tag:blogger.com,1999:blog-78413955067358348282024-02-20T11:59:55.726-08:00TradeTradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.comBlogger63125tag:blogger.com,1999:blog-7841395506735834828.post-79188188900287521392013-11-08T06:37:00.002-08:002013-11-08T06:37:24.448-08:00Advantages and Disadvantages of Short-Term Financing<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
The three possible financing
policies described above were distinguished by the relative amounts of
short-term debt used under each policy. The aggressive policy called for the
greatest use of short-term debt, while the conservative policy called for the
least. Maturity matching fell in between. Although short-term credit is
generally riskier than long-term credit, using short-term funds does have some
significant advantages. The pros and cons of short-term financing are
considered in this section.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Speed</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
A short-term loan can be obtained
much faster than long-term credit. lenders will insist on a more thorough
financial examination before extending long-term credit and the loan agreement
will have to be spelled out in considerable detail because a lot can happen
during the life of a 10 to 20 year loan. Therefore if funds are needed in a
hurry the firm should look to the short-term markets.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Flexibility</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
If its needs for funds are
seasonal or cyclical, a firm may not want to commit itself to long-term debt
for three reasons: (1) Flotation costs are higher for long-term debt than for
short-term credit. (2) Although long-term debt can be repaid early, provided
the loan agreement includes a prepayment provision, prepayment penalties can be
expensive. Accordingly, if a firm thinks its need for funds will diminish in
the near future, it should choose short-term debt. (3) Long-term loan
agreements always contain provisions, or covenants, which constrain the firm’s
future actions. Short-term credit agreements are generally less restrictive.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Cost of Long-Term Versus Short-Term
Debt</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
The yield curve is normally
upward sloping, indicating that interest rates are generally lower on
short-term debt. Thus, under normal conditions, interest costs at the time the
funds are obtained will be lower if the firm borrows on a short-term rather
than a long-term basis.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Risks of Long-Term Versus Short-Term
Debt</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Even though short-term rates are
often lower than long-term rates, short-term credit is riskier for two reasons:
(1) If a firm borrows on a long-term basis, its interest costs will be
relatively stable over time, but if it uses short-term credit, its interest
expense will fluctuate widely, at times going quite high. For example, the rate
banks charge large corporations for short-term debt more than tripled over a
two-year period in the 1980s, rising from 6.25 to 21 percent. Many firms that
had borrowed heavily on a short-term basis simply could not meet their rising
interest costs and as a result, bankruptcies hit record levels during that
period. (2) If a firm borrows heavily on a short-term basis, a temporary
recession may render it unable to repay this debt. If the borrower is in a weak
financial position, the lender may not extend the loan, which could force the
firm into bankruptcy. Braniff Airlines, which failed during a credit crunch in
the 1980s, is an example. Another good example of the riskiness of short-term
debt is provided by Transamerica Corporation, a major financial services
company. Transamerica’s chairman, Mr. Beckett, described how his company was
moving to reduce its dependency on short-term loans whose costs vary with
short-term interest rates. According to Beckett, Transamerica had reduced its
variable-rate (short-term) loans by about $450 million over a two-year period.
We aren’t going to go through the enormous increase in debt expense again that
had such a serious impact on earnings, he said. The company’s earnings fell
sharply because money rates rose to record highs. We were almost entirely in
variable rate debt, he said, but currently about 65 percent is fixed rate and
35 percent variable, We’ve come a long way, and we’ll keep plugging away at it.
Transamerica’s earnings were badly depressed by the increase in short-term
rates, but other companies were even less fortunate they simply could not pay
the rising interest charges and this forced them into bankruptcy.</div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-34666542405043185732013-09-20T06:44:00.002-07:002013-09-20T06:44:36.369-07:00Alternative Current Asset Financing Policies<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
Most businesses experience
seasonal and/or cyclical fluctuations. For example, construction firms have
peaks in the spring and summer, retailers peak around Christmas and the
manufacturers who supply both construction companies and retailers follow
similar patterns. Similarly, virtually all businesses must build up current
assets when the economy is strong. but they than see off inventories and reduce
receivables when the economy slacks off. still, current assets rarely drop to
zero-companies have some permanent current assets, which are the current assets
on hand at the low point of the cycle. Then, as sales increase during the
upswing, current assets must be increased and these additional current assets
are defined as temporary current assets. The manner in which the permanent and
temporary current assets are financed is called the firm’s current asset
financing policy.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>Maturity Matching, or “Self-Liquidating”,
Approach</b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
The maturity matching, or “self-liquidating”,
approach calls for matching asset and liability maturities as shown in Panel a
of Figure 17-1. This strategy minimizes the risk that the firm will be unable
to pay off its maturing obligations. To illustrate, suppose a company borrows
on a one year basis and uses the funds obtained to build and equip a plant.
Cash flows from the plant (profits plus depreciation) would not be sufficient
to pay off the loan at the end of only one year, so the loan would have to be
renewed. If for some reason the lender refused to renew the loan, then the
company would have problems. Had the plant been financed with long-term debt,
however, the required loan payments would have been better matched with cash
flows from profits and depreciation, and the problem of renewal would not have
arisen.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
At the limit, a firm could
attempt to match exactly the maturity structure of its assets and liabilities.
Inventory expected to be sold in 30-days could be financed with a 30-day bank
loan; a machine expected to last for 5-years could be financed with a 5-year
loan; a 20-year building could be financed with a 20-year mortgage bond; and so
forth. Actually of course, two factors prevent this exact maturity matching: (1)
there is uncertainty about the lives of assets, and (2) some common equity must
be used and common equity has no maturity. To illustrate the uncertainty
factor, a firm might finance inventories with a 30-day loan, expecting to sell
the inventories and then use the cash to retire the loan. But if sales were
slow, the cash would not be forthcoming, and the use of short-term credit could
end up causing a problem. Still if a firm makes an attempt to match asset and
liability maturities, we would define this as a moderate current asset
financing policy.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>Aggressive Approach</b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Panel b of Figure 17-1
illustrates the situation for a relatively aggressive firm which finances all
of its fixed assets with long-term capital and part of its permanent current
assets with short-term, nonspontaneous credit. Note that we used the term “relatively”
in the title for panel b because there can be different degrees of
aggressiveness. For example, the dashed line in panel b could have been drawn
below the line designating fixed assets, indicating that all of the permanent
current assets and part of the fixed assets were financed with short-term
credit; this would be a highly aggressive, extremely nonconservative position
and the firm would be very much subject to dangers from rising interest rates
as well as to loan renewal problems. However, short-term debt is often cheaper
than long-term debt, and some firms are willing to sacrifice safety for the
chance of higher profits. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>Conservative Approach</b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Panel c of Figure 17-1 has the
dashed line above the line designating permanent current assets indicating that
permanent capital is being used to finance all permanent asset requirements and
also to meet some of the seasonal needs. In this situation, the firm uses a
small amount of short-term, nonspontaneous credit to meet its peak
requirements, but it also meets a part of its seasonal needs by “storing
liquidity” in the form of marketable securities. The humps above the dashed
line represent short-term financing, while the troughs below the dashed line
represent short-term security holdings. Panel c represents a very safe,
conservative current asset financing policy.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Chrysler, which in 1996 had $8.7
billion of cash and marketable securities, fits the panel c pattern. Its
chairman, Robert Eaton, stated that these liquid assets will be needed during
the next recession and he cited as evidence the fact that Chrysler had an
operating cash deficit of more than $4 billion during the 1991-1992 recession.
However, some of Chrysler’s could borrow funds in the future if need be, so the
extra $6.7 billion should be redeployed to earn more than the 3 percent after
taxes it was getting. The Chrysler example illustrates the fact that there is
no clear, precise answer to the question of how much cash and securities a firm
should hold.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com5tag:blogger.com,1999:blog-7841395506735834828.post-23259353227482126882013-09-09T08:27:00.003-07:002013-09-09T08:27:09.995-07:00Influencing Credit Policy<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
In addition to the factors
discussed in previous sections two other points should be made regarding credit
policy.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Profit Potential</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
We have emphasized the costs of
granting credit. However, if it is possible to sell on credit and also to impose
a carrying charge on the receivables that are outstanding, then credit sales
can actually be more profitable than cash sales. This is especially true for
consumer durables (autos, appliances, and so on), but it is also true for
certain types of industrial equipment. Thus, GM’s General Motors Acceptance
Corporation (GMAC) unit, which finances automobiles, is highly profitable, as
is Sears’s credit subsidiary. Some encyclopedia companies even lose money of
cash sales but more than make up these losses from the carrying charges on
their credit sales. Obviously, such companies would rather sell on credit than
for cash!</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
The carrying charges on
outstanding credit are generally about 18 percent on a nominal basis: 1.5
percent per month, so 1.5% × 12 = 18%. This is equivalent to an effective
annual rate of (1.015)<sup>12</sup> – 1.0 = 19.6%. Having receivables
outstanding that earn more than 18 percent is highly profitable unless there
are too many bad debt losses.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Legal Considerations</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
It is illegal under the Robinson
Patman Act, for a firm to charge prices that discriminate between customers
unless these differential prices are cost-justified. The same holds true for
credit it is illegal to offer more favorable credit terms to one customer or
class of customers than to another, unless the differences are cost-justified.</div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-43617089366136507832013-09-08T08:42:00.003-07:002013-09-08T08:42:45.056-07:00Cash Discounts<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
The last element in the credit
policy decision, the use of cash discounts for early payment, is analyzed by
balancing the costs and benefits of different cash discounts. For example, a
firm might decide to change its credit terms from “net 30”, which means that
customers must pay within 30 days to “2/10. net 30”, where a 2 percent discount
is given if payment is made in ten days. This change should produce two
benefits: (1) It should attract new customers who consider the discount to be a
price reduction and (2) the discount should cause a reduction in the days sales
outstanding, because some existing customers will pay more promptly in order to
get the discount. Offsetting these benefits is the dollar cost of the
discounts. The optimal discount percentage is establish at the point where the
marginal costs and benefits are exactly offsetting.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
If sales are seasonal, a firm may
use seasonal dating on discounts. For example Slimware Inc. a swimsuit
manufacturer, sells on terms of 2/10, net 30, May I dating. This means that the
effective invoice date is May I, even if the sale was made back in January. The
discount may be taken up to May 10; otherwise the full amount must be paid on
May 30. Slimware produces throughout the year, but retail sales of bathing
suits are concentrated in the spring and early summer. By offering seasonal
dating, the company induces induces some of its customers to stock up early,
saving Slimware some storage costs and also nailing down sales.</div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-60017865748307058632013-09-04T08:30:00.004-07:002013-09-04T08:30:45.576-07:00Collection Policy<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
Collection policy refers to the
procedures the firm follows to collect past-due accounts. For example, a letter
might be sent to customers when a bill is 10 days past due: a more severe
letter, followed by a telephone call, would be sent if payment is not received
within 30 days and the account would be turned over to a collection agency
after 90 days.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
The collection process can be
expensive in terms of both out-of-pocket expenditures and lost
goodwill-customers dislike being turned over to a collection agency. However,
at least some firmness is needed to prevent an undue lengthening of the
collection period and to minimize outright losses. A balance must be struck
between the costs and benefits of different collection policies.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Changes in collection policy
influence sales, the collection period and the bad debt loss percentage. All of
this should be taken into account when setting the credit policy.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-23029859151919728232013-09-02T06:47:00.002-07:002013-09-02T06:47:13.901-07:00The Credit Period And Standards<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
A firm’s regular credit terms,
which include the credit period and discount, might call for sales on a 2/10.
net 30 basis to all “acceptable” customers. Here customers who pay within 10
days would be given a 2 percent discount, and others would be required to pay
within 30 days. its credit standards would be applied to determine which
customers qualify for the regular credit terms, and the amount of credit
available to each customer.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Credit Standards</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u><span style="text-decoration: none;"><br /></span></u></b></div>
<div class="MsoNormal" style="text-align: justify;">
Credit standards refer to the
financial strength and creditworthiness a customer must exhibit in order to
qualify for credit. If a customer does not qualify for the regular credit
terms, it can still purchase from the firm, but under more restrictive terms.
For example, a firm’s regular credit terms might call for payment after 30
days, and these terms might be extended to all qualified customers. The firm’s
credit standards would be applied to determine which customers qualified for
the regular credit terms and how much credit each should receive. The major
factors considers when setting credit standards relate to the likelihood that a
given customer will pay slowly or perhaps end up as a bad debt loss.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Setting credit standards requires
a measurement of credit quality, which is defined in terms of the probability
of a customer’s default. The probability estimate for a given customer is, for
the most part, a subjective judgment. Nevertheless, credit evaluation is a
well-established practice, and a good credit manager can make reasonably
accurate judgments of the probability of default by different classes of
customers.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Managing a credit department
requires fast, accurate, and up-to-date information. To help get such
information, the National Association of Credit Management (a group with 43,000
member firms) persuaded TRW, a large credit reporting agency, to develop a
computer-based telecommunications network for the collection, storage,
retrieval, and distribution of credit information. A typical business credit
report would include the following pieces of information:</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<ol start="1" style="margin-top: 0in;" type="1">
<li class="MsoNormal" style="mso-list: l0 level1 lfo1; tab-stops: list .5in; text-align: justify;">A summary balance sheet and income statement.</li>
<li class="MsoNormal" style="mso-list: l0 level1 lfo1; tab-stops: list .5in; text-align: justify;">A number of key rations, with trend information.</li>
<li class="MsoNormal" style="mso-list: l0 level1 lfo1; tab-stops: list .5in; text-align: justify;">Information obtained from the firm’s suppliers
telling whether it pays promptly or slowly, and whether it has recently
failed to make any payments.</li>
<li class="MsoNormal" style="mso-list: l0 level1 lfo1; tab-stops: list .5in; text-align: justify;">A verbal description of the physical condition of the
firm’s operations.</li>
<li class="MsoNormal" style="mso-list: l0 level1 lfo1; tab-stops: list .5in; text-align: justify;">A verbal description of the backgrounds of the firm’s
owners, including any previous bankruptcies, lawsuits divorce settlement
problems, and the like.</li>
<li class="MsoNormal" style="mso-list: l0 level1 lfo1; tab-stops: list .5in; text-align: justify;">A summary rating, ranging from A for the best credit
risks down to F for those that are deemed likely to default.</li>
</ol>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Although a great deal of credit
information is available, it must still be processed in a judgmental manner.
Computerized information systems can assist in making better credit decisions,
but in the final analysis, most credit decisions are really exercises in
information judgment.</div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-54296250552426859972013-08-31T01:01:00.001-07:002013-08-31T04:59:01.971-07:00Credit Policy<div dir="ltr" style="text-align: left;" trbidi="on">
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<div class="MsoNormal" style="text-align: justify;">
The success or failure of a
business depends primarily on the demand for its products as a rule, the higher
its sales, the larger its profits and the higher its stock price. Sales, in
turn, depend on a number of factors, some exogenous but others under the firm’s
control. The major controllable determinants of demand are sales prices,
product quality, advertising and the firm’s credit policy. Credit policy in
turn, consists of these four variables.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
1.<span style="mso-tab-count: 1;"></span> Credit period, which is the length of time buyers are given
to pay for their purchases.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
2.<span style="mso-tab-count: 1;"> </span>Credit standards, which refer to the
required financial strength of acceptable credit customers.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
3.<span style="mso-tab-count: 1;"> </span>Collection policy, which is measured by its
toughness or laxity in attempting to collect on <span style="mso-spacerun: yes;"> </span>slow-paying accounts.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
4.<span style="mso-tab-count: 1;"> </span>Discounts given for early payment, including
the discount percentage and how rapidly payment must be made to qualify for the
discount.</div>
<div class="MsoNormal" style="tab-stops: 57.75pt; text-align: justify;">
<span style="mso-tab-count: 1;"> </span></div>
<div class="MsoNormal" style="text-align: justify;">
The credit manager is responsible
for administering the firm’s credit policy. However, because of the pervasive
importance of credit, the credit policy itself is normally established by the
executive committee, which usually consists of the president plus the
vice-presidents of finance, marketing and production.</div>
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Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-971400241134823392013-08-24T04:59:00.001-07:002013-08-24T04:59:08.089-07:00Marketable Securities<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
Realistically the management of
cash and marketable securities cannot be separated-management of one implies
management of the other. We focused on cash management. Now we turn to
marketable securities.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Marketable securities typically
provide much lower yields than operating assets. For example, recently Chrysler
held a $8.7 billion portfolio of short-term marketable securities that yielded
about 6 percent but its operating assets provided a return of about 14 percent.
Why would a company such as Chrysler have such large holdings of low-yielding
assets?</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
In many cases, companies hold
marketable securities for the same reasons they hold cash. Although these
securities are not the same as cash, in most cases they can be converted to cash
on very short notice (often just a few minutes) with a single telephone call.
Moreover, while cash an most commercial checking accounts yield northing,
marketable securities provide at least a modest return. For this reason, many
firms hold at least some marketable securities in lieu of larger cash balances,
liquidating part of the portfolio to increase the cash account when cash
outflows exceed inflows. In such situations the marketable securities could be
used as a substitute for transactions balances, for precautionary balances for
speculative balances or for all three. In most cases the securities are held
primarily for precautionary purposes most firms prefer to rely on bank credit
to make temporary transactions or to meet speculative needs, but they may still
hold some liquid assets to guard against a possible shortage of bank credit.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
A few years ago Chrysler had
essentially no cash it was incurring huge losses and those losses had drained
its cash account. Then a new management team took over improved operations and
began generating positive cash flows, Chryslers cash (and marketable
securities) was up to $8.7 billion, and analysts were forecasting a further
buildup over the next year or so to more than $10 billion. Management
indicated, in various statements, that the cash hoard was necessary to enable
the company to weather the next downturn in auto sales. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Although setting the target cash
balance is to a large extent judgmental analytical rules can be applied to help
formulate better judgments. For example, years ago William Baumol recognized
that the trade-off between cash and marketable securities is similar to the one
firms face when setting the optimal level of inventory. Baumol applied the EOQ
inventory model to determine the optimal level of cash balances, he suggested
that cash holdings should be higher if costs are high and the time to liquidate
marketable securities is long, but that those holdings should be lower if
interest rates are low. His logic was that if it is expensive and time consuming
to convert securities to cash and if securities do not earn much because interest
rates are low, then it does not pay to hold securities as opposed to cash. It
does pay to hold securities if interest rates are high and the securities can
be converted to cash quickly and cheaply. </div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-91115447551994921142013-08-17T00:16:00.004-07:002013-08-17T00:16:47.156-07:00Cash Management Techniques<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
Cash management has changed significantly
over the last 20 years for two reasons. First, from the early 1970s to the
mid-1980s, there was an upward tread in interest rates which increased the
opportunity cost of holding cash. This encouraged financial managers to search
for more efficient ways of managing cash. Second, technological developments,
particularly computerized electronic funds transfer mechanisms, changed the way
cash is managed.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Most cash management activities
are performed jointly by the firm and its banks. Effective cash management
encompasses proper management of cash inflows and outflows, which entails (1)
synchronizing cash flows, (2) using float, (3) accelerating collections, (4)
getting available funds to where they are needed, and (5) controlling
disbursements. Most business is conducted by large firms, many of which operate
regionally, nationally, or even globally. They collect cash from many sources
and make payments from a number of different cities or even countries. For
example, companies such as IBM, General Motors, and Hewlett Packard have
manufacturing plants all around the world, even more sales officers, and bank
accounts in virtually every city where they do business. Their collection
points follow sales patterns. Some disbursements are made from local offices,
but most are made in the cities where manufacturing occurs, or else from the
home office. Thus, a major corporation might have hundreds or ever thousands of
bank accounts and since there is no reason to thinks that inflows and outflows
will balance in each account, a system must be in place to transfer funds from
where they come in to where they are needed, to arrange loans to cover net
corporate shortfalls, and to invest net corporate surpluses without delay. We discuss
the most commonly used techniques for accomplishing these tasks in the
following sections.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Cash Flow Synchronization</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
If you as an individual were to
receive income once a year, you would probably put it in the bank, draw down
your account periodically, and have an average balance during the year equal to
about half your annual income. If you received income monthly instead of once a
year, you would operate similarly, but now your average balance would be much
smaller. If you could arrange to receive income daily and to pay rent, tuition,
and other charges on a daily basis, and if you were confident of your
forecasted inflows and outflows, then you could hold a very small average cash
balance.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Exactly the same situation holds
for businesses – by improving their forecasts and by arranging things so that
cash receipts coincide with cash requirements, firms can reduce their
transactions balances to a minimum. Recognizing all this, utility companies,
oil companies, credit card companies and so on, arrange to bill customers and
to pay their own bills, on regular “billing cycles” throughout the month. This
synchronization of cash flows provides cash when it is needed and thus enables
firms to reduce cash balances, decrease bank loans, lower interest expenses,
and boost profits.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Speed up the Check-Clearing
Process</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
When a customer writes and mails
a check, this does not mean that the funds are immediately available to the
receiving firm. Most to us have been told by someone that “the check is in the
mail”, and we have also deposited a check in our account and then been told
that we cannot write our own checks against this deposit until the <b>check-clearing</b>
process has been completed. Our bank must first make sure that the check we
deposited is good and the funds are available before it will give us cash.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
In practice, it may take a long
time for a firm to process incoming checks and obtain the use of the money. A
check must first be delivered through the mail and then be cleared through the
banking system before the money can be put to use. Checks received from customers
in distant cities are especially subject to delays because of mail time and
also because more parties are involved. For example, assume that we receive a
check and deposit it in our bank. Our bank must send the check to the bank on
which it was drawn. Only when this latter bank transfers funds to our bank are
the funds available for us to use. Checks are generally cleared through the
Federal Reserve System or through a clearinghouse set up by the banks in a
particular city. Of course, if the check is deposited in the same bank on which
it was drawn, that bank merely transfers funds by bookkeeping entries from one
depositor to another. The length of time required for checks to clear is thus a
function of the distance between the payer’s and the payee’s banks. In the case
of private clearinghouses, it can range from one to three days. Checks are
generally cleared through the Federal Reserve System in about two days, but
mail delays can slow down things on each end of the Fed’s involvement in the
process.</div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-28117793833043691862013-08-14T07:25:00.001-07:002013-08-14T07:25:52.242-07:00The Cash Budget<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
The firm estimates its needs for
cash as a part of its general budgeting, or forecasting, process. First, it
forecasts sales, its fixed asset and inventory requirements, and the times when
payments must be made. This information is combined with projections about when
accounts receivable will be collected, tax payment dates, dividend and interest
payment dates, and so on. All of this information is summarized in the <b>cash
budget</b>, which shows the firm’s projected cash inflows and outflows over
some specified period. Generally, firms use a monthly cash budget forecasted
over the next year, plus a more detailed daily or weekly cash budget for the
coming month. The monthly cash budgets are used for planning purposes, and the
daily or weekly budgets for actual cash control.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
The cash budget provides more
detailed information concerning a firm’s future cash flows than do the
forecasted financial statements. We developed Allied Food Products 2012
forecasted financial statements. Allied projected 2012 sales were $3,300
million, resulting in a net cash flow from operations of $162 million. When all
expenditures and financing flows are considered, Allied cash account is
projected to increase by $1 million in 2012. Does this mean that Allied will
not have to worry about cash shortages during 2012? To answer this question, we
must construct Allied cash budget for 2012.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
To simplify the example, we will
only consider Allied cash budget for the last half of 2012. Further, we will
not list every cash flow but rather focus on the operating cash flows. Allied
sales peak is in September, shortly after the majority of its raw food inputs
have been harvested. All sales are made on terms of 2/10, net 40, meaning that
a 2 percent discount is allowed if payment is made within 10 days, and if the
discount is not taken, the full amount is due in 40 days. However, like most
companies, Allied finds that some of its customers delay payment up to 90 days.
Experience has shown that payment on 20 percent of Allied dollar sales is made
during the month in which the sale is made – these are the discount sales. On
70 percent of sales, payment is made during the month immediately following the
month of sale, and on 10 percent of sales payment is made in the second month
following the month of sale.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
The costs to Allied of
foodstuffs, spices, preservatives, and packaging materials average 70 percent
of the sales prices of the finished products. These purchases are generally
made one month before the firm expects to sell the finished products, but
Allied purchase terms with its suppliers allow it to delay payments for 30
days. Accordingly, if July sales are forecasted at $300 million, then purchases
during June will amount to $210 million, and this amount will actually be paid
in July.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Such other cash expenditures as wages
and rent are also built into the cash budget, and Allied must make estimated
tax payments of $30 million on September 15 and $20 million on December 15.
Also, a $100 million payment for a new plant must be made in October. Assuming
that Allied <b>target cash balance</b> is $10 million, and that it projects $15
million to be on hand on July 1, 2012, what will its monthly cash surpluses or
short fails be for the period from July to December? </div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-42420039245870998702013-08-13T08:00:00.002-07:002013-08-13T08:00:52.341-07:00Stock Dividends and Stock Splits<div dir="ltr" style="text-align: left;" trbidi="on">
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<div class="MsoNormal" style="text-align: justify;">
Stock dividends and stock splits
are related to the firm’s cash dividend policy. The rationale for stock
dividends and splits can best be explained through an example. We will use Porter
Electronic Controls Inc, a $700 million electronic components manufacturer, for
this purpose. Since its inception, Porter’s markets have been expanding and the
company has enjoyed growth in sales and earnings. Some of its earnings have
been paid out in dividends, but some are also retained each year, causing its
earnings per share and stock price to grow. The company began its life with
only a few thousand shares outstanding, and after some years of growth, each of
Porter’s shares had a very high EPS and DPS. When a ‘normal’ P/E ratio was
applied, the derived market price was so high that few people could afford to
buy a “round lot” of 100 shares. This limited the demand for the stock and thus
kept the total market value of the firm below what it would have been if more
shares, at a lower price had been outstanding. To correct this situation,
Porter “split its stock” as described in the next section.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Stock Splits</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Although there is little
empirical evidence to support the contention, there is nevertheless a
widespread belief in financial circles that an optimal price range exists for
stocks. “Optimal” means that if the price is within this range, the
price/earnings ratio, hence the firm’s value will be maximized. Many observers,
including Porter’s management, believe that the best range for most stocks is
from $20 to $80 per share. Accordingly if the price of Porter’s stock rose to
$80, management would probably declare a two-for-one stock split, thus doubling
the number of shares outstanding halving the earnings and dividends per share,
and thereby lowering the stock price. Each stockholder would have more shares,
but each share would be worth less. If the post-split price were $40, Porter’s
stockholders would be exactly as well off as they were before the split,
However, if the stock price were to stabilize above $40, stockholders would be
better off. Stock splits can be of any size-for example, the stock could be
split two-for-one, three-for-one, one-and-a half-for-one, or in any other way.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Stock Dividends</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Stock dividends are similar to
stock splits in that they “divide the pie into smaller slices” without
affecting the fundamental position of the current stockholders. On a 5 percent
stock dividend, the holder of 100 shares would receive an additional 5 shares (without
cost); on a 20 percent stock dividend the same holder would receive 20 new
shares; and so on. Again, the total number of shares is increased so earnings
dividends and price per share all decline.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
If a firm wants to reduce the
price of its stock, should it use a stock split or a stock dividend? Stock
splits are generally used after a sharp price run-up to produce a large price
reduction. Stock dividends used on a regular annual basis will keep the stock
price more or less constrained. For example, if a firm’s earnings and dividends
were growing at about 10 percent per year, its stock price would tend to go up
at about that same rate, and it would soon be outside the desired trading
range. A 10 percent annual stock dividend would maintain the stock price within
the optimal trading range. Note, though that small stock dividends create
bookkeeping problems and unnecessary expenses so firms today use stock splits
far more often than stock dividends.</div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-90952545270808733462013-08-12T08:14:00.001-07:002013-08-12T08:14:38.397-07:00Dividend Stability<div dir="ltr" style="text-align: left;" trbidi="on">
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<div class="MsoNormal" style="text-align: justify;">
The stability of dividends is
also important. Profits and cash flows vary over time, as do investment
opportunities. Taken alone, this suggests that corporations should vary their
dividends over time, increasing them when cash flows are large and the need for
funds is low and lowering them when cash is in short supply relative to
investment opportunities. However, many stockholders rely on dividends to meet
expenses and they would be seriously inconvenienced if the dividend stream were
unstable. Further reducing dividends to make funds available for capital
investment could send incorrect signals and that could drive down stock prices.
Thus, maximizing its stock price requires a firm to balance its internal needs
for funds against the needs and desires of its stockholders. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
How should this balance be
struck: that is, how stable and dependable should a firm attempt to make its
dividends? It is impossible to give a definitive answer to this question, but
the following points are relevant:</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
1.<span style="mso-tab-count: 1;"> </span>Virtually every publicly owned company makes
a five to ten year financial forecast of earnings and dividends. Such forecasts
are never made public they are used for internal planning purposes only.
However, security analysts construct similar forecasts and do make them available
to investors; see value line for an example. Further, virtually every internal
five to ten year corporate forecast we have seen for a normal company projects
a trend of higher earnings and dividends. Both managers and investors know that
economic conditions may cause actual results to differ from forecasted results,
but “normal” companies expect to grow.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
2.
<span style="mso-tab-count: 1;"> </span>Years ago, when inflation was not
persistent, the term “stable dividend policy” meant a policy of paying the same
dollar dividend year after year. AT&T was a prime example of a company with
a stable dividend policy - it paid $9 per year ($2.25 per quarter) for 25
straight years. Today, though most companies and stockholders expect earnings
to grow over time as a result of retained earnings and inflation. Further,
dividends are normally expected to grow more or less in line with earnings.
Thus today a “stable dividend policy” generally means increasing the dividend
at a reasonably steady rate. For example, Rubbermaid made this statement in a
recent annual report:</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Dividends per share were
increased for the 34<sup>th</sup> consecutive year out goal is to increase
sales, earnings and per share by 15% per year, while achieving a 21% return on
beginning shareholders equity. It is also the Company’s objective to pay
approximately 30% of current year’s earnings as dividends, which will permit us
to retain sufficient capital to provide for future growth.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Rubbermaid used the word “approximately”
in discussing its payout ratio because ever if earnings vary a bit from the
target level the company still planned to increase the dividend by the target
growth rate. Even though Rubbermaid did not mention the dividend growth rate in
the statement, analysts can calculate the growth rate and see that it is the
same 15 percent as indicated for sales and earnings:</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
g=b(ROE)</div>
<div class="MsoNormal" style="text-align: justify;">
=(1-Payout) (ROE)</div>
<div class="MsoNormal" style="text-align: justify;">
=0.7(21%)=15%</div>
<div class="MsoNormal" style="text-align: justify;">
Here b is the fraction of
earnings that are retained, or 1.0 minus the payout ratio. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Companies with volatile earnings
and cash flows would be reluctant to make a commitment to increase the dividend
each year so they would not make such a detailed statement even so most
companies would like to be able to exhibit the kind of stability Rubbermaid has
shown, and they try to come as close to it as they can.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Dividend stability has two
components: (1) How dependable is the growth rate, and (2) can we count on at
least receiving the current dividend in the future? The most stable policy,
from an investor’s standpoint, is that of a firm whose dividend growth rate is
predictable such a company’s total return (dividend yield plus capital gains
yield) would be relatively stable over the long run, and its stock would be a
good hedge against inflation. The second most stable policy is where
stockholders can be reasonably sure that the current dividend will not be
reduced it may not grow at a steady rate, but management will probably be able
to avoid cutting the dividend. The least stable situation is where earnings and
cash flows are so volatile that investors cannot count on the company to
maintain the current dividend over a typical business cycle.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
3.
<span style="mso-tab-count: 1;"> </span>Most observers believe that dividend
stability is desirable. Assuming this position is correct; investors prefer
stocks that pay more predictable dividends to stocks which pay the same average
amount of dividends but in a more erratic manner. This means that the cost of
equity will be minimized and the stock price maximized, if a firm stabilizes
its dividends as much as possible.</div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-8885202971852948262013-08-11T06:34:00.001-07:002013-08-11T06:34:02.391-07:00Other Dividend Policy Issues<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
Before we discuss how dividend
policy is set in practice, we must examine two other theoretical issues that could
affect our views toward dividend policy: (1) the information content or
signaling hypothesis and (2) the clientele effect.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Information Content, or
Signaling, Hypothesis</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
When MM set forth their dividend
irrelevance theory, they assumed that every-one investors and managers alike
has identical information regarding the firm’s future earnings and dividend. In
reality, however, different investors have different views on both the level of
future dividend payments and the uncertainty inherent in those payments and
managers have better information about future prospects than public
stockholders. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
It has been observed that an increase
in the dividend is often accompanied by an increase in the price of a stock
while a dividend cut generally leads to a stock price decline. This could
indicate that investors, in the aggregate, prefer dividends to capital gains.
However, MM argued differently. They noted the well-established fact that
corporations are reluctant to cut dividends, hence do not raise dividends
unless they anticipate higher earnings in the future. Thus, MM argued that a
higher-than-expected dividend increase is a “signal” to investors that the firm’s
management forecasts good future earnings.<sup>4</sup> Conversely a dividend
reduction or a smaller-than-expected increase, is a signal that management is
forecasting poor earnings in the future. Thus MM argued that investor’s
reactions to changes in dividend policy do not necessarily show that investors
prefer dividends to retained earnings. Rather, they argue that price changes
following dividend actions simply indicate that there is an important
information or signaling content in dividend announcements. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Like mot other aspects of
dividend policy, empirical studies of signaling have had mixed result. There is
clearly some information content in dividend announcements. However, it is
difficult to tell whether the stock price changes that follow increase or
decreases in dividends reflect only signaling effects or both signaling and
dividend preference. Still signaling effects should definitely be considered
when a firm is contemplating a change in dividend policy.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Clientele Effect</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
As we indicated earlier,
different groups, or clienteles of stockholders prefer different dividend
payout policies. For example retired individuals and university endowment funds
generally prefer cash income so they may want the firm to pay out a high
percentage of its earnings. Such investors (and pension funds) are often in low
or even zero tax brackets so taxes are of no concern. On the other hand,
stockholders in their peak earning years might prefer reinvestment, because
they have less need for current investment income and would simply reinvest
dividends received, after first paying income taxes on those dividends. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
If a firm retains and reinvests
income rather than paying dividends those stockholders who need current income
would be disadvantaged. The value of their stock might increase but they would
be forced to go to the trouble and expense of selling off some of their shares
to obtain cash. Also some institutional investors (or trustees for individuals)
would be legally precluded from selling stock and then “spending capital”. On the
other hand, stockholders who are saving rather then spending dividends might
favor the low dividend policy for the less the firm pays out in dividends the
less these stockholders will have to pay in current taxes, and the less trouble
and expense they will have to go through to reinvest their after-tax dividends.
Therefore, investors who want current investment income should own shares in
high dividend payout firms, while investors with no need for current investment
income should own shares in low dividend payout firms. For example investors
seeking high cash income might invest in electric utilities, which averaged a
79 percent payout from 1991 through 1995, while those favoring growth could
invest in the semiconductor industry, which paid out only 7 percent. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
To the extent that stockholders
can switch firms, a firm can change from one dividend payout policy to another
and then let stockholders who do not like the new policy sell to other
investors who do. However, frequent switching would be inefficient because of (1)
brokerage costs, (2) the likelihood that stockholders who are selling will have
to pay capital gains taxes, and (3) a possible shortage of investors who like
the firms newly adopted dividend policy. Thus, management should be hesitant to
change its dividend policy, because a change might cause current shareholders
to sell their stock, forcing the stock price down. Such a price decline might
be temporary, but it might also be permanent if few new investors are attracted
by the new dividend policy, then the stock price would remain depressed. Of
course, the new policy might attract an even larger clientele than the firm had
before in which case the stock price would rise.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<span style="font-family: "Times New Roman"; font-size: 12.0pt; mso-ansi-language: EN-US; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US;">Evidence from several
studies suggests that there is an fact a clientele effect.<sup>5</sup> MM and others
have argued that one clientele is as good as another, so the existence of a
clientele effect does not necessarily imply that one dividend policy is better
than any other. MM may be wrong, though and neither they nor anyone else can
prove that the aggregate makeup of investors permits firms to disregard
clientele effects. This issue, like most others in the dividend arena, is still
up in the air. </span></div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-17301971748274750432013-08-08T00:17:00.002-07:002013-08-08T00:25:01.723-07:00Dividends Versus Capital Gains : What Do Investors Prefer?<div dir="ltr" style="text-align: left;" trbidi="on">
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<div class="MsoNormal" style="text-align: justify;">
When deciding how much cash to
distribute to stockholders, financial managers must keep in mind that the
firm’s objective is to maximize shareholder value. Consequently, the target
payout ratio-defined as the percentage of net income to be paid out as cash
dividends –should be based in large part on investors, preferences for
dividends versus capital gains: do investors prefer (1) to have the firm
distribute income as cash dividends or (2) to have it either repurchase stock
or else plow the earnings back into the business, both of which should result
in capital gains? This preference can be considered in terms of the constant
growth stock valuation model:</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: .3in;">
D<sub>1</sub></div>
<div class="MsoNormal" style="text-align: justify;">
P<sub>0</sub> = -------------</div>
<div class="MsoNormal" style="text-align: justify; text-indent: .3in;">
<span style="mso-spacerun: yes;"> </span>K<sub>s</sub> - g</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
If the company increases the
payout ratio, it raises D<sub>1</sub>. This increase in the numerator, taken
alone, would cause the stock price to rise. However, if D<sub>1</sub> is
raised, then less money will be available for reinvestment, that will cause the
expected growth rate to decline, and that would tend to lower the stock’s
price. Thus any change in payout policy will have two opposing effects.
Therefore, the firm’s optimal dividend policy must strike a balance between
current dividends and future growth so as to maximize the stock price. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
In this section we examine three
theories of investor preference: (1) the dividend irrelevance theory, (2) the “bird-in-the-hand”
theory and (3) the tax preference theory.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Dividend Irrelevance Theory</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
It has been argued that dividend
policy has no effect on either the price of a firm’s stock or its cost of
capital. If dividend policy has no significant effects, then it would be
irrelevant. The principal proponents of the dividend irrelevance theory are Merton
Miller and Franco Modigliani (MM)<sup>1</sup>. They argued that the firm’s
value is determined only by its basic earning power and its business risk. In
other words, MM argued that the value of the firm depends only on the income
produced by its assets not on how this income is split between dividends and retained
earnings. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
To understand MM’s argument that
dividend policy is irrelevant, recognize that any shareholder can construct his
or her own dividend policy. For example, if a firm does not pay dividends, a
shareholder who wants a 5 percent dividend can “create” it by selling 5 percent
of his or her stock. Conversely, if a company pays a higher dividend than an
investor desires, the investor can use the unwanted dividends to buy additional
shares of the company’s stock. If investors could buy and sell shares and thus
create their own dividend policy without incurring costs, then the firm’s
dividend policy would truly be irrelevant. Note, though that investors who want
additional dividends must incur brokerage costs to sell shares, and investors
who do not want dividends must first pay taxes on the unwanted dividends and
then incur brokerage costs to purchase shares with the after-tax dividends.
Since taxes and brokerage costs certainly exist, dividend policy may well be
relevant. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
In developing their dividend
theory. MM made a number of assumptions, especially the absence of taxes and
brokerage costs. Obviously, taxes and brokerage costs do exist, so the MM
irrelevance theory may not be true. However, MM argued (correctly) that all
economic theories are based on simplifying assumptions, and that the validity
of a theory must be judged by empirical tests, not by the realism of its
assumptions. We will discuss empirical tests of MM’s dividend irrelevance
theory shortly. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Bird-in-the-Hand Theory</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
The principal conclusion of MM’s
dividend irrelevance theory is that dividend policy does not affect the
required rate of return on equity K<sub>s</sub>. This conclusion has been hotly
debated in academic circles. In particular, Myron Gordon and John Lintner
argued that K<sub>s</sub> decreases as the dividend payout is increased because
investors are less certain of receiving the capital gains which are supposed to
result from retaining earnings than they are of receiving dividend payments.<sup>2</sup>
Gordon and Lintner said, in effect that investors value a dollar of expected
dividends more highly than a dollar of expected capital gains because the
dividend yield component, D<sub>1</sub>/P<sub>0</sub>, is less risky than the g
component in the total expected return equation, K<sub>s</sub>=D<sub>1</sub>/P<sub>0</sub>
+ g.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
MM disagreed. They argued that K<sub>s</sub>
is independent of dividend policy, which implies that investors are indifferent
between D<sub>1</sub>/P<sub>0</sub> and g and, hence, between dividends and
capital gains. MM called the Gordon-Lintner argument the <b>bird-in-the-hand</b>
fallacy because, in MM’s view, most investors plan to reinvest their dividends
in the stock of the same or similar firms, and in any event the riskiness of
the firm’s cash flows to investors in the long run is determined by the
riskiness of operating cash flows not by dividend payout policy.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Tax Preference Theory</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
There are three tax-related
reasons for thinking that investors might prefer a low dividend payout to a
high payout: (1) Long-term capital gains are taxed at a maximum rate of 28
percent, whereas dividend income is taxed at effective rates which go up to
39.6 percent. Therefore, wealthy investors (who own most of the stock and
receive most of the dividends) might prefer to have companies retain and plow
earnings back into the business. Earnings growth would presumably lead to stock
price increases, and lower-taxed capital gains would be substituted fro
higher-taxed dividends. (2) Taxes are not paid on the gain until a stock is
sold. Due to time value effects, a dollar of taxes paid in the future has a
lower effective cost than a dollar paid today. (3) If a stock is held by
someone until he or she dies, no capital gains tax is due at all-the
beneficiaries who receive the stock can use the stocks’ value on the death day
as their cost basis and thus completely escape the capital gains tax. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Because of these tax advantages,
investors may prefer to have companies retain most of their earnings. If so
investors would be willing to pay more for low-payout companies than for
otherwise similar high-payout companies.</div>
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Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-43169187249471866522013-08-05T08:18:00.003-07:002013-08-05T08:18:46.697-07:00Capital Structure Decisions<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
In addition to the types of
analyses discussed above, firms generally consider the following factors when
making capital structure decisions:</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<b>1.<span style="mso-tab-count: 1;"> </span>Sales Stability.</b> A firm whose sales are
relatively stable can safely take on more debt and incur higher fixed changes
than a company with unstable sales. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<b>2.<span style="mso-tab-count: 1;"> </span>Asset structure.</b> Firms whose assets are
suitable as security for loans tend to use debt rather heavily. General-purpose
assets which can be used by many businesses make good collateral. Whereas
special-purpose assets do not. Thus real estate companies are usually highly
leveraged, whereas companies involved in technological research are not.</div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<b>3.<span style="mso-tab-count: 1;"> </span>Operating leverage.</b> Other things the
same, a firm with less operating leverage is better able to employ financial
leverage because it will have less business risk. (This is discussed in greater
detail in Appendix 13.A.)</div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<b>4.<span style="mso-tab-count: 1;"> </span>Growth rate.</b> Other things the same,
faster-growing firms must rely more heavily on external capital. Further, the
flotation costs involved in selling common stock exceed those incurred when
selling debt, which encourages them to rely more heavily on debt. At the same
time, however rapidly growing firms often face greater uncertainty, which tends
to reduce their willingness to use debt. </div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<b>5.<span style="mso-tab-count: 1;"> </span>Profitability.</b> One often, observes that
firms with very high rates of return on investment use relatively little debt.
Although there is no theoretical justification for this fact, one practical
explanation is that very profitable firms such as Intel, Microsoft, and
Coca-Cola simply do not need to do much debt financing, Their high rates of
return enable them to do most of their financing with internally generated
funds.</div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<b>6.<span style="mso-tab-count: 1;"> </span>Taxes.</b> Interest is a deductible expense,
and deductions are most valuable to firms with high tax rates. Therefore the
higher a firm’s tax rate, the greater the advantage of debt. </div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<b>7.<span style="mso-tab-count: 1;"> </span>Control.</b> The effect of debt versus stock
on a management’s control position can influence capital structure. If management
currently has voting control (over 50 percent of the stock) but is not in a
position to buy any more stock, it may choose debt for new financings. On the
other hand management may it may choose debt for new financings. On the other
hand, management may decide to use equity if the firm’s financial situation is
so weak that the use of debt might subject it to serious risk of default,
because if the firm goes into default, the managers will almost surely lose
their jobs. However, if too little debt is used, management runs the risk of a
takeover. Thus, control considerations could lead to the use of either debt or
equity, because the type of capital that best protects management will very
from situation to situation. In any event, if management is at all insecure, it
will consider the control situation.</div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<b>8.<span style="mso-tab-count: 1;"> </span>Management attitudes.</b> Since no one can
prove that one capital structure will lead to higher stock prices than another,
management can exercise its own judgment about the proper capital structure.
Some managements tend to be more conservative than others and thus use less
debt than the average firm in their industry, whereas aggressive managements
use more debt in the quest for higher profits.</div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<b>9.<span style="mso-tab-count: 1;"> </span>Lender and rating agency attitudes.</b>
Regardless of managers own analyses of the proper leverage factors for their
firms, lenders and rating agencies attitudes frequently influence financial
structure decisions. In the majority of cases, the corporation discusses its
capital structure with lenders and rating agencies and gives much weight to
their advice. For example, one large utility was recently told by Moody and
Standard & Poor that its bonds would be downgraded if it issued more bonds.
This influenced its decision to finance its expansion with common equity. </div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<b>10.<span style="mso-tab-count: 1;"> </span>Market conditions.</b> Conditions in the stock
and bond markets undergo both long and short run changes that can have an important
bearing on a firm’s optimal capital structure. For example, during a recent
credit crunch, the junk bond market dried up and their was simply no market at
a reason able interest rate for any new long term bonds rated below triple B.
Therefore, low rated companies in need of capital were forced to go to the
stock market or to the short term debt market, regardless of their target capital
structures. When conditions eased, however these companies sold bonds to get
their capital structures back on target.</div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<b>11.<span style="mso-tab-count: 1;"> </span>The firm’s internet condition.</b> A firm’s
own internal condition can also have a bearing on its target capital structure.
For example, suppose a firm has just successfully completed an R&D program
and it forecasts higher earnings in the immediate future. However, the new
earnings are not yet anticipated by investors, hence are not reflected in the
stock price. This company would not want to issue stock it would prefer to
finance with debt until the higher earnings materialize and are reflected in
the stock price. Then it could sell an issue of common stock, retire the debt
and return to its target capital structure. This point was discussed earlier in
connection with asymmetric information and signaling. </div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<br /></div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<b>12.<span style="mso-tab-count: 1;"> </span>Financial flexibility.</b> An astute corporate
treasurer made this statement to the authors:</div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify; text-indent: -.3in;">
<span style="mso-tab-count: 1;"> </span>Our company can earn a lot more money
from good capital budgeting and operating decisions than from good financing
decisions. Indeed we are not sure exactly how financing decisions affect our
stock price, but we know for sure than having to turn down a promising venture
because funds are not available will reduce our long run profitability. For
this reason my primary goal as treasurer is to always be in a position to raise
the capital needed to support operations. </div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify;">
We also know
that when times are good we can raise capital with either stocks or bonds but
when times are bad, suppliers of capital are much more willing to make funds
available if we give them a secured position and this means debt. Further when
we sell a new issue of stock this sends a negative signal to investors, so
stock sales by a mature company such as ours are not desirable.</div>
<div class="MsoNormal" style="margin-left: .3in; text-align: justify;">
Putting all
these thoughts together gives rise to the goal of maintaining financial
flexibility, which from an operational viewpoint means maintaining adequate
reserve borrowing capacity. Determining an adequate reserve borrowing capacity
is judgmental bit it clearly depends on the factors discussed including the
firm’s forecasted need for funds, predicted capital market conditions
management’s confidence in its forecasts and the consequences of a capital
shortage.</div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-23752666842205812752013-07-31T06:08:00.000-07:002013-07-31T06:08:11.622-07:00Trade off Theory<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
The preceding arguments led to
the development of what is called “the trade-off theory of leverage,” in which
firms trade off the benefits of debt financing (favor-able corporate tax
treatment) against the higher interest rates and bankruptcy costs. A summary of
the trade-off theory is expressed graphically in Figure 13-10. Here are some
observations about the figure:</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
1. The fact that interest is a
deductible expense makes debt less expensive than common or preferred stock. In
effect, the government pays part of the cost of debt capital, or to put it
another way, debt provides tax shelter benefits. As a result, using debt causes
more of the firm’s operating income (EBIT) to flow through to investors, so the
more debt a company uses, the higher its value and stock price. Under the
assumptions of the Modigliani-Miller with-taxes paper, a firm’s stock price
will be maximized if it uses virtually 100 percent debt, and the line labeled
“MM Result Incorporating the Effects of Corporate Taxation” in Figure 13-10
expresses their idea of the relationship between stock prices and debt.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
2. In the real world firms rarely
use 100 percent debt. One reason is the fact that stocks benefit from the lower
capital gains tax. More importantly, firm’s limit their use of debt to hold
down bankruptcy-related costs. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
3. There is some threshold level
of debt, labeled D<sub>1</sub> in Figure 13-10, below which the probability of
bankruptcy is so low as to be immaterial. Beyond D<sub>1</sub>, how-ever,
bankruptcy-related costs become increasingly important, and they reduce the tax
benefits of debt at an increasing rate. In the range from D<sub>1</sub> to D<sub>2</sub>
bankruptcy-related costs reduce but do not completely offset the tax benefits of
debt, so the firm’s stock price rises (but at a decreasing rate) as its debt
ratio increases. However, beyond D<sub>2</sub>, bankruptcy-related costs exceed
the tax benefits, so from this point of increasing the debt ratio lowers the
value of the stock. Therefore, D<sub>2</sub> is the optimal capital structure.
Of course, D<sub>1</sub> and D<sub>2</sub> vary from firm to firm, depending on
their business risk and bankruptcy costs.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
4. While theoretical and
empirical work supports the general shape of the curves in Figures 13-8 and
13-10, these graphs must be taken as approximations, not as precisely defined
function. The numbers in Figure 13-8 are shown out to two decimal places, but
that is merely for illustrative purposes the numbers are not nearly that
accurate in view of the fact that the data on which the graph is based are
judgmental estimates. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
5. Another disturbing aspect of
capital structure theory as expressed in Figure 13-10 is the fact that many
large, successful firms, such as Intel and Microsoft use far less debt than the
theory suggests. This point led to the development of signaling theory, which is
discussed below.</div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-60552261237759134252013-07-29T05:05:00.000-07:002013-07-29T05:05:03.325-07:00Capital Structure Theory<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
Modern capital structure theory
began in 1958, when Professors Franco Modigliani and Merton Miller (hereafter
MM) published what has been called the most influential finance article ever
written.<sup>11</sup> MM proved under a very restrictive set of assumptions,
that a firm’s value is unaffected by its capital structure. Put another way –
MM’s results suggest that it does not matter how a firm finances its
operations, so capital structure is irrelevant. However, MM’s study was based
on some unrealistic assumptions, including the following:</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
1. There are no brokerage costs.</div>
<div class="MsoNormal" style="text-align: justify;">
2. There are no taxes.</div>
<div class="MsoNormal" style="text-align: justify;">
3. There are no bankruptcy costs.</div>
<div class="MsoNormal" style="text-align: justify;">
4. Investors can borrow at the
same rate as corporations.</div>
<div class="MsoNormal" style="text-align: justify;">
5. All investors have the same
information as management about the firm’s future investment <span style="mso-spacerun: yes;"></span>opportunities.</div>
<div class="MsoNormal" style="text-align: justify;">
6. EBIT is not affected by the
use of debt.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Despite the fact that some of
these assumptions are obviously unrealistic, MM’s irrelevance result is
extremely important. By indicating the conditions under which capital structure
is irrelevant, MM also provided us with some clues about what is required for
capital structure to be relevant and hence to affect a firm’s value. MM’s work
marked the beginning of modern capital structure research, and subsequent
research has focused on relaxing the MM assumptions in order to develop a more
realistic theory of capital structure. Research in this area is quite
extensive, but the highlights are summarized in the following sections.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>The Effect of Taxes</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
MM published a follow-up paper in
1963 in which they relaxed the assumption that there are no corporate taxes.<sup>13</sup>
The tax code allows corporations to deduct interest payments as an expense, but
dividend payments to stockholders are not deductible. This differential treatment
encourages corporations to use debt in their capital structures. Indeed, MM
demonstrated that if all their other assumptions hold, this differential
treatment leads to a situation which calls for 100 percent debt financing. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
However, this conclusion was
modified several years later by Merton Miller (this time without Modigliani)
when he brought in the effects of personal taxes.<sup>14</sup> He noted that
all of the income from bonds is generally interest, which is taxed as personal
income at rates going up to 39.6 percent, while income from stocks generally
comes partly from dividends and partly from capital gains. Further capital
gains are taxed at a maximum rate of 28 percent and this tax is deferred until
the stock is sold and the gain realized. If stock is held until the owner dies,
on capital gains tax whatever must be paid. So, on balance, returns on common
stocks are taxed at lower effective rates than returns on debt. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Because of the tax situation,
Miller argued that investors are willing to accept relatively low before-tax
returns on stock relative to the before-tax returns on bonds. For example, an
investor might require a return of 10 percent on Bigbee’s bonds, and if stock
income were taxed at the same rate as bond income, the required rate of return
on Bigbee’s stock might be 16 percent because of the of the stock’s greater
risk. However, in view of the favorable treatment of income on the stock,
investors might be willing to accept a before-tax return of only 14 percent on
the stock. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Thus, as Miller pointed out, (1)
the deductibility of interest favors the use of debt financing, but (2) the
more favorable tax treatment of income from stocks lowers the required rate of
return on stock and thus favors the use of equity financing. It is difficult to
say what the net effect of these two factors is. Most observers believe that
interest deductibility has the stronger effect, hence that our tax system still
favors the corporate use of debt. However, that effect is certainly reduced by
the lower capital gains tax rate. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
One can observe changes in
corporate financing patterns following major changes in tax rates. For example,
in 1993 the top personal tax rate on interest and dividends was raised sharply,
but the capital gains tax rate was not increased. This could be expected to
result in a greater reliance on equity financing, especially through retained
earnings, and that has indeed been the case.</div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-38120350453303995532013-07-28T06:43:00.000-07:002013-07-28T06:43:04.896-07:00Liquidity and Cash Flow Analysis<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
There are some practical
difficulties with the types of analyses described thus far in the description,
including the following. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
1. It is virtually impossible to
determine exactly how either P/E ratios or equity capitalization rates (k<sub>s</sub>
values) are affected by different degrees of financial leverage. The best we
can do is make educated guesses about these relationships. therefore,
management rarely, if ever, has sufficient confidence in the type of analysis
set forth in table 13-5 and Figure 13-8 to use it as the sole determinant of
the target capital structure.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
2. A firm’s managers may be more
or less conservative than the average stockholder, hence management may set a
somewhat different target capital structure than the one that would maximize
the stock price. The managers of a publicly owned firm would never admit this,
for unless they owned voting control, they would quickly be removed from
office. However, in view of the uncertainties about what constitutes the value-maximizing
capital structure, management could always say that the target capital
structure employed is, in its judgment, the value-maximizing structure, and it
would be difficult to prove otherwise. Still, if management is far off target,
especially on the low side then chances are high that some other firm or
management group will take the company over, increase its leverage, and thereby
raise its value. This point is discussed in more detail. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
3. Managers of large firms,
especially those which provide vital services such as electricity or
telephones, have a responsibility to provide continuous service; therefore,
they must refrain from using leverage to the point where the firms’ long-run
viability is endangered. Long-run viability may conflict with short-run stock
price maximization and capital cost minimization.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
For all of these reasons,
managers are concerned about the effects of financial leverage on the risk of
bankruptcy, so an analysis of potential financial distress is an important
input in all capital structure decisions. Accordingly, managements give
considerable weight to financial strength indicators such as the
times-interest-earned (TIE) ratio. The lower this ratio, the higher the
probability that a firm will default on its debt and be forced into bankruptcy.
</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
The tabular material in the lower
section of Figure 13-9 shows Bigbee’s expected TIE ratio at several different
debt/assets. If the debt/assets ratio were only 10 percent, the expected TIE
would be a high 25 times, and the probability of the actual TIE falling below
1.0 would be only 6.4 percent. However, the expected interest coverage ratio
would decline rapidly if the debt ratio were increased and the probability of
the actual TIE falling below 1.0 would rise, We must stress that the coverage’s
shown in the table are the expected values at different debt ratios, and that
the actual TIE at any debt ratio would be higher if sales exceeded the expected
$200,000 level, but lower if sales fell below $200,000. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Figure 13-9 graphs Bigbee’s probability
of default at different levels of debt. In Bigbee’s case, the TIE ratio has a
normal distribution, and we used that fact to find the area under the normal
curve to the left of 1.0. This number represents the probability that the
company will have a TIE ratio less than 1.0 and thus will not be covering its
interest expense. We have defined this area to be the probability of default.
As you can see from the graph, the chance of default increases as the debt
ratio increases.</div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com1tag:blogger.com,1999:blog-7841395506735834828.post-90500012034328777902013-07-25T22:22:00.001-07:002013-07-25T22:22:54.321-07:00Business and Financial Risk<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
When we examined risk from the
viewpoint of the individual investor, we distinguished between risk on a
stand-alone basis, where an asset’s cash flows are analyzed by themselves, and
risk in a portfolio context, where the cash flow’s from a number of assets are
combined and then the consolidated cash flows are analyzed. In a portfolio
context, we saw that an asset’s risk can be divided into two components:
diversifiable risk, which can be diversified away and hence is of little concern
to most investors, and market risk, which is measured by the beta coefficient
and which reflects broad market movements that cannot be eliminated by
diversification and therefore is of concern to all investors. We examined risk
from the viewpoint of the corporation, and we considered how capital budgeting
decisions affect the firm’s riskiness.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Now we introduce two new
dimensions of risk:</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
1. Business risk, which is the
riskiness of the firm’s assets if it uses no debt. </div>
<div class="MsoNormal" style="text-align: justify;">
2. Financial risk, which is the
additional risk placed on the common stockholders as a result of the decision
to use debt.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b><u>Business Risk</u></b></div>
<div class="MsoNormal" style="text-align: justify;">
Business risk is defined as the
uncertainty inherent in projections of future returns on assets (ROA), and t is
the single most important determinant of capital structure. Consider Bigbee
Electronics Company, a firm that currently uses 100 percent equity. Since the
company has no debt, its ROE moves in lock-step with its ROA, and either ROE or
ROA can be examined to estimate business risk. Figure 13-1 gives some clues
about Bigbee’s business risk. The top graph shows the trend in ROE (and ROA)
from 1987 through 1997; this graph gives both security analysts and Bigbee’s management
an idea of the extent to which ROE has varied in the past and might vary in the
future. The bottom graph shows the beginning-of-year, subjectively estimated
probability distribution of Bigbee’s ROE for 1997 based on the trend line in
the top section of Figure 13-1. The estimate was made at the beginning of 1997,
and the expected 12 percent was read from the trend line. As the graphs
indicate, the actual ROE in 1997 (8%) fell below the expected value (12%).</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Bigbee’s past fluctuations in ROE
were caused by many factors-booms and recessions in the national economy,
successful new products introduced both by Bigbee and by its competitors, labor
strikes, a fire in Bigbee’s major plant, and so on. Similar events will
doubtless occur in the future, and when they do, ROE will rise or fall.
Further, there is always the possibility that a long-term disaster will strike,
permanently depressing the company’s earning power. For example, a competitor
might introduce a new product that would permanently lower Bigbee’s earnings.<sup>2</sup>
Uncertainty about Bigbee’s future ROE is the company’s basic business risk.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Business risk varies from one
industry to another and also among firms in a given industry. Further, business
risk can change over time. For example, the electric utilities were regarded
for years as having little business risk, but the introduction of competition
in recent years altered their situation, producing sharp declines in ROE for
some companies and greatly their situation. Producing sharp declines in ROE for
some companies and greatly increasing the industry’s business risk. Today, food
processors and grocery retailers are frequently cited as examples of industries
with low business risk. Whereas cyclical manufacturing industries such as steel
are regarded as having relatively high business risk. Smaller companies,
especially single product firms, also have relatively high business risk.<sup>3</sup></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>Business risk depends on a
number of factors, including the following:</b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>1. Demand (unit sales)
variability.</b> The more stable a firm’s unit sales, other things held
constant, the lover its business risk. The amount of competition a firm face is
a factor here:</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>2. Sales price variability.</b>
Firms whose products are sold in highly volatile markets are exposed to more
business risk than similar firms whose output prices are relatively stable.
Again, the amount of competition faced is important. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>3. Input price variability.</b>
Firm whose input costs. Including product development costs, are highly
uncertain are exposed to high business risk.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>4. Ability to adjust output
prices for changes in input prices.</b> Some firms have little difficulty in
raising their own output prices when input costs rise, and the greater the
ability to adjust output prices, the lower the business risk. This factor is
especially important during periods of high inflation. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>5. The extent to which costs
are fixed: operating leverage.</b> If a high percentage of costs are fixed,
hence do not decline when demand decreases, this increases the company’s business
risk. This factor is called operating leverage, and it is discussed at length
in the next section. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Each of these factors in influenced
by the firm’s industry characteristics, but each is also controllable to some
extent by management. For example, many firms can through their marketing policies,
take actions to stabilize both unit sales and sales prices. However, such
stabilization may require either large expenditures on advertising or price
concessions to induce customers to commit to purchase fixed quantities at fixed
prices in the future. Similarly, firms such as Bigbee Electronics can reduce
the volatility of future input costs by negotiating long-term labor and
materials supply contracts, but they may have to agree to pay prices above the
current market price to obtain these contracts.<sup>4</sup> </div>
</div>
Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-53630983906941061342013-07-23T07:07:00.001-07:002013-07-23T07:07:01.897-07:00The Target Capital Structure<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
Firms should first analyze a
number of factors, then establish a target capital structure. This target may
change over time as conditions change, but at any given moment, management
should have a specific capital structure in mind. If the actual debt ratio is
below the target level, expansion capital will probably be raised by issuing
debt, whereas if the debt ratio is above the target equity will probably be
used.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<ul style="margin-top: 0in;" type="disc">
<li class="MsoNormal" style="mso-list: l0 level1 lfo1; tab-stops: list .5in; text-align: justify;">Using more debt raises the risk borne by stockholders.</li>
<li class="MsoNormal" style="mso-list: l0 level1 lfo1; tab-stops: list .5in; text-align: justify;">However, using more debt generally leads to a higher
expected rate of return.</li>
</ul>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Higher risk tends to lower a
stock’s price, but a higher expected rate of return raises it. Therefore the
optimal capital structure must strike that balance between risk and return which
maximizes the firm’s stock price.</div>
<div class="MsoNormal" style="text-align: justify;">
Four primary factors influence
capital structure decisions.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
1. Business risk or the riskiness
inherent in the firm’s operations if it used no debt. The greater the firm’s
business risk. the lower its optimal debt ratio.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
2. The firm’s tax position. A
major reason for using debt is that interest is deductible, which lowers the
effective cost of debt. However, if most of a firm’s income is already <span style="mso-spacerun: yes;"> </span>sheltered from taxes by depreciation tax
shields, interest on currently out standing debt, or tax loss carry-forwards
its tax rate will be low. so additional debt will not be as advantageous as it
would be to a firm with a higher effective tax rate. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
3. Financial flexibility, or the
ability to raise capital on reasonable terms under adverse conditions.
Corporate treasurers know that a steady supply of capital is necessary for
stable operations, which is vital for long-run success. They also know that
when money is tight in the economy, or when a firm is experiencing operating difficulties,
suppliers of capital prefer to provide funds to companies with strong balance
sheets. Therefore, both the potential future need for funds and the
consequences of a funds shortage influence the target capital structure-the
greater the probable future need for capital and the worse the consequences of
a capital shortage, the stronger the balance sheet should be.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
4. Managerial conservatism or
aggressiveness. Some managers are more aggressive than others,<span style="mso-spacerun: yes;"> </span>hence some firm’s are more inclined to use
debt in a effort to boost profits. This factor does not affect the true
optimal, or value maximizing. Capital structure, but it does influence the
manager-determined target capital structure. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
These four points largely
determine the target capital structure, but operating conditions can cause the
actual capital structure to vary from the target. For example, Illinois power
has a target debt ratio of about 45 percent, but large losses associated with a
nuclear plant forced it to write down its common equity, and that raised the
debt ratio above the target level. The company is now trying to get its equity
back up to the target level.</div>
<br />
<div id="__tbSetup">
</div>
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Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-68199095668001566272013-07-22T07:19:00.001-07:002013-07-22T07:19:11.285-07:00Introduction To Project Risk Analysis<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
Three separate and distinct types
of risk can be identified:</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>1. Stand-alone risk,</b> which
is the project’s risk disregarding the fact that is but one asset within the
firm’s portfolio of assets and that the firm is but one stock in a typical
investor’s portfolio of stocks. Stand-alone risk is measured by the variability
of the project’s expected returns. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>2. Corporate, or within-firm,
risk,</b> which is the project’s risk to the corporation, giving consideration
to the fact that the project represents only one of the firm’s portfolio of
assets, hence that some of its risk effects on the firm’s profits will be
diversified away. Corporate risk is measured by the project’s impact on
uncertainty about the firm’s future earnings.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>3. Market, or beta, risk,</b>
which is the riskiness of the project as seen by a well-diversified stockholder
who recognizes that the project is only one of the firm’s assets and that the
firm’s stock is but one small part of the investor’s total portfolio. Market
risk is measured by the project’s effect on the firm’s beta coefficient.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
As we shall see, a particular
project may have high stand-alone risk, yet because of portfolio effects,
taking it on may not have much effect on either the firm’s risk or that of its
owners.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Taking on a project with a high
degree of either stand-alone or corporate risk will not necessarily affect the
firm’s beta. However, if the project has highly uncertain returns, and if those
returns are highly correlated with returns on the firm’s other assets and with
most other assets in the economy, the project will have a high degree of all
types of risk. For example, suppose General Motors decides to undertake a major
expansion to build electric autos. GM is not sure how its technology will work
on a mass production basis, so there are great risks in the venture-its
stand-alone risk is high. Management also estimates that the project will do
best if the economy is strong, for then people will have more money to spend on
the new autos. This means that the project will tend to do well if GM’s profits
are highly correlated with those of most other firms, the project’s beta will
also be high. Thus, this project will be risky under all three definitions of
risk. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Market risk is important because
of its effect on a firm’s stock price: Beta affects k, and k affects the stock
price. Corporate risk is also important, for these three reasons:</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
1. Undiversified stockholders,
including the owners of small businesses, are more concerned about corporate
risk than about market risk.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
2. Empirical studies of the
determinants of required rates of return (k) generally find that both market
and corporate risk affect stock prices. This suggests that investors, even
those who are will diversified, consider factors other than market risk when
they establish required returns. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
3. The firm’s stability is
important to its managers, workers, customers, suppliers and creditors, as well
as to the community in which it operates. Firms that are in serious danger of bankruptcy,
or even of suffering low profits and reduced output, have difficulty
attract9ing and retaining good managers and workers. Also both suppliers and customers
are reluctant to depend on weak firm’s and such firms have difficulty borrowing
money at reasonable interest rates. These factors tend to reduce risky firms
profitability and hence their stock prices and this makes corporate risk
significant.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
For these three reasons,
corporate risk is important even if a firm’s stockholders are well diversified.</div>
<br />
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Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-88792699212670392052013-07-21T07:40:00.005-07:002013-07-21T07:40:39.058-07:00The Market For Common Stock<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
Some companies are so small that
their common stocks are not actively traded; they are owned by only a few
people, usually the companies’ managers. Such firms are said to be privately
owned, or closely held, corporations, and their stock is called closely held
stock. In contrast, the stocks of most larger companies are owned by a large
number of investors, most of whom are not active in management. Such companies
are called publicly owned corporations, and their stock is called publicly held
stock.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
As we saw in the stocks of
smaller publicly owned firms are not listed on an exchange; they trade in the
over-the-counter (OTC) market, and the companies and their stocks are said to
be unlisted. However, larger publicly owned companies generally apply for
listing on an organized security exchange, and they and their stocks are said
to be listed. Often companies are first listed on a regional exchange such as
the Pacific Coast or Midwest Exchange. Then, as they grow, they move up to the
American Stock Exchange (AMEX). Finally, if they grow large enough they are
listed on the Big Board, the New York Stock Exchange (NYSE). About 7,000 stocks
are traded in the OTC market, but in terms of market value of both outstanding
shares and daily transactions, <span style="mso-spacerun: yes;"> </span>the NYSE
is most important, having about 55 percent of the business.</div>
<div class="MsoNormal" style="text-align: justify;">
A recent study found that
institutional investors owned about 46 percent of all publicly held common
stocks, included are pension plans (26 percent), mutual funs (10 percent),
foreign investors (6 percent), insurance companies (3 percent), and brokerage
firms (1 percent). These institutions buy and sell relatively actively,
however, so they account for about 75 percent of all transactions. Thus,
institutional investors have a heavy influence on the prices of individual
stocks.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>Types of Stock Market
Transactions</b></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
We can classify stock market
transactions into three distinct types:</div>
<div class="MsoNormal" style="text-align: justify;">
<b>1.</b> <b>Trading in the
outstanding shares of established, publicly owned companies: the secondary
market. </b>Allied Food Products, the company we analyzed in earlier chapters,
has 50 million shares of stock outstanding. If the owner of 100 shares sells
his or her stock, the trade is said to have occurred in the secondary market.
Thus, the market for outstanding shares, or used shares, is the secondary
market. The company received no new money when sales occur in this market.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>2. Additional shares sold by
established, publicly owned companies: the primary market.</b> if allied decides
to sell (or issue) an additional 1 million shares to raise new equity capital,
this transaction is said to occur in the primary market<sup>2</sup>.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>3. Initial public offerings by
privately held firms: the IPO market.</b> Several years ago, the Coors Brewing
Company, which was owned by the Coors family at the time, decided to sell some
stock to raise capital needed for a major expansion program<sup>3</sup>. This
type of transaction is called going public whenever stock in a closely held
corporation is offered to the public for the first time, the company is said to
be going public. The market for stock that is just being offered to the public
is called the initial public offering (IPO) market. IPOs have received a lot of
attention in recent years, primarily because a number of ‘hot’ issues have
realized spectacular gains often in the first few minutes of trading. Consider
the recent IPO of Boston Rotisserie Chicken, which has since been renamed
Boston Market. The company’s underwriter, Merrill Lynch, set an offering price
of $20 a share. However, because of intense demand for the issue the stock’s
price rose 75 percent within the first two hours of trading. by the end of the
first day, the stock price had risen by 143 percent, and the company’s
end-of-the-day market value was $800 million which was particularly startling,
given that the company had recently reported a $5 million loss on only $8.3
million of sales. More recently, shares of the trendy restaurant chain planet
Hollywood rose nearly 50 percent in its first day of trading and when Netscape
first his the market, its stock’s price hit $70 a share versus an offering
price of only $28 a share. (See the Industry Practice box above, “A Wild
Initial Day of Trading”).</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Table 8-1 Lists the largest, the
best performing, and the worst performing IPOs of 1996, and it shows how they
performed from their offering dates through year-end 1996. As the table shows,
not all IPOs are as well received as were Netscape and Boston Chicken.
Moreover, even if you are able to identify a “hot” issue, it is often difficult
to purchase shares in the initial offering. These deals are generally
oversubscribed, which means that the demand for shares at the offering price
exceeds the number of shares issued. In such instances, investment bankers
favor large institutional investors (who are their best customers), and small
investors find it hard if not impossible, to get in on the ground floor. They
can buy the stock in the after-market, but evidence suggests that if you do not
get in on the ground floor, the average IPO under performs the overall market
over the longer run<sup>4</sup>.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Finally, it is important to
recognize that firms can go public without raising any additional capital. For
example, the Ford Motor Company was once owned exclusively by the Ford family.
When Henry Ford died, he left a substantial part of his stock to the Ford
Foundation. When the Foundation later sold some of this stock to the general
public the Ford Motor Company went public, even though the company raised no
capital in the transaction.</div>
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Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-30381910866032750652013-07-20T09:16:00.006-07:002013-07-20T09:16:49.270-07:00Zero Coupon Bonds<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
To understand hoe zeros are used
and analyzed, consider the zeros that are going to be issued by Vandenberg
Corporation, a shopping center developer. Vandenberg is developing a new
shopping center in San Diego. California, and it needs $50 million. The company
does not anticipate major cash flows from the project for about five years.
However, Pieter Vandenberg, the president, plans to sell the center once it is
fully developed and rented. Which should take about five years. Therefore, Vandenberg
wants to use a financing vehicle that will not require cash outflows for five
years, and he has decided on a five year zero coupon bond, with a maturity
value of $1,000. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Vandenberg Corporation is an
A-rated company, and A-rated zeros with five year maturities yield 6 percent at
this time (five-year coupon bonds also yield 6 percent). The company is in the
40 percent federal-plus-state tax bracket. Pieter Vandenberg wants to know the
firm’s after-tax cost of debt if it uses 6 percent, five-year maturity zeros,
and he also wants to know what the bond’s cash flows will be. Table 7A-1
provides an analysis of the situation and the following numbered paragraphs
explain the table itself.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
1. The information in the “Basic
Data” section, except the issue price was given in the preceding paragraph, and
the information in the “Analysis” section was calculated using the known data.
The maturity value of the bond is always set at $1,000 or some multiple
thereof.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>2.</b> The issue price is the PV of
$1,000, discounted back five years at the rate k<sub>d</sub>=6%, annual
compounding. Using the tables, we find PV=$1,000(0.7473) =$747.30. Using a financial
calculator, we input N=5,1=6, PMT=0, and FV=1000, the press the PV key to find
PV=$747.26. Note that $747.26. Compounded annually for five years at 6 percent,
will grow to $1,000 as shown by the time line on Line 1 in table 7A-1.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>3.</b> The accrued values as shown on
Line 1 in the analysis section represent the compounded value of the bond at
the end of each year. The accrued value for Year 0 is the issue price; the
accrued value for Year 1 is found as $747.26(1.06)=$792.10; the accrued value
at the end of year 2 is $747.26(1.06)<sup>2</sup>=$839.62; and in general the
value at the end of any year in is </div>
<div class="MsoNormal" style="text-align: justify;">
Accrued value at the end of Year
n=issue price × (1+k<sub>3</sub>)<sup>n</sup>. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>4.</b> The interest deduction as
shown on Line 2 represents the increase in accrued value during the year. Thus,
interest in Year 1=$792.10 - $747.26=$44.84. in general, </div>
<div class="MsoNormal" style="text-align: justify;">
Interest in year n=Accrued value<sub>n</sub>
– Accrued value<sub>n-1</sub>.</div>
<div class="MsoNormal" style="text-align: justify;">
This method of calculating
taxable interest is specified in the Tax Code.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>5.</b> The company can deduct
interest each year, even though the payment is not made in cash. This deduction
lowers the taxes that would otherwise be paid, producing the following savings:</div>
<div class="MsoNormal" style="text-align: justify;">
Tax savings <span style="mso-tab-count: 1;"> </span>= (Interest deduction) (T).</div>
<div class="MsoNormal" style="text-align: justify;">
<span style="mso-tab-count: 2;"> </span>=
$44.84 (0.4)</div>
<div class="MsoNormal" style="text-align: justify;">
<span style="mso-tab-count: 2;"> </span>=
$17.94 in year 1.</div>
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Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-76454668127308163932013-07-20T08:05:00.000-07:002013-07-20T08:05:04.060-07:00Bond Markets<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
Corporate bonds are traded
primarily in the over-the-counter market. Most bonds are owned by and traded
amount the large financial institutions (for example, life insurance companies,
mutual funds, and pension funds, all of which deal in very large blocks of
securities), and it is relatively easy for the over-the-counter bond dealers to
arrange the transfer of large blocks of bonds among the relatively few holders
of the bonds. It would be much more difficult to conduct similar operations in
the stock market among the literally millions of large and small stockholders,
so a higher percentage of stock trades occur on the exchanges.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Information on bond trades in the
over-the-counter market is not published, but a representative group of bonds
is listed and traded on the bond division of the NYSE. Figure 7-6 gives a
section of the bond market page of The Wall Street journal for trading on
September 18, 1996. A total of 310 issues were traded on that date, but we show
only the bonds of Cleveland Electric company. Note that Cleveland electric had
three different bonds that were traded on September 18; the company actually
had more than ten bond issues outstanding, but most of them did not trade on
that date. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
The bonds of Cleveland Electric
and other companies can have various denominations, but for convenience we
generally think of each bond as having a par value of $1,000 this is how much
per bond the company borrowed and how much it must someday repay. However,
since other denominations are possible, for trading and reporting purposes
bonds are quoted as percentages of par. Looking at the first bond listed in the
data in Figure 7-6, we see that there is an 8<sup>3</sup>/<sub>4 </sub><span style="mso-spacerun: yes;"> </span>just after the company’s name; this indicates
that the bond is of the series which pays 8<sup>3</sup>/<sub>4</sub> percent
interest, or 0.0875($1,000)=$87.50 of interest per year. The 8<sup>3</sup>/<sub>4
</sub>percent is the bond’s coupon rate. The Cleveland Electric bonds, and all
the others listed in the Journal, pay interest semiannually, so all rates are
nominal, not EAR rates. The 05 which comes next indicates that this bond
matures and must be repaid in the year 2005; it is not shown in the figure but
this bond was issued in 1970, so it had a 35 year original maturity. The 8.9 in
the second column is the bond’s current yield; Current yield =$87.50/$980=8.93%,
rounded to 8.9 percent. The 477 in the third column indicates that 477 of these
bonds were traded on September 18, 1996. Since the price shown in the fourth
column is expressed as a percentage of par, the bond closed at 98 percent.
Which translates to $980, the same as the previous day’s close. </div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<span style="font-family: "Times New Roman"; font-size: 12.0pt; mso-ansi-language: EN-US; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US;">Coupon rates are
generally set at levels which reflect the “going rate of interest” on the day a
bond is issued. If the rates were set lower, investors simply would not buy the
bonds at the $1,000 par value, so the company could not borrow the money it
needed. Thus, bonds generally sell at their par values on the day they are
issued, but bond prices fluctuate thereafter as interest rates change.</span><br />
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Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0tag:blogger.com,1999:blog-7841395506735834828.post-34195870737198577862013-07-19T00:40:00.000-07:002013-07-19T00:40:04.254-07:00Who Issues Bonds ?<div dir="ltr" style="text-align: left;" trbidi="on">
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<br />
<div class="MsoNormal" style="text-align: justify;">
A bond is a long-term contract
under which a borrower agrees to make payments of interest and principal, on
specific dates, to the holders of the bond. Fox example, on January 2, 1998,
Allied Food Products borrowed $50 million by selling 50,000 individual bonds
for $1,000 each. Allied received the $50 million, and in exchange it promised
to make annual interest payments and to repay the $50 million on a specified
maturity date.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
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Investors have many choices when
investing in bonds, but bonds are classified into four main types: Treasury,
corporate, municipal, and foreign. Each type differs with respect to expected
return and degree of risk.</div>
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<b>Treasury bonds</b>, sometimes
referred to as government bonds, are issued by the federal government<sup>1</sup>.
It is reasonable to assume that the federal government will make good on its
promised payments, so these bonds have no default risk. However, Treasury bond
prices decline when interest rates rise, so they are not free of all risks.</div>
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<b>Corporate bonds,</b> as the name
implies, are issued by corporations. Unlike Treasury bonds, corporate bonds are
exposed to default risk-if the issuing company gets into trouble, it may be
unable to make the promised interest and principal payments. Different
corporate bonds have different levels of default risk, depending on the issuing
company’s characteristics and on the terms of the specific bond. Default risk
is often referred to as “credit risk”, the larger the default or credit risk,
the higher the interest rate the issuer must pay.</div>
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<b>Municipal bonds</b>, or
“munis”, are issued by state and local governments. Like corporate bonds, munis
have default risk. However, munis offer one major advantage over all other
bonds: the interest earned on most municipal bonds is exempt from federal taxes,
and also from state taxes if the holder is a resident of the issuing state.
Consequently municipal bonds carry interest rates that are considerably lower
than those on corporate bonds with the same default risk.</div>
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<b>Foreign bonds</b> are issued
by foreign governments or foreign corporations. Foreign corporate bonds are, of
course, exposed to default risk, and so are some foreign government bonds. An
additional risk exists if the bonds are denominated in a currency other than
that of the investor’s home currency. For example, if you purchase corporate
bonds denominated in Japanese yen, you will lose money-even if the company does
not default on its bonds if the Japanese yen falls relative to the dollar.</div>
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Tradehttp://www.blogger.com/profile/07771886235703224501noreply@blogger.com0