Liquidity and Cash Flow Analysis

There are some practical difficulties with the types of analyses described thus far in the description, including the following.

1. It is virtually impossible to determine exactly how either P/E ratios or equity capitalization rates (k_s 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.

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.

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.

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.

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.

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.

Business and Financial Risk

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.

Now we introduce two new dimensions of risk:

1. Business risk, which is the riskiness of the firm’s assets if it uses no debt.

2. Financial risk, which is the additional risk placed on the common stockholders as a result of the decision to use debt.

Business Risk

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%).

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.² Uncertainty about Bigbee’s future ROE is the company’s basic business risk.

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.³

Business risk depends on a number of factors, including the following:

1. Demand (unit sales) variability. 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:

2. Sales price variability. 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.

3. Input price variability. Firm whose input costs. Including product development costs, are highly uncertain are exposed to high business risk.

4. Ability to adjust output prices for changes in input prices. 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.

5. The extent to which costs are fixed: operating leverage. 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.

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.⁴

The Target Capital Structure

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.

• Using more debt raises the risk borne by stockholders.
• However, using more debt generally leads to a higher expected rate of return.

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.

Four primary factors influence capital structure decisions.

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.

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  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.

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.

4. Managerial conservatism or aggressiveness. Some managers are more aggressive than others,  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.

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.

Introduction To Project Risk Analysis

Three separate and distinct types of risk can be identified:

1. Stand-alone risk, 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.

2. Corporate, or within-firm, risk, 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.

3. Market, or beta, risk, 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.

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.

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.

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:

1. Undiversified stockholders, including the owners of small businesses, are more concerned about corporate risk than about market risk.

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.

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.

For these three reasons, corporate risk is important even if a firm’s stockholders are well diversified.

The Market For Common Stock

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.

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,  the NYSE is most important, having about 55 percent of the business.

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.

Types of Stock Market Transactions

We can classify stock market transactions into three distinct types:

1. Trading in the outstanding shares of established, publicly owned companies: the secondary market. 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.

2. Additional shares sold by established, publicly owned companies: the primary market. 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 market².

3. Initial public offerings by privately held firms: the IPO market. 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 program³. 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”).

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 run⁴.

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.

Zero Coupon Bonds

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.

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.

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.

2. The issue price is the PV of $1,000, discounted back five years at the rate k_d=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.

3. 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)²=$839.62; and in general the value at the end of any year in is

Accrued value at the end of Year n=issue price × (1+k₃)ⁿ.

4. 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,

Interest in year n=Accrued value_n – Accrued value_n-1.

This method of calculating taxable interest is specified in the Tax Code.

5. 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:

Tax savings     = (Interest deduction) (T).

                        = $44.84 (0.4)

                        = $17.94 in year 1.

Bond Markets

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.

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.

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 8³/₄  just after the company’s name; this indicates that the bond is of the series which pays 8³/₄ percent interest, or 0.0875($1,000)=$87.50 of interest per year. The 8³/₄ 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.

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.