Trade off Theory

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:

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.

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.

3. There is some threshold level of debt, labeled D₁ in Figure 13-10, below which the probability of bankruptcy is so low as to be immaterial. Beyond D₁, how-ever, bankruptcy-related costs become increasingly important, and they reduce the tax benefits of debt at an increasing rate. In the range from D₁ to D₂ 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 D₂, bankruptcy-related costs exceed the tax benefits, so from this point of increasing the debt ratio lowers the value of the stock. Therefore, D₂ is the optimal capital structure. Of course, D₁ and D₂ vary from firm to firm, depending on their business risk and bankruptcy costs.

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.

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.

Capital Structure Theory

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.¹¹ 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:

1. There are no brokerage costs.

2. There are no taxes.

3. There are no bankruptcy costs.

4. Investors can borrow at the same rate as corporations.

5. All investors have the same information as management about the firm’s future investment opportunities.

6. EBIT is not affected by the use of debt.

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.

The Effect of Taxes

MM published a follow-up paper in 1963 in which they relaxed the assumption that there are no corporate taxes.¹³ 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.

However, this conclusion was modified several years later by Merton Miller (this time without Modigliani) when he brought in the effects of personal taxes.¹⁴ 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.

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.

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.

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.

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.

Who Issues Bonds ?

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.

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.

Treasury bonds, sometimes referred to as government bonds, are issued by the federal government¹. 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.

Corporate bonds, 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.

Municipal bonds, 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.

Foreign bonds 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.

Some Trends in Security Trading Procedures

From the NYSE’s inception in 1792 until the 1970s, the vast majority of all stock trading occurred on the Exchange and was conducted by member firms. The NYSE established a set of minimum brokerage commission rates, and no member firm could charge a commission lower than the set rate. This was a monopoly pure and simple. However, on May 1, 1975, the Securities and Exchange Commission (SEC), with strong prodding from the Antitrust Division of the Justice Department, forced the NYSE to abandon its fixed commissions. Commission rates declined dramatically, falling in some cases as much as 95 percent from former levels.

These changes were a boon to the in the investing public, but not to the brokerage industry. Several “full-service” brokerage houses went bankrupt, and others were forced to merge with stronger firms. The number of brokerage house has declined from literally thousands in the 1960s to a much smaller number of large, strong, nationwide companies. Many of which are units of diversified financial service corporations. Deregulation has also spawned a number of “discount brokers”. Some of which are affiliated with commercial banks mutual fund investment companies³. There has also been a rise in “third market” activities. Where large financial institutions trade both listed and unlisted stocks among themselves on a 24-hour basis. Buyers and sellers in this market are located all around the globe-New York. Scan Francisco, Tokyo, Singapore, Zurich, and London-and this makes the 24-hour trading day a necessity. The exchanges have resisted extending their trading hours because it would inconvenience members, but competition will eventually force all major exchanges to operate around the clock. Today, institutional investors, and even some individuals, can trade by computer at any time, day or night.

The Over-The-Counter Market

In contrast to the organized security exchanges, the over-the-counter market is a nebulous, intangible organization. An explanation of the term “over-the-counter” will help clarify exactly what this market is. As noted above, the exchanges operate as auction markets-buy and sell orders come in more or less simultaneously, and exchange members match these orders. If a stock is traded less frequently, perhaps because it is the stock of a new or a small firm, few buy and sell orders come in and matching them within a reasonable length of time would be difficult. To avoid this problem, some brokerage firms maintain an inventory of such stocks-they buy when individual investors want to sell and sell when investors want to buy. At one time, the inventory of securities was kept in a safe and the stocks, when bought and sold, were literally passed over the counter.

Today, the over-the-counter market is defined to include all facilities that are needed to conduct security transactions not conducted on the organized exchanges. These facilities consist of (1) the relatively few dealers who hold inventories of over-the-counter securities and who are said to “make a market” in these securities: (2) the thousands of brokers who act as agents in bringing the dealers together with investors; and (3) the computers, terminals, and electronic networks that provide a communications link between dealers and brokers. The dealers who make a market in a particular stock continuously quote a price at which they are willing to buy the stock (the bid price) and a price at which they will sell shares (the asked price). Each dealer’s prices, which are adjusted as supply and demand conditions change, can be read off computer screens all across the country. The spread between bid and asked prices represents the dealer’s markup or profit.

Brokers and dealers who make up the over-the-counter market are members of a self-regulating body known as the National Association of Securities Dealers (NASD), which licenses brokers and oversees trading practices. The computerized trading network used by NASD is known as the NASD Automated Quotation System (NASDAQ), and the wall Street journal and other newspapers provide information on NASDAQ transactions.

In terms of numbers of issues, the majority of stocks are traded over the counter, and trading volume is greater on NASDAQ stocks than on the NYSE. However, because the stocks of most large companies are listed on the exchanges, more than half on the dollar volume of stock trading takes place on the exchanges. In recent years, many large companies-including Microsoft, Intel, MCI, and Apple-have elected to remain NASDAQ stocks, so the over-the-counter market is growing faster than the exchanges.

The Stock Market

As noted earlier, secondary markets are those in which outstanding previously issued securities are traded. By far the most active secondary market, and the most important one to financial manages, is the stock market. Here the prices of firm’s stocks are established. Since the primary goal of financial management is to maximize the firm’s stock price, a knowledge of the stock market is important to anyone involved in managing a business.

The Stock Exchanges

There are two basic types of stock markets: (1) organized exchanges, which include the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and several regional exchanges, and (20 the less formal over-the-counter market. since the organized exchanges have actual physical market locations and are easier to describe and understand, we consider them first.

The organized security exchanges are tangible physical entities. Each of the larger ones occupies its own building, has a limited number of members, and has an elected governing body its board of governors. Members are said to have “seats” on the exchange although everybody stands up. These seats which are bought and sold, give the holder the right to trade on the exchange. There are more than 1,300 seats on the New York Stock Exchange, and recently NYSE seats were selling for about $1.5 million.

Most of the larger Investment Banking houses operate brokerage departments, and they own seats on the exchanges and designate one or more of their officers as members. The exchanges are open on all normal working days, with the members meeting in a large room equipped with telephones and other electronic equipment that enable each member to communicate with his or her firm’s offices throughout the country.

Like other markets, security exchanges facilitate communication between buyers and sellers. For example, Merrill Lynch (the largest brokerage firm) might received an order in its Atlanta office from a customer who wants to buy 100 shares of AT&T stock. Simultaneously, Dean Witter’s Denver office might receive an order from a customer wishing to sell 100 shares of AT&T. Each broker communicates by wire with the firm’s representative on the NYSE. Other brokers through out the country are also communicating with their own exchange members. The exchange members with sell orders offer the shares for sale, and they are bid for by the members with buy orders. Thus, the exchanges operate as auction markets².

The Financial Market

Businesses, individuals and governments often need to raise capital. For example suppose Carolina Power & Light (CP&L) forecasts an increase in the demand for electricity in North Carolina and the company decides to build a new power plant. Because CP&L almost certainly will not have the $2 billion or so necessary to pay for the plant, the company will have to raise this capital in the financial markets. Or suppose Mr. Fong, the proprietor for a San Francisco hardware store, decides to expand into appliances. Where will he get the money to buy the initial inventory of TV sets, washers an freezers? Similarly, if the Johnson family wants to buy a home that costs $100,000, but they have only $20,000 in savings, how can they raise the additional $80,000? If the city of New York wants to borrow $200 million to finance a new sewer plant, or the federal government needs more than $100 billion to cover its projected 1997 deficit, they too need access to the capital markets.

On the other hand, some individuals and firms have incomes which are greater than their current expenditures, so they have funds available to inverts. For example, Carol Hawk has an income of $36,000 but her expenses are only $30,000, and in 1997 Ford Motor Company had accumulated more than $19 billion of excess cash, which it needs to invest.

Types of Markets

People and organizations wanting to borrow money are brought together with those having surplus funds in the financial markets. Note that markets is plural there are a great many different financial markets in a developed economy such as ours. Each market deals with a somewhat different type of instrument in terms of the instruments maturity and the assets backing it. Also different markets serve different types of customers, or operate in different parts of the country. Here are some of the major types of markets:

1. Physical asset markets (also called “tangible” or “real” asset markets) are those for such products as wheat, autos, real estate, computers and machinery. Financial asset markets, on the other hand deal with stocks bonds notes mortgages, and other claims on real assets, as well as with derivative securities whose values are derived from changes in the prices of other assets.

2. Spot markets and futures markets are terms that refer to whether the assets are being bought or sold for “on-the-spot” delivery (literally, within a few days) or for delivery at some future date such as six months or a year into the future.

3. Money markets are the markets for short-term, highly liquid debt securities. The New York and London money markets have long been the world’s largest but Tokyo is rising rapidly. Capital markets are the markets for long term debt and corporate stocks. The New York Stock Exchange, where the stocks of the largest U.S. corporations are traded, is a prime example of a capital market. There is no hard and fast rule on this, but when describing debt markets, “short term” generally means less than one year, “intermediate term” means one to five years and “long term” means more than five years.

4. Mortgage markets deal with loans on residential, commercial, and industrial real estate, and on farmland, while consumer credit markets involve loans on autos and appliances as well as loans for education vacations and so on.

5. World national regional and local markets also exist. Thus, depending on an organization’s size and scope of operations, it may be confined to a strictly local even neighborhood market.

6. Primary Markets are the markets in which corporations raise new capital. If Microsoft were to sell a new issue of common stock to raise capital, this would be a primary market transaction. The corporation selling the newly created stock receives the proceeds from the sale in a primary market transaction.  

Secondary markets are markets in which existing already outstanding, securities are traded among investors. Thus if Jane Doe decided to buy 1,000 shares of AT&T stock, the purchase would occur in the secondary market. The New York Stock Exchange is a secondary market, since it deals in outstanding as opposed to newly issued, stocks and bonds. Secondary markets also exist for mortgages, various other types of loans, and other financial assets. The corporation whose securities are being traded is not involved in a secondary market transaction and thus does not receive any funds from such a sale.

7. Private market, where transactions are worked out directly between two parties are differentiated from public markets, where standardized contracts are traded on organized exchanges. Bank loans and private placements of debt with insurance companies are examples of private market transactions. Since these transactions are private, they may be structured in any manner that appeals to the two parties. By contrast securities that are issued in public markets (for example, common stock and corporate bonds) are ultimately held by a large number of individuals. Public securities must have fairly standardized contractual features, both to appeal to a broad range of investors and also because public investors cannot afford the time to study unique, non-standardized contracts. their diverse ownership also ensures that public securities are relatively liquid. Private market securities are therefore, more tailor-made but less liquid, whereas public market securities are more liquid but subject to greater standardization.

 

The Federal Income Tax System

The value of any financial asset (including stocks, bonds, and mortgages) as well as most real assets such as plants or even entire firms depends on the stream of cash flows produced by the asset. Cash flows from an asset consist of usable income plus depreciation and usable income means income after taxes.

Our tax laws can be changed by congress and in recent years changes have occurred frequently. Indeed a major change has occurred on average, every three to four years since 1913, when our federal income tax system began. Further, certain parts of our tax system are tied to the rate of inflation, so changes occur automatically each year, depending on the rate of inflation during the previous year. Therefore, although this section will give you a good background on the basic nature of our tax system, you should consult current rate schedules and other data published by the internal Revenue Service (available in U.S. post offices) before you file your personal or business tax returns.

Currently (1997), federal income tax rates for individuals go up to 39.6 percent, and when social security, Medicare and state and city income taxes are included, the marginal tax rate on an individual’s income can easily exceed 50 percent. Business income is also taxed heavily. The income from partnerships and proprietorships is reported by the individual owners as personal income and consequently, is taxed at federal-plus-state rates going up to 50 percent or more. Corporate profits are subject to federal income tax rates of up to 39 percent, plus state income taxes. Furthermore, corporations pay taxes and then distribute after-tax income to their stockholders as dividends, which are also taxed. So, corporate income is really subject to double taxation. Because of the magnitude of the tax bite, taxes play a critical role in many financial decisions.

As this text is being written, a Republican Congress and a Democratic administration are debating the merits of different changes in the tax laws. To stimulate investment depreciation schedules may be liberalized and capital gains may be taxed at a lower rate. Even in the unlikely event that no explicit changes are made in the tax laws, changes will still occur because certain aspects of the tax calculation are tied to the inflation rate. Tax rates and other factors will almost certainly be different from those we provide. Still, if you understand this section you will understand the basics of our tax system, and you will know how to operate under the revised tax code.

Taxes are so complicated that university law schools offer master’s degrees in taxation to lawyers, many of whom are also CPAs. In a field complicated enough to warrant such detailed study, only the highlights can be covered in a book such as this. This is rally enough, because business managers and investors should and do rely on tax specialists rather than trusting their own limited knowledge. Still it is important to know the basic elements of the tax system as a starting point for discussions with tax experts.

Individual Income Taxes

Individuals pay taxes on wages and salaries, on investment income (dividends, interest, and profits from the sale of securities,) and on the profits of proprietorships and partnerships. Our tax rates are progressive that is the higher one’s income, the larger the percentage paid in taxes. Table 2-5 gives the tax rates for single individuals and married couples filing joint returns under the rate schedules that were in effect in April 1997.

1. Taxable income is defined as gross income less a set of exemptions and deductions which are spelled out in the instructions to the tax forms individuals must file. When filing a tax return in 1997 for the tax year 1996, each taxpayer received an exemption of $2.550 for each dependent, including the taxpayer, which reduces taxable income. However, this exemption is indexed to rise with inflation and the exemption is phased out (taken away) for high-income taxpayers. Also, certain expenses including mortgage interest paid, state and local income taxes paid and charitable contributions, can be deducted and thus be used to reduce taxable income, but again, high-income taxpayers lose most of these deductions.

2. The marginal tax rate is defined as the tax rate on the last unit of income. Marginal rates begin at 15 percent and rise to 39.6 percent. Note, though that when consideration is given to the phase-out of exemptions and deductions to Social Security and Medicare taxes, and to state taxes, the marginal tax rate can actually exceed 50 percent.

3. One can calculate average tax rates from the data in Table 2.5. For example, if Jill Smith, a single individual, had taxable income of $35,000. her tax bill would be $3.600 + ($35,000-$24,000) (0.28) = $3,600+$3,080=$6,680. Her average tax rate would be $6.680/$35,000=19.1% versus a marginal rate of 28 percent. If Jill received a raise of $1,000, bringing her income to $36,000. she would have to pay $280 of it as taxes, so her after-tax raise would be $720. In addition, her Social Security and Medicare taxes would increase by $76,50. Which would cut her net raise to $643,50.

4. As indicated in the notes to the table, the tax code indexes tax brackets to inflation to avoid the bracket creep that occurred several years ago and that in reality raised tax rates substantially.

Taxes on Dividend and Interest Income. Dividend and interest income received by individuals from corporate securities is added to other income and thus is taxed at rates going up to about 50 percent.

Alternative Forms of Business Organization

There are three main forms of business organization: (1) sole proprietorships. (2) partnerships.  and (3) corporations. plus several hybrid forms. In terms of numbers, about 80 percent of businesses are operated as sole proprietorships. while most of the remainder are divided equally between partnerships and corporations. Based on dollar value of sales, however, about 80 percent of all business is conducted by corporations, about 13 percent by sole proprietorships and about 7 percent by partnerships and hybrids. Because most business is conducted by corporations, we will concentrate on them is this book. However it is important to understand the differences among the various forms.

Sole Proprietorship

A sole proprietorship is an unincorporated business owned by one individual. Going into business as a sole proprietor is easy one merely begins business operations. However, even the smallest businesses normally must be licensed by a governmental unit.

The proprietorship has three important advantages: (1) it is easily and inexpensively formed, (2) it is subject to few government regulations, and (3) the business avoids corporate income taxes.

The proprietorship also has three important limitations: (1) It is difficult for a proprietorship to obtain large sums of capital; (2) the proprietor has unlimited personal liability for the business’s debts, which can result in losses that exceed the money he or she invested in the company; and (3) the life of a business organized as a proprietorship is limited to the life of the individual who created it. For these three reasons. Sole proprietorships are used primarily for small business operations. However, businesses are frequently started as proprietorships and then converted to corporations when their growth causes the disadvantages of being a proprietorship to outweigh the advantages.

Partnership

A partnership exists whenever two or more persons associate to conduct a non-corporate business. Partnerships many operate under different degrees of formality ranging from informal, oral understandings to formal agreements filed with the secretary of the state in which the partnership was formed. The major advantage of a partnership is its low cost and ease of formation. The disadvantages are similar to those associated with proprietorships: (1) unlimited liability. (2) Limited life of the organization. (3) Difficulty of transferring ownership and (4) difficulty of raising large amounts of capital. The tax treatment of a partnership is similar to that for proprietorships, which is often an advantage.

Regarding liability the partners can potentially lose all of their personal assets even assets not invested in the business because under partnership law each partner is liable for the business’s debts. Therefore, if any partner is unable to meet his or her pro rata liability in the event the partnership goes bankrupt the remaining partners must make good on the unsatisfied claims, drawing on their personal assets to the extent necessary. The partners of the national accounting firm Laventhol and Horwath, a huge partnership which went bankrupt as a result of suits filed by investors who relied on faulty audit statements about the perils of doing business as a partnership. Thus, a Texas partner who audits a business which goes under can bring ruin to a millionaire New York partner who never went near the client company.

The first three disadvantages unlimited liability, impermanence of the organization and difficulty of transferring ownership lead to the fourth the difficulty partnerships have in attracting substantial amounts of capita. This is generally not a problem for a slow-growing business, but if a business’s products or services really catch on and if it needs to raise large amounts of capital to capitalize on its opportunities the difficulty in attracting capital becomes a real drawback. thus growth companies such as Hewlett-Packard and Microsoft generally begin life as a proprietorship or partnership, but at some point their founders find it necessary to convert to a corporation.

Corporation

A corporation is a legal entity created by a state, and it is separate and distinct from its owners and managers. This separateness gives the corporation three major advantages: (1) Unlimited life. A corporation can continue after its original owners and managers are deceased. (2) Easy transferability of ownership interest. Ownership interests can be divided into shares of stock, which in turn, can be transferred far more easily than can proprietorship or partnership interests. (3) Limited liability. Losses are limited to the actual funds invested. To illustrate limited liability, suppose you invested $10.000 in a partnership which then went bankrupt owing $1 million. Because the owners are liable for the debts of a partnership, you could be assessed for a share of the company’s debt, and you could be held liable for the entire $1 million if your partners could not pay their shares. Thus an investor in a partnership is exposed to unlimited liability. On the other hand, if you invested $10.000 in the stock of a corporation which then went bankrupt, your potential loss on the investment would be limited to your $10.000 investment.²  These three factors unlimited life. Easy transferability of ownership interest and limited liability make it much easier for corporations than for proprietorships or partnerships to raise money in the capital markets. The corporate form offers significant advantages over proprietorships and partnerships, but it also has two disadvantages: (1) Corporate earnings may be subject to double taxation the earnings of the corporation are taxed at the corporate level, and then any earnings paid out as dividends are taxed again as income to the stockholders. (2) Setting up a corporation and filing the many required state and federal reports, is more complex and time consuming than for a proprietorship or a partnership.

A proprietorship or a partnership can commence operations without much paperwork, but setting up a corporation requires that the incorporators prepare a charter and set of bylaws. Although personal computer software that creates charters and bylaws is now available, a lawyer is required if the fledgling corporation has any nonstandard features. The charter includes the following information: (1) Name of the proposed corporation, (2) Types of activities it will pursue, (3) amount of capital stock, (4) Number of directors and (5) Names and addresses of directors. The charter is filed with the secretary of the state in which the firm will be incorporated, and when it is approved, the corporation is officially in existence³. Then after the corporation is in operation quarterly and annual employment, financial and tax reports must be filed with state and federal authorities.

The bylaws are a set rules drawn up by the founders of the corporation. Included are such points as (1) how directors are to be elected (all elected each year or perhaps one-third each year for three-year terms); (2) Whether the existing stockholders will have the first right to buy any new shares the firm issues, and (3) procedures for changing the bylaws themselves should conditions require it. The value of any business other than a very small one will probably be maximized if it is organized as a corporation for the following three reasons:

1. Limited liability reduces the risks borne by investors and other things held constant the lower the firm’s risk the higher its value.

2. A firm’s value is dependent on its growth opportunities which in turn are dependent on the firm’s ability to attract capital. Since corporations can attract capital more easily than can unincorporated businesses, they are better able to take advantage of growth opportunities.

3. The value of an asset also depends on its liquidity which means the ease of selling the asset and converting it to cash at a “fair market value”. Since an investment in the stock of a corporation is much more liquid than a similar investment in a proprietorship or partnership, this too enhances the value of a corporation.

As we will se later most firms are managed with value maximization in mind and this in turn, has caused most large businesses to be organized as corporations.