollars
506
An Overview of Corporate Financing 507
of house mortgages and credit card loans are packaged each year and resold as asset-
backed bonds.
Reverse floaters. Floating-rate bonds that pay a higher rate of interest when other in-
terest rates fall and a lower rate when other rates rise are called reverse floaters. They
are riskier than normal bonds. When interest rates rise, the prices of all bonds fall, but
the prices of reverse floaters suffer a double whammy because the coupon payments on
the bonds fall as the discount rate rises. In 1994 Orange County, California, learned this
the hard way, when it invested heavily in reverse floaters. Robert Citron, the treasurer,
was betting that interest rates would fall. He was wrong; interest rates rose sharply and
partly as a result of its investment in reverse floaters, the county lost $1.7 billion.
These three examples illustrate the great variety of potential security designs. As
long as you can convince investors of its attractions, you can issue a callable, subordi-
nated, floating-rate bond denominated in euros. Rather than combining features of ex-
isting securities, you may be able to create an entirely new one. We can imagine a cop-
per mining company issuing preferred shares on which the dividend fluctuates with the
world copper price. We know of no such security, but it is perfectly legal to issue it | Brealey |
and—who knows?—it might generate considerable interest among investors.
Variety is intrinsically good. People have different tastes, levels of wealth, rates of
tax, and so on. Why not offer them a choice? Of course the problem is the expense of
designing and marketing new securities. But if you can think of a new security that will
appeal to investors, you may be able to issue it on especially favorable terms and thus
increase the value of your company.
Convertible Securities
WARRANT Right to buy
shares from a company at a
stipulated price before a set
date.
We have seen that companies sometimes have the option to repay an issue of bonds be-
fore maturity. There are also cases in which investors have an option. The most dramatic
case is provided by a warrant, which is nothing but an option. Companies often issue
warrants and bonds in a package.
(cid:1) EXAMPLE 2
Warrants
Macaw Bill wishes to make a bond issue, which could include some warrants as a
“sweetener.” Each warrant might allow you to purchase one share of Macaw stock at a
price of $50 any time during the next 5 years. If Macaw’s stock performs well, that op-
tion could turn out to be very valuable. For instance, if the stock price at the end of the
5 years is $80, then you pay the company $50 and receive in exchange a share worth
$80. Of course, an investment in warrants also has its perils. If the price of Macaw stock
fails to rise above $50, then the warrants expire worthless.
CONVERTIBLE BOND
Bond that the holder may
exchange for a specified
amount of another security.
A convertible bond gives its owner the option to exchange the bond for a predeter-
mined number of common shares. The convertible bondholder hopes that the company’s
share price will zoom up so that the bond can be converted at a big profit. But if the
shares zoom down, there is no obligation to convert; the bondholder remains just that.
Not surprisingly, investors value this option to keep the bond or exchange it for shares,
508 SECTION FIVE
INTERNALLY
GENERATED FUNDS
Cash reinvested in the firm:
depreciation plus earnings
not paid out as dividends.
and therefore a convertible bond sells at a higher price than a comparable bond that is
not convertible.
The convertible is rather like a package of a bond and a warrant. But there is an im-
portant difference: when the owners of a convertible wish to exercise their options to
buy shares, they do not pay cash—they just exchange the bond for shares of the stock.
Companies may also issue convertible preferred stock. In this case the investor re-
ceives preferred stock with fixed dividend payments but has the option to exchange this
preferred stock for the company’s common stock. The preferred stock issued by Heinz
is convertible into common stock.
These examples do not exhaust the options encountered by the financial manager.
Patterns of Corporate Financing
We have now completed our tour of corporate securities. You may feel like the tourist
who has just gone through 12 cathedrals in 5 days. But there will be plenty of time in
later material for reflection and analysis. For now, let’s look at how firms use these
sources of finance.
Firms have two broad sources of cash. They can raise money from external
sources by an issue of debt or equity. Or they can plow back part of their
profits. When the firm retains cash rather than paying the money out as
dividends, it is increasing shareholders’ investment in the firm.
Figure 5.4 summarizes the sources of capital for United States corporations. The
most striking aspect of this figure is the dominance of internally generated funds, de-
fined as depreciation plus earnings that are not paid out as dividends.6 During the 1980s
internally generated cash covered approximately three-quarters of firms’ capital re-
quirements.
DO FIRMS RELY TOO HEAVILY
ON INTERNAL FUNDS?
Gordon Donaldson, in a survey of corporate debt policies, encountered several firms
which acknowledged “that it was their long-term object to hold to a rate of growth | Brealey |
which was consistent with their capacity to generate funds internally.” A number of
other firms appeared to think less hard about expenditure proposals that could be fi-
nanced internally.7
At first glance, this behavior doesn’t make sense. As we have already noted, retained
profits are additional capital invested by shareholders and represent, in effect, a com-
pulsory issue of shares. A firm that retains $1 million could have paid out the cash as
dividends and then sold new common shares to raise the same amount of additional
capital. The opportunity cost of capital ought not to depend on whether the project is fi-
nanced by retained profits or a new stock issue.
6 Remember that depreciation is a noncash expense.
7 See G. Donaldson, Corporate Debt Capacity, Division of Research, Graduate School of Business Adminis-
tration, Harvard University, Boston, 1961, Chapter 3, especially pp. 51–56.
FIGURE 5.4
Sources of funds,
nonfinancial corporate
sector.
)
s
r
a
l
l
o
d
f
o
s
n
o
i
l
l
i
b
(
s
d
n
u
f
f
o
e
c
r
u
o
S
800
700
600
500
400
300
200
100
0
(cid:2)100
(cid:2)200
(cid:2)300
An Overview of Corporate Financing 509
Internal funds
Net equity issues
Debt instruments
0
8
9
1
1
8
9
1
2
8
9
1
3
8
9
1
4
8
9
1
5
8
9
1
6
8
9
1
7
8
9
1
8
8
9
1
9
8
9
1
0
9
9
1
1
9
9
1
2
9
9
1
3
9
9
1
4
9
9
1
5
9
9
1
6
9
9
1
7
9
9
1
8
9
9
1
9
9
9
1
Year
Source: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System,
1999. Values for 1999 are for first two quarters, expressed at annual rates.
Why then do managers have an apparent preference for financing by retained earn-
ings? Perhaps managers are simply taking the line of least resistance, dodging the dis-
cipline of the securities markets.
Think back, where we pointed out that a firm is a team, consisting of managers,
shareholders, debtholders, and so on. The shareholders and debtholders would like to
monitor management to make sure that it is pulling its weight and truly maximizing
market value. It is costly for individual investors to keep checks on management. How-
ever, large financial institutions are specialists in monitoring, so when the firm goes to
the bank for a large loan or makes a public issue of stocks or bonds, managers know
that they had better have all the answers. If they want a quiet life, they will avoid going
to the capital market to raise money and they will retain sufficient earnings to be able
to meet unanticipated demands for cash.
We do not mean to paint managers as loafers. There are also rational reasons for re-
lying on internally generated funds. The costs of new securities are avoided, for exam-
ple. Moreover, the announcement of a new equity issue is usually bad news for in-
vestors, who worry that the decision signals lower profits.8 Raising equity capital from
internal sources avoids the costs and the bad omens associated with equity issues.
(cid:1) Self-Test 7
“Since internal funds provide the bulk of industry’s needs for capital, the securities mar-
kets serve little function.” Does the speaker have a point?
8 Managers do have insiders’ insights and naturally are tempted to issue stock when the stock price looks good
to them, that is, when they are less optimistic than outside investors. The outside investors realize all this and
will buy a new issue only at a discount from the preannouncement price.
510 SECTION FIVE
EXTERNAL SOURCES OF CAPITAL
Of course firms don’t rely exclusively on internal funds. They also issue securities and
retire them, sometimes in big volume. For example, in the early 1990s Heinz dramati-
cally increased its reliance on new debt by issuing considerable amounts of bonds. Be-
tween 1991 and 1993, its outstanding long-term debt more than doubled. After 1994,
however, Heinz reduced its reliance on new debt financing, and its level of outstanding
long-term debt stabilized. Despite this, the ratio of debt to the book value of equity con-
tinued to rise. The ratio continued to rise because Heinz was buying back shares from
the public. So over this period, Heinz had negative net stock issues.
Figure 5.5 shows the ratio of the book value of Heinz’s long-term debt to both the | Brealey |
book value and market value of its equity. The ratio based on book values rose through-
out the 1990s. However, the ratio of debt to the market value of equity was far more sta-
ble. This reflects the great rise in stock market values in the 1990s, which allowed the
market value of Heinz’s equity to keep up with its issues of long-term debt.
If you look back at Figure 5.4, you will see that Heinz was not alone in its use of
share repurchases in the latter part of the 1990s. The figure shows that for most of this
period corporate America was making large issues of debt and using part of the money
to buy back common stock. Despite this policy, debt-to-equity ratios did not rise. The
high profit levels during this period resulted in record-setting levels of internally gen-
erated funds. As a result, despite the share repurchases, common equity rose in line with
long-term debt.
The net effect of these financing policies is shown in Figure 5.6, which confirms that
debt-to-equity ratios for United States firms in the 1990s were relatively stable in book-
value terms but declined considerably in market-value terms. Again, this reflects the
run-up of stock prices during this period.
United States corporations are carrying more debt than they did 30 years ago.
Should we be worried? It is true that higher debt ratios mean that more companies are
likely to fall into financial distress when a serious recession hits the economy. But all
companies live with this risk to some degree, and it does not follow that less risk is
better. Finding the optimal debt ratio is like finding the optimal speed limit: we can
agree that accidents at 30 miles per hour are less dangerous, other things being equal,
FIGURE 5.5
Debt-to-equity ratios for H. J.
Heinz Company.
D/E book
D/E market
o
i
t
a
r
y
t
i
u
q
e
-
o
t
-
t
b
e
D
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00
1980
1985
1990
Year
1995
2000
An Overview of Corporate Financing 511
FIGURE 5.6
Debt-to-equity ratio,
nonfinancial corporate
sector.
o
i
t
a
r
y
t
i
u
q
e
-
o
t
-
t
b
e
D
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0.0
D/E book
D/E market
1988
1990
1992
1994
1996
1998
Year
than accidents at 60 miles per hour, but we do not therefore set the national speed limit
at 30. Speed has benefits as well as risks. So does debt.
Summary
What are the major classes of securities issued by firms to raise capital?
Companies may raise money from shareholders by issuing more shares. They also raise
money indirectly by plowing back cash that could otherwise have been paid out as
dividends.
Preferred stock offers a fixed dividend but the company has the discretion not to pay it.
It can’t, however, then pay a dividend on the common stock. Despite its name, preferred
stock is not a popular source of finance, but it is useful in special situations.
When companies issue debt, they promise to make a series of interest payments and to
repay the principal. However, this liability is limited. Stockholders have the right to default
on their obligation and to hand over the assets to the debtholders. Unlike dividends on
common stock and preferred stock, the interest payments on debt are regarded as a cost and
therefore they are paid out of before-tax income. Here are some forms of debt:
• Fixed-rate and floating-rate debt
• Funded (long-term) and unfunded (short-term) debt
• Callable and sinking-fund debt
• Senior and subordinated debt
• Secured and unsecured debt
•
Investment grade and junk debt
• Domestic and international debt
• Publicly traded debt and private placements
The fourth source of finance consists of options and optionlike securities. The simplest
option is a warrant, which gives its holder the right to buy a share from the firm at a set
price by a set date. Warrants are often sold in combination with other securities.
512 SECTION FIVE
Convertible bonds give their holder the right to convert the bond to shares. They therefore
resemble a package of straight debt and a warrant.
What are recent trends in firms’ use of different sources of finance?
Internally generated cash is the principal source of company funds. Some people worry | Brealey |
about that; they think that if management does not go to the trouble of raising money, it may
be profligate in spending it.
In the late 1990s, net equity issues were negative; that is, companies repurchased more
equity than they issued. At the same time companies issued large quantities of debt.
However, large levels of internally generated funds in this period allowed book equity to
increase despite the share repurchases, with the result that the ratio of long-term debt to
book value of equity was fairly stable. Moreover, the stock market boom of the 1990s meant
that the ratio of debt to the market value of equity actually fell considerably during this
period.
Related Web
Links
www.AshtonAnalytics.com/ Information about the debt markets
www.finpipe.com/ See “Types of Debt” for descriptions of many debt instruments
www.fcnbd.com/corporate/capital/mezzanine/index.html A menu of choices for corporations
Key Terms
issuing different kinds of debt
www.corpfinet.com/ The corporate finance network
www.hoovers.com/ Information about corporations and corporate financing
treasury stock
issued shares
outstanding shares
authorized share capital
par value
additional paid-in capital
retained earnings
majority voting
cumulative voting
proxy contest
preferred stock
net worth
floating-rate preferred
prime rate
funded debt
sinking fund
callable bond
subordinated debt
secured debt
eurodollars
eurobond
private placement
protective covenant
lease
warrant
convertible bond
internally generated funds
Quiz
1. Equity Accounts. The authorized share capital of the Alfred Cake Company is 100,000
shares. The equity is currently shown in the company’s books as follows:
Common stock ($1.00 par value)
Additional paid-in capital
Retained earnings
Common equity
Treasury stock (2,000 shares)
Net common equity
$ 60,000
10,000
30,000
100,000
5,000
95,000
a. How many shares are issued?
b. How many are outstanding?
c. How many more shares can be issued without the approval of shareholders?
An Overview of Corporate Financing 513
2. Equity Accounts.
a. Look back at problem 1. Suppose that the company issues 10,000 shares at $5 a share.
Which of the above figures would change?
b. What would happen to the company’s books if instead it bought back 1,000 shares at $5
per share?
3. Financing Terms. Fill in the blanks by choosing the appropriate term from the following
list: lease, funded, floating-rate, eurobond, convertible, subordinated, call, sinking fund,
prime rate, private placement, public issue, senior, unfunded, eurodollar rate, warrant,
debentures, term loan.
a. Debt maturing in more than 1 year is often called _________ debt.
b. An issue of bonds that is sold simultaneously in several countries is traditionally called
a(n) _________.
c. If a lender ranks behind the firm’s general creditors in the event of default, the loan is
said to be _________.
d. In many cases a firm is obliged to make regular contributions to a(n) _________, which
is then used to repurchase bonds.
e. Most bonds give the firm the right to repurchase or _________ the bonds at specified
prices.
f. The benchmark interest rate that banks charge to their customers with good to excellent
credit is generally termed the _________.
g. The interest rate on bank loans is often tied to short-term interest rates. These loans are
usually called _________ loans.
h. Where there is a(n) _________, securities are sold directly to a small group of institu-
tional investors. These securities cannot be resold to individual investors. In the case of
a(n) _________, debt can be freely bought and sold by individual investors.
i. A long-term rental agreement is called a(n) _________.
j. A(n) _________ bond can be exchanged for shares of the issuing corporation.
k. A(n) _________ gives its owner the right to buy shares in the issuing company at a pre-
determined price.
4. Financing Trends. True or false? Explain.
a. In several recent years, nonfinancial corporations in the United States have repurchased
more stock than they have issued.
b. A corporation pays tax on only 30 percent of the common or preferred dividends it re-
| Brealey |
ceives from other corporations.
c. Because of the tax advantage, a large fraction of preferred shares is held by corporations.
5. Preferred Stock. In what ways is preferred stock like long-term debt? In what ways is it like
common stock?
Practice
Problems
6. Voting for Directors. If there are 10 directors to be elected and a shareholder owns 90
shares, indicate the maximum number of votes that he or she can cast for a favorite candi-
date under
a. majority voting
b. cumulative voting
514 SECTION FIVE
Solutions to
Self-Test
Questions
7. Voting for Directors. The shareholders of the Pickwick Paper Company need to elect five
directors. There are 400,000 shares outstanding. How many shares do you need to own to
ensure that you can elect at least one director if the company has
a. majority voting
b. cumulative voting
Hint: How many votes in total will be cast? How many votes are required to ensure that at
least one-fifth of votes are cast for your choice?
8. Equity Accounts. Look back at Table 5.8.
a. Suppose that Heinz issues 10 million shares at $55 a share. Rework Table 5.8 to show the
company’s equity after the issue.
b. Suppose that Heinz subsequently repurchased 500,000 shares at $60 a share. Rework part
(a) to show the effect of the further change.
9. Equity Accounts. Common Products has just made its first issue of stock. It raised $2 mil-
lion by selling 200,000 shares of stock to the public. These are the only shares outstanding.
The par value of each share was $1.50. Fill in the following table:
Common shares (par value)
Additional paid-in capital
Retained earnings
Net common equity
________
________
________
$2,500,000
10. Protective Covenants. Why might a bond agreement limit the amount of assets that the firm
can lease?
11. Bond Yields. Other things equal, will the following provisions increase or decrease the yield
to maturity at which a firm can issue a bond?
a. A call provision
b. A restriction on further borrowing
c. A provision of specific collateral for the bond
d. An option to convert the bonds into shares
12. Income Bonds. Income bonds are unusual. Interest payments on such bonds may be skipped
or deferred if the firm’s income is insufficient to make the payment. In what way are these
bonds like preferred stock? Why might a firm choose to issue an income bond instead of
preferred stock?
13. Preferred Stock. Preferred stock of financially strong firms sometimes sells at lower yields
than the bonds of those firms. For weaker firms, the preferred stock has a higher yield. What
might explain this pattern?
1 Par value of common shares must be $1 × 100,000 shares = $100,000. Additional paid-in
capital is ($15 – $1) × 100,000 = $1,400,000. Since book value is $4,500,000, retained
earnings must be $3,000,000. Therefore, the accounts look like this:
Common shares ($1.00 par value per share)
Additional paid-in capital
Retained earnings
Net common equity
100,000
1,400,000
3,000,000
$4,500,000
An Overview of Corporate Financing 515
2 Book value is $10 million. At a discount rate of 10 percent, the market value of the firm
ought to be $2 million × 20-year annuity factor at 10% = $17 million, which exceeds book
value. At a discount rate of 20 percent, market value falls to $9.7 million, which is below
book value.
3 The corporation’s after-tax yield on the bonds is 10% – (.35 × 10%) = 6.5%. The after-tax
yield on the preferred is 8% – [.35 × (.30 × 8%)] = 7.16%. The preferred stock provides the
higher after-tax rate despite its lower before-tax rate. For the individual, the tax rate on both
the preferred and the bond is equal to 35 percent, so the investment with the higher before-
tax rate also provides the higher after-tax rate.
4 Because the coupon on floating-rate debt adjusts periodically to current market conditions,
the bondholder is less vulnerable to changes in market yields. The coupon rate paid by the
bond is not locked in for as long a period of time. Therefore, prices of floaters should be
less sensitive to changes in market interest rates.
5 The callable bond will sell at a lower price. Investors will not pay as much for the callable | Brealey |
bond since they know that the firm may call it away from them if interest rates fall. Thus
they know that their capital gains potential is limited, which makes the bond less valuable.
If both bonds are to sell at par value, the callable bond must pay a higher coupon rate as
compensation to the investor for the firm’s right to call the bond.
6 The extra debt makes it more likely that the firm will not be able to make good on its prom-
ised payments to its creditors. If the new debt is not junior to the already-issued debt, then
the original bondholders suffer a loss when their bonds become more susceptible to default
risk. A protective covenant limiting the amount of new debt that the firm can issue would
have prevented this problem. Investors, having witnessed the problems of the RJR bond-
holders, generally demanded the covenant on future debt issues.
7 Capital markets provide liquidity for investors. Because individual stockholders can always
lay their hands on cash by selling shares, they are prepared to invest in companies that re-
tain earnings rather than pay them out as dividends. Well-functioning capital markets allow
the firm to serve all its stockholders simply by maximizing value. Capital markets also pro-
vide managers with information. Without this information, it would be very difficult to de-
termine opportunity costs of capital or to assess financial performance.
HOW CORPORATIONS
ISSUE SECURITIES
Venture Capital
The Initial Public Offering
Arranging a Public Issue
The Underwriters
Who Are the Underwriters?
General Cash Offers by Public Companies
General Cash Offers and Shelf Registration
Costs of the General Cash Offer
Market Reaction to Stock Issues
The Private Placement
Summary
Appendix: Hotch Pot’s New Issue Prospectus
Planet Hollywood shares are offered to investors.
IPOs often provide stellar first-day returns, but their long-term performance tends to be weak.
Reuters/Ethan Miller/Archive Photos
517
B
ill Gates and Paul Allen founded Microsoft in 1975, when both
were around 20 years old. Eleven years later Microsoft shares were sold
to the public for $21 a share and immediately zoomed to $35. The largest
shareholder was Bill Gates, whose shares in Microsoft then were worth
$350 million.
In 1976 two college dropouts, Steve Jobs and Steve Wozniak, sold their most valu-
able possessions, a van and a couple of calculators, and used the cash to start manufac-
turing computers in a garage. In 1980, when Apple Computer went public, the shares
were offered to investors at $22 and jumped to $36. At that point, the shares owned by
the company’s two founders were worth $414 million.
In 1994 Marc Andreesen, a 24-year-old from the University of Illinois, joined with
an investor, James Clark, to found Netscape Communications. Just over a year later
Netscape stock was offered to the public at $28 a share and immediately leapt to $71.
At this price James Clark’s shares were worth $566 million, while Marc Andreesen’s
shares were worth $245 million.
Such stories illustrate that the most important asset of a new firm may be a good
idea. But that is not all you need. To take an idea from the drawing board to a prototype
and through to large-scale production requires ever greater amounts of capital.
To get a new company off the ground, entrepreneurs may rely on their own savings
and personal bank loans. But this is unlikely to be sufficient to build a successful en-
terprise. Venture capital firms specialize in providing new equity capital to help firms
over the awkward adolescent period before they are large enough to “go public.” In the
first part of this material we will explain how venture capital firms do this.
If the firm continues to be successful, there is likely to come a time when it needs to
tap a wider source of capital. At this point it will make its first public issue of common
stock. This is known as an initial public offering, or IPO. In the second section of the
material we will describe what is involved in an IPO.
A company’s initial public offering is seldom its last. Earlier we saw that internally | Brealey |
generated cash is not usually sufficient to satisfy the firm’s needs. Established compa-
nies make up the deficit by issuing more equity or debt. The remainder of this material
looks at this process.
After studying this material you should be able to
(cid:1) Understand how venture capital firms design successful deals.
(cid:1) Understand how firms make initial public offerings and the costs of such offerings.
(cid:1) Know what is involved when established firms make a general cash offer or a pri-
vate placement of securities.
(cid:1) Explain the role of the underwriter in an issue of securities.
518
VENTURE CAPITAL
Money invested to finance a
new firm.
How Corporations Issue Securities 519
Venture Capital
You have taken a big step. With a couple of friends, you have formed a corporation to
open a number of fast-food outlets, offering innovative combinations of national dishes
such as sushi with sauerkraut, curry Bolognese, and chow mein with Yorkshire pudding.
Breaking into the fast-food business costs money, but, after pooling your savings and
borrowing to the hilt from the bank, you have raised $100,000 and purchased 1 million
shares in the new company. At this zero-stage investment, your company’s assets are
$100,000 plus the idea for your new product.
That $100,000 is enough to get the business off the ground, but if the idea takes off,
you will need more capital to pay for new restaurants. You therefore decide to look for
an investor who is prepared to back an untried company in return for part of the prof-
its. Equity capital in young businesses is known as venture capital and it is provided
by specialist venture capital firms, wealthy individuals, and investment institutions such
as pension funds.
Most entrepreneurs are able to spin a plausible yarn about their company. But it is as
hard to convince a venture capitalist to invest in your business as it is to get a first novel
published. Your first step is to prepare a business plan. This describes your product, the
potential market, the production method, and the resources—time, money, employees,
plant, and equipment—needed for success. It helps if you can point to the fact that you
are prepared to put your money where your mouth is. By staking all your savings in the
company, you signal your faith in the business.
The venture capital company knows that the success of a new business depends on
the effort its managers put in. Therefore, it will try to structure any deal so that you have
a strong incentive to work hard. For example, if you agree to accept a modest salary
(and look forward instead to increasing the value of your investment in the company’s
stock), the venture capital company knows you will be committed to working hard.
However, if you insist on a watertight employment contract and a fat salary, you won’t
find it easy to raise venture capital.
You are unlikely to persuade a venture capitalist to give you as much money as you
need all at once. Rather, the firm will probably give you enough to reach the next major
checkpoint. Suppose you can convince the venture capital company to buy 1 million
new shares for $.50 each. This will give it one-half ownership of the firm: it owns 1 mil-
lion shares and you and your friends also own 1 million shares. Because the venture
capitalist is paying $500,000 for a claim to half your firm, it is placing a $1 million
value on the business. After this first-stage financing, your company’s balance sheet
looks like this:
FIRST-STAGE MARKET-VALUE BALANCE SHEET
(figures in millions)
Assets
Cash from new equity
Other assets
Value
$ .5
.5
$1.0
Liabilities and Shareholders’ Equity
New equity from venture capital
Your original equity
Value
$ .5
.5
$1.0
(cid:1) Self-Test 1
Why might the venture capital company prefer to put up only part of the funds up-
front? Would this affect the amount of effort put in by you, the entrepreneur? Is your
520 SECTION FIVE
willingness to accept only part of the venture capital that will eventually be needed a
good signal of the likely success of the venture?
| Brealey |
Suppose that 2 years later your business has grown to the point at which it needs a
further injection of equity. This second-stage financing might involve the issue of a fur-
ther 1 million shares at $1 each. Some of these shares might be bought by the original
backers and some by other venture capital firms. The balance sheet after the new fi-
nancing would then be as follows:
SECOND-STAGE MARKET-VALUE BALANCE SHEET
(figures in millions)
Assets
Cash from new equity
Other assets
Value
Liabilities and Shareholders’ Equity
$1.0
2.0
$3.0
New equity from second-stage financing
Equity from first stage
Your original equity
Value
$1.0
1.0
1.0
$3.0
Notice that the value of the initial 1 million shares owned by you and your friends
has now been marked up to $1 million. Does this begin to sound like a money machine?
It was so only because you have made a success of the business and new investors are
prepared to pay $1 to buy a share in the business. When you started out, it wasn’t clear
that sushi and sauerkraut would catch on. If it hadn’t caught on, the venture capital firm
could have refused to put up more funds.
You are not yet in a position to cash in on your investment, but your gain is real. The
second-stage investors have paid $1 million for a one-third share in the company. (There
are now 3 million shares outstanding, and the second-stage investors hold 1 million
shares.) Therefore, at least these impartial observers—who are willing to back up their
opinions with a large investment—must have decided that the company was worth at
least $3 million. Your one-third share is therefore also worth $1 million.
For every 10 first-stage venture capital investments, only two or three may survive
as successful, self-sufficient businesses, and only one may pay off big. From these sta-
tistics come two rules of success in venture capital investment. First, don’t shy away
from uncertainty; accept a low probability of success. But don’t buy into a business un-
less you can see the chance of a big, public company in a profitable market. There’s no
sense taking a big risk unless the reward is big if you win. Second, cut your losses; iden-
tify losers early, and, if you can’t fix the problem—by replacing management, for ex-
ample—don’t throw good money after bad.
The same advice holds for any backer of a risky startup business—after all, only a
fraction of new businesses are funded by card-carrying venture capitalists. Some start-
ups are funded directly by managers or by their friends and families. Some grow using
bank loans and reinvested earnings. But if your startup combines high risk, sophisti-
cated technology, and substantial investment, you will probably try to find venture-
capital financing.
The Initial Public Offering
Very few new businesses make it big, but those that do can be very profitable. For ex-
ample, an investor who provided $1,000 of first-stage financing for Intel would by mid-
2000 have reaped $43 million. So venture capitalists keep sane by reminding them-
INITIAL PUBLIC
OFFERING (IPO)
offering of stock to the
general public.
First
How Corporations Issue Securities 521
selves of the success stories1—those who got in on the ground floor of firms like Intel
and Federal Express and Lotus Development Corporation.2 If a startup is successful, the
firm may need to raise a considerable amount of capital to gear up its production ca-
pacity. At this point, it needs more capital than can comfortably be provided by a small
number of individuals or venture capitalists. The firm decides to sell shares to the pub-
lic to raise the necessary funds.
A firm is said to go public when it sells its first issue of shares in a general
offering to investors. This first sale of stock is called an initial public offering,
or IPO.
An IPO is called a primary offering when new shares are sold to raise additional cash
for the company. It is a secondary offering when the company’s founders and the ven-
ture capitalist cash in on some of their gains by selling shares. A secondary offer there- | Brealey |
fore is no more than a sale of shares from the early investors in the firm to new in-
vestors, and the cash raised in a secondary offer does not flow to the company. Of
course, IPOs can be and commonly are both primary and secondary: the firm raises new
cash at the same time that some of the already-existing shares in the firm are sold to the
public. Some of the biggest secondary offerings have involved governments selling off
stock in nationalized enterprises. For example, the Japanese government raised $12.6
billion by selling its stock in Nippon Telegraph and Telephone and the British govern-
ment took in $9 billion from its sale of British Gas. The world’s largest IPO took place
in 1999 when the Italian government raised $19.3 billion from the sale of shares in the
state-owned electricity company, Enel.
ARRANGING A PUBLIC ISSUE
Once a firm decides to go public, the first task is to select the underwriters.
UNDERWRITER Firm
that buys an issue of
securities from a company
and resells it to the public.
Underwriters are investment banking firms that act as financial midwives to a
new issue. Usually they play a triple role—first providing the company with
procedural and financial advice, then buying the stock, and finally reselling it
to the public.
SPREAD Difference
between public offer price
and price paid by
underwriter.
A small IPO may have only one underwriter, but larger issues usually require a syn-
dicate of underwriters who buy the issue and resell it. For example, the initial public of-
fering by Microsoft involved a total of 114 underwriters.
In the typical underwriting arrangement, called a firm commitment, the underwriters
buy the securities from the firm and then resell them to the public. The underwriters re-
ceive payment in the form of a spread—that is, they are allowed to sell the shares at a
slightly higher price than they paid for them. But the underwriters also accept the risk
that they won’t be able to sell the stock at the agreed offering price. If that happens, they
will be stuck with unsold shares and must get the best price they can for them. In the
more risky cases, the underwriter may not be willing to enter into a firm commitment
and handles the issue on a best efforts basis. In this case the underwriter agrees to sell
as much of the issue as possible but does not guarantee the sale of the entire issue.
522 SECTION FIVE
PROSPECTUS Formal
summary that provides
information on an issue of
securities.
UNDERPRICING
Issuing securities at an
offering price set below the
true value of the security.
Before any stock can be sold to the public, the company must register the stock with
the Securities and Exchange Commission (SEC). This involves preparation of a detailed
and sometimes cumbersome registration statement, which contains information about
the proposed financing and the firm’s history, existing business, and plans for the fu-
ture. The SEC does not evaluate the wisdom of an investment in the firm but it does
check the registration statement for accuracy and completeness. The firm must also
comply with the “blue-sky” laws of each state, so named because they seek to protect
the public against firms that fraudulently promise the blue sky to investors.3
The first part of the registration statement is distributed to the public in the form of
a preliminary prospectus. One function of the prospectus is to warn investors about the
risks involved in any investment in the firm. Some investors have joked that if they read
prospectuses carefully, they would never dare buy any new issue. The appendix to this
material is a possible prospectus for your fast-food business.
The company and its underwriters also need to set the issue price. To gauge how
much the stock is worth, they may undertake discounted cash-flow calculations like
those described earlier. They also look at the price-earnings ratios of the shares of the
firm’s principal competitors.
Before settling on the issue price, the underwriters may arrange a “roadshow,” which | Brealey |
gives the underwriters and the company’s management an opportunity to talk to poten-
tial investors. These investors may then offer their reaction to the issue, suggest what
they think is a fair price, and indicate how much stock they would be prepared to buy.
This allows the underwriters to build up a book of likely orders. Although investors are
not bound by their indications, they know that if they want to remain in the underwrit-
ers’ good books, they must be careful not to renege on their expressions of interest.
The managers of the firm are eager to secure the highest possible price for their
stock, but the underwriters are likely to be cautious because they will be left with any
unsold stock if they overestimate investor demand. As a result, underwriters typically
try to underprice the initial public offering. Underpricing, they argue, is needed to
tempt investors to buy stock and to reduce the cost of marketing the issue to customers.
Underpricing represents a cost to the existing owners since the new investors
are allowed to buy shares in the firm at a favorable price. The cost of
underpricing may be very large.
It is common to see the stock price increase substantially from the issue price in the
days following an issue. Such immediate price jumps indicate the amount by which the
shares were underpriced compared to what investors were willing to pay for them. A
study by Ibbotson, Sindelar, and Ritter of approximately 9,000 new issues from 1960 to
1987 found average underpricing of 16 percent.4 Sometimes new issues are dramati-
cally underpriced. In November 1998, for example, 3.1 million shares in theglobe.com
3 Sometimes states go beyond blue-sky laws in their efforts to protect their residents. In 1980 when Apple
Computer Inc. made its first public issue, the Massachusetts state government decided the offering was too
risky for its residents and therefore banned the sale of the shares to investors in the state. The state relented
later, after the issue was out and the price had risen. Massachusetts investors obviously did not appreciate this
“protection.”
4 R. G. Ibbotson, J. L. Sindelar, and J. R. Ritter, “Initial Public Offerings,” Journal of Applied Corporate Fi-
nance 1 (Summer 1988), pp. 37–45. Note, however, that initial underpricing does not mean that IPOs are su-
perior long-run investments. In fact, IPO returns over the first 3 years of trading have been less than a con-
trol sample of matching firms. See J. R. Ritter, “The Long-Run Performance of Initial Public Offerings,”
Journal of Finance 46 (March 1991), pp. 3–27.
Project Analysis 523
SEE BOX
were sold in an IPO at a price of $9 a share. In the first day of trading 15.6 million
shares changed hands and the price at one point touched $97. Unfortunately, the bo-
nanza did not last. Within a year the stock price had fallen by over two-thirds from its
first-day peak. The nearby box reports on the phenomenal performance of Internet IPOs
in the late 1990s.
(cid:1) EXAMPLE 1
Underpricing of IPOs
Suppose an IPO is a secondary issue, and the firm’s founders sell part of their holding
to investors. Clearly, if the shares are sold for less than their true worth, the founders
will suffer an opportunity loss.
But what if the IPO is a primary issue that raises new cash for the company? Do the
founders care whether the shares are sold for less than their market value? The follow-
ing example illustrates that they do care.
Suppose Cosmos.com has 2 million shares outstanding and now offers a further 1
million shares to investors at $50. On the first day of trading the share price jumps to
$80, so that the shares that the company sold for $50 million are now worth $80 mil-
lion. The total market capitalization of the company is 3 million × $80 = $240 million.
The value of the founders’ shares is equal to the total value of the company less the
value of the shares that have been sold to the public—in other words, $240 – $80 = $160
million. The founders might justifiably rejoice at their good fortune. However, if the | Brealey |
company had issued shares at a higher price, it would have needed to sell fewer shares
to raise the $50 million that it needs, and the founders would have retained a larger
share of the company. For example, suppose that the outside investors, who put up $50
million, received shares that were worth only $50 million. In that case the value of the
founders’ shares would be $240 –$50 = $190 million.
The effect of selling shares below their true value is to transfer $30 million of value
from the founders to the investors who buy the new shares.
Unfortunately, underpricing does not mean that anyone can become wealthy by buy-
ing stock in IPOs. If an issue is underpriced, everybody will want to buy it and the un-
derwriters will not have enough stock to go around. You are therefore likely to get only
a small share of these hot issues. If it is overpriced, other investors are unlikely to want
it and the underwriter will be only too delighted to sell it to you. This phenomenon is
known as the winner’s curse.5 It implies that, unless you can spot which issues are un-
derpriced, you are likely to receive a small proportion of the cheap issues and a large
proportion of the expensive ones. Since the dice are loaded against uninformed in-
vestors, they will play the game only if there is substantial underpricing on average.
(cid:1) EXAMPLE 2
Underpricing of IPOs and Investor Returns
Suppose that an investor will earn an immediate 10 percent return on underpriced IPOs
and lose 5 percent on overpriced IPOs. But because of high demand, you may get only
5 The highest bidder in an auction is the participant who places the highest value on the auctioned object.
Therefore, it is likely that the winning bidder has an overly optimistic assessment of true value. Winning the
auction suggests that you have overpaid for the object—this is the winner’s curse. In the case of IPOs, your
ability to “win” an allotment of shares may signal that the stock is overpriced.
FINANCE IN ACTION
Internet Shares: Loopy.com?
The tiny images are like demented postage stamps
coming jerkily to life; the sound is prone to break up and
at times could be coming from a bathroom plughole.
Welcome to the Internet live broadcasting experience.
However, despite offering audio-visual quality that
would have been unacceptable in the pioneering days
of television, a small, loss-making company called
Broadcast.com broke all previous records when it made
its Wall Street debut on July 17th.
Shares in the Dallas-based company were offered at
$18 and reached as high as $74 before closing at
$62.75— a gain of nearly 250% on the day after a feed-
ing frenzy in which 6.5m shares changed hands. After
the dust had settled, Broadcast.com was established
as a $1 billion company, and its two 30-something
founders, Mark Cuban and Todd Wagner, were worth
nearly $500m between them.
In its three years of existence, Broadcast.com, for-
merly known as AudioNet, has lost nearly $13m, and its
offer document frankly told potential investors that it
had absolutely no idea when it might start to make
money. So has Wall Street finally taken leave of its
senses?
The value being placed on Broadcast.com is not ob-
viously loopier than a number of other gravity-defying
Internet stocks, particularly the currently fashionable
“ portals” — gateways to the Web— such as Yahoo! and
America Online. Yahoo!, the Internet’s leading content
aggregator, has nearly doubled in value since June. On
the back of revenue estimates of around $165m, it has
a market value of $8.7 billion.
Mark Hardie, an analyst with the high-tech con-
sultancy Forrester Research, does not believe, in any
case, that the enthusiasm for Broadcast.com has been
overdone. He says: “ There are no entrenched players in
this space. The ‘old’ media are aware that the intelli-
gence to exploit the Internet lies outside their organiza-
tions and are standing back waiting to see what hap- | Brealey |
pens. Broadcast.com is well-positioned to be a service
intermediary for those companies and for other content
owners.” Persuaded?
Source: © 1998 The Economist Newspaper Group, Inc. Reprinted
with permission. Further reproduction prohibited. www.economist.
com.
half the shares you bid for when the issue is underpriced. Suppose you bid for $1,000 of
shares in two issues, one overpriced and the other underpriced. You are awarded the full
$1,000 of the overpriced issue, but only $500 worth of shares in the underpriced issue.
The net gain on your two investments is (.10 × $500) – (.05 × $1,000) = 0. Your net profit
is zero, despite the fact that on average, IPOs are underpriced. You have suffered the
winner’s curse: you “win” a larger allotment of shares when they are overpriced.
(cid:1) Self-Test 2
FLOTATION COSTS
The costs incurred when a
firm issues new securities to
the public.
524
What is the percentage profit earned by an investor who can identify the underpriced
issues in Example 2? Who are such investors likely to be?
The costs of a new issue are termed flotation costs. Underpricing is not the only
flotation cost. In fact, when people talk about the cost of a new issue, they often think
only of the direct costs of the issue. For example, preparation of the registration state-
ment and prospectus involves management, legal counsel, and accountants, as well as
underwriters and their advisers. There is also the underwriting spread. (Remember, un-
derwriters make their profit by selling the issue at a higher price than they paid for it.)
Table 5.10 summarizes the costs of going public. The table includes the underwrit-
ing spread and administrative costs as well as the cost of underpricing, as measured by
the initial return on the stock. For a small IPO of no more than $10 million, the under-
TABLE 5.10
Average expenses of 1,767
initial public offerings,
1990–1994a
How Corporations Issue Securities 525
Value of Issue
(millions of dollars)
Direct
Costs, %b
Average First-Day
Return, %b
Total
Costs, %c
2–9.99
10–19.99
20–39.99
40–59.99
60–79.99
80–99.99
100–199.99
200–499.99
500 and up
All issues
16.96
11.63
9.70
8.72
8.20
7.91
7.06
6.53
5.72
11.00
16.36
9.65
12.48
13.65
11.31
8.91
7.16
5.70
7.53
12.05
25.16
18.15
18.18
17.95
16.35
14.14
12.78
11.10
10.36
18.69
a The table includes only issues where there was a firm underwriting commitment.
b Direct costs (i.e., underwriting spread plus administrative costs) and average initial return are expressed as
a percentage of the issue price.
c Total costs (i.e., direct costs plus underpricing) are expressed as a percentage of the market price of the
share.
Source: J. R. Ritter et al., “The Costs of Raising Capital,” Journal of Financial Research 19, No. 1, Spring
1996. Reprinted by permission.
writing spread and administrative costs are likely to absorb 15 to 20 percent of the pro-
ceeds from the issue. For the very largest IPOs, these direct costs may amount to only
5 percent of the proceeds.
(cid:1) EXAMPLE 3
Costs of an IPO
When the investment bank Goldman Sachs went public in 1999, the sale was partly a
primary issue (the company sold new shares to raise cash) and partly a secondary one
(two large existing shareholders cashed in some of their shares). The underwriters ac-
quired a total of 69 million Goldman Sachs shares for $50.75 each and sold them to the
public at an offering price of $53.6 The underwriters’ spread was therefore $53 – $50.75
= $2.25. The firm and its shareholders also paid a total of $9.2 million in legal fees and
other costs. By the end of the first day’s trading Goldman’s stock price had risen to $70.
Here are the direct costs of the Goldman Sachs issue:
Direct Expenses
Underwriting spread
Other expenses
Total direct expenses
69 million × $2.25 = $155.25 million
9.2
$164.45 million
The total amount of money raised by the issue was 69 million × $53 = $3,657 million.
Of this sum 4.5 percent was absorbed by direct expenses (that is, 164.45/3,657 = .045).
In addition to these direct costs, there was underpricing. The market valued each | Brealey |
share of Goldman Sachs at $70, so the cost of underpricing was 69 million × ($70 –
6 No prizes for guessing which investment bank acted as lead underwriter.
526 SECTION FIVE
$53) = $1,173 million, resulting in total costs of $164.45 + $1,173 = $1,337.45 million.
Therefore, while the total market value of the issued shares was 69 million × $70 =
$4,830 million, direct costs and the costs of underpricing absorbed nearly 28 percent of
the market value of the shares.
(cid:1) Self-Test 3
Suppose that the underwriters acquired Goldman Sachs shares for $60 and sold them to
the public at an offering price of $64. If all other features of the offer were unchanged
(and investors still valued the stock at $70 a share), what would have been the direct
costs of the issue and the costs of underpricing? What would have been the total costs
as a proportion of the market value of the shares?
The Underwriters
We have described underwriters as playing a triple role—providing advice, buying a
new issue from the company, and reselling it to investors. Underwriters don’t just help
the company to make its initial public offering; they are called in whenever a company
wishes to raise cash by selling securities to the public.
Most companies raise capital only occasionally, but underwriters are in the
business all the time. Established underwriters are careful of their reputation
and will not handle a new issue unless they believe the facts have been
presented fairly to investors. Thus, in addition to handling the sale of an
issue, the underwriters in effect give it their seal of approval. This implied
endorsement may be worth quite a bit to a company that is coming to the
market for the first time.
Underwriting is not always fun. On October 15, 1987, the British government final-
ized arrangements to sell its holding of British Petroleum (BP) shares at £3.30 a share.
This huge issue involving more than $12 billion was underwritten by an international
group of underwriters and simultaneously marketed in a number of countries. Four days
after the underwriting arrangement was finalized, the October stock market crash oc-
curred and stock prices nose-dived. The underwriters appealed to the British govern-
ment to cancel the issue but the government hardened its heart and pointed out that the
underwriters knew the risks when they agreed to handle the sale.7 By the closing date
of the offer, the price of BP stock had fallen to £2.96 and the underwriters had lost more
than $1 billion.
WHO ARE THE UNDERWRITERS?
Since underwriters play such a crucial role in new issues, we should look at who they
are. Several thousand investment banks, security dealers, and brokers are at least spo-
7 The government’s only concession was to put a floor on the underwriters’ losses by giving them the option
to resell their stock to the government at £2.80 a share. The BP offering is described and analyzed in C. Mus-
carella and M. Vetsuypens, “The British Petroleum Stock Offering: An Application of Option Pricing,” Jour-
nal of Applied Corporate Finance 1 (1989), pp. 74–80.
How Corporations Issue Securities 527
TABLE 5.11
Top underwriters of U.S. debt
and equity, 1998 (figures in
billions)
Underwriter
Value of Issues
Merrill Lynch
Salomon Smith Barney
Morgan Stanley Dean Witter
Goldman Sachs
Lehman Brothers
Credit Suisse First Boston
J. P. Morgan
Bear Stearns
Chase Manhattan
Donaldson Lufkin & Jenrette
All underwriters
Source: Securities Data Co.
$ 304
225
203
192
147
127
89
83
71
61
$1,820
radically involved in underwriting. However, the market for the larger issues is domi-
nated by the major investment banking firms, which specialize in underwriting new is-
sues, dealing in securities, and arranging mergers. These firms enjoy great prestige, ex-
perience, and financial muscle. Table 5.11 lists some of the largest firms, ranked by
total volume of issues in 1998. Merrill Lynch, the winner, raised a total of $304 billion.
Of course, only a small proportion of these issues was for companies that were coming
to the market for the first time.
| Brealey |
Earlier we pointed out that instead of issuing bonds in the United States, many cor-
porations issue international bonds in London, which are then sold to investors outside
the United States. In addition, new equity issues by large multinational companies are
increasingly marketed to investors throughout the world. Since these securities are sold
in a number of countries, many of the major international banks are involved in under-
writing the issues. For example, look at Table 5.12 which shows the names of the prin-
cipal underwriters of international issues in 1998.
TABLE 5.12
Top underwriters of
international issues of
securities, 1998 (figures in
billions)
Underwriter
Value of Issues
Warburg Dillon Read
Merrill Lynch
Morgan Stanley Dean Witter
Goldman Sachs
ABN AMRO
Deutsche Bank
Paribas
J. P. Morgan
Barclays Capital
Credit Suisse First Boston
All underwriters
Source: Securities Data Co.
$ 63.6
52.3
43.6
42.5
41.5
39.0
38.7
36.0
31.1
25.7
$665.5
528 SECTION FIVE
SEASONED OFFERING
Sale of securities by a firm
that is already publicly
traded.
RIGHTS ISSUE Issue of
securities offered only to
current stockholders.
General Cash Offers
by Public Companies
After the initial public offering a successful firm will continue to grow and from time
to time it will need to raise more money by issuing stock or bonds. An issue of addi-
tional stock by a company whose stock already is publicly traded is called a seasoned
offering. Any issue of securities needs to be formally approved by the firm’s board of
directors. If a stock issue requires an increase in the company’s authorized capital, it
also needs the consent of the stockholders.
Public companies can issue securities either by making a general cash offer to in-
vestors at large or by making a rights issue, which is limited to existing shareholders.
In the latter case, the company offers the shareholders the opportunity, or right, to buy
more shares at an “attractive” price. For example, if the current stock price is $100, the
company might offer investors an additional share at $50 for each share they hold. Sup-
pose that before the issue an investor has one share worth $100 and $50 in the bank. If
the investor takes up the offer of a new share, that $50 of cash is transferred from the
investor’s bank account to the company’s. The investor now has two shares that are a
claim on the original assets worth $100 and on the $50 cash that the company has
raised. So the two shares are worth a total of $150, or $75 each.
(cid:1) EXAMPLE 4
Rights Issues
Easy Writer Word Processing Company has 1 million shares outstanding, selling at $20
a share. To finance the development of a new software package, it plans a rights issue,
allowing one new share to be purchased for each 10 shares currently held. The purchase
price will be $10 a share. How many shares will be issued? How much money will be
raised? What will be the stock price after the rights issue?
The firm will issue one new share for every 10 old ones, or 100,000 shares. So
shares outstanding will rise to 1.1 million. The firm will raise $10 × 100,000 = $1 mil-
lion. Therefore, the total value of the firm will increase from $20 million to $21 mil-
lion, and the stock price will fall to $21 million/1.1 million shares = $19.09 per share.
In some countries the rights issue is the most common or only method for issuing
stock, but in the United States rights issues are now very rare. We therefore will con-
centrate on the mechanics of the general cash offer.
GENERAL CASH OFFERS AND SHELF
REGISTRATION
GENERAL CASH OFFER
Sale of securities open to all
investors by an already-
public company.
When a public company makes a general cash offer of debt or equity, it essentially fol-
lows the same procedure used when it first went public. This means that it must first
register the issue with the SEC and draw up a prospectus.8 Before settling on the issue
price, the underwriters will usually contact potential investors and build up a book of
8 The procedure is similar when a company makes an international issue of bonds or equity, but as long as | Brealey |
these issues are not sold publicly in the United States, they do not need to be registered with the SEC.
SHELF REGISTRATION
A procedure that allows firms
to file one registration
statement for several issues
of the same security.
How Corporations Issue Securities 529
likely orders. The company will then sell the issue to the underwriters, and they in turn
will offer the securities to the public.
Companies do not need to prepare a separate registration statement every time they
issue new securities. Instead, they are allowed to file a single registration statement cov-
ering financing plans for up to 2 years into the future. The actual issues can then be sold
to the public with scant additional paperwork, whenever the firm needs cash or thinks
it can issue securities at an attractive price. This is called shelf registration—the regis-
tration is put “on the shelf,” to be taken down, dusted off, and used as needed.
Think of how you might use shelf registration when you are a financial manager.
Suppose that your company is likely to need up to $200 million of new long-term debt
over the next year or so. It can file a registration statement for that amount. It now has
approval to issue up to $200 million of debt, but it isn’t obliged to issue any. Nor is it
required to work through any particular underwriters—the registration statement may
name the underwriters the firm thinks it may work with, but others can be substituted
later.
Now you can sit back and issue debt as needed, in bits and pieces if you like. Sup-
pose Merrill Lynch comes across an insurance company with $10 million ready to in-
vest in corporate bonds, priced to yield, say, 7.3 percent. If you think that’s a good deal,
you say “OK” and the deal is done, subject to only a little additional paperwork. Mer-
rill Lynch then resells the bonds to the insurance company, hoping for a higher price
than it paid for them.
Here is another possible deal. Suppose you think you see a window of opportunity
in which interest rates are “temporarily low.” You invite bids for $100 million of bonds.
Some bids may come from large investment bankers acting alone, others from ad hoc
syndicates. But that’s not your problem; if the price is right, you just take the best deal
offered.
Thus shelf registration gives firms several different things that they did not have pre-
viously:
1. Securities can be issued in dribs and drabs without incurring excessive costs.
2. Securities can be issued on short notice.
3. Security issues can be timed to take advantage of “market conditions” (although any
financial manager who can reliably identify favorable market conditions could make
a lot more money by quitting and becoming a bond or stock trader instead).
4. The issuing firm can make sure that underwriters compete for its business.
Not all companies eligible for shelf registration actually use it for all their public is-
sues. Sometimes they believe they can get a better deal by making one large issue
through traditional channels, especially when the security to be issued has some unusual
feature or when the firm believes it needs the investment banker’s counsel or stamp of
approval on the issue. Thus shelf registration is less often used for issues of common
stock than for garden-variety corporate bonds.
COSTS OF THE GENERAL CASH OFFER
Whenever a firm makes a cash offer, it incurs substantial administrative costs. Also, the
firm needs to compensate the underwriters by selling them securities below the price
that they expect to receive from investors. Figure 5.7 shows the average underwriting
spread and administrative costs for several types of security issues in the United States.9
9 These figures do not capture all administrative costs. For example, they do not include management time
spent on the issue.
530 SECTION FIVE
FIGURE 5.7
Total direct costs as a percentage of gross proceeds. The total direct costs for initial
public offerings (IPOs), seasoned equity offerings (SEOs), convertible bonds, and
straight bonds are composed of underwriter spreads and other direct expenses.
)
%
(
s
t
s
o
c
t
c
e
r
i
d
l
a
t
o
T
20
15
10
5
0
2– 9.99
10– 19.99
20– 39.99
IPOs
SEOs
| Brealey |
Convertibles
Bonds
40– 59.99
60– 79.99
Proceeds ($ millions)
80– 99.99
100– 199.99
200– 499.99
500– up
Source: Immoo Lee, Scott Lochhead, Jay Ritter, and Quanshui Zhao, “The Costs of Raising Capital,” Journal of Financial Research 19 (Spring
1996), pp. 59–74. Copyright © 1996. Reprinted by permission.
The figure clearly shows the economies of scale in issuing securities. Costs may ab-
sorb 15 percent of a $1 million seasoned equity issue but less than 4 percent of a $500
million issue. This occurs because a large part of the issue cost is fixed.
Figure 5.7 shows that issue costs are higher for equity than for debt securities—the
costs for both types of securities, however, show the same economies of scale. Issue
costs are higher for equity than for debt because administrative costs are somewhat
higher, and also because underwriting stock is riskier than underwriting bonds. The un-
derwriters demand additional compensation for the greater risk they take in buying and
reselling equity.
(cid:1) Self-Test 4
Use Figure 5.7 to compare the costs of 10 issues of $15 million of stock in a seasoned
offering versus one issue of $150 million.
MARKET REACTION TO STOCK ISSUES
Because stock issues usually throw a sizable number of new shares onto the market, it
is widely believed that they must temporarily depress the stock price. If the proposed
issue is very large, this price pressure may, it is thought, be so severe as to make it al-
most impossible to raise money.
This belief in price pressure implies that a new issue depresses the stock price tem-
porarily below its true value. However, that view doesn’t appear to fit very well with the
notion of market efficiency. If the stock price falls solely because of increased supply,
How Corporations Issue Securities 531
then that stock would offer a higher return than comparable stocks and investors would
be attracted to it as ants to a picnic.
Economists who have studied new issues of common stock have generally found that
the announcement of the issue does result in a decline in the stock price. For industrial
issues in the United States this decline amounts to about 3 percent.10 While this may not
sound overwhelming, such a price drop can be a large fraction of the money raised. Sup-
pose that a company with a market value of equity of $5 billion announces its intention
to issue $500 million of additional equity and thereby causes the stock price to drop by
3 percent. The loss in value is .03 × $5 billion, or $150 million. That’s 30 percent of the
amount of money raised (.30 × $500 million = $150 million).
What’s going on here? Is the price of the stock simply depressed by the prospect of
the additional supply? Possibly, but here is an alternative explanation.
Suppose managers (who have better information about the firm than outside in-
vestors) know that their stock is undervalued. If the company sells new stock at this low
price, it will give the new shareholders a good deal at the expense of the old share-
holders. In these circumstances managers might be prepared to forgo the new invest-
ment rather than sell shares at too low a price.
If managers know that the stock is overvalued, the position is reversed. If the com-
pany sells new shares at the high price, it will help its existing shareholders at the ex-
pense of the new ones. Managers might be prepared to issue stock even if the new cash
were just put in the bank.
Of course investors are not stupid. They can predict that managers are more likely to
issue stock when they think it is overvalued and therefore they mark the price of the
stock down accordingly.
The tendency for stock prices to decline at the time of an issue may have
nothing to do with increased supply. Instead, the stock issue may simply be a
signal that well-informed managers believe the market has overpriced the
stock.11
The Private Placement
Whenever a company makes a public offering, it must register the issue with the
SEC. It could avoid this costly process by selling the issue privately. There are no hard- | Brealey |
and-fast definitions of a private placement, but the SEC has insisted that the security
should be sold to no more than a dozen or so knowledgeable investors.
10 See, for example, P. Asquith and D. W. Mullins, “Equity Issues and Offering Dilution,” Journal of Finan-
cial Economics 15 (January–February 1986), pp. 61–90; R. W. Masulis and A. N. Korwar, “Seasoned Equity
Offerings: An Empirical Investigation,” Journal of Financial Economics 15 (January–February 1986), pp.
91–118; W. H. Mikkelson and M. M. Partch, “Valuation Effects of Security Offerings and the Issuance
Process,” Journal of Financial Economics 15 (January–February 1986), pp. 31–60. There appears to be a
smaller price decline for utility issues. Also Marsh observed a smaller decline for rights issues in the United
Kingdom; see P. R. Marsh, “Equity Rights Issues and the Efficiency of the UK Stock Market,” Journal of Fi-
nance 34 (September 1979), pp. 839–862.
11 This explanation was developed in S. C. Myers and N. S. Majluf, “Corporate Financing and Investment De-
cisions When Firms Have Information that Investors Do Not Have,” Journal of Financial Economics 13
(1984), pp. 187–222.
PRIVATE PLACEMENT
Sale of securities to a limited
number of investors without
a public offering.
532 SECTION FIVE
One disadvantage of a private placement is that the investor cannot easily resell the
security. This is less important to institutions such as life insurance companies, which
invest huge sums of money in corporate debt for the long haul. However, in 1990 the
SEC relaxed its restrictions on who could buy unregistered issues. Under the new rule,
Rule 144a, large financial institutions can trade unregistered securities among them-
selves.
As you would expect, it costs less to arrange a private placement than to make a pub-
lic issue. That might not be so important for the very large issues where costs are less
significant, but it is a particular advantage for companies making smaller issues.
Another advantage of the private placement is that the debt contract can be custom-
tailored for firms with special problems or opportunities. Also, if the firm wishes later
to change the terms of the debt, it is much simpler to do this with a private placement
where only a few investors are involved.
Therefore, it is not surprising that private placements occupy a particular niche in the
corporate debt market, namely, loans to small and medium-sized firms. These are the
firms that face the highest costs in public issues, that require the most detailed investi-
gation, and that may require specialized, flexible loan arrangements.
We do not mean that large, safe, and conventional firms should rule out private
placements. Enormous amounts of capital are sometimes raised by this method. For ex-
ample, AT&T once borrowed $500 million in a single private placement. Nevertheless,
the advantages of private placement—avoiding registration costs and establishing a di-
rect relationship with the lender—are generally more important to smaller firms.
Of course these advantages are not free. Lenders in private placements have to be
compensated for the risks they face and for the costs of research and negotiation. They
also have to be compensated for holding an asset that is not easily resold. All these fac-
tors are rolled into the interest rate paid by the firm. It is difficult to generalize about
the differences in interest rates between private placements and public issues, but a typ-
ical yield differential is on the order of half a percentage point.
Summary
How do venture capital firms design successful deals?
Infant companies raise venture capital to carry them through to the point at which they can
make their first public issue of stock. More established publicly traded companies can issue
additional securities in a general cash offer.
Financing choices should be designed to avoid conflicts of interest. This is especially
important in the case of a young company that is raising venture capital. If both managers | Brealey |
and investors have an important equity stake in the company, they are likely to pull in the
same direction. The willingness to take that stake also signals management’s confidence in
the new company’s future. Therefore, most deals require that the entrepreneur maintain large
stakes in the firm. In addition, most venture financing is done in stages that keep the firm
on a short leash, and force it to prove at several crucial points that it is worthy of additional
investment.
How do firms make initial public offerings and what are the costs of such offerings?
The initial public offering is the first sale of shares in a general offering to investors. The
sale of the securities is usually managed by an underwriting firm which buys the shares
from the company and resells them to the public. The underwriter helps to prepare a
prospectus, which describes the company and its prospects. The costs of an IPO include
How Corporations Issue Securities 533
direct costs such as legal and administrative fees, as well as the underwriting spread—the
difference between the price the underwriter pays to acquire the shares from the firm and
the price the public pays the underwriter for those shares. Another major implicit cost is the
underpricing of the issue—that is, shares are typically sold to the public somewhat below
the true value of the security. This discount is reflected in abnormally high average returns
to new issues on the first day of trading.
What are some of the significant issues that arise when established firms make a
general cash offer or a private placement of securities?
There are always economies of scale in issuing securities. It is cheaper to go to the market
once for $100 million than to make two trips for $50 million each. Consequently, firms
“bunch” security issues. This may mean relying on short-term financing until a large issue
is justified. Or it may mean issuing more than is needed at the moment to avoid another
issue later.
A seasoned offering may depress the stock price. The extent of this price decline varies,
but for issues of common stocks by industrial firms the fall in the value of the existing stock
may amount to a significant proportion of the money raised. The likely explanation for this
pressure is the information the market reads into the company’s decision to issue stock.
Shelf registration often makes sense for debt issues by blue-chip firms. Shelf
registration reduces the time taken to arrange a new issue, it increases flexibility, and it may
cut underwriting costs. It seems best suited for debt issues by large firms that are happy to
switch between investment banks. It seems least suited for issues of unusually risky
securities or for issues by small companies that most need a close relationship with an
investment bank.
Private placements are well-suited for small, risky, or unusual firms. The special
advantages of private placement stem from avoiding registration expenses and a more direct
relationship with the lender. These are not worth as much to blue-chip borrowers.
What is the role of the underwriter in an issue of securities?
The underwriter manages the sale of the securities for the issuing company. The
underwriting firms have expertise in such sales because they are in the business all the time,
whereas the company raises capital only occasionally. Moreover, the underwriters may give
an implicit seal of approval to the offering. Because the underwriters will not want to
squander their reputation by misrepresenting facts to the public, the implied endorsement
may be quite important to a firm coming to the market for the first time.
Related Web
Links
www.FreeEDGAR.com/default.htm Information on registration of new securities offerings
http://cbs.marketwatch.com/news/current/ipo_rep.htx?source=htx/http2_mw List of new
IPOs
www.cob.ohio-state.edu/~fin/resources_education/credit.htm The changing mix of corporate
financing
www.investorama.com/features/proxystatements.html The role of the proxy statement in in-
vestor relations
www.vnpartners.com/primer.htm Venture capital as a source of project financing
Key Terms
| Brealey |
venture capital
initial public offering (IPO)
underwriter
spread
prospectus
underpricing
flotation costs
seasoned offering
rights issue
general cash offer
shelf registration
private placement
534 SECTION FIVE
Quiz
1. Underwriting.
a. Is a rights issue more likely to be used for an initial public offering or for subsequent is-
sues of stock?
b. Is a private placement more likely to be used for issues of seasoned stock or seasoned
bonds by an industrial company?
c. Is shelf registration more likely to be used for issues of unseasoned stocks or bonds by a
large industrial company?
2. Underwriting. Each of the following terms is associated with one of the events beneath.
Can you match them up?
a. Shelf registration
b. Firm commitment
c. Rights issue
A. The underwriter agrees to buy the issue from the company at a fixed price.
B. The company offers to sell stock to existing stockholders.
C. Several issues of the same security may be sold under the same registration.
3. Underwriting Costs. State for each of the following pairs of issues which you would expect
to involve the lower proportionate underwriting and administrative costs, other things equal:
a. A large issue/a small issue
b. A bond issue/a common stock issue
c. A small private placement of bonds/a small general cash offer of bonds
4. IPO Costs. Why are the issue costs for debt issues generally less than those for equity is-
sues?
5. Venture Capital. Why do venture capital companies prefer to advance money in stages?
6. IPOs. Your broker calls and says that you can get 500 shares of an imminent IPO at the of-
fering price. Should you buy? Are you worried about the fact that your broker called you?
Practice
Problems
7. IPO Underpricing. Having heard about IPO underpricing, I put in an order to my broker
for 1,000 shares of every IPO he can get for me. After 3 months, my investment record is as
follows:
IPO
Shares Allocated
to Me
Price per
Share
Initial
Return
A
B
C
D
500
200
1,000
0
$10
20
8
12
7%
12
–2
23
a. What is the average underpricing of this sample of IPOs?
b. What is the average initial return on my “portfolio” of shares purchased from the four
IPOs I bid on? Calculate the average initial return, weighting by the amount of money in-
vested in each issue.
c. Why have I performed so poorly relative to the average initial return on the full sample
of IPOs? What lessons do you draw from my experience?
8. IPO Costs. Moonscape has just completed an initial public offering. The firm sold 3 mil-
lion shares at an offer price of $8 per share. The underwriting spread was $.50 a share. The
How Corporations Issue Securities 535
price of the stock closed at $11 per share at the end of the first day of trading. The firm in-
curred $100,000 in legal, administrative, and other costs. What were flotation costs as a frac-
tion of funds raised? Were flotation costs for Moonscape higher or lower than is typical for
IPOs of this size (see Table 5.10)?
9. IPO Costs. Look at the illustrative new issue prospectus in the appendix.
a. Is this issue a primary offering, a secondary offering, or both?
b. What are the direct costs of the issue as a percentage of the total proceeds? Are these
more than the average for an issue of this size?
c. Suppose that on the first day of trading the price of Hotch Pot stock is $15 a share. What
are the total costs of the issue as a percentage of the market price?
d. After paying her share of the expenses, how much will the firm’s president, Emma Lu-
cullus, receive from the sale? What will be the value of the shares that she retains in the
company?
10. Flotation Costs. “For small issues of common stock, the costs of flotation amount to about
15 percent of the proceeds. This means that the opportunity cost of external equity capital is
about 15 percentage points higher than that of retained earnings.” Does this follow?
11. Flotation Costs. When Microsoft went public, the company sold 2 million new shares (the
primary issue). In addition, existing shareholders sold .8 million shares (the secondary issue)
and kept 21.1 million shares. The new shares were offered to the public at $21 and the un- | Brealey |
derwriters received a spread of $1.31 a share. At the end of the first day’s trading the mar-
ket price was $35 a share.
a. How much money did the company receive before paying its portion of the direct costs?
b. How much did the existing shareholders receive from the sale before paying their portion
of the direct costs?
c. If the issue had been sold to the underwriters for $30 a share, how many shares would the
company have needed to sell to raise the same amount of cash?
d. How much better off would the existing shareholders have been?
12. Flotation Costs. The market value of the marketing research firm Fax Facts is $600 million.
The firm issues an additional $100 million of stock, but as a result the stock price falls by 2
percent. What is the cost of the price drop to existing shareholders as a fraction of the funds
raised?
13. Flotation Costs. Young Corporation stock currently sells for $30 per share. There are 1 mil-
lion shares currently outstanding. The company announces plans to raise $3 million by of-
fering shares to the public at a price of $30 per share.
a. If the underwriting spread is 8 percent, how many shares will the company need to issue
in order to be left with net proceeds of $3 million?
b. If other administrative costs are $60,000 what is the dollar value of the total direct costs
of the issue?
c. If the share price falls by 3 percent at the announcement of the plans to proceed with a
seasoned offering, what is the dollar cost of the announcement effect?
14. Private Placements. You need to choose between the following types of issues:
A public issue of $10 million face value of 10-year debt. The interest rate on the debt would
be 8.5 percent and the debt would be issued at face value. The underwriting spread would
be 1.5 percent and other expenses would be $80,000.
A private placement of $10 million face value of 10-year debt. The interest rate on the
private placement would be 9 percent but the total issuing expenses would be only
$30,000.
536 SECTION FIVE
Challenge
Problem
a. What is the difference in the proceeds to the company net of expenses?
b. Other things equal, which is the better deal?
c. What other factors beyond the interest rate and issue costs would you wish to consider
before deciding between the two offers?
15. Rights. In 2001 Pandora, Inc., makes a rights issue at a subscription price of $5 a share. One
new share can be purchased for every four shares held. Before the issue there were 10 mil-
lion shares outstanding and the share price was $6.
a. What is the total amount of new money raised?
b. What is the expected stock price after the rights are issued?
16. Rights. Problem 15 contains details of a rights offering by Pandora. Suppose that the com-
pany had decided to issue the new stock at $4 instead of $5 a share. How many new shares
would it have needed to raise the same sum of money? Recalculate the answers to problem
15. Show that Pandora’s shareholders are just as well off if it issues the shares at $4 a share
rather than the $5 assumed in problem 15.
17. Rights. Consolidated Jewels needs to raise $2 million to pay for its Diamonds in the Rough
campaign. It will raise the funds by offering 200,000 rights, each of which entitles the owner to
buy one new share. The company currently has outstanding 1 million shares priced at $20 each.
a. What must be the subscription price on the rights the company plans to offer?
b. What will be the share price after the rights issue?
c. What is the value of a right to buy one share?
d. How many rights would be issued to an investor who currently owns 1,000 shares?
e. Show that the investor who currently holds 1,000 shares is unaffected by the rights issue.
Specifically, show that the value of the rights plus the value of the 1,000 shares after the
rights issue equals the value of the 1,000 shares before the rights issue.
18. Rights. Associated Breweries is planning to market unleaded beer. To finance the venture it
proposes to make a rights issue with a subscription price of $10. One new share can be pur- | Brealey |
chased for each two shares held. The company currently has outstanding 100,000 shares
priced at $40 a share. Assuming that the new money is invested to earn a fair return, give
values for the
a. number of new shares
b. amount of new investment
c. total value of company after issue
d. total number of shares after issue
e. share price after the issue
19. Venture Capital. Here is a difficult question. Pickwick Electronics is a new high-tech com-
pany financed entirely by 1 million ordinary shares, all of which are owned by George Pick-
wick. The firm needs to raise $1 million now for stage 1 and, assuming all goes well, a fur-
ther $1 million at the end of 5 years for stage 2.
First Cookham Venture Partners is considering two possible financing schemes:
Buying 2 million shares now at their current valuation of $1.
Buying 1 million shares at the current valuation and investing a further $1 million at
the end of 5 years at whatever the shares are worth.
The outlook for Pickwick is uncertain, but as long as the company can secure the additional
finance for stage 2, it will be worth either $2 million or $12 million after completing stage
Solutions to
Self-Test
Questions
How Corporations Issue Securities 537
2. (The company will be valueless if it cannot raise the funds for stage 2.) Show the possi-
ble payoffs for Mr. Pickwick and First Cookham and explain why one scheme might be pre-
ferred. Assume an interest rate of zero.
1 Unless the firm can secure second-stage financing, it is unlikely to succeed. If the entre-
preneur is going to reap any reward on his own investment, he needs to put in enough ef-
fort to get further financing. By accepting only part of the necessary venture capital, man-
agement increases its own risk and reduces that of the venture capitalist. This decision
would be costly and foolish if management lacked confidence that the project would be
successful enough to get past the first stage. A credible signal by management is one that
only managers who are truly confident can afford to provide. However, words are cheap and
there is little to be lost by saying that you are confident (although if you are proved wrong,
you may find it difficult to raise money a second time).
2 If an investor can distinguish between overpriced and underpriced issues, she will bid only
on the underpriced ones. In this case she will purchase only issues that provide a 10 percent
gain. However, the ability to distinguish these issues requires considerable insight and re-
search. The return to the informed IPO participant may be viewed as a return on the re-
sources expended to become informed.
3 Direct expenses:
Underwriting spread = 69 million × $4
Other expenses
Total direct expenses
Underpricing = 69 million × ($70 – $64)
Total expenses
Market value of issue = 69 million × $70
$ 276.0 million
9.2
$ 285.2 million
$ 414.0 million
$ 699.2 million
$4,830.0 million
Expenses as proportion of market value = 699.2/4,830 = .145 = 14.5%.
4 Ten issues of $15 million each will cost about 9 percent of proceeds, or .09 × $150 million
= $13.5 million. One issue of $150 million will cost only 4 percent of $150 million, or $6
million.
MINICASE
Pet.Com was founded in 1997 by two graduates of the University
of Wisconsin with help from Georgina Sloberg, who had built up
an enviable reputation for backing new start-up businesses.
Pet.Com’s user-friendly system was designed to find buyers for
unwanted pets. Within 3 years the company was generating rev-
enues of $3.4 million a year, and, despite racking up sizable losses,
was regarded by investors as one of the hottest new e-commerce
businesses. The news that the company was preparing to go pub-
lic therefore generated considerable excitement.
The company’s entire equity capital of 1.5 million shares was
owned by the two founders and Ms. Sloberg. The initial public of-
fering involved the sale of 500,000 shares by the three existing
shareholders, together with the sale of a further 750,000 shares by
the company in order to provide funds for expansion.
| Brealey |
The company estimated that the issue would involve legal
fees, auditing, printing, and other expenses of $1.3 million, which
would be shared proportionately between the selling shareholders
and the company. In addition, the company agreed to pay the un-
derwriters a spread of $1.25 per share.
The roadshow had confirmed the high level of interest in the
issue, and indications from investors suggested that the entire
issue could be sold at a price of $24 a share. The underwriters,
however, cautioned about being too greedy on price. They
pointed out that indications from investors were not the same as
firm orders. Also, they argued, it was much more important to
have a successful issue than to have a group of disgruntled share-
holders. They therefore suggested an issue price of $18 a share.
That evening Pet.Com’s financial manager decided to run
538 SECTION FIVE
through some calculations. First she worked out the net receipts
to the company and the existing shareholders assuming that the
stock was sold for $18 a share. Next she looked at the various
costs of the IPO and tried to judge how they stacked up against
the typical costs for similar IPOs. That brought her up against the
question of underpricing. When she had raised the matter with
the underwriters that morning, they had dismissed the notion that
the initial day’s return on an IPO should be considered part of the
issue costs. One of the members of the underwriting team had
asked: “The underwriters want to see a high return and a high
stock price. Would Pet.Com prefer a low stock price? Would that
make the issue less costly?” Pet.Com’s financial manager was not
convinced but felt that she should have a good answer. She won-
dered whether underpricing was only a problem because the ex-
isting shareholders were selling part of their holdings. Perhaps
the issue price would not matter if they had not planned to sell.
Appendix: Hotch Pot’s New Issue Prospectus12
How Corporations Issue Securities 539
PROSPECTUS
800,000 Shares
Hotch Pot, Inc.
Common Stock ($.01 par value)
Of the 800,000 shares of Common Stock offered hereby, 500,000 shares are being sold
by the Company and 300,000 shares are being sold by the Selling Stockholders. See
“Principal and Selling Stockholders.” The Company will not receive any of the pro-
ceeds from the sale of shares by the Selling Stockholders.
Before this offering there has been no public market for the Common Stock. These se-
curities involve a high degree of risk. See “Certain Factors.”
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED
BY THE SECURITIES AND EXCHANGE COMMISSION NOR HAS THE
COMMISSION PASSED ON THE ACCURACY OR ADEQUACY OF THIS
PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMI-
NAL OFFENSE.
Price to Public
Underwriting
Discount
Proceeds to
Company1
Proceeds to Selling
Shareholders
Per share
Total
$12.00
$9,600,000
$1.30
$1,040,000
$10.70
$5,350,000
$10.70
$3,210,000
1 Before deducting expenses payable by the Company estimated at $400,000, of which $250,000 will be
paid by the Company and $150,000 by the Selling Stockholders.
The Common Stock is offered, subject to prior sale, when, as, and if delivered to and
accepted by the Underwriters and subject to approval of certain legal matters by their
counsel and by counsel for the Company and the Selling Shareholders. The Underwrit-
ers reserve the right to withdraw, cancel, or modify such offer and reject orders in whole
or in part.
Silverman Pinch Inc.
April 1, 2000
No person has been authorized to give any information or to make any representations,
other than as contained therein, in connection with the offer contained in this Prospec-
tus, and, if given or made, such information or representations must not be relied upon.
This Prospectus does not constitute an offer of any securities other than the registered
securities to which it relates or an offer to any person in any jurisdiction where such an
offer would be unlawful. The delivery of this Prospectus at any time does not imply that | Brealey |
information herein is correct as of any time subsequent to its date.
IN CONNECTION WITH THIS OFFERING, THE UNDERWRITER MAY
OVERALLOT OR EFFECT TRANSACTIONS WHICH STABILIZE OR
12 Most prospectuses have content similar to that of the Hotch Pot prospectus but go into considerably more
detail. Also, we have omitted from the Hotch Pot prospectus the company’s financial statements.
540 SECTION FIVE
How Corporations Issue Securities 540
MAINTAIN THE MARKET PRICE OF THE COMMON STOCK OF THE
COMPANY AT A LEVEL ABOVE THAT WHICH MIGHT OTHERWISE
PREVAIL IN THE OPEN MARKET. SUCH STABILIZING, IF COMMENCED,
MAY BE DISCONTINUED AT ANY TIME.
Prospectus Summary
The following summary information is qualified in its entirety by the detailed informa-
tion and financial statements appearing elsewhere in this Prospectus.
The Company: Hotch Pot, Inc. operates a chain of 140 fast-food outlets in the United
States offering unusual combinations of dishes.
The Offering: Common Stock offered by the Company 500,000 shares;
Common Stock offered by the Selling Stockholders 300,000 shares;
Common Stock to be outstanding after this offering 3,500,000 shares.
Use of Proceeds: For the construction of new restaurants and to provide working
capital.
THE COMPANY
Hotch Pot, Inc. operates a chain of 140 fast-food outlets in Illinois, Pennsylvania, and
Ohio. These restaurants specialize in offering an unusual combination of foreign dishes.
The Company was organized in Delaware in 1990.
USE OF PROCEEDS
The Company intends to use the net proceeds from the sale of 500,000 shares of Com-
mon Stock offered hereby, estimated at approximately $5 million, to open new outlets
in midwest states and to provide additional working capital. It has no immediate plans
to use any of the net proceeds of the offering for any other specific investment.
DIVIDEND POLICY
The company has not paid cash dividends on its Common Stock and does not anticipate
that dividends will be paid on the Common Stock in the foreseeable future.
CERTAIN FACTORS
Investment in the Common Stock involves a high degree of risk. The following factors
should be carefully considered in evaluating the Company:
Substantial Capital Needs. The Company will require additional financing to
continue its expansion policy. The Company believes that its relations with its lenders
are good, but there can be no assurance that additional financing will be available in the
future.
How Corporations Issue Securities 541
The Company is in competition with a number of restaurant chains
Competition.
supplying fast food. Many of these companies are substantially larger and better capi-
talized than the Company.
CAPITALIZATION
The following table sets forth the capitalization of the Company as of December 31,
1999, and as adjusted to reflect the sale of 500,000 shares of Common Stock by the
Company.
Long-term debt
Stockholders’ equity
Common stock –$.01 par value, 3,000,000 shares outstanding,
3,500,000 shares outstanding, as adjusted
Paid-in capital
Retained earnings
Total stockholders’ equity
Total capitalization
Actual
As Adjusted
(in thousands)
$ —
30
$ —
35
1,970
3,200
5,200
$5,200
7,315
3,200
10,550
$10,550
SELECTED FINANCIAL DATA
[The Prospectus typically includes a summary income statement and balance sheet.]
MANAGEMENT’S ANALYSIS OF RESULTS OF
OPERATIONS AND FINANCIAL CONDITION
Revenue growth for the year ended December 31, 1999, resulted from the opening of
ten new restaurants in the Company’s existing geographic area and from sales of a new
range of desserts, notably crepe suzette with custard. Sales per customer increased by
20% and this contributed to the improvement in margins.
During the year the Company borrowed $600,000 from its banks at an interest rate of
2% above the prime rate.
BUSINESS
Hotch Pot, Inc. operates a chain of 140 fast-food outlets in Illinois, Pennsylvania, and
Ohio. These restaurants specialize in offering an unusual combination of foreign dishes.
50% of company’s revenues derived from sales of two dishes, sushi and sauerkraut and | Brealey |
curry bolognese. All dishes are prepared in three regional centers and then frozen and
distributed to the individual restaurants.
MANAGEMENT
The following table sets forth information regarding the Company’s directors, executive
officers, and key employees:
542 SECTION FIVE
Name
Age
Position
Emma Lucullus
Ed Lucullus
28
33
President, Chief Executive Officer, & Director
Treasurer & Director
Emma Lucullus Emma Lucullus established the Company in 1990 and has been its
Chief Executive Officer since that date.
Ed Lucullus Ed Lucullus has been employed by the Company since 1990.
EXECUTIVE COMPENSATION
The following table sets forth the cash compensation paid for services rendered for the
year 1999 by the executive officers:
Name
Capacity
Cash Compensation
Emma Lucullus
Ed Lucullus
President and Chief Executive Officer
Treasurer
$130,000
$ 95,000
CERTAIN TRANSACTIONS
At various times between 1990 and 1999 First Cookham Venture Partners invested a
total of $1.5 million in the Company. In connection with this investment, First Cookham
Venture Partners was granted certain rights to registration under the Securities Act of
1933, including the right to have their shares of Common Stock registered at the Com-
pany’s expense with the Securities and Exchange Commission.
PRINCIPAL AND SELLING STOCKHOLDERS
The following table sets forth certain information regarding the beneficial ownership of
the Company’s voting Common Stock as of the date of this prospectus by (i) each per-
son known by the Company to be the beneficial owner of more than 5% of its voting
Common Stock, and (ii) each director of the Company who beneficially owns voting
Common Stock. Unless otherwise indicated, each owner has sole voting and dispositive
power over his shares.
Name of
Beneficial Owner
Emma Lucullus
Ed Lucullus
First Cookham
Venture Partners
Hermione Kraft
Shares Beneficially
Owned prior to Offering
Number
Percent
400,000
400,000
1,700,000
200,000
13.3
13.3
66.7
6.7
Shares
to Be Sold
25,000
25,000
250,000
—
Shares Beneficially
Owned after Offering
Number
Percent
375,000
375,000
1,450,000
200,000
12.9
12.9
50.0
6.9
DESCRIPTION OF CAPITAL STOCK
The Company’s authorized capital stock consists of 10,000,000 shares of voting Com-
mon Stock.
How Corporations Issue Securities 543
As of the date of this Prospectus, there are 4 holders of record of the Common Stock.
Under the terms of one of the Company’s loan agreements, the Company may not pay
cash dividends on Common Stock except from net profits without the written consent
of the lender.
UNDERWRITING
Subject to the terms and conditions set forth in the Underwriting Agreement, the Un-
derwriter, Silverman Pinch Inc., has agreed to purchase from the Company and the Sell-
ing Stockholders 800,000 shares of Common Stock.
There is no public market for the Common Stock. The price to the public for the Com-
mon Stock was determined by negotiation between the Company and the Underwriter
and was based on, among other things, the Company’s financial and operating history
and condition, its prospects, and the prospects for its industry in general, the manage-
ment of the Company, and the market prices of securities for companies in businesses
similar to that of the Company.
LEGAL MATTERS
The validity of the shares of Common Stock offered by the Prospectus is being passed
on for the Company by Blair, Kohl, and Chirac and for the Underwriter by Chretien
Howard.
LEGAL PROCEEDINGS
Hotch Pot was served in January 2000 with a summons and complaint in an action
commenced by a customer who alleges that consumption of the Company’s products
caused severe nausea and loss of feeling in both feet. The Company believes that the
complaint is without foundation.
EXPERTS
The consolidated financial statements of the Company have been so included in re-
liance on the reports of Hooper Firebrand, independent accountants, given on the au-
thority of that firm as experts in auditing and accounting.
FINANCIAL STATEMENTS
[Text and tables omitted.]
Appendix B
Leasing
Leverage and Capital Structure
LEASING
547
548 APPENDIX B
| Brealey |
OPERATING LEASE
Usually a shorter-term lease
under which the lessor is
responsible for insurance,
taxes, and upkeep. May be
cancelable by the lessee on
short notice.
LEASING VERSUS BUYING
As far as the lessee is concerned, it is the use of the asset that is important, not neces-
sarily who has title to it. One way to obtain the use of an asset is to lease it. Another
way is to obtain outside financing and buy it. Thus, the decision to lease or buy amounts
to a comparison of alternative financing arrangements for the use of an asset.
Figure B.1 compares leasing and buying. The lessee, Sass Company, might be a hos-
pital, a law firm, or any other firm that uses computers. The lessor is an independent
leasing company that purchased the computer from a manufacturer such as Hewlett-
Packard (HP). Leases of this type, in which the leasing company purchases the asset
from the manufacturer, are called direct leases. Of course, HP might choose to lease its
own computers, and many companies, including HP and some of the other companies
mentioned previously, have set up wholly owned subsidiaries called captive finance
companies to lease out their products.1
As shown in Figure B.1, whether it leases or buys, Sass Company ends up using the
asset. The key difference is that in one case (buy), Sass arranges the financing,
purchases the asset, and holds title to the asset. In the other case (lease), the leasing
company arranges the financing, purchases the asset, and holds title to the asset.
OPERATING LEASES
Years ago, a lease in which the lessee received an equipment operator along with the
equipment was called an operating lease. Today, an operating lease (or service lease)
is difficult to define precisely, but this form of leasing has several important character-
istics.
First of all, with an operating lease, the payments received by the lessor are usually
not enough to allow the lessor to fully recover the cost of the asset. A primary reason is
that operating leases are often relatively short-term. Therefore, the life of the lease may
be much shorter than the economic life of the asset. For example, if you lease a car for
two years, the car will have a substantial residual value at the end of the lease, and the
lease payments you make will pay off only a fraction of the original cost of the car. The
lessor in an operating lease expects to either lease the asset again or sell it when the
lease terminates.
A second characteristic of an operating lease is that it frequently requires that the les-
sor maintain the asset. The lessor may also be responsible for any taxes or insurance. Of
course, these costs will be passed on, at least in part, to the lessee in the form of higher
lease payments.
The third, and perhaps most interesting, feature of an operating lease is the cancela-
tion option. This option can give the lessee the right to cancel the lease before the ex-
piration date. If the option to cancel is exercised, the lessee returns the equipment to the
lessor and ceases to make payments. The value of a cancelation clause depends on
whether technological and/or economic conditions are likely to make the value of the
asset to the lessee less than the present value of the future lease payments under the
lease.
To leasing practitioners, these three characteristics define an operating lease. How-
ever, as we will see shortly, accountants use the term in a somewhat different way.
1 In addition to arranging financing for asset users, captive finance companies (or subsidiaries) may purchase
their parent company’s accounts receivable. General Motors Acceptance Corporation (GMAC) and General
Electric (GE) Capital are examples of captive finance companies.
Leasing 549
FIGURE B.1
Leasing vs. Buying
Buy
Lease
Sass Co. buys asset and uses asset;
financing raised by debt
Sass Co. leases asset from lessor;
lessor owns asset
Manufacturer
of asset
Manufacturer
of asset
Sass Co. arranges
financing and
buys asset from
manufacturer
Lessor arranges
financing and
buys asset
Sass Co. | Brealey |
1. Uses asset
2. Owns asset
Lessor
1. Owns asset
2. Does not use asset
Lessee (Sass Co.)
1. Uses asset
2. Does not own asset
Sass Co. leases
asset from lessor
If Sass Co. buys the asset, then it will own the asset and use it. If Sass Co. leases the asset, the lessor will own the
asset, but Sass Co. will still use it as the lessee.
If Sass Co. buys the asset, then it will own the asset and use it. If Sass Co. leases the asset, the lessor will own the asset, but Sass Co. will
still use it as the lessee.
FINANCIAL LEASE
Typically a longer-term, fully
amortized lease under which
the lessee is responsible for
main-tenance, taxes, and
insurance. Usually not
cancelable by the lessee
without penalty.
TAX-ORIENTED LEASE
A financial lease in which the
lessor is the owner for tax
purposes. Also called a true
lease or a tax lease.
FINANCIAL LEASES
A financial lease is the other major type of lease. In contrast to the situation with an
operating lease, the payments made under a financial lease (plus the anticipated resid-
ual, or salvage, value) are usually sufficient to fully cover the lessor’s cost of purchas-
ing the asset and pay the lessor a return on the investment. For this reason, a financial
lease is sometimes said to be a fully amortized or full-payout lease, whereas an operat-
ing lease is said to be partially amortized. Financial leases are often called capital
leases by the accountants.
With a financial lease, the lessee (not the lessor) is usually responsible for insurance,
maintenance, and taxes. It is also important to note that a financial lease generally can-
not be canceled, at least not without a significant penalty. In other words, the lessee
must make the lease payments or face possible legal action.
The characteristics of a financial lease, particularly the fact that it is fully amortized,
make it very similar to debt financing, so the name is a sensible one. There are three
types of financial leases that are of particular interest: tax-oriented leases, leveraged
leases, and sale and leaseback agreements. We consider these next.
Tax-Oriented Leases
A lease in which the lessor is the owner of the leased asset for tax purposes is called a
tax-oriented lease. Such leases are also called tax leases or true leases. In contrast, a
conditional sales agreement lease is not a true lease. Here, the “lessee” is the owner for
tax purposes. Conditional sales agreement leases are really just secured loans. The fi-
nancial leases we discuss in this material are all tax leases.
Tax-oriented leases make the most sense when the lessee is not in a position to use
tax credits or depreciation deductions that come with owning the asset. By arranging
for someone else to hold title, a tax lease passes these benefits on. The lessee can ben-
550 APPENDIX B
LEVERAGED LEASE A
financial lease in which the
lessor borrows a substantial
fraction of the cost of the
leased asset on a
nonrecourse basis.
SALE AND LEASEBACK
A financial lease in which the
lessee sells an asset to the
lessor and then leases it
back.
efit because the lessor may return a portion of the tax benefits to the lessee in the form
of lower lease costs.
Leveraged Leases
A leveraged lease is a tax-oriented lease in which the lessor borrows a substantial por-
tion of the purchase price of the leased asset on a nonrecourse basis, meaning that if the
lessee stops making the lease payments, the lessor does not have to keep making the
loan payments. Instead, the lender must proceed against the lessee to recover its invest-
ment. In contrast, with a single-investor lease, if the lessor borrows to purchase the
asset, the lessor remains responsible for the loan payments regardless of whether or not
the lessee makes the lease payments.
Sale and Leaseback Agreements
A sale and leaseback occurs when a company sells an asset it owns to another party
and immediately leases it back. In a sale and leaseback, two things happen:
1. The lessee receives cash from the sale of the asset.
2. The lessee continues to use the asset.
| Brealey |
Often, with a sale and leaseback, the lessee may have the option to repurchase the
leased asset at the end of the lease.
An example of a sale and leaseback occurred in July 1985 when the city of Oakland,
California, used the proceeds from the sale of its city hall and 23 other buildings to help
meet the liabilities of its $150 million Police and Retirement System, which was un-
derfunded by about $60 million. As part of the same transaction, Oakland leased back
the buildings to provide for their continued use.
A little more recently, in March 1998, cash-strapped Korean Airlines announced
plans to sell 14 of its aircraft and then lease them back from the purchaser. Although
the purchaser was not revealed, it was widely understood that KAL was working with
General Electric Capital Aviation Services, one of the largest lessors specializing in air-
craft. Under terms of the deal, KAL would raise about $386 million in badly needed
cash without giving up control of its planes.
CONCEPT QUESTIONS
• What are the differences between an operating lease and a financial lease?
• What is a tax-oriented lease?
• What is a sale and leaseback agreement?
Accounting and Leasing
Before November 1976, leasing was frequently called off–balance sheet financing. As
the name implies, a firm could arrange to use an asset through a lease and not neces-
sarily disclose the existence of the lease contract on the balance sheet. Lessees had to
report information on leasing activity only in the footnotes to their financial statements.
In November 1976, the Financial Accounting Standards Board (FASB) issued its
Statement of Financial Accounting Standards No. 13 (FASB 13), “Accounting for
Leases.” The basic idea of FASB 13 is that certain financial leases must be “capital-
Leasing 551
ized.” Essentially, this requirement means that the present value of the lease payments
must be calculated and reported along with debt and other liabilities on the right-hand
side of the lessee’s balance sheet. The same amount must be shown as the capitalized
value of leased assets on the left-hand side of the balance sheet. Operating leases are
not disclosed on the balance sheet. Exactly what constitutes a financial or operating
lease for accounting purposes will be discussed in just a moment.
The accounting implications of FASB 13 are illustrated in Table B.1. Imagine a firm
that has $100,000 in assets and no debt, which implies that the equity is also $100,000.
The firm needs a truck costing $100,000 (it’s a big truck) that it can lease or buy. The
top of the table shows the balance sheet assuming that the firm borrows the money and
buys the truck.
If the firm leases the truck, then one of two things will happen. If the lease is an op-
erating lease, then the balance sheet will look like the one in Part B of the table. In this
case, neither the asset (the truck) nor the liability (the present value of the lease pay-
ments) appears. If the lease is a capital lease, then the balance sheet will look more like
the one in Part C of the table, where the truck is shown as an asset and the present value
of the lease payments is shown as a liability.2
As we discussed earlier, it is difficult, if not impossible, to give a precise definition
of what constitutes a financial lease or an operating lease. For accounting purposes, a
lease is declared to be a capital lease, and must therefore be disclosed on the balance
sheet, if at least one of the following criteria is met:
1. The lease transfers ownership of the property to the lessee by the end of the term of
the lease.
TABLE B.1
Leasing and the balance
sheet
A. Balance Sheet with Purchase
(the company finances a $100,000 truck with debt)
$100,000
Truck
$100,000
Other assets
$200,000
Debt
Equity
Total assets
Total debt plus
equity
B. Balance Sheet with Operating Lease
(the company finances the truck with an operating lease)
Truck
Other assets
$000,000
$100,000
Debt
Equity
Total assets
$100,000
Total debt plus
equity
C. Balance Sheet with Capital Lease
(the company finances the truck with a capital lease)
$100,000
$100,000
$200,000
$000,000
$100,000
$100,000
| Brealey |
Assets under
capital lease
Other assets
Total assets
$100,000
$100,000
$200,000
Obligations under
capital lease
Equity
Total debt plus
$100,000
$100,000
$200,000
In the first case, a $100,000 truck is purchased with debt. In the second case, an operating lease is used; no balance
sheet entries are created. In the third case, a capital (financial) lease is used; the lease payments are capitalized as a
liability, and the leased truck appears as an asset.
2 We have made the simplifying assumption that the present value of the lease payments under the capital
lease is equal to the cost of the truck. In general, it is the present value of the payments that must be reported,
not the cost of the asset.
552 APPENDIX B
2. The lessee can purchase the asset at a price below fair market value (bargain pur-
chase price option) when the lease expires.
3. The lease term is 75 percent or more of the estimated economic life of the asset.
4. The present value of the lease payments is at least 90 percent of the fair market value
of the asset at the start of the lease.
If one or more of the four criteria are met, the lease is a capital lease; otherwise, it
is an operating lease for accounting purposes.
A firm might be tempted to try and “cook the books” by taking advantage of the
somewhat arbitrary distinction between operating leases and capital leases. Suppose a
trucking firm wants to lease a $100,000 truck. The truck is expected to last for 15 years.
A (perhaps unethical) financial manager could try to negotiate a lease contract for 10
years with lease payments having a present value of $89,000. These terms would get
around Criteria 3 and 4. If Criteria 1 and 2 were similarly circumvented, the arrange-
ment would be an operating lease and would not show up on the balance sheet.
There are several alleged benefits from “hiding” financial leases. One of the advan-
tages of keeping leases off the balance sheet has to do with fooling financial analysts,
creditors, and investors. The idea is that if leases are not on the balance sheet, they will
not be noticed.
Financial managers who devote substantial effort to keeping leases off the balance
sheet are probably wasting time. Of course, if leases are not on the balance sheet, tra-
ditional measures of financial leverage, such as the ratio of total debt to total assets, will
understate the true degree of financial leverage. As a consequence, the balance sheet
will appear “stronger” than it really is. But it seems unlikely that this type of manipu-
lation would mislead many people.
CONCEPT QUESTIONS
• For accounting purposes, what constitutes a capital lease?
• How are capital leases reported?
Taxes, the IRS and Leases
The lessee can deduct lease payments for income tax purposes if the lease is deemed to
be a true lease by the Internal Revenue Service. The tax shields associated with lease
payments are critical to the economic viability of a lease, so IRS guidelines are an im-
portant consideration.
Essentially, the IRS requires that a lease be primarily for business purposes and not
merely for purposes of tax avoidance.
In broad terms, a lease that is valid from the IRS’s perspective will meet the follow-
ing standards:
1. The term of the lease must be less than 80 percent of the economic life of the asset.
If the term is greater than this, the transaction will be regarded as a conditional sale.
2. The lease should not include an option to acquire the asset at the end of the lease
term at a price below the asset’s then–fair market value. This type of bargain option
would give the lessee the asset’s residual scrap value, implying an equity interest.
3. The lease should not have a schedule of payments that are very high at the start of
Leasing 553
the lease term and thereafter very low. If the lease requires early “balloon” pay-
ments, this will be considered evidence that the lease is being used to avoid taxes
and not for a legitimate business purpose. The IRS may require an adjustment in the
payments for tax purposes in such cases.
4. The lease payments must provide the lessor with a fair market rate of return. The | Brealey |
profit potential of the lease to the lessor should be apart from the deal’s tax benefits.
5. Renewal options must be reasonable and reflect the fair market value of the asset at
the time of renewal. This requirement can be met by, for example, granting the les-
see the first option to meet a competing outside offer.
The IRS is concerned about lease contracts because leases sometimes appear to be
set up solely to defer taxes. To see how this could happen, suppose that a firm plans to
purchase a $1 million bus that has a five-year life for depreciation purposes. Assume
that straight-line depreciation to a zero salvage value is used. The depreciation expense
would be $200,000 per year. Now suppose the firm can lease the bus for $500,000 per
year for two years and buy the bus for $1 at the end of the two-year term. The present
value of the tax benefits is clearly less if the bus is bought than if the bus is leased. The
speedup of lease payments greatly benefits the firm and basically gives it a form of ac-
celerated depreciation. In this case, the IRS might decide that the primary purpose of
the lease was to defer taxes.
CONCEPT QUESTIONS
• Why is the IRS concerned about leasing?
• What are some of the standards the IRS uses in evaluating a lease?
The Cash Flows from Leasing
To begin our analysis of the leasing decision, we need to identify the relevant cash
flows. The first part of this section illustrates how this is done. A key point, and one to
watch for, is that taxes are a very important consideration in a lease analysis.
THE INCREMENTAL CASH FLOWS
Consider the decision confronting the Tasha Corporation, which manufactures pipe.
Business has been expanding, and Tasha currently has a five-year backlog of pipe or-
ders for the Trans-Missouri Pipeline.
The International Boring Machine Corporation (IBMC) makes a pipe-boring ma-
chine that can be purchased for $10,000. Tasha has determined that it needs a new ma-
chine, and the IBMC model will save Tasha $6,000 per year in reduced electricity bills
for the next five years.
Tasha has a corporate tax rate of 34 percent. For simplicity, we assume that five-year
straight-line depreciation will be used for the pipe-boring machine, and, after five years,
the machine will be worthless. Johnson Leasing Corporation has offered to lease the
same pipe-boring machine to Tasha for lease payments of $2,500 paid at the end of each
of the next five years. With the lease, Tasha would remain responsible for maintenance,
insurance, and operating expenses.3
3 We have assumed that all lease payments are made in arrears, that is, at the end of the year. Actually, many
leases require payments to be made at the beginning of the year.
554 APPENDIX B
TABLE B.2
Incremental cash flows for
Tasha Corp. from leasing
instead of buying
Susan Smart has been asked to compare the direct incremental cash flows from leas-
ing the IBMC machine to the cash flows associated with buying it. The first thing she
realizes is that, because Tasha will get the machine either way, the $6,000 savings will
be realized whether the machine is leased or purchased. Thus, this cost savings, and any
other operating costs or revenues, can be ignored in the analysis.
Upon reflection, Ms. Smart concludes that there are only three important cash flow
differences between leasing and buying:4
1. If the machine is leased, Tasha must make a lease payment of $2,500 each year.
However, lease payments are fully tax deductible, so the aftertax lease payment
would be $2,500 (cid:3) (1 (cid:2) .34) (cid:4) $1,650. This is a cost of leasing instead of buying.
2. If the machine is leased, Tasha does not own it and cannot depreciate it for tax pur-
poses. The depreciation would be $10,000/5 (cid:4) $2,000 per year. A $2,000 deprecia-
tion deduction generates a tax shield of $2,000 (cid:3) .34 (cid:4) $680 per year. Tasha loses
this valuable tax shield if it leases, so this is a cost of leasing.
3. If the machine is leased, Tasha does not have to spend $10,000 today to buy it. This
| Brealey |
is a benefit from leasing.
The cash flows from leasing instead of buying are summarized in Table B.2. Notice
that the cost of the machine shows up with a positive sign in Year 0. This is a reflection of
the fact that Tasha saves the initial $10,000 equipment cost by leasing instead of buying.
A NOTE ON TAXES
Susan Smart has assumed that Tasha can use the tax benefits of the depreciation al-
lowances and the lease payments. This may not always be the case. If Tasha were los-
ing money, it would not pay taxes and the tax shelters would be worthless (unless they
could be shifted to someone else). As we mentioned before, this is one circumstance
under which leasing may make a great deal of sense. If this were the case, the relevant
lines in Table B.2 would have to be changed to reflect a zero tax rate.
CONCEPT QUESTIONS
• What are the cash flow consequences of leasing instead of buying?
• Explain why the $10,000 in Table B.2 has a positive sign.
Lease
versus Buy
Aftertax
lease
payment
Lost
depreciation
tax shield
Cost of
machine
Total cash
flow
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
(cid:2)$1,650
(cid:2)$1,650
(cid:2)$1,650
(cid:2)$1,650
(cid:2)$1,650
(cid:2)$0,680
(cid:2)$0,680
(cid:2)$0,680
(cid:2)$0,680
(cid:2)$0,680
(cid:1)$10,000
(cid:1)$10,000 (cid:2)$2,330
(cid:2)$2,330
(cid:2)$2,330
(cid:2)$2,330
(cid:2)$2,330
4 There is a fourth consequence of leasing that we do not discuss here. If the machine has a nontrivial resid-
ual value, then, if we lease, we give up that residual value. This is another cost of leasing instead of buying.
Leasing 555
Lease or Buy?
Based on our discussion thus far, Ms. Smart’s analysis comes down to this: if Tasha
Corp. leases instead of buying, it saves $10,000 today because it avoids having to pay
for the machine, but it must give up $2,330 per year for the next five years in exchange.
We now must decide whether getting $10,000 today and then paying back $2,330 per
year is a good idea.
A PRELIMINARY ANALYSIS
Suppose Tasha were to borrow $10,000 today and promise to make aftertax payments
of $2,330 per year for the next five years. This is essentially what Tasha will be doing
if it leases instead of buying. What interest rate would Tasha be paying on this “loan”?
Note that we need to find the unknown rate for a five-year annuity with payments of
$2,330 per year and a present value of $10,000. It is easy to verify that the rate is 5.317
percent.
Suppose Tasha were to borrow $10,000 today and promise to make aftertax pay-
ments of $2,330 per year for the next five years. This is essentially what Tasha will be
doing if it leases instead of buying. What interest rate would Tasha be paying on this
“loan”? Note that we need to find the unknown rate for a five-year annuity with pay-
ments of $2,330 per year and a present value of $10,000. It is easy to verify that the rate
is 5.317 percent.
The cash flows for our hypothetical loan are identical to the cash flows from leasing
instead of buying, and what we have illustrated is that when Tasha leases the machine,
it effectively arranges financing at an aftertax rate of 5.317 percent. Whether this is a
good deal or not depends on what rate Tasha would pay if it simply borrowed the money.
For example, suppose Tasha can arrange a five-year loan with its bank at a rate of
7.57575 percent. Should Tasha sign the lease or should it go with the bank?
Because Tasha is in a 34 percent tax bracket, the aftertax interest rate would be
7.57575 (cid:4) (1 (cid:2) .34) = 5 percent. This is less than the 5.317 percent implicit aftertax
rate on the lease. In this particular case, Tasha would be better off borrowing the money
because it would get a better rate.
We have seen that Tasha should buy rather than lease. The steps in our analysis can
be summarized as follows:
1. Calculate the incremental aftertax cash flows from leasing instead of buying.
2. Use these cash flows to calculate the implicit aftertax interest rate on the lease.
3. Compare this rate to the company’s aftertax borrowing cost and choose the cheaper
| Brealey |
source of financing.
The most important thing to note from our discussion thus far is that in evaluating a
lease, the relevant rate for the comparison is the company’s aftertax borrowing rate. The
fundamental reason is that the alternative to leasing is long-term borrowing, so the af-
tertax interest rate on such borrowing is the relevant benchmark.
THREE POTENTIAL PITFALLS
There are three potential problems with the implicit rate that we calculated on the lease.
First of all, we can interpret this rate as the internal rate of return, or IRR, on the deci-
sion to lease rather than buy, but doing so can be confusing. To see why, notice that the
556 APPENDIX B
NET ADVANTAGE TO
LEASING (NAL)
The
NPV that is calculated when
deciding whether to lease an
asset or to buy it.
IRR from leasing is 5.317 percent, which is greater than Tasha’s aftertax borrowing cost
of 5 percent. Normally, the higher the IRR, the better, but we decided that leasing was
a bad idea here. The reason is that the cash flows are not conventional; the first cash
flow is positive and the rest are negative, which is just the opposite of the conventional
case. With this cash flow pattern, the IRR represents the rate we pay, not the rate we get,
so the lower the IRR, the better.
A second, and related, potential pitfall has to do with the fact that we calculated the
advantage of leasing instead of buying. We could have done just the opposite and come
up with the advantage of buying instead of leasing. If we did this, the cash flows would
be the same, but the signs would be reversed. The IRR would be the same. Now, how-
ever, the cash flows would be conventional, so we could interpret the 5.317 percent IRR
as saying that borrowing and buying is better.
The third potential problem is that our implicit rate is based on the net cash flows of
leasing instead of buying. There is another rate that is sometimes calculated, which is
based solely on the lease payments. If we wanted to, we could note that the lease pro-
vides $10,000 in financing and requires five payments of $2,500 each. It would be
tempting to then determine an implicit rate based on these numbers, but the resulting
rate would not be meaningful for making lease versus buy decisions, and it should not
be confused with the implicit return on leasing instead of borrowing and buying.
Perhaps because of these potential sources of confusion, the IRR approach we have
outlined thus far is not as widely used as the NPV-based approach that we describe next.
NPV ANALYSIS
Now that we know that the relevant rate for evaluating a lease versus buy decision is the
firm’s aftertax borrowing cost, an NPV analysis is straightforward. We simply discount
the cash flows back to the present at Tasha’s aftertax borrowing rate of 5 percent as fol-
lows:
NPV (cid:4) $10,000 (cid:2) 2,330 (cid:3) (1 (cid:2) 1/1.055)/.05
(cid:4) (cid:2)$87.68
The NPV from leasing instead of buying is 2$87.68, verifying our earlier conclusion
that leasing is a bad idea. Once again, notice the signs of the cash flows; the first is pos-
itive, the rest are negative. The NPV we have computed here is often called the net ad-
vantage to leasing (NAL). Surveys indicate that the NAL approach is the most popu-
lar means of lease analysis in the real world.
A MISCONCEPTION
In our lease versus buy analysis, it looks as though we ignored the fact that if Tasha bor-
rows the $10,000 to buy the machine, it will have to repay the money with interest. In
fact, we reasoned that if Tasha leased the machine, it would be better off by $10,000
today because it wouldn’t have to pay for the machine. It is tempting to argue that if
Tasha borrowed the money, it wouldn’t have to come up with the $10,000. Instead,
Tasha would make a series of principal and interest payments over the next five years.
This observation is true, but not particularly relevant. The reason is that if Tasha bor-
rows $10,000 at an aftertax cost of 5 percent, the present value of the aftertax loan pay-
ments is simply $10,000, no matter what the repayment schedule is (assuming that the
| Brealey |
Leasing 557
loan is fully amortized). Thus, we could write down the aftertax loan repayments and
work with these, but it would just be extra work for no gain.
LEASE EVALUATION
In our Tasha Corp. example, suppose Tasha is able to negotiate a lease payment of
$2,000 per year. What would be the NPV of the lease in this case?
With this new lease payment, the aftertax lease payment would be $2,000 (cid:3) (1 (cid:2)
.34) (cid:4) $1,320, which is $1,650 (cid:2) 1,320 (cid:4) $330 less than before. Referring back to
Table B.2, note that the aftertax cash flows would be (cid:2)$2,000 instead of (cid:2)$2,330. At
5 percent, the NPV would be:
NPV (cid:4) $10,000 (cid:2) 2,000 (cid:3) (1 (cid:2) 1/1.055)/.05
(cid:4) (cid:2)$1341.05
Thus, the lease is very attractive.
CONCEPT QUESTIONS
• What is the relevant discount rate for evaluating whether or not to lease an asset?
Why?
• Explain how to go about a lease versus buy analysis.
LEVERAGE AND CAPITAL
STRUCTURE
559
560 APPENDIX B
The Capital Structure Question
How should a firm go about choosing its debt-equity ratio? Here, as always, we assume
that the guiding principle is to choose the course of action that maximizes the value of
a share of stock. However, when it comes to capital structure decisions, this is essen-
tially the same thing as maximizing the value of the whole firm, and, for convenience,
we will tend to frame our discussion in terms of firm value.
The WACC (Weighted Average Cost of Capital) tells us that the firm’s overall cost
of capital is a weighted average of the costs of the various components of the firm’s cap-
ital structure. When we described the WACC, we took the firm’s capital structure as
given. Thus, one important issue that we will want to explore is what happens to the cost
of capital when we vary the amount of debt financing, or the debt-equity ratio.
A primary reason for studying the WACC is that the value of the firm is maximized
when the WACC is minimized. The WACC is the discount rate appropriate for the firm’s
overall cash flows. Since values and discount rates move in opposite directions, mini-
mizing the WACC will maximize the value of the firm’s cash flows.
Thus, we will want to choose the firm’s capital structure so that the WACC is mini-
mized. For this reason, we will say that one capital structure is better than another if it
results in a lower weighted average cost of capital. Further, we say that a particular debt-
equity ratio represents the optimal capital structure if it results in the lowest possible
WACC. This optimal capital structure is sometimes called the firm’s target capital
structure as well.
CONCEPT QUESTIONS
• What is the relationship between the WACC and the value of the firm?
• What is an optimal capital structure?
The Effect of Financial Leverage
In this section, we examine the impact of financial leverage on the payoffs to stock-
holders. As you may recall, financial leverage refers to the extent to which a firm relies
on debt. The more debt financing a firm uses in its capital structure, the more financial
leverage it employs.
As we describe, financial leverage can dramatically alter the payoffs to shareholders
in the firm. Remarkably, however, financial leverage may not affect the overall cost of
capital. If this is true, then a firm’s capital structure is irrelevant because changes in cap-
ital structure won’t affect the value of the firm.
THE IMPACT OF FINANCIAL LEVERAGE
We start by illustrating how financial leverage works. For now, we ignore the impact of
taxes. Also, for ease of presentation, we describe the impact of leverage in terms of its
effects on earnings per share, EPS, and return on equity, ROE. These are, of course, ac-
counting numbers and, as such, are not our primary concern. Using cash flows instead
of these accounting numbers would lead to precisely the same conclusions, but a little
more work would be needed.
Leverage and Capital Structure 561
TABLE B.3
Current and proposed
capital structures for the
Trans Am Corporation
Assets
Debt
Equity
| Brealey |
Debt-equity ratio
Share price
Current
Proposed
$8,000,000
$0
$8,000,000
0
$20
$8,000,000
$4,000,000
$4,000,000
1
$20
Shares outstanding
400,000
200,000
Interest rate
10 %
10 %
Financial Leverage, EPS, and ROE: An Example
The Trans Am Corporation currently has no debt in its capital structure. The CFO, Ms.
Morris, is considering a restructuring that would involve issuing debt and using the pro-
ceeds to buy back some of the outstanding equity. Table B.3 presents both the current
and proposed capital structures. As shown, the firm’s assets have a market value of $8
million, and there are 400,000 shares outstanding. Because Trans Am is an all-equity
firm, the price per share is $20.
The proposed debt issue would raise $4 million; the interest rate would be 10 per-
cent. Since the stock sells for $20 per share, the $4 million in new debt would be used
to purchase $4 million/20 (cid:4) 200,000 shares, leaving 200,000 outstanding. After the re-
structuring, Trans Am would have a capital structure that was 50 percent debt, so the
debt-equity ratio would be 1. Notice that, for now, we assume that the stock price will
remain at $20.
To investigate the impact of the proposed restructuring, Ms. Morris has prepared
Table B.4, which compares the firm’s current capital structure to the proposed capital
structure under three scenarios. The scenarios reflect different assumptions about the
firm’s EBIT. Under the expected scenario, the EBIT is $1 million. In the recession sce-
nario, EBIT falls to $500,000. In the expansion scenario, it rises to $1.5 million.
To illustrate some of the calculations in Table B.4, consider the expansion case.
EBIT is $1.5 million. With no debt (the current capital structure) and no taxes, net in-
come is also $1.5 million. In this case, there are 400,000 shares worth $8 million total.
EPS is therefore $1.5 million/400,000 (cid:4) $3.75 per share. Also, since accounting return
on equity, ROE, is net income divided by total equity, ROE is $1.5 million/8 million (cid:4)
18.75%.
With $4 million in debt (the proposed capital structure), things are somewhat differ-
ent. Since the interest rate is 10 percent, the interest bill is $400,000. With EBIT of $1.5
million, interest of $400,000, and no taxes, net income is $1.1 million. Now there are
only 200,000 shares worth $4 million total. EPS is therefore $1.1 million/200,000 (cid:4)
$5.5 per share versus the $3.75 per share that we calculated above. Furthermore, ROE
is $1.1 million/4 million (cid:4) 27.5%. This is well above the 18.75 percent we calculated
for the current capital structure.
EPS versus EBIT
The impact of leverage is evident in Table B.4 when the effect of the restructuring on
EPS and ROE is examined. In particular, the variability in both EPS and ROE is much
larger under the proposed capital structure. This illustrates how financial leverage acts
to magnify gains and losses to shareholders.
In Figure B.3, we take a closer look at the effect of the proposed restructuring. This
figure plots earnings per share, EPS, against earnings before interest and taxes, EBIT,
562 APPENDIX B
TABLE B.4
Capital structure
scenarios for the Trans
Am Corporation
Current Capital Structure: No Debt
Recession
$500,000
0
$500,000
6.25 %
$1.25
Expected
$1,000,000
0
$1,000,000
12.50 %
$2.50
Proposed Capital Structure: Debt (cid:4) $4 million
Recession
$500,000
400,000
$100,000
2.50 %
$.50
Expected
$1,000,000
400,000
$ 600,000
15.00 %
$3.00
Expansion
$1,500,000
0
$1,500,000
18.75%
$3.75
Expansion
$1,500,000
400,000
$1,100,000
27.50 %
$5.50
EBIT
Interest
Net income
ROE
EPS
EBIT
Interest
Net income
ROE
EPS
for the current and proposed capital structures. The first line, labeled “No debt,” repre-
sents the case of no leverage. This line begins at the origin, indicating that EPS would
be zero if EBIT were zero. From there, every $400,000 increase in EBIT increases EPS
by $1 (because there are 400,000 shares outstanding).
The second line represents the proposed capital structure. Here, EPS is negative if
EBIT is zero. This follows because $400,000 of interest must be paid regardless of the | Brealey |
firm’s profits. Since there are 200,000 shares in this case, the EPS is –$2 per share as
shown. Similarly, if EBIT were $400,000, EPS would be exactly zero.
The important thing to notice in Figure B.2 is that the slope of the line in this sec-
ond case is steeper. In fact, for every $400,000 increase in EBIT, EPS rises by $2, so
the line is twice as steep. This tells us that EPS is twice as sensitive to changes in EBIT
because of the financial leverage employed.
Another observation to make in Figure B.2 is that the lines intersect. At that point,
EPS is exactly the same for both capital structures. To find this point, note that EPS is
equal to EBIT/400,000 in the no-debt case. In the with-debt case, EPS is (EBIT –
$400,000)/200,000. If we set these equal to each other, EBIT is:
EBIT/400,000 (cid:4) (EBIT – $400,000)/200,000
EBIT (cid:4) 2 (cid:3) (EBIT – $400,000)
EBIT (cid:4) $800,000
When EBIT is $800,000, EPS is $2 per share under either capital structure. This is
labeled as the break-even point in Figure B.2; we could also call it the indifference
point. If EBIT is above this level, leverage is beneficial; if it is below this point, it is
not.
There is another, more intuitive, way of seeing why the break-even point is $800,000.
Notice that, if the firm has no debt and its EBIT is $800,000, its net income is also
$800,000. In this case, the ROE is $800,000/8,000,000 (cid:4) 10%. This is precisely the
same as the interest rate on the debt, so the firm earns a return that is just sufficient to
pay the interest.
EXAMPLE: BREAK-EVEN EBIT
The MPD Corporation has decided in favor of a capital restructuring. Currently, MPD
uses no debt financing. Following the restructuring, however, debt will be $1 million.
Leverage and Capital Structure 563
FIGURE B.2
Financial leverage: EPS
and EBIT for the Trans
Am Corporation
Earnings per
share ($)
With debt
No debt
Advantage
to debt
Break-even point
Disadvantage
to debt
400,000
800,000 1,200,000
Earnings before
interest and
taxes ($)
4
3
2
1
0
–1
–2
The interest rate on the debt will be 9 percent. MPD currently has 200,000 shares out-
standing, and the price per share is $20. If the restructuring is expected to increase EPS,
what is the minimum level for EBIT that MPD’s management must be expecting? Ig-
nore taxes in answering.
To answer, we calculate the break-even EBIT. At any EBIT above this the increased fi-
nancial leverage will increase EPS, so this will tell us the minimum level for EBIT.
Under the old capital structure, EPS is simply EBIT/200,000. Under the new capital
structure, the interest expense will be $1 million (cid:3) .09 (cid:4) $90,000. Furthermore, with
the $1 million proceeds, MPD will repurchase $1 million/20 (cid:4) 50,000 shares of stock,
leaving 150,000 outstanding. EPS is thus (EBIT – $90,000)/150,000.
Now that we know how to calculate EPS under both scenarios, we set them equal to
each other and solve for the break-even EBIT:
EBIT/200,000
(cid:4) (EBIT – $90,000)/150,000
EBIT (cid:4) (4/3) (cid:3) (EBIT – $90,000)
EBIT (cid:4) $360,000
Verify that, in either case, EPS is $1.80 when EBIT is $360,000. Management at MPD
is apparently of the opinion that EPS will exceed $1.80.
Section 6
Mergers, Acquisitions, and Corporate
Control
International Financial Management
MERGERS, ACQUISITIONS,
AND CORPORATE
CONTROL
The Market for Corporate
Control
Method 1: Proxy Contests
Method 2: Mergers and Acquisitions
Method 3: Leveraged Buyouts
Method 4: Divestitures and Spin-offs
Sensible Motives for Mergers
Economies of Scale
Economies of Vertical Integration
Combining Complementary Resources
Mergers as a Use for Surplus Funds
Dubious Reasons for Mergers
Diversification
The Bootstrap Game
Evaluating Mergers
Mergers Financed by Cash
Mergers Financed by Stock
A Warning
Another Warning
Merger Tactics
Who Gets the Gains?
Leveraged Buyouts
Barbarians at the Gate?
Mergers and the Economy
Merger Waves
Do Mergers Generate Net Benefits?
Summary
A merger is consummated.
These two managers are clearly delighted, but why do companies decide to merge? | Brealey |
Reuters/Peter Morgan/Archive Photos
567
I
n recent years the scale and pace of merger activity have been remark-
able. For example, Table 6.1 lists just a few of the important mergers of
1998 and 1999. Notice that the United States does not have a monopoly
on merger activity. In recent years many of the largest mergers have involved
European firms.
The mergers listed in Table 6.1 involved big money. During periods of intense
merger activity financial managers spend considerable time either searching for firms
to acquire or worrying whether some other firm is about to take over their company.
When one company buys another, it is making an investment, and the basic princi-
ples of capital investment decisions apply. You should go ahead with the purchase if it
makes a net contribution to shareholders’ wealth. But mergers are often awkward trans-
actions to evaluate, and you have to be careful to define benefits and costs properly.
Many mergers are arranged amicably, but in other cases one firm will make a hos-
tile takeover bid for the other. We describe the principal techniques of modern merger
warfare, and since the threat of hostile takeovers has stimulated corporate restructurings
and leveraged buyouts (LBOs), we describe them too, and attempt to explain why these
deals have generated rewards for investors. We close with a look at who gains and loses
from mergers and we discuss whether mergers are beneficial on balance.
After studying this material you should be able to
(cid:1) Describe ways that companies change their ownership or management.
(cid:1) Explain why it may make sense for companies to merge.
(cid:1) Estimate the gains and costs of mergers to the acquiring firm.
(cid:1) Describe takeover defenses.
(cid:1) Summarize the evidence on whether mergers increase efficiency and on how the gains
from mergers are distributed between shareholders of the acquired and acquiring firms.
(cid:1) Explain some of the motivations for leveraged and management buyouts of the firm.
Year
1999
1999
1999
1999
1999
1999
1999
1999
1998
1998
1998
1998
1998
1998
Buying Company
Selling Company
Payment, Billions
of Dollars
MCI WorldCom
Viacom
AT&T
Travelers Group
Exxon
TotalFina (France)
Olivetti (Italy)
Vodafone (UK)
British Petroleum (UK)
Daimler-Benz (Germany)
Zeneca (UK)
Nationsbank Corp.
WorldCom Inc.
Norwest Corp.
Sprint
CBS
MediaOne Group
Citicorp
Mobil Corp.
Elf Aquitaine (France)
Telecom Italia (Italy)
Air Touch Communications
Amoco Corp.
Chrysler
Astra (Sweden)
BankAmerica Corp.
MCI Communications
Wells Fargo & Co.
115
35
54
83
80
55
58
61
48
38
35
62
42
34
TABLE 22.1
Some important recent
mergers
568
Mergers, Acquisitions, and Corporate Control 569
The Market for Corporate Control
The shareholders are the owners of the firm. But most shareholders do not feel like the
boss, and with good reason. Try buying a share of General Motors stock and marching
into the boardroom for a chat with your employee, the chief executive officer.
The ownership and management of large corporations are almost always separated.
Shareholders do not directly appoint or supervise the firm’s managers. They elect the
board of directors, who act as their agents in choosing and monitoring the managers of
the firm. Shareholders have a direct say in very few matters. Control of the firm is in
the hands of the managers, subject to the general oversight of the board of directors.
The separation of ownership and management or control creates potential agency
costs. Agency costs occur when managers or directors take actions adverse to share-
holders’ interests.
The temptation to take such actions may be ever-present, but there are many forces
and constraints working to keep managers’ and shareholders’ interests in line. As we
pointed out earlier, managers’ paychecks in large corporations are almost always tied to
the profitability of the firm and the performance of its shares. Boards of directors take
their responsibilities seriously—they may face lawsuits if they don’t—and therefore are
reluctant to rubber-stamp obviously bad financial decisions.
But what ensures that the board has engaged the most talented managers? What hap- | Brealey |
pens if managers are inadequate? What if the board of directors is derelict in monitor-
ing the performance of managers? Or what if the firm’s managers are fine, but re-
sources of the firm could be used more efficiently by merging with another firm? Can
we count on managers to pursue arrangements that would put them out of jobs?
These are all questions about the market for corporate control, the mechanisms by
which firms are matched up with management teams and owners who can make the
most of the firm’s resources. You should not take a firm’s current ownership and man-
agement for granted. If it is possible for the value of the firm to be enhanced by chang-
ing management or by reorganizing under new owners, there will be incentives for
someone to make a change.
There are four ways to change the management of a firm. These are (1) a
successful proxy contest in which a group of stockholders votes in a new
group of directors, who then pick a new management team; (2) the purchase
of one firm by another in a merger or acquisition; (3) a leveraged buyout of
the firm by a private group of investors; and (4) a divestiture, in which a firm
either sells part of its operations to another company or spins it off as an
independent firm.
We will review briefly each of these methods.
METHOD 1: PROXY CONTESTS
Shareholders elect the board of directors to keep watch on management and replace un-
satisfactory managers. If the board is lax, shareholders are free to elect a different
board. In theory this ensures that the corporation is run in the best interests of share-
holders.
In practice things are not so clear-cut. Ownership in large corporations is widely dis-
persed. Usually even the largest single shareholder holds only a small fraction of the
570 SECTION SIX
PROXY CONTEST
Takeover attempt in which
outsiders compete with
management for
shareholders’ votes. Also
called proxy fight.
MERGER Combination of
two firms into one, with the
acquirer assuming assets
and liabilities of the target
firm.
shares. Most shareholders have little notion who is on the board or what the members
stand for. Management, on the other hand, deals directly with the board and has a per-
sonal relationship with its members. In many corporations, management sits on the
committee that nominates candidates for the board. It is not surprising that some boards
seem less than aggressive in forcing managers to run a lean, efficient operation and to
act primarily in the interests of shareholders.
When a group of investors believes that the board and its management team should
be replaced, they can launch a proxy contest. A proxy is the right to vote another share-
holder’s shares. In a proxy contest, the dissident shareholders attempt to obtain enough
proxies to elect their own slate to the board of directors. Once the new board is in con-
trol, management can be replaced. A proxy fight is therefore a direct contest for control
of the corporation.
But most proxy contests fail. Dissidents who engage in such fights must use their
own money, while management can use the corporation’s funds and lines of communi-
cation with shareholders to defend itself. Such fights can cost millions of dollars.1
Institutional shareholders such as large pension funds have become more aggressive
in pressing for managerial accountability. These funds have been able to gain conces-
sions from firms without initiating proxy contests. For example, firms have agreed to
split the jobs of chief executive officer and chairman of the board of directors. This en-
sures that an outsider is responsible for keeping watch over the company. Also, more
firms now bar corporate insiders from serving on the committee that nominates candi-
dates to the board. Perhaps as a result of shareholder pressure, boards also seem to be
getting more aggressive. For example, outside directors were widely credited for has-
tening the recent replacement of top management at Coke and British Airwaves.
METHOD 2: MERGERS AND ACQUISITIONS
| Brealey |
Proxy contests are rare, and successful ones are rarer still. Poorly performing managers
face a greater risk from acquisition. If the management of one firm observes another
firm underperforming, it can try to acquire the business and replace the poor managers
with its own team. In practice, corporate takeovers are the arenas where contests for cor-
porate control are usually fought.
There are three ways for one firm to acquire another. One possibility is to merge the
two companies into one, in which case the acquiring company assumes all the assets
and all the liabilities of the other. Such a merger must have the approval of at least 50
percent of the stockholders of each firm.2 The acquired firm ceases to exist, and its for-
mer shareholders receive cash and/or securities in the acquiring firm. In many mergers
there is a clear acquiring company, whose management then runs the enlarged firm.
However, a merger is often a combination of two equals with both managements hav-
ing a major say in the running of the new company. For example, the $330 billion pro-
posed merger between Time Warner and AOL is a merger of equals.
A second alternative is for the acquiring firm to buy the target firm’s stock in ex-
change for cash, shares, or other securities. The acquired firm may continue to exist as
a separate entity, but it is now owned by the acquirer. The approval and cooperation of
the target firm’s managers are generally sought, but even if they resist, the acquirer can
1 J. H. Mulherin and A. B. Poulsen provide an analysis of proxy fights in “Proxy Contests and Corporate
Change: Implications for Shareholder Wealth,” Journal of Financial Economics 47 (1998), pp. 279–313.
2 Corporate charters and state laws sometimes specify a higher percentage.
TENDER OFFER
Takeover attempt in which
outsiders directly offer to buy
the stock of the firm’s
shareholders.
ACQUISITION Takeover
of a firm by purchase of that
firm’s common stock or
assets.
LEVERAGED BUYOUT
(LBO)
Acquisition of the
firm by a private group using
substantial borrowed funds.
MANAGEMENT BUYOUT
(MBO)
Acquisition of the
firm by its own management
in a leveraged buyout.
Mergers, Acquisitions, and Corporate Control 571
attempt to purchase a majority of the outstanding shares. By offering to buy shares
directly from shareholders, the acquiring firm can bypass the target firm’s management
altogether. The offer to purchase stock is called a tender offer. If the tender offer is
successful, the buyer obtains control and can, if it chooses, toss out incumbent man-
agement.
The third approach is to buy the target firm’s assets. In this case ownership of the
assets needs to be transferred, and payment is made to the selling firm rather than di-
rectly to its stockholders. Usually, the target firm sells only some of its assets, but oc-
casionally it sells all of them. In this case, the selling firm continues to exist as an in-
dependent entity, but it becomes an empty shell—a corporation engaged in no business
activity.
The terminology of mergers and acquisitions (M&A) can be confusing. These
phrases are used loosely to refer to any kind of corporate combination or takeover. But
strictly speaking, merger means the combination of all the assets and liabilities of two
firms. The purchase of the stock or assets of another firm is an acquisition.
METHOD 3: LEVERAGED BUYOUTS
Sometimes a group of investors takes over a firm by means of a leveraged buyout, or
LBO. The LBO group takes the firm private and its shares no longer trade in the secu-
rities markets. Usually a considerable proportion of LBO financing is borrowed, hence
the term leveraged buyout.
If the investor group is led by the management of the firm, the takeover is called a
management buyout, or MBO. In this case, the firm’s managers actually buy the firm
from the shareholders and continue to run it. They become owner-managers. We will
discuss LBOs and MBOs later.
METHOD 4: DIVESTITURES AND SPIN-OFFS
Firms not only acquire businesses; they also sell them. Divestitures are part of the mar- | Brealey |
ket for corporate control. In recent years the number of divestitures has been about half
the number of mergers.
Instead of selling a business to another firm, companies may spin off the business by
separating it from the parent firm and distributing stock in the newly independent com-
pany to the shareholders of the parent company. For example, in 1996, AT&T was split
into four separate firms: AT&T continued to operate telecommunication services, Lu-
cent took responsibility for telecommunication equipment manufacturing, NCR took on
the computer business, and AT&T Capital, which handled leasing, was spun off and
sold to another firm. Instead of holding shares in one megafirm, AT&T’s shareholders
were given shares in Lucent and NCR as well as AT&T. Investors clearly welcomed this
move: when the announcement of the split was made in 1995, AT&T’s shares jumped
11 percent.
Probably the most frequent motive for spin-offs is improved efficiency. Companies
sometimes refer to a business as being a “poor fit.” By spinning off a poor fit, the man-
agement of the parent company can concentrate on its main activity. If each business
must stand on its own feet, there is no risk that funds will be siphoned off from one in
order to support unprofitable investments in the other. Moreover, if the two parts of the
business are independent, it is easy to see the value of each and to reward managers ac-
cordingly.
572 SECTION SIX
Sensible Motives for Mergers
We now look more closely at mergers and acquisitions and consider when they do and
do not make sense. Mergers are often categorized as horizontal, vertical, or conglom-
erate. A horizontal merger is one that takes place between two firms in the same line of
business; the merged firms are former competitors. Most of the mergers around the turn
of the twentieth century were of this type. Recent examples of horizontal mergers have
occurred in banking, such as the merger between Deutsche Bank and Bankers Trust,
and in oil, such as the merger between Exxon and Mobil.
A horizontal merger can be blocked if it would be anticompetitive or create too much
market power. The Mobil and Exxon merger was challenged, but it was finally con-
summated after the two companies agreed to sell a number of service stations to other
retailers.
During the 1920s, vertical mergers were predominant. A vertical merger is one in
which the buyer expands backward toward the source of raw material or forward in the
direction of the ultimate consumer. Thus a soft drink manufacturer might buy a sugar
producer (expanding backward) or a fast-food chain as an outlet for its product (ex-
panding forward). Pepsi owns BurgerKing, for example.
A conglomerate merger involves companies in unrelated lines of business. For ex-
ample, before it went belly up in 1999, the Korean conglomerate, Daewoo, had nearly
400 different subsidiaries and 150,000 employees. It built ships in Korea, manufactured
microwaves in France, TVs in Mexico, cars in Poland, fertilizers in Vietnam, and man-
aged hotels in China and a bank in Hungary. No U.S. company is as diversified as Dae-
woo, but in the 1960s and 1970s it was common in the United States for unrelated busi-
nesses to merge. However, the number of conglomerate mergers declined in the 1980s.
In fact much of the action in the 1980s came from breaking up the conglomerates that
had been formed 10 to 20 years earlier.
(cid:1) Self-Test 1
Are the following hypothetical mergers horizontal, vertical, or conglomerate?
a. IBM acquires Apple Computer.
b. Apple Computer acquires Stop & Shop (a supermarket chain).
c. Stop & Shop acquires Campbell Soup.
d. Campbell Soup acquires IBM.
We have already seen that one motive for a merger is to replace the existing man-
agement team. If this motive is important, one would expect that poorly performing
firms would tend to be targets for acquisition; this seems to be the case.3 However,
firms also acquire other firms for reasons that have nothing to do with inadequate man- | Brealey |
agement. Many mergers and acquisitions are motivated by possible gains in efficiency
from combining operations. These mergers create synergies. By this we mean that the
two firms are worth more together than apart.
3 For example, Palepu found that investors in firms that were subsequently acquired earned relatively low rates
of return for several years before the merger. See K. Palepu, “Predicting Takeover Targets: A Methodological
and Empirical Analysis,” Journal of Accounting and Economics 8 (March 1986), pp. 3–36.
Mergers, Acquisitions, and Corporate Control 573
A merger adds value only if synergies, better management, or other changes
make the two firms worth more together than apart.
It would be convenient if we could say that certain types of mergers are usually suc-
cessful and other types fail. Unfortunately, there are no such simple generalizations.
Many mergers that appear to make sense nevertheless fail because managers cannot
handle the complex task of integrating two firms with different production processes,
accounting methods, and corporate cultures. Moreover, the value of most businesses de-
pends on human assets—managers, skilled workers, scientists, and engineers. If these
people are not happy in their new roles in the acquiring firm, the best of them will leave.
Beware of paying too much for assets that go down in the elevator and out to the park-
ing lot at the close of each business day.
With this caveat in mind, we will now consider possible sources of synergy.
ECONOMIES OF SCALE
Just as most of us believe that we would be happier if only we were a little richer, so
managers always seem to believe their firm would be more competitive if only it were
just a little bigger. They hope for economies of scale, that is, the opportunity to spread
fixed costs across a larger volume of output. The banking industry provides many ex-
amples. By the 1970s, it was clear that the United States had too many small, local
banks. Some (now very large) banks grew by systematically buying up smaller banks
and streamlining their operations. Most of the cost savings came from consolidating
“backoffice” operations, such as computer systems for processing checks and credit-
card transactions and payments.
These economies of scale are the natural goal of horizontal mergers. But they have
been claimed in conglomerate mergers, too. The architects of these mergers have
pointed to the economies that come from sharing central services such as accounting,
financial control, and top-level management.
ECONOMIES OF VERTICAL INTEGRATION
Large industrial companies commonly like to gain as much control and coordination as
possible over the production process by expanding back toward the output of the raw
material and forward to the ultimate consumer. One way to achieve this is to merge with
a supplier or a customer. Consider Du Pont’s purchase of an oil company, Conoco. This
was vertical integration because petroleum is the ultimate raw material for much of Du
Pont’s chemical production.
Do not assume that more vertical integration is necessarily better than less. Carried
to extremes, it is absurdly inefficient. For example, before the Polish economy was re-
structured, LOT, the Polish state airline, found itself raising pigs to make sure that its
employees had fresh meat on their tables. (Of course, in a centrally managed economy
it may prove necessary to grow your own meat, since you can’t be sure you’ll be able to
buy it.)
Vertical integration is less popular recently. Many companies are finding it more ef-
ficient to outsource the provision of many activities. For example, Du Pont seems to
have become less convinced of the benefits of vertical integration, for in 1999 it sold
off Conoco.
574 SECTION SIX
COMBINING COMPLEMENTARY RESOURCES
Many small firms are acquired by large firms that can provide the missing ingredients
necessary for the firm’s success. The small firm may have a unique product but lack the
engineering and sales organization necessary to produce and market it on a large scale. | Brealey |
The firm could develop engineering and sales talent from scratch, but it may be quicker
and cheaper to merge with a firm that already has ample talent. The two firms have
complementary resources—each has what the other needs—so it may make sense for
them to merge. Also the merger may open up opportunities that neither firm would pur-
sue otherwise. Federal Express’s purchase of Caliber System, a trucking company, is an
example. Federal Express specializes in shipping packages by air, mostly for overnight
delivery. Caliber’s RMS subsidiary moves nonexpress packages by truck. RMS greatly
increases Federal Express’s capability to move packages on the ground. At the same
time, RMS-originated business can move easily on the Federal Express system when
rapid or distant delivery is essential.
(cid:1) EXAMPLE 1
Complementary Resources
Of course two large firms may also merge because they have complementary resources.
Consider the 1989 merger between two electric utilities, Utah Power & Light and
PacifiCorp, which serves customers in California. Utah Power’s peak demand comes in
the summer, for air conditioning. PacifiCorp’s peak comes in the winter, for heating.
The savings from combining the two firms’ generating systems were estimated at $45
million annually.
MERGERS AS A USE FOR SURPLUS FUNDS
Suppose that your firm is in a mature industry. It is generating a substantial amount of
cash, but it has few profitable investment opportunities. Ideally such a firm should dis-
tribute the surplus cash to shareholders by increasing its dividend payment or by repur-
chasing its shares. Unfortunately, energetic managers are often reluctant to shrink their
firm in this way.
If the firm is not willing to purchase its own shares, it can instead purchase some-
one else’s. Thus firms with a surplus of cash and a shortage of good investment oppor-
tunities often turn to mergers financed by cash as a way of deploying their capital.
Firms that have excess cash and do not pay it out or redeploy it by acquisition often
find themselves targets for takeover by other firms that propose to redeploy the cash for
them. During the oil price slump of the early 1980s, many cash-rich oil companies
found themselves threatened by takeover. This was not because their cash was a unique
asset. The acquirers wanted to capture the companies’ cash flow to make sure it was not
frittered away on negative-NPV oil exploration projects. We return to this free-cash-
flow motive for takeovers later.
We have discussed how mergers may make economic sense, but things can still go
wrong when managers don’t do their homework. That was the case for Converse Inc.,
which produces athletic shoes. In May 1995 Converse announced that it was acquiring
Apex One, a leading maker of sportswear. Apex brought with it a number of valuable
licenses for professional and college teams. As one enthusiast observed, “By letting
them outfit athletes from head to toe, the Apex deal potentially puts them on an even
Mergers, Acquisitions, and Corporate Control 575
keel with Nike and Reebok.” However, 85 days later Converse closed down Apex One
after incurring a $46 million loss on its investment.
What went wrong? The problem appears to have begun when Apex was several
months late in introducing its fall product lines. Converse’s management complained
that, in light of these delays, Apex’s $100 million revenue projection at the time of the
purchase had been unrealistic and over the next 3 months projections were progres-
sively scaled back to $40 million. Inevitably, the closure of Apex was followed by a vol-
ley of legal suits.4
Dubious Reasons for Mergers
The benefits that we have described so far all make economic sense. Other arguments
sometimes given for mergers are more dubious. Here are two.
DIVERSIFICATION
We have suggested that the managers of a cash-rich company may prefer to see that
cash used for acquisitions. That is why we often see cash-rich firms in stagnant indus- | Brealey |