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ª ALAN SCHEIN/ALAMY 12 Home Depot CHAPTER Cash Flow Estimation and Risk Analysis Home Depot Keeps Growing Home Depot Inc (HD) has grown phenomenally in recent years, and that growth continues At the beginning of 1990, HD had 118 stores with annual sales of $2.8 billion By early 2008, it had 2,234 stores and annual sales of $77 billion Stockholders have benefited mightily from this growth as the stock’s price has increased from a split-adjusted $1.87 in 1990 to $40 in early 2007, or by 2,039% However, the more recent news has not been as good In the face of a declining housing market, the company has struggled In May 2008, it announced the closing of 12 underperforming stores Still, despite the poor housing market, the company continues to open new stores in areas it thinks the stores will well It costs, on average, over $20 million to purchase land, construct a new store, and stock it with inventory Therefore, it is critical that the company perform a financial analysis to determine whether a potential store’s expected cash flows will cover its costs Home Depot uses information from its existing stores to forecast its new stores’ 364 expected cash flows Thus far, its forecasts have been outstanding, but there are always risks First, a store’s sales might be less than projected, especially if the economy weakens Second, some of HD’s customers might bypass the store altogether and buy directly from manufacturers through the Internet Third, its new stores could “cannibalize,” or take sales away from, its existing stores To avoid cannibalization while still opening enough new stores to generate substantial growth, HD has been developing complementary formats For example, it recently rolled out its Expo Design Center chain, which offers one-stop sales and service for kitchen, bath, and other remodeling and renovation work; and in 2007, it acquired a Chinese home improvement chain to jump-start its operations in that nation Rational expansion decisions require detailed assessments of the forecasted cash flows, along with a measure of the risk that forecasted sales might not be realized That information can then be used to determine the risk-adjusted NPV associated with each potential project In this Chapter 12 Cash Flow Estimation and Risk Analysis chapter, we describe techniques for estimating projects’ cash flows, as well as projects’ risks Companies such as 365 Home Depot use these techniques on a regular basis when making capital budgeting decisions PUTTING THINGS IN PERSPECTIVE The basic principles of capital budgeting were covered in Chapter 11 Given a project’s expected cash flows, it is easy to calculate the primary decision criterion— the NPV—as well as the supplemental criteria, IRR, MIRR, payback, and discounted payback However, in the real world, cash flow numbers are not just handed to you—rather, they must be estimated based on information from various sources Moreover, uncertainty surrounds the forecasted cash flows, and some projects are more uncertain and thus riskier than others In this chapter, we review examples that illustrate how project cash flows are estimated, discuss techniques for measuring and then dealing with risk, and discuss how projects are evaluated once they go into operation Finally, we discuss techniques to use when evaluating mutually exclusive projects that have unequal lives When you finish this chapter, you should be able to: Identify “relevant” cash flows that should and should not be included in a capital budgeting analysis Estimate a project’s relevant cash flows and put them into a time line format that can be used to calculate a project’s NPV, IRR, and other capital budgeting metrics Explain how risk is measured and use this measure to adjust the firm’s WACC to account for differential project riskiness Correctly calculate the NPV of mutually exclusive projects that have unequal lives l l l l 12-1 CONCEPTUAL ISSUES IN CASH FLOW ESTIMATION Before the cash flow estimation process is illustrated, we need to discuss several important conceptual issues A failure to handle these issues properly can lead to incorrect NPVs and thus bad capital budgeting decisions 12-1a Cash Flow versus Accounting Income We saw in Chapter that there is a difference between cash flows and accounting income We also saw that cash is what people and firms spend or reinvest; so the present value of cash flows, not accounting income, is the basis of a firm’s value That’s why, in the last chapter, we discounted net cash flows, not net income, to find projects’ NPVs Many things can lead to differences between net cash flows and net income First, depreciation is not a cash outlay, but it is deducted when net income is calculated Second, net income is based on the depreciation rate the firm’s accountants decide to use, not necessarily on the depreciation rate allowed by the IRS, and it is the IRS rate that determines cash flows Moreover, if a project requires an addition to working capital, this directly affects cash flows but not net income Other factors also differentiate net income from cash flow, but the 366 Part Investing in Long-Term Assets: Capital Budgeting important thing to keep in mind is this: For capital budgeting purposes, the project’s cash flows, not its accounting income, is the key item 12-1b Timing of Cash Flows In theory, capital budgeting analyses should deal with cash flows exactly when they occur; hence, daily cash flows theoretically would be better than annual flows However, it would be costly to estimate and analyze daily cash flows, and they would probably be no more accurate than annual estimates because we simply cannot accurately forecast at a daily level out 10 years or so into the future Therefore, we generally assume that all cash flows occur at the end of the year Note, though, for projects with highly predictable cash flows, it might be useful to assume that cash flows occur at midyear (or even quarterly or monthly); but for most purposes, we assume end-of-year flows 12-1c Incremental Cash Flows Incremental Cash Flow A cash flow that will occur if and only if the firm takes on a project Incremental cash flows are flows that will occur if and only if some specific event occurs In capital budgeting, the event is the firm’s acceptance of a project and the project’s incremental cash flows are ones that occur as a result of this decision Cash flows such as investments in buildings, equipment, and working capital needed for the project are obviously incremental, as are sales revenues and operating costs associated with the project However, some items are not so obvious, as we explain later in this section 12-1d Replacement Projects Two types of projects can be distinguished: expansion projects, where the firm makes an investment, such as a new Home Depot store, and replacement projects, where the firm replaces existing assets, generally to reduce costs For example, suppose Home Depot is considering replacing some of its delivery trucks The benefit would be lower fuel and maintenance expenses, and the shiny new trucks also might improve the company’s image and reduce pollution Replacement analysis is complicated by the fact that almost all of the cash flows are incremental, found by subtracting the new cost numbers from the old numbers Thus, the fuel bill for a more efficient new truck might be $10,000 per year versus $15,000 for the old truck The $5,000 savings is the incremental cash flow that would be used in the replacement analysis Similarly, we would need to find the difference in depreciation and other factors that affect cash flows Once we have found the incremental cash flows, we use them in a “regular” NPV analysis to decide whether to replace the asset or to continue using it 12-1e Sunk Costs Sunk Cost A cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected A sunk cost is an outlay that was incurred in the past and cannot be recovered in the future regardless of whether the project under consideration is accepted In capital budgeting, we are concerned with future incremental cash flows—we want to know if the new investment will produce enough incremental cash flow to justify the incremental investment Because sunk costs were incurred in the past and cannot be recovered regardless of whether the project is accepted or rejected, they are not relevant in the capital budgeting analysis To illustrate this concept, suppose Home Depot spent $2 million to investigate a potential new store and obtain the permits required to build it That $2 million would be a sunk cost—the money is gone, and it won’t come back regardless of whether or not the new store is built Not handling sunk costs properly can lead to incorrect decisions For example, suppose Home Depot completed the analysis and found that it must spend an additional $17 million, on top of the $2 million site study, to open the store Suppose Chapter 12 Cash Flow Estimation and Risk Analysis 367 it then used as the required investment $19 million and found a projected NPV of negative $1 million This would indicate that HD should reject the new store However, that would be a bad decision The real issue is whether the incremental $17 million would result in incremental cash inflows sufficient to produce a positive NPV If the $2 million sunk cost is disregarded, as it should be, the true NPV will be a positive $1 million Therefore, the failure to deal properly with the sunk cost would lead to turning down a project that would add $1 million to stockholders’ value 12-1f Opportunity Costs Associated with Assets the Firm Owns Another issue relates to opportunity costs associated with assets the firm already owns For example, suppose Home Depot owns land with a market value of $2 million and that land will be used for the new store if HD decides to build it If HD decides to go forward with the project, only another $15 million will be required, not the typical $17 million because HD would not need to buy the required land Does this mean that HD should use $15 million as the cost of the new store? The answer is no If the new store is not built, HD could sell the land and receive a cash flow of $2 million This $2 million is an opportunity cost— something that HD would not receive if the land was used for the new store Therefore, the $2 million must be charged to the new project, and a failure to so would artificially and incorrectly increase the new project’s NPV If this is not clear, consider the following example Assume that a firm owns a building and equipment with a market (resale) value of $10 million The property is not being used, and the firm is considering using it for a new project The only required additional investment would be $100,000 for working capital, and the new project would produce a cash inflow of $50,000 forever If the firm has a WACC of 10% and evaluates the project using only the $100,000 of working capital as the required investment, it would find an NPV of $50,000/0.10 ¼ $500,000 Does this mean that the project is a good one? The answer is no The firm can sell the property for $10 million, which is a much larger amount than $500,000 Opportunity Cost The best return that can be earned on assets the firm already owns if those assets are not used for the new project 12-1g Externalities Another potential problem involves externalities, which are defined as the effects of a project on other parts of the firm or the environment The three types of externalities—negative within-firm externalities, positive within-firm externalities, and environmental externalities—are explained next Externality An effect on the firm or the environment that is not reflected in the project’s cash flows Negative Within-Firm Externalities As noted earlier, when retailers such as Home Depot open new stores that are too close to their existing stores, this takes customers away from their existing stores In this case, even though the new store has positive cash flows, its existence reduces some of the firm’s current cash flows This type of externality is called cannibalization because the new business eats into the company’s existing business Manufacturers also can experience cannibalization Thus, if Cengage Learning, the publisher of this book, decides to publish another introductory finance text, that new book will presumably reduce sales of this one Those lost cash flows should be taken into account, and that means charging them as a cost when analyzing the proposed new book Dealing properly with negative externalities can be tricky If Cengage decides not to publish the new book because of its cannibalization effects, might another publisher publish it, causing our book to lose sales regardless of what Cengage does? Logically, Cengage must examine the total situation, which is more than a simple mechanical analysis Experience and knowledge of the industry is required to make good decisions Cannibalization The situation when a new project reduces cash flows that the firm would otherwise have had Part Investing in Long-Term Assets: Capital Budgeting One of the best examples of a company fouling up as a result of not dealing correctly with cannibalization effects was IBM’s response when transistors made personal computers possible in the 1970s IBM’s mainframe computers were the biggest game in town, and they generated huge profits But IBM also had the technology, entered into the PC market, and for a time was the leading PC company However, top management decided to rein back the PC division because managers were afraid it would hurt the more profitable mainframe business That decision opened the door for Microsoft, Intel, Dell, Hewlett-Packard, and others; and IBM went from being the most profitable firm in the world to one whose very survival was threatened This experience highlights the fact that while it is essential to understand the theory of finance, it is equally important to understand the business environment, including how competitors are likely to react to a firm’s actions A great deal of judgment goes into making good financial decisions Positive Within-Firm Externalities Cannibalization occurs when new products compete with old ones However, a new project also can be complementary to an old one, in which case cash flows in the old operation will be increased when the new one is introduced For example, Apple’s iPod was a profitable product; but when Apple made an investment in another project, its music store, that investment boosted sales of the iPod So if an analysis of the proposed music store indicated a negative NPV, the analysis would not be complete unless the incremental cash flows that would occur in the iPod division were credited to the music store That might well change the project’s NPV from negative to positive Environmental Externalities The most common type of negative externality is a project’s impact on the environment Government rules and regulations constrain what companies can do, but firms have some flexibility in dealing with the environment For example, suppose a manufacturer is studying a proposed new plant The company could meet the environmental regulations at a cost of $1 million, but the plant would still emit fumes that might cause ill feelings in its neighborhood Those ill feelings would not show up in the cash flow analysis, but they still should be considered Perhaps a relatively small additional expenditure would reduce the emissions substantially, make the plant look good relative to other plants in the area, and provide goodwill that would help the firm’s sales and negotiations with governmental agencies in the future Of course, everyone’s profits depend on the earth remaining healthy, so companies have an incentive to things to protect the environment even though those actions are not required However, if one firm decides to take actions that are good for the environment but costly, its products must reflect the higher costs If its competitors decide to get by with less costly but less environmentally friendly processes, they can price their products lower and make more money Of course, more environmentally friendly companies can advertise their environmental efforts, and this might—or might not—offset the higher costs All of this illustrates why government regulations are necessary, both nationally and internationally Finance, politics, and the environment are all interconnected LF TEST SE 368 Why should companies use a project’s cash flows rather than accounting income when determining a project’s NPV? Explain the following terms: incremental cash flow, sunk cost, opportunity cost, externality, and cannibalization Provide an example of a “good” externality, that is, one that increases a project’s true NPV 369 Chapter 12 Cash Flow Estimation and Risk Analysis 12-2 ANALYSIS OF AN EXPANSION PROJECT In Chapter 11, we analyzed two projects, S and L We were given the cash flows and used them to illustrate how the NPV, IRR, MIRR, and payback are calculated Now we demonstrate how cash flows are actually estimated, using our old Project S to demonstrate the procedure We explain the process in Table 12-1 Look at it as we discuss the analysis Note that the dollars are in thousands; we omitted Table 12-1 A 10 11 12 13 14 15 16 17 18 19 20 21 22 Cash Flow Estimation and Analysis for Expansion Project S B Depreciation 26 27 28 Alternative depreciation Cost: 35 36 37 38 D Investment Outlays at Time = Equipment Net WC Net Cash Flows Over the Project’s Life Unit sales Sales price Variable cost per unit Sales revenues = Units ϫ Price Variable costs = Units ϫ Cost/unit Fixed operating costs except depreciation Depreciation: Accelerated from table below Total operating costs EBIT (or operating income) Taxes on operating income 40% After-tax project operating income Add back depreciation Salvage value (taxed as ordinary income) Tax on salvage value (SV is taxed at 40%) Recovery of net working capital Project net cash flows (Time Line) 23 24 25 29 30 31 32 33 34 C Cost: E F G H I 537 $10.00 $5.092 $5,370 2,735 2,000 297 $5,032 $ 338 135 $ 203 297 520 $10.00 $5.391 $5,200 2,803 2,000 405 $5,208 -$ -3 -$ 405 505 $10.00 $5.228 $5,050 2,640 2,000 135 $4,775 $ 275 110 $ 165 135 $ 500 $ 400 $ 300 -$ 900 -100 -$1,000 490 $10.00 $6.106 $4,900 2,992 2,000 63 $5,055 -$ 155 -62 -$ 93 63 50 -20 100 $ 100 $900 Accelerated Rate Depreciation 33% $297 45% $405 15% $135 7% $63 $900 Straight line Rate Depreciation 25% $225 25% $225 25% $225 25% $225 Project Evaluation @ WACC = 10% Formulas Straight line Accelerated $64.44 =NPV(D29,F22:I22)+E22 $78.82 NPV 13.437% =IRR(E22:I22) 14.489% IRR 11.731% =MIRR(E22:I22,D29,D29) 12.106% MIRR 2.60 =G2+(-E22-F22-G22)/H22 2.33 Payback Accelerated depreciation rates are set by Congress We show the approximate rates for a 4-year asset in 2008 Companies also have the option of using straight-line depreciation Under IRS rules, salvage value is not deducted when establishing the depreciable basis However, if a salvage payment is received, it is called a recapture of depreciation and is taxed at the 40% rate If the firm owned assets that would be used for the project but would be sold if the project is not accepted, the after-tax value of those assets would be shown as an ”opportunity cost” in the ”Investment Outlays” section If this project would reduce sales and cash flows from one of the firm's other divisions, then the after-tax cannibalization effect, or ”externality,” would be deducted from the net cash flows shown on Row 22 If the firm had previously incurred costs associated with this project, but those costs could not be recovered regardless of whether this project is accepted, then they are ”sunk costs” and should not enter the analysis 370 Part Investing in Long-Term Assets: Capital Budgeting three zeros to streamline the presentation Also note that we used Excel to make Table 12-1 We could have used a calculator and plain paper, but Excel is much better in dealing with arithmetic You don’t need to know Excel to understand the discussion; but if you plan to work in finance—or in almost any business function—you should learn something about it The column headers in the table, the A through I, and the row headers, through 38, designate cells, which contain the data For example, the equipment needed for Project S will cost $900, and that number is shown in Cell E4 as a negative The equipment is expected to have a salvage value of $50 at the end of the project’s 4-year life; this is shown in Cell I19.1 The new project will require $100 of working capital; this is shown in Cell E5 as a negative number because it is a cost and then as a positive number in Cell I21 because it is recovered at the end of Year The total investment at Time is $1,000, which is shown in Cell E22 Unit sales of Project S are shown on Row 7; they are expected to decline somewhat over the project’s 4-year life The sales price, a constant $10, is shown on Row The projected variable cost per unit is given on Row 9; it generally increases over time due to expected increases in materials and labor Sales revenues, which are calculated as units multiplied by price, are given on Row 10 Variable costs, equal to units multiplied by VC/unit, are given on Row 11; and fixed costs excluding depreciation, which are a constant $2,000, are shown on Row 12 Depreciation is found as the annual rate allowed by the IRS times the depreciable basis As noted in Chapter 3, Congress sets the depreciation rates that can be used for tax purposes and these are the tax rates used in the capital budgeting analysis Congress permits firms to depreciate assets by the straightline method or by an accelerated method As we will see, profitable firms are better off using accelerated depreciation We discuss depreciation more fully in Appendix 12A; but to simplify things for this chapter, we assume that the applicable accelerated rates for a project with a 4-year life are as given on Row 24 of the depreciation section of the table and that straight-line rates are as given on Row 27 Thus, we assume that if the firm uses accelerated depreciation, it will write off 33% of the basis during Year 1, another 45% in Year 2, and so forth These are the rates used to obtain the cash flows shown in the table The depreciable basis is the cost of the equipment including any shipping or installation costs, or $900 as shown in Cells E4, C24, and C27 The total depreciation over the years equals the cost of the equipment If for some reason the firm decided to use straight-line depreciation, it could write off a constant $225 per year Its total cash flows over the entire years would be the same as under accelerated depreciation; but under straight line, those cash flows would come in a bit slower because the firm would have higher tax payments in the early years and lower tax payments later on We calculate the annual cash flows for Project S over the years in Columns F, G, H, and I, ending with the net cash flows shown on Row 22 The numbers in Cells E22 through I22 amount to a cash flow time line, and they are the same numbers used in Chapter 11 for Project S Since the numbers are the same, the NPV, IRR, MIRR, and Payback shown in Cells C31 through C34 are the same as those we calculated in Chapter 11 The Excel model used to create Table 12-1 is part of the chapter Excel model available on the text’s web site We recommend that anyone with a computer and The equipment will be fully depreciated after years Therefore, the $50 estimated salvage value will exceed the book value, which will be zero This $50 gain is classified as a recapture of depreciation, and it is taxed at the same rate as ordinary income Chapter 12 Cash Flow Estimation and Risk Analysis some familiarity with Excel access the model and work through it to see how the table was generated Anyone doing real-world capital budgeting today would use such a model; and our model provides a good template, or starting point, if and when you need to analyze an actual project 12-2a Effect of Different Depreciation Rates If we replaced the accelerated depreciation numbers in Table 12-1 with the constant $225 values that would exist under straight line, the result would be a cash flow time line on Row 22 that has the same total flows However, in the early years, the cash flows resulting from straight-line depreciation would be lower than those now in the table; and the later years’ cash flows would show higher numbers You know that dollars received earlier have a higher present value than dollars received later Therefore, Project S’s NPV is higher if the firm uses accelerated depreciation The exact effect is shown in the Project Evaluation section of Table 12-1—the NPV is $78.82 under accelerated depreciation and $64.44, or 18% less, with straight line Now suppose Congress wants to encourage companies to increase their capital expenditures to boost economic growth and employment What change in depreciation would have the desired effect? The answer is to make accelerated depreciation even more accelerated For example, if the firm could write off this 4-year equipment at rates of 50%, 35%, 10%, and 5%, its early tax payments would be lower, early cash flows would be higher, and the project’s NPV would be higher than that shown in Table 12-1 12-2b Cannibalization Project S does not involve any cannibalization effects Suppose, however, that Project S would reduce the net after-tax cash flows of another division by $50 per year No other firm would take on this project if our firm turns it down In this case, we would add a row at about Row 18 and deduct $50 for each year If this were done, Project S would end up with a negative NPV; hence, it would be rejected On the other hand, if Project S would cause additional flows in some other division (a positive externality), those after-tax inflows should be attributed to Project S 12-2c Opportunity Costs Now suppose the $900 initial cost shown in Table 12-1 was based on the assumption that the project would save money by using some equipment the company now owns and that equipment would be sold for $100, after taxes, if the project is rejected The $100 is an opportunity cost, and it should be reflected in our calculations We would add $100 to the project’s cost The result would be an NPV of $78.82 − $100 ¼ −$21.18, so the project would be rejected 12-2d Sunk Costs Now suppose the firm had spent $150 on a marketing study to estimate potential sales This $150 could not be recovered regardless of whether the project is accepted or rejected Should the $150 be charged to Project S when determining its NPV for capital budgeting purposes? The answer is no We are interested only in incremental costs The $150 is not an incremental cost; it is a sunk cost Therefore, it should not enter into the analysis One additional point should be made about sunk costs If the $150 expenditure was actually made, in the final analysis, Project S would turn out to be a loser: Its NPV would be $78.82 − $150 ¼ −$71.18 If we could somehow back up and 371 Part Investing in Long-Term Assets: Capital Budgeting reconsider the project before the $150 had been spent, we would see that the project should be rejected However, we can’t back up—at this point, we can either abandon the project or spend $1,000 and go forward with it If we go forward, we will receive an incremental NPV of $78.82, which would reduce the loss from −$150 to −$71.18 12-2e Other Changes to the Inputs Variables other than depreciation also could be varied, and these changes would alter the calculated cash flows and thus NPV and IRR For example, we could increase or decrease the projected unit sales, the sales price, the variable and/or the fixed costs, the initial investment cost, the working capital requirements, the salvage value, and even the tax rate if we thought Congress was likely to raise or lower taxes Such changes could be made easily in an Excel model, making it possible to see the resulting changes in NPV and IRR immediately This is called sensitivity analysis, and we discuss it later in the chapter when we take up procedures for measuring projects’ risks LF TEST SE 372 In what ways is the setup for finding a project’s cash flows similar to the projected income statements for a new single-product firm? In what ways would the two statements be different? (One would find cash flows; the other, net income.) Would a project’s NPV for a typical firm be higher or lower if the firm used accelerated rather than straight-line depreciation? Why? How could the analysis in Table 12-1 be modified to consider cannibalization, opportunity costs, and sunk costs? Why does working capital appear as both a negative and a positive number in Table 12-1? 12-3 REPLACEMENT ANALYSIS2 In the last section, we assumed that Project S was an entirely new project So all of its cash flows were incremental—they occurred only if the firm accepted the project This is true for expansion projects; but for replacement projects, we must find cash flow differentials between the new and old projects and these differentials are the incremental flows that we analyze We evaluate a replacement decision in Table 12-2, which is set up much like Table 12-1, but with data on both a new, highly efficient machine (which will be depreciated on an accelerated basis) and the old machine (which is depreciated on a straight-line basis) Here we find the firm’s cash flows when it continues using the old machine, then the cash flows when it decides to use the new one Finally, we subtract the old flows from the new to arrive at the incremental cash flows We used Excel in our analysis; but again, we could have used a calculator or pencil and paper Here are the key inputs used in the analysis No additional working capital is needed This section is somewhat technical, but it can be omitted without loss of continuity Chapter 12 Cash Flow Estimation and Risk Analysis Data applicable to both machines: Sales revenues, which would remain constant Expected life of the new and old machines WACC for the analysis Tax rate $2,500 years 10% 40% Data for old machine: Market (salvage) value of the old machine today Old labor, materials, and other costs per year Old machine’s annual depreciation $400 $1,000 $100 Data for new machine: Cost of new machine New labor, materials, and other costs per year $2,000 $400 The key here is to find the incremental cash flows As noted previously, we find the cash flows from the operation with the old machine, then find the cash flows with the new machine, then find the differences in the cash flows This is what we in Parts I, II, and III of Table 12-2 Since there will be an additional expenditure to buy the new machine, that cost is shown in Cell E13 However, we can sell the old machine for $400, so that is shown as an inflow in Cell E14 The net cash outlay at Time is $1,600, as shown in Cell E23 The net cash flows based on the old machine are shown on Row 11, and those for the new one are on Row 23 Then on Row 25, we show the differences in the cash flows with and without replacement—these are the incremental cash flows used to find the replacement NPV When we evaluate the incremental cash flows, we see that the replacement has an NPV of $80.28, so the old machine should be replaced.3 In some instances, replacements add capacity as well as lower operating costs When this is the case, sales revenues in Part II would be increased; and if that led to a need for more working capital, that number would be shown as a Time expenditure along with a recovery at the end of the project’s life These changes would, of course, be reflected in the differential cash flows on Row 25 What role incremental cash flows play in a replacement analysis? SE LF TEST If you were analyzing a replacement project and you suddenly learned that the old equipment could be sold for $1,000 rather than $100, would this new information make the replacement look better or worse? (Better; the net initial investment would be lower.) In Table 12-2, we assumed that output would not change if the old machine was replaced Suppose output would actually double How would this change be dealt with in the framework of Table 12-2? We could have found the incremental cash flows by calculating the differences in the only factors that change, the net cost of the new machine, operating cost savings reduced for the taxes, and the differences in depreciation, which save some taxes This procedure is shown in the lower section of the table The two procedures produce the same incremental cash flows and NPV, as they must 373 A-36 Appendix C Selected Equations and Tables Market value Þ ¼ PV of expected future free cash flows ðV of company Company FCF1 FCF2 FCF1 ỵ ỵ ỵ ẳ ỵ WACCị1 ỵ WACCị1 ỵ WACCị2 Horizon value VCompany at tẳN ị ẳ FCFNỵ1 =WACC gFCF ị Market value of equity ẳ Book value ỵ PV of all future EVAs Vp ¼ Dp rp ^r p ¼ Dp Vp CHAPTER 10 10 1 10 10 After-tax % % of Cost of % of Cost of B CB C B C B CB CB C WACC ẳ@ of A@ cost of A ỵ @ preferred A@ preferred A ỵ @ common A@ common A debt debt stock stock equity equity ¼ wd rd Tị ỵ w p rp ỵ After-tax cost of debt ¼ Interest rate on new debt À Tax savings ¼ rd À rd T ¼ rd ð1 Tị Component cost of preferred stock ẳ rp ẳ Dp Pp Required rate of return ¼ Expected rate of return rs ẳ rRF ỵ RP ẳ D1 =P0 ỵ g ẳ ^r s rs ẳ rRF ỵ RPM ịbi ẳ rRF ỵ rM rRF ịbi ^0 ẳ P ẳ D1 ỵ rs ị1 X Dt tẳ1 ^0 ẳ P ỵ D2 ỵ rs ị2 ỵ ỵ D1 ỵ rs ị1 ỵ rs Þt D1 rs À g rs ¼ ^r s ¼ D1 ỵ Expected g P0 Cost of equity from new stock ẳ re ẳ Retained earnings breakpoint ẳ D1 ỵg P0 ð1 À FÞ Addition to retained earnings for the year Equity fraction CHAPTER 11 NPV ẳ CF0 ỵ ẳ N X tẳ0 CF0 ỵ CF1 CF2 CFN ỵ ỵ ỵ ỵ rị1 ỵ rị2 ỵ rịN CFt ỵ rịt CF1 CF2 CFN ỵ ỵ ỵ ẳ0 ỵ IRRị1 ỵ IRRị2 ỵ IRRịN N X CFt t ẳ0 tẳ0 ỵ IRRÞ w c rs Appendix C Selected Equations and Tables N X N X tẳ0 COFt ẳ ỵ rịt PV costs ẳ CIFt ỵ rịNt tẳ0 ỵ MIRRịN TV ỵ MIRRịN Unrecovered cost Number of at start of year Payback ẳ years prior to ỵ Cash flow during full recovery full recovery year CHAPTER 13 Value of option ¼ Expected NPV with option À Expected NPV without option CHAPTER 14 EBIT ¼ PQ À VQ À F ¼ QBE ¼ F PÀV bL ¼ bU ẵ1 ỵ TịD=Eị bU ẳ bL =ẵ1 ỵ ð1 À TÞðD=Eފ CHAPTER 15 Retained earnings required to help finance new investments ẳ Net income ẵTarget equity ratioịTotal capital budgetị Dividends ẳ Net income CHAPTER 16 Inventory Average Payables Cash conversion ỵ collection deferral ẳ conversion period period period cycle Inventory conversion period ¼ Inventory Cost of goods sold per day Average collection period ðACP or DSOị ẳ Payables deferral period ẳ Receivables Sales=365 Payables Payables ¼ Purchases per day Cost of goods sold=365 Accounts receivable ¼ Sales per day  Length of collection period Receivables ¼ ðADSÞðDSOÞ Nominal annual cost of trade credit ¼ Discount % 365  Discount 100 À Discount % Days credit is À outstanding period Simple interest rate per day ¼ Nominal rate Days in year Interest charge for month ¼ ðRate per dayÞðAmount of loanÞðDays in monthÞ Approximate annual rateAdd-on ¼ Interest paid ðAmount receivedÞ=2 A-37 A-38 Appendix C Selected Equations and Tables CHAPTER 17 AFN ¼ Projected asset À ¼ increase ðA0*=S0 ÞÁS À Full capacity ¼ sales Spontaneous liabilities À increase ðL0*=S0 ÞÁS Increase in retained earnings À MS1 ð1 À PayoutÞ Actual sales Percentage of capacity at which fixed assets were operated Target fixed assets=Sales ¼ Actual fixed assets Full capacity sales Required level ¼ ðTarget fixed assets=SalesịProjected salesị of fixed assets CHAPTER 18 Exercise value ẳ Current stock price Strike price V ẳ PẵNd1 ị XerRF t ẵNd2 ị lnP=Xị ỵ ẵrRF ỵ 2 =2ịt p  t p d2 ẳ d1  t d1 ¼ Values of the Areas under the Standard Normal Distribution Function z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 0000 0398 0793 1179 1554 1915 2257 2580 2881 3159 3413 3643 3849 4032 4192 4332 4452 4554 4641 4713 4773 4821 4861 4893 0040 0438 0832 1217 1591 1950 2291 2611 2910 3186 3438 3665 3869 4049 4207 4345 4463 4564 4649 4719 4778 4826 4864 4896 0080 0478 0871 1255 1628 1985 2324 2642 2939 3212 3461 3686 3888 4066 4222 4357 4474 4573 4656 4726 4783 4830 4868 4898 0120 0517 0910 1293 1664 2019 2357 2673 2967 3238 3485 3708 3907 4082 4236 4370 4484 4582 4664 4732 4788 4834 4871 4901 0160 0557 0948 1331 1700 2054 2389 2704 2995 3264 3508 3729 3925 4099 4251 4382 4495 4591 4671 4738 4793 4838 4875 4904 0199 0596 0987 1368 1736 2088 2422 2734 3023 3289 3531 3749 3944 4115 4265 4394 4505 4599 4678 4744 4798 4842 4878 4906 0239 0636 1026 1406 1772 2123 2454 2764 3051 3315 3554 3770 3962 4131 4279 4406 4515 4608 4686 4750 4803 4846 4881 4909 0279 0675 1064 1443 1808 2157 2486 2794 3078 3340 3577 3790 3980 4147 4292 4418 4525 4616 4693 4756 4808 4850 4884 4911 0319 0714 1103 1480 1844 2190 2517 2823 3106 3365 3599 3810 3997 4162 4306 4429 4535 4625 4699 4761 4812 4854 4887 4913 0359 0753 1141 1517 1879 2224 2549 2852 3133 3389 3621 3830 4015 4177 4319 4441 4545 4633 4706 4767 4817 4857 4890 4916 Appendix C Selected Equations and Tables z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 2.4 2.5 2.6 2.7 2.8 2.9 3.0 4918 4938 4953 4965 4974 4981 4987 4920 4940 4955 4966 4975 4982 4987 4922 4941 4956 4967 4976 4982 4987 4925 4943 4957 4968 4977 4982 4988 4927 4945 4959 4969 4977 4984 4988 4929 4946 4960 4970 4978 4984 4989 4931 4948 4961 4971 4979 4985 4989 4932 4949 4962 4972 4979 4985 4989 4934 4951 4963 4973 4980 4986 4990 4936 4952 4964 4974 4981 4986 4990 CHAPTER 19 Direct quotation: U:S: $ required unit of foreign currency Indirect quotation: Units of foreign currency U: S: $ Forward exchange rate ỵ rh ị ẳ Spot exchange rate ỵ rf ị Ph ¼ ðPf ÞðSpot rateÞ Spot rate ¼ Ph Pf CHAPTER 20 Price paid for bond with warrants ¼ Straight-debt value of bond ỵ Value of warrants Par value of bond given up Shares received Par value of bond given up Conversion ratio CRị ẳ Pc Conversion price Pc ị ẳ A-39 This page intentionally left blank INDEX A Abandonment option, 402 Abandonment/shutdown options, 402–403 Abercrombie & Fitch, 549 Accounting income vs cash flow, 365 Accounting standards, global, 96 Accounts payable (trade credit), 509–511 Accounts receivable, 506–509 credit policy, 506, 507 modifying, 540 monitoring, 508 Accruals, 516 Accrued liabilities, 516 Acquiring company, 661 Acquisitions and mergers, 655 Actual (realized) rate of return, 276 Additional funds needed (AFN), 530 Add-on interest, 514 Adjustable rate preferred stock, 627 AFN equation, 530–534 After-tax cost of debt, 311 Aggressive approach, 492 Airbus, 335 Alternative estimates, averaging the, 317 Alternative minimum tax (AMT), 71 American Depository Receipts (ADRs), 612 American terms, 601 Amortization, 62 Amortized loan, 150–151 Amortized schedule, 151 Anheuser-Busch, 398–399 Annual compounding, 145 Annual depreciation rates, 396 Annual percentage rate (APR), 147 Annual report, 54 Annuity, 133–134 future value of an ordinary, 134–136 present value of an ordinary, 137–138 Annuity due, 134 Annuity payments (PMT), finding, 138 Arbitrage, 670 Arbitrage operations, 670 Arrearages, 625 Asset management ratio, 88 Assets, opportunity costs association with, 367 purchase below replacement cost, 657 Asymmetric information, 439 Auction rate preferred stock (ARPS), 628 Average, collection period (ACP), 495 stock’s beta, 245 tax rate, 69 B Balance sheet, 56–60 forecasted, 537 Bank loans, 511–515 cost of, 513 line of credit, 512 revolving credit agreement, 513 Bankruptcy, and reorganization, 219 effect on capital structure, 437 Banks and underwriters, 37 Barings, 558 Base-case, NPV, 376 scenario, 378 Basic earning power (BEP) ratio, 97 Basic EPS, 646 Before-tax cost of debt, 310 Behavioral finance, 49 Behavioral finance theory, 49 Benchmarking, 104 Best Buy Company, 488 Best-case scenario, 378 Beta, and CAPM, concerns about, 257 coefficient, 245 changes in, 256 risk, within-firm and, 381–382 Bird-in-the-hand fallacy, 459 Black-Scholes Option Pricing Model (OPM), 565, 566–570 Boeing, 335 Bond, 195 Bond characteristics, 196–200 call provisions, 198 coupon interest rate, 197 maturity date, 197 other features, 199 par value, 197 sinking funds, 199 Bond markets, 220 Bond ratings, 215 changes in, 218 criteria for, 216 importance of, 217 Bond riskiness, assessing, 210–214 Bond risks, interest rate risk, 210 interest rate vs reinvestment rate, 213 reinvestment rate risk, 213 Bond valuation, 200–203 Bond values, changes over time, 206–209 Bond yields, 203–205 yield to call, 204 yield to maturity, 203 Bondholders vs stockholders, 20 Bondholders, stockholders, and managers, conflicts between, 18–21 Bonds and valuation, 194 Bonds with semiannual coupons, 209–210 Bonds, bankruptcy and reorganization, 219 Bonds, issuers of, 195–196 Bonds, most active, 221 Bonds, risk in market, 194 Bond-yield-plus-risk-premium approach, 315 Breakup value, 658 Business activity, 185 Business and financial risk, 419–429 Business climate, 616 Business decisions, interest rates and, 185–187 Business ethics, 15–18 company behavior, 15 employees and unethical behavior, 17 unethical behavior, 16 Business organization, forms of, 6–8 Business risk, 419 Business trends, important, 14–15 C Call option, 558 Call option, factors affecting the value, 560 Call provision, 198 Cannibalization, 367, 371 Capital, alternative sources of, 472 external, cost of raising, 319 increased cost of, 318 Capital allocation process, 28–29 Capital Asset Pricing Model (CAPM), 240–249, 268 and Beta, concerns about, 257 approach, cost of retained earnings, 314 I-1 I-2 Index Capital Asset Pricing Model (CAPM) (continued ) beta coefficient, 245 estimating market risk premium, 252 expected portfolio returns, 241 portfolio risk, 242 Capital budget, optimal, 406, 407, 408 Capital budgeting, 336 Asian/Pacific region, 380 basics of, 335 competition in aircraft industry, 335 decision criteria, 356 internal rate of return, 341–344 international, 614–616 methods and conclusions, 355–356 modified internal rate of return, 347–349 net present value, 338–341 overview, 336–338 payback period, 353–355 post-audit, 408–409 real options and other topics, 398 reinvestment rate assumptions, 346–347 risk analysis in, 374–375 Capital component, 309 Capital gain or loss, 70 Capital gains, corporate, 73 reasons preferred, 459 vs dividends, 457–460 Capital gains yield, 276 Capital intensity ratio, 533 Capital leases, 630 Capital market, 5, 30 international money and, 609–612 Capital rationing, 408 Capital structure(s), and leverage, 416 determining optimal, 429–435 effect of bankruptcy, 437 effect of taxes, 436 global, 444 international, 616–617 leading auto companies, 454 optimal, 432 signaling theory, 439 target, 417–418 trade-off theory, 438 variations in, 443–445 Capital structure changes, WACC and, 430 Capital structure decisions, checklist for, 441–443 Capital structure theory, 435–441 CAPM (See also Capital Asset Pricing Model) Carry-back, corporate loss, 73 Carry-forward, corporate loss, 73 Carve-out, 674 Cash, and marketable securities, 501–504 currency, 502 demand deposits, 502 Cash budget, 498–501 Cash conversion cycle (CCC), 495–497 calculating from financial statements, 496 calculating the targeted, 495 Cash flow (CFt), 142 incremental, 366 timing of, 366 uneven, 142–143 vs accounting income, 365 Cash flow estimation, and risk analysis, 364 concepts in, 364–368 Home Depot growth, 364 Cash flow statement, 62–66 massaging, 65 Cash flows, earnings, and dividends, 467 normal and nonnormal, 344 CCC (See also cash conversion cycle) CIT Corporation, 623–624 Citigroup Inc., 37 Class life, 396 Classified stock, 272 Clientele effect, 461 Clienteles, 461 Closely held corporation, 40 Coca-Cola, 178, 179 Coefficient of variation (CV), 238 Collection policy, 506 Commercial, bank, 34 paper, 515 Commodity futures, 572 Commodity price exposure, 580 Common stock, approaches to valuing, 290 cost of new, 318–320 EVA approach, 290 external equity, 320 floatation costs, 318 increased cost of capital, 318 market for, 40–43 P/E multiple approach, 290 types of, 272–273 Compound interest, 125 vs simple, 125 Compounding, 124 Compounding periods, semiannual and other, 145–147 Compounding process, graphic view, 129 Congeneric merger, 659 Conglomerate merger, 659 Conservative approach, 494 Consol, 140 Consolidated corporate tax returns, 73 Constant growth (Gordon) model, 278 conditions for, 282 Constant growth stock, 278–283 illustration, 279 Constraints, dividend, 472 Contracts, forward and futures, 571–574 Conversion, price Pc, 640 ratio, CR, 640 value, Ct , 641 Convertible, bond, 199 ratio and conversion price, 640 security, 639 Convertibles, 639–645 and warrants, comparison of, 645–646 component cost of, 641 conversion ratio and conversion price, 640 preferred stock, leasing, and warrants, 623 reducing agency cost, 645 reporting earnings when outstanding, 646–647 used in financing, 644 Corporate, or strategic, alliances, 672 Corporate (within-firm) risk, 375 Corporate alliances, 672–673 Corporate bonds, 196 types of, 215 Corporate capital gains, 73 Corporate finance, Corporate loss carry-back and carry-forward, 73 Corporate managers, implications of risk and returns, 258–259 Corporate objectives, statement of, 527 Corporate raider, 19 Corporate scope, 527 Corporate strategies, 527 Corporate tax returns, consolidated, 73 Corporate taxes, 71 Corporate valuation model, 286, 288 vs discounted dividend models, 290 Corporation(s), closely held, 40 global, 593 interest and dividends paid by a, 72 interest and dividends received by a, 72 multinational, 593 publicly owned, 41 valuing the entire, 286–291 Correlation, 243 Correlation coefficient, 243 Cost of bonds with warrants, 638 Index Cost of capital, 306 adjusting for risk, 323–325 creating value at GE, 306 definitions, 309–310 global variations in, 322 increased, 318 marginal, 406 problems with estimates, 325–326 risk-adjusted, 375 Cost of debt, 310–312 Cost of money, 163–164 Cost of new common stock, 313, 318–320 and flotation costs, 318 external equity, 320 increased cost of capital, 318 Cost of preferred stock, 312 Cost of retained earnings, 313 alternative estimates average, 317 bond-yield-plus-risk-premium approach, 315 CAPM approach, 314 discounted cash flow (DCF) approach, 315 dividend-yield-plus-growth-rate approach, 315 Costly trade credit, 511 Costs associated with assets, 367 Country risk, 612 measuring, 613 Coupon interest rate, 197 Coupon payment, 197 Coupons, semiannual, bonds with, 209–210 Credit availability, increased, 635 Credit instruments, new opportunities and risks, 577 Credit period, 506 Credit policy, 506 setting and implementing, 507 Credit score, 507 Credit standards, 506 Credit terms, 507 Cross rate, 600 Crossover rate, 350 Cumulative, 625 Currency board arrangement, 599 Currency, 502 Current asset financing, aggressive approach, 492 approaches compared, 494 conservative approach, 494 maturity matching approach, 492 self-liquidating approach, 492 Current asset financing policy, 492, 491–494 Current asset investment policies, 490–491 Current ratio, 87 Current yield, 205 D Days sales outstanding (DSO), 89 Dealer market, 40 Debenture, 215 Debt, financing, used to constrain managers, 440 management ratio, 91–94 ratio, 93 Declaration date, 469 Default risk, 214–220 bankruptcy and reorganization, 219 bond ratings, 215, 216–219 debentures, 215 mortgage bonds, 215 subordinated debentures, 215 types of corporate bonds, 215 Default risk premium (DRP), 172 Defensive merger, 658 Defensive tactics for mergers, 669 Demand deposits, 502 Depreciation rates, effect of different, 371 Depreciation, 62 Derivative(s), 33, 556 and risk management, 552 background on, 556–557 commodity price exposure, 580 futures, 578 inverse floater, 576 other types of, 574–577 security price exposure, 578 structured notes, 575 swaps, 574, 579 use and misuse of, 581 used to reduce risk, 577–581 Derivatives market, Barings and Sumitomo, 558 Detachable warrants, 636 Determinants of market interest rates, 168–174 Diluted EPS, 646 Direct quotations, 602 Discount, 506 Discount bond, 202 Discount on forward rate, 603 Discounted cash flow (DCF) approach, 315 Discounted dividend model, 275–278 vs corporate valuation, 290 Discounted payback, 354 Discounting, 130 Process for, graphic view, 131 Diversifiable risk, 243 Diversification, 657 Diversifying overseas, benefits of, 250 Divestiture, 674–676 types of, 674 illustrations, 674 Dividend distribution, 456 Dividend irrelevance theory, 458 Dividend policy, alternative sources of capital, 472 constraints on, 472 effects of, 473 factors influencing, 471–473 in practice, establishing, 461–470 investment opportunities, 472 I-3 Dividend policy issues, 460–461 Dividend reinvestment plan (DRIP), 470–471 Dividend yields, 276 around the world, 466 Dividends, and interest paid by a corporation, 72 and interest received by a corporation, 72 earnings, and cash flows, 467 expected, basis for stock value, 277 payment procedures, 469 reasons preferred, 458 vs capital gains, 457–460 vs growth, 280-282 Dividend-yield-plus-growth-rate approach, 315 Domestic vs multinational financial management, 596–597 Dow Jones Industrial Average, 45 DuPont equation, 100–101 Duration, 211 E Earnings, cash flows, and dividends, 467 reporting when warrants or convertibles are outstanding, 646–647 EBITDA, 62 Economic value added (EVA) vs net income, 107 Effective (equivalent) annual rate (EFF % or EAR), 148 Efficient markets hypothesis (EMH), 47, 49 Enron, 53–54 Equilibrium, 12, 302 Equilibrium stock prices, changes in, 302–303 Equity residual method, 662 Equivalent annual annuity (EAA) method, 383, 384 Eurobond, 609 Eurocredits, 609 Eurodollar, 609 European terms, 601 EVA approach to valuing stock, 290 Excess capacity adjustments, 533 Exchange and interest rates, inflation and, 608–609 Exchange rate, 598 Exchange risk rate, 612 Ex-dividend date, 469 Executive compensation, intrinsic values, stock prices, and, 10–13 Exercise value vs option price, 561 Exercise value, 561 Expansion project, analysis of, 369–372 cannibalization, 371 changes to inputs, 372 I-4 Index Expansion project (continued ) depreciation rates, 371 opportunity costs, 371 sunk costs, 371 Expected dividends, basis for stock value, 277 Expected inflation, impact of, 253 Expected rate of return, r, 234, 276, 313 Expected return on a portfolio, 241 Expected risk premium, 315 Expected total return, 276 External capital, cost of raising, 319 External equity, when to use, 320 Externality, 367 environmental, 368 negative within-firm, 367 positive within-firm, 368 ExxonMobil, intrinsic stock value, 299–292 F Fair value in mergers, 670 Federal budget deficits or surpluses, 184 Federal reserve policy, 183 Finance, capital markets, corporate, defined, 4–6 investments, jobs in, vs economics and accounting, within an organization, Finance theory, behavioral, 49 Financial analysis on the Internet, 67 Financial calculators, time value problems, 126, 128 Financial futures, 572 Financial institutions, 34–38 Financial leases, 630 Financial leverage, 425 Financial management, multinational vs domestic, 596–597 multinational, 592 overview, striking the right balance, Financial markets, 30–34 and institutions, 26 necessary for growing economy, 26–27 recent trends, 31–34 types of, 30–31 Financial merger, 662 Financial plan, 528 Financial planning, AFN equation, 530–534 and forecasting, 525 General Electric, 525–528 excess capacity adjustments, 533 sales forecast, 528–529 strategic, 527–528 Financial report, balance sheet, 56–60 Financial risk, 419–423, 424–429 Financial services corporation, 34 Financial statement analysis, 84 analyzing stocks, 84 Financial statements, and reports, 54 cash flow, and taxes, 53 forecasted, 534 interpreting, 108–109 modifying accounts receivable, 540 modifying inventories, 540 other special studies, 541 quality of, 53 warning signs, 105 Financing, off balance sheet, 630 short-term, 516–517 use of warrants, 637 Financing mergers, 670 Financing policies, current asset, 491–494 Fixed assets turnover ratio, 90 Fixed-peg arrangement, 599 Fixed-rate bond, 197 Flexibility option, 405–406 Floatation cost, 319 added to project cost, 318 Floating-rate bond, 197 Flotation cost adjustment, 319 Ford Motor Company, 121 Forecasted balance sheet, 537 ratios and EPS, 537 Forecasted financial statements, 534–538 balance sheet, 537 income statement, 537 inputs, 534 ratios and EPS, 537 used for operations, 538 Forecasted income statement, 537 Foreign bonds, 196, 609 Foreign currency quotations, interbank, 601 Foreign exchange rate, cross rates, 600 quotations, 600–602 Foreign trade deficit, 184 Formula approach, finding FV, 126 Forward and futures contracts, 571–574 Forward contract, 571 Forward exchange rate, 603 Founders’ shares, 273 Fractional time periods, 149 Free cash flow, 67 and small businesses, 68 Free trade credit, 511 Freely-floating regime, 599 Friendly merger, 661 Friendly vs hostile takeovers, 660–661 Funds, spontaneously generated, 530 Future value (FV), 124–129 financial calculators, 126, 128 formula approach, 126 graphic view of compounding process, 129 of an ordinary annuity, 134–136 of uneven cash flow stream, 143–144 spreadsheets, 127 step-by-step approach, 125 Futures, 578 and forward contracts, 571–574 Futures contract, 571 Futures market, 30 FVAN, 134 G General Electric, 2–3, 306–307, 525–528 creating value at, 306 Global accounting standards, 96 Global corporations, 593 Global perspective boxes, 14, 38, 96, 250, 322, 380, 444, 466, 558, 613 Global variations in the cost of capital, 322 Going public, 41 Golden parachutes, 669 Gordon-Lintner’s theory, 459 Growth option, 400 Growth (expansion) options, 400–402 Growth rate, g, 276 Growth vs dividends, 280–282 H Half-year convention, 396 Hamada equation, 431 Hedging, 578 Herman Miller, Inc., 505 Historical risk premium, 315 Holder-of-record date, 469 Home Depot Inc., 364–365, 366, 367 Horizon (terminal) value, 284 Horizontal merger, 659 Hostile merger, 661 Hostile takeover, 19 Hostile vs friendly takeovers, 660–661 Humped yield curve, 176 Hybrid financing, 623 I Incentive signaling, 460 Income bond, 200 Income statement, 60, 61, 62 forecasted, 537 Income taxes, 69–74 Index Incremental cash flow, 366 Indenture, 215 Independent projects, 340, 343, 352 Indexed (purchasing power) bond, 200 Indirect quotations, 602 Inflation, 163 and interest rates, link between, 178 impact of expected, 253 interest and exchange rates, 608–609 Inflation premium (IP), 170 Information content (signaling), 460 Information technology (IT), 14 Initial public offering (IPO) market, 41 for 2007, 42 Inputs, changes to, 372 Interbank foreign currency quotations, 601 Interest, simple vs compound, 125 Interest and dividends, paid by a corporation, 72 received by a corporation, 72 Interest charges, calculating, 513–514 Interest rate(s), 162 and business decisions, 185–187 and inflation, link between, 178 I, finding, 132–133, 139 comparing, 147–149 determinants of market, 168–174 inflation, and exchange rates, 608–609 low as stimulus, 162 term structure of, 175 yield curve used to estimate future, 180–182 Interest rate (price) risk, 210 Interest rate levels, 165–168 macroeconomic factors influence, 183–185 Interest rate parity, 604–605 Interest rate risk, 173 Internal rate of return (IRR), 341–344 International Accounting Standards Committee, 96 International capital budgeting, 614–616 International capital structures, 616–617 International credit markets, 609 International factors, 184 International money and capital markets, 609–612 International money system, 598–600 terminology, 598 International stock, markets, 611 investing in, 613–314 Internet, financial analysis on the, 67 Intrinsic value, 12, 273, 274 investor concerns, 274 stock prices, and executive compensation, 10–13 vs stock price, 273–275 Inventories, 504–505 modifying, 540 Inventory conversion period, 495 Inventory turnover ratio, 89 Inverse floater, 576 Inverted (abnormal) yield curve, 176 Investing overseas, 612 Investment, vertically integrated, 594 Investment bank, 34 Investment banker role, 668–671 arbitrage operations, 670 arranging mergers, 669 developing defensive tactics, 669 establishing fair value, 670 financing mergers, 670 Investment horizon, 213 Investment opportunities, 472 Investment policies, current asset, 490–491 Investment timing options, 403–405 Investment-grade bond, 216 Investors, implications of risk and returns, 258–259 IRR compared to NPV, 343 IRR schedule, 406 J Joint venture, 673 Junk bond, 216, 670 K Kellogg Co., 416–417 L Leases, evaluation by the lessee, 632 factors affecting decisions, 635 financial statement effects, 630 off balance sheet financing, 630 SFAS #13, 630 types of, 629–630 Leasing, 629–635 warrants, convertibles, and preferred stock, 623 Lessee, 629 Lessor, 629 Leverage, capital structure and, 416 Leveraged buyout (LBO), 673 Limited liability company (LLC), Limited liability partnership (LLP), Line of credit, 512 Liquid asset, 87 Liquidation, 674 Liquidity premium (LP), 173 high-grade bond, 173 I-5 Liquidity ratio, 87–88 Lockbox, 502 Long hedges, 578 Long-term Equity AnticiPation Security (LEAPS), 560 Low-regular-dividend-plus-extras, 467 M Macroeconomic factors, and interest rate levels, 183–185 Managed-float regime, 599 Managers, stockholders, and bondholders, conflicts between, 18–21 vs stockholders, 18 Managers’ personal incentives, 658 Marginal cost of capital, 406 Marginal investor, 12, 275 Marginal tax rate, 69 Market, initial public offering (IPO), 41 measuring the, 45 recent performance, 45 Market (beta) risk, 375 Market efficiency, conclusions about, 50 Market for common stock, 40–43 Market instruments, summary of, 32 Market interest rates, determinants of, 168–174 Market multiple analysis, 665 Market portfolio, 244 Market price of a bond with warrants, 636 Market price, 12, 276 Market risk, 243 premium, RPM, 251 estimating, 252 Market value ratios, 98–99 Market/book (M/B) ratio, 99 Marketable securities, 503 cash and, 501–504 Markets, tale of three, 229 Maturity date, 197 Maturity matching approach, 492 Maturity risk premium (MRP), 173 McDonald’s, global Big Mac prices, 606–607 Merger, 656 Mergers, analysis of, 661–668 and acquisitions, 655 arbitrage operations, 670 arrangement of, 669 asset purchase below replacement cost, 657 corporate alliances, 672–673 defensive tactics for, 669 details of, 667 discounted cash flow analysis, 662 diversification, 657 establishing fair value, 670 I-6 Index Mergers (continued ) estimating discount rate, 664 financing of, 670 level of activity, 659–660 managers’ personal incentives, 658 post-merger control, 667 pro forma cash flow statements, 662 rationale for, 656–658 recent large, 671 reshaping corporate landscape, 655 role of investment bankers, 668–671 samples of large, 660 setting bid price, 665 tax considerations, 657 types of, 659 value created, 671–672 valuing cash flows, 664 valuing the target firm, 662 Microsoft, 456–457, 486 risk management, 584 Mission statement, 527 Moderate investment current asset policy, 491 Modified IRR (MIRR), 347–349 Modigliani-Miller theory, 435 and Yogi Berra, 436 Monetary arrangements, current, 599 Money market, 30 Money market funds, 35 Monte Carlo simulation, 379 Mortgage bond, 215 Multinational (global) corporations, 593–596 Multinational financial management, 592 U.S firms, 592 Multinational vs domestic financial management, 596–597 Multiple IRRs, 344–345 Municipal bonds, 196 Mutual funds, 35 Mutually exclusive projects, 340, 343, 352 N Nasdaq Composite Index, 45 Nasdaq market, 39–40 National Whistle-Blower Center, 17 Natural hedge, 556 Negative working capital, operating with, 497 Net income vs economic value added (EVA), 107 Net present value (NPV), 338–341 compared to IRR, 343 profiles, 349–353 Net present value profile, 349 Net working capital, 59, 489 Nominal (quoted) interest rate, INOM, 147 Nominal (quoted) risk-free rate, rRF, 170 Nonconstant growth stocks, valuing, 283–286 Nonnormal cash flows, 344 Normal cash flows, 344 Normal yield curve, 176 NPV (See also net present value) Number of periods (N), finding, 138 Number of years, N, finding, 134 O Occupational Safety and Health Administration (OSHA), 17 Off balance sheet financing, 630 Operating breakeven, 421 Operating income, 61 Operating leases, 629 Operating leverage, 421 Operating margin, 95 Operating merger, 662 Operating plan, 528 Opportunity cost, 130, 367, 371 and assets, 367 Optimal capital budget, 406, 407, 408 Optimal capital structure, 417, 432 determining, 429–435 Optimal dividend policy, 458 Option, 558–563 types and markets, 558 Option price vs exercise value, 561 Option pricing models, assumptions and equations, 567 illustration, 568 introduction to, 563–566 (See also Black-Scholes Option Pricing Model) Option value, 401 Ordinary (deferred) annuity, 134 Original issue discount (OID) bond, 197 Original maturity, 198 Over-the-counter (OTC) market, 39 P P/E multiple approach to valuing stock, 290 Par value, 197 Partnership, Payables deferral period, 495 Payback period, 353–355 Payment (PMT), 142 Payment date, 470 Payment procedures, 469 Perfect hedge, 579 Permanent current assets, 492 Perpetuity, 140–141 Physical location exchanges, 39 Poison pills, 669 Political risk, 615 Portfolio context, risk in, 240–249 Portfolio risk, 242, 245 beta coefficient, 245 Post-audit, 408 Post-merger control, 667 Preemptive right, 272 Preferred stock, 291–292, 624–627 advantages and disadvantages, 627 basic features, 625 leasing, warrants, and convertibles, 623 Premium bond, 203 Premium on forward rate, 603 Present value (PV), 124, 130–132 graphic view of discounting process, 131 of an ordinary annuity, 137–138 Price/earnings (P/E) ratio, 98 PricewaterhouseCoopers (PWC), 14 Primary EPS, 646 Primary market, 30 Prime rate, 513 Private equity investments, 673 Private market, 31 Probability distribution, 233 Procter & Gamble, 552–553 Production opportunities, 163 Profit margin, 94 Profitability ratios, 95–97 Progressive tax, 69 Project cost, flotation costs added to, 318 Promissory note, 511 Proprietorship, Proxy, 271 Proxy fight, 271 Public market, 31 Publicly owned corporation, 41 Purchasing power parity (PPP), 605–608 Pure expectations theory, 180 Put option, 559 valuation of, 590–591 Putable bond, 200 Put-call parity, 590 PVAN, 138 Q Quick (acid test) ratio, 88 R Raider, corporate, 19 Rate of return, 313 and risk, relationship, 251–257 changes in beta coefficient, 256 changes in risk aversion, 255 impact of expected inflation, 253 Index implications for corporate managers, 258–259 implications for investors, 258–259 risk and, 229 Ratio analysis, 86 Ratios, analyzing effects of changing, 540–541 and EPS, 537 in different industries, 102 summary of, 103 uses and limitations of, 105–106 Real options, 400 and capital budgeting topics, 398 introduction to, 399–400 Real risk-free rate of interest, r*, 169 Realized rate of return, 241 Regression, used to improve financial forecasts, 539–540 Regression analysis, 539 Regular interest, 514 Reinvestment rate assumptions, 346–347 Reinvestment rate risk, 174, 213 Relaxed current asset policy, 491 Relevant risk, 245 Reorganization, bankruptcy and, 219 Repatriation of earnings, 615 Replacement analysis, 372–374 Replacement chain (common life) approach, 382 Replacement projects, 366 Reports, financial statement, 54 Required rate of return, 276, 313 Required returns, 238, 313 risk aversion and, 238 Reserve borrowing capacity, 440 Residual dividend model, 462, 463 Residual value, 635 estimated, 635 Restricted investment current asset policy, 491 Retained earnings, 56–58, 61, 62 Retained earnings breakpoint, 320 Retention ratio, 530 Retirement concerns, 122 Return on common equity (ROE), 97 Return on total assets (ROA), 96 Returns, stock markets and, 43–46 Revolving credit agreement, 513 Risk, 163, 232 adjusting the cost of capital for, 323–325 business and financial, 419–429 changes in beta coefficient, 256 changes in risk aversion, 255 coefficient of variation, 238 derivatives used to reduce, 577–581 impact of expected inflation, 253 implications for corporate managers, 258–259 implications for investors, 258–259 measuring stand-alone, 236, 376–381 measuring with historical data, 237 reasons to manage, 553–556 stand-alone, 232–240 standard deviation, 236 statistical measures of stand-alone, 233 Risk analysis, and cash flow estimation, 364 Home Depot growth, 364 in capital budgeting, 374–375 Risk and rates of return, 229 relationship, 251–257 Risk and return, trade-off between, 239 Risk aversion, 239 and required returns, 238 changes in, 255 Risk in portfolio context, the CAPM, 240–249 Risk management, 581–583 approach to, 582 derivatives and, 552 Risk premium (RP), 217, 239, 315 Risk premium for stock, 251, 252 Risk-adjusted cost of capital, 375 Riskless hedge, 563 Risks, credit instruments create new opportunities and, 577 ROE, potential misuses of, 107–108 S S corporation, 7, 74 Sale and leaseback, 629 Sales forecast, 528–529 Sarbanes-Oxley Act, 5, 17, 53 Scenario analysis, 378 Secondary market, 30 Secured loan, 516 Security in short-term financing, 516–517 Security Market Line (SML) equation, 253 Security price exposure, 578 Self-liquidating approach, 492 Semiannual and other compounding periods, 145–147 Semiannual compounding, 145 Semiannual coupons, bonds with, 209–210 Sensitivity analysis, 376 SFAS #13, 630 Share repurchases, 456 Shareholder, distributions, dividends and share repurchases, 456 value, stock prices and, 8–10 wealth maximization, 9, 14 I-7 Short hedges, 578 Short-term financing, use of security in, 516–517 Signal, 440, 460 Signaling theory, 439 Simple interest, 125, 514 vs compound, 125 Sinking fund provision, 199 Sinking funds, 199 Small business, taxation of, 74 Special studies, 541 Speculation, 578 Spin-off, 674 Spontaneous funds, 516 Spontaneously generated funds, 530 Spot market, 30 Spot rate, 603 Spreadsheets, TVM problems, 127 Stand-alone risk, 232, 233, 234–240, 375 coefficient of variation, 238 measuring, 236, 376–381 statistical measures of, 233 Standard deviation (sigma), 236, 237 Starbucks, 83 Statement of cash flows, 62–66 Statement of corporate objectives, 527 Statement of stockholders’ equity, 66 Step-by-step approach, finding FV, 125 Stepped-up exercise prices, 638 Stock, types of common, 272–273 Stock dividends, 474 and stock splits, 473–475 Stock market(s), 38–40 and returns, 43–46 efficiency, 46–50 equilibrium, 301–303 global indices, 610 international, 611 OTC and Nasdaq, 39 physical location, 39 reporting, 43 returns, 46 transactions, types of, 41 Stock options, expensing executive, 565 Stock prices, and shareholder value, 8–10 effect of split and dividends, 474 intrinsic values, and executive compensation, 10–13 recent trends, 231–232 vs intrinsic value, 273–275 Stock repurchases, 475, 476–479 advantages of, 477 conclusions on, 478 disadvantages of, 478 effects of, 476 Stock splits, 473 and dividends, effect on stock prices, 474 Stock value, expected dividends as basis for, 277 I-8 Index Stockholder rights, control of the firm, 271 preemptive right, 272 Stockholders, legal rights and privileges, 270–272 managers, and bondholders, conflicts between, 18–21 vs bondholders, 20 vs managers, 18 Stockholders’ equity, 55–57, 62, 66 Stocks, and their valuation, 269 searching for the right stock, 269 that don’t pay dividends, evaluating, 287 Strategic alliances, 672 Strategic business plan, 337 Strategic planning, 527–528 Strike (exercise) price, 558 Structured note, 575 Subordinated debenture, 215 Sumitoma Corporation, 558 Sunk cost, 366, 371 Supernormal (nonconstant) growth, 283 Supply chain management, 505 Survivorship bias, 252 Sustainable growth rate, 531 Swap, 574, 579 Symmetric information, 439 Synergy, 657 T Takeover, 271 hostile, 19 hostile vs friendly, 660–661 Target capital structure, 417–418 Target cash balance, 499 Target company, 661 Target firm, valuing, 662 Target payout ratio, 457 setting, 462 Tax considerations, 657 Tax depreciation, 396–397 Tax loss carry-back or carry-forward, 73 Tax returns, consolidated corporate, 73 Taxation of small business, 74 Taxes, corporate, 71 effect on capital structure, 436 income, 69–74 individual, 69 Temporary current assets, 492 Tender offer, 661 Term structure of interest rates, 175–176 Terminal (horizon) date, 284 3M’s cost of capital, 334 Time line, 123 Time preferences for consumption, 163 Time value of money, 122 Times-interest-earned (TIE) ratio, 94 Total assets, total debt to, 93 Total assets turnover ratio, 91 Total debt to total assets, 93 Total return, 207 Trade credit, 509 Trade-off theory, 438 Trading in foreign exchange, 602–604 Treasury bonds, 194, 196 almost riskless, 171 Trend analysis, 99 U Unequal project lives, 382–384 conclusions, 384 equivalent annual annuities (EAA), 383 replacement chains, 382 Unethical behavior, and employees, 17 consequences of, 16 Uneven (nonconstant) cash flows, 142 Uneven cash flows, 142–143 solving for I, 144–145 Uneven cash flow stream, future value of, 143–144 Unlevered beta, 432 V Vertical merger, 659 Vertically integrated investment, 594 W WACC (See weighted average cost of capital) Warrant(s), 199, 635–639 and convertibles, comparison of, 645–646 component cost of bonds with, 638 convertibles, preferred stock, and leasing, 623 initial market price of a bond, 636 problems with, 639 reporting earnings when outstanding, 646–647 use in financing, 637 Weighted average cost of capital (WACC), 310, 321 and capital structure changes, 430 factors affecting, 321–323 factors firm can control, 322 factors firm cannot control, 321 overview, 307–309 Whistle-blowers, protection for, 17 White knight, 669 White squire, 669 Window dressing techniques, 106 Within-firm and beta risk, 381–382 Working capital, 58, 489 background, 489–490 operating with negative, 497 Working capital management, 488 Best Buy, 488 WorldCom, 53–54 Worst-case scenario, 378 Y Yield curve, 175 shape determined, 176–180 used to estimate future interest rates, 180–182 Yield spread, 217 Yield to call (YTC), 204 Yield to maturity (YTM), 203 Yogi Berra, 436 Z Zero coupon bond, 197 Zero growth stock, 282 FREQUENTLY USED SYMBOLS/ABBREVIATIONS ACP ADR APR A/R b bL bU BEP BVPS CAPM CCC CF CFPS CR CV Dp Dt DCF D/E DPS DRIP DRP DSO e EAR EBIT EBITDA EPS EVA F FCF FVN FVAN g I INT IP IPO IRR I/YR ln(P/X) LP M M/B MIRR MRP MVA N N(di) NPV NWC Average collection period American depository receipt Annual percentage rate Accounts receivable Beta coefficient, a measure of an asset s riskiness Levered beta Unlevered beta Basic earning power Book value per share Capital Asset Pricing Model Cash conversion cycle Cash flow; CFt is the cash flow in Period t Cash flow per share Conversion ratio Coefficient of variation Dividend of preferred stock Dividend in Period t Discounted cash flow Debt-to-equity ratio Dividends per share Dividend reinvestment plan Default risk premium Days sales outstanding Approximately equal to 2.7183 Effective annual rate, EFF% Earnings before interest and taxes; operating income Earnings before interest, taxes, depreciation, and amortization Earnings per share Economic value added (1) Fixed operating costs (2) Flotation cost Free cash flow Future value for Year N Future value of an annuity for N years Growth rate in earnings, dividends, and stock prices Interest rate; also referred to as r Interest payment in dollars Inflation premium Initial public offering Internal rate of return Interest rate key on some calculators Natural logarithm of stock price divided by exercise price Liquidity premium Maturity value of a bond Market-to-book ratio Modified internal rate of return Maturity risk premium Market value added Calculator key denoting number of periods Area under a standard normal distribution function Net present value Net working capital Pf Ph P/E PMT PPP PV PVAN Q QBE r "r ^ r r* rd re rf rh ri rM rNOM rp rPER rRF rs r ROA ROE RP RPM RR S SML Ỉ  2 t T TIE TVN V VB Vp VC WACC X YTC YTM ¼ price of the stock today (2) Sales price per unit of product sold Price of good in foreign country Price of good in home country Price/earnings ratio Payment of an annuity Purchasing power parity Present value Present value of an annuity for N years Quantity produced or sold Break-even quantity (1) A percentage discount rate, or cost of capital; also referred to as I (2) Nominal risk-adjusted required rate of return “r bar,” historic, or realized, rate of return “r hat,” an expected rate of return Real risk-free rate of return Before-tax cost of debt Cost of new common stock (outside equity) Interest rate in foreign country Interest rate in home country Required return for an individual firm or security Return for “the market,” or an “average” stock Nominal rate of interest; also referred to as INOM (1) Cost of preferred stock (2) Portfolio’s return Periodic rate of return Rate of return on a risk-free security (1) Cost of retained earnings (2) Required return on common stock Correlation coefficient; also denoted as R when historical data are used Return on assets Return on equity Risk premium Market risk premium Retention rate (1) Sales (2) Estimated standard deviation for sample data Security Market Line Summation sign Standard deviation Variance Time period Marginal income tax rate Times interest earned A stock’s horizon, or terminal, value at t ¼ N (1) Variable cost per unit (2) Current value of a call option Bond value Value of preferred stock Total variable costs Weighted averaged cost of capital Exercise price of option Yield to call Yield to maturity
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