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Prematriculation: Finance http://courseware.hbs.


Prematriculation: Finance
Welcome to Finance

ou are about to begin Harvard Business School's interactive Finance tutorial, which will introduce you to
the principles of finance. Successful completion of this course will prepare you for further study of financial
management, financial markets, and financial instruments and the application of these disciplines in
organizations throughout the world.

Using the Tutorial

he structure of the Harvard Business School Finance tutorial and its navigational tools are easy to
master. If you are reading this text, you must have clicked on the navigation item labeled Using the Tutorial
on the left.

Please click on the Help icon in the upper-right corner of the tutorial to view a clickable animation on how to
use this tutorial. You will be able to refer back to these instructions throughout the tutorial.

What is Finance?

ll corporations, whether large or small, new or old, confront fundamental decisions about how to
deploy capital — that is, what to invest in — and how to raise funds needed for investment. These choices
are central to the discipline of corporate financial management. Fundamentally, the study of corporate
finance covers the principles, analytical tools, and institutional knowledge a manager needs to make good
investment and financing decisions. In addition, however, a well-run corporation needs a financial
infrastructure — systems for monitoring cash and cash flow, for creating operating and financial budgets,
for measuring and reporting its financial and operating performance, for managing its current and expected
tax liabilities, and so forth. Defined broadly, the field of finance covers all these topics, and many related
ones as well, such as the markets in which financial contracts are priced and traded, and the institutions
that use, support, and regulate them. This tutorial cannot cover all the material a qualified manager needs
to know; rather, its goal is to get you started and prepare you for further study.

Tutorial Overview

ach module in this tutorial will introduce new financial concepts and tools. These will often be
illustrated in the context of a simple, stylized company, called the Golden State Canning Company. To
cement your understanding of the material, you will be asked to complete various exercises as you proceed
through each module. Along the way, you will also get to see and use some real-world corporate data. For
example, you'll use financial information from the J. M. Smucker Company to help you evaluate a project
proposed for Golden State Canning. Each module ends with a capsule summary of the material just

If you are already familiar with basic finance concepts and tools, you may wish to take the pretest before
beginning the tutorial. If you are not very familiar with finance, simply skip the pretest to save time. If you
take the pretest and answer 75% of the questions correctly, you are already reasonably well prepared for
further study and need not continue with the tutorial. However, you should feel free to explore the tutorial
anyway, focusing on areas in which you want to refresh your knowledge. If you answer less than 75%
correctly, start at the beginning of the tutorial and go through the material in the order in which it is
presented. When you are finished, you should take Final Exam 1 to test yourself. If you answer 75% of
these questions correctly, you are finished! Otherwise, you should go back and review parts of the tutorial
that gave you difficulty and then take Final Exam 2.

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The first part of the tutorial consists of four modules focused on analyzing a company's past, current, and
future performance, mostly using its financial statements. These modules include an Introduction, Ratio
Analysis, the Cash Cycle and Growth, and Financial Forecasting. The next module covers Rearranging
Financial Statements and serves as preparation for the Capital Structure module that immediately follows,
as well as later material on valuation. The next two modules cover Time Value of Money, Project Valuation,
and Risk & Return. The final module pulls many ideas together to cover a big topic: Valuing a Business.

Pretest Introduction

elcome to the pre-assessment test for the HBS Finance tutorial. This test will allow you to assess
your knowledge of some basic financial principles.

To advance from one question to the next, select one of the answer choices and click the Submit button. After
submitting your answer, you will not be able to change it or return to the question, so make sure you are
satisfied with your selection before you submit each answer.

Your results will be displayed immediately upon completion of the test. The results screen will display each
question with a graphic notation indicating your score: X for incorrect and check mark for correct.

Click Pretest in the menu bar to the left to begin. You can also return to your test results at any time (after
completing the exam) by clicking Pretest Introduction and then Pretest.

Good Luck!


[Exam content not shown]


n this section you will use common analytical tools to assess a company's financial condition and
performance. In other words, how is the company doing? What sort of shape is it in? You will be introduced to
financial ratio analysis, common-size financial statements, the cash cycle, sources and uses analysis,
sustainable growth, and the preparation of forecasts and pro forma financial statements.

Financial Statements

earning to analyze businesses requires learning to work with financial statements much as a portrait
artist must learn to draw, or a physician must learn anatomy. Financial statements do not give a complete
or an ideal rendering of a business, but they are ubiquitous and convenient.

They share a common form across many different types of businesses.

They express everything in common units.
They provide a systematic way of linking the past, present, and (expected) future performance.

Perhaps most important, they are fundamentally quantitative, a characteristic sometimes bemoaned for the
limitations it implies, but one that conveys the boon of mathematical manipulability. Imagine how difficult it
would be to evaluate a business if we could represent it only pictorially, or in words, but not with numbers.

This tutorial presumes you are familiar with basic financial accounting. In particular, it makes extensive use
of corporate income statements and balance sheets. If you have not already done so, please complete the
HBS Financial Accounting Tutorial for a comprehensive introduction to financial accounting and basic
financial statements.

Golden State Canning

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his chapter illustrates financial statement analysis with a simple business. To get started, please adopt
the perspective of a prospective owner and manager of the business, as follows.

Download Financial Statements here.

Ratio Analysis

he first step in analyzing Golden State's potential is to examine its recent performance and current
financial condition. Finance professionals use a myriad of different financial ratios to assess financial health —
so many, in fact, that it helps to group them into categories. Here are six basic categories:


Be aware that not everyone uses the same categories, and different analysts may define a given ratio


ost financial ratios consist of a simple comparison between items of interest from a balance sheet
and/or income statement that yield insight into condition or performance.

For example, looking at Golden State's balance sheet we can compare its equity to its assets and compute
the equity to asset ratio in 2007.


ou are looking for a business with growth possibilities. More generally, investors and managers want
their businesses to produce more cash, to become more valuable. In short, they are looking for growth. We
usually measure growth as a rate of change over time in a specific item of interest, such as sales, assets,
profits, or cash flow.

One of the attractions of Golden State is the possibility of growing the business. Has it been growing lately?
How fast? How consistently? Historic growth rates may be an indicator of future growth potential.

Compound Average Growth Rate

In addition to computing a company's year-to-year growth rates, we may be interested in average

growth rates over a longer period. One way to measure this is to compute a compound average growth
rate (CAGR). The CAGR is the single constant growth rate that, when compounded over a finite number
of years, produces the observed end point from the observed starting value.


Compute Golden State's year-to-year growth rates for sales, as well as the CAGR for Golden State's sales
from 2004 to 2007.

Operating Profit

You decide to investigate Golden State's growth further by computing the growth in its operating profit.

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Operating profit is often referred to as earnings before interest and taxes (EBIT).


n addition to knowing whether a company is growing, we want to know if it is profitable. We could

simply look at gross profit, operating profit, and net income, to see if each is positive or negative. But that's
not enough. It helps to compare profits to something. For example, how much sales were required to
generate a given profit? How large an asset base was required? If we compare operating profit to sales, we
get the operating margin. Comparing operating profit to assets is one way to measure pre-tax return
on assets.

Profit Margins

We observed positive, if unimpressive sales growth for Golden State. Operating profit grew faster but was
uneven over time. To get a clearer picture of Golden State's profitability, let's look at its profit margins.
We can think of profit margins in a hierarchy in which each successive margin takes an additional factor
into account.

Return on Equity

Since, if you decide to buy Golden State, you will be investing most of your savings, you are interested in
how much profit the company will produce, compared to your investment. The return on beginning
equity (ROBE) compares net income during a given year to owner's equity at the beginning of the year.
ROBE is a popular measure of financial performance among investors and managers and will be discussed
in greater detail in future chapters. Another common variant of this ratio is ROE, which compares net
income during the year to end-of-year owner's equity.


any financial ratios are intended to help assess the efficiency of a company's operations. Some
analysts call this category "Activity Ratios". For example we may want to measure how well a business
employs its plant and equipment, its inventory, its credit from suppliers, and so forth. Or we may want to
know how quickly its receivables are collected or how long some products stay in inventory before a sale.

Asset Turnover

Now, compute average asset turnover for the remaining three years, to see if there is a trend.


For a manufacturing company or a retailer, we would like to know how long it takes the company to
produce and sell its goods. The longer it takes, the more financing will be required. A common ratio
compares the cost of goods sold to inventory. Note that once again, this combines an item from the
income statement (COGS) to one from the balance sheet (inventory) so we have to stipulate beginning,
ending, or average inventory. Dividing COGS by ending inventory gives (ending) inventory turnover. Let's
compute this for Golden State for 2007.

Another common formulation of an inventory ratio is days in inventory. It uses the same basic
information, but expresses the amount of inventory held in terms of the number of days of COGS it
represents. To compute days in inventory, we express inventory as a fraction of COGS (this is simply the
reciprocal of inventory turnover) and then apply that fraction to 365 days per year.

All else equal, we prefer a lower number of days in inventory, which corresponds to a higher inventory
turnover. Higher turnover indicates a need for less inventory and correspondingly lower capital
requirements to finance the inventory. But industries vary widely, and sometimes a company may be
willing to carry more inventory if it furthers some other goal. For example, it may be possible to charge
higher prices or reach more or better customers by carrying more inventory.

Let's examine Golden State's Days in Inventory for the whole period 2004-2007. Golden State's days in
inventory rose steadily from 2004 to 2006 and fell slightly in 2007. However, the seasonal nature of

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Golden State's business should make us careful about interpreting this result.

Seasonality and Cyclicality

Like many businesses, Golden State's canning operations are seasonal: the company is canning more
produce at certain times of the year than others. Seasonal patterns are generally predictable — they
follow the calendar. Golden State's seasonal peak is driven by the growing season. For other companies,
such as retailers, the seasonal peak may be driven by consumers' buying habits — for example,
purchasing gifts for holidays or suntan lotion in the summer.


or an asset, liquidity denotes "closeness to cash," or the ease with which the asset can be converted to
cash without a loss of value. For an entire company, liquidity is associated with the company's ability to
meet known near-term cash obligations and/or to cope with unexpected needs for cash.

Liquidity ratios provide an indication of a company's ability to pay or "liquidate" short-term obligations,
generally, those falling due within one year. Illiquidity may have serious consequences if it results in default
on debt obligations or if it impairs future access to credit. On the other hand, excessive liquidity may reflect
poor asset utilization.

Current Ratio

The most common measure of liquidity is the current ratio. The current ratio simply compares current
assets to current liabilities. Current assets include cash, marketable securities, and working capital items
that will turn into cash within one year. Current liabilities include amounts owed to suppliers, employees,
lenders, and the government within a year. A low current ratio may be an early warning of future liquidity
problems as near-term obligations come due in greater amounts than are covered by contemporaneous
liquid assets.

Let's examine Golden State's liquidity by calculating its current ratio during 2003-2007.

Quick Ratio

Another measure of liquidity is simply the amount of cash on hand. We can easily see that Golden State's
cash dropped steadily from 2004 to 2006.

How tight were things in 2007? To get an idea, let's compute the company's quick ratio for 2007. The
quick ratio is like the current ratio, except that inventories are excluded from current assets. Why?
Because inventory is generally considered less liquid than receivables (and it is certainly less liquid than


inancial leverage (sometimes called "gearing") is created when a company borrows money to fund its
operations. Debt creates fixed financial charges, namely interest and principal payments, that make a
company's net earnings and cash flow more volatile.

Debt Ratio

One of the most common leverage ratios compares debt to capital, also commonly called the debt ratio.
This is an indication, for Golden State, of the extent to which Mr. Cota has utilized debt to finance the
company's operations. In other words, what fraction of Golden State's capital is debt as opposed to
equity? Be aware that "debt ratio" is a name applied to a variety of differently defined ratios — it is
important to check the particular definition being used by a given analyst. For the moment, we will
compute Golden State's debt ratio as interest-bearing debt divided by interest-bearing debt plus equity.

Times Interest Earned

The times interest earned ratio (also known as the "interest coverage ratio") is another measure of

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leverage. It examines the extent to which a company's earnings cover its interest payments. Sometimes
this ratio is computed using cash flow instead of operating profit in the numerator.


The future performance of a business is uncertain — it could be better or worse, depending on what
happens in the world. We can think of this uncertainty as risk, and note that it varies across businesses and
industries, so we would like to measure it.

Risk is difficult to measure using data solely from financial statements, and it will be studied in greater
detail in a future chapter. For now, note that none of the ratios mentioned so far measures risk directly
(though leverage is associated with financial risk). So how can we assess it? One possibility is to scan
historical operating results to get an idea of the volatility of sales or profit, for example. But we have
already seen in the Golden State example that such variability could arise in many ways, not all of which
have to do with risk.

Fixed to Variable Costs

One indicator of operating risk is the ratio of fixed costs to variable costs in a company's operations.
Variable costs vary directly with sales, while fixed costs remain constant regardless of higher or lower
sales. Published financial statements seldom provide unambiguous separations or allocations of variable
and fixed costs, though many companies perform such allocations internally, precisely as a means of
understanding risk. All else equal, a higher proportion of fixed costs denotes higher operating risk. At the
same time, it denotes the potential for economies of scale — the possibility of growing sales without
increasing fixed costs, which translates into higher operating margins (this is known as "operating

Let's compare Golden State's ratio of fixed to variable costs.

What is the 2007 ratio?

Common-size Financial Statements

ou have already covered the main categories of financial ratios. Common-size financial statements
provide a quick and comprehensive look at some of them, and a consistent means of comparison for some.

A common-size financial statement is simply one that has been scaled by a single parameter, such as sales
or assets, so that each item is expressed in relative or percentage terms, rather than in units of currency.
Such statements make it easy to spot trends over time that are not due to growth. And they facilitate
comparisons of different companies in relative terms, regardless of differences in size.

While many of the ratios introduced above come naturally out of a common-size income statement or
balance sheet (e.g., the gross margin, operating margin, debt ratios, etc.), others do not, because they
consist of items from both the balance sheet and income statement (for example, asset turnover).

Balance Sheet

Common-size balance sheets typically express all items as a percent of total assets.

Complete the missing items in Golden State's 2007 common-size balance sheet.

Income Statement

Common-size income statements generally express all items as a percent of net sales, enabling us to
study Golden State's cost and profit structures.

Complete the missing items in Golden State's 2007 common-size income statement.


By looking at Golden State's common-size financial statements over the years we can spot potentially
important trends:


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The preceding section covered only a small fraction of the many different ratios that you may encounter in
the real world of financial analysis. Different analysts and managers compute different ratios. More
confusingly, each may define a given ratio differently from someone else. How should you decide which
variation of a particular ratio to look at? It depends, of course, on what you are trying to learn about a
company. It also depends on personal preferences, available data, and available benchmarks.

The computation of financial ratios is fairly mechanical, as you have seen. Interpreting them, however, is
seldom so straightforward. Most have little or no intrinsic meaning. That is, even though they address
important topics, such as growth and profitability, and they are inherently comparisons — of say, operating
profit to sales — they must be subjected to still further comparisons to be meaningful. So if we find, for
example, that Golden State's operating margin is 8%, how do we know whether to be impressed or

This section provides some guidance. Financial ratios are usually interpreted according to one or another of
four basic comparisons: changes over time, peer companies, pre-specified budgets or targets, and rules of


One of the most informative ways to interpret a company's ratios is to compare them to the same
company's past performance. You have already performed this sort of comparison for many of Golden
State's ratios.

Industry Comparison

Though we can see Golden State's profit margins rise and fall over time, we have no external benchmark
to help us decide whether they are impressive or disappointing. One set of useful benchmarks is other
companies in the same business, perhaps even direct competitors, whose financial statements may be
available for comparison. Sometimes such comparisons are done company by company.


Rules of Thumb

Finally, some analysts develop rules of thumb to help them interpret ratios. For example, one might say
that the current ratio should be greater than 1.0 as a rule of thumb. At their best, rules of thumb reflect
a capable analyst's years of experience. At their worst, they are subjective notions that should be
challenged or at least supplemented with other data.

Golden State Canning

The following video reviews some of what we have learned about Golden State through our study of its
financial ratios and highlights some topics for further study and investigation.

List of Common Ratios

his section presents a compendium of common ratios. You should not expect to memorize all the
ratios and their formulas, at least not now. Instead, a PDF file containing the formulas of the ratios
presented in this chapter can be downloaded by clicking here.


Growth ratios could be computed for almost any item on the balance sheet or income statement.
However, analysts usually focus on growth in sales, operating profit, net income, the working capital
accounts, fixed assets, and total assets. We can look at year-to-year growth rates or at average rates. An
average may be compounded (as we computed the CAGR) above, or not. A compounded average is
sometimes referred to as a "geometric mean" while a non-compounded average of year-to-year rates is
an "arithmetic mean."


This is a list of common measures of profitability.

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There is an abundance of efficiency ratios. A sample of common ones follows.


This section provides formulas and definitions for some liquidity ratios.


You can compute the following measures of leverage.


You can compute three measures of risk.


ome of the limitations of ratio analysis and common-size financial statements are:

Ratios based solely on financial statements overlook other crucial determinants of performance and
financial conditions. For example, market share is an important measure of performance that cannot be
computed solely from financial statements;
It may be difficult to identify truly similar companies for external comparisons;
Accounting methods may differ across otherwise similar companies, e.g., for companies in different
A given company may change accounting methods over time;
Ratios may be distorted by non-operating activities and transactions, by extraordinary events, and
discontinued operations.
Ratios may be distorted by seasonality and cyclicality;
Most ratios are computed using book values rather than market values, which may be substantially
different. For example, a debt-to-assets measure of leverage that seems high when computed in terms of
book values might be quite reasonable if a company's fixed assets are worth substantially more than their
book values.


ou should now have a general understanding of ratio analysis and its purpose to managers and
investors. In particular, you learned:

How to compute ratios in the six categories of growth, profitability, efficiency, liquidity, leverage, and
How to create common-size financial statements;
How common ratios are chosen and interpreted;
Some of the limitations of ratio analysis.

Cash Cycle and Growth

ven a profitable company will experience financial problems if it runs out of cash. This is especially true
for companies that are growing quickly. Rapid growth creates a need for financing that, if not prudently met,
can precipitate a crisis or, at a minimum, retard growth. One of the keys to managing growth from a financial
perspective is the cash cycle.

This chapter introduces the cash cycle and some analytical tools that help managers understand and manage
it. These include source and uses analysis, and internal and sustainable growth rates.

Cash Cycle

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he cash cycle is sometimes called the operating or net working capital (NWC) cycle. It is a
representation of the movement of cash through a cycle of operations. For example, the operating cycle of
a wholesaler begins with the purchase of goods from a supplier, which is held as inventory until a customer
purchases the goods, and eventually pays the wholesaler, who in turn pays the supplier. The order in which
these events occur, and the length of time between them, drive the natural flow of cash in and out of the
business. This operating cycle involves different steps, depending on the business being examined. That is,
the operating cycle for a manufacturer will be different from that of a wholesaler or retailer, or a service
company. Accordingly, the cash cycles for each will differ as well.

To some extent the characteristics of the cash cycle are determined by fundamental properties of a given
business, such as Golden State's seasonal canning business. But managerial choices affect the cash cycle as
well — for example, how much credit the company chooses to extend to its customers will lengthen or
shorten the cycle.

Cash versus Profit

Note that the cash cycle focuses on cash flow rather than profit. What is the difference? Profit is defined
by accounting principles and rules that are not designed to track cash flow and consequently do not
correspond to it.

Why does it matter that we track and manage cash flow in addition to profit? Without cash flow, even a
profitable company will go out of business. With it, even an unprofitable one may operate for a long time.

Inflows and Outflows

Think of the cash cycle as reflecting a recurring set of activities. A company buys goods, sells them,
collects cash, and uses the cash to buy more goods, sells them, and so forth. Every company has a cash


You might suppose that for a healthy business, the inflows and outflows that comprise the cash cycle will
balance each other out, so there is nothing to worry about. Indeed, in the long run we would expect a
profitable business to have greater inflows than outflows, and hence still less to worry about. But for
most businesses, the outflows happen before the inflows. Golden State has to buy the peaches and cans
before it can sell them to a customer. This fundamental fact creates a financing need. Let's examine
Golden State's cash cycle.

Knowing that Golden State's cash conversion cycle is some certain number of days is helpful, but it's not
enough. When Mr. Cota goes to his bank for a loan to cover his financing need, he has to borrow an
amount of money, not a number of days. How large a loan is implied by a cash conversion cycle of, say
15 days? It depends on the scale of operations. For a large canning operation, 15 days is a larger loan
than for a smaller operation.


The simple fact that outflows precede inflows creates a need for financing of the basic working capital
accounts. Sometimes this need for financing is simply referred to as a need for working capital. Golden
State will have to find lenders or shareholders willing to contribute capital to meet this need (retained
earnings are funds contributed by shareholders). How much capital depends on how large operations are:
we saw that larger operations require more capital. Recall that Golden State wants to grow — it wants to
become larger and larger. Growth will require even more capital. The higher the growth, the more capital
is required. In effect, a growing firm is using cash collected from yesterday's sales to fund tomorrow's
purchases. This causes a shortfall because a growing firm is bigger tomorrow than it was yesterday.


So far, we have only considered the working capital accounts. A more complete look at the cash cycle
would include other sources and uses of cash as well.

Cash Conversion Cycle

We mentioned the cash conversion cycle (CCC) above in the context of the working capital cycle. Let's

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compute it now for Golden State using some of the key ratios we examined in an earlier chapter. The CCC
combines three ratios: days in inventory, collection period and payables period. For simplicity, assume
that credit purchases are equal to COGS in your calculation of days payable.


We saw in the previous module that seasonal patterns in a business affect its financial appearance. Such
seasonal patterns obviously affect the operating cycle and, in turn, the cash cycle.

Sources and Uses

nother way of monitoring a company's funding needs and patterns is to prepare a statement of
Sources and Uses of funds. Accountants have specialized formats for such statements, which you have
already studied elsewhere. A useful shortcut for preparing a sources and uses analysis is simply to take
balance sheets from two different dates and subtract one from the other. The amount by which each line in
the balance sheet has changed from one date to the other is then categorized as either a source or a use of
funds. Because balance sheets balance, it will always be the case (within rounding error) that sources equal

Let's construct Golden State's sources and uses statement using the balance sheets provided by Mr. Cota.
In particular, we are interested in what happened to the company while it was run by the hired manager. So
let's compare year-end 2004 to 2006. This will show us what happened during the manager's two-year
stint. The diagram below, for example, shows that Accounts Receivable declined from 2006 to 2007 by $4.2
thousand. This change represents a source of funds.


Two steps are necessary to create a statement of sources and uses:

1. Compute the changes between two balance sheets. Often these will be from one year end to the
but we could choose any period of interest. For Golden State we are looking now at a two-year
2. Then the observed changes need to be classified as either sources or uses.

Now we need to categorize each change in Golden State's balance sheet as either a source or a use.


Sources of funds come from reducing an asset or increasing a liability.

Uses of funds come from increasing an asset or decreasing a liability.

Golden State

Test your knowledge by constructing a sources and uses statement for 2006-2007, and then compare
it to the 2004-2006 statement. This will highlight some differences between the company's
performance under the manager versus Mr. Cota.


s we have seen, growth amplifies the natural need for financing implied by a cash cycle in which
outflows precede inflows. This will be true for Golden State as well, should you decide to acquire it and
succeed in growing it. Increasing the company's sales will require purchasing more produce and cans, and
this must be done before the output can be sold. After the output is sold, credit must be extended to
customers. Moreover, in the long run, with sustained growth, Golden State will need additional funds to
expand capacity. In fact, the company's growth rate in the future might be constrained by its ability to
obtain adequate financing. How fast can Golden State grow? This depends in part, of course, on the market
for canned produce and competitive conditions. But we will focus here on the financing problem.

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Internal Growth Rate

A company's internal growth rate is the rate at which it can grow without any new external funding (from
banks or shareholders for example), and assuming its operating ratios remain unchanged. Without
external funding, the company's only source of funds for growth is its retained earnings. So its internal
growth rate is simply the ratio of new retained earnings to beginning-of-period assets. New retained
earnings will equal net income minus dividends, sometimes computed as net income times the retention
rate. The retention rate is simply the fraction of net income not paid out as dividends

Sustainable Growth Rate

Another measure of a company's capacity for financing growth is its sustainable growth rate. This is
the rate at which a company can grow if (1) it does not issue any new external equity and (2) it keeps its
operating and financing ratios constant. The sustainable growth rate is generally higher than the internal
growth rate for a firm with leverage. The internal growth rate is computed assuming no new external
financing of any kind. By contrast, the sustainable growth rate is computed assuming no new external
equity; in other words, the sustainable growth rate assumes new external borrowing in amounts
necessary to keep the debt ratio constant. This new borrowing supports more growth, which is why the
sustainable growth rate is higher than the internal growth rate.

How is the sustainable growth rate calculated? It equals the retention rate times the return on beginning

Why is the sustainable growth rate tied to the return on equity? To see why, assume no dividends, so the
retention rate is 100%. Now, since operating and financing ratios are presumed constant, the only way to
grow the balance sheet is with new financing. New financing is tied to new earnings, which in turn
determine how much new borrowing must be done to keep leverage constant. Sales may only grow as
fast as assets, given constant operating ratios. In this way, growth is constrained by the rate at which
equity can be augmented by earnings. In other words, sustainable growth must equal the return on

DuPont Formula

The internal and sustainable growth rates (the retention rate times ROBA and ROBE, respectively) are
useful benchmarks. They both indicate that the more profitable a company is the faster it can grow, all
else equal. The so-called "DuPont formula" is a restatement of ROBE in terms of other ratios.


The internal and sustainable growth rates are useful benchmarks, but not hard constraints. Can a
company grow faster than its sustainable growth rate? Certainly. How? We have already seen via the
DuPont formula that a change in ratios (e.g. profitability, efficiency, or leverage) translates into a change
in ROBE and hence, sustainable growth. Even more fundamentally, a company wishing to grow fast could
simply issue new external equity - i.e., sell more stock to investors. Many high growth companies do
exactly that.

Nothing so far has shown us that a particular growth rate is optimal. It is true that raising leverage or
selling shares, for example, permits higher growth. But repeated increases in leverage could also lead to
bankruptcy. And repeated issuances of new shares may dilute ownership. How fast to grow a company
and how to finance the growth are complex managerial problems.


he dominant theme in this chapter is the importance of managing cash, which must be understood in
the context of a company's operating cycle.

You discovered the importance of the cash cycle and its relationship to the operating cycle, particularly the
working capital accounts. And you saw the interrelationship of the working capital accounts in the cash

You learned how to create a statement of source and uses to analyze the funding of a company over a
given period.

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You learned how to compute internal and sustainable growth rates for a company, and the relationship
between each of these and basic financial ratios covered in the previous chapter.

Financial Forecasting

n previous sections we studied a company's performance and financial condition by analyzing its past and
present financial statements. In this section we will look forward rather than backward and construct
projected financial statements to gain insight into a company's likely future performance and financial

Projected financial statements are often called pro forma statements. They can help address many questions
a manager might be interested in, such as: what will our financing requirements be if we grow sales at 10%
next year? If we grow at 10% for each of the next five years? What will happen to earnings per share if we
increase leverage? Will a recession cause us to violate a covenant on our bank loan? And so forth.

Basic Ingredients

inancial forecasts and pro forma financial statements are based on a few key inputs that will certainly
vary from case to case, but are always present.

A business forecast may be simple or elaborate. For example, the gist of a forecast might be simply a 10%
growth in sales. Or it might involve projecting market size, penetration, a certain product price,
competitors' reactions, and hence, market share. The forecast should be consistent with the business
strategy articulated by top management.

Given a strategy and key elements of a business forecast, there are policies to be set in support of it, such
as how to manage working capital accounts, how much to spend on marketing and promotions, on R&D,
etc. Managers set these policies and the pro forma financial statements should incorporate them.

Economic factors such as inflation rates, interest rates, and exchange rates will affect the company's

Pro formas rely on accounting relationships such as the equivalence of of assets and liabilities plus equity,
and the link between profit and retained earnings.

The Process

nce formulated, forecasts should be scrutinized and tested. This process may be formal and rigorous
or somewhat less formal, depending on how the forecast is to be used. Tests for reasonableness take many
forms, such as comparisons to past performance, to competitors, to macroeconomic indicators or other
external benchmarks. Ultimately, it helps to be skeptical and demand clear support. For example:

Bias, Error and Uncertainty

ven good forecasts are fallible in the sense that they may not come true. In judging a forecast, it is
important to distinguish between error and bias. Errors are simply mistakes, but over a long period and
many forecasts, we would expect that the mistakes will tend to even out — sometimes things go better
than expected and sometimes worse. In contrast, biases are systematic tendencies to under or
overestimate, and as such they don't cancel out even over a long period. Some biases arise unintentionally,
perhaps through simple optimism or pessimism. Others may be deliberately built into a forecast, for
example, to reflect a "best case" or "worst case" scenario, or to ensure conservatism. Most analysts will try
to get rid of unintentional biases thorough testing and vetting of forecasts. Deliberate biases should be
explained and supported.

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Pro Formas

ro forma balance sheets are projections of a company's assets, liabilities, and equity. Pro forma
income statements contain projections of revenues, costs, and profit. In almost all respects, pro forma
financial statements are just like any regular statements, except that they haven't happened yet and might
never happen. Although hypothetical, they still follow all the usual accounting rules: balance sheets must
balance; retained earnings must equal the prior balance plus net income minus dividends; net fixed assets
must equal the beginning balance plus capital expenditures minus depreciation; and so forth.

To be informative, pro forma financial statements should be prepared with a clear mission. What am I
trying to figure out? For example, a common goal is to estimate the amount of external funding required by
proposed business plans. This can be expressed in a simple equation.

The pro forma just described will not tell us how to raise the required additional funding. Should we use
long-term debt or short-term debt? Should we raise equity by selling additional stock? To answer such
questions, we might devise still more pro formas. To help us decide, we could prepare pro formas reflecting
the different possibilities and then analyze and compare key ratios, such as leverage and coverage, for

Percent of Sales Forecasting

One of the simplest approaches to preparing pro formas is "percent of sales" forecasting, so called
because it projects many income statement and balance sheet accounts as a percent of sales. In its
purest form, it simply scales all projections up or down with projected sales. If sales are expected to
grow 10%, then so does everything else.

Let's prepare and interpret pro forma statements for Golden State in 2008. We'll use a modified version
of percent-of-sales forecasting, in which many, but not all, items are tied to sales growth.

First, we consult Mr. Cota and find out that he expects Golden State's revenue to increase by 6% from
2007 to 2008. Now we will construct pro forma financial statements to estimate how much additional
external financing will be required to support this level of growth.

Accounts Classification

A key step in computing Golden State's 2008 pro forma statements is to determine which accounts we
think should vary directly with sales. The percent of sales method classifies accounts into two


Fixed Accounts

First, let's see how accounts that do not vary with sales are forecasted. For now we will assume
interest expenses and the revolving credit to be fixed at last year's level. (The reason for this choice
will become apparent later. Note that for all accounts that vary with sales, subtotals and totals are
initially left blank and will be added in subsequent slides.)

Historical Variations

For each of the accounts that vary with sales, a forecast is prepared based on each account's expected
relationship with sales. This relationship is often inferred from historical financial statements. So our
first step is to estimate these historical relationships.

Projecting Accounts

The following two examples illustrate projecting an account for the income statement and balance
sheet, respectively, using percent of sales forecasting.

Let's project Golden State's costs of goods sold (COGS), the next item on the income statement below

Let's examine a balance sheet account now. We can estimate accounts payable, which we expect to

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vary with sales.


Interest Expense

Now we come to a standard problem in pro forma preparation. We haven't made a careful forecast for
Golden State's 2008 interest expense yet, since this depends on how much it borrows, not on sales.
But we don't know how much the company will borrow until we know what its external funding need is!
It is as though we need to already know the answer in order to compute the answer. Fortunately, there
is a simple procedure we can follow. In essence, we take a guess at interest expense, and then see
what the guess implies about funding needs. Then we suppose the funding need is met with debt, and
calculate a reasonable amount of interest on all the debt. We compare that "reasonable amount" to our
initial guess. If they aren't same, we change our guess and go through the process again, repeating
until the "reasonable amount" of interest equals the guessed-at interest. Let's walk through the
process for Golden State.


The manager Mr. Cota hired for 2005 prepared some forecasts for 2005, using the actual 2004
financial statements as a starting point. As an exercise, finish his pro forma statements for 2005 by
calculating interest expenses and revolving credit for 2005, and making sure the balance sheet
balances. Assume an 8 percent interest rate on revolving credit and long-term debt accounts.
Remember to iterate until your interest expense is consistent with the outstanding amount of debt
and the external funding need is zero. Report back with your findings.


We noted in previous sections that Golden State's operations are highly seasonal. Bear in mind that the
pro forma balance sheet we just prepared is as of a certain date, specifically, the end of the calendar
year. The negative external funding requirement corresponds to December 31, 2008. But we know that
Golden State's peak financing period is earlier, at harvest time or just after, when inventory is higher and
receivables have not yet been collected. We should expect that external funding requirements at that
time might be quite different, and maybe even positive! To address this reality, highly seasonal
businesses generally compute quarterly, or even monthly, pro forma forecasts to make sure they have
adequate funding at their seasonal peak without violating loan covenants.

Golden State's Expansion

The 2008 pro forma statements assumed 6% sales growth, based on conversations with Mr. Cota and,
most likely, his current intentions for managing Golden State.

However, you are interested in Golden State for its growth potential, and you expect to formulate more
ambitious growth plans if you acquire it.

Let's walk through the process of creating such pro formas. These are more complex than the one we
just looked at, so we'll divide the process into three steps.

Step 1

The first task is to prepare business forecasts and operating policies. Key features of an illustrative plan
for expanding Golden State are:

Normal operations during 2008, according to Mr. Cota's operating plan, while preparations are made
to begin expanding in 2009.
Use of the cold storage capacity to extend canning operations well beyond the current seasonal
Development of new products based on different types of produce and gourmet and/or all natural
recipes, to be introduced as branded goods in local and regional distribution channels.
Extension of existing lines into regional distribution to boost sales growth.
Use of the jarring line both to increase annual output and to produce new lines.
New activities will require expenditures for product development and marketing, new overhead,
added capital spending, additional inventory due both to the new lines and the extended season.

The accompanying chart above summarizes key operating assumptions associated with this expansion

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Six Year Golden
State Pro Formas

Step 2

The next step is to put the operating forecasts into the appropriate lines in pro forma income
statements and balance sheets for the period 2009-2013. (For 2008, we will use the pro formas we
already prepared.)

We have enough information to complete the income statements all the way through "operating profit."

On the balance sheets, we have everything we need for the asset side. We have all the current
liabilities except for the revolving credit, along with long-term debt. In other words, we have only a
little more to do to finish the statements.

Six Year Golden
State Pro Formas

Step 3

Download Six Year Golden State Pro Formas

Download Six Year Golden State Pro Formas

Download Six Year Golden State Pro Formas

We repeat the above steps for 2010 and so forth.


Let's have a closer look at the six-year forecasts for Golden State to see what they can tell us.


All business forecasts are characterized by uncertainty. A good analyst will use his or her knowledge of
the business to identify key uncertainties and test key assumptions. What if sales grow by 3% or 10%
rather than 6%? What if this level of growth requires additional spending on marketing?

Three approaches are commonly used to test the reasonableness of forecasts: sensitivity analysis,
scenario analysis, and simulation.

Sensitivity Analysis

Sensitivity analysis focuses on one variable and computes the effect on the plug figure (or some
other item of interest) of a change in that single variable, assuming everything else stays constant.

Let's see what happens if Golden State's sales were to grow at 3%, holding all other assumptions

Scenario Analysis

While sensitivity analysis studies changes in one assumption at a time, scenario analysis combines
concurrent changes in many assumptions. The combinations of assumptions are intended to
correspond to particular scenarios, chosen either because they are particularly likely or particularly
salient in some other way.

For example, suppose a competing canning company opens a new factory in the vicinity of Golden
State's operations. This new competition almost certainly would affect Golden State in more than one
way. The scenario might include lower sales volume, the need to lower sales prices, competition for
local crops, rising raw material prices, etc.


Finally, simulations are sophisticated statistical analyses performed by computer programs using both
the mathematics of probability and statistics and raw computing power. A common version of this sort

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of analysis is called Monte Carlo Simulation.


ou should now understand the basic principles underlying financial forecasts and be familiar with
some simple techniques. In particular, you learned:

That pro forma statements are projections of a company's future financial statements. They will depend
on the forecast date and time-frame.
Financial forecasts combine several basic ingredients: a business forecast, managerial choices, external
variables, and accounting identities.
The simplest pro formas employ percent-of-sales forecasts, a technique whereby most accounts vary
directly with sales. Note, though, that simplicity is not always a paramount consideration, and many
businesses employ much more sophisticated forecasting techniques.
How external funding needs may be estimated using pro forma financial statements using an iterative
How to test assumptions and outputs for reasonableness.

Rearranging Financial Statements

s you have seen elsewhere, financial statements are prepared according to fixed rules — for example,
the U.S.'s generally accepted accounting principles (GAAP). Some set of rules is obviously necessary to ensure
consistency and completeness. However, some problems faced by managers and investors may be addressed
more effectively by rearranging items from the balance sheet and income statement. For example, grouping
similar items together may facilitate an analysis of capital structure choice or valuation.

This section presents a few ways in which finance professionals sometimes rearrange financial statements.
Once again we will use Golden State to illustrate the ideas. You will make further use of these "new" financial
statements in later chapters, when the usefulness of the rearrangement will become more apparent.

Real vs. Financial

ne common rearrangement is designed to identify and separate real activities from financial
activities. Real activities are comprised of the business chores that generate cash by producing goods and
services for customers — production, sales, R&D, marketing, and so forth. Financial activities are associated
with the distribution of cash to the firm's investors — the payment of interest, principal, and dividends, or
the issuance of new debt or equity. For concreteness, we can think of a stylized balance sheet with a "real"
side and a "financial" side.

Balance Sheet

Let's create this stylized balance sheet for Golden State. All the accounts that arise from canning produce
will be put on the left side. Accounts that have to do with lenders and shareholders will be put on the


Income Statement

The same classification principle can be applied to the income statement.


We should emphasize that this rearrangement facilitates some financial analyses, which is why we
consider it. We are not claiming that the accounts prepared according to GAAP are "wrong." Clearly, an
account payable, for example, really is a liability, which is why GAAP rules put it on the right side. But
beyond separating assets and liabilities, we are making a further distinction between real and financial

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activities of the firm.

Cash vs. Non-Cash

nother important distinction made by analysts is between cash and non-cash items, especially in
income statements. You should already be familiar with the difference between cash versus accrual


etailed financial statements provide a substantial amount of valuable information. Sometimes that
detail makes analysis cumbersome. Even worse, the complexity in corporate financial data can cause
errors, oversight, and simple irrelevance when it finds its way into financial analyses.

For many financial analyses it helps to aggregate or condense items into a few broad categories. For
example, a simplified balance sheet might contain only four items, two on each side. On the left: net
working capital and net fixed assets, both reflecting "real" activities as described above. On the right: debt
and equity, both reflecting financial activities.

Let's take Golden State's balance sheet and summarize it using the four aggregated accounts: net working
capital, net fixed assets, debt, and equity.


Why is this simplified balance sheet useful? Without the clutter of financial detail, it's easy to see, for
example, how capital-intensive a company is, how much net working capital it requires compared to net
fixed assets, and broadly, how it has been financed.

Some analysts also calculate financial ratios using just such a stylized and simplified balance sheet.
Likewise, we will do so in succeeding chapters on capital structure and valuation. Note that the actual
number appearing as total assets, for example, will be different under this formulation than under US
GAAP and the formulation we used in earlier chapters. That in turn will affect the ratio we compute for,
say, asset turnover. So it will be important to be clear about definitions and consistent in their


Finally, it will not always be possible to simplify things so neatly. Let's consider some accounts and
activities that complicate things.

Sometimes companies have assets that simply aren't part of their production of goods and services,
which may make us hesitate to lump them in with either net working capital or net fixed assets. A good
example is excess cash — a cash balance or holdings of marketable securities clearly in excess of what is
required for canning produce. Another example is idle land — property the company owns but is not
currently using in its operations. We often will keep excess cash and other non-operating assets in a
separate category, even in a simplified balance sheet.

Some investors own claims that have features of both debt and equity, such as convertible bonds. A
convertible bond is like debt in that it is a fixed claim with stipulated interest and principle payments due
at certain times. It is like equity in that it may actually be converted, at the holder's option, into a certain
number of shares of stock. We may need an additional category for such securities, depending on the
analysis being performed.

Some accounts are aggregations of a lot of small miscellaneous items. It may be difficult to determine
whether they are real or financial, and difficult to know where to put them. How much it matters depends
on the task at hand, but may well require further investigation.

Just as some securities are both debt-like and equity-like, some activities have both real and financial
aspects. A good example is employee stock options. Employees receive them as compensation, so they
are part of production, which makes them "real". But they are securities (technically warrants) issued by

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the firm and may turn into equity, which makes them "financial."


his chapter focused on ways of rearranging and summarizing information provided on financial
statements to make it more useful for a given task. You learned to:

Differentiate real from financial activities and create stylized balance sheets reflecting both;
Distinguish cash from non-cash items in income statements;
Summarize financial information into simplified financial statements that provide a quick overview of key
elements of a corporate structure.

Capital Structure

ompanies must raise capital to finance their operations — that is, to acquire the fixed assets and
working capital required by their business activities. Capital structure refers to the mix of securities, debt,
and equity for example, that a company issues for this purpose. In practice, many choices must be made. In
this chapter we consider a few of the basic ones. First, we ask why capital structure even matters, and if it
does, whether we can identify or describe an optimal one. The primary choice involves the mix between debt
and equity financing. Secondary choices cover many issues; for example long- vs. short-term debt, fixed- vs.
floating-rate debt, public vs. private securities, etc. This section will focus on the primary choice, namely how
to determine the optimal mix between debt and equity. But in doing so, we will cover concepts that help with
other choices as well.

Formulation of the Problem

he classic problem of optimal capital structure may be framed in two ways. Managers pick a capital
structure to:

Maximize the value of the firm or

Minimize the cost of capital

In fact, these two approaches are equivalent: they lead to the same optimum. Why? Note that if managers
found a way to raise capital more cheaply — i.e., to lower the cost of capital by tinkering with the capital
structure — the associated savings would increase the value of the firm. Put differently, once the value of
the firm is truly maximized, it must be the case that capital costs are as low as possible — otherwise firm
value wouldn't be maximized.

Before we consider how to maximize firm value or minimize capital costs, let's take a look at the basic
differences between debt and equity securities.


debt instrument is a contract between borrower and lender that describes each party's obligations to
the other. Generally, the lender is required to provide specific sums to the borrower, often immediately but
sometimes at future times depending on circumstances. The borrower makes a binding promise to repay
the borrowed amounts at specific times and generally agrees to pay interest on the unpaid principal. The
contract may include other promises by both sides — such as loan covenants, promises to keep records, to
make regular disclosures, and so forth. But the main idea is that in exchange for receiving a loan, the
borrower agrees to pay it back with interest.

The loan itself is recorded by the borrowing company on its balance sheet as a liability; for the lender it is

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an asset. Sometimes the contract between the parties allows the loan to be sold, assigned or transferred by
the lender to another party, who receives interest and principal payments in the place of the original lender.
An example of this are publicly traded bonds or debentures — they are actually loans with standardized
features that permit them to be bought and sold in a market without any day-to-day involvement by the
borrowing company.

In previous chapters you saw that Golden State had two main types of debt outstanding: a mortgage loan
and a working capital loan in the form of a revolving credit agreement.

Fixed Claim

Debt is often referred to as a fixed claim against a company's assets. If the borrower fails to make a
promised payment when it is due, such a failure is called a default. When default occurs, the lender has
certain rights.

The details of the bankruptcy process differ from country to country, sometimes substantially, and they
are beyond the scope of this chapter. But we will see that the possibility of bankruptcy is an important
consideration for companies in their determination of the optimal mix of debt and equity.

Another important feature of corporate debt is limited liability. That is, if a payment comes due and the
company can't make it, the stockholders are not required to reach into their own pockets to bail out their
company. Limited liability has an important consequence: a company may default on a debt payment if
its assets are worth less than the total amounts owed. In that case, the lenders end up with the assets
rather than the shareholders. So, if Golden State goes bankrupt and is liquidated, Mr. Cota won't be
losing his house and personal possessions, but he will lose Golden State.

Additional Debt Characteristics

Debt contracts may have many additional features that we will not analyze here, but we will mention
some common ones:

Seniority: Seniority (or lack of it) reflects the priority assigned to a given debt relative to debts of the
same borrower, as agreed in the contracts. A senior debt must be paid before a junior or "subordinated"
debt in case of bankruptcy or liquidation.
Security: Secured creditors have legal interests (called "liens") in specific assets (called "collateral")
designated for the protection of their loans, even in the event of bankruptcy. Creditors are said to be fully
secured if the value of the collateral is greater than or equal to the debt amount. Unsecured creditors
have no specific collateral and are entitled to a portion of the distribution of the remaining assets once
secured claims are satisfied.
Debt covenants: Covenants are rules set forth in a debt contract that impose limits on a borrower's
debts in relationship to its operations or its equity. For example, a debt covenant might stipulate that a
company's debt-to-equity ratio may not exceed 0.5, thus restricting its ability to borrow without earning
or issuing more equity. Common covenants include interest coverage ratios, cash, and net working capital
Callability: A debt security is callable if the borrower has the right to repay it early, before it actually
comes due. This gives the borrowing corporation flexibility to rearrange its capital structure as business
or capital markets change. Non-callable bonds lack this feature and investors pay somewhat more for
them, secure in the knowledge that they can hold an attractive bond until maturity instead of getting
their money back early.


ow let's look at equity. In contrast to debt, common equity is a residual claim. That is, shareholders
are entitled to whatever is left over after interest and principal payments have been made. This leftover
value is less certain with respect to both amount and timing than contractually-stipulated debt payments.
Consequently, equity is said to be riskier than debt. In extreme cases, equity may even turn out to be
worthless. Let's examine the concept of equity as a residual claim in the case of Golden State.

Unlike debt, common equity is issued without a fixed term or maturity and is not denominated in any
specific currency. This is so even though shareholders obviously pay for their shares in a specific currency
and the stock's price may be quoted in a given currency. But no payout scheme is stipulated in advance.

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Instead, the board of directors decides quarter-by-quarter to declare a dividend or not, depending on how
the company is doing (generally, dividends are declared as a certain amount of a certain currency, but in
fact could take other forms).

In short, common stockholders share the residual earnings of the company once all other claimants have
been paid and, via their voting rights, they participate in the governance of the company. Shareholders do
not vote on day-to-day operating decisions. Rather, they elect the board and may vote on unusual or
substantial actions, such as a sale of the company.

Financial Leverage and Risk

ou have already encountered the concept of financial "leverage" or "gearing" in the earlier chapter on
ratio analysis. Financial leverage is created whenever a company borrows money because the debt gives
rise to fixed charges — principal and interest payments. Just as fixed operating charges create operating
leverage, fixed financial charges create financial leverage.

In effect, a company redistributes the inherent risk of its business when it issues debt. Golden State's
canning business carries certain natural uncertainties (e.g., the size of the crop, the quality of the fruit,
customers' demand for certain types of fruit, etc.). Golden State's lenders have a claim that is less risky
than the canning business because it is contractually fixed — Golden State makes certain payments
regardless of whether it is having a good year or a bad year. So are the lenders bearing much of the risk of
the canning business? No, but the risk is still there. So who is bearing it? Mr. & Mrs. Cota — the
shareholders. For example, Golden State pays the required interest payment each year, regardless of
Golden State's operating profits. Consequently, Golden State's shareholders — Mr. Cota and his wife — have
a claim that is more risky than the canning business. The promise to pay lenders a fixed amount amplifies
the natural ups and downs in the canning business.


We have just seen that when Golden State borrows money, its owners experience an increase in risk.
They must get something in return, or they wouldn't allow Golden State to borrow (after all, Mr. Cota
controls the company; he could simply refuse to borrow). In exchange for bearing more risk, the Cotas
receive a higher expected return.

To see how this works, we'll look at the effect of leverage on ROE or, more specifically ROBE — the return
on beginning equity. To do that, we need to establish the relationship between business risk (now we'll
associate risk with fluctuations in EBIT rather than dots) and net income (which is the numerator of

Golden State's EBIT and ROE

Let's see what happens to Golden State's ROE if we increase the company's leverage. (Unless noted,
whenever we say "ROE" we mean, more precisely, return on beginning equity, or ROBE. Many analysts
use ROE and ROBE interchangeably, which unfortunately leaves room for confusion.)

Specifically, let's consider a hypothetical Golden State with twice as much debt as the "real" Golden
State. We'll stipulate that the two companies are otherwise identical. In effect, we are assuming that
Mr. Cota levers Golden State up by taking out additional loans and reducing his equity investment by
the same amount. Below are partial income statements and balance sheets for 2007 and 2006 for the
two Golden States.

Using the relationship between EBIT and net income, compute ROBE under the two capital structures.
Assume a tax rate of 36 percent.

We can repeat the previous exercise for Golden State from 2004 to 2005. Graphing these results
highlights not only the increased returns to debt, but also the increased risk.


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e have just seen that leverage is associated with increases in risk and return for the shareholders
of a company. That's an important principle. But we still don't know the net effect on firm value and/or the
cost of capital. Does an increase in leverage increase the value of the firm? Until we can answer this
question, we don't know how much to borrow.

Franco Modigliani and Merton Miller published a paper in 1958 which showed that in perfect capital markets
with no taxes, the proportion of debt and equity has no effect on the firm's value. Leverage is irrelevant!
Their paper showed that equity's increased risk due to leverage is exactly offset by the higher expected
return, leaving the value to shareholders unchanged. This important result is the starting point for all the
current theories of optimal capital structure we will examine later.

Before looking at those theories, let's illustrate the irrelevance result.


What if the values of the levered firm (Golden State) and the unlevered firm (Grandma's Applesauce)
were different? In that case, an arbitrage opportunity would exist, which is another way of saying
something is wrong with the markets — they would not, in fact, be perfect.

Arbitrage is the simultaneous purchase and sale of the same or identical assets for different prices. Such
a transaction, if it were possible, generates an instantaneous profit without entailing any risk. Financial
economists often invoke the requirement of "no arbitrage" as a necessary characteristic of market
equilibrium. That is, a market may not be considered to be in equilibrium if it is possible to earn profits
without taking any risk. Certainly it would be wrong to describe such a market as "perfect". Moreover,
investors seeking to profit from such opportunities would by their very actions drive them out of the
market — prices would adjust so as to make the arbitrage profits disappear.

Miller and Modigliani showed that if their irrelevance proposition (they called it "Proposition 1") failed to
hold, i.e. if the value of the unlevered firm were greater than the value of the levered firm, or vice versa,
then an arbitrage opportunity would exist. Let's see what this means with numbers.

M&M 1

When we introduced Miller & Modigliani's ("M&M") Proposition 1, we said it required no taxes and perfect
markets. More formally, Proposition 1 holds under the following conditions:

No Taxes: Neither firms nor investors have any tax obligations.

No Costs of Financial Distress: Firms that default on their obligations can reorganize or recapitalize
themselves costlessly.
Symmetric Information: Investors and managers all have the same information.
Complete Markets: Investors and companies all have the same opportunities for borrowing and
Invariant Investment Behavior: Firms do not change the assets they invest in or the way they
manage them according to their financing choices.

Under these conditions, the value of the firm is independent of its capital structure, and only depends on
the value of its assets. So important is this result that some economists argue that the term "perfect
market" should be defined as one for which M&M Proposition 1 holds.

In the real world, not all of the M&M conditions hold, and consequently capital structure may indeed
matter. In the following sections, we will relax some of the conditions required by M&M Proposition 1 and
see what effects this has on firm value. From there we can infer some of the determinants of optimal
capital structure.

Relaxing M&M Condition - Taxes

irst we relax the condition of No Taxes. In most countries, corporate interest expenses are deductible
while corporate dividend payments are not. Consequently, substituting debt for equity in the capital

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structure, that is, increasing the firm's leverage, reduces corporate income taxes. This is because interest
expenses reduce taxable income and hence, actual taxes paid. The reduction in taxes that comes from
deducting interest expenses is called the interest tax shield.

Firm Value with Tax Shields

In the presence of conventional corporate tax rules, the value of a levered firm exceeds the value of an
all-equity firm because interest tax shields reduce the corporate tax bill. Not only that, but if the levered
firm remains levered, it will benefit from interest tax shields this year and next year and the year after

that, and so on in perpetuity. Consequently, the value of a levered firm, V , equals the value of an

otherwise identical unlevered firm, V , plus the present value of expected future interest tax shields,


The relationship between interest tax shields and the value of the firm implies, as shown in the graph
below, that the value-maximizing capital structure is 100% debt, because more debt always means more
tax shields. This sounds unrealistic, and it is. We need to relax more of the M&M conditions to get closer
to reality.

Note the optimal debt to equity ratio is unbounded — essentially 100% debt.

Cost of Financial Distress

e just saw that a corporation can reduce its tax bill by employing leverage in its capital structure.
More debt implied lower taxes, which suggested the best policy is to maximize debt. But companies don't
do this. Why not? At least part of the reason is costs of financial distress (CFD), sometimes also called
"bankruptcy costs". Financial distress occurs when a company is unable to honor its debt contract: it
defaults, or at least is in danger of doing so. Defaulting on a debt does not necessarily lead to bankruptcy,
but it generally does entail some difficult times and associated costs. What kinds of costs? Some costs are
direct, such as the fees paid to attorneys, advisors, and lenders to restructure a firm's obligations. Others
are indirect, such as a loss of employees or customers, while the company and its managers are diverted or
distracted by financial problems. Good employees and customers are costly to replace. CFD are difficult to
measure accurately, though we can make some helpful qualitative points about them.

Separating Costs and Probabilities

At the time a firm decides to borrow, it is not in distress and not planning to encounter it. At that time,
financial distress is a contingency — an event that might or might not happen in the future. It is helpful
to think of such events in terms of their likelihood of occurrence. Similarly, it is helpful to think of the cost
of financial distress in terms of probabilities and present values. We can define the present value of the
cost of financial distress, or PV(CFD), as the probability of distress times the present value of the
associated costs:

An analogy may be helpful.

Direct and Indirect Costs

Let's focus first on costs of distress. These are the direct and indirect costs that a company incurs when it
defaults on its obligations, or scrambles to avoid doing so. Generally, they arise due to, or at least in the
presence of conflict between claimants when a firm defaults. In that situation, there often is not enough
value to satisfy everyone (otherwise the firm would not be defaulting) and so there are disagreements
and contests to claim what limited value is available. Such conflict gives rise to the direct and indirect
costs already mentioned, which may be substantial. It is important to point out that we are only
interested in those costs that would not have arisen if the company had not borrowed money in the first
place. In other words, suppose the trigger for the default is a drop in sales due to a recession. Even an
all-equity-financed firm will be harmed by a recession. The lost sales and profits due to the recession are
not costs of financial distress. What we mean by CFD are the further costs incurred when a levered firm

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actually defaults.

CFD may be higher or lower depending on the nature of a company's business and the types of assets it
employs. For example, let's compare a hotel chain to an advertising agency.

When a company's resources are so small or so illiquid that it is in danger of defaulting, some potential
conflicts of interest become actual conflicts. Some of the firm's activities become zero-sum games: one
party's gain is another's loss. For example, there is an obvious conflict between the firm as borrower and
its lenders. But that's not all. There may be conflict between lenders — senior versus junior, secured
versus unsecured, domestic versus foreign. Or conflict between large and small shareholders, family and
non-family shareholders.

Why is such conflict costly? Everyone, the firm itself included, has to spend resources on monitoring,
preventing, and resolving disputes and potential disputes. It costs money to make sure you aren't being
taken advantage of by another claimant. For that matter, it costs something just to figure out what your
vulnerabilities may be. It costs money to challenge an action someone has already taken or proposes to
take; you might have to go to court to do it. And it costs money to figure out the best way to restructure
or reorganize the firm so it can go back to tending its business instead of putting out financial fires.
Finally, some of the indirect costs we have already mentioned may be exacerbated by this sort of conflict.
Your customers might decide it is easier to deal with another firm while you are preoccupied by disputes
with your lenders.


We have just looked at some of the factors that affect the cost of financial distress, given that distress
has occurred. But what affects the likelihood of financial distress? For most firms the single biggest
contributor to the probability of distress is the degree of leverage; in other words, the probability of
default is positively related to how much you borrow. This is perhaps not surprising, since it was one of
the reasons that we previously singled out leverage as a key barometer of a company's financial health,
and one of the reasons we developed ratios such as interest coverage and the debt ratio. But we can
describe another important feature of the relationship between leverage and CFD.

Tax Shields and CFD - The Static Tradeoff Model

ow we have the pieces necessary to put together the simplest model of optimal capital structure. The
so-called Static Tradeoff Model considers what happens when two of the M&M conditions are relaxed in
conformance with the real world. In a world with both taxes and costs of financial distress, we trade off the
benefits of one against the costs of the other. Let's depict the essence of the Static Tradeoff Model with a
formula and a graph.


The Static Tradeoff Model is intuitively appealing. Real companies do in fact worry about minimizing
taxes, and they clearly worry about financial distress, too. So the model has these broad considerations
in their proper places.

The Static Tradeoff Model is consistent with some of what we observe about real capital structures, but
only at a very basic level. For example, it does appear to be true that companies in industries with lots of
tangible assets do tend to borrow more than those in industries characterized by lots of intangible assets.
But we also observe inter- and intra-industry differences in debt levels that are clearly inconsistent with
the model. Nor does the model do a good job of explaining how and why capital structures change over
time or how they vary across countries.

We have mentioned some drawbacks that prevent the model from being universally accepted and

We have probably overestimated the present value of interest tax shields. There are several reasons for
this. First, we have ignored investors' personal taxes, which could affect how markets price corporate
bonds and probably reduce the apparent corporate tax advantage of debt. For example, if the
government taxed investors' income from owning corporate bonds more highly than their income from
owning stocks, then some of the taxes saved by corporations would be offset by higher taxes paid by
investors. Investors would recognize this and demand to be compensated with higher interest rates. That

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in turn would reduce the value to the corporation of the interest tax shields. This makes sense in theory,
but it is very hard to estimate how large the effect is in reality.

Another reason we may have overestimated the value of interest tax shields is that we have ignored
other ways to save taxes that don't require leverage and therefore may not entail costs of financial
distress - depreciation tax shields and investment tax credits, for example. If a company can reduce or
eliminate its taxes by other means, then it will not avail itself of interest tax shields to the extent
predicted by the model.

The measurement problem alluded to earlier for CFD raises another serious practical limitation. It means
that even though the model confirms the existence of a unique optimal capital structure, we can't
actually locate that optimum for a real company. If a company can't locate the optimum, the company
doesn't know whether it actually is obeying the model and neither do we.

Alternative Models

artly because of the inadequacies of the Static Tradeoff Model, other models have been developed. In
general they are more advanced and we will not explore them in detail. But a couple of things are worth
noting. First, all of them are due to some departure from the M&M conditions. Second, though some have
led to interesting insights about corporate behavior and some have a measure of empirical support, none
satisfactorily explains all we observe in real-world capital structures. This continues to be an area of active

In this section we'll give a flavor of the different types of models that arise from relaxing other of the M&M
conditions, in addition to taxes and costs of financial distress.

Pecking Order Hypothesis

One such model derives from an assumption of asymmetric information. That is, insiders such as
managers and large shareholders are assumed to know more about a company than outsiders. But
outsiders know that they know less, so they are reluctant to buy risky securities from the company when
the company is trying to raise new money. Why? The reasoning goes something like this:

The basic idea is that outsiders will charge more for capital when they think they are at an information
disadvantage, and they will do this even if the company is not actively trying to exploit its advantage.

Outsiders' reluctance to buy risky securities lest insiders exploit their information advantage gives rise to
a hierarchy or "pecking order" among sources of funds. The Pecking Order theory says that in the
presence of information asymmetries, firms prefer to access funding sources in the following order:

One of the most interesting features of the Pecking Order Hypothesis is that unlike the Static Tradeoff
model, it does not imply a unique optimal capital structure. Instead, it prescribes an optimal choice each
time the company needs to raise funds. But the choice depends only indirectly, if at all, on the company's
current capital structure.

To see the contrast between predictions made by the Static Tradeoff Model on the one hand and the
Pecking Order on the other, consider what each says about the behavior of more profitable companies.
Static Tradeoff says that such companies have an obvious need to shield their high profits from tax, and
therefore will tend to lever up. The Pecking Order says that such companies may have ample sources of
internal funds and will not resort to expensive external financing and may therefore have lower debt
ratios. Pecking Order theories do explain some behavior that the Static Tradeoff Model cannot. However,
the Pecking Order does not perform as well for small, young, and/or fast-growing companies.

Agency Costs

Agency costs refer to costs that arise when someone (a "principal") has to rely on someone else (an
"agent") to get something done. This is costly because the agent has a built-in conflict unless his or her
interests are identical with the principal's interests, which is rare. So maybe the agent doesn't work hard
enough, or pays less attention, or even steals from the principal. To avoid this, the principal has to incur
some kind of costs — monitoring, or auditing, or even actual theft. We saw that Mr. Cota had this
problem when he hired a new general manger to run Golden State — the man simply didn't run the
company the way Mr. Cota would have done it himself and this cost the Cotas two years of poor results

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and un-retirement.

Here's another example. Suppose a company is distressed — it's at or near the point of insolvency. At
this point, the lenders really own the firm and it should be run for their benefit. But shareholders control
the board of directors and still call the shots, at least until there is an actual default. What will
shareholders do in this situation? They might decide they have nothing to lose and make some very risky
bets — bets that they wouldn't make if they were playing with their own money instead of the lenders'.
Let's see how this works with a numerical example.

Product Market Models

Another class of models of capital structure comes from relaxing the M&M condition that day-to-day
management of the business is invariant with respect to capital structure. Some of these models are
complex and involve game theory. But their spirit is this: that beyond the obvious problem of how to
raise capital, capital structure may help a firm defend and exploit a profitable product market position by
deterring competitors or would-be competitors.

Consider a company that has cultivated a very profitable market niche; so profitable, in fact, that other
firms may be tempted to enter the same niche, which would erode margins. As a warning to such
would-be competitors, our incumbent firm might signal its intention of fighting any entry with, say, price
wars or legal battles. To back up the implied threat, it may make a show of how great its potential
resources are, such as cash and ready lines of credit. In contrast the threat may not be credible if the
incumbent has already used its debt capacity. This is an ad hoc story, to be sure, rather than a formal
model, but it implies a low debt ratio for the incumbent for reasons that have nothing to do with taxes or
costs of financial distress.

Control and Governance Issues

Sometimes a company's capital structure may be an artifact of other choices it has made. For example,
Golden State, a family-controlled business, may avoid issuing equity even if it would otherwise make
sense to do so, in order to maintain a certain degree of family control over voting shares. If Mr. Cota is in
need of new external funds he may well find himself borrowing more than he otherwise would, even
without regard to information asymmetries and a pecking order, just to avoid diluting his voting control.

As another example, we might see a company lever itself past the point of any plausible need for tax
shields, in order to reduce the amount of equity outstanding. The reduced pool of equity may be more
easily concentrated in a few hands to facilitate fast, efficient decision-making in order to effect a
turnaround. It is, in effect, a means of improving the governance of the firm, and may even be a
temporary state that lasts only until necessary changes have been made, at which point a more
"conventional" capital structure may be adopted in its place.

Payout Policy

ur final topic in this chapter is payout policy, which is certainly related to capital structure choice, and
in a way is the opposite of the securities issuance problem. When companies issue debt or equity they are
looking to bring money into the firm. Sometimes they need or want to do the opposite — get money back
out of the firm and into the hands of investors, usually shareholders.

The two main ways to get cash out to shareholders are to pay dividends and to buy back common stock.
From a company's perspective, these two actions are virtually equivalent: they both reduce cash and they
both reduce shareholders' equity, and they do so without affecting anything else (ignoring for the moment
any signaling effects associated with the choice of one action over the other). However, at the shareholder
level, the higher taxation of dividends compared to capital gains makes repurchases potentially more
advantageous. First, let's show that without taxes shareholders are indifferent between dividends or share

Let's now add taxes to the above scenario. This exercise shows that if investors pay higher taxes on
dividends than on capital gains, which is usually the case, investors will prefer repurchase plans over
dividend payouts. Suppose shareholders pay 30% tax on dividends and 15% on capital gains. Note that
capital gains taxes are paid only on capital gains when the stock is actually sold. So we'll compare two
scenarios: immediate sale and no immediate sale.

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What do we observe about companies' payout practices?

Tax authorities have long understood the tax advantage, and in some countries will impute a "dividend"
and impose the associated tax either on the company or its shareholders, even if the payout in question
took the form of a share repurchase. In other countries, public companies are simply prohibited from
repurchasing their own stock (this has to do with concerns about stock price manipulation in addition to
tax optimization). In the United States it is not uncommon for companies to use dividends as a way to
make relatively small but steady payments to shareholders and to employ share repurchases for larger,
less frequent payouts.

In general, mature companies with relatively slow growth tend to pay more dividends, while younger,
faster-growing companies pay little or nothing. This is due at least in part to the simple fact that young,
growing concerns need large amounts of financing — they are concerned about getting money into the
company, rather than getting it out — while mature companies are more likely to produce excess cash. In
countries or industries where operations are less transparent, a regular dividend payout may provide
investors with a tangible signal of the company's continuing healthy condition — it's hard to fake good
health by paying dividends forever even when things are going badly!

Because investors sometimes interpret dividends as a signal, companies tend to smooth them over time
— to avoid sending a confusing signal — whereas they allow repurchases vary with economic


ou learned the basic principles associated with debt and equity and the corporate use of financial
leverage. You learned a simple model of optimal capital structure and got a flavor of more complex models.
And you learned how payout decisions are related to capital structure decisions and hence, informed by
some of the same principles. You should understand that:

Debt is a fixed claim and equity is a residual claim.

As a fixed claim, debt is cheaper than equity because it is less risky.
Increasing leverage increases both the risk and the expected return on equity.
With no taxes and perfect markets a firm's capital structure is irrelevant — it cannot affect the firm's
value. (This is the famous M&M proposition 1, which forms the basis for all models on capital structure
under imperfect markets.)
The simplest model of optimal capital structure is the Static Tradeoff Model, which is based on comparing
the marginal benefit of interest tax shields to the marginal costs of financial distress.
The Static Tradeoff Model is not easy to apply, however, and in any case is too simple to explain
real-world capital structures and corporate behavior.
Other models, based on relaxing other specific M&M conditions provide helpful ideas.
No currently available model is universally accepted or applied.
As a means of getting cash out of (rather than into) a company, dividends and share repurchases are
economically very similar. They are treated differently for tax purposes, which may affect which one a given
shareholder prefers.
In the real world, dividends tend to be smoothed over time, while share repurchases fluctuate with
economic cycles and the fortunes of the firm.

Time Value of Money and Project Valuation

any corporate decisions involve considerations of value: how much is a business, a brand, a project, or
a facility worth? Even more to the point, how much is it worth compared to what it costs? A common way to
estimate value is to model the business or project as a stream of cash flows expected to occur over time, and
to compute the present value of the stream. This general method is called discounted cash flow (DCF)
analysis and it may be applied to many business situations. This chapter presents the principles behind DCF
valuation and the mathematics of discounting. Future chapters treat the problem of how to develop a discount
rate for use in a DCF analysis and how to apply the methodology to value an entire company.

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This chapter also examines common investment criteria: net present value (NPV), internal rate of return
(IRR), and payback period. You will see how each is calculated, what each is used for, and the strengths and
weaknesses of each as an investment criterion.


he time value of money embodies the premise that a dollar today is worth more than a dollar
tomorrow. A dollar not consumed today may be saved and invested. Consequently, a dollar invested today
will be worth a dollar plus interest tomorrow. The time value of money is expressed by the following

Compounding and Discounting

f we know present value we can always convert it to future value by a process called "compounding".
Compounding is the mathematical computation of how much interest will be earned in the first year, then in
the second year, including interest on interest, and so forth for as long as the investment is outstanding.
You have probably used the concept of compounding to calculate how much your savings account will be
worth at some future date when you want to spend the accumulated funds.

Discounting is simply the reverse of compounding. When compounding you begin with a present value and
turn it into a future value by multiplying by (1 + r) for as many years as necessary. When discounting, you
begin with a known future value and you compute an equivalent present value, now dividing by (1 + r). For
example, suppose you are saving money to purchase a car. You would like to know how much money you
need to invest today in an account paying 10 percent annual interest if you want to be sure to have $20
thousand dollars at a specific future date. Let's do the discounting.

You deposit $100 at 5% interest for the first year, with the interest increasing each year by one percentage point. What is the
value after five years?

a. $140.2

b. $127.6

c. $135.0

d. None of the above

Suppose that instead of the annually escalating interest rates you invested your $100 in an account that paid a constant 7%
annual interest rate (the average of the escalating rates). Would you have more, less, or the same amount of money at the end
of five years, compared to the $140.2 from the previous exercise?

a. More

b. The same

c. Less

You were hoping to have $200 after investing for five years, rather than the $140.2 shown in the previous exercise. Supposing
you can find an investment that pays 8% annual interest instead of 7%, how much do yo u need to invest today to achieve your

a. $123.0

b. $136.1

c. $156.7

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d. $142.7

PV of a Cash Flow Stream

So far we have discounted only one future cash flow from future value to present value, but many
investments involve multiple cash flows occurring at different points in time. For example, suppose you
own a government bond that will pay you $100 today and each year for the next four years, a total of
five payments. What is the value of such a bond today? It cannot be $500, the sum of the payments,
because you won't receive them all today. Instead, we can compute the value as the sum of the present
value of each of the five payments. If t denotes the point in time at which each payment occurs and r
denotes the market interest rate on five-year government bonds (let's assume r = 5%), then the formal
expression of this is:

Next, we will apply the discounting concept and mathematics to value a business project that Golden
State might want to undertake.

Valuing Golden State's Jarring Line Project

Making the Decision

Incremental Cash Flows

Mr. Cota gives us some calculations made by the previous manager showing the number of jars (5,000
per season) that the line can handle, and the expected wholesale price of a jar of fruit, assuming no price
increases. The same set of calculations shows the COGS for jarred fruit, and reveals that the gross profit
margin is the same — 23% — for jarred fruit as it is for Golden State's canning operations. With this
information, we can calculate the annual incremental gross profit for the jarring line.

We will have to pay additional commissions to the sales team to promote and sell the jarred product.
Incremental commissions of 3% imply a cost of $525 per year ($17,500 x 0.03 = $525), which we will
subtract from incremental gross profit.

The resulting annual incremental cash flow is:

The incremental operating cash flow we just computed can be derived in other ways, too. Another
common approach is to apply a tax rate (actually 1 minus the tax rate) directly to the $3,500 we
computed as incremental gross profit less commissions, and then add the tax shield associated with
incremental depreciation.

This is the same result we calculated above.

The depreciation tax shield, which equals the depreciation charge times the tax rate, is simply the
amount of taxes saved by virtue of being able to deduct depreciation from our taxable income.

Yet another common derivation of the incremental operating cash flow begins with taxable income as
computed previously:

We subtract taxes from this amount as before (tax at 36% = $540), which gives us incremental net

But net income does not equal cash flow, because some of the expense we charged against the project
was non-cash, namely depreciation of $2,000. So we add back the non-cash depreciation to the net

Note that we obtain the same annual incremental operating cash flow estimate of $2,960 from all three

Net Working Capital

Many business projects, such as Golden State's jarring line, require incremental investments in working
capital. That is, the cash cycle we examined in a previous chapter is affected by changes in accounts
payable, accounts receivable, inventory, and so forth that come about as a result of operating the jarring
line. In general, we will need to estimate these effects in order to capture all of the incremental cash
flows associated with a project like the jarring line.

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Putting It All Together

We now have nearly enough information to compute the present value of Golden State's jarring line,
assuming we keep it and operate it.

There will be an $800 investment in inventory, followed by incremental operating cash flows of $2,960
every year for five years. We'll assume that these cash flows don't start until 2009, one year from now.

Investment Decision Criteria

e've done some analysis of the incremental cash flows associated with Golden State's jarring line.
But we have not yet used them to make a business decision about the line. Should we keep it or sell it? In
this section we'll examine some common criteria used to make such decisions, and more generally to
evaluate proposed investments. They are:

Net present value

Payback period and discounted payback period
Internal rate of return.

Net Present Value

Now we know the present value of operating the jarring line is $11,078. To what should this figure be
compared? It should be compared to the value of the jarring line if we do not operate it. If we don't
operate it, it just sits there, producing nothing, so a value of $0 is one possible point of comparison. But
recall that Mr. Cota suggested selling the line and told us it would fetch $10,000 if we sold it right away in
2008. This is a more sensible comparison than $0.

More generally, NPV is the difference between how much a project is worth (the PV) and how much it
costs (the investment). When NPV is greater than 0, the project is worth more than it costs and
conversely when NPV is less than 0, the project costs more than it's worth. Accordingly, a project's NPV is
the amount by which wealth or firm value increases or decreases if you undertake the project.

This last observation leads naturally to a powerful rule for making investment decisions. The rule is:

Invest in all projects for which NPV is greater than 0.

These are the projects that increase wealth, because they are worth more than they cost. This is the rule
a person would follow to maximize wealth, or that a firm would follow to maximize its value.

The general formula for NPV is:

The NPV rule leads to simple decision criteria. Examine all projects and:

In real business situations, the calculations on which NPV rests may be very complex, and inputs are
estimated with varying degrees of confidence. Sometimes pertinent considerations are left out of the
present value calculations, simply because they are too difficult to quantify. Consequently, some firms
use NPV as in important, but not decisive or exclusive, consideration in their decisions about investment
opportunities. And many firms supplement it with other calculations and criteria. We will present two of
them, payback period and internal rate of return.

Payback Period

he payback period is defined as the time it takes to recoup the original investment in a project. All
else being equal, companies prefer shorter payback periods due to the time value of money and,
perhaps, because of risk considerations.

Computing the payback period is usually straightforward after incremental cash flows have been
estimated. One simply computes the accumulated cash flow for each year, beginning in year zero and
compares the accumulated cash flow to the initial investment. The payback period is the point in time at
which accumulated cash flow equals the initial outlay.

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Let's figure out the payback period for Golden State's jarring line project.

The payback period for Golden State's jarring project is approximately 3 years and 8 months.

The main advantage of the payback period calculation is its simplicity. Unfortunately, it includes no formal
treatment of the time value of money. Perhaps even more seriously, it ignores all cash flows beyond the
payback period. So a project with a very large, but somewhat distant, payoff is not treated kindly by this

Discounted Payback Period

A variation on payback period is Discounted Payback Period. The difference is that instead of using
cumulative cash flow to calculate the payback, one uses cumulative discounted cash flow. This
variation considers the time value of money, but still ignores cash flow beyond the payback horizon.

The discounted payback period for the jarring project is approximately 4.5 years. As you would expect,
it is longer than using the non-discounted cash flows.

Internal Rate of Return

nother investment criterion is Internal Rate of Return (IRR). The IRR is defined as the discount rate
at which the NPV of an investment equals zero. To use IRR as an investment criterion, one compares it to
the cost of capital. Typically, projects for which IRR exceeds the cost of capital are projects for which

In Golden State's jarring project, we used a discount rate of 8%. In reality, determining the appropriate
discount rate relies on a number of factors, such as prevailing interest rates and the inherent riskiness of
the project. We will consider how to estimate costs of capital in the next chapter.

Golden State's Jarring Project

Using the discounted incremental cash flows for Golden State, we can determine the IRR for the jarring
project. The process of determining an IRR is iterative: apply different discount rates to the NPV
calculation until
NPV = 0.

Excel has an IRR function to accelerate this process. Insert the cost of the project into Year 2008 and
apply the IRR function across the relevant incremental cash flows.

When using Excel or other means of calculation, it is critical to place cash flows in the correct periods.


The relationship between the NPV and discount rate may be plotted on a graph. In the case of the
jarring line project, the graph looks like this:

As the discount rate increases, the NPV falls and the point where it crosses the discount rate axis (NPV
= 0) is the IRR. In many circumstances, the NPV and IRR methods lead to the same conclusion. If an
investment has a positive NPV, its IRR is typically greater than the cost of capital and vice versa.

In cases where the cash flows do not follow a typical pattern of outflow followed by several years of
inflow, the IRR approach can yield incorrect or ambiguous results. More specifically, in cases where the
signs (plus or minus) of the stream of cash flows change more than once, there will be more than one
IRR. By its nature, the IRR also implicitly assumes that interim cash flows - that is cash you receive
between the beginning and the end of the project - are reinvested for the life of the project and yield a
return equal to the IRR. This may not be true in practice, and is not similarly assumed by the NPV


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perpetuity is a stream of cash flows that occur at regular intervals and last forever. An example of a
true perpetuity is the consol bond issued by the British government. What is the present value of a
perpetuity? To calculate it, add up the present values of all the cash flows at a discount rate of r:

This looks cumbersome, but fortunately, the mathematics of infinite series provides us with a simple
formula for the present value of a perpetuity that pays us $1 one year from now (at t = 1), and another
dollar every year thereafter forever.

The formula is:

This is a very useful formula for some businesses and investments, because a going concern, for example,
may generate cash flow for a very long time, approximately "forever". To use the formula in such a setting,
we modify it as follows:

where "CF" is the amount of cash generated each year, beginning in year one, and r is the discount rate.

Growing Perpetuities

The formulae above assume the cash flow remains constant. There is a similarly simple formula for the
present value of a perpetuity where the cash flows grow at a constant rate, g, every year. The formula is:

where CF is the initial cash flow, r is the discount rate and g is the constant growth rate of the cash flows.
Note that when g=0, this formula reduces to the same one presented above.

We will revisit perpetuities when we perform the valuation of Golden State as an entity. For now, it is
important to note that the growth rate, g, must be less than the discount rate, r. Fortunately, this is not
an unreasonable condition to impose — no company, indeed no economy, can produce a cash flow that
grows faster than the discount rate forever.


n this chapter we covered the time value of money and how to perform a simple project valuation. You
should have an understanding of:

The concept of the time value of money.

How to perform discounting and compounding on a single cash flow and calculate the present value of a
stream of cash flows.
The concept of incremental cash flows
Different methods for computing incremental cash flows.
NPV as a primary investment decision making criterion.
Payback period and IRR as additional financial characteristics of investment proposals, and the limitations
of each approach.
How to calculate the present value of perpetuities.

Risk & Return

n the previous chapter we used the discounted cash flow (DCF) relationship to estimate the present value
of a stream of cash flows. Recall the basic DCF equation:

When the cash flows are known with certainty, the discount rate should be the risk-free rate of return, which

we'll now designate as r . In most business situations, however, future cash flows are uncertain as to both

timing and amount. To handle risky cash flows, we need to modify the basic DCF equation. In the numerator,

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we use expected cash flow, denoted as E(CF ). In the denominator, we use a discount rate, k, which includes

a risk premium such that k > r .

In this chapter, we will explore both modifications, with particular emphasis on risk and the risk premium.


e will be covering many topics, some in detail, so a roadmap will help show how the topics fit

Expected Cash Flow

or risky future cash flows, we must consider the likelihood of different possible outcomes. We do this
with a probability distribution that shows the probability of each possible cash flow outcome:

E(CF), Mean and Mode

E(CF) differs from a simple unweighted average because we have multiplied each possibility by its
probability of occurrence. A simple unweighted average is calculated by summing all values and dividing
the total by the number of occurrences, ignoring probabilities. The mode is the value that occurs with the
highest frequency — the most likely outcome.

Skewed Distributions

Risk-Adjusted Discount Rates

hy do we need a risk premium in the discount rate? Consider two projects, A and B.

The diagram shows the cash flow distributions for A and B. Note that the E(CF) for both investments is the
same. Unless we adjust the discount rate our DCF equation would assign these two projects the same
value. Is this reasonable?

No it isn't. Project A cash flows near the mean have greater likelihoods than the same possible cash flows
for Project B. In other words, project B is riskier than project A. If the two actually had the same value,
risk-averse investors would prefer the less risky project A — no one would be willing to invest in B. The
riskier project, B, must have a lower price (in effect it must offer a higher expected return) or no one would
invest in it. In other words, we expect the risk premium to be higher for B than for A.

Risk Premium

The difference between the required expected return on a risky versus a risk-free investment is called the
risk premium.

If you invest in a risk-free security such as a government bond you earn a return equal to r , also

known as the time value of money. If instead you invest in a risky security, such as a company's shares
of stock, you demand a higher expected return. Accordingly, when you discount riskier cash flows, you
apply a higher discount rate.

In general, the appropriate discount rate for risky future cash flows has two components: time value (the

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risk-free rate) and a risk premium. The riskier the proposed project, the greater the risk premium
included in the expected return on it. This relationship can be represented in a graph as follows:

In short, we compute the present value of a risky project by discounting its expected cash flows at a rate
k that includes a risk premium. The magnitude of the risk premium depends on the riskiness of the
project. Note that, all else equal, the higher the risk premium in k, the lower the resulting present value,
which is as we would expect.

Value Maximization & Opportunity Cost

ecall how we used the DCF relationship in the case of Golden State's jarring line project. We were
trying to decide whether it was better to sell the line or operate it. To make this decision, we wanted to
know which alternative was more valuable. Without saying so, we were behaving like value maximizers.

The goal of value maximization has important implications for k, our discount rate. To maximize value, we
must use a discount rate equal to the opportunity cost of funds, sometimes called the opportunity cost of
capital or simply the cost of capital.

Definition: the opportunity cost of capital is the expected return on an alternative investment with the
same risk as the project under consideration.

In the case of Golden State's jarring line project, we were simply given a discount rate of 8%. We didn't
stop to ask whether 8% actually represented the opportunity cost of funds. We did consider the opportunity
cost of operating the line: By operating it, we gave up the value of selling it. We need to think similarly
about the discount rate: The opportunity cost of funds is the return we could earn by investing in an
alternative project with the same risk as the jarring line.


Two important points come from the assumption of value maximization:

Number 1: For a value maximizer there is no such thing as "free" capital, even if someone is willing
give it to you free of charge.

What is the cost of capital?

a. 0%

b. the return you can receive on an investment with similar risk

c. the current risk free rate

d. none of the above

Number 2: For value maximizers, capital markets matter a great deal in the determination of k.
Because that's where the "alternative investment with the same risk" comes from. Your set of
alternative investments is, in effect, what we mean by "the capital markets."

This makes us want to know how capital markets incorporate risk into the asset prices we observe.


e are now ready to learn about the Capital Asset Pricing Model and its role in determining discount


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he Capital Asset Pricing Model (CAPM) was developed in the 1960s and is widely used in various forms
today. We won't formally derive it, but we will cover the principles it relies upon and look at its implications
for corporate finance, in particular for developing discount rates in a DCF valuation.

First we make some explicit assumptions about investors and investments:

Investors' goal is to maximize their wealth.

Investors are risk averse: they will prefer the less risky of two investment alternatives that are
otherwise identical.
In choosing their investment portfolios, investors worry about both risk and expected returns (and
nothing else).
Any risky investment can be described in terms of the risk it entails and the expected return it offers.
Returns on risky assets have normal (bell-shaped) probability distributions.

Risk & Expected Return For a Risky Asset

Now picture a typical business investment, which we can think of as a risky asset. Instead of drawing the
probability distribution for future cash flow, we'll draw it in terms of future return on investment. (Note
that the distribution of returns is implied by the distribution of future values.)

We can use the distribution of returns to identify two key characteristics of the asset: expected return
(the mean of the distribution) and variance of returns (how spread out the distribution is). The latter is

usually denoted by sigma squared, σ . Variance is a measure of how uncertain the returns are; in

other words, it measures risk. So we are already talking about risk and return — just what we wanted.

Measuring Volatility

The mean, median, and mode of a distribution all convey information about center of the distribution, but
none of these measures dispersion. In other words, how "spread out" the distribution is. As we saw
earlier, two distributions could have the same mean and median, and yet be differently dispersed around
the central value.

Variance is a probability-weighted measure of dispersion around the mean: the more spread out the
distribution is, the higher the variance. Project A has a lower variance than Project B, but they have the
same mean, mode, and median.

If we know the variance of a distribution of returns, we can easily convert it to the standard deviation of
the distribution simply by taking the square root. In finance, this parameter is known as the volatility of
returns (denoted as σ) and is used as a measure of risk.

Two Risky Assets

Portfolio Returns


While the expected return on the portfolio is indeed a simple weighted average of A's and B's expected
returns, the standard deviation is not; it's more complicated.

You may have seen the formula for the variance of the sum of two random variables:

The standard deviation of the portfolio's returns is then the square root of this expression.

It is often the case for two economic or financial variables that, even though both are random, they are
related to one another. That is, there is a measurable tendency for both to take on high or low values
at the same time, or for one to be high when the other is low. In such cases, they are said to
"co-vary." The relationship may be positive or negative and the tendency may be stronger or weaker.
This relationship between two variables is called their covariance.

More formally, we define covariance as a numerical expression of the linear association between two
variables. A positive (or negative) covariance indicates a positive (or negative) relationship.

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Intuitively, you can think of plotting realized values for the random variables x and y on a graph. If you
see an obvious "best-fit" straight line that could be drawn through the collection of points, then the two
variables have a non-zero covariance. If the "best-fit" line slopes upward, the covariance is positive; if
downward, covariance is negative. When there is no "best-fit" line, there is no linear relationship
between the variables — we say they are independent of one another — and their covariance is zero.

How do we calculate covariance? Formally:

If this expression for covariance looks unfamiliar, recall the definition of variance, which you have
encountered previously:

In words, the variance of x is the expected value of squared differences from the mean of x. The
reason for squaring is to ensure that a given distance from the mean has the same effect on variance

regardless of whether the actual value is above or below the mean. For example, 2 = 4 and

(-2) = 4.

Returning to our scatterplot, we would think that the slope of the best-fit line should be related to
covariance, and it is! Formally, the best-fit line is a regression line, and its slope will equal the ratio of
the covariance of X and Y to the variance of X.

Benefits of Diversification

Now let's return to our portfolios composed of assets A and B. Because A and B aren't perfectly
correlated, by investing some money in each, instead of 100% in one or the other, the investor
benefits from the effect of diversification: Some of the randomness in A is offset by randomness in B.

The property of correlation is similar, intuitively, to covariance, and in fact there is a formal
relationship. Cov(A,B) may be written as ρσAσB where σA denotes the standard deviation of A (and
likewise for B) and ρ is the correlation coefficient for A and B, which is defined to be between 1.0 and
-1.0. By manipulating the relationship just stated, we can see that the correlation between A and B, r,
must equal Cov(A,B)/σAσB.

Many Risky Assets

In the real world there are many risky assets, not just two. How does this affect the problem? It is
certainly still the case that investors benefit from diversification. But there are many more possible
combinations of securities to consider as potential portfolios. For a large number of risky assets, the set
of all possible portfolios has a distinct shape — it looks like a broken eggshell.

If we could choose from among all these possible portfolios, which would we choose? We can eliminate
most of them very easily. Here's a simple rule: Eliminate any portfolio for which we can find an
alternative that gives the same expected return for less risk or a greater expected return for the same

Adding the Risk-free Asset

Let's add some more features to the picture. Recall the risk-free asset (e.g. a government bond)
examined in the previous chapter. Where would it fit in our graph? It must be on the vertical axis because

it has no risk (σ = 0). And its return must equal r , the risk-free rate. So it's easy to plot.

Now suppose we allow the investor to build portfolios from this riskless asset and any of the efficient
portfolios on the efficient frontier. What would they look like? Because the riskless asset is riskless, it is
not correlated with any of the risky asset portfolios. Therefore all combinations of the riskless asset and
an efficient portfolio must lie on the straight line passing through the risk-free asset and the particular
portfolio. Is this line a new efficient frontier?

The Capital Market Line

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This special line that describes all the portfolios that could be formed by combinations of the market and
either borrowing or lending at the risk-free rate is called the Capital Market Line (CML). The CAPM
says wealth-maximizing investors should invest only in portfolios that lie on this line. Anything else is
dominated by some portfolio on the CML.

The CML gives us another important piece of information. It tells us how much extra return an investor
may expect when investing in a riskier, rather than a safer, portfolio: the slope of the CML gives the
amount of extra return per unit of extra risk. Portfolios on the CML to the left of the market are less
risky; those to the right are more risky. But every one of them has an expected return proportional to its
risk, where risk is defined to be the standard deviation of portfolio returns.

The Security Market Line

Now we have a concrete relationship between risk and expected return. We know that the price of risk —
the amount of additional return you get per unit of additional risk (the slope of the CML) — is determined
by the riskless asset and the market portfolio. This has an important implication for the equilibrium
returns (and hence, prices) of individual securities: Each will be priced according to the amount of risk it
contributes to the market portfolio. Put another way, we know now that it's the riskiness of the market
portfolio that determines the market price of risk. Therefore, what matters for an individual stock is how
much riskier it makes the market.

How much risk does an individual stock add to a portfolio comprised of many stocks? Let's find out.

Therefore, what determines the risk premium for an individual stock is not its volatility, but rather how
much of its volatility cannot be diversified away in a large portfolio. This is often referred to as
"systematic risk" or "non-diversifiable risk." Because investors cannot get rid of it simply by diversifying,
they will demand a higher expected return for bearing it. This insight leads to another graph of risk and
return, this time for individual securities, rather than efficient portfolios.

The CAPM has told us how to think about and measure risk: For a portfolio, we care about variance or
standard deviation of the portfolio's returns. For individual assets or securities we care about systematic
risk: how much risk they contribute to the market portfolio. The CAPM also has told us that the price of
risk is determined by the risk premium on the market portfolio. That means we should measure risk for
an individual security relative to the market as a whole.

The risk of the market as a whole is simply the variance of returns on the market portfolio. We saw that
an individual stock's non-diversifiable risk is determined by its covariance with the market portfolio.
Therefore a sensible measure of systematic risk for an individual stock should be the ratio of the two:
covariance with the market over the variance of the market.

This measure of (relative) systematic risk is called "beta":

The CAPM Equation

We are now ready to summarize the CAPM in an equation. It is:

Let's recall what we mean by "beta." Beta for asset x equals the ratio of its covariance with the market to
the variance of the market. This is exactly the definition proposed above.

Note that beta is a measure of relative risk. The β for the market as a whole is 1.0 by construction.
[Recall that the covariance of the market with the market must equal the variance of the market. And the
variance of the market divided by itself equals 1.0.] An asset that has β < 1 is less risky than the market
and expected to move less than the market in response to a given shock. An asset with β > 1 is riskier
than the market and expected to move more than the market.

Using the CAPM Equation

How is the CAPM relationship used by finance professionals? It has three basic components: the risk-free

rate, r ; the beta, β , and the equity market risk premium (R -r ). Let's examine each in


Using the same equation, we will now examine beta.

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Betas are routinely calculated and published, and are widely available from commercial sources, such as
Standard & Poor's, Valueline and Bloomberg. It will seldom be necessary for you to run a regression to
estimate your own betas.

Sample betas with respect to S&P 500 for 12 months ending November 2007:

We will now examine the equity market risk premium.

The equity market risk premium (EMRP) is the expected return on the market portfolio over and above
the risk-free rate, for the term of the cash flows to be discounted. In practice, this parameter may not be
directly observed and so must be estimated.

Common ways of estimating the EMRP include statistical analysis of historical data on stock market
returns; survey data on today's investors' expectations regarding future returns on the market; and
returns implied by or inferred from current levels of market indices.

We will not examine these methodologies in detail here, but rather observe that for US dollar cash flows,
finance professionals today commonly use values of the EMRP between 4% and 6%. We will use 5% in
our calculations here.


e are now ready to learn how discount rates are determined.

Project Discount Rates

e can think of Golden State's jarring line project as a risky asset. If we had a beta for the jarring
line, we could use the CAPM equation to calculate a discount rate for the DCF valuation we performed in the
previous chapter. Unfortunately, Golden State itself has no publicly traded stock, and its jarring line project
certainly doesn't, so we cannot simply run a regression to get a beta for it. What should we do?

A common procedure is to use a beta for a company or a sample of companies that we think are similar to
Golden State and/or its project. What do we mean by "similar"? We mean companies that face the same
systematic risks as Golden State (because it's systematic risk that determines the risk premium in a
discount rate).

We can get a beta for Smucker's stock from various sources (and we should be aware that different sources
may publish different betas, depending on the observation period and frequency used to obtain data on
stock returns, and on the particular regression techniques employed to estimate a beta). And from the J.M.
Smucker annual report, we can extract some important financial and operating information.

Costs of Debt & Equity

Before we use Smucker's beta in an actual CAPM calculation, let's pause and consider how we'll use the
result. The beta we have comes from observing returns on Smucker's stock, not its jarring line per se or
even its larger fruit-preserving operations. These aren't traded — only the stock is.

Smucker's operations are the source of its business risk, yet it is the stock for which we have a beta. How
can we use it?

To infer the riskiness of Smucker's operations from the beta of its stock, we can call once more upon the
principle of the conservation of business risk, introduced in an earlier chapter. Simply put, a company's
suppliers of capital, as a group, must bear all of the risk of its operations. In other words, the riskiness of
the securities a company issues to its investors must be the same, in the aggregate, as the riskiness of
its operations. Put even more bluntly, all of the risk on the left side of the balance sheet must be borne
by investors on the right side: lenders and shareholders.

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So to calculate a discount rate for Smucker's operations, we need to know its cost of debt (K ), cost of

equity (K ) and the market values of its debt and equity.

The Cost of Equity

We have enough information to calculate Smucker's cost of equity, K using the CAPM equation.

Weighted Average Debt and Equity Costs

Smucker's debt value

The book value of debt from Smucker's balance sheet (as rearranged and simplified) was $695 million,
and we will assume that this equals the market value of Smucker's debt. [This is a common, though
sometimes imperfect assumption: that the book value of debt equals its market value.]

Smucker's equity value

Now we need the market value of Smucker's equity. On April 30, 2007, Smucker's closing stock price was
$56.10, and we have the number of shares outstanding from the annual report (56.78 million).
Multiplying the stock price price by the number of shares outstanding gives us the market value of
Smucker's equity of approximately $3,880 million.

Smucker's debt and equity ratios

Smucker's debt is $695 million, as we saw above, and the market value of equity is $ 3,185 million.
Therefore Smucker's enterprise value:

Smucker's cost of debt

The only missing ingredient now is Smucker's cost of debt. This should be the expected return a lender
would require on newly-issued fixed-rate debt of Smucker, as of April 30, 2007. But if Smucker isn't
actually issuing new debt on that date, how to we know what its cost of debt is? As usual, we consult the
capital market. We want to know what other companies with similar credit quality are paying. Or we look
at the market values of traded bonds for such companies to find out the current yield. For simplicity, let's
suppose we discover Smucker's cost of debt is 7.0%.

We can think of the rate just calculated for Smucker as its Cost of Capital. How is helpful? We have
argued, in effect, that it can be used as a discount rate for DCF valuations of projects that are just like
Smucker in their systematic risk and capital structures. Golden State's jarring project, for example, might
be similar enough to Smucker that Smucker's cost of capital is a good benchmark for a discount rate.
Recall from the previous chapter that we used 8% as a rate for the jarring project. Now we see from the
data on Smucker that 8% was close, but might have been a bit low. On the other hand, Golden State's
jarring line project might not be as risky as Smucker's operations, which would imply it deserves a
somewhat lower rate.

We know that the beta of 0.82 for Smucker's stock reflects both its operating risk and the degree of
leverage in the capital structure. If we could remove the effect of the leverage, we would obtain a beta
reflecting only operating risk. In other words, we want to know what Smucker's beta would be if it
employed zero leverage. Such a debt-free beta is sometimes called an "asset beta" or an "unlevered

Once we obtain an unlevered beta, we can then adjust it for use with Golden State by "re-levering" it.
That is, we can figure out what the beta should be for Golden State's equity, given Golden State's capital
structure (which is different from Smucker's).

The basic relationship between stock betas and asset or unlevered betas is:

[We'll note in passing that this is a simplified version of a more complex relationship that you will
eventually learn when you study more finance. More complex versions of this relationship involve the
debt ratio, a beta for the debt, and the tax rate.] We can use this simple equation to unlever Smucker's
beta of 0.82, removing the effect of Smucker's 18% debt to capital ratio.

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Golden State's Cost of Capital

Now that we have estimated Smucker's unlevered β we can use it to compute a cost of equity for Golden
State. To do so we need to adjust it (i.e., "re-lever" it) to reflect Golden State's capital structure, which is
different from Smucker's. In doing so we will be assuming, in effect, that both companies have the same
unlevered β because they have similar businesses.

Now we'll calculate the effect of Golden State's capital structure on its beta by re-levering the unlevered
beta. We know that the re-levered beta will be higher than 0.67. But how much higher? We can use the
same relationship to re-lever that we used to unlever. Rewriting it gives:

Now we can use the CAPM equation to calculate a cost of equity, K , for Golden State:

Note that Golden State's cost of equity is much higher than Smucker's (14.0% versus 9.7%). The
difference is entirely due to the difference in their capital structures, since we know that underlying each
number is the same unlevered beta of 0.67. We know it's the same because we derived it from the beta
of Smucker's stock (therefore, it must characterize Smucker), and we applied it to Golden State's (so it
characterizes Golden State as well). The magnitude of this difference in costs of equity reminds us why
we must be careful about unlevering and re-levering betas — differences in leverage make a big
difference in costs of equity!

Now that we have a cost of equity, we are almost ready to compute a cost of capital for Golden State. We
still need a cost of debt for Golden State, and we probably can't use Smucker's cost of debt. Golden
State's cost of debt should be a bit higher because lenders may charge more to lend to Golden State
given its higher leverage and smaller size. To get a good sense of Golden State's cost of debt, you would
need to check current rates in the credit markets and, just as important, talk to some prospective lenders
about your plans for the company after you buy it. For now, let's recall the pro forma financial statements
we prepared in a previous chapter, in which we used an interest rate of 8%.

How does Golden State's cost of capital compare to Smucker's? It's higher, but the difference is not
nearly as great as the difference between their costs of equity. The difference between costs of equity
was more than 4%, but the difference between their costs of capital is only about 1%.

Golden State is using a lot more debt, which is less costly than equity. But it has to pay more for its debt
and it pays a lot more for its equity. The very fact that Golden State is using less equity makes its equity
riskier, and we know that increasing risk increases the expected return on equity — in other words, it
makes equity more expensive. And using more debt makes debt more expensive. Consequently, the cost
of capital ends up being mostly determined by the risk-free rate of interest and the unlevered beta. (In
other words by time value of money and the systematic risk of operations, which is where we began our
discussion of discount rates.)


e are now ready to learn about the Weighted Average Cost of Capital and its uses.

The Weighted Average Cost of Capital

ou may have noticed that the cost of capital we computed for Golden State was higher than for

Smucker, and both were higher than the 9.0% we just computed for R . We know that the

differences must be due to leverage, since R is a rate for an unlevered firm, whereas

Smucker has nearly 20% debt in its capital structure, and Golden State much more: 60%. [Actually some

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of the differences are due to other factors: oversimplifications in some of our equations, and our rough
guesses at the costs of debt.]

It seems that as leverage rose, so did the cost of capital. And yet, we saw in an earlier chapter on capital
structure that leverage actually adds value, so long as we don't use "too much." Where does the added
value come from? Mostly from tax savings associated with leverage. Our formula above for the cost of
capital omits any consideration of taxes.

Another common formulation of the cost of capital is called the "Weighted Average Cost of Capital," or
WACC, and it is given by this equation.

What's the difference? Notice that the weighted cost of debt is multiplied by (1-t) where t equals the tax
rate. This modification is intended to reflect the fact that interest is tax-deductible, as we noted in the
chapter on capital structure.

Suppose that both Smucker and Golden State face a tax rate of 36%. Let's use the same parameters as

above for D, E, V, K , and K to compute a WACC for both companies.

When we compare the WACCs for Smucker's and Golden State, we see some interesting things. Golden
State's WACC of 8.67% is lower than Smucker's WACC of 8.76%. Before including taxes, we computed a
cost of capital for Golden State (10.4%) that was higher than Smucker's (9.2%). We also see that both

WACCs are lower than the R we computed above (9.0%). Before including taxes, both

costs of capital were higher than R . Finally, the WACCs for these companies are very

close together: the difference is less than one tenth of one percent. In other words, on an after-tax basis, it
appears that Golden State and Smucker's have nearly identical costs of capital which, again, is comforting
since we have assumed the same level of systematic risk for each. Golden State's greater use of leverage
raised its costs of debt and equity and its pre-tax cost of capital. But on an after-tax basis, the effect of the
leverage was very slight.

So, what is the right discount rate? R ? The pre-tax cost of capital,

K (and we should note here that K is also

a weighted average and is sometimes even called the "pre-tax WACC")? Or WACC?

Since WACC is so widely used, and because the formula has some intuitive appeal, many people assume or
assert that it is "correct." But we should not be hasty. In fact, it is not always correct in a strict technical
sense and may not even be preferable to other alternatives.

Flow Charts

e've now proposed three candidates for consideration as discount rates, depending on the task at
hand. They are a bit different one from another, even though they are related. And some of them go by
more than one name.

To avoid confusion, let's review what we've done by constructing some flow charts.

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First we'll construct a flow chart for R for Golden State. R is also called

the cost of unlevered equity, or k .


n this chapter, we refined our use of the basic DCF relationship to account for the fact that business
cash flows are risky. We made adjustments to the cash flows (in the numerator) and to the discount rate (in
the denominator). More specifically, we learned that:

We should use expected cash flow in the numerator, which is obtained from probability distributions for
cash flows.
The discount rate in the DCF calculation should be an opportunity cost of funds. That is, it should be the
expected return you could earn on alternative investment with the same risk.
The discount rate in a DCF valuation is adjusted to reflect the riskiness of a project or investment being
evaluated. The discount rate is composed of two parts: the return on a risk-free investment plus a risk
premium for the project being considered. The higher the risk, the greater the premium.
The Capital Asset Pricing Model gives us a logical framework for relating risk to expected return for risky
assets or securities and for portfolios comprised of such assets.

In a portfolio of many assets, diversification reduces risk.

The extent to which this is so depends on correlations among asset returns.
The lower the correlation, the greater the diversification and the lower the risk of the portfolio.

We also learned:

The observed beta for a company's stock is affected by the capital structure of the company.
We used a simple relationship to remove (or reinsert) the effect of leverage on beta.
We noted that the risk premium for operations is a weighted average of the risk premia for debt and
equity, according to the principle of risk conservation.
Therefore a weighted average of the cost of debt and the cost of equity gives a cost of capital that is a
plausible candidate for a discount rate.

Another plausible candidate is R , which may be estimated simply by inserting an

unlevered beta in the CAPM equation.

The weighted average cost of capital (WACC) is also commonly used as a discount rate in DCF
calculations when the cash flows have the same risk as the company as a whole.
The WACC formula is:

This WACC formula includes a term, (1-t), intended to reflect the deductibility of interest.
Though widely used, WACC is not always the preferred discount rate.

Valuing a Business

ur examination of Golden State Canning arose from an interest in possibly buying it. In this chapter, we

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will estimate how much the business is worth to aid our thinking about what sort of a transaction and
purchase price we might propose to Mr. Cota. This valuation exercise also will give us an opportunity to
synthesize and apply many of the concepts covered in previous chapters.

Basic Approaches

he most common approaches to valuing a business fall into three main categories: the Balance Sheet
Approach, the Market Approach and the Income Approach.

DCF Ingredients

o perform a DCF valuation of Golden State, we will need three basic ingredients:

We'll examine each of these in turn and then put them together to obtain a value for the company.

Enterprise FCF

Just as we wanted incremental cash flows for the jarring line when we were evaluating that project, we
now want incremental cash flows for all of Golden State, now that we are evaluating the entire company.
Once again, we recognize that future cash flows are uncertain, so we think in terms of their probability
distributions. And once again, it is the expected cash flow that is to be discounted for a given year — that
is, the mean of the corresponding probability distribution.

The cash flows we want to discount are often called "Enterprise Free Cash Flows" or sometimes simply
"Free Cash Flows" or "FCF." They include the obvious elements of operating profit: revenue, cost of goods
sold, selling, general, and administrative costs, taxes, and so forth. But they also include some additional
elements that may be less intuitive. Let's examine a "recipe" for Enterprise FCF.

Here is a basic formula for Enterprise free cash flow. Let's examine each element in turn.

Now let's take a moment to examine the FCF recipe to see what is not included.

Pro Forma Financials

How are projections for Enterprise FCF developed in practice? A firm's expected future performance
depends on many factors, some of which are outside management's control. Nevertheless, two key
determinants are management's business strategy and operating plans. In short, how Golden State
performs over the next five or six years depends a great deal on how its owners plan to operate it.

Before employing FCF projections in a DCF valuation it makes sense to examine them carefully, to
check for consistency and reasonableness.

Discount Rates

The next step is to figure out what discount rate to apply to Golden State's Enterprise FCF. Recall in the
previous chapter on risk and return that we computed several different rates for Golden State that are
possible candidates for the discount rate we need.

It clearly is not the cost of equity alone, nor the cost of debt alone, which are required expected returns
of Golden State's equity and debt investors, respectively. Neither reflects the capital structure of the
whole company.

The unlevered cost of equity, also known as the expected return on assets, is the cost of equity
associated with an all-equity capital structure. In fact, for a firm with zero debt, the cost of (unlevered)
equity is the cost of capital and would be a good candidate for a discount rate. We computed the cost of
unlevered equity as 9.0%

Our pro formas actually show Golden State with some leverage and we assumed in the previous chapter
that Golden State would adopt a target capital structure containing 60% debt and 40% equity. We
computed a pre-tax cost of capital as a weighted average of the costs of debt and equity.

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The final candidate is WACC, which we computed as 8.67% - call it 8.7%. We made several cautionary
points about WACC in the previous chapter. Though WACC is commonly used as a discount rate, it makes
specific assumptions on tax rates, capital structure and tax shields. We should also note that if the cost of
debt is "too high" in the pre-tax cost of debt, it is too high in the WACC calculation as well.

Recall the formula & result:

For now, we will use WACC = 8.7% as our prime candidate for a discount rate for the FCFs. But keep in
mind there are other possibilities and we will revisit them when we consider sensitivity analyses.

Terminal Value

The terminal value is the expected value of the enterprise at a specific future date, namely the end of the
year-by-year projection period. For our analysis of Golden State this date, called the terminal horizon, is

Terminal values are sometimes estimated as perpetuities.

The value of Golden State in 2013 is expected to be about a million dollars according to the calculation
just performed. Compared to the rest of our FCF, this is a big number and it will have a significant impact
on the concluded DCF value when we're all finished. This is often the case for a going concern, so it pays
to be careful with the terminal value and examine the inputs closely.

To illustrate, let's compute a Normalized FCF for 2014 as follows.

Now that we've opened this issue, let's consider another approach to the perpetuity. Some analysts might
say "let's be conservative and project zero growth in perpetuity" (that is, not even growth due to inflation
is considered). So the denominator in the perpetuity formula will set g=0. What does this mean for the
numerator? One view says that normalized FCF for 2014 is simply equal to EBIT(1-t) for 2013. This is
because with zero growth, depreciation should equal capital expenditures and no additions to net working
capital should be required. Accordingly, the terminal value in 2013 becomes:

Clearly, the numerator in the perpetuity formula is worthy of some careful analysis, including the
examination of sensitivities. Let's move on to the denominator in the formula.

The first term in the denominator is k, the discount rate. This should reflect the time value of money (the
risk-free rate of return) for a very long period and a risk premium that reflects the systematic risk of the
cash flows. If the firm is going to have a constant debt ratio in perpetuity, it may also be appropriate to
adjust the discount rate, as WACC does, for interest tax shields.

An obvious upper boundary for the growth rate, g, is k, the discount rate. As g approaches k, the
resulting present value approaches infinity, which is silly. When g>k, the denominator actually is
negative, which is equally silly.

Putting It Together

e now have all the elements we need to calculate the value of Golden State. We have the free cash
flows for years 2008 through 2013, the terminal value of the business and the discount rate for calculating
the present value of the business.

The next step is to calculate a discount factor for each year by applying the WACC of 8.7% to each year.

Recall from the time value of money that the discount factor is 1/(1+k) where k is the discount rate, in

this case 8.7%, and t is the number of periods for the discount factor.

What does this number mean? Is it the amount you should offer to Mr. Cota to purchase the company? Let's
step back and look at how we reached this number.

We made projections of the future cash flows of Golden State based on expectations about how the
business would perform given certain operating plans. We also made assumptions about the steady-state
capital structure of Golden State, its comparability to other companies, like Smucker's, and its costs of debt

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and equity. Using these inputs, we calculated that the present value of Golden State's operations is about
$1 million.

Sensitivity Analysis

e can use our pro formas and the discounted cash flow model to ask "what if" questions and
observe how the value of Golden State changes by varying key inputs. Examples of managerial "what if"
question are:

In our pro formas, we assumed sales growth of 15% from 2008 through 2013. Let's see what happens if we
lower the sales growth of the existing lines to 10% a year from 2008 through 2013.

Download Sensitivity Analysis

Aside from managerial questions, another reason to perform sensitivity analyses is to gauge our confidence
in the concluded value given that we may harbor some uncertainty about some of the inputs. For example,
we might want to know how sensitive the value is to the discount rate, given that we considered rates that
ranged from 8.7% to 10.4%, so we vary the rate in the model and observe the effect on value.

You can see how Golden State's valuation is sensitive to changes in the inputs used in the financial models.
While the effect of varying a single input may seem predictable, the combined effect of changes in multiple
inputs is seldom so clear. Performing sensitivity analyses is therefore essential to building confidence in
financial models. Fortunately, today's powerful computers and analytical software make this chore relatively
easy from a computational perspective. The harder part is understanding which variables deserve the most


ur DCF valuation of Golden State is helpful, but it's just a beginning. Let's pause to examine our
conclusion and raise some other pertinent considerations.


n this chapter you learned how to apply basic DCF techniques to value an operating business. We

The elements of Enterprise Free Cash Flows

What's included and what isn't
Possible discount rates
The unlevered cost of equity
The pre-tax cost of capital
The (after-tax) WACC
Terminal value calculations
The use of the perpetuity formula
Inputs and cautions
Putting the pieces together and interpreting the result
Sensitivity analyses

Final Exam 1 Introduction

elcome to the post-assessment test for the HBS Finance tutorial. This test will allow you to assess
your knowledge of some basic financial principles.

To advance from one question to the next, select one of the answer choices and click the Submit button. After

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submitting your answer, you will not be able to change it or return to the question, so make sure you are
satisfied with your selection before you submit each answer.

Your exam results will be displayed immediately upon completion of the exam. The results screen will display
each question with a graphic notation indicating your score: X for incorrect and check mark for correct.

Click Final Exam 1 in the menu bar to the left to begin. You can also return to your test results at any time
(after completing the exam) by clicking Final Exam 1 Introduction and then Final Exam 1.

Good luck!

Final Exam 1

[Exam content not shown]

Final Exam 2 Introduction

elcome to the second post-assessment test for the HBS Finance tutorial. This test will allow you to
assess your knowledge of some basic financial principles.

To advance from one question to the next, select one of the answer choices and click the Submit button. After
submitting your answer, you will not be able to change it or return to the question, so make sure you are
satisfied with your selection before you submit each answer.

Your exam results will be displayed immediately upon completion of the exam. The results screen will display
each question with a graphic notation indicating your score: X for incorrect and check mark for correct.

Click Final Exam 2 in the menu bar to the left to begin. You can also return to your test results at any time
(after completing the exam) by clicking Final Exam 2 Introduction and then Final Exam 2.

Good luck!

Final Exam 2

[Exam content not shown]

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