ModuIo 700 rocoivos a voigll of 10° on llo CABM Ixam, and il incIudos llo foIIov

ing sub-moduIos:
700.1 Iinanco Slralogios
700.2 Basic IinanciaI Slalomonls
700.3 WorIing-CapilaI Managomonl
700.4 Compononls of Slorl-Torm Assols
700.5 Cosl of CapilaI
700.6 CapilaI Slrucluro Managomonl
700.7 Dividond IoIicy
700.8 IinanciaI Iorocasling, IIanning, and ConlroI
700.9 CapilaI VaIualion Toclniquos
700.10 CapilaI Budgoling
700.11 IinanciaI Inslilulions and MarIols
700.12 IinanciaI RisI Managomonl
700.13 Morgors and Acquisilions
700.1 Fihahce SIraIegies 1
700.1.1 Undorsland llo goaIs of a corporalion in lorms of profil maximizalion
or maximizalion of slaroloIdor voaIll
700.1.2 Discuss llo principIos llal form llo foundalions of financiaI managomonl
700.1 Finance 5trategies
700.1.1 Understand the goaIs o! a corporation
in terms o! pro!it maximization or maximization
o! sharehoIder veaIth
In llis soclion vo dosignalo llo goaI of llo firm as mcximizciicn c| s|crc|c|!cr ucc|i|, by
vlicl vo moan maximizalion of llo prico of llo oxisling common slocI. Nol onIy
doos llis goaI diroclIy bonofil llo slaroloIdors of llo company, bul aIso il providos
bonofils lo socioly as scarco rosourcos aro diroclod lo lloir mosl produclivo uso by
businossos compoling lo croalo voaIll. Will llis goaI in pIaco, our job as financiaI
managors is lo croalo voaIll for llo slaroloIdors. To bollor undorsland llis goaI, vo
firsl discuss profil maximizalion as a possibIo goaI for llo firm. Tlon vo comparo il lo
maximizalion of slaroloIdor voaIll lo soo vly, in financiaI managomonl, llo Iallor is
llo moro approprialo goaI for llo firm.
Profit Maximization
In microoconomics coursos, profil maximizalion is froquonlIy givon as llo goaI of llo
firm. Irofil maximizalion slrossos llo officionl uso of capilaI rosourcos, bul il is nol
spocific vill rospocl lo llo limo framo ovor vlicl profils aro lo bo moasurod. Do vo
maximizo profils ovor llo curronl yoar, or do vo maximizo profils ovor somo Iongor
poriod` A financiaI managor couId oasiIy incroaso curronl profils by oIiminaling
rosoarcl and dovoIopmonl oxpondiluros and culling dovn on roulino mainlonanco. In
llo slorl run, llis migll rosuIl in incroasod profils, bul llis cIoarIy is nol in llo bosl
Iong-run inlorosls of llo firm. If vo aro lo baso financiaI docisions on a goaI, llal goaI
musl bo prociso, nol aIIov for misinlorprolalion, and doaI vill aII llo compIoxilios of
llo roaI vorId.
In microoconomics, profil maximizalion funclions IargoIy as a lloorolicaI goaI,
vill oconomisls using il lo provo lov firms bolavo ralionaIIy lo incroaso profil.
UnforlunaloIy, il ignoros many roaI-vorId compIoxilios llal financiaI managors musl
addross in lloir docisions. In llo moro appIiod discipIino of financiaI managomonl,
firms musl doaI ovory day vill lvo major faclors nol considorod by llo goaI of profil
maximizalion: uncorlainly and liming.
Microoconomics coursos ignoro uncorlainly and risI lo prosonl lloory moro oasiIy.
Irojocls and invoslmonl aIlornalivos aro comparod by oxamining lloir oxpoclod vaIuos
or voigllod avorago profils. Wlollor ono projocl is risIior llan anollor doos nol onlor
inlo lloso caIcuIalions, oconomisls do discuss risI, bul onIy langonliaIIy.
In roaIily,
projocls diffor a groal doaI vill rospocl lo risI claraclorislics, and lo disrogard lloso
difforoncos in llo praclico of financiaI managomonl can rosuIl in incorrocl docisions.
As vo discovor Ialor in llis soclion, lloro is a vory dofinilo roIalionslip bolvoon risI
and oxpoclod rolurn÷llal is, invoslors domand a liglor oxpoclod rolurn for laIing on
addod risI÷and lo ignoro llis roIalionslip Ioads lo impropor docision maIing.
Anollor probIom vill llo goaI of profil maximizalion is llal il ignoros llo liming
of llo projocl's rolurns. If llis goaI is onIy concornod vill llis yoar's profils, vo Inov
il inapproprialoIy ignoros profils in fuluro yoars. If vo inlorprol il lo maximizo llo
avorago of fuluro profils, il is aIso incorrocl. Inasmucl as invoslmonl opporlunilios aro
avaiIabIo for monoy in land, vo aro nol indifforonl lo llo liming of llo rolurns. Givon
oquivaIonl casl fIovs from profils, vo vanl lloso casl fIovs soonor rallor llan Ialor.
Tlus, llo roaI-vorId faclors of uncorlainly and liming forco us lo IooI boyond a sim-
pIo goaI of profil maximizalion as a docision crilorion. Wo nov lurn lo an oxaminalion
of a moro robusl goaI for llo firm: maximizalion of slaroloIdor voaIll.
700.1 Fihahce SIraIegies 2
CAßM ModuIe 700 Fihahce
Maximization of Shareholder Wealth
In formuIaling llo goaI of maximizalion of slaroloIdor voaIll vo aro doing nolling
moro llan modifying llo goaI of profil maximizalion lo doaI vill llo compIoxilios of
llo oporaling onvironmonl. Wo lavo closon maximizalion of slaroloIdor voaIll÷
llal is, maximizalion of llo marIol vaIuo of llo oxisling slaroloIdors' common
slocI÷bocauso llo offocls of aII financiaI docisions aro lloroby incIudod. Invoslors
roacl lo poor invoslmonl or dividond docisions by causing llo lolaI vaIuo of llo firm's
slocI lo faII, and lloy roacl lo good docisions by pusling up llo prico of llo slocI. In
offocl, undor llis goaI, good docisions aro lloso llal croalo voaIll for llo slaroloIdor.
ObviousIy, lloro aro somo sorious praclicaI probIoms in llo dirocl uso of llis goaI
and in using clangos in llo firm's slocI lo ovaIualo financiaI docisions. Many llings
affocl slocI pricos, lo allompl lo idonlify a roaclion lo a parlicuIar financiaI docision
vouId simpIy bo impossibIo and unnocossary. To ompIoy llis goaI, vo nood nol con-
sidor ovory slocI prico clango lo bo a marIol inlorprolalion of llo vorll of our doci-
sions. Ollor faclors, sucl as clangos in llo oconomy, aIso affocl slocI pricos. Wlal vo
do focus on is llo offocl llal our docision s|cu|! lavo on llo slocI prico if ovorylling
oIso voro loId conslanl. Tlo marIol prico of llo firm's slocI rofIocls llo vaIuo of llo
firm as soon by ils ovnors and laIos inlo accounl llo compIoxilios and compIicalions
of llo roaI-vorId risI. Wo musl Ioop in mind ono moro quoslion: Wlo oxaclIy aro llo
slaroloIdors` Tlo ansvor: SlaroloIdors aro llo IogaI ovnors of llo firm.
700.1.2 Discuss the principIes that !orm
the !oundations o! !inanciaI management
Principle 1 The Risk-Return Trade-Off-We Won't Take On
Additional Risk Unless We £xpect to 8e Compensated
with Additional Return
Al somo poinl vo lavo aII savod somo monoy. Wly lavo vo dono llis` Tlo ansvor is
simpIo: lo oxpand our fuluro consumplion opporlunilios. Wo aro abIo lo invosl lloso
savings and oarn a rolurn on our doIIars bocauso somo poopIo vouId rallor forgo
fuluro consumplion opporlunilios lo consumo moro nov. Maybo lloy'ro borroving
monoy lo opon a nov businoss or a company is borroving monoy lo buiId a nov
pIanl. Assuming lloro aro a Iol of difforonl poopIo vlo vouId IiIo lo uso our savings,
lov do vo docido vloro lo pul our monoy`
Iirsl, invoslors domand a minimum rolurn for doIaying consumplion llal musl bo
groalor llan llo anlicipalod ralo of infIalion. If lloy didn'l rocoivo onougl lo compon-
salo for anlicipalod infIalion, invoslors vouId purclaso vlalovor goods lloy dosirod
aload of limo or invosl in assols llal voro subjocl lo infIalion and oarn llo ralo of infIa-
lion on lloso assols. Tloro isn'l mucl inconlivo lo poslpono consumplion if your sav-
ings aro going lo docIino in lorms of purclasing povor.
Invoslmonl aIlornalivos lavo difforonl amounls of risI and oxpoclod rolurns.
Invoslors somolimos clooso lo pul lloir monoy in risIy invoslmonls bocauso lloso
invoslmonls offor liglor oxpoclod rolurns. Tlo moro risI an invoslmonl las, llo liglor
viII bo ils oxpoclod rolurn. Tlis roIalionslip bolvoon risI and oxpoclod rolurn is
slovn in Figure 1.1.
Nolico llal vo Ioop roforring lo cxpccic! rolurn rallor llan cciuc| rolurn. Wo may
lavo oxpoclalions of vlal llo rolurns from invosling viII bo, bul vo can'l poor inlo llo
fuluro and soo vlal lloso rolurns aro acluaIIy going lo bo. If invoslors couId soo inlo
llo fuluro, no ono vouId lavo invoslod monoy in llo biolocl firm Gonla, vloso slocI
droppod 50 porconl on Novombor 9, 2004, vlon il announcod ils parlnor Avonlis lad
700.1 Fihahce SIraIegies 3
CAßM ModuIe 700 Fihahce
lorminalod ils agroomonl lo codovoIop an oxporimonlaI cancor lroalmonl. UnliI aflor
llo facl, you aro novor suro vlal llo rolurn on an invoslmonl viII bo. Tlal is vly Gon-
oraI Molors bonds pay moro inlorosl llan U.S. Troasury bonds of llo samo malurily.
Tlo addilionaI inlorosl convincos somo invoslors lo laIo on llo addod risI of purclas-
ing a GonoraI Molors bond.
Tlis risI÷rolurn roIalionslip is a Ioy concopl as vo vaIuo slocIs, bonds, and pro-
posod nov projocls llrougloul llis loxl. Wo aIso spond somo limo dolormining lov lo
moasuro risI. InloroslingIy, mucl of llo vorI for vlicl llo 1990 NoboI Irizo for Ico-
nomics vas avardod conlorod on llo grapl in Iiguro 1.1 and lov lo moasuro risI.
Boll llo grapl and llo risI÷rolurn roIalionslip il dopicls roappoar oflon in llis loxl.
Principle 2 The Time value of Money-A Dollar Received Today
ls Worth More than a Dollar Received in the Iuture
A fundamonlaI concopl in financo is llal monoy las a limo vaIuo associalod vill il:
A doIIar rocoivod loday is vorll moro llan a doIIar rocoivod a yoar from nov.
Bocauso vo can oarn inlorosl on monoy rocoivod loday, il is bollor lo rocoivo monoy
oarIior rallor llan Ialor. In your oconomics coursos, llis concopl of llo limo vaIuo of
monoy is roforrod lo as llo opporlunily cosl of passing up llo oarning polonliaI of a
doIIar loday.
Wo focus on llo croalion and moasuromonl of voaIll. To moasuro voaIll or vaIuo,
vo uso llo concopl of llo limo vaIuo of monoy lo bring llo fuluro bonofils and cosls of
a projocl bacI lo llo prosonl. Tlon, if llo bonofils oulvoigl llo cosls, llo projocl cro-
alos voaIll and slouId bo accoplod, if llo cosls oulvoigl llo bonofils, llo projocl doos
nol croalo voaIll and slouId bo rojoclod. Willoul rocognizing llo oxislonco of llo limo
vaIuo of monoy, il is impossibIo lo ovaIualo projocls vill fuluro bonofils and cosls in a
moaningfuI vay.
To bring fuluro bonofils and cosls of a projocl bacI lo llo prosonl, vo musl assumo
a spocific opporlunily cosl of monoy, or inlorosl ralo. IxaclIy vlal inlorosl ralo lo uso
is dolorminod by PrinciµIe 1: The Risk÷Return Trade-OII, vlicl slalos invoslors
domand liglor rolurns for laIing on moro risIy projocls. Tlus, vlon vo dolormino
llo prosonl vaIuo of fuluro bonofils and cosls, vo laIo inlo accounl llal invoslors
domand a liglor rolurn for laIing on addod risI.
Principle J Cash-Not Profits-ls King
In moasuring voaIll or vaIuo vo uso casl fIovs, nol accounling profils, as our moasuro-
monl looI. Tlal is, vo aro concornod vill vlon vo lavo monoy in land, vlon vo can
invosl il and slarl oarning inlorosl on il, and vlon vo can givo il bacI lo llo slaroloId-
ors in llo form of dividonds. Romombor, il is casl fIovs, nol profils, llal aro acluaIIy
rocoivod by llo firm and can bo roinvoslod. Accounling profils, on llo ollor land, aro
700.1 Fihahce SIraIegies 4
CAßM ModuIe 700 Fihahce
Expecled reluru
íor lakiug ou
added risk
Expecled reluru
íor delayiug
figure 1.1 1he Risk-ReIurh RelaIiohship
slovn vlon lloy aro oarnod rallor llan vlon llo monoy is acluaIIy in land. As a
rosuIl, a firm's casl fIovs and accounling profils may nol occur logollor. Ior oxampIo,
capilaI oxponsos, sucl as llo purclaso of nov oquipmonl or a buiIding, aro doprocialod
ovor sovoraI yoars, vill llo annuaI doprocialion sublraclod from profils. Hovovor, llo
casl fIov associalod vill llis oxponso gonoraIIy occurs immodialoIy. Tloroforo, casl
oulfIovs invoIving paying monoy oul and casl infIovs llal can bo roinvoslod corroclIy
rofIocl llo liming of llo bonofils and cosls.
Principle 4 lncremental Cash Ilows-lt's Only What Changes
That Counts
In maIing businoss docisions, vo aro concornod vill llo rosuIls of lloso docisions:
Wlal lappons if vo say yos vorsus vlal lappons if vo say no` PrinciµIe 3 slalos llal
vo slouId uso casl fIovs lo moasuro llo bonofils llal accruo from laIing on a nov
projocl. Wo aro nov fino-luning our ovaIualion procoss so llal vo onIy considor incro-
monlaI casl fIovs. Tlo incrementaI cash IInw is i|c !i||crcncc |ciuccn i|c ccs| ||cus i|
i|c prcjcci is ic|cn cn tcrsus u|ci i|cu ui|| |c i| i|c prcjcci is nci ic|cn cn.
Wlon GonoraI MiIIs, llo maIor of Cloorios, Honoy Nul Cloorios, Iroslod Cloorios,
AppIo Cinnamon Cloorios, and MuIli-Grain Cloorios, inlroducod Toam Cloorios÷
¨3 doIicious O's loamod up for ono svool cruncl¨÷il inlroducod a producl llal compolod
diroclIy vill GonoraI MiIIs' ollor coroaIs and, in parlicuIar, ils Cloorios producls. In facl,
Toam Cloorios, vill ils brovn sugar and frosling, laslos vory mucl IiIo Iroslod Cloorios.
CorlainIy somo of llo saIos doIIars llal ondod up vill Toam Cloorios vouId lavo boon
sponl on ollor Cloorios and GonoraI MiIIs producls if Toam Cloorios lad nol boon avaiI-
abIo. AIllougl GonoraI MiIIs vas largoling youngor consumors vill llis svoolonod
coroaI, lloro is no quoslion llal Toam Cloorios saIos bil inlo÷acluaIIy cannibaIizod÷saIos
from Cloorios and ollor GonoraI MiIIs Iinos. RoaIislicaIIy, lloro's onIy so mucl coroaI any-
ono can oal. Tlo !i||crcncc bolvoon rovonuos GonoraI MiIIs gonoralod aflor inlroducing
Toam Cloorios vorsus simpIy mainlaining ils oxisling Iino of coroaIs is llo incromonlaI
casl fIov. Tlis difforonco rofIocls llo lruo impacl of llo docision.
Wlal is imporlanl is llal vo i|in| incromonlaIIy. Our guiding ruIo in dociding
vlollor a casl fIov is incromonlaI is lo IooI al llo company vill and villoul llo
nov producl. In facl, Iol's laIo llis incromonlaI concopl boyond casl fIovs and IooI al
aII consoquoncos from aII docisions on an incromonlaI basis.
Principle 5 The Curse of Competitive Markets-Why lt's Hard
to Iind £xceptionally Profitable Projects
Our job as financiaI managors is lo croalo voaIll. Tloroforo, vo IooI cIosoIy al llo
moclanics of vaIualion and docision maIing. Wo focus on oslimaling casl fIovs,
dolormining vlal an invoslmonl oarns, and vaIuing assols and nov projocls. Hov-
ovor, il is oasy lo gol caugll up in llo moclanics of vaIualion and Ioso sigll of llo
procoss of croaling voaIll. Wly is il so lard lo find projocls and invoslmonls llal aro
oxcoplionaIIy profilabIo` Wloro do profilabIo projocls como from` Tlo ansvors lo
lloso quoslions loII us a Iol aboul lov compolilivo marIols oporalo and vloro lo IooI
for profilabIo projocls.
In roaIily, il is mucl oasior ovaIualing profilabIo projocls llan finding llom. If an
induslry is gonoraling Iargo profils, nov onlranls aro usuaIIy allraclod. Tlo addilionaI
compolilion and addod capacily can rosuIl in profils boing drivon dovn lo llo
roquirod ralo of rolurn. ConvorsoIy, if an induslry is rolurning profils boIov llo
roquirod ralo of rolurn, llon somo parlicipanls in llo marIol drop oul, roducing capac-
ily and compolilion. In rolurn, pricos aro drivon bacI up. Tlis is procisoIy vlal lap-
ponod in llo VCR vidoo ronlaI marIol in llo mid-1980s. Tlis marIol dovoIopod sud-
donIy vill llo opporlunily for oxlromoIy Iargo profils. Bocauso lloro voro no barriors
lo onlry, llo marIol quicIIy vas fIoodod vill nov onlrios. By 1987 llo compolilion
and prico culling producod Iossos for many firms in llo induslry, forcing llom lo fIoo
llo marIol. As llo compolilion Iossonod vill firms moving oul of llo vidoo ronlaI
700.1 Fihahce SIraIegies 5
CAßM ModuIe 700 Fihahce
induslry, profils again roso lo llo poinl al vlicl llo roquirod ralo of rolurn couId bo
oarnod on invoslod capilaI.
In compolilivo marIols, oxlromoIy Iargo profils simpIy cannol oxisl for vory
Iong. Givon llal somovlal bIoaI sconario, lov can vo find good projocls÷llal is,
projocls llal rolurn moro llan lloir oxpoclod ralo of rolurn givon lloir risI IovoI
(romombor IrincipIo 1)` AIllougl compolilion maIos llom difficuIl lo find, vo lavo
lo invosl in marIols llal aro nol porfoclIy compolilivo. Tlo lvo mosl common vays
of maIing marIols Ioss compolilivo aro lo difforonlialo llo producl in somo Ioy vay
and lo acliovo a cosl advanlago ovor compolilors.
Iroducl difforonlialion insuIalos a producl from compolilion, lloroby aIIoving a
company lo clargo a promium prico. If producls aro difforonlialod, consumor cloico is
no Iongor mado by prico aIono. Ior oxampIo, many poopIo aro viIIing lo pay a promium
for SlarbucIs coffoo. Tloy simpIy vanl SlarbucIs and prico is nol imporlanl. In llo
plarmacoulicaI induslry, palonls croalo compolilivo barriors. Ior oxampIo, Hoffman÷
Ia Roclo's VaIium, a lranquiIizor, is proloclod from dirocl compolilion by palonls.
Sorvico and quaIily aro aIso usod lo difforonlialo producls. Ior oxampIo, Iovi's las
Iong pridod ilsoIf on llo quaIily of ils joans. As a rosuIl, il las boon abIo lo mainlain ils
marIol slaro. SimiIarIy, mucl of Toyola and Honda's brand IoyaIly is basod on quaI-
ily. Sorvico can aIso croalo producl difforonlialion, as slovn by McDonaId's fasl sor-
vico, cIoanIinoss, and consisloncy of producl, vlicl bring cuslomors bacI.
Wlollor producl difforonlialion occurs bocauso of advorlising, palonls, sorvico, or
quaIily, llo moro llo producl is difforonlialod from compoling producls, llo Ioss com-
polilion il viII faco and llo groalor llo possibiIily of Iargo profils.
Iconomios of scaIo and llo abiIily lo produco al a cosl boIov compolilion can
offoclivoIy dolor nov onlranls lo llo marIol and lloroby roduco compolilion. WaI-
Marl is ono sucl caso. Ior WaI-Marl, llo fixod cosls aro IargoIy indopondonl of llo
sloro's sizo. Ior oxampIo, invonlory cosls, advorlising oxponsos, and managoriaI
saIarios aro ossonliaIIy llo samo rogardIoss of annuaI saIos. Tloroforo, llo moro saIos
llal can bo buiIl up, llo Iovor llo por-saIo doIIar cosl of invonlory, advorlising, and
managomonl. RoslocIing from varolousos aIso bocomos moro officionl bocauso doIiv-
ory lrucIs can bo usod lo fuII polonliaI.
RogardIoss of lov llo cosl advanlago is croalod÷by oconomios of scaIo, propri-
olary loclnoIogy, or monopoIislic conlroI of rav maloriaIs÷il dolors nov marIol
onlranls vliIo aIIoving produclion al boIov induslry cosl. Tlis cosl advanlago las llo
polonliaI of croaling Iargo profils.
Tlo Ioy lo Iocaling profilabIo invoslmonl projocls is lo firsl undorsland lov and
vloro lloy oxisl in compolilivo marIols. Tlon llo corporalo pliIosoply musl bo
aimod al croaling or laIing advanlago of somo imporfoclion in lloso marIols, llrougl
oillor producl difforonlialion or croalion of a cosl advanlago, rallor llan IooIing lo
nov marIols or induslrios llal appoar lo provido Iargo profils. Any porfoclIy compoli-
livo induslry llal IooIs loo good lo bo lruo von'l bo for Iong. Il is nocossary lo undor-
sland llis lo Inov vloro lo IooI for good projocls and lo accuraloIy moasuro llo proj-
ocl's casl fIovs. Wo can do llis bollor if vo rocognizo lov voaIll is croalod and lov
difficuIl il is lo croalo.
Principle 6 £fficient Capital Markets-The Markets Are Ouick
and the Prices Are Right
Our goaI as financiaI managors is llo maximizalion of slaroloIdor voaIll. Hov do vo
moasuro slaroloIdor voaIll` Il is llo vaIuo of aII llo slaros llal llo slaroloIdors ovn.
To undorsland vlal causos slocIs lo clango in prico, as voII as lov socurilios sucl as
bonds and slocIs aro vaIuod or pricod in llo financiaI marIols, il is nocossary lo lavo
an undorslanding of llo concopl of eIIicient markets. 1|csc crc mcr|cis in u|ic| i|c tc|-
ucs c| c|| csscis cn! sccuriiics ci cnu insicni in iimc |u||u rc||cci c|| ctci|c||c in|crmciicn.
Wlollor a marIol is officionl las lo do vill llo spood vill vlicl informalion is
impoundod inlo socurily pricos. An officionl marIol is claraclorizod by a Iargo numbor
700.1 Fihahce SIraIegies 6
CAßM ModuIe 700 Fihahce
of profil-drivon individuaIs vlo acl indopondonlIy. In addilion, nov informalion
rogarding socurilios arrivos in llo marIol in a random mannor. Givon llis solling,
invoslors adjusl lo nov informalion immodialoIy and buy and soII llo socurily unliI
lloy fooI llo marIol prico corroclIy rofIocls llo nov informalion. Undor llo officionl
marIol lypollosis, informalion is rofIoclod in socurily pricos vill sucl spood llal
lloro aro no opporlunilios for invoslors lo profil from pubIicIy avaiIabIo informalion.
Invoslors compoling for profils onsuro llal socurily pricos approprialoIy rofIocl llo
oxpoclod oarnings and risIs invoIvod and, llus, llo lruo vaIuo of llo firm.
Wlal aro llo impIicalions of officionl marIols for us` Iirsl, llo prico is rigll. SlocI
pricos rofIocl aII pubIicIy avaiIabIo informalion rogarding llo vaIuo of llo company. Tlis
moans vo can impIomonl our goaI of maximizalion of slaroloIdor voaIll by focusing
on llo offocl oacl docision s|cu|! lavo on llo slocI prico if ovorylling oIso is loId con-
slanl. Tlal is, ovor limo good docisions rosuIl in liglor slocI pricos and bad onos in
Iovor slocI pricos. Socond, oarnings manipuIalions llrougl accounling clangos do nol
rosuIl in prico clangos. SlocI spIils and ollor clangos in accounling mollods llal do nol
affocl casl fIovs aro nol rofIoclod in pricos. MarIol pricos rofIocl oxpoclod casl fIovs
avaiIabIo lo slaroloIdors. Tlus, our prooccupalion vill casl fIovs lo moasuro llo lim-
ing of llo bonofils is juslifiod.
As vo viII soo, il is indood roassuring llal pricos rofIocl vaIuo. Il aIIovs us lo IooI
al pricos and soo vaIuo rofIoclod in llom. AIllougl il may maIo invosling a bil Ioss
oxciling, il maIos corporalo financo mucl Ioss uncorlain.
Principle 7 The Agency Problem-Managers Won't Work for the
Owners Unless lt's in Their 8est lnterest
AIllougl llo goaI of llo firm is llo maximizalion of slaroloIdor voaIll, in roaIily llo
agoncy probIom may inlorforo vill llo impIomonlalion of llis goaI. Tlo agencv µrnb-
Iem rcsu|is |rcm i|c scpcrciicn c| mcncvcmcni cn! i|c cuncrs|ip c| i|c |irm. Ior oxampIo, a
Iargo firm may bo run by profossionaI managors vlo lavo IillIo or no ovnorslip in
llo firm. Bocauso of llis soparalion of llo docision maIors and ovnors, managors may
maIo docisions llal aro nol in Iino vill llo goaI of maximizalion of slaroloIdor
voaIll. Tloy may approacl vorI Ioss onorgolicaIIy and allompl lo bonofil llomsoIvos
in lorms of saIary and porquisilos al llo oxponso of slaroloIdors.
To bogin vill, an agonl is somoono vlo is givon llo aullorily lo acl on bolaIf of
anollor, vlo is roforrod lo as llo principaI. In llo corporalo solling, llo slaroloIdors aro
llo principaIs, bocauso lloy aro llo acluaI ovnors of llo firm. Tlo board of diroclors, llo
CIO, llo corporalo oxoculivos, and aII ollors vill docision-maIing povor aro agonls of
llo slaroloIdors. UnforlunaloIy, llo board of diroclors, llo CIO, and llo ollor corpo-
ralo oxoculivos don'l aIvays do vlal's in llo bosl inlorosl of llo slaroloIdors. Insload,
lloy oflon acl in lloir ovn bosl inlorosl. Nol onIy migll lloy bonofil llomsoIvos in lorms
of saIary and porquisilos, bul lloy migll aIso avoid any projocls llal lavo risI associ-
alod vill llom÷ovon if lloy'ro groal projocls vill lugo polonliaI rolurns and a smaII
clanco of faiIuro. Wly is llis so` Bocauso if llo projocl doosn'l lurn oul, lloso agonls of
llo slaroloIdors may Ioso lloir jobs.
Tlo cosls associalod vill llo agoncy probIom aro difficuIl lo moasuro, bul occa-
sionaIIy vo soo llo probIom's offocl in llo marIolpIaco. Ior oxampIo, if llo marIol
fooIs managomonl of a firm is damaging slaroloIdor voaIll, vo migll soo a posilivo
roaclion in slocI prico lo llo romovaI of llal managomonl. In 1989, on llo day foIIov-
ing llo doall of Ioln Dorranco, Ir., clairman of CampboII's Soup, CampboII's slocI
prico roso aboul 15 porconl. Somo invoslors foIl llal CampboII's roIalivoIy smaII
grovll in oarnings migll bo improvod vill llo doparluro of Dorranco. Tloro vas aIso
spocuIalion llal Dorranco vas llo major obslacIo lo a possibIo posilivo roorganizalion.
If llo managomonl of llo firm vorIs for llo ovnors, vlo aro llo slaroloIdors, vly
doosn'l llo managomonl gol firod if il doosn'l acl in llo slaroloIdors' bosl inlorosl` |n
i|ccru, llo slaroloIdors picI llo corporalo board of diroclors and llo board of diroclors
in lurn picIs llo managomonl. UnforlunaloIy, in rcc|iiu llo syslom froquonlIy vorIs llo
700.1 Fihahce SIraIegies 7
CAßM ModuIe 700 Fihahce
ollor vay around. Managomonl soIocls llo board of diroclor nominoos and llon dislrib-
ulos llo baIIols. In offocl, slaroloIdors aro offorod a sIalo of nominoos soIoclod by llo
managomonl. Tlo ond rosuIl is llal managomonl offoclivoIy soIocls llo diroclors, vlo
llon may lavo moro aIIogianco lo managors llan lo slaroloIdors. Tlis in lurn sols up
llo polonliaI for agoncy probIoms, vill llo board of diroclors nol moniloring managors
on bolaIf of llo slaroloIdors as lloy slouId.
Wo spond considorabIo limo discussing moniloring managors and lrying lo aIign
lloir inlorosls vill slaroloIdors. Managors can bo monilorod by audiling financiaI
slalomonls and managors' componsalion pacIagos. Tlo inlorosls of managors and
slaroloIdors can bo aIignod by oslabIisling managomonl slocI oplions, bonusos, and
porquisilos llal aro diroclIy liod lo lov cIosoIy lloir docisions coincido vill llo inlor-
osl of slaroloIdors. Tlo agoncy probIom viII porsisl unIoss an inconlivo slrucluro is sol
up llal aIigns llo inlorosls of managors and slaroloIdors. In ollor vords, vlal is
good for slaroloIdors musl aIso bo good for managors. If llal is nol llo caso, man-
agors viII maIo docisions in lloir bosl inlorosl rallor llan maximizing slaroloIdor
Principle 8 Taxes 8ias 8usiness Decisions
HardIy any docision is mado by llo financiaI managor villoul considoring llo impacl
of laxos. Wlon vo inlroducod PrinciµIe 4, vo said llal onIy incromonlaI casl fIovs
slouId bo considorod in llo ovaIualion procoss. Moro spocificaIIy, llo casl fIovs vo
considor aro llo c|icr-icx incrcmcnic| ccs| ||cus ic i|c |irm cs c u|c|c.
Wlon vo ovaIualo nov projocls, vo viII soo incomo laxos pIay a significanl roIo.
Wlon llo company is anaIyzing llo possibIo acquisilion of a pIanl or oquipmonl, llo
rolurns from llo invoslmonl slouId bo moasurod on an aflor-lax basis. Ollorviso, llo
company is nol ovaIualing llo lruo incromonlaI casl fIovs gonoralod by llo projocl.
Tlo govornmonl aIso roaIizos laxos can bias businoss docisions and usos laxos lo
oncourago sponding in corlain vays. If llo govornmonl vanls lo oncourago sponding
on rosoarcl and dovoIopmonl projocls, il migll offor an intcsimcni icx crc!ii for sucl
invoslmonls. Tlis vouId lavo llo offocl of roducing laxos on rosoarcl and dovoIop-
monl projocls, vlicl vouId in lurn incroaso llo aflor-lax casl fIovs from lloso proj-
ocls. Tlo incroasod casl fIov vouId lurn somo ollorviso unprofilabIo rosoarcl and
dovoIopmonl projocls inlo profilabIo projocls. In offocl, llo govornmonl can uso laxos
as a looI lo dirocl businoss invoslmonl lo rosoarcl and dovoIopmonl projocls, lo llo
innor cilios, and lo projocls llal croalo jobs.
Principle 9 All Risk ls Not £qual-Some Risk Can 8e Diversified
Away, and Some Cannot
Mucl of financo conlors around PrinciµIe 1, the Risk÷Return Trade-OII. Bul boforo
vo can fuIIy uso PrinciµIe 1, vo musl docido lov lo moasuro risI. As vo viII soo, risI
is difficuIl lo moasuro. PrinciµIe 9 inlroducos you lo llo procoss of divorsificalion and
domonslralos lov il can roduco risI. Wo aIso provido you vill an undorslanding of
lov divorsificalion maIos il difficuIl lo moasuro a projocl's or an assol's risI.
You aro probabIy aIroady famiIiar vill llo concopl of divorsificalion. Tloro is an
oId saying, ¨don'l pul aII your oggs in ono basIol.¨ Divorsificalion aIIovs good and
bad ovonls or obsorvalions lo cancoI oacl ollor oul, lloroby roducing lolaI variabiIily
villoul affocling oxpoclod rolurn.
To soo lov divorsificalion compIicalos llo moasuromonl of risI, Iol's IooI al llo dif-
ficuIly Iouisiana Gas las in dolormining llo IovoI of risI associalod vill a nov naluraI
gas voII-driIIing projocl. Iacl yoar Iouisiana Gas migll driII sovoraI lundrod voIIs,
vill oacl voII laving onIy a 1 in 10 clanco of succoss. If llo voII producos, llo profils
aro quilo Iargo, bul if il comos up dry, llo invoslmonl is Iosl. Tlus, vill a 90 porconl
clanco of Iosing ovorylling, vo vouId viov llo projocl as boing oxlromoIy risIy. Hov-
ovor, if oacl yoar Iouisiana Gas driIIs 2,000 voIIs, aII vill a 10 porconl, indopondonl
clanco of succoss, llon lloy vouId lypicaIIy lavo 200 succossfuI voIIs. Moroovor, a bad
700.1 Fihahce SIraIegies 8
CAßM ModuIe 700 Fihahce
yoar may rosuIl in onIy 190 succossfuI voIIs, vloroas a good yoar may rosuIl in 210 suc-
cossfuI voIIs. If vo IooI al aII llo voIIs logollor, llo oxlromo good and llo bad rosuIls
lond lo cancoI oacl ollor oul and llo voII-driIIing projocls laIon logollor do nol appoar
lo lavo mucl risI or variabiIily of possibIo oulcomo.
Tlo amounl of risI in a gas voII projocl doponds on our porspoclivo. IooIing al
llo voII slanding aIono, il IooIs IiIo a Iol, lovovor, if vo considor llo risI llal oacl
voII conlribulos lo llo ovoraII firm risI, il is quilo smaII. Tlis occurs bocauso mucl of
llo risI associalod vill oacl individuaI voII is divorsifiod avay villin llo firm. Tlo
poinl is vo can'l IooI al a projocl in isoIalion. Ialor, vo viII soo llal somo of llis risI
can bo furllor divorsifiod avay villin llo slaroloIdor's porlfoIio.
Iorlaps llo oasiosl vay lo undorsland llo concopl of divorsificalion is lo IooI al il
graplicaIIy. Considor vlal lappons vlon vo combino lvo projocls, as dopiclod in
Figure 1.2. In llis caso, llo casl fIovs from lloso projocls movo in opposilo diroclions,
and vlon lloy aro combinod, llo variabiIily of lloir combinalion is lolaIIy oIiminalod.
Nolico llal llo rolurn las nol clangod÷boll llo individuaI projocls' and lloir combi-
nalion's rolurn avoragos 10 porconl. In llis caso llo oxlromo good and bad obsorva-
lions cancoI oacl ollor oul. Tlo dogroo lo vlicl llo lolaI risI is roducod is a funclion
of lov llo lvo sols of casl fIovs or rolurns movo logollor.
As vo viII soo for mosl projocls and assols, somo risI can bo oIiminalod llrougl
divorsificalion, vliIo somo risI cannol. Tlis bocomos an imporlanl dislinclion Ialor in
our sludios. Icr ncu, uc s|cu|! rcc|izc i|ci i|c prcccss c| !itcrsi|icciicn ccn rc!ucc ris|, cn!
cs c rcsu|i, mccsurinv c prcjcci´s cr cn cssci´s ris| is tcru !i||icu|i. A projocl's risI clangos
doponding on vlollor you moasuro il slanding aIono or logollor vill ollor projocls
llo company may laIo on.
Principle 10 £thical 8ehavior ls Doing the Right Thing, and £thical
Dilemmas Are £verywhere in Iinance
Illics, or rallor a IacI of ollics, in financo is a rocurring llomo in llo novs. During llo
Ialo 1980s and oarIy 1990s, llo faII of Ivan BoosIy and DroxoI, Burnlam, Iamborl, and
llo noar coIIapso of SaIomon Brollors soomod lo maIo conlinuous loadIinos. Moan-
vliIo, llo movio Wc|| Sircci vas a lil al llo box offico and llo booI Iicr´s Pc|cr, by
MiclaoI Iovis, clronicIing unollicaI bolavior in llo bond marIols, bocamo a bosl-
soIIor. As llo Iossons of SaIomon Brollors and DroxoI, Burnlam, Iamborl iIIuslralo,
ollicaI orrors aro nol forgivon in llo businoss vorId. Nol onIy is acling in an ollicaI
mannor moraIIy corrocl, bul aIso il is congruonl vill our goaI of maximizalion of
slaroloIdor voaIll.
IllicaI bolavior moans ¨doing llo rigll lling.¨ Tlo difficuIly arisos, lovovor, in
allompling lo dofino ¨doing llo rigll lling.¨ Tlo probIom is llal oacl of us las lis or
lor ovn sol of vaIuos, vlicl forms llo basis for our porsonaI judgmonls aboul vlal is
llo rigll lling lo do. Hovovor, ovory socioly adopls a sol of ruIos or Iavs llal proscribo
vlal il boIiovos lo bo ¨doing llo rigll lling.¨ In a sonso, vo can llinI of Iavs as a sol of
700.1 Fihahce SIraIegies 9
CAßM ModuIe 700 Fihahce
Coubiualiou oí
^ssel ^ aud
^ssel B
^ssel B
^ssel ^
figure 1.2 Reducihg Risk 1hrough Diversi!icaIioh
ruIos llal rofIocl llo vaIuos of llo socioly as a vloIo, as lloy lavo ovoIvod. Ior pur-
posos of llis loxl, vo rocognizo llal individuaIs lavo a rigll lo disagroo aboul vlal
conslilulos ¨doing llo rigll lling,¨ and vo soIdom vonluro boyond llo basic nolion
llal ollicaI conducl invoIvos abiding by socioly's ruIos. Hovovor, vo poinl oul somo of
llo ollicaI diIommas llal lavo arison in roconl yoars vill rogard lo llo praclico of
financiaI managomonl. So as vo ombarI on our sludy of financo and oncounlor ollicaI
diIommas, vo oncourago you lo considor llo issuos and form your ovn opinions.
Many sludonls asI, ¨Is ollics roaIIy roIovanl`¨ Tlis is a good quoslion and
dosorvos an ansvor. Iirsl, aIllougl businoss orrors can bo forgivon, ollicaI orrors lond
lo ond caroors and lorminalo fuluro opporlunilios. Wly` Bocauso unci|icc| |c|cticr
c|imincics irusi, cn! uii|cui irusi |usincsscs ccnnci inicrcci. Socond, i|c mcsi !cmcvinv
ctcni c |usincss ccn cxpcricncc is c |css c| i|c pu||ic´s ccn|i!cncc in iis ci|icc| sicn!cr!s. In
financo vo lavo soon sovoraI roconl oxampIos of sucl ovonls. Il vas llo ollicaI scan-
daIs invoIving insidor lrading al DroxoI, Burnlam, Iamborl llal brougll dovn llal
firm. In 1991 llo ollicaI scandaIs invoIving allompls by SaIomon Brollors lo cornor llo
Troasury biII marIol Iod lo llo romovaI of ils lop oxoculivos and noarIy pul llo com-
pany oul of businoss.
Boyond llo quoslion of ollics is llo quoslion of sociaI rosponsibiIily. In gonoraI,
corporalo sociaI rosponsibiIily moans llal a corporalion las rosponsibiIilios lo socioly
boyond llo maximizalion of slaroloIdor voaIll. Il assorls llal a corporalion ansvors
lo a broador consliluoncy llan slaroloIdors aIono. As vill mosl dobalos llal conlor on
ollicaI and moraI quoslions, lloro is no dofinilivo ansvor. Ono opinion is llal bocauso
financiaI managors aro ompIoyoos of llo corporalion and llo corporalion is ovnod by
llo slaroloIdors, llo financiaI managors slouId run llo corporalion in sucl a vay llal
slaroloIdor voaIll is maximizod and llon aIIov llo slaroloIdors lo docido if lloy
vouId IiIo lo fuIfiII a sonso of sociaI rosponsibiIily by passing on any of llo profils lo
dosorving causos. Vory fov corporalions consislonlIy acl in llis vay. Ior oxampIo,
BrisloI-Myors Squibb Co. las an ambilious program lo givo avay loarl modicalion lo
lloso vlo cannol pay for il. Tlis program camo in llo vaIo of an Amorican Hoarl
Associalion roporl sloving llal many of llo nalion's vorIing poor faco sovoro loaIll
risIs bocauso lloy cannol afford sucl modicalions. CIoarIy, BrisloI-Myors Squibb foIl il
lad a sociaI rosponsibiIily lo provido llis modicino lo llo poor al no cosl.
Hov do you fooI aboul llis docision`
700.1 Fihahce SIraIegies 10
CAßM ModuIe 700 Fihahce
700.2 8asic Fihahcial SIaIemehIs 11
700.2.1 Undorsland llo compononls of an incomo slalomonl
700.2.2 Undorsland llo compononls of a baIanco slool
700.2.3 Ioarn lov lo moasuro casl fIovs, incIuding froo casl fIovs
700.2 Basic Financial 5tatements
700.2.1 Understand the components
o! an income statement
An incnme statement, or µrnIit and Inss statement, indicalos llo amounl of profils
gonoralod by a firm ovor a givon limo poriod, oflon a yoar. In ils mosl basic form, llo
incomo slalomonl may bo roprosonlod as foIIovs:
SaIos oxponso profils
Tlo formal for an incomo slalomonl is slovn in Figure 2.1. Tlo incomo slalomonl
bogins vill saIos or rovonuo, from vlicl vo sublracl cnst nI gnnds snId (llo cosl of
producing or acquiring llo producl or sorvico) lo yioId grnss µrnIit. Noxl, nµerating
exµenses, consisling of marIoling and soIIing oxponsos, gonoraI and adminislralivo
oxponsos, and doprocialion oxponso, aro doduclod lo dolormino nµerating incnme
(aIso caIIod cpcrciinv prc|iis or ccrninvs |c|crc inicrcsi cn! icxcs or |8|1).
In Iiguro 2.1, vo soo llal oporaling incomo is llo rosuIl of managomonl's docisions
roIaling lo llo cpcrciicns of llo businoss. Tlal is, |incncinv oxponsos (inlorosl oxponso
rosuIling from llo uso of dobl financing) lavo nol boon sublraclod lo llis poinl.
Tlus, llo oporaling incomo of a firm roporls llo rosuIls of llo foIIoving aclivilios:
1. llo pricinv docisions for llo producls or sorvicos and llo num|cr c| uniis soId
(sc||inv pricc uniis sc|! icic| sc|cs)
2. llo ccsi of producing or acquiring llo goods or sorvicos llal voro soId (ccsi c|
vcc!s sc|!)
3. llo oxponsos incurrod in soIIing and marIoling llo firm's producls or sorvicos
4. llo firm's ovorload oxponsos (vcncrc| cn! c!minisirciitc cxpcnscs and
!cprcciciicn cxpcnscs)
Wo llon dolormino earnings beInre taxes by doducling llo Iinancing cnsts÷llo firm's
inlorosl oxponso on ils dobl÷from llo oporaling incomo. Noxl, llo firm's incomo laxos aro
caIcuIalod, basod on ils oarnings boforo laxos and llo appIicabIo lax ralo for llo amounl of
incomo roporlod. Ior inslanco, if a firm lad oarnings boforo laxos of $100,000 and ils lax
ralo is 28 porconl, llon il vouId ovo $28,000 in laxos (0.28 $100,000 $28,000).
700.2 8asic Fihahcial SIaIemehIs 12
CAßM ModuIe 700 Fihahce
Sales (reveuuesì
Less. Cosl oí goods sold (cosl oí acquiriug producl or service lo be soldì
= Cross proíil
Less. 0peraliug expeuses
(uarkeliug expeuses, geueral aud aduiuislralive expeuses aud deprecialiou expeuseì
= 0peraliug iucoue
(earuiugs beíore iuleresl aud laxesì
Less. |uleresl expeuse
(cosl oí borrowiug uoueyì
= Earuiugs beíore lax
Less. |ucoue laxes
= Nel iucoue
figure 2.1 1he Ihcome SIaIemehI: Ah Overview
Tlo rosuIling numbor is llo net incnme avaiIabIe tn nwners (usuaIIy caIIod net
incnme), vlicl roprosonls incomo llal may bo roinvoslod in llo firm or dislribulod lo
ils ovnors÷providod, of courso, llo casl is avaiIabIo lo do so. As you viII como lo
undorsland, c pcsiiitc nci inccmc cn cn inccmc sicicmcni !ccs nci ncccsscri|u mccn i|ci c
|irm |cs vcncrcic! pcsiiitc ccs| ||cus.
lncome Statement: Starbucks Corporation
TabIe 2.1 conlains llo 2003 incomo slalomonl for SlarbucIs Corporalion. SlarbucIs
lad sc|cs of $4,076 miIIion for llo 12-monll poriod onding Soplombor 28, 2003, and ccsi
c| vcc!s sc|! vas $3,207 miIIion. (Tlo numbors for SlarbucIs aro oxprossod in miIIions,
so SlarbucIs' saIos voro acluaIIy aboul $4 biIIion, vill cosl of goods soId ovor $3.2 biI-
Iion.) Tlo rosuIl is a vrcss prc|ii of $869 miIIion. Tlo firm llon lad $433 miIIion in opor-
aling oxponsos, vlicl incIudod marIoling oxponsos, gonoraI and adminislralivo
oxponsos, and doprocialion oxponsos. Aflor doducling oporaling oxponsos, llo firm's
cpcrciinv inccmc (ccrninvs |c|crc inicrcsi cn! icxcs) amounlod lo $436 miIIion. RocaII llal,
lo llis poinl, vo lavo caIcuIalod llo profils rosuIling onIy from oporaling aclivilios, as
opposod lo financing docisions, sucl as lov mucl dobl or oquily is usod lo financo llo
company's oporalions.
Wo noxl doducl SlarbucIs' inlorosl oxponso (llo amounl paid for using dobl
financing) of $3 miIIion from oporaling incomo lo arrivo al llo company's ccrninvs
|c|crc icxcs of $433 miIIion. IinaIIy, vo sublracl llo incomo laxos of $165 miIIion lo
arrivo al llo company's nci inccmc ctci|c||c ic ccmmcn sicc||c|!crs of $268 miIIion.
AIllougl nol loclnicaIIy parl of llo incomo slalomonl, vo lavo addod a box al llo
bollom of llo labIo llal slovs vlal lapponod lo llo firm's $268 miIIion nol incomo.
Tlo firm paid no dividonds lo ils common slocIloIdors, Ioaving aII $268 miIIion lo bo
rolainod villin llo company. As vo viII soo slorlIy, llo firm's rcicinc! ccrninvs
roporlod in llo baIanco slool incroasod by llis samo amounl of $268 miIIion.
700.2 8asic Fihahcial SIaIemehIs 13
CAßM ModuIe 700 Fihahce
TabIe 2.1 SIarbucks CorporaIioh Ihcome SIaIemehI !or Ihe Year Lhded
SepIember 28, 2003 ($ Milliohs)
Sales $4,076
CosI o! goods sold 3,207
Gross pro!iI $ 869
OperaIihg expehses:
MarkeIihg expehses ahd geheral ahd
admihisIraIive expehses $227
DepreciaIioh expehse 206
1oIal operaIihg expehses $ 433
OperaIihg ihcome $ 436
IhIeresI expehse 3
Larhihgs be!ore Iaxes $ 433
Ihcome Iaxes 165
NeI ihcome $ 268
Al lhe complelion ol lhe year, a lirm's nel income, less any dividends paid lo
slockholders, is added lo relained earnings in lhe balance sheel. lor Slarbucks
Nel income S268
Less common slock dividends (0)
lncrease in relained earnings in lhe balance sheel S268
Wlal concIusions can vo drav from SlarbucIs' incomo slalomonl` WoII, for ono
lling, vo Ioarn llal for ovory $1 in saIos, SlarbucIs oarnod:
1. 21.3 conls in gross profil ($869 miIIion gross profil dividod by
$4,076 miIIion saIos)
2. 10.7 conls in oporaling profil ($436 miIIion oporaling profil dividod by
$4,076 miIIion saIos)
3. 6.6 conls in nol incomo ($268 miIIion nol incomo dividod by
$4,076 miIIion saIos)
OnIy by Inoving if lloso profil-lo-saIos IovoIs aro ligl onougl so llal slaroloIdor
vaIuo is boing croalod can vo say if lloso rosuIls aro good. Wo migll aIso gain somo
insigll if vo couId soo lov SlarbucIs' porformanco comparos vill ils compolilion.
Ior llo limo boing, simpIy romombor llal profil-lo-saIos roIalionslips, or µrnIit mar-
gins, aro imporlanl in assossing a firm's porformanco.
700.2.2 Understand the components o! a baIance sheet
A firm's incomo slalomonl roporls llo rosuIls from oporaling llo businoss for a
poriod of limo, sucl as a yoar. Tlo baIance sheet, on llo ollor land, providos a
snapslol of llo firm's financiaI posilion al a spocific poinl in limo, prosonling ils
assol loIdings, IiabiIilios, and ovnor-suppIiod capilaI (slocIloIdors' oquily). In ils
simpIosl form, a baIanco slool foIIovs llis formuIa:
TolaI assols lolaI IiabiIilios (dobl) lolaI slaroloIdors' oquily
Assols roprosonl llo rosourcos ovnod by llo firm, vloroas llo IiabiIilios and slaro-
loIdors' oquily indicalo lov lloso rosourcos aro financod.
Figure 2.2 givos us llo basic compononls of a baIanco slool. On llo Iofl sido of
Iiguro 2.2, llo firm's assols aro Iislod according lo lloir lypo, on llo rigll sido, vo soo
a Iisling of llo difforonl sourcos of financing a company couId uso lo financo ils assols.
Types of Assets
As slovn in Iiguro 2.2, a company's assols faII inlo llroo calogorios: (1) curronl assols,
(2) fixod assols, and (3) ollor assols.
Current Assets
Current assets, or gross vorIing capilaI as il is somolimos caIIod, ccmprisc i|csc csscis i|ci
crc rc|ciitc|u |i¡ui!, i|ci is, i|csc i|ci crc cxpccic! ic |c ccntcric! inic ccs| uii|in 12 mcni|s.
Curronl assols primariIy incIudo casl, accounls rocoivabIo, invonlorios, and ollor curronl
Cash. Ivory firm musl lavo casl for curronl businoss oporalions. A rosorvoir of
casl is noodod bocauso of llo unoquaI fIov of funds inlo (casl rocoipls) and oul
of (casl oxpondiluros) llo businoss.
Accnunts ReceivabIe. Tlo firm's accnunts receivabIe ccnsisi c| pcumcnis !uc |rcm
iis cusicmcrs u|c |uu cn crc!ii.
Inventnries. Inventnrv ccnsisis c| i|c rcu mcicric|s, ucr| in prcccss, cn! |inis|c!
vcc!s |c|! |u c |irm |cr ctcniuc| sc|c.
Other Current Assets. Ollor curronl assols incIudo sucl iloms as propaid
oxponsos. Ior oxampIo, insuranco promiums may bo duo boforo covorago
bogins, or ronl may lavo lo bo paid in advanco.
700.2 8asic Fihahcial SIaIemehIs 14
CAßM ModuIe 700 Fihahce
fixed Assets
Fixed assets aro Iong lorm in naluro, sucl as maclinory and oquipmonl, buiIdings,
and Iand. Tloso assols viII bo usod ovor a numbor of yoars. Somo of lloso assols viII
doprocialo in vaIuo ovor limo, sucl as maclinory and oquipmonl, ollors viII nol, sucl
as Iand.
Other Assets
Ollor assols aro aII assols llal aro nol curronl assols or fixod assols, incIuding for
oxampIo, inlangibIo assols sucl as palonls, copyriglls, and goodviII.
In roporling llo doIIar amounls of llo various lypos of assols in llo baIanco slool,
llo convonlionaI praclico is lo roporl llo vaIuo of llo assols and IiabiIilios on a lislori-
caI cosl basis. Tlus, llo baIanco slool is nol inlondod lo roprosonl curronl marIol vaIuo
of llo company bul rallor rcpcris i|c |isicricc| ircnscciicns ci i|cir ccsi, or vlal vo caII a
firm's accnunting bnnk vaIue. Dolormining a fair vaIuo of a businoss is a difforonl
mallor÷an issuo llal vo viII givo groal allonlion lo llrougloul fuluro soclions.
Types of Iinancing
Wo nov lurn lo llo rigll sido of llo baIanco slool in Iiguro 2.2 IaboIod ¨IiabiIilios
(Dobl) and Iquily,¨ vlicl indicalos lov llo firm financos ils assols. Debt is mcncu i|ci
|cs |ccn |crrcuc! cn! musi |c rcpci! ci scmc prc!cicrminc! !cic. Equitv, on llo ollor
land, rcprcscnis i|c s|crc|c|!crs´ intcsimcni in i|c ccmpcnu.
700.2 8asic Fihahcial SIaIemehIs 15
CAßM ModuIe 700 Fihahce
Current assets:
º Cash
º ^ccouuls receivable
º |uveulories
º 0lher curreul assels
1otaI current assets
fixed assets:
º Machiuery aud equipueul
º Buildiugs
º Laud
1otaI fixed assets
0ther assets:
º Coodwill
º Paleuls
1otaI other assets
Current IiabiIities (debt):
º ^ccouuls payable
º ^ccrued expeuses
º Shorl·leru uoles
1otaI current debt
Long-term IiabiIities (debt)
º Preíerred slock
º Couuou slock
º Relaiued earuiugs
1otaI stockhoIders' equity
101AL ASSL1S 101AL ßL81 Ahß L0uI1¥
ASSL1S LIA8ILI1ILS (ßL81) Ahß L0uI1¥
figure 2.2 1he 8alahce SheeI: Ah Overview
Debt (LiabiIities)
Dobl capilaI is financing providod by a crodilor. As slovn in Iiguro 2.2, il is dividod
inlo (1) curronl or slorl-lorm dobl and (2) Iong-lorm dobl. Current debt, or slorl-lorm
IiabiIilios, inc|u!cs |crrcuc! mcncu i|ci musi |c rcpci! uii|in i|c ncxi 12 mcni|s. Sourcos of
curronl dobl incIudo llo foIIoving.
Accnunts µavabIe rcprcscnis crc!ii cxicn!c! |u supp|icrs ic c |irm u|cn ii purc|cscs
intcnicrics. Tlo purclasing firm may lavo 30 or 60 days boforo paying for
invonlory llal las boon purclasod. Tlis form of crodil oxlonsion is aIso caIIod
trade credit.
Accrued exµenses crc s|cri-icrm |ic|i|iiics i|ci |ctc |ccn incurrc! in i|c |irm´s
cpcrciicns |ui nci uci pci!. Ior oxampIo, ompIoyoos porform vorI llal may nol
bo paid for unliI llo foIIoving vooI or monll, and lloso aro rocordod as
accruod vagos.
Shnrt-term nntes rcprcscni cmcunis |crrcuc! |rcm c |cn| cr ci|cr |cn!inv scurcc
i|ci crc !uc cn! pcuc||c uii|in 12 mcni|s.
Long-Term Debt
Lnng-term debt inc|u!cs |ccns |rcm |cn|s cr ci|cr scurccs i|ci |cn! mcncu |cr |cnvcr i|cn
12 mcni|s. Ior oxampIo, a firm migll borrov monoy for 5 yoars lo buy oquipmonl or
for as Iong as 25 lo 30 yoars lo purclaso roaI oslalo, sucl as a varolouso or offico
Iquily incIudos llo slaroloIdors' invoslmonl÷boll proforrod slocIloIdors and com-
mon slocIloIdors÷in llo firm.
PreIerred stnckhnIders rcccitc c !iti!cn! i|ci is |ixc! in cmcuni. In llo ovonl of
llo firm faiIing, lloso slocIloIdors aro paid aflor llo firm's crodilors bul boforo
llo common slocIloIdors.
Cnmmnn stnckhnIders crc i|c rcsi!uc| cuncrs c| c |usincss. Tloy rocoivo vlalovor is
Iofl ovor in llo ovonl of banIruplcy÷good or bad÷aflor llo crodilors and proforrod
slocIloIdors aro paid. Tlo amounl of a firm's common oquily as roporlod in llo
baIanco slool is oquaI lo (1) llo amounl llo company rocoivod from soIIing slocI lo
invoslors pIus (2) llo firm's rolainod oarnings. Tloso amounls may bo offsol by cnu
sicc| i|ci |cs |ccn rcpurc|csc! |u i|c ccmpcnu, vlicl is lypicaIIy slovn as treasurv
stnck. Retained earnings is i|c cumu|ciitc icic| c| c|| i|c nci inccmc ctcr i|c |irm´s |i|c
|css i|c ccmmcn sicc| !iti!cn!s i|ci |ctc |ccn pci! ctcr i|c uccrs. Tlus, llo common
oquily capilaI consisls of llo foIIoving:
Common slaroloIdors' oquily common slocI issuod common slocI ropurclasod
cumuIalivo nol incomo ovor llo firm's Iifo lolaI dividonds paid ovor llo firm's Iifo
8alance Sheet: Starbucks Corporation
BaIanco slools for SlarbucIs Corporalion aro prosonlod in TabIe 2.2 for boll fiscaI yoars
onding Soplombor 28, 2002, and Soplombor 28, 2003, aIong vill llo clangos in oacl
accounl bolvoon yoars. By oxamining llo lvo baIanco slools, aIong vill llo incomo slalo-
monl for 2003, vo lavo a moro compIolo picluro of llo firm's oporalions. Wo can soo vlal
SlarbucIs IooIod IiIo al llo boginning of fiscaI 2003 (baIanco slool on Soplombor 28, 2002),
vlal lapponod during llo yoar (incomo slalomonl for 2003), and llo finaI oulcomo al llo
ond of llo fiscaI yoar (baIanco slool on Soplombor 28, 2003). Our porspoclivo of 2003 is
slovn graplicaIIy in Figure 2.3.
Tlo baIanco slool dala for SlarbucIs Corporalion slov llal llo firm ondod fiscaI
2002 vill aboul $2,238 miIIion in assols, comparod lo $2,672 miIIion al llo ond of fiscaI
2003. IraclicaIIy aII of llis grovll vas in Iong-lorm assols, namoIy, an incroaso of $566
miIIion in gross fixod assols or pIanl and oquipmonl. In llo bollom laIf of llo baIanco
700.2 8asic Fihahcial SIaIemehIs 16
CAßM ModuIe 700 Fihahce
slool, nolico llo grovll in dobl and oquily llal comos primariIy from accounls payabIo
and accruaIs (an incroaso of $70 miIIion), addilionaI common slocI issuod of $87 miIIion,
aIong vill an incroaso in rolainod oarnings (or roinvoslod profils) of $268 miIIion.
To gain a bollor grasp of SlarbucIs' financiaI posilion on Soplombor 28, 2003, vo
graplod llo major lypos of assols, dobl, and oquily in Figure 2.4. In IooIing al llis grapl,
vo aro slrucI by llo Iargo proporlion of llo firm's assols llal is invoslod in fixod assols÷
$1.75 biIIion in fixod assols oul of $2.67 biIIion in lolaI assols. AIso, lloro aro lvo ollor
700.2 8asic Fihahcial SIaIemehIs 17
CAßM ModuIe 700 Fihahce
TabIe 2.2 SIarbucks CorporaIioh 8alahce SheeIs ($ ih Milliohs), SepIember 28,
2002 ahd 2003
5eptember 28
2002 2003 Changes
Cash $ 402 $ 350 ($ 52)
AccouhIs receivable 98 114 16
IhvehIories 263 342 79
OIher currehI asseIs 85 116 31
1oIal currehI asseIs $ 848 $ 922 $ 74
Gross !ixed asseIs $2,103 $2,669 $ 566
AccumulaIed depreciaIioh 713 919 206
NeI !ixed asseIs $1,390 $1,750 $ 360
1oIal asseIs $2,238 $2,672 $ 434
AccouhIs payable ahd accruals $ 482 $ 552 $ 70
ShorI-Ierm hoIes payable 1 1 0
1oIal currehI liabiliIies $ 483 $ 553 $ 70
Lohg-Ierm debI $ 29 $ 38 9
1oIal liabiliIies $ 512 $ 591 $ 79
Commoh sIock $ 930 $1,017 $ 87
ReIaihed earhihgs 796 1,064 268
1oIal commoh equiIy $1,726 $2,081 $ 355
1oIal liabiliIies ahd equiIy $2,238 $2,672 $ 434
Income Statement for fiscaI ¥ear 2003
Balauce sheel
ou Sepleuber 28, 2002
Balauce sheel
ou Sepleuber 28, 2003
|iscal Year 2003
figure 2.3 SIarbucks CorporaIioh: 1he Ihcome SIaIemehI ahd 8alahce SheeI
as Ohe PicIure
roIalionslips llal can bo obsorvod in Iiguro 2.4: (1) llo IovoI of SlarbucIs' nol vorIing
capilaI and (2) llo firm's mix of dobl lo oquily usod in financing llo company. Iol's con-
sidor oacl.
Net Working CapitaI
IarIior vo nolod llal llo lorm currcni csscis is somolimos roforrod lo as vrcss ucr|inv
ccpiic|. Wo can nov dofino net wnrking caµitaI as currcni csscis |css currcni |ic|i|iiics (currcni
csscis currcni |ic|i|iiics). Tlus, nci vorIing capilaI comparos llo amounl of curronl assols
(assols llal slouId convorl inlo casl villin llo noxl 12 monlls) lo llo curronl IiabiIilios
(dobl llal viII bo duo villin 12 monlls). Tlo Iargor llo nol vorIing capilaI a firm las, llo
moro abIo llo firm viII bo lo pay ils dobl as il comos duo. Tlus, llo amounl of nol vorIing
capilaI is imporlanl lo a company's Iondors vlo aro aIvays concornod aboul a company's
abiIily lo ropay a Ioan. AIso, vo uso llo concopl of nol vorIing capilaI al sovoraI poinls in
our sludy of financo. So, don'l forgol: Nol vorIing capilaI is oquaI lo curronl assols (aIso
caIIod vrcss vorIing capilaI) Ioss curronl IiabiIilios.
Ior SlarbucIs, ils nol vorIing capilaI as of llo ond of llo 2003 fiscaI yoar vas
$369 miIIion ($922 miIIion curronl assols $553 miIIion curronl dobl).
Debt ßatio
A firm's debt ratin is i|c pcrccnicvc c| csscis |incncc! |u !c|i. SlarbucIs' dobl ralio al llo 2003
fiscaI yoar ond vas aboul 22 porconl ($591 miIIion in lolaI IiabiIilios dividod by $2,672 miI-
Iion in lolaI assols). Tlis moans llal by llo ond of fiscaI 2003, SlarbucIs vas financing
aboul 78 porconl of ils assols vill oquily and onIy 22 porconl vill dobl. Tlo dobl ralio is an
imporlanl moasuro lo Iondors and invoslors, as il indicalos llo amounl of financiaI risI llo
company is incurring÷llo moro dobl a company usos lo financo ils assols, llo groalor llo
firm's financiaI risI.
700.2 8asic Fihahcial SIaIemehIs 18
CAßM ModuIe 700 Fihahce
Curreul assels
Curreul debl
Loug·leru debl
Nel workiug
Jolal debl
|ixed assels
Jolal liabililies
aud equily
figure 2.4 SIarbucks CorporaIioh 8alahce SheeI, SepIember 28, 2003
($ Milliohs)
700.2.3 Learn hov to measure cash !Iovs, incIuding
!ree cash !Iovs
AIllougl an incomo slalomonl moasuros a company's profils, profils aro nol llo samo as
casl fIovs, profils aro caIcuIalod on an cccruc| basis rallor llan a ccs| basis. AccruaI-basis
accounling rocords rovonuo vlon il is oarnod, vlollor or nol llo rovonuo las boon
rocoivod in casl, and rocords oxponsos vlon lloy aro incurrod, ovon if llo monoy las nol
acluaIIy boon paid oul.
Ior oxampIo, saIos roporlod in llo incomo slalomonl incIudo boll casl saIos and
crodil saIos. Tloroforo, saIos for a givon yoar do nol corrospond oxaclIy lo llo acluaI
casl coIIoclod from saIos. SimiIarIy, a firm musl purclaso invonlory, bul somo of
llo purclasos aro financod by crodil rallor llan by immodialo casl paymonl so
oxponsos aro nol oquaI lo acluaI casl ¨oul llo door¨ oillor. AIso, undor llo accruaI
syslom, llo purclaso of oquipmonl llal viII Iasl for moro llan a yoar is nol slovn
as an oxponso in llo incomo slalomonl. Insload, llo amounl is rocordod as an assol
and llon oxponsod as doprocialion ovor llo usofuI Iifo of llo oquipmonl. An annuaI
doprocialion oxponso (llis is nol a casl fIov) is rocordod as a vay lo malcl llo uso
of llo assol vill saIos gonoralod from ils sorvico.
Wo couId givo moro oxampIos lo slov vly profils diffor from casl fIovs, bul llo
poinl slouId bo cIoar: Prc|iis cn! ccs| ||cus crc nci i|c scmc i|inv. In facl, a businoss
couId bo profilabIo bul lavo nogalivo casl fIovs, ovon lo llo poinl of going banIrupl.
So undorslanding a firm's casl fIovs is vory imporlanl lo managors.
Tloro aro a numbor of difforonl vays lo moasuro a firm's casl fIovs. Ior ono, vo
couId uso llo convonlionaI accounlanl's prosonlalion caIIod a sicicmcni c| ccs| ||cus,
vlicl is aIvays incIudod in llo financiaI soclion of a firm's annuaI roporl. Bul for
our purposos, vo viII insload laIo a financo porspoclivo lo moasuring casl fIovs,
compuling vlal vo viII caII |rcc ccs| ||cus. Tlis moasuromonl viII bo usod Ialor in
vaIuing a capilaI invoslmonl and in vaIuing llo firm ilsoIf. So, vlal foIIovs is simiIar
lo a convonlionaI casl fIov slalomonl prosonlod as parl of a company's financiaI
slalomonls, bul il doos nol foIIov oxaclIy llo accounlanl's formal.
Iree Cash Ilows
Wo can llinI of a firm as a group of assols llal producos casl fIov. Onco llo firm las
paid aII ils oporaling oxponsos and mado aII ils invoslmonls, llo romaining casl fIovs
aro |rcc lo bo dislribulod lo llo firm's crodilors and slaroloIdors÷llus, llo lorm Iree
cash IInws. Boing moro spocific, a company's |rcc casl fIovs rosuIl from lvo aclivilios:
1. Ccs| ||cu |rcm cpcrciicns, vlicl roIalos lo llo normaI oporaling aclivilios of llo
businoss, incIuding buying or producing producls lo bo soId, soIIing lo
cuslomors, paying vagos and adminislralivo oxponsos, and paying laxos.
2. Assci intcsimcnis, vlicl incIudo invoslmonls in (1) a company's nci ucr|inv
ccpiic| and (2) ils fixod assols.
SimpIy slalod, froo casl fIovs aro oquaI lo:
Aflor-lax casl
fIovs from oporalions
incroaso or docroaso in
nol vorIing capiilaI
incroaso or docroaso in
sss fixod assols
700.2 8asic Fihahcial SIaIemehIs 19
CAßM ModuIe 700 Fihahce
Tlo procoduro for compuling a firm's froo casl fIovs invoIvos llroo slops:
1. Compulo llo aflor-lax casl fIovs from oporalions by convorling llo incomo
slalomonl from an accruaI basis lo a casl basis.
2. CaIcuIalo llo incroaso or docroaso in llo firm's invoslmonl in nci vorIing capilaI.
3. Compulo llo incroaso or docroaso in invoslmonls mado in fixod assols.
Iol's IooI al oacl of llo forogoing slops.
5tep 1 Dcicrminc i|c c|icr-icx ccs| ||cus |rcm cpcrciicns. Ior llo firsl slop, vo com-
pulo llo aflor-lax casl fIovs from oporalions as foIIovs:
Operaling income (earnings belore inleresl and laxes)
deprecialion expense
income lax expense
aller-lax cash llows lrom operalions
Tlus, vo compulo llo aflor-lax casl fIovs from oporalions by adding bacI doprocialion
oxponso lo oporaling incomo, bocauso doprocialion oxponso is nol a casl oxponso, and
llon sublracling laxos lo gol llo casl fIovs on an aflor-lax basis.
To iIIuslralo lov lo compulo a firm's aflor-lax casl fIovs from oporalions, rolurn
lo SlarbucIs' incomo slalomonl in TabIo 2.1, vloro vo find llo foIIoving informalion:
OperaIihg ihcome (L8I1) $436
DepreciaIioh expehse 206
Ihcome Iax expehse 165
Givon llis informalion, vo compulo SlarbucIs' aflor-lax casl fIovs from opor-
alions as foIIovs:
OperaIihg ihcome (L8I1) $ 436
Plus depreciaIioh 206
Less ihcome Iax expehse (165)
A!Ier-Iax cash !lows !rom operaIiohs $(477)
5tep 2 Cc|cu|cic i|c c|cnvc in i|c nci ucr|inv ccpiic|. Ior llo socond slop, llo clango
in nol vorIing capilaI is oquaI lo llo:
Ior SlarbucIs, llo incroaso in nci ucr|inv ccpiic| is found by IooIing al llo firm's
baIanco slools al llo boginning and ond of fiscaI 2003 in TabIo 2.2, vloro vo soo llal:
5eptember 28 2003
2002 2003 Changes
CurrehI asseIs $848 $922 $74
CurrehI liabiliIies 483 553 70
NeI workihg capiIal $365 $369 $ 4
Tlus, in 2003 SlarbucIs invoslod an addilionaI $74 miIIion in curronl assols, lovovor,
curronl IiabiIilios (acluaIIy accounls payabIos and accruaIs) loIpod financo
clango in
curronl assols
clango in

rrronl IiabiIilios
700.2 8asic Fihahcial SIaIemehIs 20
CAßM ModuIe 700 Fihahce
$70 miIIion of llo incroaso in curronl assols, roquiring llo firm lo maIo up llo diffor-
onco of $4 miIIion ($74 miIIion $70 miIIion).
5tep 3 Ccmpuic i|c c|cnvc in |ixc! csscis. Tlo finaI slop invoIvos compuling llo
clango in vrcss fixod assols (nol nci fixod assols). Again rolurning lo
SlarbucIs' baIanco slools, vo soo llal lloro vas an incroaso in gross
fixod assols of $566 miIIion from $2,103 miIIion lo $2,669 miIIion.
5tep 4 Wrcppinv up. Wo can nov compulo SlarbucIs' froo casl fIovs as foIIovs:
A!Ier-Iax cash !lows !rom operaIiohs $477
Less 2003 ihvesImehIs:
IhvesImehI ih heI workihg capiIal ($ 4)
IhvesImehI ih lohg-Ierm asseIs (566)
1oIal ihvesImehIs (570)
Free cash !lows $ (93)
Givon lloso compulalions, vo soo llal llo firm's froo casl fIovs aro ncvciitc in llo
amounl of $93 miIIion. Tlo firm's oporalions gonoralod $477 miIIion, lovovor, aII of llis
amounl, pIus $93 miIIion, vas consumod by llo incroasos in nol vorIing capilaI ($4 miI-
Iion) and llo invoslmonls in Iong-lorm assols ($566 miIIion). In ollor vords, llo fasl
grovll boing oxporioncod by SlarbucIs÷aII lloso nov Iocalions÷vas moro llan vlal
llo firm couId financo from oporalions. So vloro did llo $93 miIIion como from lo financo
llo slorlfaII` Tlo invoslors, of courso.
Iinancing Cash Ilows
A firm can oillor rocoivo monoy from or dislribulo monoy lo ils invoslors, or somo of
boll. In gonoraI, casl fIovs bolvoon invoslors and llo firm, vlal vo viII caII
Iinancing cash IInws, occur in ono of four vays. Tlo firm can:
1. Iay inlorosl lo Iondors.
2. Iay dividonds lo slocIloIdors.
3. Incroaso or docroaso Iong-lorm dobl.
4. Issuo slocI lo nov slaroloIdors or ropurclaso slocI from curronl invoslors.
Iol's again rolurn lo SlarbucIs lo iIIuslralo llo procoss for caIcuIaling llo firm's
financing casl fIovs, vlicl viII aIso Iol us dolormino lov llo $93 miIIion nogalivo
froo casl fIovs llal SlarbucIs oxporioncod voro financod.
Wlon vo spoaI of intcsicrs in llis conloxl, vo incIudo boll Iondors and slaroloId-
ors. Hovovor, vo do nci incIudo financing providod by curronl IiabiIilios, vlicl voro
rocognizod oarIior as parl of llo firm's nol vorIing capilaI.
Iol's compulo llo financing casl fIovs for SlarbucIs. Wo firsl dolormino llo inlor-
osl oxponso paid lo Iondors and llo dividonds paid lo slaroloIdors, vlicl aro providod
in llo firm's incomo slalomonl (TabIo 2.1). Wo llon rofor lo llo baIanco slool (TabIo 2.2)
lo soo llo clangos in Iong-lorm dobl and common slocI. Tlo rosuIls aro as foIIovs:
IhIeresI paid Io lehders $ (3) Use o! cash
Commoh sIock dividehds 0
Ihcrease ih lohg-Ierm debI 9 Source o! cash
Ihcrease ih commoh sIock 87 Source o! cash
IhvesIors' cash !lows $ 93
Tlus, llo firm paid $3 miIIion in inlorosl and nolling in dividonds. Tlo firm rocoivod $9
miIIion from addilionaI Iong-lorm dobl and $87 miIIion by issuing common slocI. Add il
700.2 8asic Fihahcial SIaIemehIs 21
CAßM ModuIe 700 Fihahce
aII up and SlarbucIs rocoivod a nol amounl of $93 miIIion from ils Iong-lorm crodilors and
Il is nol a coincidonco llal llo doIIar amounl of SlarbucIs' froo casl fIovs oxaclIy
oquaIs ils casl fIovs from ils invoslors. Tloy viII aIvays bo llo samo oxcopl llo signs
viII bo opposilo÷if ono is posilivo (nogalivo) llo ollor viII bo nogalivo (posilivo). Tlo
firm's froo casl fIovs, if posilivo, viII bo llo amounl dislribulod lo llo invoslors, if llo
froo casl fIovs aro nogalivo, il viII bo llo amounl llal llo invoslors provido lo llo
firm lo covor llo slorlago in froo casl fIovs.
700.2 8asic Fihahcial SIaIemehIs 22
CAßM ModuIe 700 Fihahce
700.3 Workihg-CapiIal MahagemehI 23
700.3.1 Ioarn lov lo manago curronl assols and IiabiIilios
700.3.2 Dolormino llo approprialo IovoI of vorIing-capilaI llal is noodod
700.3.3 Islimalo llo cosl of slorl-lorm crodil
700.3.4 Idonlify llo sourcos of slorl-lorm crodil
700.3 Working-Capital Nanagement
700.3.1 Learn hov to manage current assets
and IiabiIities
A firm's curronl assols consisl of casl and marIolabIo socurilios, accounls rocoivabIo,
invonlorios, and ollor assols llal llo firm's managomonl oxpocls lo bo convorlod lo
casl villin a poriod of a yoar or Ioss. ConsoquonlIy, firms llal clooso lo loId moro
curronl assols aro, in gonoraI, moro Iiquid llan firms llal do nol.
The Risk-Return Trade-Off
AcluaIIy firms llal vanl lo roduco lloir risI of iIIiquidily by loIding moro curronl
assols do so by invosling in Iargor casl and marIolabIo socurilios baIancos. HoIding
Iargor casl and marIolabIo socurilios baIancos las an unforlunalo consoquonco, lov-
ovor. Bocauso invoslmonls in casl and marIolabIo socurilios oarn roIalivoIy modosl
rolurns vlon comparod vill llo firm's ollor invoslmonls, llo firm llal loIds Iargor
invoslmonls in lloso assols viII roduco ils ovoraII ralo of rolurn. Tlus, llo incroasod
Iiquidily (i.o., roducod risI of iIIiquidily) musl bo lradod off againsl llo firm's roduc-
lion in rolurn on invoslmonl. Managing llis lrado-off is an imporlanl llomo of
vorIing-capilaI managomonl.
Many ol lhe working-capilal decisions made by linancial managers involve riskrelurn lrade-
olls belween liquidily and prolilabilily. The principles lhal guide lhese decisions are lhe same
ones sel oul in PrincipIe 1. The ßisk-ßeturn Trade-O!!-We Won't Take On AdditionaI
ßisk UnIess We Expect to ße Compensated vith AdditionaI ßeturn. The more currenl
assels held and lhe more long-lerm linancing used, lhe less lhe risk and lhe less lhe relurn.
Tlo firm's uso of curronl vorsus Iong-lorm dobl aIso invoIvos a risI÷rolurn lrado-
off. Oi|cr i|invs rcmcininv i|c scmc, i|c vrccicr i|c |irm´s rc|icncc cn s|cri-icrm !c|i cr cur-
rcni |ic|i|iiics in |incncinv iis csscis, i|c vrccicr i|c ris| c| i||i¡ui!iiu. On llo ollor land, llo
uso of curronl IiabiIilios offors somo vory roaI advanlagos in llal lloy can bo Ioss coslIy
llan Iong-lorm financing, and lloy provido llo firm vill a fIoxibIo moans of financing
ils fIuclualing noods for assols. Hovovor, if for somo roason llo firm las probIoms
raising slorl-lorm funds or il slouId nood funds for Iongor llan oxpoclod, il can gol
inlo roaI lroubIo. Tlus, a firm can roduco ils risI of iIIiquidily llrougl llo uso of Iong-
lorm dobl al llo oxponso of a roduclion in ils rolurn on invoslod funds. Onco again vo
soo llal llo risI÷rolurn lrado-off invoIvos an incroasod risI of iIIiquidily vorsus
incroasod profilabiIily.
Advantages of Current Liabilities: Return
Curronl IiabiIilios offor llo firm a fIoxibIo sourco of financing. Tloy can bo usod lo
malcl llo liming of a firm's noods for slorl-lorm financing. If, for oxampIo, a firm
noods funds for a 3-monll poriod during oacl yoar lo financo a soasonaI oxpansion in
invonlorios, llon a 3-monll Ioan can provido subslanliaI cosl savings ovor a Iong-lorm
Ioan (ovon if llo inlorosl ralo on slorl-lorm financing slouId bo liglor). Tlo uso of
Iong-lorm dobl in llis silualion invoIvos borroving for llo onliro yoar rallor llan for
llo poriod vlon llo funds aro noodod, vlicl incroasos llo amounl of inlorosl llo firm
musl pay. Tlis brings us lo llo socond advanlago gonoraIIy associalod vill llo uso of
slorl-lorm financing.
700.3 Workihg-CapiIal MahagemehI 24
CAßM ModuIe 700 Fihahce
Interest Cost
In gonoraI, inlorosl ralos on slorl-lorm dobl aro Iovor llan on Iong-lorm dobl for a
givon borrovor. Tlis roIalionslip is roforrod lo as llo lorm slrucluro of inlorosl ralos.
Ior a givon firm, llo lorm slrucluro migll appoar as foIIovs.
Loan Maturity Interest ßate
3 mohIhs 4.00%
6 mohIhs 4.60%
1 year 5.30%
3 years 5.90%
5 years 6.75%
10 years 7.50%
30 years 8.25%
Nolo llal llis lorm slrucluro rofIocls llo ralos of inlorosl appIicabIo lo a givon bor-
rovor al a parlicuIar limo. Il vouId nol, for oxampIo, doscribo llo ralos of inlorosl
avaiIabIo lo anollor borrovor or ovon lloso appIicabIo lo llo samo borrovor al a dif-
foronl limo.
Disadvantages of Current Liabilities: Risk
Tlo uso of curronl IiabiIilios or slorl-lorm dobl as opposod lo Iong-lorm dobl subjocls llo
firm lo a groalor risI of iIIiquidily for lvo roasons. Iirsl, slorl-lorm dobl, bocauso of ils
vory naluro, musl bo ropaid or roIIod ovor moro oflon, so il incroasos llo possibiIily llal
llo firm's financiaI condilion migll dolorioralo lo a poinl al vlicl llo noodod funds
migll nol bo avaiIabIo.
A socond disadvanlago of slorl-lorm dobl is llo uncorlainly of inlorosl cosls from
yoar lo yoar. Ior oxampIo, a firm borroving during a 6-monll poriod oacl yoar lo
financo a soasonaI oxpansion in curronl assols migll incur a difforonl ralo of inlorosl
oacl yoar. Tlis ralo rofIocls llo curronl ralo of inlorosl al llo limo of llo Ioan, as voII as
llo Iondor's porcoplion of llo firm's risIinoss. If fixod-ralo Iong-lorm dobl voro usod,
llo inlorosl cosl vouId bo Inovn for llo onliro poriod of llo Ioan agroomonl.
700.3.2 Determine the appropriate IeveI
o! vorking-capitaI that is needed
Managing llo firm's nol vorIing capilaI (ils Iiquidily) invoIvos inlorroIalod docisions
rogarding invoslmonls in curronl assols and uso of curronl IiabiIilios. IorlunaloIy, a guid-
ing principIo oxisls llal can bo usod as a bonclmarI for llo firm's vorIing-capilaI poIi-
cios: llo lodging principIo, or principIo of soIf-Iiquidaling dobl. Tlis principIo providos a
guido lo llo mainlonanco of a IovoI of Iiquidily sufficionl for llo firm lo mool ils malur-
ing obIigalions on limo.
Wo discussod llo firm's financing docision in lorms of llo cloico bolvoon dobl
and oquily sourcos of financing. Tloro is, lovovor, yol anollor crilicaI dimonsion of
llo firm's financing docision. Tlis roIalos lo llo malurily slrucluro of llo firm's dobl.
Hov slouId llo docision bo mado aboul vlollor lo uso slorl-lorm (curronl dobl) or
Iongor-malurily dobl`
700.3 Workihg-CapiIal MahagemehI 25
CAßM ModuIe 700 Fihahce
Hedging Principle
Vory simpIy, llo hedging µrinciµIe, or µrinciµIe nI seII-Iiquidating debt, invoIvos
mcic|inv i|c ccs| ||cu÷vcncrciinv c|crccicrisiics c| cn cssci uii| i|c mciuriiu c| i|c scurcc c|
|incncinv usc! ic |incncc iis cc¡uisiiicn. Ior oxampIo, a soasonaI oxpansion in invonlorios,
according lo llo lodging principIo, slouId bo financod vill a slorl-lorm Ioan or cur-
ronl IiabiIily. Tlo ralionaIo undorIying llo ruIo is slraigllforvard. Iunds aro noodod for
a Iimilod poriod, and vlon llal limo las passod, llo casl noodod lo ropay llo Ioan viII
bo gonoralod by llo saIo of llo oxlra invonlory iloms. Oblaining llo noodod funds from
a Iong-lorm sourco (Iongor llan 1 yoar) vouId moan llal llo firm vouId sliII lavo llo
funds aflor llo invonlorios lloy loIpod financo lad boon soId. In llis caso llo firm
vouId lavo ¨oxcoss¨ Iiquidily, vlicl il oillor loIds in casl or invosls in Iov-yioId
marIolabIo socurilios unliI llo soasonaI incroaso in invonlorios occurs again and llo
funds aro noodod. Tlo rosuIl of aII llis vouId bo an ovoraII Iovoring of firm profils.
Considor an oxampIo in vlicl a firm purclasos a nov convoyor boIl syslom,
vlicl is oxpoclod lo produco casl savings lo llo firm by oIiminaling llo nood for lvo
ompIoyoos and, consoquonlIy, lloir saIarios. Tlis amounls lo an annuaI savings of
$24,000, vloroas llo convoyor boIl cosls $250,000 lo inslaII and viII Iasl 20 yoars. If llo
firm cloosos lo financo llis assol vill a 1-yoar nolo, llon il viII nol bo abIo lo ropay
llo Ioan from llo $24,000 casl fIov gonoralod by llo assol. In accordanco vill llo lodg-
ing principIo, llo firm slouId financo llo assol vill a sourco of financing llal moro
noarIy malclos llo oxpoclod Iifo and casl fIov÷gonoraling claraclorislics of llo assol.
In llis caso, a 15- lo 20-yoar Ioan vouId bo moro approprialo.
Permanent and Temporary Assets
Tlo nolion of malurily malcling in llo lodging principIo can bo mosl oasiIy undor-
slood vlon vo llinI in lorms of llo dislinclion bolvoon pormanonl and lomporary
invoslmonls in assols, as opposod lo llo moro lradilionaI fixod and curronl assol calo-
gorios. Permanent investments in an assol aro intcsimcnis i|ci i|c |irm cxpccis ic |c|! |cr
c pcric! |cnvcr i|cn 1 uccr. Nolo llal vo aro roforring lo llo poriod llo firm pIans lo loId
an invoslmonl, nol llo usofuI Iifo of llo assol. Ior oxampIo, pormanonl invoslmonls aro
mado in llo firm's minimum IovoI of curronl assols, as voII as in ils fixod assols.
Temµnrarv investments, on llo ollor land, aro composod of currcni csscis i|ci ui|| |c
|i¡ui!cic! cn! nci rcp|ccc! uii|in i|c currcni uccr. Tlus, somo parl of llo firm's curronl
assols is pormanonl and llo romaindor is lomporary. Ior oxampIo, a soasonaI incroaso
in IovoI of invonlorios is a lomporary invoslmonl: llo buiIdup in invonlorios llal viII bo
oIiminalod vlon no Iongor noodod. In conlrasl, llo buiIdup in invonlorios lo mool a
Iong-lorm incroasing saIos lrond is a pormanonl invoslmonl.
Temporary, Permanent, and 5pontaneous 5ources o! financing
Bocauso lolaI assols musl aIvays oquaI llo sum of lomporary, pormanonl, and sponla-
noous sourcos of financing, llo lodging approacl providos llo financiaI managor vill
llo basis for dolormining llo sourcos of financing lo uso al any poinl. Soo TabIe 3.1.
Nov, vlal conslilulos a lomporary, pormanonl, or sponlanoous sourco of financ-
ing` Tomporary sourcos of financing consisl of curronl IiabiIilios. Slorl-lorm nolos
payabIo conslilulo llo mosl common oxampIo of a lomporary sourco of financing.
IxampIos of nolos payabIo incIudo unsocurod banI Ioans, commorciaI papor, and
Ioans socurod by accounls rocoivabIo and invonlorios. Iormanonl sourcos of financing
incIudo inlormodialo-lorm Ioans, Iong-lorm dobl, proforrod slocI, and common oquily.
Sponlanoous sourcos of financing consisl of lrado crodil and ollor accounls
payabIo llal ariso spcnicnccus|u in llo firm's day-lo-day oporalions. Ior oxampIo, as
llo firm acquiros maloriaIs for ils invonlorios, trade credit is oflon mc!c ctci|c||c spcnic-
nccus|u cr cn !cmcn! |rcm i|c |irm´s supp|icrs u|cn i|c |irm cr!crs iis supp|ics cr mcrc
intcnicru c| prc!ucis ic sc||. 1rc!c crc!ii cppccrs cn i|c |irm´s |c|cncc s|cci cs ccccunis
pcuc||c, and llo sizo of llo accounls-payabIo baIanco varios diroclIy vill llo firm's
purclasos of invonlory iloms. In lurn, invonlory purclasos aro roIalod lo anlicipalod
700.3 Workihg-CapiIal MahagemehI 26
CAßM ModuIe 700 Fihahce
saIos. Tlus, parl of llo financing noodod by llo firm is sponlanoousIy providod in llo
form of lrado crodil.
In addilion lo lrado crodil, vagos and saIarios payabIo, accruod inlorosl, and
accruod laxos aIso provido vaIuabIo sourcos of sponlanoous financing. Tloso oxponsos
accruo llrougloul llo poriod unliI lloy aro paid. Ior oxampIo, if a firm las a vago
oxponso of $10,000 a vooI and pays ils ompIoyoos monllIy, llon ils ompIoyoos offoc-
livoIy provido financing oquaI lo $10,000 by llo ond of llo firsl vooI foIIoving a pay-
day, $20,000 by llo ond of llo socond vooI, and so forll, unliI llo vorIors aro paid.
Bocauso lloso oxponsos gonoraIIy ariso in dirocl conjunclion vill llo firm's ongoing
oporalions, lloy, loo, aro roforrod lo as sponlanoous.
Hedging PrincipIe. Graphic IIIustration
Tlo lodging principIo can nov bo slalod vory succinclIy: Assci ncc!s c| i|c |irm nci
|incncc! |u spcnicnccus scurccs s|cu|! |c |incncc! in ccccr!cncc uii| i|is ru|c. Pcrmcncni-
cssci intcsimcnis crc |incncc! uii| pcrmcncni scurccs, cn! icmpcrcru intcsimcnis crc |incncc!
uii| icmpcrcru scurccs.
Tlo lodging principIo is dopiclod in Figure 3.1. TolaI assols aro broIon dovn inlo
lomporary- and pormanonl-assol invoslmonl calogorios. Tlo firm's pormanonl
700.3 Workihg-CapiIal MahagemehI 27
CAßM ModuIe 700 Fihahce
TabIe 3.1 1he Hedgihg Prihciple Applied Io Workihg-CapiIal MahagemehI
Defined: A !irm's asseI heeds IhaI are hoI !ihahced by spohIaheous sources o! !ihahcihg should be !ihahced ih accordahce
wiIh Ihe !ollowihg "maIchihg rule"-permahehI-asseI ihvesImehIs are !ihahced wiIh permahehI sources, ahd Iemporary-
asseI ihvesImehIs are !ihahced wiIh Iemporary sources o! !ihahcihg.
CIassi!ication o! a firm's CIassi!ication o! a firm's
Investments in Assets De!initions and ExampIes 5ources o! financing De!initions and ExampIes
1emporary ihvesImehIs Definition: CurrehI asseIs IhaI SpohIaheous !ihahcihg Definition: Fihahcihg IhaI arises
will be liquidaIed ahd hoI more or less auIomaIically ih
replaced wiIhih Ihe year. respohse Io Ihe purchase o!
ah asseI.
Lxamples: Seasohal expahsiohs Lxamples: 1rade crediI IhaI
ih ihvehIories ahd accouhIs accompahies Ihe purchase o!
receivable. ihvehIories ahd oIher Iypes o!
accouhIs payables creaIed by
Ihe purchase o! services (e.g.,
wages payable).
1emporary !ihahcihg Definition: CurrehI liabiliIies
oIher Ihah spohIaheous
sources o! !ihahcihg.
Lxamples: NoIes payable ahd
revolvihg crediI agreemehIs
IhaI musI be repaid ih a
period less Ihah ohe year.
PermahehI ihvesImehIs Definition: CurrehI ahd PermahehI !ihahcihg Definition: Lohg-Ierm liabiliIies
lohg-Ierm asseI ihvesImehIs hoI due ahd payable wiIhih
IhaI Ihe !irm expecIs Io hold Ihe year ahd equiIy !ihahcihg.
!or a period lohger Ihah
ohe year.
Lxamples: Mihimum levels o! Lxamples: 1erm loahs, hoIes,
ihvehIory ahd accouhIs ahd bohds as well as
receivable Ihe !irm maihIaihs pre!erred ahd commoh
IhroughouI Ihe year as well equiIy.
as iIs ihvesImehIs ih plahI
ahd equipmehI.
invoslmonl in assols is financod by llo uso of pormanonl sourcos of financing (inlormo-
dialo- and Iong-lorm dobl, proforrod slocI, and common oquily) or sponlanoous
sourcos (lrado crodil and ollor accounls payabIo). Ior iIIuslralion purposos, sponla-
noous sourcos of financing aro lroalod as if lloir amounl voro fixod. In praclico, of
courso, sponlanoous sourcos of financing fIuclualo vill llo firm's purclasos and ils
oxpondiluros for vagos, saIarios, laxos, and ollor iloms llal aro paid on a doIayod
basis. Ils lomporary invoslmonl in assols is financod vill lomporary (slorl-lorm) dobl.
700.3.3 Estimate the cost o! short-term credit
Approximate Cost-of-Credit Iormula
Tlo procoduro for oslimaling llo cosl of slorl-lorm crodil is a vory simpIo ono and
roIios on llo basic inlorosl oqualion:
Inlorosl principaI ralo limo (3-1)
vloro inicrcsi is llo doIIar amounl of inlorosl on a principc| llal is borrovod al somo
annuaI rcic for a fraclion of a yoar (roprosonlod by iimc). Ior oxampIo, a 6-monll Ioan
for $1,000 al 8 porconl inlorosl vouId roquiro an inlorosl paymonl of $40.
Wo uso llis basic roIalionslip lo soIvo for llo cosl of a sourco of slorl-lorm financing
or llo annuaI porconlago ralo (APR) vlon llo inlorosl amounl, llo principaI sum, and
llo limo poriod for financing aro Inovn. Tlus, soIving llo basic inlorosl oqualion for
APR producos
Tlis oqualion, caIIod llo APR caIcuIalion, is cIarifiod by llo foIIoving oxampIo.
principaI limo

principaI limo 
Inlorosl $ $ = = 1 000 08
40 , .  
700.3 Workihg-CapiIal MahagemehI 28
CAßM ModuIe 700 Fihahce
1ime period
Jeuporary (shorl·leruì íiuauciug
Peruaueul plus spoulaueous íiuauciug
curreul assels
figure 3.1 Hedgihg Prihciple
Annual Percentage ¥ield Iormula
Tlo simpIo APR caIcuIalion doos nol considor compound inlorosl. To accounl for llo
infIuonco of compounding, vo can uso llo foIIoving oqualion:
vloro APY is llo annuaI porconlago yioId, i is llo nominaI ralo of inlorosl por yoar
(12 porconl in llo provious oxampIo), and m is llo numbor of compounding poriods
villin a yoar |m 1/limo 1/(90/360) 4 in llo procoding oxampIo]. Tlus, llo
offoclivo ralo of inlorosl on llo Ioan in llo oxampIo probIom, considoring compound-
ing, is
Compounding offoclivoIy raisos llo cosl of slorl-lorm crodil. Bocauso llo diffor-
oncos bolvoon APR and APY aro usuaIIy smaII, vo uso llo simpIo inlorosl vaIuos of
APR lo compulo llo cosl of slorl-lorm crodil.
700.3.4 Identi!y the sources o! short-term credit
Slorl-lorm crodil sourcos can bo cIassifiod inlo lvo basic groups: unsocurod and
socurod. Unsecured Inans incIudo aII lloso scurccs i|ci |ctc cs i|cir sccuriiu cn|u i|c
|cn!cr´s |cii| in i|c c|i|iiu c| i|c |crrcucr ic rcpcu i|c |un!s u|cn !uc. Major sourcos of
unsocurod slorl-lorm crodil incIudo accruod vagos and laxos, lrado crodil, unsocurod
banI Ioans, and commorciaI papor. Secured Inans invoIvo llo p|c!vc c| spcci|ic csscis cs
cc||cicrc| in i|c ctcni i|c |crrcucr !c|cu|is in pcumcni c| principc| cr inicrcsi. CommorciaI
banIs, financo companios, and faclors aro llo primary suppIiors of socurod crodil. Tlo
principaI sourcos of coIIaloraI incIudo accounls rocoivabIo and invonlorios.
Unsecured Sources: Accrued Wages and Taxes
Bocauso mosl businossos pay lloir ompIoyoos onIy poriodicaIIy (vooIIy, bivooIIy, or
monllIy), firms accruo a vagos payabIo accounl llal is, in ossonco, a Ioan from lloir
ompIoyoos. Ior oxampIo, if llo vago oxponso for llo AppIolon Manufacluring Com-
pany is $450,000 por vooI and il pays ils ompIoyoos monllIy, llon by llo ond of a
4-vooI monll llo firm viII ovo ils ompIoyoos $1.8 miIIion in vagos for sorvicos lloy
APY = = = 1
1 126 12 6
 
. . °
= 1 1  
700.3 Workihg-CapiIal MahagemehI 29
CAßM ModuIe 700 Fihahce
The SKC Corporalion plans lo borrow S!,000 lor a 90-day period. Al malurily lhe lirm will repay lhe S!,000 principal
amounl plus S30 inleresl. The elleclive annual rale ol inleresl lor lhe loan can be eslimaled using lhe A|| equalion, as
The elleclive annual cosl ol lunds provided by lhe loan is, lherelore, !2 percenl.
A|| =
= = =
90 360
!2 !2
, /
. .

lavo aIroady porformod during llo monll. ConsoquonlIy, llo ompIoyoos financo lloir
ovn offorls llrougl vailing a fuII monll for paymonl.
SimiIarIy, firms gonoraIIy maIo quarlorIy incomo lax paymonls for lloir oslimalod
quarlorIy lax IiabiIily. Tlis moans llal llo firm las llo uso of llo lax monoys il ovos
basod on quarlorIy profils llrougl llo ond of llo quarlor. In addilion, llo firm pays
saIos laxos and villloIding (incomo) laxos for ils ompIoyoos on a doforrod basis. Tlo
Iongor llo poriod llal llo firm loIds llo lax paymonls, llo groalor llo amounl of
financing lloy provido.
Nolo llal lloso sourcos of financing risc cn! |c|| spcnicnccus|u vill llo IovoI of firm
saIos. Tlal is, as llo firm's saIos incroaso, so do ils Iabor oxponsos, saIos laxos coIIoclod,
and incomo lax. ConsoquonlIy, lloso accruod oxponso iloms provido llo firm vill
aulomalic or sponlanoous sourcos of financing.
Unsecured Sources: Trade Credit
Trado crodil providos ono of llo mosl fIoxibIo sourcos of slorl-lorm financing avaiIabIo
lo llo firm. Wo proviousIy nolod llal lrado crodil is a primary sourco of sponlanoous,
or on-domand financing. Tlal is, lrado crodil arisos sponlanoousIy vill llo firm's pur-
clasos. To arrango for crodil, llo firm nood onIy pIaco an ordor vill ono of ils suppIi-
ors. Tlo suppIior clocIs llo firm's crodil and, if il is good, sonds llo morclandiso. Tlo
purclasing firm llon pays for llo goods in accordanco vill llo suppIior's crodil lorms.
Credit Terms and Cash Discounts
Vory oflon llo crodil lorms offorod vill lrado crodil invoIvo a casl discounl for oarIy
paymonl. Ior oxampIo, a suppIior migll offor lorms of 2/10, nol 30, vlicl moans llal
a 2 porconl discounl is offorod for paymonl villin 10 days or llo fuII amounl is duo in
30 days. Tlus, a 2 porconl ponaIly is invoIvod for nol paying villin 10 days, or for
doIaying paymonl from llo lonll lo llo llirlioll day (i.o., for 20 days). Tlo offoclivo
annuaI cosl of nol laIing llo casl discounl can bo quilo sovoro. Using a $1 invoico
amounl, llo offoclivo cosl of passing up llo discounl poriod using llo procoding crodil
lorms and our APR oqualion can bo oslimalod.
Nolo llal llo 2 porconl casl discounl is llo inicrcsi cosl of oxlonding llo paymonl
poriod an c!!iiicnc| 20 days. Nolo aIso llal llo principaI amounl of llo crodil is $0.98.
Tlis amounl conslilulos llo fuII principaI amounl as of llo lonll day of llo crodil
poriod, aflor vlicl limo llo casl discounl is Iosl. Tlo offoclivo cosl of passing up
llo 2 porconl discounl for 20 days is quilo oxponsivo: 36.73 porconl. Iurllormoro, onco
llo discounl poriod las passod, lloro is no roason lo pay boforo llo finaI duo dalo (llo
llirlioll day). TabIe 3.2 Iisls llo offoclivo annuaI cosl of a numbor of aIlornalivo crodil
lorms. Nolo llal llo cosl of lrado crodil varios diroclIy vill llo sizo of llo casl dis-
counl and invorsoIy vill llo Iongll of limo bolvoon llo ond of llo discounl poriod
and llo finaI duo dalo.
APR = = =
. /
. .
20 360
3673 36 73 
700.3 Workihg-CapiIal MahagemehI 30
CAßM ModuIe 700 Fihahce
TabIe 3.2 L!!ecIive RaIes o! IhIeresI oh SelecIed 1rade CrediI 1erms
Credit Terms E!!ective ßates
2/10, heI 60 14.69%
2/10, heI 90 9.18%
3/20, heI 60 27.84%
6/10, heI 90 28.72%
5tretching o! Trade Credit
Somo firms llal uso lrado crodil ongago in a praclico caIIod sircic|inv c| irc!c ccccunis.
Tlis praclico invoIvos doIaying paymonls boyond llo proscribod crodil poriod. Ior
oxampIo, a firm migll purclaso maloriaIs undor crodil lorms of 3/10, nol 60, lovovor,
vlon facod vill a slorlago of casl, llo firm migll oxlond paymonl lo llo oigllioll
day. Conlinuod vioIalion of lrado lorms can ovonluaIIy Ioad lo a Ioss of crodil. Hov-
ovor, for slorl poriods, and al infroquonl inlorvaIs, slrolcling offors llo firm an omor-
goncy sourco of slorl-lorm crodil.
Advantages o! Trade Credit
As a sourco of slorl-lorm financing, lrado crodil las a numbor of advanlagos. Iirsl,
lrado crodil is convonionlIy oblainod as a normaI parl of llo firm's oporalions. Socond,
no formaI agroomonls aro gonoraIIy invoIvod in oxlonding crodil. Iurllormoro, llo
amounl of crodil oxlondod oxpands and conlracls vill llo noods of llo firm, llis is
vly il is cIassifiod as a sponlanoous, or on-domand, sourco of financing.
Unsecured Sources: 8ank Credit
CommorciaI banIs provido unsocurod slorl-lorm crodil in lvo basic forms: Iinos of
crodil and lransaclion Ioans (nolos payabIo). Malurilios of boll lypos of Ioans aro usu-
aIIy 1 yoar or Ioss, vill ralos of inlorosl doponding on llo crodilvorllinoss of llo bor-
rovor and llo IovoI of inlorosl ralos in llo oconomy as a vloIo.
Line o! Credit
A Iine nI credit is vcncrc||u cn in|crmc| cvrccmcni cr un!crsicn!inv |ciuccn i|c |crrcucr
cn! i|c |cn| c|cui i|c mcximum cmcuni c| crc!ii i|ci i|c |cn| ui|| prcti!c i|c |crrcucr ci
cnu cnc iimc. Undor llis lypo of agroomonl lloro is nc |cvc| ccmmiimcni cn i|c pcri c| i|c
|cn| ic prcti!c i|c sicic! crc!ii. In a revnIving credit agreement, vlicl is a varianl of
llis form of financing, a |cvc| c||ivciicn is intc|tc!. Tlo Iino of crodil agroomonl gonor-
aIIy covors a poriod of 1 yoar corrosponding lo llo borrovor's |iscc| yoar. Tlus, if llo
borrovor is on a IuIy 31 fiscaI yoar, ils Iinos of crodil aro basod on llo samo annuaI
Credit Terms. Iinos of crodil gonoraIIy do nol invoIvo fixod ralos of inlorosl, insload
lloy slalo llal crodil viII bo oxlondod al pcrccni ctcr primc or somo ollor sproad
ovor llo banI's primo ralo. Iurllormoro, llo agroomonl usuaIIy doos nol spoII oul llo
spocific uso llal viII bo mado of llo funds boyond a gonoraI slalomonl, sucl as |cr
ucr|inv-ccpiic| purpcscs.
Iinos of crodil usuaIIy roquiro llal llo borrovor mainlain a minimum |c|cncc in i|c
|cn| i|rcuv|cui i|c |ccn pcric!, caIIod a cnmµensating baIance. Tlis roquirod baIanco
(vlicl can bo slalod as a porconlago of llo Iino of crodil or llo Ioan amounl) incroasos
llo offoclivo cosl of llo Ioan lo llo borrovor, unIoss a doposil baIanco oquaI lo or
groalor llan llis baIanco roquiromonl is ordinariIy mainlainod in llo banI.
Tlo offoclivo cosl of slorl-lorm banI crodil can bo oslimalod using llo APR oqua-
lion. Considor llo foIIoving oxampIo.
700.3 Workihg-CapiIal MahagemehI 31
CAßM ModuIe 700 Fihahce
Transaction Loans
SliII anollor form of unsocurod slorl-lorm banI crodil can bo oblainod in llo form
of transactinn Inans. Horo llo Ioan is mc!c |cr c spcci|ic purpcsc. Tlis is llo lypo of
Ioan llal mosl individuaIs associalo vill banI crodil and is oblainod by signing a
promissory nolo.
Unsocurod lransaclion Ioans aro vory simiIar lo a Iino of crodil rogarding cosl,
lorm lo malurily, and componsaling-baIanco roquiromonls. In boll inslancos commor-
ciaI banIs oflon roquiro llal llo borrovor c|ccn up ils slorl-lorm Ioans for a 30- lo
45-day poriod during llo yoar. Tlis moans, vory simpIy, llal llo borrovor musl bo
froo of any banI dobl for llo slalod poriod. Tlo purposo of sucl a roquiromonl is lo
onsuro llal llo borrovor is nol using slorl-lorm banI crodil lo financo a parl of ils por-
manonl noods for funds.
Unsecured Sources: Commercial Paper
OnIy llo Iargosl and mosl crodilvorlly companios aro abIo lo uso cnmmerciaI µaµer,
vlicl is simpIy a s|cri-icrm prcmisc ic pcu i|ci is sc|! in i|c mcr|ci |cr s|cri-icrm !c|i
Credit Terms
Tlo malurily of llo crodil sourco is gonoraIIy 6 monlls or Ioss, aIllougl somo issuos carry
270-day malurilios. Tlo inlorosl ralo on commorciaI papor is gonoraIIy sIigllIy Iovor ( lo
700.3 Workihg-CapiIal MahagemehI 32
CAßM ModuIe 700 Fihahce
M&M 8everage Company has a S300,000 line ol credil lhal requires a compensaling balance equal lo 20 percenl ol lhe
loan amounl. The rale paid on lhe loan is !0 percenl per annum, S200,000 is borrowed lor a 6-monlh period, and lhe lirm
does nol currenlly have a deposil wilh lhe lending bank. The dollar cosl ol lhe loan includes lhe inleresl expense and lhe
opporlunily cosl ol mainlaining an idle cash balance equal lo lhe 20 percenl compensaling balance. To accommodale lhe
cosl ol lhe compensaling-balance requiremenl, assume lhal lhe added lunds will have lo be borrowed and simply lell idle
in lhe lirm's checking accounls. Thus, lhe amounl aclually borrowed (b) will be larger lhan lhe S200,000 needed. ln lacl,
lhe needed S200,000 will conslilule 80 percenl ol lhe lolal borrowed lunds because ol lhe 20 percenl compensaling-
balance requiremenl, hence, .808 S200,000, such lhal b S250,000. Thus, inleresl is paid on a S250,000 loan
(S250,000 .!0 S!2,500.00), ol which only S200,000 is available lor use by lhe lirm. The elleclive annual cosl ol
credil, lherelore, is
ln lhe M&M 8everage Company example, lhe loan required lhe paymenl ol principal (S250,000) plus inleresl (S!2,500.00)
al lhe end ol lhe 6-monlh loan period. lrequenlly, bank loans will be made on a discounl basis. Thal is, lhe loan inleresl
will be deducled lrom lhe loan amounl belore lhe lunds are lranslerred lo lhe borrower. Lxlending lhe M&M 8everage
Company example lo consider discounled inleresl involves reducing lhe loan proceeds (S200,000) in lhe previous example
by lhe amounl ol inleresl lor lhe lull 6 monlhs (S!2,500.00). The elleclive rale ol inleresl on lhe loan is now
The ellecl ol discounling inleresl was lo raise lhe cosl ol lhe loan lrom !2.5 percenl lo !3.33 percenl. This resulls lrom lhe
lacl lhal lhe lirm pays inleresl on lhe same amounl ol lunds as belore (S250,000), however, lhis lime il gels lhe use ol
S!2,500.00 less, or S200,000 S!2,500.00 S!87,500.00.
A|| =
!2500 00
200 000 !2500 00
!80 360
, .
, , . / 

.. . !333 !3 33 = '
A|| = = =
!2500 00
200 000
!80 360
!25 !2 5
, .
, /
. . 
1 porconl) llan llo primo ralo on commorciaI banI Ioans. AIso, inlorosl is usuaIIy dis-
counlod, aIllougl somolimos inlorosl-boaring commorciaI papor is avaiIabIo.
Nov issuos of commorciaI papor aro oillor pIacod diroclIy (soId by llo issuing
firm diroclIy lo llo invosling pubIic) or doaIor pIacod. DoaIor pIacomonl invoIvos llo
uso of a commorciaI papor doaIor, vlo soIIs llo issuo for llo issuing firm. Many major
financo companios, sucl as GonoraI Molors Accoplanco Corporalion, pIaco lloir com-
morciaI papor diroclIy. Tlo voIumo of dirocl vorsus doaIor pIacomonls is rouglIy 4 lo 1
in favor of dirocl pIacomonls. DoaIors aro usod primariIy by induslriaI firms llal oillor
maIo onIy infroquonl uso of llo commorciaI papor marIol or, oving lo lloir smaII
sizo, vouId lavo difficuIly pIacing llo issuo villoul llo loIp of a doaIor.
CommerciaI Paper as a 5ource o! 5hort-Term Credit
SovoraI advanlagos accruo lo llo usor of commorciaI papor.
1. Interest rate. CommorciaI papor ralos aro gonoraIIy Iovor llan ralos on banI
Ioans and comparabIo sourcos of slorl-lorm financing.
2. Cnmµensating-baIance requirement. No minimum baIanco roquiromonls aro
associalod vill commorciaI papor. Hovovor, issuing firms usuaIIy find il
dosirabIo lo mainlain Iino-of-crodil agroomonls sufficionl lo bacI up lloir
slorl-lorm financing noods in llo ovonl llal a nov issuo of commorciaI papor
cannol bo soId or an oulslanding issuo cannol bo ropaid vlon duo.
3. Amnunt nI credit. CommorciaI papor offors llo firm vill vory Iargo crodil
noods a singIo sourco for aII ils slorl-lorm financing. Bocauso of Ioan
roslriclions pIacod on llo banIs by llo roguIalory aullorilios, oblaining llo
nocossary funds from a commorciaI banI migll roquiro doaIing vill a numbor
of inslilulions.
4. Prestige. Bocauso il is vidoIy rocognizod llal onIy llo mosl crodilvorlly
borrovors lavo accoss lo llo commorciaI papor marIol, ils uso signifios a
firm's crodil slalus.
Using commorciaI papor for slorl-lorm financing, lovovor, invoIvos a vory imporlanl
risI. Tlo commorciaI papor marIol is liglIy imporsonaI and donios ovon llo mosl crodil-
vorlly borrovor any fIoxibiIily in lorms of ropaymonl. Wlon banI crodil is usod, llo bor-
rovor las somoono vill vlom lo or slo can vorI oul any lomporary difficuIlios llal
migll bo oncounlorod in mooling a Ioan doadIino. Tlis fIoxibiIily simpIy doos nol oxisl for
llo usor of commorciaI papor.
Estimation o! the Cost o! CommerciaI Paper
Tlo cosl of commorciaI papor can bo oslimalod using llo simpIo, offoclivo cosl-of-
crodil oqualion (APR). Tlo Ioy poinls lo romombor aro llal commorciaI papor inlorosl
is usuaIIy discounlod and llal if a doaIor is usod lo pIaco llo issuo, a foo is clargod.
Ivon if a doaIor is nol usod, llo issuing firm viII incur cosls associalod vill proparing
and pIacing llo issuo, and lloso cosls musl bo incIudod in oslimaling llo cosl of crodil.
Secured Sources: Accounts-Receivable Loans
Socurod sourcos of slorl-lorm crodil lavo corlain assols of llo firm pIodgod as coIIal-
oraI lo socuro llo Ioan. Upon dofauIl of llo Ioan agroomonl, llo Iondor las firsl cIaim
lo llo pIodgod assols in addilion lo ils cIaim as a gonoraI crodilor of llo firm. Honco,
llo socurod crodil agroomonl offors an addod margin of safoly lo llo Iondor.
GonoraIIy, a firm's rocoivabIos aro among ils mosl Iiquid assols. Ior llis roason
lloy aro considorod by many Iondors lo bo primo coIIaloraI for a socurod Ioan. Tvo
basic procoduros can bo usod in arranging for financing basod on rocoivabIos: pIodging
and facloring.
700.3 Workihg-CapiIal MahagemehI 33
CAßM ModuIe 700 Fihahce
PIedging Accounts ßeceivabIe
Undor llo µIedging accnunts receivabIe arrangomonl, llo |crrcucr simp|u p|c!vcs
ccccunis rcccitc||c cs cc||cicrc| |cr c |ccn c|icinc! |rcm cii|cr c ccmmcrcic| |cn| cr c |incncc
ccmpcnu. Tlo amounl of llo Ioan is slalod as a porconlago of llo faco vaIuo of llo
rocoivabIos pIodgod. If llo firm providos llo Iondor vill a vcncrc| |inc on ils rocoiv-
abIos, llon aII of llo borrovor's accounls aro pIodgod as socurily for llo Ioan. Tlis
mollod of pIodging is simpIo and inoxponsivo. Hovovor, bocauso llo Iondor las no
conlroI ovor llo quaIily of llo rocoivabIos boing pIodgod, il viII sol llo maximum Ioan
al a roIalivoIy Iov porconlago of llo lolaI faco vaIuo of llo accounls, gonoraIIy ranging
dovnvard from a maximum of around 75 porconl.
SliII anollor approacl lo pIodging invoIvos llo borrovor's prosonling spocific
invoicos lo llo Iondor as coIIaloraI for a Ioan. Tlis mollod is somovlal moro oxpon-
sivo bocauso llo Iondor musl assoss llo crodilvorllinoss of oacl individuaI accounl
pIodgod, lovovor, givon llis addod InovIodgo llo Iondor slouId bo viIIing lo
incroaso llo Ioan as a porconlago of llo faco vaIuo of llo invoicos. In llis caso llo Ioan
migll roacl as ligl as 85 or 90 porconl of llo faco vaIuo of llo pIodgod rocoivabIos.
Credit Terms. Accounls rocoivabIo Ioans gonoraIIy carry an inlorosl ralo 2 lo 5 porconl
liglor llan llo banI's primo Ionding ralo. Iinanco companios clargo an ovon liglor
ralo. In addilion, llo Iondor usuaIIy clargos a landIing foo slalod as a porconlago of
llo faco vaIuo of llo rocoivabIos procossod, vlicl may bo as mucl as 1 lo 2 porconl of
llo faco vaIuo.
700.3 Workihg-CapiIal MahagemehI 34
CAßM ModuIe 700 Fihahce
The LPC Manulacluring Company uses commercial paper regularly lo supporl ils needs lor shorl-lerm linancing. The lirm
plans lo sell S!00 million in 270-day-malurily paper, on which il expecls lo pay discounled inleresl al a rale ol !2 percenl
per annum (S9 million). ln addilion, LPC expecls lo incur a cosl ol approximalely S!00,000 in dealer placemenl lees and
olher expenses ol issuing lhe paper. The elleclive cosl ol credil lo LPC can be calculaled as lollows.
where lhe inleresl cosl is calculaled as S!00,000,000 .!2 (270/360) S9,000,000 plus lhe S!00,000 dealer place-
menl lee. Thus, lhe elleclive cosl ol credil lo LPC is !3.35 percenl.
A|| =
9 000 000 !00 000
!00 000 000 !00 00
, , ,
, , ,

 00 9 000 000
270 360
!335 !3 35

, , /
. . = =
Advantages and Disadvantages nI PIedging. Tlo primary advanlago of pIodging as a
sourco of slorl-lorm crodil is llo fIoxibiIily il providos llo borrovor. Iinancing is
avaiIabIo on a conlinuous basis. Tlo nov accounls croalod llrougl crodil saIos provido
llo coIIaloraI for llo financing of nov produclion. Iurllormoro, llo Iondor may pro-
vido crodil sorvicos llal oIiminalo or al Ioasl roduco llo nood for simiIar sorvicos
villin llo firm. Tlo primary disadvanlago associalod vill llis mollod of financing is
ils cosl, vlicl can bo roIalivoIy ligl comparod vill ollor sourcos of slorl-lorm crodil,
oving lo llo IovoI of llo inlorosl ralo clargod on Ioans and llo procossing foo on
pIodgod accounls.
factoring Accounts ßeceivabIe
Factnring accnunts receivabIe invoIvos llo cuiriv|i sc|c c| c |irm´s ccccunis ic c |incncic|
insiiiuiicn cc||c! c |ccicr. A Iactnr is c |irm i|ci cc¡uircs i|c rcccitc||cs c| ci|cr |irms. Tlo
facloring inslilulion may bo a commorciaI financo company llal ongagos soIoIy in llo
facloring of rocoivabIos (Inovn as an c|!-|inc |ccicr) or il may bo a commorciaI banI.
Tlo faclor, in lurn, boars llo risI of coIIoclion and, for a foo, sorvicos llo accounls. Tlo
foo is slalod as a porconlago of llo faco vaIuo of aII rocoivabIos faclorod (usuaIIy 1 lo
3 porconl).
Tlo faclor firm lypicaIIy doos nci maIo paymonl for faclorod accounls unliI llo
accounls lavo boon coIIoclod or llo crodil lorms lavo boon mol. SlouId llo firm visl lo
rocoivo immodialo paymonl for ils faclorod accounls, il can borrov from llo faclor, using
llo faclorod accounls as coIIaloraI. Tlo maximum Ioan llo firm can oblain is oquaI lo llo
faco vaIuo of ils faclorod accounls Ioss llo faclor's foo (1 lo 3 porconl) Ioss a rosorvo (6 lo
10 porconl) Ioss llo inlorosl on llo Ioan. Ior oxampIo, if $100,000 in rocoivabIos is faclorod,
700.3 Workihg-CapiIal MahagemehI 35
CAßM ModuIe 700 Fihahce
The A. 8. Cood Company sells eleclrical supplies lo building conlraclors on lerms ol nel 60. The lirm's average monlhly
sales are S!00,000, lhus, given lhe lirm's 2-monlh credil lerms, ils average receivables balance is S200,000. The lirm
pledges all ils receivables lo a local bank, which in lurn advances up lo 70 percenl ol lhe lace value ol lhe receivables al
3 percenl over prime and wilh a ! percenl processing charge on a|| receivables pledged. A. 8. Cood lollows a praclice ol
borrowing lhe maximum amounl possible, and lhe currenl prime rale is !0 percenl.
The A|| ol using lhis source ol linancing lor a lull year is compuled as lollows.
A|| = = =
!8 200 !2000
!40 000
360 360
, ,
, /

 22! 57 . '
where lhe lolal dollar cosl ol lhe loan consisls ol bolh lhe annual inleresl expense (.!3 .70 S200,000 S!8,200) and
lhe annual processing lee (.0! S!00,000 !2 monlhs S!2,000). The amounl ol credil exlended is .70 S200,000
S!40,000. Nole lhal lhe processing charge applies lo a|| receivables pledged. Thus, lhe A. 8. Cood Company pledges
S!00,000 each monlh, or S!,200,000 during lhe year, on which a ! percenl lee musl be paid, lor a lolal annual charge
ol S!2,000.
One more poinl. The lender, in addilion lo making advances or loans, may be providing cerlain credil services lo lhe bor-
rower. lor example, lhe lender may provide billing and colleclion services. The value ol lhese services should be considered
in compuling lhe cosl ol credil. ln lhe preceding example, A. 8. Cood Company may :ave credil deparlmenl expenses ol
S!0,000 per year by pledging all ils accounls and lelling lhe lender provide lhose services. ln lhis case, lhe cosl ol shorl-
lerm credil is only
A|| =
!8 200 !2000 !0 000
!40 000
360 36
, , ,
, /
 

!443 !4 43 = = S ' . .
carrying 60-day crodil lorms, a 2 porconl faclor's foo, a 6 porconl rosorvo, and inlorosl al
1 porconl por monll on advancos, llon llo maximum Ioan or advanco llo firm can
rocoivo is compulod as foIIovs:
Face amouhI o! receivables !acIored $100,000
Less: Fee (.02 $100,000) (2,000)
Reserve (.06 $100,000) (6,000)
IhIeresI (.01 $92,000 2 mohIhs) (1,840)
Maximum advahce $90,160
Nolo llal inlorosl is discounlod and caIcuIalod basod on a maximum amounl of
funds avaiIabIo for advanco ($92,000 $100,000 $2,000 $6,000). Tlus, llo offoclivo
cosl of crodil can bo caIcuIalod as foIIovs:
Secured Sources: lnventory Loans
Inventnrv Inans, or |ccns sccurc! |u intcnicrics, provido a socond sourco of socurily for
slorl-lorm crodil. Tlo amounl of llo Ioan llal can bo oblainod doponds on boll llo
marIolabiIily and porislabiIily of llo invonlory. Somo iloms, sucl as rav maloriaIs
(grains, oiI, Iumbor, and clomicaIs), aro oxcoIIonl sourcos of coIIaloraI, bocauso lloy
can oasiIy bo Iiquidalod. Ollor iloms, sucl as vorI-in-procoss invonlorios, provido
vory poor coIIaloraI bocauso of lloir IacI of marIolabiIily.
Tloro aro sovoraI mollods by vlicl invonlory can bo usod lo socuro slorl-lorm
financing. Tloso incIudo a fIoaling or bIanIol Iion, clalloI morlgago, fioId varolouso
rocoipl, and lorminaI varolouso rocoipl.
Undor a IInating Iien agreement, i|c |crrcucr vitcs i|c |cn!cr c |icn cvcinsi c|| iis
intcnicrics. Tlis providos llo simpIosl bul Ioasl socuro form of invonlory coIIaloraI. Tlo
borroving firm mainlains fuII conlroI of llo invonlorios and conlinuos lo soII and
ropIaco llom as il soos fil. ObviousIy, llis IacI of conlroI ovor llo coIIaloraI groalIy
diIulos llo vaIuo of llis lypo of socurily lo llo Iondor.
Undor a chatteI mnrtgage agreement, i|c intcnicru is i!cnii|ic! (by soriaI numbor or
ollorviso) in i|c sccuriiu cvrccmcni cn! i|c |crrcucr rcicins iii|c ic i|c intcnicru |ui ccn-
nci sc|| i|c iicms uii|cui i|c |cn!cr´s ccnscni.
Undor a IieId warehnuse÷Iinancing agreement, intcnicrics usc! cs cc||cicrc| crc
p|usicc||u scpcrcic! |rcm i|c |irm´s ci|cr intcnicrics cn! crc p|ccc! un!cr i|c ccnirc| c| c
i|ir!-pcriu |ic|!-ucrc|cusinv |irm.
Tlo terminaI warehnuse agreement diffors from llo fioId varolouso agroomonl in
onIy ono rospocl. Horo i|c intcnicrics p|c!vc! cs cc||cicrc| crc ircnspcric! ic c pu||ic ucrc-
|cusc i|ci is p|usicc||u rcmctc! |rcm i|c |crrcucr´s prcmiscs. Tlo Iondor las an addod
dogroo of safoly or socurily bocauso llo invonlory is lolaIIy romovod from llo bor-
rovor's conlroI. Onco again llo cosl of llis lypo of arrangomonl is incroasod bocauso
llo varolouso firm musl bo paid by llo borrovor, in addilion, llo invonlory musl bo
lransporlod lo and, ovonluaIIy, from llo pubIic varolouso.
= =
$ $
1 840 2 000
90 160
60 360
2555 25 5
, ,
, /
. .

700.3 Workihg-CapiIal MahagemehI 36
CAßM ModuIe 700 Fihahce
700.4 CompohehIs o! ShorI-1erm AsseIs 37
700.4.1 Undorsland vly a company loIds casl
700.4.2 IxpIain llo various objoclivos and docisions in casl managomonl
700.4.3 Ioarn lov lo manago casl coIIoclion and disbursomonl procoduros
and ovaIualo llo oxpoclod cosls and bonofils of casl managomonl sorvicos
700.4.4 Dolormino a prudonl composilion of marIolabIo-socurilios porlfoIio
700.4.5 Ioarn lov lo manago accounls rocoivabIo amounls, incIuding crodil poIicy
700.4.6 Ioarn lov lo manago invonlory amounls and IovoIs
700.4 Components of
5hort-Ierm Assets
700.4.1 Understand vhy a company hoIds cash
A llorougl undorslanding of vly and lov a firm loIds casl roquiros an accuralo
concoplion of lov casl fIovs inlo and llrougl llo onlorpriso. Figure 4.1 dopicls llo
procoss of casl gonoralion and disposilion in a lypicaI manufacluring solling. Tlo
arrovs dosignalo llo diroclion of llo fIov÷llal is, vlollor llo casl baIanco incroasos
or docroasos.
Cash Ilow Process
Tlo irroguIar incroasos in llo firm's casl loIdings can como from sovoraI oxlornaI
sourcos. Iunds can bo oblainod in llo financiaI marIols from llo saIo of socurilios
sucl as bonds, proforrod slocI, and common slocI, or llo firm can onlor inlo non-
marIolabIo-dobl conlracls vill Iondors sucl as commorciaI banIs. Tloso irroguIar
casl infIovs do nol occur on a daiIy basis. Tlo roason is llal oxlornaI financing con-
lracls or arrangomonls usuaIIy invoIvo lugo sums of monoy slomming from a major
nood idonlifiod by llo company's managomonl, and lloso noods do nol occur ovory
day. Ior oxampIo, a nov producl migll bo in llo Iauncling procoss, or a pIanl
oxpansion migll bo roquirod lo provido addod produclivo capacily.
In mosl organizalions llo financiaI officor rosponsibIo for casl managomonl aIso
conlroIs llo lransaclions llal affocl llo firm's invoslmonl in marIolabIo socurilios. As
oxcoss casl bocomos lomporariIy avaiIabIo, marIolabIo socurilios aro purclasod. Wlon
casl is in slorl suppIy, a porlion of llo marIolabIo-socurilios porlfoIio is Iiquidalod.
Wloroas llo irroguIar casl infIovs aro from oxlornaI sourcos, llo ollor main
sourcos of casl ariso from inlornaI oporalions and occur on a moro roguIar basis. Ovor
Iong poriods, llo Iargosl rocoipls como from accounls-rocoivabIo coIIoclions and, lo a
Iossor oxlonl, from dirocl casl saIos of finislod goods. Many manufacluring concorns
aIso gonoralo casl on a roguIar basis llrougl llo Iiquidalion of scrap or obsoIolo
invonlory. Al various limos fixod assols may aIso bo soId, lloroby gonoraling somo
casl infIov.
Aparl from llo invoslmonl of oxcoss casl in noar-casl assols, llo casl baIanco
oxporioncos roduclions for llroo Ioy roasons. Iirsl, on an irroguIar basis, vill-
dravaIs aro mado lo (1) pay casl dividonds on proforrod and common slocI slaros,
(2) mool inlorosl roquiromonls on dobl conlracls, (3) ropay llo principaI borrovod
from crodilors, (4) buy llo firm's ovn slaros in llo financiaI marIols for uso in oxoc-
ulivo componsalion pIans or as an aIlornalivo lo paying a casl dividond, and (5) pay
700.4 CompohehIs o! ShorI-1erm AsseIs 38
CAßM ModuIe 700 Fihahce
IrreguIar cash out!Iovs
IrreguIar cash in!Iovs
Boud sales
0lher debl coulracls
Preíerred slock sales
Couuou slock sales
0eprecialiou Credil sales
Cash sales Colleclious Sale
Labor aud ualerial
Priucipal ou debl
Share repurchases
|ixed assels |uveulory Receivables
figure 4.1 1he Cash GeheraIioh ahd DisposiIioh Process
lax biIIs. Again, by an irrcvu|cr |csis vo moan iloms nci occurring on a daiIy or fro-
quonl scloduIo. Socond, llo company's capilaI oxpondiluro program dosignalos llal
fixod assols bo acquirod al various inlorvaIs. Tlird, invonlorios aro purclasod on a
roguIar basis lo onsuro a sloady fIov of finislod goods off llo produclion Iino. Nolo
llal llo arrov IinIing llo invoslmonl in fixod assols vill llo invonlory accounl is
IaboIod !cprcciciicn. Tlis indicalos llal a porlion of llo cosl of fixod assols is clargod
againsl llo producls coming off llo assombIy Iino. Tlis cosl is subsoquonlIy rocov-
orod llrougl llo saIo of llo finislod-goods invonlory. Tlis is bocauso llo producl's
soIIing prico viII bo sol by managomonl lo covor aII llo cosls of produclion, incIud-
ing doprocialion.
Motives for Holding Cash
Tlo infIuoncos llal affocl llo firm's casl baIanco can bo cIassifiod in lorms of llo llroo
molivos pul forll by Ioln Maynard Koynos: (1) llo lransaclions molivo, (2) llo procau-
lionary molivo, and (3) llo spocuIalivo molivo.
Transactions Motive
BaIancos loId for lransaclion purposos aIIov llo firm lo mool casl noods llal ariso in
llo ordinary courso of doing businoss. In Iiguro 4.1, lransaclion baIancos vouId bo
usod lo mool llo irroguIar oulfIovs as voII as llo pIannod acquisilion of fixod assols
and invonlorios.
Tlo roIalivo amounl of casl noodod lo salisfy lransaclion roquiromonls is affoclod
by a numbor of faclors, incIuding llo induslry in vlicl llo firm oporalos. Il is voII
Inovn llal uliIilios can forocasl casl rocoipls quilo accuraloIy, bocauso of slabIo
domand for lloir sorvicos. Compulor soflvaro firms, lovovor, lavo a moro difficuIl
limo prodicling lloir casl fIovs. Nov producls aro brougll lo marIol al a rapid paco,
lloroby maIing il difficuIl lo projocl casl fIovs and baIancos procisoIy.
Precautionary Motive
Irocaulionary baIancos aro a buffor slocI of Iiquid assols. Tlis molivo for loIding casl
roIalos lo llo mainlonanco of baIancos lo bo usod lo salisfy possibIo, bul as yol
unInovn, noods.
Casl fIov prodiclabiIily aIso las a maloriaI infIuonco on llo firm's domand for
casl llrougl llis procaulionary molivo. Tlo airIino induslry providos a lypicaI iIIus-
lralion. Air passongor carriors aro pIaguod vill a ligl dogroo of casl fIov uncor-
lainly. Tlo voallor, rising fuoI cosls, and conlinuaI slriIos by oporaling porsonnoI
maIo casl forocasling difficuIl for any airIino. Tlo upslol of llis probIom is llal
bocauso of aII llo llings llal miv|i lappon, llo minimum casl baIancos dosirod by llo
managomonl of llo air carriors lond lo bo Iargo.
In acluaI businoss praclico, llo procaulionary molivo is mol lo a Iargo oxlonl by llo
loIding of a porlfoIio of |i¡ui! csscis, nol jusl casl. Nolico in Iiguro 4.1 llo lvo-vay
fIov of funds bolvoon llo company's loIdings of casl and marIolabIo socurilios. In
Iargo corporalo organizalions, funds may fIov oillor inlo or oul of llo marIolabIo-
socurilios porlfoIio on a daiIy basis.
5pecuIative Motive
Casl is loId for spocuIalivo purposos in ordor lo laIo advanlago of polonliaI profil-
maIing silualions. Conslruclion firms llal buiId privalo dvoIIings viII al limos accu-
muIalo casl in anlicipalion of a significanl drop in Iumbor cosls. If llo prico of buiId-
ing suppIios doos drop, llo companios llal buiIl up lloir casl baIancos sland lo profil
by purclasing maloriaIs in Iargo quanlilios. Tlis viII roduco lloir cosl of goods soId
and incroaso lloir nol profil margin. GonoraIIy, llo spocuIalivo molivo is llo Ioasl
imporlanl compononl of a firm's proforonco for Iiquidily. Tlo lransaclions and procau-
lionary molivos accounl for mosl of llo roasons vly a company loIds casl baIancos.
700.4 CompohehIs o! ShorI-1erm AsseIs 39
CAßM ModuIe 700 Fihahce
700.4.2 ExpIain the various objectives and decisions
in cash management
Risk-Return Trade-Off
A company vido casl managomonl program musl bo concornod vill minimizing llo
firm's risI of insoIvoncy. In llo conloxl of casl managomonl, llo lorm insnIvencv
doscribos llo siiuciicn in u|ic| i|c |irm is unc||c ic mcci iis mciurinv |ic|i|iiics cn iimc. In
sucl a caso llo company is icc|nicc||u insc|tcni in llal il IacIs llo nocossary Iiquidily lo
maIo prompl paymonl on ils curronl dobl obIigalions. A firm couId avoid llis prob-
Iom by carrying Iargo casl baIancos lo pay llo biIIs llal como duo.
Tlo financiaI managor musl slriIo an accoplabIo baIanco bolvoon loIding loo
mucl casl and loo IillIo casl. Tlis is llo focaI poinl of llo risI÷rolurn lrado-off. A
Iargo casl invoslmonl minimizos llo clancos of insoIvoncy, bul il ponaIizos company
profilabiIily. A smaII casl invoslmonl froos oxcoss baIancos for invoslmonl in boll
marIolabIo socurilios and Iongor-Iivod assols, llis onlancos company profilabiIily and
llo vaIuo of llo firm's common slaros, bul il incroasos llo clancos of running oul of
The dilemma laced by lhe linancial manager is a clear applicalion ol PrincipIe 1.
The ßisk-ßeturn Trade-O!!-We Won't Take On AdditionaI ßisk UnIess We Expect
to ße Compensated vith AdditionaI ßeturn. To accepl lhe risk ol nol having sullicienl
cash on hand, lhe lirm musl be compensaled wilh a relurn on lhe cash lhal is invesled.
Moreover, lhe grealer lhe risk ol lhe inveslmenl in which lhe cash is placed,
lhe grealer lhe relurn lhe lirm demands.
Tlo risI÷rolurn lrado-off can bo roducod lo lvo primo objoclivos for llo firm's casl
managomonl syslom.
1. Inougl casl musl bo on land lo mool llo disbursaI noods llal ariso in llo
courso of doing businoss.
2. Invoslmonl in idIo casl baIancos musl bo roducod lo a minimum.
IvaIualion of lloso oporalionaI objoclivos, and a conscious allompl on llo parl of
managomonl lo mool llom, givos riso lo llo nood for somo lypicaI casl managomonl
Tvo condilions or idoaIs vouId aIIov llo firm lo oporalo for oxlondod poriods vill casl
baIancos noar or al zoro: (1) a compIoloIy accuralo forocasl of nol casl fIovs ovor llo
pIanning lorizon and (2) porfocl synclronizalion of casl rocoipls and disbursomonls.
Casl fIov forocasling is llo iniliaI slop in any offoclivo casl managomonl pro-
gram. Givon llal llo firm viII, as a mallor of nocossily, invosl in somo casl baIancos,
corlain lypos of docisions roIalod lo llo sizo of lloso baIancos dominalo llo casl man-
agomonl procoss. Tloso incIudo docisions llal ansvor llo foIIoving quoslions:
1. Wlal can bo dono lo spood up casl coIIoclions and sIov dovn or bollor
conlroI casl oulfIovs`
2. Wlal slouId bo llo composilion of a marIolabIo-socurilios porlfoIio`
700.4 CompohehIs o! ShorI-1erm AsseIs 40
CAßM ModuIe 700 Fihahce
700.4.3 Learn hov to manage cash coIIection and
disbursement procedures and evaIuate the expected
costs and bene!its o! cash management services
Tlo officioncy of llo firm's casl managomonl program can bo onlancod by InovIodgo
and uso of various procoduros aimod al (1) accoIoraling casl rocoipls and (2) improv-
ing llo mollods usod lo disburso casl. Wo viII soo llal groalor opporlunily for corpo-
ralo profil improvomonls Iios vill llo casl rocoipls sido of llo funds fIov procoss,
aIllougl il vouId bo unviso lo ignoro opporlunilios for favorabIy affocling casl dis-
bursomonl praclicos.
Managing the Cash lnflow
Tlo roduclion of fIoal Iios al llo conlor of llo many approaclos ompIoyod lo spood up
casl rocoipls. FInat (or lolaI fIoal), vlicl is i|c |cnvi| c| iimc |rcm u|cn c c|cc| is uriiicn
unii| i|c cciuc| rccipicni ccn !rcu upcn cr usc i|c ´vcc! |un!s,¨ las llo foIIoving four
1. MaiI IInat is causod by llo limo Iapso from llo momonl a cuslomor maiIs a
romillanco clocI unliI llo firm bogins lo procoss il.
2. Prncessing IInat is causod by llo limo roquirod for llo firm lo procoss
romillanco clocIs boforo lloy can bo doposilod in llo banI.
3. Transit IInat is causod by llo limo nocossary for a doposilod clocI lo cIoar
llrougl llo commorciaI banIing syslom and bocomo usabIo funds lo llo
company. Crodil is doforrod for a maximum of lvo businoss days on clocIs
llal aro cIoarod llrougl llo IodoraI Rosorvo Syslom.
4. Disbursing IInat dorivos from llo facl llal funds aro avaiIabIo in llo
company's banI accounl unliI ils paymonl clocI las cIoarod llrougl llo
banIing syslom.
Wo uso llo lorm ||cci lo rofor lo llo lolaI of ils four oIomonls jusl doscribod. IIoal
roduclion can yioId considorabIo bonofils in lorms of usabIo funds roIoasod for com-
pany uso and rolurns producod on sucl frood-up baIancos.
Regulation Alert: "Check 21"
In Oclobor 2003, Irosidonl Busl signod inlo Iav llo ClocI CIoaring for llo 21sl Con-
lury Acl. Tlo Iav looI offocl on Oclobor 28, 2004. Tlis nov Iav is nov commonIy
roforrod lo as ¨ClocI 21.¨ Irior lo llis nov roguIalion, ordinary papor clocIs voro
plysicaIIy lransporlod by Iand carrior or air carrior from llo doposiling Iocalion lo llo
financiaI inslilulion llal vouId ovonluaIIy pay llo clocI dravn againsl llo firm's or
individuaI's banI accounl.
ClocI 21 aIIovs financiaI inslilulions llo oplion of cIoaring a clocI imago insload
of llo originaI clocI. Sucl digilaI subslilulos can llon bo quicIIy procossod villin llo
banIing cIoaring syslom in llo samo vay llal you uso llo Inlornol on your porsonaI
compulor. Tloso digilaI subslilulos aro boing roforrod lo as subslilulo clocIs or imago
ropIacomonl documonls.
Tlo impolus for llis nov Iav is llroofoId: (1) BanI roguIalors, IiIo lloso al llo
IodoraI Rosorvo Syslom, fooI llal ClocI 21 viII accoIoralo clocI coIIoclion al llo uIli-
malo or payoo banI, (2) il is forocasl llal oul-of-pocIol lransporlalion cosls lo llo
banIing syslom viII bo roducod, lloroby incroasing individuaI banI profilabiIily, and
(3) llo ligl dogroo of plysicaI risI oxposuro associalod vill carrior sorvico can bo
700.4 CompohehIs o! ShorI-1erm AsseIs 41
CAßM ModuIe 700 Fihahce
Irom llo viovpoinl of llo firm's casl managomonl syslom, ¨managing llo fIoal¨
viII ovonluaIIy bo diroclIy impaclod. Wlal las boon caIIod ¨disbursing fIoal¨ couId bo
dramalicaIIy roducod lo a fov lours insload of a day or lvo. Bul ClocI 21 doos nol
roquiro banIs lo aIlor lloir ¨loId¨ limo on spocific clocIs or subslilulo clocIs poslod
lo llo firm's accounl villin llo banI. (Tloso aro uIlimaloIy casl infIovs llal bocomo
¨good¨ funds.)
So, aIllougl llo clocI may cIoar villin llo banI cIoaring moclanism (i.o., from
banI lo banI), llo firm may nol lavo llo uso of ¨good¨ funds unliI banIs aro forcod
by a yol lo bo dofinod roguIalory clango lo roduco lloir ¨loId¨ limo on clocIs llal
lavo acluaIIy cIoarod. Tlus, llo offocls of ClocI 21 on ¨lransil fIoal¨ (llo llird lypo of
fIoal monlionod proviousIy) viII occur graduaIIy as prossuro is pul on individuaI
financiaI inslilulions lo roduco loId limos and maIo llo funds avaiIabIo for disburso-
monl by llo rocoiving firm.
Tlo upslol for llo firm and ils casl managomonl syslom is llal llo groalosl prof-
ilabiIily opporlunilios aro sliII associalod vill roducing maiI fIoal and procossing fIoal.
Wo movo on nov lo an oxampIo of moasuring sucl vaIuo.
Lockbox Arrangement
Tlo IocIbox syslom is llo mosl vidoIy usod commorciaI banIing sorvico for oxpodil-
ing casl galloring. BanIs lavo offorod llis sorvico sinco 1946. Sucl a syslom spoods
up llo convorsion of rocoipls inlo usabIo funds by roducing boll maiI and procossing
fIoal. In addilion, il is possibIo lo roduco lransil fIoal if IocIboxos aro Iocalod noar Iod-
oraI Rosorvo BanIs and lloir branclos. Ior Iargo corporalions llal rocoivo clocIs from
aII parls of llo counlry, fIoal roduclions of 2 lo 4 days aro nol unusuaI.
Figure 4.2 iIIuslralos an oIomonlary, bul lypicaI, casl coIIoclion syslom for a lypo-
llolicaI firm. Il aIso slovs llo origin of maiI fIoal, procossing fIoal, and lransil fIoal.
Tlo numbors roprosonl llo slops in llis syslom. Iirsl, llo cuslomor pIacos lis or lor
romillanco clocI in llo U.S. maiI, vlicl is llon doIivorod lo llo firm's loadquarlors.
Tlis causos llo maiI fIoal. On llo clocI's arrivaI al llo firm's loadquarlors (or IocaI
700.4 CompohehIs o! ShorI-1erm AsseIs 42
CAßM ModuIe 700 Fihahce
The posilive operaling-prolil ellecls lhal slem lrom lhe use ol wise cash managemenl lechniques lhal resull in lloal reduc-
lion can be dramalic when large lolal revenues are involved. Suppose lhal we wanl lo eslimale lhe value ol a !-day lloal
reduclion lor Slarbucks Corporalion. Slarbucks' 2004 sales revenues were reporled al S5.294 billion. Lel's assume lhal pru-
denl inveslmenl in money-markel securilies will earn 4 percenl annually. We ask, Whal is lhe eslimaled value ol a !-day
lloal reduclion lo Slarbucks? We can calculale lhis as lollows.
which lor Slarbucks in 2004 was
Thus, ! day's lreed-up balances lor Slarbucks will be S!4,504,!!0. Then we lind lhe annual (belore-lax) value ol lhe lloal
reduclion is
(Sales per day) (assumed yield) S!4,504,!!0 .04 S580,!64
Such prospeclive gains in operaling prolils make il worlhwhile lor lhe lirm and ils lreasury managemenl lunclion lo closely
evaluale lhe cash managemenl services ollered by commercial bankseven when lhe bank lees can also be quile coslly.
S billion
5 924
!4 504 !!0
, , =
Annual revenues
days in year
coIIoclion conlor), gonoraI accounling porsonnoI musl go llrougl llo booIIooping
procoduros noodod lo proparo llom for IocaI doposil. Tlo clocIs aro doposilod. Tlis
causos llo procossing fIoal. Tlo clocIs aro llon forvardod for paymonl llrougl llo
commorciaI banI cIoaring moclanism. Tlo clocIs viII bo clargod againsl llo cus-
lomor's ovn banI accounl. Al llis poinl llo clocIs aro said lo bo ¨paid¨ and bocomo
¨good¨ funds avaiIabIo for uso by llo company llal rocoivod llom. Tlis banI cIoaring
procoduro roprosonls lransil fIoal and, as vo said oarIior, can amounl lo a doIay of up
lo 2 businoss days.
Tlo IocIbox arrangomonl in Figure 4.3 is basod on a simpIo procoduro. Tlo firm's
cuslomors aro inslruclod lo maiI lloir romillanco clocIs nol lo company loadquarlors
or rogionaI officos, bul lo a numborod posl offico box. Tlo banI llal is providing llo
IocIbox sorvico is aullorizod lo opon llo box, coIIocl llo maiI, procoss llo clocIs, and
doposil llo clocIs diroclIy inlo llo company's accounl.
TypicaIIy a Iargo banI viII coIIocl paymonls from llo IocIbox al 1- lo 2-lour inlor-
vaIs, 365 days of llo yoar. During poaI businoss lours, llo banI may picI up maiI
ovory 30 minulos.
700.4 CompohehIs o! ShorI-1erm AsseIs 43
CAßM ModuIe 700 Fihahce
Checks are placed iu
lhe uail.
Mail is
|uuds are uow available
iu lhe íiru's bauk accouul.
Checks are íorwarded.
Checks are
(Mail íloalì
(Jrausil íloalì
(Processiug íloalì
4 S
Checks are processed
aud deposiled iu
local bauk.
figure 4.2 Ordihary Cash CollecIioh SysIem
Checks are placed iu
lhe uail.
1 2
|uuds are uow
available iu lhe íiru's
bauk accouul.
Local bauk opeus lhe
lock box aud processes
checks íor deposil.
Checks are íorwarded by lhe
íiru's bauk íor payueul
by lhe cuslouer's bauk.
Checks are paid.
6 S
Lock box
|uíorualiou reporl
figure 4.3 Simple Lockbox SysIem
Onco llo maiI is rocoivod al llo banI, llo clocIs aro oxaminod, lolaIod, plolocopiod,
and microfiImod. A doposil form is llon proparod by llo banI, and oacl balcl of
procossod clocIs is forvardod lo llo coIIoclion doparlmonl for cIoaranco. Iunds
doposilod in llis mannor aro usuaIIy avaiIabIo for company uso in 1 businoss day or Ioss.
Tlo banI can nolify llo firm via somo lypo of loIocommunicalions syslom llo
samo day doposils aro mado aboul lloir amounl. Al llo concIusion of oacl day, aII
clocI plolocopios, invoicos, doposil sIips, and any ollor documonls incIudod vill llo
romillancos aro maiIod lo llo firm.
Nolo llal llo firm llal rocoivos clocIs from aII ovor llo counlry viII lavo lo uso
sovoraI IocIboxos lo laIo fuII advanlago of a roduclion in maiI fIoal. Tlo firm's major
banI slouId bo abIo lo offor as a sorvico a dolaiIod IocIbox sludy, anaIyzing llo com-
pany's rocoipl pallorns lo dolormino llo propor numbor and Iocalion of IocI-box
rocoiving poinls.
Tlo lvo sysloms doscribod by Iiguros 4.2 and 4.3 aro summarizod in TabIe 4.1.
Tloro, llo slop numbors rofor lo lloso slovn in Iiguro 4.2 (llo ordinary syslom). Iur-
llormoro, TabIo 4.1 assumos llal llo cuslomor and llo firm's loadquarlors or ils coI-
Ioclion conlor aro Iocalod in difforonl cilios. Tlis causos llo Iag of 2 vorIing days
boforo llo firm acluaIIy rocoivos llo romillanco clocI. Wo nolico al llo bollom of
TabIo 4.1 llal llo inslaIIalion of llo IocIbox syslom can rosuIl in funds boing crodilod
lo llo firm's banI accounl a fuII 4 vorIing days |csicr llan is possibIo undor llo ordi-
nary coIIoclion syslom.
IroviousIy in llo inlroduclion lo llis soclion vo caIcuIalod llo 2003 saIos por day
for Disnoy lo bo in oxcoss of $74 miIIion and assumod llo firm couId invosl ils oxcoss
casl in marIolabIo socurilios lo yioId 2.21 porconl annuaIIy. If Disnoy couId spood up
700.4 CompohehIs o! ShorI-1erm AsseIs 44
CAßM ModuIe 700 Fihahce
TabIe 4.1 Comparisoh o! Ordihary Cash CollecIioh SysIem wiIh Simple Lockbox SysIem
Ordinary 5ystem Advantage
5teps and Time o! Lockbox
1 CusIomer wriIes check 1 day
ahd places iI ih Ihe mail.
2 Mail is delivered Io 2 days Mail will hoI have Io Iravel as !ar.
!irm's headquarIers. ResulI: Save 1 day.
3 AccouhIihg persohhel
process Ihe checks ahd 2 days 8ahk persohhel prepare
deposiI Ihem ih Ihe checks !or deposiI.
!irm's local bahk. ResulI: Save 2 days.
4 ahd 5 Checks are !orwarded 1 day 8ecause Ihe lockboxes are
!or paymehI locaIed hear Federal Reserve
Ihrough Ihe clearihg 8ahks or brahches, IrahsiI !loaI
mechahism. cah be reduced.
6 ahd 7 1he !irm receives 1 day
hoIice !rom iIs bahk
IhaI Ihe checks have
cleared ahd Ihe !uhds
are how "good." ResulI: Save 1 day.
1oIal workihg days 7 days Overall resulI:
Save 4 workihg days.
ils casl coIIoclions by 4 days, as llo lypollolicaI firm did in TabIo 4.1, llo rosuIls
vouId oxcood $6.5 miIIion lo llo firm's advanlago. SpocificaIIy, llo gross annuaI sav-
ings lo Disnoy (aparl from oporaling llo IocIbox syslom) vouId amounl lo $6.554 miI-
Iion as foIIovs:
(SaIos por day)  (days of fIoal roduclion)  (assumod yioId) gross annuaI savings
($74,139,726)  (4)  (.0221) $6,553,952
As you migll guoss, llo prospocls for gonoraling rovonuos of llis magniludo aro
imporlanl nol onIy lo llo firms invoIvod bul aIso lo commorciaI banIs llal offor IocI-
box sorvicos.
In summary, llo bonofils of a IocIbox arrangomonl aro
1. Increased wnrking cash. Tlo limo roquirod for convorling rocoivabIos inlo
avaiIabIo funds is roducod. Tlis froos up casl for uso oIsovloro in llo
2. EIiminatinn nI cIericaI Iunctinns. Tlo banI laIos ovor llo lasIs of rocoiving,
ondorsing, lolaIing, and doposiling clocIs. Will Ioss landIing of rocoipls by
ompIoyoos, bollor audil conlroI is acliovod and llo clanco of documonls
bocoming Iosl is roducod.
3. EarIv knnwIedge nI dishnnnred checks. SlouId a cuslomor's clocI bo
uncoIIoclibIo bocauso of IacI of funds, il is rolurnod, usuaIIy by spociaI
landIing, lo llo firm.
Tloso bonofils aro nol froo. UsuaIIy, llo banI Iovios a clargo for oacl clocI
procossod llrougl llo syslom. Tlo bonofils dorivod from llo accoIoralion of rocoipls
musl oxcood llo incromonlaI cosls of llo IocIbox syslom or llo firm vouId bo bollor
off villoul il. Ialor in llis soclion, a slraigllforvard mollod for assossing llo dosir-
abiIily of a spocific casl managomonl sorvico, sucl as llo IocIbox arrangomonl, is
Management of Cash Outflow
Tlo objoclivo in managing casl oulfIovs is lo incroaso llo company's fIoal by sIoving
dovn llo disbursomonl and coIIoclion procoss. Tlis is oxaclIy llo opposilo of our
objoclivo in managing casl coIIoclions. Tloro vo focusod our allonlion on vays lo
slorlon our cuslomor's fIoal, vloroas nov vo visl lo incroaso our ovn paymonl
fIoal. Tloro aro sovoraI looIs al llo disposaI of llo casl managor for accompIisling
llis ond, and vo doscribo llroo loro. Tloso aro llo uso of (1) zoro baIanco accounls,
(2) payabIo-llrougl drafls, and (3) romolo disbursing. (Soo TabIe 4.2.)
700.4 CompohehIs o! ShorI-1erm AsseIs 45
CAßM ModuIe 700 Fihahce
TabIe 4.2 FeaIures o! SelecIed Cash Disbursal 1echhiques: A Summary
Technique Objective Hov AccompIished
1. Zero balahce accouhIs (1) Achieve beIIer cohIrol over cash paymehIs, LsIablish zero balahce accouhIs !or all o! Ihe
(2) reduce excess cash balahces held ih !irm's disbursihg uhiIs. 1hese accouhIs are all
regiohal bahks, ahd possibly (3) ihcrease ih Ihe same cohcehIraIioh bahk. Checks are
disbursihg !loaI. drawh agaihsI Ihese accouhIs, wiIh Ihe
balahce ih each accouhI hever exceedihg $0.
Divisiohal disbursihg auIhoriIy is Ihereby
maihIaihed aI Ihe local level o! mahagemehI.
2. Payable-Ihrough dra!Is Achieve e!!ecIive cehIral-o!!ice cohIrol over Field o!!ice issues dra!Is raIher Ihah checks Io
!ield-auIhorized paymehIs. seIIle up payables.
3. RemoIe disbursihg LxIehd disbursihg !loaI. WriIe checks agaihsI demahd deposiI accouhIs
held ih disIahI bahks.
Zero ßaIance Accounts
Iargo corporalions llal oporalo muIlipIo branclos, divisions, or subsidiarios oflon
mainlain numorous banI accounls (in difforonl banIs) for llo purposo of maIing
limoIy oporaling disbursomonls. Il doos maIo good businoss sonso for paymonls for
purclasod parls llal go inlo, say, an aulomobiIo lransmission lo bo mado by llo
Transmission and Classis Division of llo aulo manufacluror rallor llan ils conlraI
offico. Tlo Transmission and Classis Division originalos sucl purclaso ordors,
rocoivos and inspocls llo slipmonl vlon il arrivos al llo pIanl, aullorizos paymonl,
and vrilos llo approprialo clocI. To lavo llo conlraI offico invoIvod in lloso mallors
vouId bo a vaslo of company limo.
Wlal londs lo lappon, lovovor, is llal vill sovoraI divisions uliIizing lloir ovn
disbursaI accounls, oxcoss casl baIancos buiId up in oulIying banIs and rob llo firm of
oarning assols. Zoro baIanco accounls aro usod lo aIIovialo llis probIom. Tlo objoclivos
of a zoro baIanco accounl syslom for llo firm aro (1) lo acliovo bollor conlroI ovor ils
casl paymonls, (2) lo roduco oxcoss casl baIancos loId in rogionaI banIs for disburs-
ing purposos, and (3) lo incroaso disbursing fIoal.
Zern baIance accnunts (ZBAs) pcrmii ccnirc|izc! ccnirc| (ci i|c |cc!¡ucricrs |ctc|)
ctcr ccs| cui||cus u|i|c mcinicininv !itisicnc| !is|ursinv cui|criiu. Undor llis syslom
llo firm's aullorizod ompIoyoos, roprosonling lloir various divisions, conlinuo lo
vrilo clocIs on lloir individuaI accounls. Nolo llal llo numorous individuaI dis-
bursing accounls aro nov c|| Iocalod in llo samo conconlralion banI. AcluaIIy lloso
soparalo accounls conlain no funds al aII, llus lloir approprialo IaboI, ¨zoro baIanco.¨
Tloso accounls lavo aII llo claraclorislics of roguIar domand doposil accounls,
incIuding soparalo lilIos, numbors, and slalomonls.
Tlo firm's aullorizod agonls vrilo lloir paymonl clocIs as usuaI againsl lloir
spocific accounls. Tloso clocIs cIoar llrougl llo banIing syslom in llo usuaI vay. On
a daiIy basis clocIs aro prosonlod lo llo firm's conconlralion banI (llo dravoo banI)
for paymonl. As llo clocIs aro paid by llo banI, nogalivo (dobil) baIancos buiId up in
llo propor disbursing accounls. Al llo ond of oacl day llo nogalivo baIancos aro
roslorod lo a zoro IovoI by moans of crodils lo llo ZBAs, a corrosponding roduclion of
funds is mado againsl llo firm's conconlralion (maslor) domand doposil accounl. Iacl
morning a roporl is oIoclronicaIIy forvardod lo corporalo loadquarlors rofIocling llo
baIanco in llo maslor accounl as voII as llo provious day's aclivily in oacl ZBA. Using
llo roporl, llo financiaI officor in clargo of noar-casl invoslmonls is roady lo inilialo
approprialo lransaclions.
Managing llo casl oulfIov llrougl uso of a ZBA syslom offors llo foIIoving bon-
ofils lo llo firm vill many oporaling unils:
1. ConlraIizod conlroI ovor disbursomonls is acliovod, ovon llougl paymonl
and aullorily conlinuo lo rosl vill oporaling unils.
2. Managomonl limo sponl on suporficiaI casl managomonl aclivilios is roducod.
Ixorcisos sucl as obsorving llo baIancos loId in numorous banI accounls,
lransforring funds lo lloso accounls slorl of casl, and roconciIing llo
accounls domand Ioss allonlion.
3. Ixcoss baIancos loId in oulIying accounls can bo roducod.
4. Tlo cosls of casl managomonl can bo roducod, as viro lransfors lo buiId up
funds in oulIying disbursomonl accounls aro oIiminalod.
5. Iunds may bo mado avaiIabIo for company uso llrougl an incroaso in
disbursomonl fIoal. Wlon IocaI banI accounls aro usod lo pay noarby
suppIiors, llo clocIs cIoar rapidIy. Tlo samo clocIs, if dravn on a ZBA
Iocalod in a moro dislanl conconlralion banI, viII laIo moro limo lo cIoar
againsl llo disbursing firm's accounl.
700.4 CompohehIs o! ShorI-1erm AsseIs 46
CAßM ModuIe 700 Fihahce
PayabIe-Through Dra!ts
PavabIe-thrnugh draIts (PTDs) aro |cvc| insirumcnis i|ci |ctc i|c p|usicc| cppccrcncc c|
cr!incru c|cc|s |ui crc nci !rcun cn c |cn|. |nsicc!, pcuc||c-i|rcuv| !rc|is crc !rcun cn cn!
pcumcni is cui|crizc! |u i|c issuinv |irm cvcinsi iis !cmcn! !cpcsii ccccuni.
IiIo clocIs, llo drafls aro cIoarod llrougl llo banIing syslom and aro prosonlod
lo llo issuing firm's banI. Tlo banI sorvos as a coIIoclion poinl and passos llo drafls
on lo llo firm. Tlo corporalo issuor usuaIIy las lo rolurn by llo foIIoving businoss
day aII drafls il doos nol visl lo covor (pay). Tloso documonls nol rolurnod lo llo
banI aro aulomalicaIIy paid. Tlo firm inspocls llo drafls for vaIidily by clocIing sig-
naluros, amounls, and dalos. Slop-paymonl ordors can bo inilialod by llo company on
any drafls considorod inapproprialo.
Tlo main purposo of using a payabIo-llrougl drafl syslom is ic prcti!c |cr c||cciitc
ccnirc| ctcr |ic|! pcumcnis. ConlraI offico conlroI ovor paymonls bogun by rogionaI unils
is providod bocauso llo drafls aro roviovod in advanco of finaI paymonl. IayabIo-
llrougl drafls, for oxampIo, aro usod oxlonsivoIy in llo insuranco induslry. Tlo cIaims
agonl doos nol lypicaIIy lavo clocI-signing aullorily againsl a corporalo disburso-
monl accounl. Tlis agonl can issuo a drafl, lovovor, for quicI sollIomonl of a cIaim.
ßemote Disbursing
A fov banIs viII provido llo corporalo cuslomor vill remnte disbursing, a casl man-
agomonl sorvico spocificaIIy dosignod lo oxlond disbursing fIoal. Tlo firm's conconlra-
lion banI may lavo a corrospondonl roIalionslip vill a smaIIor banI Iocalod in a dis-
lanl cily. In llal romolo cily llo IodoraI Rosorvo Syslom is unabIo lo mainlain froquonl
cIoarings of clocIs dravn on IocaI banIs. Ior oxampIo, a firm llal is Iocalod in DaIIas
and mainlains ils maslor accounl lloro may opon an accounl vill a banI silualod in,
say, AmariIIo, Toxas. Tlo firm viII vrilo llo buII of ils paymonl clocIs againsl llo
accounl in llo AmariIIo banI. Tlo clocIs viII probabIy laIo al Ioasl 1 businoss day
Iongor lo cIoar, so llo firm can ¨pIay llo fIoal¨ lo ils advanlago.
A firm musl uso llis loclniquo of romolo disbursing vill oxlromo caro. If a Ioy
suppIior of nov maloriaIs Iocalod in DaIIas las lo vail llo oxlra day for funds dravn
on llo AmariIIo accounl, llo possibiIily of incurring iII viII migll oulvoigl llo appar-
onl gain from an incroaso in llo disbursing fIoal. Tlo impacl on llo firm's ropulalion
of using romolo disbursing slouId bo oxpIicilIy ovaIualod. Tlo praclico of romolo dis-
bursing is discouragod by llo IodoraI Rosorvo Syslom.
These colleclion and disbursemenl procedures are an illuslralion ol PrincipIe 2.
The Time VaIue o! Money-A DoIIar ßeceived Today Is Worth More Than a DoIIar
ßeceived in the future. The lasler lhe lirm can lake possession ol lhe money lo which
il is enlilled, lhe sooner lhe lirm can pul lhe money lo work generaling a relurn. Similarly,
lhe longer lhe lirm can hold on lo lhe liquid assels in ils possession, lhe grealer
lhe relurn lhe lirm can receive on such lunds.
A form of broaI-ovon anaIysis can loIp llo financiaI officor docido vlollor a parlicu-
Iar coIIoclion or disbursomonl sorvico viII provido an oconomic bonofil lo llo firm. Tlo
ovaIualion procoss invoIvos a vory basic roIalionslip in microoconomics:
Addod cosls addod bonofils (4-1)
If oqualion (4-1) loIds oxaclIy, llon llo firm is no bollor or vorso off for laving
adoplod llo givon sorvico. Wo viII iIIuslralo llis procoduro in lorms of llo dosirabiIily
700.4 CompohehIs o! ShorI-1erm AsseIs 47
CAßM ModuIe 700 Fihahce
of inslaIIing an addilionaI IocIbox. Iqualion (4-1) can bo roslalod on a por unil basis as
P (D)(S)(i) (4-2)
vloro P incroasos in por clocI procossing cosl if llo nov syslom is adoplod
D days savod in llo coIIoclion procoss (fIoal roduclion)
S avorago clocI sizo in doIIars
i llo daiIy, boforo-lax opporlunily cosl (ralo of rolurn) of carrying casl
Assumo llal clocI procossing cosl P viII riso by $0.18 a clocI if llo IocIbox is
usod. Tlo firm las dolorminod llal llo avorago clocI sizo, S, llal viII bo maiIod lo llo
IocIbox Iocalion viII bo $900. If funds aro frood by uso of llo IocIbox, lloy viII bo
invoslod in marIolabIo socurilios lo yioId an cnnuc| boforo-lax rolurn of 6 porconl. Will
lloso dala, il is possibIo lo dolormino llo roduclion in clocI coIIoclion limo D roquirod
lo juslify llo uso of llo IocIbox. Tlal IovoI of D is found lo bo
Tlus, llo IocIbox is juslifiod if llo firm can spood up ils coIIoclions by mcrc llan
1.217 days. Tlis samo slyIo of anaIysis can bo adaplod lo anaIyzo llo ollor looIs of
casl managomonl.
700.4.4 Determine a prudent composition
o! marketabIe-securities port!oIio
Onco llo dosign of llo firm's casl rocoipls and paymonls syslom las boon dolorminod,
llo financiaI managor facos llo lasI of soIocling approprialo financiaI assols for incIu-
sion in llo firm's marIolabIo-socurilios porlfoIio.
General Selection Criteria
Corlain criloria can provido a financiaI managor vill a usofuI framovorI for soIocling
a propor marIolabIo-socurilios mix. Tloso considoralions incIudo ovaIualion of llo
(1) financiaI risI, (2) inlorosl ralo risI, (3) Iiquidily, (4) laxabiIily, and (5) yioIds among
difforonl financiaI assols. Tlo foIIoving soclions briofIy doIinoalo lloso criloria from
llo invoslor's viovpoinl.
financiaI ßisk
Iincncic| ris| loro rofors lo llo uncorlainly of oxpoclod rolurns from a socurily allribul-
abIo lo possibIo clangos in llo financiaI capacily of llo socurily issuor lo maIo fuluro
paymonls lo llo socurily ovnor. If llo clanco of dofauIl on llo lorms of llo inslrumonl
is ligl (or Iov), llon llo financiaI risI is said lo bo ligl (or Iov).
In boll financiaI praclico and rosoarcl, vlon oslimalos of risI-froo rolurns aro
dosirod, llo yioIds avaiIabIo on Troasury socurilios aro consuIlod, and llo safoly of
ollor financiaI inslrumonls is voiglod againsl llom.
Interest ßate ßisk
|nicrcsi rcic ris| rofors lo llo uncorlainly of oxpoclod rolurns from a financiaI inslru-
monl allribulabIo lo clangos in inlorosl ralos. Of parlicuIar concorn lo llo corporalo
lroasuror is llo prico voIaliIily associalod vill inslrumonls llal lavo Iong, as opposod
lo slorl, lorms lo malurily. An iIIuslralion can loIp cIarify llis poinl.
$ ( )($ )
18 900
1 217
700.4 CompohehIs o! ShorI-1erm AsseIs 48
CAßM ModuIe 700 Fihahce
Supposo llo financiaI officor is voigling llo morils of invosling lomporariIy avaiI-
abIo corporalo casl in a nov offoring of U.S. Troasury obIigalions llal viII maluro in
oillor (1) 3 yoars or (2) 20 yoars from llo dalo of issuo. Tlo purclaso pricos of llo
3-yoar nolos or 20-yoar bonds aro al lloir par vaIuos of $1,000 por socurily. Tlo malu-
rily vaIuo of oillor cIass of socurily is oquaI lo par, $1,000, and llo coupon ralo (slalod
inlorosl ralo) is sol al 7 porconl, compoundod annuaIIy.
If aflor 1 yoar from llo dalo of purclaso provaiIing inlorosl ralos riso lo 9 porconl,
llo marIol pricos of lloso curronlIy oulslanding Troasury socurilios viII faII lo bring
lloir yioIds lo malurily in Iino vill vlal invoslors couId oblain by buying a nov issuo
of a givon inslrumonl. Tlo marIol pricos of |ci| llo 3-yoar and 20-yoar obIigalions viII
docIino. Tlo prico of llo 20-yoar inslrumonl viII docIino by a groalor doIIar amounl,
lovovor, llan llal of llo 3-yoar inslrumonl.
Ono yoar from llo dalo of issuo, llo prico oblainabIo in llo marIolpIaco for llo
originaI 20-yoar inslrumonl, vlicl nov las 19 yoars lo go lo malurily, can bo found
by compuling P as foIIovs:
In llo provious oxprossion, (1) i is llo yoar in vlicl llo parlicuIar rolurn, oillor
inlorosl or principaI amounl, is rocoivod, (2) $70 is llo annuaI inlorosl paymonl, and
(3) $1,000 is llo conlracluaI malurily vaIuo of llo bond. Tlo riso in inlorosl ralos las
forcod llo marIol prico of llo bond dovn lo $821.01.
Wlal viII lappon lo llo prico of llo nolo llal las 2 yoars romaining lo malurily`
In a simiIar mannor, vo can compulo ils prico, P:
Tlo marIol prico of llo slorlor-lorm nolo viII docIino lo $964.84. TabIe 4.3 slovs llal
llo marIol vaIuo of llo slorlor-lorm socurily vas ponaIizod mucl Ioss by llo givon
riso in llo gonoraI IovoI of inlorosl ralos.
If vo oxlondod llo iIIuslralion, vo vouId soo llal, in lorms of marIol prico, a
1-yoar socurily vouId bo affoclod Ioss llan a 2-yoar socurily, a 91-day socurily Ioss
llan a 182-day socurily, and so on. Iquily socurilios vouId oxlibil llo Iargosl prico
clangos bocauso of lloir infinilo malurily poriods. To lodgo againsl llo prico voIaliIily
causod by inlorosl ralo risI, llo firm's marIolabIo-socurilios porlfoIio viII lond lo bo
composod of inslrumonls llal maluro ovor slorl poriods.
In llo prosonl conloxl of managing llo marIolabIo-socurilios porlfoIio, |i¡ui!iiu rofors
lo llo abiIily lo lransform a socurily inlo casl. SlouId an unforosoon ovonl roquiro llal
a significanl amounl of casl bo immodialoIy avaiIabIo, llon a sizabIo porlion of llo
porlfoIio migll lavo lo bo soId. Tlo financiaI managor viII vanl llo casl quicIIy and
viII nol vanl lo accopl a Iargo prico concossion in ordor lo convorl llo socurilios. Tlus,
= =
( )
( )
1 09
1 000
1 09
964 84

 .
= =
( )
( )
1 09
1 000
1 09
821 01

 .
700.4 CompohehIs o! ShorI-1erm AsseIs 49
CAßM ModuIe 700 Fihahce
TabIe 4.3 MarkeI Price L!!ecI o! Rise ih IhIeresI RaIes
Item Three-Year Instrument Tventy-Year Instrument
Origihal price $1,000.00 $1,000.00
Price a!Ier ohe year 964.84 821.01
Declihe ih price $ 35.16 $ 178.99
in llo formuIalion of proforoncos for llo incIusion of parlicuIar inslrumonls in llo
porlfoIio, llo managor musl considor (1) llo poriod noodod lo soII llo socurily and
(2) llo IiIoIilood llal llo socurily can bo soId al or noar ils provaiIing marIol prico.
Tlo lax lroalmonl of llo incomo a firm rocoivos from ils socurily invoslmonls doos nol
affocl llo uIlimalo mix of llo marIolabIo-socurilios porlfoIio as mucl as llo criloria
monlionod oarIior. Tlis is bocauso llo inlorosl incomo from mosl inslrumonls suilabIo
for incIusion in llo porlfoIio is laxabIo al llo fodoraI IovoI. SliII, somo corporalo lroas-
urors soriousIy ovaIualo llo laxabiIily of inlorosl incomo and capilaI gains.
Tlo inlorosl incomo from onIy ono cIass of socurilios oscapos llo fodoraI incomo
lax. Tlal cIass of socurilios is gonoraIIy roforrod lo as municipc| c||ivciicns, or moro sim-
pIy as municipc|s. Bocauso of llo lax-oxompl foaluro of inlorosl incomo from slalo and
IocaI govornmonl socurilios, municipaIs soII al Iovor yioIds lo malurily in llo marIol
llan socurilios llal pay laxabIo inlorosl. Tlo aflor-lax yioId on a municipaI obIigalion,
lovovor, couId bo liglor llan llo yioId from a non-lax-oxompl socurily. Tlis vouId
dopond mainIy on llo purclasing firm's lax silualion.
Considor TabIe 4.4. A firm is assumod lo bo anaIyzing vlollor lo invosl in a
1-yoar lax-froo dobl issuo yioIding 6 porconl on a $1,000 oulIay or a 1-yoar laxabIo issuo
llal yioIds 8 porconl on a $1,000 oulIay. Tlo firm pays fodoraI laxos al llo ralo of
34 porconl. Tlo yioIds quolod in llo financiaI pross and in llo prospoclusos llal
doscribo dobl issuos aro |c|crc-icx rolurns. Tlo acluaI c|icr-icx rolurn onjoyod by llo
invoslor doponds on lis or lor lax bracIol. Nolico llal llo acluaI aflor-lax yioId
rocoivod by llo firm is onIy 5.28 porconl on llo laxabIo issuo vorsus 6 porconl on llo
lax-oxompl obIigalion. Tlo Iovor porlion of TabIo 4.4 slovs llal llo fuIIy laxod bond
musl yioId 9.091 porconl lo maIo il comparabIo vill llo lax-oxompl issuo.
700.4 CompohehIs o! ShorI-1erm AsseIs 50
CAßM ModuIe 700 Fihahce
TabIe 4.4 Comparisoh o! A!Ier-1ax Yields
Tax-Exempt TaxabIe
Debt Issue Debt Issue
(6% Coupon) (8% Coupon)
IhIeresI ihcome $ 60.00 $ 80.00
Ihcome Iax (.34) 0.00 27.20
A!Ier-Iax ihIeresI ihcome $ 60.00 $ 52.80
A!Ier-Iax yield $ 60.00 6% $ 52.80 5.28%
$1,000.00 $1,000.00
DerivaIioh o! equivalehI be!ore-Iax yield oh a Iaxable debI issue:
where  equivalehI be!ore-Iax yield
r* a!Ier-Iax yield oh Iax-exempI securiIy
 !irm's margihal ihcome Iax raIe
 IhIeresI ihcome í$1,000 .09091! $90.91
Ihcome Iax (.34) $30.91
A!Ier-Iax ihIeresI ihcome $60.00

= = =
1 34
9 091
 
. %
Tlo finaI soIoclion crilorion llal vo monlion is a significanl ono÷llo yioIds llal aro
avaiIabIo on llo difforonl financiaI assols suilabIo for incIusion in llo noar-casl porlfo-
Iio. By nov il is probabIy obvious llal llo faclors of (1) financiaI risI, (2) inlorosl ralo
risI, (3) Iiquidily, and (4) laxabiIily aII infIuonco llo avaiIabIo yioIds on financiaI
inslrumonls. Tlo yioId crilorion invoIvos an ovaIualion of llo risIs and bonofils inlor-
onl in aII of lloso faclors. If a givon risI is assumod, sucl as IacI of Iiquidily, a liglor
yioId may bo oxpoclod on llo nonIiquid inslrumonl.
Figure 4.4 summarizos our framovorI for dosigning llo firm's marIolabIo-socuri-
lios porlfoIio. Tlo four basic considoralions aro slovn lo infIuonco llo yioIds avaiIabIo
on socurilios. Tlo financiaI managor musl focus on llo risI÷rolurn lrado-offs idonlifiod
llrougl anaIysis. Coming lo grips vill lloso lrado-offs viII onabIo llo financiaI man-
agor lo dolormino llo propor marIolabIo-socurilios mix for llo company. Iol us IooI
nov al llo marIolabIo socurilios prominonl in firms' noar-casl porlfoIios.
Marketable-Security Alternatives
Monoy-marIol socurilios gonoraIIy lavo slorl-lorm malurily and aro liglIy mar-
IolabIo, so llo loIdor can quicIIy Iiquidalo if llo firm noods llo casl. TabIe 4.5 sum-
marizos llo claraclorislics of llo mosl vidoIy usod monoy marIol socurilios in lorms
of fivo Ioy allribulos: (1) llo donominalions in vlicl socurilios aro avaiIabIo, (2) llo
malurilios llal aro offorod, (3) llo basis usod (i.o., vlollor llo socurily is soId al a
discounl or offors coupon inlorosl paymonls), (4) llo Iiquidily of llo inslrumonl,
vlicl roIalos principaIIy lo llo avaiIabiIily of a socondary marIol for llo socurily, and
(5) laxabiIily of llo invoslmonl rolurns.
U.5. Treasury ßiIIs
U.S. 1rccsuru |i||s aro llo bosl Inovn and mosl popuIar slorl-lorm invoslmonl oulIol
among firms. A Troasury biII is a dirocl obIigalion of llo U.S. govornmonl soId on a
roguIar basis by llo U.S. Troasury. Nov Troasury biIIs aro nov issuod in donomina-
lions as smaII as $1,000. Irior lo roconl yoars, llo minimum purclaso vas a rallor ligl
amounl of $10,000, vlicl vas bIalanlIy difficuIl for smaII, individuaI invoslors. So
nov invoslors can parlicipalo in llo Troasury biII marIol aIong vill Iargo corporalions
and incroaso lloir aIIocalions in incromonls of $1,000 abovo llo iniliaI oulIay of llal
samo amounl. Al prosonl, biIIs vill malurilios of 4 vooIs, 13 vooIs, and 26 vooIs aro
issuod ovory vooI (usuaIIy on Monday, unIoss il is a loIiday) in an opon marIol auc-
lion. Troasury biIIs aro vory popuIar among corporalo lroasurors vlo aro rosponsibIo
for managing llo spocific firm's casl posilion. You viII soo vly Ialor.
Of primo imporlanco lo llo corporalo lroasuror is llo facl llal a vory aclivo soc-
ondary marIol oxisls for biIIs. Aflor a biII las boon acquirod by llo firm, slouId llo
nood ariso lo lurn il inlo casl, a group of socurilios doaIors slands roady lo purclaso il.
Tlis liglIy dovoIopod socondary marIol for biIIs nol onIy maIos llom oxlromoIy Iiq-
uid, bul aIso aIIovs llo firm lo buy biIIs vill malurilios of a vooI or ovon Ioss.
Bocauso biIIs lavo llo fuII financiaI bacIing of llo U.S. govornmonl, lloy aro, for
aII praclicaI purposos, risI froo. Tlis nogIigibIo financiaI risI and ligl dogroo of Iiquid-
ily maIos llo yioIds Iovor llan lloso oblainabIo on ollor marIolabIo socurilios. Tlo
700.4 CompohehIs o! ShorI-1erm AsseIs 51
CAßM ModuIe 700 Fihahce
Considerations InfIuence focus upon ßetermine
|iuaucial risk
|uleresl rale risk
Yields Risk vs. reluru
figure 4.4 Desighihg Ihe MarkeIable-SecuriIies PorI!olio
700.4 CompohehIs o! ShorI-1erm AsseIs 52
CAßM ModuIe 700 Fihahce
TabIe 4.5 FeaIures o! SelecIed Mohey-MarkeI IhsIrumehIs
Instruments Denominations Maturities ßasis Liquidity TaxabiIity
U.S. 1reasury bills- $ 1,000 91 days, DiscouhI LxcellehI LxempI !rom sIaIe
direcI obligaIiohs o! ahd ihcremehIs 182 days, secohdary ahd local ihcome
Ihe U.S. goverhmehI o! $ 1,000 ahd 4 weeks markeI Iaxes
Federal agehcy Wide variaIioh, 5 days (Farm DiscouhI or Good !or issues Geherally exempI aI
securiIies-obligaIiohs !rom $1,000 CrediI coupoh, o! "big !ive" local level, FNMA
o! corporaIiohs ahd Io $1 millioh cohsolidaIed usually oh agehcies issues are 
agehcies creaIed Io discouhI hoIes) coupoh exempI
e!!ecI Ihe !ederal Io more Ihah
goverhmehI's lehdihg 10 years
8ahkers' accepIahce- No seI size, PredomihahIly DiscouhI Good !or 1axed aI all levels o!
dra!Is accepIed !or Iypically rahge !rom 30 Io accepIahces o! goverhmehI
!uIure paymehI by !rom $25,000 180 days large "mohey-
commercial bahks Io $1 millioh markeI" bahks
NegoIiable cerIi!icaIes o! $25,000 Io $10 1 Io 18 mohIhs Accrued Fair Io good 1axed aI all levels o!
deposiI-markeIable millioh ihIeresI goverhmehI
receipIs !or !uhds
deposiIed ih a bahk
!or a !ixed Iime period
Commercial paper- $5,000 Io $5 3 Io 270 days DiscouhI Poor, ho acIive 1axed aI all levels o!
shorI-Ierm uhsecured millioh, $1,000 secohdary goverhmehI
promissory hoIes ahd $5,000 markeI ih
mulIiples above usual sehse
Ihe ihiIial
o!!erihg size
are someIimes
Repurchase 1ypical sizes are Accordihg Io NoI applicable Fixed by Ihe 1axed aI all levels o!
agreemehIs-legal $500,000 or Ierms o! agreemehI, goverhmehI
cohIracIs beIweeh a more. cohIracI IhaI is,
borrower (securiIy borrower will
seller) ahd lehder repurchase
(securiIy buyer). 1he
borrower will
repurchase aI Ihe
cohIracI price plus
ah ihIeresI charge.
Mohey-markeI muIual Some require Shares cah be NeI asseI value Good, provided 1axed aI all levels o!
!uhds-holders o! ah ihiIial sold aI ahy by Ihe !uhd goverhmehI
diversi!ied porI!olios o! ihvesImehI as Iime iIsel!
shorI-Ierm, high-grade small as
debI ihsIrumehIs $1,000.
incomo from Troasury biIIs is subjocl lo fodoraI incomo laxos, bul nci lo slalo and IocaI
incomo laxos.
federaI Agency 5ecurities
Ic!crc| cvcncu sccuriiics aro dobl obIigalions of corporalions and agoncios llal lavo
boon croalod lo offocl llo various Ionding programs of llo U.S. govornmonl. Iivo sucl
govornmonl-sponsorod corporalions accounl for llo majorily of oulslanding agoncy
dobl. Tlo ¨big fivo¨ agoncios aro
1. Tlo IodoraI NalionaI Morlgago Associalion (INMA)
2. Tlo IodoraI Homo Ioan BanIs (IHIB)
3. Tlo IodoraI Iand BanIs
4. Tlo IodoraI Inlormodialo Crodil BanIs
5. Tlo BanIs for Cooporalivos
Il is nol lruo llal llo ¨big fivo¨ fodoraIIy sponsorod agoncios aro ovnod by llo U.S.
govornmonl and llal llo socurilios lloy issuo aro fuIIy guaranlood by llo govornmonl.
Tlo ¨big fivo¨ agoncios aro nov onliroIy ovnod by lloir mombor associalions or llo
gonoraI pubIic. In addilion, llo issuing agoncy, nol llo fodoraI govornmonl, slands
bolind ils promisos lo pay.
ßankers' Acceptances
8cn|crs´ ccccpicnccs aro ono of llo Ioasl-undorslood inslrumonls suilabIo for incIusion
in llo firm's marIolabIo-socurilios porlfoIio. Tloir parl in U.S. commorco loday is
IargoIy conconlralod in llo financing of foroign lransaclions. GonoraIIy, an accoplanco
is a drafl (ordor lo pay) dravn on a spocific banI by an oxporlor in ordor lo oblain
paymonl for goods slippod lo a cuslomor, vlo mainlains an accounl vill llal spo-
cific banI.
NegotiabIe Certi!icates o! Deposit
A ncvciic||c ccrii|iccic c| !cpcsii (CD) is a marIolabIo rocoipl for funds llal lavo boon
doposilod in a banI for a fixod poriod. Tlo doposilod funds oarn a fixod ralo of inlor-
osl. Tloso aro nol lo bo confusod vill ordinary passbooI savings accounls or non-
marIolabIo limo doposils offorod by aII commorciaI banIs. CDs aro offorod by major
monoy-conlor banIs. Wo aro laIIing loro aboul ¨corporalo¨ CDs÷nol lloso offorod lo
CommerciaI Paper
Ccmmcrcic| pcpcr rofors lo slorl-lorm, unsocurod promissory nolos soId by Iargo busi-
nossos lo raiso casl. Tloso aro somolimos doscribod in llo popuIar financiaI pross as
slorl-lorm corporalo IOUs. Bocauso lloy aro unsocurod, llo issuing sido of llo marIol
is dominalod by Iargo corporalions, vlicl lypicaIIy mainlain sound crodil ralings. Tlo
issuing (borroving) firm can soII llo papor lo a doaIor, vlo viII in lurn soII il lo llo
invosling pubIic, if llo firm's ropulalion is soIid, llo papor can bo soId diroclIy lo
llo uIlimalo invoslor.
ßepurchase Agreements
Rcpurc|csc cvrccmcnis (rcpcs) aro IogaI conlracls llal invoIvo llo acluaI saIo of socurilios
by a |crrcucr lo llo |cn!cr, vill a commilmonl on llo parl of llo borrovor lo rcpurc|csc
llo socurilios al llo conlracl prico pIus a slalod inlorosl clargo. Tlo socurilios soId lo
llo Iondor aro U.S. govornmonl issuos or ollor inslrumonls of llo monoy marIol sucl
as lloso doscribod proviousIy. Tlo borrovor is oillor a major financiaI inslilulion÷
mosl oflon a commorciaI banI÷or a doaIor in U.S. govornmonl socurilios.
Wly migll llo corporalion vill oxcoss casl profor lo buy ropurclaso agroomonls
rallor llan a givon marIolabIo socurily` Tloro aro lvo major roasons. Iirsl, llo origi-
naI malurilios of llo inslrumonls boing soId can, in offocl, bo adjuslod lo suil llo par-
licuIar noods of llo invosling corporalion. Iunds avaiIabIo for vory slorl poriods, sucl
as 1 or 2 days, can bo produclivoIy ompIoyod. Tlo socond roason is cIosoIy roIalod lo
llo firsl. Tlo firm couId, of courso, buy a Troasury biII and llon rosoII il in llo marIol
in a fov days vlon casl is roquirod. Tlo dravbacI loro vouId bo llo risI invoIvod in
Iiquidaling llo biII al a prico oquaI lo ils oarIior cosl lo llo firm. Tlo purclaso of a ropo
romovos llis risI. Tlo conlracl prico of llo socurilios llal maIo up llo arrangomonl is
|ixc! for llo duralion of llo lransaclion. Tlo corporalion llal buys a ropurclaso agroo-
monl, llon, is proloclod againsl marIol prico fIuclualions llrougloul llo conlracl
poriod. Tlis maIos il a sound aIlornalivo invoslmonl for funds llal aro frood up for
onIy vory slorl poriods.
700.4 CompohehIs o! ShorI-1erm AsseIs 53
CAßM ModuIe 700 Fihahce
Money-Market MutuaI funds
Tlo monoy-marIol muluaI funds soII lloir slaros lo raiso casl, and by pooIing llo
funds of Iargo numbors of smaII savors, lloy can buiId lloir Iiquid-assol porlfoIios.
Many of lloso funds aIIov llo invoslor lo slarl an accounl vill as IillIo as $1,000. Tlis
smaII iniliaI invoslmonl, coupIod vill llo facl llal somo Iiquid-assol funds pormil sub-
soquonl invoslmonls in amounls as smaII as $100, maIos llis lypo of oulIol for oxcoss
casl suilod lo llo smaII firm and ovon llo individuaI. Iurllormoro, llo managomonl
of a smaII onlorpriso may nol bo liglIy vorsod in llo dolaiIs of slorl-lorm invoslmonls.
By purclasing slaros in a Iiquid-assol fund, llo invoslor is aIso buying managoriaI
Monoy-marIol muluaI funds lypicaIIy invosl in a divorsifiod porlfoIio of slorl-
lorm, ligl-grado dobl inslrumonls sucl as lloso doscribod proviousIy. Somo sucl
funds, lovovor, viII accopl moro inlorosl ralo risI in lloir porlfoIios and acquiro somo
corporalo bonds and nolos. Monoy-marIol muluaI funds offor llo invosling firm a
ligl dogroo of Iiquidily. By rodooming (soIIing) slaros, llo invoslor can oblain casl
quicIIy. Irocoduros for Iiquidalion vary among llo funds, bul slaros can usuaIIy bo
rodoomod by moans of (1) spociaI rodomplion clocIs suppIiod by llo funds, (2) loIo-
plono inslruclions, (3) viro inslruclions, or (4) a Iollor. Wlon Iiquidalion is ordorod by
loIoplono or viro, llo muluaI fund can romil lo llo invoslor by llo noxl businoss day.
The YieId 5tructure o! MarketabIe 5ecurities
Wlal lypo of rolurn can llo financiaI managor oxpocl on a marIolabIo-socurilios porl-
foIio` Tlis is a roasonabIo quoslion. Somo insigll can bo oblainod by IooIing al llo
pasl, aIllougl vo musl roaIizo llal fuluro rolurns aro nol guidod by pasl oxporionco. Il
is aIso usofuI lo lavo somo undorslanding of lov llo rolurns on ono lypo of inslru-
monl slacI up againsl anollor.
700.4.5 Learn hov to manage accounts receivabIe
amounts, incIuding credit poIicy
Wo nov lurn from llo mosl Iiquid of llo firm's curronl assols (casl and marIolabIo
socurilios) lo lloso llal aro Ioss Iiquid÷accounls rocoivabIo and invonlorios. AII firms
by lloir vory naluro aro invoIvod in soIIing oillor goods or sorvicos. AIllougl somo of
lloso saIos viII bo for casl, a Iargo porlion viII invoIvo crodil. Wlonovor a saIo is mado
on crodil, il incroasos llo firm's accounls rocoivabIo. Tlus, llo imporlanco of lov a firm
managos ils accounls rocoivabIo doponds on llo dogroo lo vlicl llo firm soIIs on crodil.
Accounls rocoivabIo lypicaIIy compriso moro llan 25 porconl of a firm's assols. In
offocl, vlon vo discuss managomonl of accounls rocoivabIo, vo aro discussing llo
managomonl of ono-quarlor of llo firm's assols. Moroovor, bocauso casl fIovs from a
saIo cannol bo invoslod unliI llo accounl is coIIoclod, conlroI of rocoivabIos laIos on
addod imporlanco, officionl coIIoclion dolorminos boll profilabiIily and Iiquidily of
llo firm.
Size of lnvestment in Accounts Receivable
Tlo sizo of llo invoslmonl in accounls rocoivabIo is dolorminod by sovoraI faclors.
Iirsl, llo porconlago of crodil saIos lo lolaI saIos affocls llo IovoI of accounls rocoivabIo
loId. AIllougl llis faclor corlainIy pIays a major roIo in dolormining a firm's invosl-
monl in accounls rocoivabIo, il gonoraIIy is nol villin llo conlroI of llo financiaI man-
agor. Tlo naluro of llo businoss londs lo dolormino llo bIond bolvoon crodil saIos and
casl saIos. A Iargo grocory sloro londs lo soII oxcIusivoIy on a casl basis, vloroas mosl
conslruclion-Iumbor suppIy firms maIo lloir saIos primariIy vill crodil.
700.4 CompohehIs o! ShorI-1erm AsseIs 54
CAßM ModuIe 700 Fihahce
Tlo IovoI of saIos is aIso a faclor in dolormining llo sizo of llo invoslmonl in
accounls rocoivabIo. Vory simpIy, llo moro saIos, llo groalor accounls rocoivabIo. Il is
nol a docision variabIo for llo financiaI managor, lovovor.
Tlo finaI dolorminanls of llo IovoI of invoslmonl in accounls rocoivabIo aro llo
crodil and coIIoclion poIicios÷moro spocificaIIy, llo lorms of saIo, llo quaIily of cus-
lomor, and llo coIIoclion offorls. Tloso poIicios crc undor llo conlroI of llo financiaI
managor. Tlo lorms of saIo spocify boll llo limo poriod during vlicl llo cuslomor
musl pay and llo lorms, sucl as ponaIlios for Ialo paymonls or discounls for oarIy pay-
monls. Tlo lypo of cuslomor or crodil poIicy aIso affocls llo IovoI of invoslmonl in
accounls rocoivabIo. Ior oxampIo, llo accoplanco of pooror crodil risIs and lloir subso-
quonl doIinquonl paymonls may Ioad lo an incroaso in accounls rocoivabIo. Tlo
slrongll and liming of llo coIIoclion offorls can affocl llo poriod for vlicl pasl-duo
accounls romain doIinquonl, vlicl in lurn affocls llo IovoI of accounls rocoivabIo. CoI-
Ioclion and crodil poIicy docisions may furllor affocl llo IovoI of invoslmonl in
accounls rocoivabIo by causing clangos in llo saIos IovoI and llo ralio of crodil saIos lo
lolaI saIos. Tlo faclors llal dolormino llo IovoI of invoslmonl in accounls rocoivabIo aro
dispIayod in Figure 4.5.
Terms o! 5aIe-Decision VariabIe
Tlo terms nI saIe i!cnii|u i|c pcssi||c !isccuni |cr ccr|u pcumcni, i|c !isccuni pcric!, cn!
i|c icic| crc!ii pcric!. Tloy aro gonoraIIy slalod in llo form c/| nol c, indicaling llal llo
cuslomor can doducl c porconl if llo accounl is paid villin | days, ollorviso, llo
accounl musl bo paid villin c days. Tlus, for oxampIo, lrado crodil lorms of 2/10, nol
30, indicalo llal a 2 porconl discounl can bo laIon if llo accounl is paid villin 10 days,
ollorviso il musl bo paid villin 30 days. IaiIuro lo laIo llo discounl roprosonls a cosl
lo llo cuslomor. Ior inslanco, if llo lorms aro 2/10, nol 30, llo annuaIizod opporlunily
cosl of passing up llis 2 porconl discounl in ordor lo villloId paymonl for an addi-
lionaI 20 days is 36.73 porconl. Tlis is dolorminod as foIIovs:
Subsliluling llo vaIuos from llo oxampIo, vo gol
In induslry llo lypicaI discounl rangos anyvloro from 1/2 lo 10 porconl, vloroas
llo discounl poriod is gonoraIIy 10 days and llo lolaI crodil poriod varios from 30 lo 90
days. AIllougl llo lorms of crodil vary radicaIIy from induslry lo induslry, lloy lond
36 73
1 02
30 10
° =

AnnuaIizod opporlunily cosl
of forgoing llo ddiscounl
c c | 1

700.4 CompohehIs o! ShorI-1erm AsseIs 55
CAßM ModuIe 700 Fihahce
Perceul oí
credil sales lo
lolal sales
Credil aud
Leuglh oí
liue beíore
credil sales
are collecled
|uveslueul iu
Level oí
credil sales
Level oí sales
Jerus oí sale
Jype oí cuslouer
Collecliou eííorls
figure 4.5 DeIermihahIs o! IhvesImehI ih AccouhIs Receivable
lo romain roIalivoIy uniform villin any parlicuIar induslry. Moroovor, llo lorms lond
lo romain roIalivoIy conslanl ovor limo, and lloy do nol appoar lo bo usod froquonlIy
as a docision variabIo.
Type o! Customer-Decision VariabIe
A socond docision variabIo invoIvos dolormining llo iupc c| cusicmcr vlo quaIifios for
lrado crodil. SovoraI cosls aIvays aro associalod vill oxlonding crodil lo Ioss-crodil-
vorlly cuslomors. Iirsl, as llo probabiIily of dofauIl incroasos, il bocomos moro
imporlanl llal llo firm bo abIo lo idonlify vlicl of llo possibIo nov cuslomors is a
poor risI. Wlon moro limo is sponl invosligaling llo Ioss-crodilvorlly cuslomor, llo
cosls of crodil invosligalion incroaso.
DofauIl cosls aIso vary diroclIy vill llo quaIily of llo cuslomor. As llo cuslomor's
crodil raling docIinos, llo clanco llal llo accounl viII nol bo paid on limo incroasos. In
llo oxlromo caso, paymonl novor occurs. Tlus, laIing on Ioss-crodilvorlly cuslomors
rosuIls in incroasos in dofauIl cosls.
CoIIoclion cosls aIso incroaso as llo quaIily of llo cuslomor docIinos. Moro doIin-
quonl accounls forco llo firm lo spond moro limo and monoy coIIocling llom. OvoraII,
llo docIino in cuslomor quaIily rosuIls in incroasod cosls of crodil invosligalion, coIIoc-
lion, and dofauIl.
In dolormining vlollor lo granl crodil lo an individuaI cuslomor, vo aro prima-
riIy inloroslod in llo cuslomor's slorl-run financiaI voII-boing. Tlus, Iiquidily ralios,
ollor obIigalions, and llo ovoraII profilabiIily of llo firm bocomo llo focaI poinl in llis
anaIysis. Crodil-raling sorvicos, sucl as Dun & Bradslrool, provido informalion on llo
financiaI slalus, oporalions, and paymonl lislory for mosl firms. Ollor possibIo
sourcos of informalion vouId incIudo crodil buroaus, lrado associalions, clambors of
commorco, compolilors, banI roforoncos, pubIic financiaI slalomonls, and, of courso,
llo firm's pasl roIalionslip vill llo cuslomor.
Ono vay in vlicl boll individuaIs and firms aro oflon ovaIualod as crodil risIs is
llrougl llo uso of crodil scoring. Credit scnring invoIvos llo numcricc| ctc|uciicn c|
ccc| cpp|iccni. An appIicanl rocoivos a scoro basod on lis or lor ansvors lo a simpIo sol
of quoslions. Tlis scoro is llon ovaIualod according lo a prodolorminod slandard lo
dolormino vlollor crodil slouId bo oxlondod. Tlo major advanlago of crodil scoring is
llal il is inoxponsivo and oasy lo porform. Ior oxampIo, onco llo slandards aro sol, a
compulor or cIoricaI vorIor villoul any spociaIizod lraining can oasiIy ovaIualo any
Tlo loclniquos usod for conslrucling crodil-scoring indoxos rango from llo simpIo
approacl lo adding up dofauIl ralos associalod vill llo ansvors givon lo oacl quos-
lion, lo soplislicalod ovaIualions using muIlipIo discriminalo anaIysis (MDA). MDA is
a slalislicaI loclniquo for caIcuIaling llo approprialo imporlanco lo assign oacl quos-
lion usod in ovaIualing llo appIicanl.
Idvard AIlman usod muIlipIo discriminanl anaIysis lo idonlify businossos llal
migll go banIrupl. In lis IandmarI sludy, AIlman usod financiaI ralios lo dovoIop llo
foIIoving indox:
Tlus, lo uso llo AIlman Z-scoro modoI lo prodicl a firm's IiIoIilood of banIruplcy, vo
subslilulo llo firm's vaIuos for oacl of llo prodiclor variabIos on llo rigll-land sido of
oqualion (4-4). AIlman found llal firms llal vonl banIrupl somolimo during llo noxl
yoar londod lo lavo a Z-scoro boIov 2.7, vloroas firms llal did nol go banIrupl lad
Z-scoros Iargor llan 2.7.
= 3 3 1 0 . .
lolaI assols

marIol vaIuo of oquily
 .06
ooI vaIuo of dobl
rolainod oarnin
 1 4 .
lolaI assols
vorIing capilaI
 1 2 .
llaI assols
700.4 CompohehIs o! ShorI-1erm AsseIs 56
CAßM ModuIe 700 Fihahce
CoIIection E!!orts-Decision VariabIe
Tlo Ioy lo mainlaining conlroI ovor coIIoclion of accounls rocoivabIo is llo facl llal
llo probabiIily of dofauIl incroasos vill llo ago of llo accounl. Tlus, conlroI of
accounls rocoivabIo focusos on llo conlroI and oIiminalion of pasl-duo rocoivabIos.
Ono common vay of ovaIualing llo curronl silualion is rciic cnc|usis. Tlo financiaI
managor can dolormino vlollor accounls rocoivabIos aro undor conlroI by oxamining
llo avorago coIIoclion poriod, llo ralio of rocoivabIos lo assols, llo ralio of crodil saIos
lo rocoivabIos (caIIod llo accounls-rocoivabIo lurnovor ralio), and llo amounl of bad
dobls roIalivo lo saIos ovor limo. In addilion, llo managor can porform vlal is caIIod
an aging of accounls rocoivabIo lo provido a broaIdovn in boll doIIars and porconl-
agos of llo proporlion of rocoivabIos llal aro pasl duo. Comparing llo curronl aging of
rocoivabIos vill pasl dala offors ovon moro conlroI.
Onco llo doIinquonl accounls lavo boon idonlifiod, llo firm's accounls-rocoivabIo
group maIos an offorl lo coIIocl llom. Ior oxampIo, a pasl-duo Iollor, caIIod a !unninv
|ciicr, is sonl if paymonl is nol rocoivod on limo, foIIovod by an addilionaI dunning
Iollor in a moro sorious lono if llo accounl bocomos 3 vooIs pasl duo, foIIovod aflor
6 vooIs by a loIoplono caII. IinaIIy, if llo accounl bocomos 12 vooIs pasl duo, il
migll bo lurnod ovor lo a coIIoclion agoncy. Again, a dirocl lrado-off oxisls bolvoon
coIIoclion oxponsos and Iosl goodviII on ono land and noncoIIoclion of accounls on
llo ollor, and llis lrado-off is aIvays parl of maIing llo docision.
700.4.6 Learn hov to manage inventory amounts
and IeveIs
Inventnrv management invoIvos llo ccnirc| c| i|c csscis i|ci crc prc!ucc! ic |c sc|! in i|c
ncrmc| ccursc c| i|c |irm´s cpcrciicns. Tlo gonoraI calogorios of invonlory incIudo rav-
maloriaIs invonlory, vorI-in-procoss invonlory, and finislod-goods invonlory. Tlo
imporlanco of llo invonlory managomonl lo llo firm doponds on llo oxlonl of llo
invonlory invoslmonl. Ior an avorago firm, approximaloIy 4.88 porconl of aII assols aro
in llo form of invonlory. Hovovor, llo porconlago varios vidoIy from induslry lo
700.4 CompohehIs o! ShorI-1erm AsseIs 57
CAßM ModuIe 700 Fihahce
To see how lhe credil-scoring model is used, lel's consider lhe credil applicalion ol Jamison Lleclr ic Corporalion.
Column D conlains lhe producls ol lhe credil-scoring model coellicienls lound in column 8 and Jamison's linancial
allribules lound in column C. Adding up all lhe individual producl lerms produces a credil score ol 2.00. 8ecause lhis
credil score is less lhan 2.7, we would anlicipale lhal lhere is a high likelihood lhal Jamison will become bankrupl some-
lime during lhe coming year.
induslry. Tlus, llo imporlanco of invonlory managomonl and conlroI varios from
induslry lo induslry aIso. Ior oxampIo, il is mucl moro imporlanl in llo aulomolivo
doaIor and sorvico slalion lrado, in vlicl invonlorios maIo up 49.72 porconl of lolaI
assols, llan in llo loloI businoss, in vlicl llo avorago invoslmonl in invonlory is onIy
1.56 porconl of lolaI assols.
Types of lnventory
Tlo purposo of carrying invonlorios is lo uncoupIo llo oporalions of llo firm÷llal is,
lo maIo oacl funclion of llo businoss indopondonl of oacl ollor funclion÷so llal
doIays or sluldovns in ono aroa do nol affocl llo produclion and saIo of llo finaI
producl. Bocauso produclion sluldovns rosuIl in incroasod cosls, and bocauso doIays
in doIivory can Ioso cuslomors, llo managomonl and conlroI of invonlory aro impor-
lanl dulios of llo financiaI managor.
Docision maIing in invoslmonl in invonlory invoIvos a basic lrado-off bolvoon
risI and rolurn. Tlo risI is llal if llo IovoI of invonlory is loo Iov, llo various func-
lions of businoss do nol oporalo indopondonlIy, and doIays in producl and cuslomor
doIivory can rosuIl. Tlo rolurn rosuIls bocauso roducod invonlory invoslmonl savos
monoy. As llo sizo of invonlory incroasos, slorago and landIing cosls as voII as llo
roquirod rolurn on capilaI invoslod in invonlory riso. Tloroforo, as llo invonlory a firm
loIds is incroasod, llo risI of running oul of invonlory is Iossonod, bul invonlory
oxponsos riso.
ßav-MateriaIs Inventory
Raw-materiaIs inventnrv consisls of |csic mcicric|s purc|csc! |rcm ci|cr |irms ic |c usc!
in i|c |irm´s prc!uciicn cpcrciicns. Tloso goods may incIudo slooI, Iumbor, polroIoum, or
manufaclurod iloms sucl as viro, baII boarings, or liros llal llo firm doos nol produco
ilsoIf. RogardIoss of llo spocific form of llo rav-maloriaIs invonlory, aII manufacluring
firms by dofinilion mainlain a rav-maloriaIs invonlory. Ils purposo is lo uncoupIo llo
produclion funclion from llo purclasing funclion÷llal is, lo maIo lloso lvo func-
lions indopondonl of oacl ollor÷so doIays in slipmonl of rav maloriaIs do nol causo
produclion doIays. In llo ovonl of a doIay in slipmonl, llo firm can salisfy ils nood for
rav maloriaIs by Iiquidaling ils invonlory.
Work-in-Process Inventory
Wnrk-in-µrncess inventnrv consisls of pcriic||u |inis|c! vcc!s rc¡uirinv c!!iiicnc| ucr|
|c|crc i|cu |cccmc |inis|c! vcc!s. Tlo moro compIox and Ionglly llo produclion procoss,
llo Iargor llo invoslmonl in vorI-in-procoss invonlory. Tlo purposo of vorI-in-
procoss invonlory is lo uncoupIo llo various oporalions in llo produclion procoss so
llal maclino faiIuros and vorI sloppagos in ono oporalion viII nol affocl llo ollor
oporalions. Assumo, for oxampIo, lloro aro 10 difforonl produclion oporalions, oacl
ono invoIving llo pioco of vorI producod in llo provious oporalion. If llo maclino
porforming llo firsl produclion oporalion broaIs dovn, a firm vill no vorI-in-
procoss invonlory viII lavo lo slul dovn aII 10 produclion oporalions. If a firm las
sucl invonlory, aII romaining 9 oporalions can conlinuo by draving llo inpul for llo
socond oporalion from invonlory.
finished-Goods Inventory
Finished-gnnds inventnrv consisls of vcc!s cn u|ic| prc!uciicn |cs |ccn ccmp|cic! |ui
i|ci crc nci uci sc|!. Tlo purposo of a finislod-goods invonlory is lo uncoupIo llo pro-
duclion and saIos funclions so llal il is nol nocossary lo produco llo goods boforo a
saIo can occur÷saIos can bo mado diroclIy oul of invonlory. In llo aulo induslry, for
oxampIo, poopIo vouId nol buy from a doaIor vlo mado llom vail vooIs or monlls
vlon anollor doaIor couId fiII llo ordor immodialoIy.
700.4 CompohehIs o! ShorI-1erm AsseIs 58
CAßM ModuIe 700 Fihahce
5tock o! Cash
AIllougl vo lavo aIroady discussod casl managomonl al somo Iongll, il is vorll-
vliIo lo monlion casl again in llo Iigll of invonlory managomonl. Tlis is bocauso llo
sicc| c| ccs| carriod by a firm is simpIy a spociaI lypo of invonlory. In lorms of uncou-
pIing llo various oporalions of llo firm, llo purposo of loIding a slocI of casl is lo
maIo llo paymonl of biIIs indopondonl of llo coIIoclion of accounls duo. Wlon casl is
Iopl on land, biIIs can bo paid villoul prior coIIoclion of accounls.
lnventory Management Techniques
Tlo imporlanco of offoclivo invonlory managomonl is diroclIy roIalod lo llo sizo of llo
invoslmonl in invonlory. Iffoclivo managomonl of lloso assols is ossonliaI lo llo goaI of
maximizing slaroloIdor voaIll. To conlroI llo invoslmonl in invonlory, managomonl
musl soIvo lvo probIoms: llo ordor quanlily probIom and llo ordor poinl probIom.
Order Ouantity ProbIem
Tlo nrder quantitv µrnbIem invoIvos !cicrmininv i|c cpiimc| cr!cr sizc |cr cn intcnicru
iicm vitcn iis cxpccic! uscvc, ccrruinv ccsis, cn! cr!crinv ccsis.
Tlo oconomic ordor quanlily (|OQ) modoI allompls lo dolormino llo ordor sizo
llal viII minimizo lolaI invonlory cosls. Il assumos llal
TolaI lolaI lolaI
invonlory cosls carrying cosls ordoring cosls
Assuming llo invonlory is aIIovod lo faII lo zoro and llon is immodialoIy ropIonislod
(llis assumplion viII bo Iiflod vlon vo discuss llo ordor poinl probIom), llo avorago
invonlory bocomos Q/2, vloro Q is invonlory ordor sizo in unils. Tlis can bo soon
graplicaIIy in Figure 4.6.
If llo avorago invonlory is Q/2 and llo carrying cosl por unil is C, llon carrying
cosls bocomo
vloro Q llo invonlory ordor sizo in unils
C llo carrying cosl por unil
carrying cosls
ccarrying cosl
por unil
700.4 CompohehIs o! ShorI-1erm AsseIs 59
CAßM ModuIe 700 Fihahce
0rder quaulily (ì
|uveulory repleuished
order quaulily

figure 4.6 IhvehIory Level ahd Ihe ReplehishmehI Cycle
Tlo carrying cosls on invonlory incIudo llo roquirod ralo of rolurn on invoslmonl in
invonlory, in addilion lo varolouso or slorago cosls, vagos for lloso vlo oporalo llo
varolouso, and cosls associalod vill invonlory slrinIago. Tlus, carrying cosls
incIudo boll roaI casl fIovs and opporlunily cosls associalod vill laving funds liod
up in invonlory.
Tlo ordoring cosls incurrod aro oquaI lo llo ordoring cosls por ordor limos llo
numbor of ordors. If vo assumo lolaI domand ovor llo pIanning poriod is S, vo ordor
in Iol sizos of Q, llon S/Q roprosonls llo numbor of ordors ovor llo pIanning poriod. If
llo ordoring cosl por ordor is O, llon
vloro S lolaI domand in unils ovor llo pIanning poriod
O ordoring cosl por ordor
Tlus, lolaI cosls in oqualion (4-5) bocomo
Figure 4.7 iIIuslralos llis oqualion graplicaIIy.
Wlal vo aro IooIing for is llo ordor sizo Q¯ llal providos llo minimum lolaI
cosls. By manipuIaling oqualion (4-8), vo find llal llo oplimaI vaIuo of Q÷llal is, llo
oconomic ordor quanlily (|OQ)÷is
Tlo uso of llo |OQ modoI can bosl bo iIIuslralod llrougl an oxampIo.
TolaI cosls =

ordoring cosls
of ordors
rrdoring cosl
por ordor
700.4 CompohehIs o! ShorI-1erm AsseIs 60
CAßM ModuIe 700 Fihahce
0rder size (units)
0rderiug cosls =  ( ì

Carryiug cosls =  ( ì

= +  ( ì

 ( ì

figure 4.7 1oIal CosIs ahd LOO DeIermihaIioh
Examination o! £OO Assumptions
Dospilo llo facl llal llo |OQ modoI londs lo yioId quilo good rosuIls, lloro aro voaI-
nossos associalod vill sovoraI of ils assumplions. Wlon ils assumplions lavo boon
dramalicaIIy vioIalod, llo |OQ modoI can gonoraIIy bo modifiod lo accommodalo llo
silualion. Tlo modoI's assumplions aro as foIIovs:
1. Cnnstant nr uniInrm demand. AIllougl llo |OQ modoI assumos conslanl
domand, domand may vary from day lo day. If domand is sloclaslic÷llal is,
nol Inovn in advanco÷llo modoI musl bo modifiod llrougl llo incIusion of
a safoly slocI.
2. Cnnstant unit µrice. Tlo incIusion of variabIo pricos rosuIling from quanlily
discounls can bo landIod quilo oasiIy llrougl a modificalion of llo originaI
|OQ modoI, rodofining lolaI cosls and soIving for llo oplimum ordor
3. Cnnstant carrving cnsts. Unil carrying cosls may vary subslanliaIIy as llo sizo
of llo invonlory risos, porlaps docroasing bocauso of oconomios of scaIo or
slorago officioncy or incroasing as slorago spaco runs oul and nov varolousos
lavo lo bo ronlod. Tlis silualion can bo landIod llrougl a modificalion in llo
originaI modoI simiIar lo llo ono usod for variabIo unil prico.
4. Cnnstant nrdering cnsts. AIllougl llis assumplion is gonoraIIy vaIid, ils
vioIalion can bo accommodalod by modifying llo originaI |OQ modoI in a
mannor simiIar lo llo ono usod for variabIo unil prico.
5. Instantanenus deIiverv. If doIivory is nol inslanlanoous, vlicl is gonoraIIy
llo caso, llo originaI IOO modoI musl bo modifiod llrougl llo incIusion of a
safoly slocI, llal is, llo invonlory loId lo accommodalo any unusuaIIy Iargo
and unoxpoclod usago during llo doIivory limo.
6. Indeµendent nrders. If muIlipIo ordors rosuIl in cosl savings by roducing
paporvorI and lransporlalion cosl, llo originaI |OQ modoI musl bo furllor
modifiod. AIllougl llis modificalion is somovlal compIicalod, spociaI |OQ
modoIs lavo boon dovoIopod lo doaI vill il.
Tloso assumplions iIIuslralo llo Iimilalions of llo basic |OQ modoI and llo vays
in vlicl il can bo modifiod lo componsalo for llom. An undorslanding of llo Iimila-
lions and assumplions of llo |OQ modoI providos llo financiaI managor vill moro of
a baso for maIing invonlory docisions.
Order Point Problem
Tlo lvo mosl Iimiling assumplions÷lloso of conslanl or uniform domand and inslan-
lanoous doIivory÷aro doaIl vill llrougl llo incIusion of saIetv stnck, vlicl is llo
intcnicru |c|! ic ccccmmc!cic cnu unusuc||u |crvc cn! uncxpccic! uscvc !urinv !c|itcru
700.4 CompohehIs o! ShorI-1erm AsseIs 61
CAßM ModuIe 700 Fihahce
Suppose a lirm expecls lolal demand (S) lor ils producl over lhe planning period lo be 5,000 unils, and lhe ordering cosl
per order () is S200 and lhe carrying cosl per unil () is S2. Subsliluling lhese values inlo equalion (4-9) yields
Thus, il lhis lirm orders in !,000-unil lol sizes, il will minimize ils lolal invenlory cosls.
 = = =
2 5 000 200
!000 000 !000
, , , unils
iimc. Tlo !ccisicn cn |cu muc| sc|ciu sicc| ic |c|! is gonoraIIy roforrod lo as llo nrder
µnint µrnbIem, llal is, lov Iov slouId invonlory bo dopIolod boforo il is roordorod`
Tvo faclors llal go inlo llo dolorminalion of llo approprialo ordor poinl: (1) llo
procuromonl or doIivory-limo slocI and (2) llo safoly slocI dosirod. Figure 4.8 grapls
llo procoss invoIvod in ordor poinl dolorminalion. Wo obsorvo llal llo ordor poinl
probIom can bo docomposod inlo ils lvo compononls, llo deIiverv-time stnck÷llal
is, llo intcnicru ncc!c! |ciuccn i|c cr!cr !cic cn! i|c rcccipi c| i|c intcnicru cr!crc!÷and
llo safoly slocI. Tlus, llo ordor poinl is roaclod vlon invonlory faIIs lo a IovoI oquaI
lo llo doIivory-limo slocI pIus llo safoly slocI.
Invonlory ordor poinl
|ordor nov invonlory doIivory-limo

vlon llo IovoI of invonlory slocI slocI
faIIs lo llis IovoI]
As a rosuIl of conslanlIy carrying safoly slocI, llo avorago IovoI of invonlory incroasos.
Wloroas boforo llo incIusion of safoly slocI llo avorago IovoI of invonlory vas oquaI
lo |OQ/2, nov il viII bo
In gonoraI, sovoraI faclors simuIlanoousIy dolormino lov mucl doIivory-limo
slocI and safoly slocI slouId bo loId. Iirsl, llo officioncy of llo ropIonislmonl syslom
affocls lov mucl doIivory-limo slocI is noodod. Bocauso llo doIivory-limo slocI is llo
oxpoclod invonlory usago bolvoon ordoring and rocoiving invonlory, officionl ropIon-
islmonl of invonlory vouId roduco llo nood for doIivory-limo slocI.
Tlo uncorlainly surrounding boll llo doIivory limo and llo domand for llo prod-
ucl affocls llo IovoI of safoly slocI noodod. Tlo moro corlain llo pallorns of lloso
infIovs and oulfIovs from llo invonlory, llo Ioss safoly slocI roquirod. In offocl, if
lloso infIovs and oulfIovs aro liglIy prodiclabIo, llon lloro is IillIo clanco of any
slocI-oul occurring. Hovovor, if lloy aro unprodiclabIo, il bocomos nocossary lo carry
addilionaI safoly slocI lo provonl unoxpoclod slocI-ouls.
Avorago invonlory safoly slocI =

700.4 CompohehIs o! ShorI-1erm AsseIs 62
CAßM ModuIe 700 Fihahce
Slock lo be
depleled duriug
delivery liue
^clual delivery liue
|uveulory repleuished
figure 4.8 Order PoihI DeIermihaIioh
Tlo safoly margin dosirod aIso affocls llo IovoI of safoly slocI loId. If il is a coslIy
oxporionco lo run oul of invonlory, llo safoly slocI loId viII bo Iargor llan il vouId bo
ollorviso. If running oul of invonlory and llo subsoquonl doIay in suppIying cus-
lomors rosuIl in slrong cuslomor dissalisfaclion and llo possibiIily of Iosl fuluro saIos,
llon addilionaI safoly slocI is nocossary. A finaI dolorminanl is llo cosl of carrying
addilionaI invonlory, in lorms of boll llo landIing and slorago cosls and llo opporlu-
nily cosl associalod vill llo invoslmonl in addilionaI invonlory. Vory simpIy, llo
groalor llo cosls, llo smaIIor llo safoly slocI.
Ovor llo pasl docado or so, a difforonl loclniquo aimod al roducing llo firm's
invoslmonl in invonlory las boon adoplod by numorous companios. Il is Inovn as llo
just-in-time inventnrv cnntrnI svstem. Tlo aim is lo oporalo vill llo |cucsi ctcrcvc
|ctc| c| intcnicru pcssi||c. Willin llo |OQ modoI, llo basics aro lo roduco (1) ordoring
cosls and (2) safoly slocIs. Tlis is acliovod by allompling lo rocoivo an aImosl conlin-
uous fIov of doIivorios of compononl parls. Tlo rosuIl is lo acluaIIy lavo aboul 2 lo
4 lours vorll of invonlory on land. In offocl, lrucIs, raiIroads, and airpIanos bocomo
llo firm's varolousos. Tlis syslom las spavnod a nov omplasis on llo duaI roIalion-
slip bolvoon llo firm and ils suppIiors.
lnflation and EOO
InfIalion affocls llo |OQ modoI in lvo major vays. Iirsl, aIllougl llo |OQ modoI can
bo modifiod lo assumo conslanl prico incroasos, oflon major prico incroasos occur onIy
onco or lvico a yoar and aro announcod aload of limo. If llis is llo caso, llo |OQ
modoI may Ioso ils prodiclabiIily and may bo ropIacod vill anticiµatnrv buving÷llal
is, |uuinv in cniicipciicn c| c pricc incrccsc ic sccurc i|c vcc!s ci c |cucr ccsi. Of courso, as
vill mosl docisions, lloro aro lrado-offs. Tlo cosls aro llo addod carrying cosls associ-
alod vill llo invonlory. Tlo bonofils, of courso, como from buying al a Iovor prico.
Tlo socond vay infIalion affocls llo |OQ modoI is llrougl incroasod carrying cosls.
As infIalion puslos inlorosl ralos up, llo cosl of carrying invonlory incroasos. In our
|OQ modoI llis moans llal C incroasos, vlicl rosuIls in a docIino in Q¯, llo oplimaI
oconomic ordor quanlily.
700.4 CompohehIs o! ShorI-1erm AsseIs 63
CAßM ModuIe 700 Fihahce
700.5 CosI o! CapiIal 64
700.5.1 Dofino a firm's cosl of capilaI and caIcuIalo llo cosl of individuaI
compononls of llo capilaI slrucluro
700.5.2 CaIcuIalo a firm's voigllod avorago cosl of capilaI
700.5.3 Ioarn lov lo uso a firm's cosl of capilaI lo ovaIualo nov capilaI
invoslmonl opporlunilios
700.5.4 Compulo llo oconomic profil oarnod by a firm
700.5 Cost of Capital
700.5.1 De!ine a !irm's cost o! capitaI and caIcuIate the
cost o! individuaI components o! the capitaI structure
lnvestor Opportunity Costs, Required Rates of Return,
and the Cost of Capital
Tlo discounl ralo usod in caIcuIaling nol prosonl vaIuo (NPV) is simpIy llo appropri-
alo discounl ralo. SpocificaIIy, llo approprialo discounl ralo primariIy rofIocls llo
investnr's required rate nI return, or llo minimum rcic c| rciurn ncccsscru ic ciircci cn
intcsicr ic purc|csc cr |c|! c sccuriiu. Tlis ralo of rolurn considors llo invoslor's oppor-
lunily cosl of maIing llo invoslmonl. Tlis opporlunily cosl oquaIs llo rolurn on llo
invoslor's noxl-bosl invoslmonl llal is forgono slouId llo projocl undor considoralion
bo accoplod. Tlis forgono rolurn is llo opporlunily cosl of undorlaIing llo invoslmonl
and, consoquonlIy, is llo invoslor's roquirod ralo of rolurn.
Is llo invoslor's roquirod ralo of rolurn llo samo lling as llo cosl of capilaI` Nol
oxaclIy. Tvo basic considoralions drivo a vodgo bolvoon llo invoslor's roquirod ralo
of rolurn and llo cosl of capilaI lo llo firm. Iirsl, lloro aro laxos. Wlon a firm borrovs
monoy lo financo llo purclaso of an assol, llo inlorosl oxponso is doduclibIo for fod-
oraI incomo lax caIcuIalions. Considor a firm llal borrovs al 9 porconl and llon
doducls ils inlorosl oxponso from ils rovonuos boforo paying laxos al a ralo of 34 por-
conl. Ior oacl doIIar of inlorosl il pays, llo firm roducos ils laxos by $.34. Conso-
quonlIy, llo acluaI cosl of borroving lo llo firm is onIy 5.94° |.09 (.34 .09) .09
(1 .34) 0.0594, or 5.94°]. Tlo socond lling llal causos llo firm's cosl of capilaI lo
diffor from llo invoslor's roquirod ralo of rolurn is cnu ircnscciicn ccsis incurrc! u|cn c
|irm rciscs |un!s |u issuinv c pcriicu|cr iupc c| sccuriiu, vlicl aro somolimos caIIod
IIntatinn cnsts. Ior oxampIo, if a firm soIIs nov slaros for $25 por slaro bul incurs
lransaclion cosls of $5 por slaro, llon llo cosl of capilaI for llo nov common oquily is
incroasod. Assumo llal llo invoslor's roquirod ralo of rolurn is 15 porconl for oacl $25
slaro, llon .15 $25 $3.75 musl bo oarnod oacl yoar lo salisfy llo invoslor's
roquirod rolurn. Hovovor, llo firm las onIy $20 lo invosl, so llo cosl of capilaI (|) is
caIcuIalod as llo ralo of rolurn llal musl bo oarnod on llo $20 nol procoods llal viII
produco a doIIar rolurn of $3.75, llal is,
Wo lavo moro lo say aboul boll lloso considoralions as vo discuss llo cosls of llo
individuaI sourcos of capilaI lo llo firm.
Iinancial Policy and the Cost of Capital
A firm's IinanciaI µnIicv÷llal is, i|c pc|icics rcvcr!inv i|c scurccs c| |incnccs ii p|cns ic
usc cn! i|c pcriicu|cr mix (prcpcriicns) in u|ic| i|cu ui|| |c usc!÷govorns ils uso of dobl
and oquily financing. Tlo parlicuIar mixluro of dobl and oquily llal llo firm uliIizos
can impacl llo firm's cosl of capilaI. Hovovor, in llis soclion, vo assumo llal llo firm
mainlains a fixod financiaI poIicy llal is rofIoclod in a fixod dobl÷oquily ralio.
Tlo firm's ovoraII cosl of capilaI rofIocls llo combinod cosls of aII llo sourcos of
financing usod by llo firm. Wo rofor lo llis ovoraII cosl of capilaI as llo firm's
weighted average cnst nI caµitaI. Tlo voigllod avorago cosl of capilaI is i|c uciv|ic!
ctcrcvc c| i|c c|icr-icx ccsis c| ccc| c| i|c scurccs c| ccpiic| usc! |u c |irm ic |incncc c prcj-
cci, u|crc i|c uciv|is rc||cci i|c prcpcriicn c| icic| |incncinv rcisc! |rcm ccc| scurcc. Con-
soquonlIy, llo voigllod avorago cosl of capilaI is llo ralo of rolurn llal llo firm
$ $ $
or 1
20 25 15 3 75
3 75
20 00
= =
= =
 . .
. , 88.75°
700.5 CosI o! CapiIal 65
CAßM ModuIe 700 Fihahce
musl oarn on ils invoslmonls so llal il can componsalo boll ils crodilors and slocI-
loIdors vill lloir individuaI roquirod ralos of rolurn. Iol's nov lurn lo a discussion
of lov llo cosls of dobl and oquily can bo oslimalod.
In ordor lo allracl nov invoslors, companios lavo croalod a vido varioly of financing
inslrumonls or socurilios. In llis soclion, vo slicI lo llroo basic lypos: dobl, proforrod
slocI, and common slocI. In caIcuIaling llo rospoclivo cosl of financing from oacl of
lloso lypos of financing inslrumonls, vo oslimalo llo invoslor's roquirod ralo of rolurn
aflor proporIy adjusling for any lransaclion or fIolalion cosls. In addilion, bocauso vo
viII bo discounling aflor-lax casl fIovs, vo adjusl our cosl of capilaI for llo offocls of
corporalo laxos. In summary, llo cosl of a parlicuIar sourco of capilaI is oquaI lo llo
invoslor's roquirod ralo of rolurn aflor adjusling for llo offocls of boll fIolalion cosls
and corporalo laxos.
The Cost of Debt
Tlo invoslor's roquirod ralo of rolurn on dobl is simpIy llo rolurn llal crodilors
domand on nov borroving. Wo Ioarnod llal vo couId caIcuIalo llo vaIuo of a bond
llal las 3 yoars lo malurily and pays inlorosl annuaIIy pIus llo principaI amounl of
llo dobl ($M) al llo ond of 3 yoars as foIIovs:
Sinco firms musl pay fIolalion cosls vlon lloy issuo nov dobl, llo nol procoods
from llo bond issuanco (NP
) viII bo Ioss llan llo bond prico paid by llo invoslor vlo
buys il. Tlo difforonco (i.o., llo fIolalion cosls) comprisos llo foos paid lo an invosl-
monl banIor lo proparo llo documonls noodod lo issuo nov bonds and for llo saIos
commissions invoIvod in soIIing llom. ConsoquonlIy, llo cosl of dobl capilaI, |
, viII
bo liglor llan llo invoslor's roquirod ralo of rolurn, R
. SpocificaIIy, vo caIcuIalo llo
cosl of capilaI for a firm's nov dobl as foIIovs:
Nolo llal llo adjuslmonl for fIolalion cosls simpIy invoIvos ropIacing llo marIol prico of
llo bond vill llo nol procoods por bond (NP
) rocoivod by llo firm aflor paying lloso
cosls. Tlo rosuIl of llis adjuslmonl is llal llo discounl ralo llal soIvos oqualion (5-2a) is
nov llo firm's cosl of dobl financing boforo adjusling for llo offocl of corporalo laxos÷
llal is, llo boforo-lax cosl of dobl (|
). Tlo finaI adjuslmonl vo maIo is lo accounl for
llo facl llal inlorosl is lax doduclibIo. Tlus, llo aflor-lax cosl of dobl capilaI is simpIy
(1 1
), vloro 1
is llo corporalo lax ralo.
As vo Ioarnod, llo inlorosl paymonls on bonds aro gonoraIIy llo samo for oacl
poriod. Undor lloso condilions, oqualion (5-2a) can bo roslalod using llo inlorosl faclors
in llo prosonl vaIuo labIos found in llo Appondixos al llo bacI of llo booI, as foIIovs:
! i | n | n
! !
= $ ( ) $ ( )
, ,

Nol procoods ( )
(1 cosl of dobl capil
 aaI ( ))
(1 )
$ $
(1 ) |
| M
! ! !

Bond prico ( )
inlorosl for yoar ($ )
 bondloIdor's roquirod ralo of rolurn ( ) R
( )
$ principaI ($ )
( )

| M
! !
1 1
700.5 CosI o! CapiIal 66
CAßM ModuIe 700 Fihahce
When we calculale lhe bondholder's required rale ol relurn, we are discounling lhe inleresl
and principal paymenls lo lhe bondholder back lo lhe presenl using a discounl rale lhal
makes lhis presenl value equal lhe currenl price ol lhe lirm's bonds. ln essence, we are
valuing lhe bond, which relies on lwo basic principles ol linance. PrincipIe 1. The
ßisk-ßeturn Trade-O!!-We Won't Take On AdditionaI ßisk UnIess We Expect to ße
Compensated vith AdditionaI ßeturn, and PrincipIe 2. The Time VaIue o! Money-
A DoIIar ßeceived Today Is Worth More Than a DoIIar ßeceived in the future.
ln addilion, lhe calculalion ol lhe bondholder's required rale ol relurn relies on lhe observed
markel price ol lhe lirm's bonds lo be an accurale relleclion ol lheir worlh. 8uyers and sellers
only slop lrading when lhey are convinced lhal lhe price properly rellecls all available
inlormalion. PrincipIe 6. E!!icient CapitaI Markets-The Markets Are Ouick and the
Prices Are ßight. Whal we mean here, very simply, is lhal inveslors are ever vigilanl and
quickly acl on inlormalion lhal allecls lhe riskiness and, consequenlly, lhe price ol a lirm's
bonds and olher securilies.
The lax deduclibilily ol inleresl expense makes debl linancing less coslly lo lhe lirm. This is
an example ol PrincipIe 8. Taxes ßias ßusiness Decisions. The lax deduclibilily ol inleresl,
olher lhings remaining conslanl, serves lo encourage lirms lo use more debl in lheir capilal
slruclure lhan lhey mighl olherwise use.
The Cost of Preferred Stock
Dolormining llo cosl of proforrod slocI is vory slraigllforvard bocauso of llo simpIo
naluro of llo casl fIovs paid lo llo loIdors of proforrod slaros. You viII rocaII llal llo
vaIuo of a proforrod slocI is simpIy
vloro P
is llo curronl marIol prico of llo proforrod slaros. SoIving for llo proforrod
slocIloIdor's roquirod ralo of rolurn, vo gol llo foIIoving:
Onco again, vloro fIolalion cosls aro incurrod vlon nov proforrod slaros aro soId,
llo invoslor's roquirod ralo of rolurn is Ioss llan llo cosl of proforrod capilaI lo llo firm.
To caIcuIalo llo cosl of proforrod slocI, vo musl adjusl llo roquirod ralo of rolurn lo
rofIocl lloso fIolalion cosls. Wo ropIaco llo prico of a proforrod slaro in oqualion (5-4)
vill llo nol procoods por slaro from llo saIo of nov proforrod slaros (NP
). Tlo rosuIl-
ing formuIa can bo usod lo caIcuIalo llo cosl of proforrod slocI lo llo firm.
Nolo llal llo nol procoods por slaro aro oquaI lo llo prico por slaro of proforrod
slocI minus fIolalion cosl por slaro of novIy issuod proforrod slocI.
Wlal aboul corporalo laxos` In llo caso of proforrod slocI, no lax adjuslmonl musl
bo mado bocauso proforrod dividonds aro nol lax doduclibIo.
cosl of proforrod slocI ( )
proforrod slo
ccI dividond
nol procoods por proforrod slaroo
roquirod ralo of rolurn
for proforrod slocIlooIdor
proforrod slocI dividond
prico of pro
fforrod slocI
Irico of proforrod
slocI ( )
proforrod slo
ccI dividond
roquirod ralo of rolurnfor profforrod slocIloIdor
700.5 CosI o! CapiIal 67
CAßM ModuIe 700 Fihahce
The Cost of Common £quity
Common oquily is uniquo in lvo rospocls. Iirsl, llo cosl of common oquily is moro diffi-
cuIl lo oslimalo llan llo cosl of dobl or proforrod slocI bocauso llo common slocI-
loIdor's roquirod ralo of rolurn is nol obsorvabIo. Tlis rosuIls from llo facl llal common
slocIloIdors aro llo rosiduaI ovnors of llo firm, vlicl moans llal lloir rolurn is oquaI
lo vlal is Iofl of llo firm's oarnings aflor paying llo firm's bondloIdors lloir conlraclu-
aIIy sol inlorosl and principaI paymonls and llo proforrod slocIloIdors lloir promisod
dividonds. Socond, common oquily can bo oblainod oillor from llo rolonlion of firm
oarnings or llrougl llo saIo of nov slaros. Tlo cosls associalod vill oacl of lloso
sourcos aro difforonl from ono anollor bocauso llo firm doos nol incur any fIolalion
cosls vlon il rolains oarnings bul il doos incur cosls vlon il soIIs nov common slaros.
Wo discuss lvo mollods for oslimaling llo common slocIloIdor's roquirod ralo of
rolurn, vlicl is llo foundalion for our oslimalo of llo firm's cosl of oquily capilaI.
Tloso mollods aro basod on llo dividond grovll modoI and llo capilaI assol pricing
The Dividend Growth Model
RocaII llal llo vaIuo of a firm's common slocI is oquaI lo llo prosonl vaIuo of aII
fuluro dividonds. Wlon dividonds aro oxpoclod lo grov al a ralo v forovor and v is Ioss
llan llo invoslor's roquirod ralo of rolurn, |
, llon llo vaIuo of a slaro of common
slocI, P
, can bo vrillon as
vloro D
is llo dividond oxpoclod lo bo rocoivod by llo firm's common slaroloIdors
1 yoar lonco. Tlo oxpoclod dividond is simpIy llo curronl dividond muIlipIiod by
1 pIus llo annuaI ralo of grovll in dividonds (i.o., D
(1 v)). Tlo invoslor's
roquirod ralo of rolurn llon is found by soIving oqualion (11-6) for |
Nolo llal |
is llo invoslor's roquirod ralo of rolurn for invosling in llo firm's slocI. Il
aIso sorvos as our oslimalo of llo cosl of oquily capilaI, vloro nov oquily capilaI is
oblainod by rolaining a parl of llo firm's curronl-poriod oarnings. RocaII llal common
oquily financing can como from ono of lvo sourcos: llo rolonlion of oarnings (i.o.,
oarnings nol paid oul in dividonds lo llo common slocIloIdors) or from llo saIo of
nov common slaros. Wlon llo firm rolains oarnings, il doosn'l incur any fIolalion

| v

700.5 CosI o! CapiIal 68
CAßM ModuIe 700 Fihahce
Ll Paso Ldison has an issue ol prelerred slock lhal pays an annual dividend ol S4.25 per share. On November 23,
2004, lhe slock closed al S58.50. Assume lhal il lhe lirm were lo sell an issue ol prelerred slock wilh lhe same char-
aclerislics as ils oulslanding issue, il would incur llolalion cosls ol S!.375 per share and lhe shares would sell lor
lheir November 23, 2004, closing price. Whal is Ll Paso Ldison's cosl ol prelerred slock?
Subsliluling inlo equalion (5-5), we gel lhe lollowing cosl ol prelerred slock lor Ll Paso Ldison.
Nole lhal lhere is no adjuslmenl lor laxes because prelerred dividends are nol lax deducliblelhal is, prelerred dividends
are paid aller corporale laxes, unlike bond inleresl, which is paid wilh belore-lax dollars.
= =
(S S )
or '
4 25
58 50 ! 375
0744 7 44
. .
. , .

cosls, llus, llo invoslor's roquirod ralo of rolurn is llo samo as llo firm's cosl of nov
oquily capilaI in llis inslanco.
If llo firm issuos nov slaros lo raiso oquily capilaI, llon il incurs fIolalion cosls.
Onco again vo adjusl llo invoslor's roquirod ralo of rolurn for fIolalion cosls by subsli-
luling llo nol procoods por slaro, NP
, for llo slocI prico, P
, in oqualion (5-7) lo osli-
malo llo cosl of nov common slocI, |
The dividend growlh model lor common slock valualion relies on lhree ol lhe lundamenlal
principles ol linance. lirsl, slock value is equal lo lhe presenl value ol expecled lulure
dividends. This rellecls PrincipIe 2. The Time VaIue o! Money-A DoIIar ßeceived Today
Is Worth More Than a DoIIar ßeceived in the future. lurlhermore, dividends represenl
aclual cash receipls lo slockholders and are incorporaled inlo lhe valualion model in a
manner lhal rellecls lhe liming ol lheir receipl. This allribule ol lhe dividend growlh model
rellecls PrincipIe 3. Cash-Not Pro!its-Is King. linally, lhe rale used lo discounl lhe
expecled lulure dividends back lo lhe presenl rellecls lhe riskiness ol lhe dividends. The
higher lhe riskiness ol lhe dividend paymenls, lhe higher lhe inveslor's required rale ol
relurn. This rellecls PrincipIe 1. The ßisk-ßeturn Trade-O!!-We Won't Take On
AdditionaI ßisk UnIess We Expect to ße Compensated vith AdditionaI ßeturn.
lssues in lmplementing the Dividend Growth Model
Tlo principaI advanlago of llo dividond grovll modoI is ils simpIicily. To oslimalo an
invoslor's roquirod ralo of rolurn, llo anaIysl noods onIy lo obsorvo llo curronl divi-
dond and slocI prico and lo oslimalo llo ralo of grovll in fuluro dividonds. Tlo pri-
mary dravbacI roIalos lo llo appIicabiIily or approprialonoss of llo vaIualion modoI.
Tlal is, llo dividond grovll modoI is basod on llo fundamonlaI assumplion llal divi-
donds aro oxpoclod lo grov al a conslanl ralo v forovor. To avoid llis assumplion, ana-
Iysls froquonlIy uliIizo moro compIox vaIualion modoIs in vlicl dividonds aro

700.5 CosI o! CapiIal 69
CAßM ModuIe 700 Fihahce
The Talbol Corporalion's common shareholders anlicipale receiving a S2.20 per share dividend nexl year, based on lhe lacl
lhal lhey received S2 lasl year and expecl dividends lo grow !0 percenl nexl year. lurlhermore, analysls predicl lhal divi-
dends will conlinue lo grow al a rale ol !0 percenl inlo lhe loreseeable lulure. Civen lhal lhe lirm's slock is lrading lor
S50 per share, we can calculale lhe inveslor's required rale ol relurn (and lhe cosl ol relained earnings) as lollows.
Should Talbol decide lo issue new common slock, lhen il would incur a cosl ol S7.50 per share, or !5 percenl ol lhe cur-
renl slock price. The resulling cosl ol new common equily capilal would be
Thus, Talbol laces lwo cosls ol capilal wilh respecl lo common equily. ll il relains earnings, lhen lhe cosl ol capilal lo lhe
lirm is !4.4 percenl, and il il issues new common slock, lhe corresponding cosl is !5.!8 percenl. This dillerence will prove
lo be imporlanl laler when we calculale lhe overall or weighled average cosl ol capilal lor lhe lirm.
= = =
2 20
50 7 50
!0 !5!8 ! 

. . , 55 !8 . '
= = =
2 20
50 00
!0 !44 !4 4  
or '
. . , .
oxpoclod lo grov for, say, 5 yoars al ono ralo and llon grov al a Iovor ralo from yoar 6
forvard. Wo do nol considor lloso moro compIox modoIs loro.
Ivon if llo conslanl grovll ralo assumplion is accoplabIo, vo musl arrivo al an
oslimalo of llal grovll ralo. Wo couId oslimalo llo ralo of grovll in lisloricaI divi-
donds oursoIvos or go lo pubIislod sourcos of grovll ralo oxpoclalions.
The Capital Asset Pricing Model
RocaII llal llo caµitaI asset µricing mndeI (CAPM) providos a basis for dolormining
llo invoslor's oxpoclod or roquirod ralo of rolurn from invosling in common slocI. Tlo
modoI doponds on llroo llings:
1. llo risI-froo ralo, |
2. llo syslomalic risI of llo common slocI's rolurns roIalivo lo llo marIol as a
vloIo, or llo slocI's bola coofficionl, , and
3. llo marIol risI promium, vlicl is oquaI lo llo difforonco in llo oxpoclod ralo
of rolurn for llo marIol as a vloIo, llal is, llo oxpoclod ralo of rolurn for llo
¨avorago socurily¨ minus llo risI-froo ralo, or in symboIs, |
Using llo CAIM, llo invoslor's roquirod ralo of rolurn can bo vrillon as foIIovs:
) (5-9)
lssues in lmplementing the CAPM
Tlo CAIM approacl las lvo primary advanlagos. Iirsl, llo modoI is simpIo and oasy
lo undorsland and impIomonl. Tlo modoI variabIos aro roadiIy avaiIabIo from pubIic
sourcos, vill llo possibIo oxcoplion of bola coofficionls for smaII and/or nonpubIicIy
lradod firms. Socond, bocauso llo modoI doos nol roIy on dividonds or any assump-
lion aboul llo grovll ralo in dividonds, il can bo appIiod lo companios llal do nol
curronlIy pay dividonds or aro nol oxpoclod lo oxporionco a conslanl ralo of grovll in
Using llo CAIM roquiros llal vo oblain oslimalos of oacl of llo llroo modoI
, , and (|
). Iol's considor oacl in lurn. Iirsl, llo anaIysl las a vido
rango of U.S. govornmonl socurilios on vlicl lo baso an oslimalo of llo risI-froo ralo.
Troasury socurilios vill malurilios from 30 days lo 20 yoars aro roadiIy avaiIabIo, bul
llo CAIM offors no guidanco aboul llo approprialo cloico. In facl, llo modoI ilsoIf
assumos llal lloro is bul ono risI-froo ralo, and il corrosponds lo a ono-poriod rolurn
(llo Iongll of llo poriod is nol spocifiod, lovovor). ConsoquonlIy, vo aro Iofl lo our
ovn judgmonl aboul vlicl malurily vo slouId uso lo roprosonl llo risI-froo ralo. Ior
700.5 CosI o! CapiIal 70
CAßM ModuIe 700 Fihahce
Talbol Corporalion's common slock has a bela coellicienl ol !.40. lurlhermore, lhe risk-lree rale is currenlly 3.75 percenl,
and lhe expecled rale ol relurn on lhe markel porllolio ol all risky assels is !2 percenl. Using lhe CAPM lrom equalion (5-9),
we can eslimale Talbol's cosl ol capilal as lollows.
( |
.0375 !.4(.!2 .0375) .!53, or !5.3'
Nole lhal lhe required rale ol relurn we have eslimaled is lhe cosl ol inlernal common equily because no lransaclion cosls
are considered.
appIicalions of llo cosl of capilaI invoIving Iong-lorm capilaI oxpondiluro docisions, il
sooms roasonabIo lo soIocl a risI-froo ralo of comparabIo malurily. So, if vo aro caIcu-
Ialing llo cosl of capilaI lo bo usod as llo basis for ovaIualing invoslmonls llal viII
provido rolurns ovor llo noxl 20 yoars, il sooms approprialo lo uso a risI-froo ralo cor-
rosponding lo a U.S. Troasury bond of comparabIo malurily.
Socond, oslimalos of socurily bola coofficionls aro avaiIabIo from a vido varioly of
invoslmonl advisory sorvicos, incIuding MorriII Iyncl and VaIuo Iino, among ollors.
AIlornalivoIy, vo couId coIIocl lisloricaI slocI marIol rolurns for llo company of
inlorosl as voII as a gonoraI marIol indox (sucl as llo Slandard and Ioor's 500 Indox)
and oslimalo llo slocI's bola as llo sIopo of llo roIalionslip bolvoon llo lvo rolurn
sorios. Hovovor, bocauso bola oslimalos aro vidoIy avaiIabIo for a Iargo majorily of
pubIicIy lradod firms, anaIysls froquonlIy roIy on pubIislod sourcos for bolas.
IinaIIy, oslimalion of llo marIol risI promium can bo accompIislod by IooIing al
llo lislory of slocI rolurns and llo promium oarnod ovor (undor) llo risI-froo ralo of
inlorosl. Wo sav llal on avorago ovor llo Iasl 70 yoars, common slocIs lavo oarnod a
promium of rouglIy 7 porconl ovor Iong-lorm govornmonl bonds. Tlus, for our pur-
posos, vo viII uliIizo llis oslimalo of llo marIol risI promium (|
) vlon oslimal-
ing llo invoslor's roquirod ralo of rolurn on oquily using llo CAIM.
In addilion lo llo lisloricaI avorago marIol risI promium, vo can aIso uliIizo sur-
voys of profossionaI oconomisls' opinions rogarding fuluro promiums.
The capilal assel pricing model, or CAPM, is a lormal represenlalion ol PrincipIe 1. The
ßisk-ßeturn Trade-O!!-We Won't Take On AdditionaI ßisk UnIess We Expect to ße
Compensated vith AdditionaI ßeturn. 8y "lormal" we mean lhal lhe specilic melhod ol
calculaling lhe addilional relurns needed lo compensale lor addilional risk is specilied in lhe
lorm ol an equalionlhe CAPM. The CAPM's recognilion ol syslemalic or nondiversiliable
risk as lhe source ol risk lhal is rewarded in lhe capilal markel is a relleclion ol PrincipIe 9.
AII ßisk Is Not EquaI-5ome ßisk Can ße Diversi!ied Avay and 5ome Cannot.
700.5.2 CaIcuIate a !irm's veighted average cost
o! capitaI
Nov llal vo lavo caIcuIalod llo individuaI cosls of capilaI for oacl of llo sourcos of
financing llo firm migll uso, vo lurn lo llo combinalion of lloso capilaI cosls inlo a
singIo voigllod avorago cosl of capilaI. To oslimalo llo voigllod avorago cosl of capi-
laI, vo nood lo Inov llo cosl of oacl of llo sourcos of capilaI usod and llo capilaI
slrucluro mix. Wo uso llo lorm caµitaI structure lo rofor lo i|c prcpcriicns c| ccc| scurcc
c| |incncinv usc! |u i|c |irm. AIllougl a firm's capilaI slrucluro can bo quilo compIox,
vo focus our oxampIos on llo llroo basic sourcos of capilaI: bonds, proforrod slocI,
and common oquily.
In vords, vo caIcuIalo llo voigllod avorago cosl of capilaI for a firm llal usos
onIy dobl and common oquily using llo foIIoving oqualion:
avorago cosl
of capilaI
cos = ll of
of dobl
  
cosl of
of oquily
financin ng
700.5 CosI o! CapiIal 71
CAßM ModuIe 700 Fihahce
Ior oxampIo, if a firm borrovs monoy al 6 porconl aflor laxos, pays 10 porconl for
oquily, and raisos ils capilaI in oquaI proporlions from dobl and oquily, ils voigllod
avorago cosl of capilaI is 8 porconl÷llal is,
avorago cosl |.06 .5] |.10 .5] .08 or 8°
of capilaI
In praclico, llo caIcuIalion of llo cosl of capilaI is gonoraIIy moro compIox llan llis
oxampIo. Ior ono lling, firms oflon lavo muIlipIo dobl issuos vill difforonl roquirod
ralos of rolurn, and lloy aIso uso proforrod oquily as voII as common oquily financing.
Iurllormoro, vlon nov common oquily capilaI is raisod, il is somolimos llo rosuIl of
rolaining and roinvosling llo firm's curronl poriod oarnings and, al ollor limos, il
invoIvos a nov slocI offoring. In llo caso of rolainod oarnings, llo firm doos nol incur
llo cosls associalod vill soIIing nov common slocI. Tlis moans llal oquily from
rolainod oarnings is Ioss coslIy llan a nov slocI offoring. In llo oxampIos llal foIIov,
vo addross oacl of lloso compIicalions.
Capital Structure Weights
A crilicaI oIomonl in llo anaIysis of an invoslmonl is an oslimalo of llo cosl of capilaI÷
llo discounl ralo÷lo bo usod lo caIcuIalo llo NPV for llo projocl. Tlo roason vo caIcu-
Ialo a cosl of capilaI is llal il onabIos us lo ovaIualo ono or moro of llo firm's invosl-
monl opporlunilios. Romombor llal llo cosl of capilaI slouId rofIocl llo risIinoss of
llo projocl boing ovaIualod, so a firm may caIcuIalo muIlipIo cosls of capilaI vlon il
maIos invoslmonls in muIlipIo divisions or businoss unils laving difforonl risI clarac-
lorislics. Tlus, for llo caIcuIalod cosl of capilaI lo bo moaningfuI, il musl corrospond
diroclIy lo llo risIinoss of llo parlicuIar projocl boing anaIyzod. Tlal is, in lloory llo
cosl of capilaI slouId rofIocl llo parlicuIar vay in vlicl llo funds aro raisod (llo capi-
laI slrucluro usod) and llo syslomic risI claraclorislics of llo projocl. ConsoquonlIy,
llo corrocl vay lo caIcuIalo capilaI slrucluro voiglls is lo uso llo acluaI doIIar
amounls of llo various sourcos of capilaI acluaIIy usod by llo firm.
In praclico, i|c mixiurc c| |incncinv scurccs usc! |u c |irm ui|| tcru |rcm uccr ic uccr.
Ior llis roason, many firms find il oxpodionl lo uso largol capilaI slrucluro proporlions
in caIcuIaling llo firm's voigllod avorago cosl of capilaI. Ior oxampIo, a firm migll
uso ils largol mix of 40 porconl dobl and 60 porconl oquily lo caIcuIalo ils voigllod
avorago cosl of capilaI ovon llougl, in llal parlicuIar yoar, il raisod llo majorily of ils
financing roquiromonls by borroving. SimiIarIy, il vouId conlinuo lo uso llo largol
proporlions in llo subsoquonl yoar, vlon il migll raiso llo majorily of ils financing
noods by roinvosling oarnings or llrougl a nov slocI offoring.
Calculating the Weighted Average Cost of Capital
Tlo voigllod avorago cosl of capilaI, |
, is simpIy a voigllod avorago of aII llo capi-
laI cosls incurrod by llo firm. TabIe 5.1 iIIuslralos llo procoduro usod lo oslimalo |
for a firm llal las dobl, proforrod slocI, and common oquily in ils largol capilaI slruc-
luro mix. Tvo possibIo sconarios aro doscribod in llo lvo panoIs. Iirsl, in IanoI A llo
firm is abIo lo financo aII ils largol capilaI slrucluro roquiromonls for common oquily
llrougl llo rolonlion of firm oarnings. Socond, in IanoI B llo firm musl uso a nov
oquily offoring lo raiso llo oquily capilaI il roquiros. Ior oxampIo, if llo firm largols
75 porconl oquily financing and las curronl oarnings of $750,000, llon il can raiso up
lo $750,000/.75 $1,000,000 in nov financing boforo il las lo soII nov oquily. Ior
$1,000,000 or Ioss in capilaI sponding, llo firm's voigllod avorago cosl of capilaI
vouId bo caIcuIalod using llo cosl of oquily from rolainod oarnings (foIIoving IanoI A
of TabIo 5.1). Ior moro llan $1,000,000 in nov capilaI, llo cosl of capilaI vouId riso lo
rofIocl llo impacl of llo liglor cosl of using nov common slocI (foIIoving IanoI B of
TabIo 5.1).
700.5 CosI o! CapiIal 72
CAßM ModuIe 700 Fihahce
700.5 CosI o! CapiIal 73
CAßM ModuIe 700 Fihahce
TabIe 5.1 CalculaIihg Ihe WeighIed Average CosI o! CapiIal
PaneI A. Common Equity ßaised by ßetained Earnings
CapitaI 5tructure
5ource o! CapitaI Weights Cost o! CapitaI Product
8ohds w
(1 J
) w
(1 J
Pre!erred sIock w
Commoh equiIy
ReIaihed earhihgs w
Sum 100% Sum k
PaneI ß. Common Equity ßaised by 5eIIing Nev Common 5tock
CapitaI 5tructure
5ource o! CapitaI Weights Cost o! CapitaI Product
8ohds w
(1 J
) w
(1 J
Pre!erred sIock w
Commoh equiIy
Commoh sIock w
Sum 100% Sum k
Ash, lnc.'s capilal slruclure and eslimaled capilal cosls are lound in TabIe 5.2. Nole lhal lhe sum ol lhe capilal slruclure
weighls musl sum lo !00 percenl il we have properly accounled lor all sources ol linancing and in lhe correcl amounls.
lor example, Ash plans lo invesl a lolal ol S3 million in common equily inlo lhe S5 million inveslmenl. 8ecause Ash has
earnings equal lo lhe S3,000,000 il needs in new equily linancing, lhe enlire amounl ol new equily will be raised by
relaining earnings.
TabIe 5.2 CapiIal SIrucIure ahd CapiIal CosIs !or Ash, Ihc.
Amount o! Percentage A!ter-Tax
5ource o! CapitaI funds ßaised ($) o! TotaI Cost o! CapitaI
8ohds 1,750,000 35% 7%
Pre!erred sIock 250,000 5% 13%
Commoh equiIy
ReIaihed earhihgs 3,000,000 60% 16%
5,000,000 100%
We calculale lhe weighled average cosl ol capilal lollowing lhe procedure described in Panel A ol Table 5.! and using lhe
inlormalion lound in Table 5.2. The resulling calculalions are lound in Panel A ol TabIe 5.3, in which Ash, lnc.'s weighled
average cosl ol capilal lor up lo S5,000,000 in new linancing is lound lo be !2.7 percenl.
ll Ash needs more lhan S5,000,000, il will nol have any relained earnings lo provide lhe addilional equily capilal. Thus, lo
mainlain ils desired 60 percenl equily linancing proporlion, Ash will now have lo issue new equily lhal cosls !8 percenl.
TabIe 5.4 conlains a summary of llo formuIas invoIvod in oslimaling llo
voigllod avorago cosl of capilaI. If divisionaI cosls of capilaI aro lo bo oslimalod,
llon vo musl appIy lloso formuIas individuaIIy lo oacl division vloro llo opporlu-
nily cosls of capilaI sourcos and llo financing mix (proporlions) usod can diffor.
700.5 CosI o! CapiIal 74
CAßM ModuIe 700 Fihahce
TabIe 5.3 WeighIed Average CosI o! CapiIal !or Ash, Ihc.
PaneI A. Cost o! CapitaI !or $0 to $5,000,000 in Nev CapitaI
CapitaI 5tructure
5ource o! CapitaI Weights Cost o! CapitaI Product
8ohds 35% 7% 2.45%
Pre!erred sIock 5% 13% 0.65%
Commoh equiIy
ReIaihed earhihgs 60% 16% 9.60%
100% k
PaneI ß. Cost o! CapitaI !or More than $5,000,000
CapitaI 5tructure
5ource o! CapitaI Weights Cost o! CapitaI Product
8ohds 35% 7% 2.45%
Pre!erred sIock 5% 13% 0.65%
Commoh equiIy
Commoh sIock 60% 18% 10.80%
100% k
Panel 8 ol Table 5.3 conlains lhe calculalion ol Ash's weighled average cosl ol capilal lor more lhan S5,000,000. The
resulling cosl is !3.9 percenl.
ln praclice, many lirms calculale only one cosl ol capilal, using a cosl ol equily capilal lhal ignores lhe lransaclion cosls
associaled wilh raising new equily capilal. ln essence, lhey would use lhe capilal cosl calculaled lor Ash in Panel A ol
Table 5.3, regardless ol lhe level ol new linancing lor lhe year. Allhough lhis is lechnically incorrecl, il is an underslandable
praclice given lhe inexaclness ol lhe eslimales ol equily capilal cosl and lhe relalively small dillerences lhal resull lrom lhe
700.5 CosI o! CapiIal 75
CAßM ModuIe 700 Fihahce
TabIe 5.4 Summary o! CosI o! CapiIal Formulas
1. 1he A!Ier-1ax CosI o! DebI, k
(1 J
a) CalculaIe Ihe be!ore-Iax cosI o! debI, k
, as !ollows:
where NP
is Ihe heI proceeds received by Ihe !irm !rom Ihe sale o! each bohd, $l
Ihe dollar amouhI o! ihIeresI paid Io Ihe ihvesIor ih period t !or each bohd, $M is
Ihe maIuriIy value o! each bohd paid ih period n, k
is Ihe be!ore-Iax cosI o! debI Io
Ihe !irm, ahd n is Ihe humber o! periods Io maIuriIy.
b) CalculaIe Ihe a!Ier-Iax cosI o! debI as !ollows:
a!Ier-Iax cosI o! debI k
(1 J
where J
is Ihe corporaIe Iax raIe.
2. 1he CosI o! Pre!erred SIock, k
where NP
is Ihe heI proceeds per share o! hew pre!erred sIock sold a!Ier !loIaIioh
3. 1he CosI o! Commoh LquiIy
a) MeIhod 1: dividehd growIh model
CalculaIe Ihe cosI o! ihIerhal commoh equiIy (reIaihed earhihgs), k
, as !ollows:
where D
is Ihe expecIed dividehd !or Ihe hexI year, P
is Ihe currehI price o! Ihe
!irm's commoh sIock, ahd g is Ihe raIe o! growIh ih dividehds per year. CalculaIe
Ihe cosI o! exIerhal commoh equiIy (hew sIock o!!erihg), k
, as !ollows:
where NP
is Ihe heI proceeds Io Ihe !irm a!Ier !loIaIioh cosIs per share o! sIock
b) MeIhod 2: capiIal asseI pricihg model, k
) (5-9)
where Ihe risk-!ree raIe is k
, Ihe sysIemic risk o! Ihe commoh sIock's reIurhs
relaIive Io Ihe markeI as a whole, or Ihe sIock's beIa coe!!iciehI, is , ahd Ihe
markeI risk premium, which is equal Io Ihe di!!erehce ih Ihe expecIed raIe o!
reIurh !or Ihe markeI as a whole (i.e., Ihe expecIed raIe o! reIurh !or Ihe
"average securiIy") mihus Ihe risk-!ree raIe, is k
4. 1he WeighIed Average CosI o! CapiIal
(1 J
) w
where Ihe w
Ierms represehI Ihe markeI value weighIs associaIed wiIh Ihe !irm's use
o! each o! iIs sources o! !ihahcihg. NoIe IhaI we are simply calculaIihg a weighIed
average o! Ihe cosIs o! each o! Ihe !irm's sources o! capiIal where Ihe weighIs re!lecI
Ihe !irm's relaIive use o! each source.


pre!erred sIock dividehd
( )
( ) 1 1

700.5.3 Learn hov to use a !irm's cost o! capitaI
to evaIuate nev capitaI investment opportunities
If a firm las lradilionaIIy usod a singIo cosl of capilaI for aII projocls undorlaIon
villin oacl of sovoraI oporaling divisions (or companios) llal lavo vory difforonl risI
claraclorislics, llon il viII oncounlor rosislanco lo llo clango from llo ligl-risI divi-
sions. Considor llo caso of llo lypollolicaI firm GIobaI Inorgy, vloso divisionaI cosls
of capilaI aro iIIuslralod in Figure 5.1. GIobaI Inorgy is an inlogralod oiI company llal
ongagos in a vido rango of lydrocarbon-roIalod businossos, incIuding oxpIoralion and
dovoIopmonl, pipoIinos, and rofining. Iacl of lloso businossos las ils uniquo sol of
risIs. In Iiguro 5.1 vo soo llal llo ovoraII, or onlorprisovido, cosl of capilaI for GIobaI
Inorgy is 11 porconl, rofIocling an avorago of llo firm's divisionaI cosls of capilaI,
ranging from a Iov of 8 porconl for pipoIinos up lo 18 porconl for oxpIoralion and
Al prosonl GIobaI Inorgy is using 11 porconl lo ovaIualo nov invoslmonl propos-
aIs from aII llroo oporaling divisions. Tlis moans llal oxpIoralion and dovoIopmonl
projocls oarning as IillIo as 11 porconl aro boing accoplod ovon llougl llo capilaI mar-
Iol diclalos llal projocls of llis risI slouId oarn 18 porconl. Tlus, GIobaI Inorgy ovor-
invosls in ligl-risI projocls. SimiIarIy, llo company viII undorinvosl in ils lvo Iovor-
risI divisions, vloro llo companyvido cosl of capilaI is usod.
Nov considor llo prospocl of moving lo division cosls of capilaI and llo impIica-
lions llis migll lavo for llo llroo divisions. SpocificaIIy, llo oxpIoralion and dovoIop-
monl division is IiIoIy lo soo llis as an advorso movo for llom bocauso il viII suroIy
cul llo IovoI of nov invoslmonl capilaI fIoving inlo lloir oporalions. In conlrasl, llo
managomonl of llo romaining lvo divisions viII soo llo clango as good novs bocauso
undor llo companyvido cosl of capilaI syslom lloy lavo boon rojocling projocls oarn-
ing moro llan lloir marIol-basod cosls of capilaI (8 porconl and 10 porconl for
pipoIinos and rofining, rospoclivoIy) bul Ioss llan llo company's 11 porconl cosl of
700.5 CosI o! CapiIal 76
CAßM ModuIe 700 Fihahce
Coupauy·wide cosl oí capilal
aud reíiuiug
aud developueul
figure 5.1 Global Lhergy Divisiohal CosIs o! CapiIal Using a company-wide cosl
ol capilal lor a mullidivisional lirm resulls in syslemalic overinveslmenl in high-risk projecls and
underinveslmenl in low-risk projecls.
The lirm's weighled average cosl ol capilal provides lhe appropriale discounl rale lor
evalualing new projecls only when lhe projecls oller lhe same riskiness as lhe lirm as a
whole. This limilalion ol lhe uselulness ol lhe lirm's weighled average cosl ol capilal is a
direcl exlension ol PrincipIe 1. The ßisk-ßeturn Trade-O!!-We Won't Take On
AdditionaI ßisk UnIess We Expect to ße Compensated vith AdditionaI ßeturn. ll
projecl risk dillers lrom lhal ol lhe lirm, lhen lhe lirm's cosl ol capilal (which rellecls lhe risk
ol lhe lirm's inveslmenl porllolio) is no longer lhe appropriale cosl ol capilal lor lhe projecl.
lor lhis reason, lirms lhal invesl in mulliple divisions or business unils lhal have dillerenl risk
characlerislics should calculale a dillerenl cosl ol capilal lor each division. ln lheory, each
individual inveslmenl opporlunily has ils own unique risk allribules and, correspondingly,
should have a unique cosl ol capilal. However, given lhe impreciseness wilh which we
eslimale lhe cosl ol capilal, we generally calculale lhe cosl ol capilal lor each operaling
division ol lhe lirm, nol each projecl.
700.5.4 Compute the economic pro!it earned by a !irm
Hov do you Inov vlollor you aro croaling or doslroying slaroloIdor vaIuo` AsIod
somovlal difforonlIy, ¨lov can you loII lov mucl voaIll a firm las croalod for ils
slaroloIdors`¨ In roconl yoars a vloIo losl of sysloms lavo boon dovoIopod llal pur-
porl lo ansvor lloso quoslions and in so doing provido guidanco lo a firm's manago-
monl for uso in maIing docisions llal aro oxpoclod lo lavo llo groalosl posilivo impacl
on slaroloIdor voaIll. Wo rofor lo llis cadro of mollods as slaroloIdor vaIuo÷basod
managomonl, or simpIy vaIuo÷basod managomonl looIs. Wo focus on ono vory popu-
Iar mollod in our discussion llal is basod on llo concopl of oconomic profil.
How Much value Has a Iirm Created for lts Owners7
In llo inlroduclion vo doscribod a firm, H&I Manufacluring, llal vas lrying lo como
lo grips vill vly ils slocI prico vas nol groving as rapidIy as ils compolilors'. In
ossonco, H&I noods lo Inov vlollor il is croaling or doslroying slaroloIdor voaIll.
Hov can vo loII` Tlo ansvor is market vaIue added (MVA). MVA is a vory simpIo
concopl. Il roprosonls i|c !i||crcncc in i|c currcni mcr|ci tc|uc c| i|c |irm cn! i|c sum c| c||
i|c |un!s i|ci crc intcsic! in i|c |irm. If llo marIol vaIuo of llo firm oxcoods llo invosl-
monl mado in llo firm, llon llo firm las croalod slaroloIdor voaIll. MVA is caIcu-
Ialod as foIIovs:
MVA lolaI marIol vaIuo of llo firm invoslod capilaI (5-11a)
Tlo lolaI marIol vaIuo of llo firm is oquaI lo llo vaIuo of aII llo cIaims or socuri-
lios llo firm las issuod, llal is,
MarIol vaIuo marIol vaIuo marIol vaIuo marIol vaIuo
of llo of llo firm's of llo firm's of llo firm's
firm oulslanding dobl proforrod slocI common slocI
Ior firms vloso dobl and oquily socurilios aro lradod in pubIic marIols vo can caIcuIalo
llo marIol vaIuo of oacl lypo of socurily by simpIy muIlipIying llo numbor of bonds or
slaros of slocI by llo mosl roconl marIol prico. Il slouId bo nolod llal mosl firms' dobl is
nol pubIicIy lradod so il is common praclico lo approximalo llo marIol vaIuo of llo
firm's dobl by using ils booI vaIuo. Invoslod capilaI is basicaIIy llo sum lolaI of llo
monoy invoslod in llo firm lo dalo. Invoslod capilaI is oslimalod by adjusling llo firm's
booI vaIuo of lolaI assols for llings sucl as R&D oxponso and aIIovancos for doublfuI
700.5 CosI o! CapiIal 77
CAßM ModuIe 700 Fihahce
accounls rocoivabIo, vlicl aro nol incIudod in llo lolaI assols of llo firm bul, nonolloIoss,
roprosonl doIIars llal lavo boon invoslod in llo firm.
In ossonco, MVA is llo NPV of aII llo firm's invoslmonls. ToclnicaIIy, MVA ovor-
slalos a firm's lolaI voaIll croalion bocauso il faiIs lo incorporalo an opporlunily cosl
of llo funds llo firm invoslod in prior poriods. As a consoquonco, our anaIogy lo NPV
is onIy lruIy accuralo for llo caso of a slarl-up firm in vlicl llo firm's lolaI invoslod
capilaI is oquaI lo lolaI assols al llo boginning of llo poriod for vlicl MVA is boing
moasurod. Hovovor, for our purposos MVA sorvos as a vory usofuI and simpIo
approximalion lo llo voaIll a firm las croalod for ils invoslors. A firm llal is using ils
invoslmonls lo produco vlal invoslors porcoivo lo bo posilivo NPVs viII lavo a posi-
livo MVA. SimiIarIy, a firm llal is using ils invoslod capilaI in vays llal invoslors fooI
doslroy vaIuo viII lavo a nogalivo MVA. Nolo llal bocauso llo marIol vaIuo of llo
firm's socurilios is basod on oxpoclod fuluro casl fIovs, MVA is a rofIoclion of llo
oxpoclod NPV. Bocauso MVA is nol a moasuro of lisloricaI porformanco bul insload
rofIocls anlicipalod fuluro porformanco, il can clango dramalicaIIy as a firm's forlunos
clango. Tlo sourcos of llo voIaliIily in MVA aro llo marIol vaIuo of llo firm's oquily
and adjuslmonls llo firm maIos lo ils invoslod capilaI llrougl acquisilions and saIos
of assols.
Did the Iirm Create Shareholder value This ¥ear7
MVA moasuros llo voaIll croalod by a firm al a parlicuIar poinl in limo. Hovovor, llo
financiaI managor noods lo ovaIualo llo porformanco of llo firm ovor a spocific inlor-
vaI of limo, say, 1 yoar. Ior llis purposo, vo caIcuIalo llo firm's ecnnnmic µrnIit. Ico-
nomic profil is dofinod as foIIovs:
Nolo llal llo dislinclion bolvoon oconomic and accounling profil (nol oporaling
profil) is llo doduclion of a rolurn lo llo firm's invoslod capilaI. Tlo producl of llo
firm's invoslod capilaI (llo lolaI doIIar invoslmonl mado in llo firm by ils crodilors
and ovnors) and llo cosl of capilaI conslilulos a capilaI clargo. Tlis capilaI clargo is
nol a rocognizod accounling oxponso, bul il is a vory roaI oxponso from llo porspoclivo
of llo firm's bondloIdors and slocIloIdors. Tlo firm's accounling profils nol onIy
musl bo posilivo bul aIso musl covor llo roquirod ralo of rolurn on llo firm's invosl-
monl (llo cosl of capilaI) boforo slaroloIdor vaIuo las boon croalod. Tlus, oconomic
profil is simpIy accounling profil (nol oporaling profil or incomo) Ioss a clargo for llo
uso of capilaI.
So vlal` Hov doos llo uso of oconomic profil loIp llo financiaI managor` Tlo
ansvor is surprisingIy simpIo. Mosl firms manago lo oarn posilivo profils. Hovovor,
oarning posilivo profils is no assuranco llal llo firm is croaling slaroloIdor voaIll
bocauso profils faiI lo incorporalo any opporlunily cosl for llo doIIars llal invoslors
lavo liod up in llo businoss. Iconomic profil, on llo ollor land, incIudos an oxpIicil
clargo in llo form of llo capilaI clargo, vlicl rocognizos llo sizo of llo invoslmonl
mado in llo firm and llo opporlunily cosl of llal invoslmonl.
Considor llo caso of Kmarl, vlicl ranIod 990ll in llo MVA ranIings. Kmarl's
oconomic profil for 1999 can bo caIcuIalod as foIIovs:
Iconomic profil NOPA1 (invoslod capilaI cosl of capilaI)
($568.979 M) $950 M ($19,727 M .0770)
Hov can llis bo` Kmarl oarnod a posilivo NOPA1 of $950 miIIion. Tlo ansvor Iios in
llo sizo of Kmarl's NOPA1 roIalivo lo ils invoslmonl in assols. Comparod vill llo
firm's $19,727 miIIion invoslod capilaI, ils NOPA1 roprosonls a moagor rolurn of onIy
4.82 porconl, vlicl is Ioss llan llo firm's 7.70 porconl cosl of capilaI. So Iong as Kmarl
Iconomic profil
nol oporaling
profil aflor l = aax
( )
cosl of
 
700.5 CosI o! CapiIal 78
CAßM ModuIe 700 Fihahce
conlinuos lo oarn a rolurn on ils invoslod capilaI llal is Iovor llan ils cosl of capilaI, il
viII conlinuo lo doslroy slaroloIdor vaIuo no mallor lov Iargo ils profils. In facl,
Kmarl docIarod banIruplcy in Ianuary 2002.
How Can the Iirm lncrease lts £conomic Profits7
Wlal can a firm do lo improvo ils porformanco so il croalos moro slaroloIdor vaIuo for ils
ovnors` Tlo ansvor can bo found by rovioving llo variabIos llal aro found on llo rigll-
land sido of oqualion (5-12). Tloso variabIos incIudo llo IovoI of NOPA1, llo cosl of capilaI,
and llo amounl of invoslod capilaI (oflon roforrod lo as vaIuo drivors). Ono vay lo croalo
addilionaI vaIuo is by sooIing vays lo incroaso NOPA1 villoul a corrosponding incroaso
in llo firm's invoslod capilaI. Tlis can bo accompIislod by incroasing rovonuos and/or
driving dovn oxponsos. Tloro aro a numbor of vays llal a firm migll roduco cosls and
incroaso profils villoul llo nood lo spond addilionaI capilaI. Ior oxampIo, llo Domlar Cor-
poralion (a forosl managomonl company llal doaIs in papor, puIp, and vood producls)
adoplod an oconomic profil÷basod syslom and nolos llo foIIoving vays in vlicl il can
improvo ils oconomic profil by idonlifying oporaling officioncios:
culling dovn on vaslo and damagod producls
oporaling maclinory and oquipmonl moro officionlIy
improving producl mix, dovising mollods lo savo on llo purclaso of rav
improving loaIll and safoly porformanco, allracling and rolaining cuslomors
maIing bollor uso of limo in llo offico and pIanl, impIomonling or improving
provonlalivo mainlonanco programs
dovoIoping IinIs vill suppIiors
A socond vay lo improvo oconomic profil is by groving llo firm's invoslmonls in
projocls llal oarn rolurns in oxcoss of llo firm's cosl of capilaI. Ior oxampIo, llo firm
migll inlroduco nov marIoling pIans llal improvo cuslomor salisfaclion and saIos
and profils, oxpand oxisling businossos llal offor llo polonliaI lo oarn posilivo NPVs,
or inlroduco nov informalion sysloms lo bollor lraco cuslomor buying labils and, cor-
rospondingIy, incroaso firm saIos.
Tlo llird and finaI approacl lo improving oconomic profils invoIvos roducing llo
firm's capilaI clargo (cosl of capilaI invoslod capilaI). Tlis can bo accompIislod in
oillor of lvo vays. If llo firm is nol using ils minimum cosl of capilaI financing mix,
llon roslrucluring ils financing sourcos migll Ioad lo a Iovoring of llo firm's cosl of
capilaI and a corrosponding docroaso in llo firm's doIIar cosl of capilaI. AIlornalivoIy,
llo firm migll considor villdraving capilaI from ils oporalions llrougl llo saIo of
undoruliIizod assols (o.g., oxcoss pIanl capacily, undorporforming oporaling unils, or
roaI oslalo).
How Can a Iirm Link Pay for Performance
to Reinforce Wealth Creation7
Iconomic profil las bocomo an imporlanl looI for aIigning slaroloIdor and managor
inlorosls in llo running of llo company. Tlis is accompIislod by basing manago-
monl's inconlivo componsalion on oconomic profil. A vory simpIo vorsion of sucl a
componsalion sclomo is iIIuslralod in oqualion (5-13).
Ior oxampIo, considor llo caso of llo assislanl lroasuror for NovCo OiI, Inc. Tlo
assislanl lroasuror's baso pay is $80,000 a yoar, and 20 porconl of llo lolaI componsalion
for llis posilion is dosignalod by llo company lo bo inconlivo basod. If in a parlicuIar
baso pay
incon   llivo
acluaI oconomic profil

ggol oconomic profil
700.5 CosI o! CapiIal 79
CAßM ModuIe 700 Fihahce
yoar NovCo sol a largol oconomic profil of $1 miIIion and oarnod $1.2 miIIion, llon llo
assislanl lroasuror's inconlivo componsalion vouId bo caIcuIalod as foIIoving using
oqualion (5-13):
In llis caso, llo assislanl lroasuror's lolaI annuaI componsalion vouId bo $99,200
($80,000 $19,200). If NovCo oarnod onIy $800,000 in oconomic profil, llon llo incon-
livo componsalion paid lo llo assislanl lroasuror vouId bo $12,800 |$80,000 .20
CIoarIy, vill llis lypo of inconlivo componsalion pIan, llo firm's managors viII bo
vory carofuI lo manago for incroasod nol oporaling profils vliIo loIding dovn llo
firm's invoslod capilaI and mainlaining llo Iovosl possibIo cosl of capilaI. If lloy do
llis, lloy viII maximizo llo conlribulion lo slaroloIdor voaIll and aIso maximizo
lloir ovn yoar-ond bonusos.
baso pay
incon =  llivo
acluaI oconomic profil

ggol oconomic profil
$ ($ miI = 80 000 0 20 1 2 , . .   IIion $ miIIion)
19 200 =
700.5 CosI o! CapiIal 80
CAßM ModuIe 700 Fihahce
700.6 CapiIal SIrucIure MahagemehI 81
700.6.1 Dofino llo lorms businoss risI, financiaI risI, financiaI Iovorago, and
oporaling Iovorago and compulo llo broaI-ovon poinl in lorms of saIos doIIars
and unils of oulpul
700.6.2 CaIcuIalo a firm's dogroo of oporaling Iovorago, financiaI Iovorago, and
combinod (lolaI) Iovorago, incIuding llo financing mix
700.6.3 Ioarn lov lo uso llo basic looIs of capilaI slrucluro managomonl
700.6 Capital 5tructure Nanagement
700.6.1 De!ine the terms business risk, !inanciaI risk,
!inanciaI Ieverage, and operating Ieverage and
compute the break-even point in terms o! saIes doIIars
and units o! output
In sludying capilaI-budgoling loclniquos, vo roforrod lo risk as llo |i|c|u tcric|i|iiu
cssccicic! uii| cxpccic! rctcnuc cr inccmc sirccms. Bocauso our allonlion is nov focusod
on llo firm's financing docision rallor llan ils invoslmonl docision, il is usofuI lo sopa-
ralo llo incomo slroam varialions allribulabIo lo (1) llo company's oxposuro lo busi-
noss risI and (2) ils docision lo incur financiaI risI.
Business risk rofors lo llo rc|ciitc !ispcrsicn (tcric|i|iiu) in i|c |irm´s cxpccic! ccrninvs
|c|crc inicrcsi cn! icxcs (|8|1). If vlal accounlanls caII ¨ollor incomo¨ and ¨ollor
oxponsos¨ aro oquaI lo zoro, llo |8|1 is oquaI lo nol oporaling incomo. Tloso lorms aro
usod inlorclangoabIo. Figure 6.1 slovs a subjoclivoIy oslimalod probabiIily dislribulion
of noxl yoar's |8|1 for Iiorco Grain Company and llo samo lypo of projoclion
for Iiorco's Iargor compolilor, BIacIburn Sood Company. Tlo oxpoclod vaIuo of |8|1 for
Iiorco is $100,000, vill an associalod slandard dovialion of $20,000. If noxl yoar's |8|1
for Iiorco foII ono slandard dovialion slorl of llo oxpoclod $100,000, llo acluaI |8|1
vouId oquaI $80,000. BIacIburn's oxpoclod |8|1 is $200,000, and llo sizo of llo associ-
alod slandard dovialion is $20,000. Tlo slandard dovialion for llo oxpoclod IovoI of |8|1
is llo samo for boll firms. Wo vouId say llal Iiorco's dogroo of businoss risI oxcoods
BIacIburn's bocauso of ils Iargor coofficionl of varialion of oxpoclod |8|1, as foIIovs:
Tlo roIalivo disporsion in llo firm's |8|1 slroam, moasurod loro by ils oxpoclod coof-
ficionl of varialion, is llo rcsi!uc| offocl of sovoraI causaI infIuoncos. Disporsion in oporal-
ing incomo doos nol ccusc businoss risI, rallor, llis disporsion, vlicl vo caII businoss
risI, is llo rcsu|i of sovoraI infIuoncos. Tlo company's cosl slrucluro, producl domand
claraclorislics, and inlrainduslry compolilivo posilion aII affocl ils businoss risI oxposuro.
Sucl businoss risI is a dirocl rosuIl of llo firm's invoslmonl docision. Il is llo firm's assol
slrucluro, aflor aII, llal givos riso lo boll llo IovoI and variabiIily of ils oporaling profils.
Iiorco's coofficionl of
varialion of oxpoclodd
BIacIburn's coof
= =
20 000
100 000
fficionl of
varialion of oxpoclod
20 0 , 000
200 000
$ ,
. =
700.6 CapiIal SIrucIure MahagemehI 82
CAßM ModuIe 700 Fihahce
Pierce Craiu Coupauy Blackburu Seed Coupauy
L8I1 ($ in thousands)
$80 $100 $180 $200
figure 6.1 SubiecIive ProbabiliIy DisIribuIioh o! NexI Year's L8lJ
FinanciaI risk, convorsoIy, is a dirocl rosuIl of llo firm's financing docision. In llo
conloxl of soIocling a propor financing mix, llis risI appIios lo (1) i|c c!!iiicnc| tcric|i|-
iiu in ccrninvs ctci|c||c ic i|c |irm´s ccmmcn s|crc|c|!crs cn! (2) i|c c!!iiicnc| c|cncc c|
insc|tcncu |crnc |u i|c ccmmcn s|crc|c|!cr ccusc! |u i|c usc c| |incncic| |ctcrcvc. Nolo llal
llo concopl of financiaI risI usod loro diffors from llal usod in our oxaminalion of
casl and marIolabIo socurilios managomonl.
FinanciaI Ieverage moans |incncinv c pcriicn c| i|c |irm´s csscis uii| sccuriiics |ccrinv c
|ixc! (|imiic!) rcic c| rciurn in lopos of incroasing llo uIlimalo rolurn lo llo common slocI-
loIdors. Tlo docision lo uso dobl or proforrod slocI in llo financiaI slrucluro of llo corpo-
ralion moans llal lloso vlo ovn llo common slaros of llo firm aro oxposod lo financiaI
risI. Any givon IovoI of variabiIily in |8|1 is magnifiod by llo firm's uso of financiaI
Iovorago, and sucl addilionaI variabiIily is ombodiod in llo variabiIily of oarnings avaiI-
abIo lo llo common slocIloIdor and oarnings por slaro. If lloso magnificalions aro noga-
livo, llo common slocIloIdor las a liglor clanco of insoIvoncy llan vouId lavo oxislod
lad llo uso of fixod-clargo socurilios (dobl and proforrod slocI) boon avoidod.
In llo rosl of llis soclion, vo sludy loclniquos llal pormil a prociso assossmonl of
llo oarnings slroam variabiIily causod by (1) oporaling Iovorago and (2) financiaI Iovor-
ago. Oµerating Ieverage rofors lo llo incurrcncc c| |ixc! cpcrciinv ccsis in i|c |irm´s
inccmc sirccm. To undorsland llo naluro and imporlanco of oporaling Iovorago, vo
nood lo drav on llo basics of cosl-voIumo-profil anaIysis, or |rcc|-ctcn cnc|usis.
Tlo loclniquo of broaI-ovon anaIysis is famiIiar lo Iogions of businosspoopIo. Il is uso-
fuIIy appIiod in a vido array of businoss sollings, incIuding boll smaII and Iargo organ-
izalions. Tlis looI is vidoIy accoplod by llo businoss communily for lvo roasons: Il is
basod on slraigllforvard assumplions, and companios lavo found llal llo informalion
gainod from llo broaI-ovon modoI is bonoficiaI in docision-maIing silualions.
Objective and Uses
Tlo objoclivo of broaI-ovon anaIysis is lo dolormino llo broaI-ovon quanlily of oulpul
by sludying llo roIalionslips among llo firm's cosl slrucluro, voIumo of oulpul, and
profil. AIlornalivoIy, llo firm ascorlains llo broaI-ovon IovoI of saIos doIIars llal corro-
sponds lo llo broaI-ovon quanlily of oulpul. Wo dovoIop llo fundamonlaI roIalion-
slips by conconlraling on unils of oulpul and llon oxlond llo procoduro lo pormil
dirocl caIcuIalion of llo broaI-ovon saIos IovoI.
Wlal is moanl by llo broaI-ovon quanlily of oulpul` Il is llal quanlily of oulpul,
donominalod in unils, llal rosuIls in an |8|1 IovoI oquaI lo zoro. Uso of llo broaI-ovon
modoI, lloroforo, onabIos llo financiaI officor (1) lo dolormino llo quanlily of oulpul
llal musl bo soId lo covor aII oporaling cosls, as dislincl from financiaI cosls, and (2) lo
caIcuIalo llo |8|1 llal viII bo acliovod al various oulpul IovoIs.
£ssential £lements of the 8reak-£ven Model
To impIomonl llo broaI-ovon modoI, vo musl soparalo llo produclion cosls of llo
company inlo lvo muluaIIy oxcIusivo calogorios: fixod cosls and variabIo cosls. You
viII rocaII from your sludy of basic oconomics llal in llo Iong run aII cosls aro vari-
abIo. BroaI-ovon anaIysis, lloroforo, is a slorl-run concopl.
Assumed 8ehavior of Costs
fixed Costs
Fixed cnsts, aIso roforrod lo as indirect cnsts, !c nci tcru in icic| cmcuni cs sc|cs tc|umc
cr i|c ¡ucniiiu c| cuipui c|cnvcs ovor somo roIovanl rango of oulpul. TolaI fixod cosls
aro indopondonl of llo quanlily of producl producod and oquaI somo conslanl doIIar
amounl. As produclion voIumo incroasos, fixod cosl por unil of producl faIIs, as fixod
cosls aro sproad ovor Iargor and Iargor quanlilios of oulpul. Figure 6.2 grapls llo
700.6 CapiIal SIrucIure MahagemehI 83
CAßM ModuIe 700 Fihahce
bolavior of lolaI fixod cosls vill rospocl lo llo company's roIovanl rango of oulpul.
Tlis lolaI is slovn lo bo unaffoclod by llo quanlily of producl llal is manufaclurod
and soId. Ovor somo ollor roIovanl oulpul rango, llo amounl of lolaI fixod cosls migll
bo liglor or Iovor for llo samo company.
In a manufacluring solling, somo spocific oxampIos of fixod cosls aro
1. Adminislralivo saIarios
2. Doprocialion
3. Insuranco
4. Iump sums sponl on inlormillonl advorlising programs
5. Iroporly laxos
6. Ronl
VariabIe Costs
VariabIe cnsts aro somolimos roforrod lo as direct cnsts. VariabIo cosls aro |ixc! pcr
unii c| cuipui |ui tcru in icic| cs cuipui c|cnvcs. TolaI variabIo cosls aro compulod by
laIing llo variabIo cosl por unil and muIlipIying il by llo quanlily producod and soId.
Tlo broaI-ovon modoI assumos proporlionaIily bolvoon lolaI variabIo cosls and saIos.
Tlus, if saIos riso by 10 porconl, il is assumod llal variabIo cosls viII riso by 10 porconl.
Figure 6.3 grapls llo bolavior of lolaI variabIo cosls vill rospocl lo llo company's roI-
ovanl rango of oulpul. TolaI variabIo cosls aro soon lo dopond on llo quanlily of prod-
ucl llal is manufaclurod and soId. Nolico llal if zoro unils of llo producl aro manufac-
lurod, llon variabIo cosls aro zoro, bul fixod cosls aro groalor llan zoro. Tlis impIios
llal somo conlribulion lo llo covorago of fixod cosls occurs as Iong as llo soIIing prico
por unil oxcoods llo variabIo cosls por unil. Tlis loIps oxpIain vly somo firms viII
oporalo a pIanl ovon vlon saIos aro lomporariIy doprossod÷llal is, lo provido somo
incromonl of rovonuo lovard llo covorago of fixod cosls.
Ior a manufacluring oporalion, somo oxampIos of variabIo cosls incIudo
1. Dirocl Iabor
2. Dirocl maloriaIs
3. Inorgy cosls (fuoI, oIoclricily, naluraI gas) associalod vill llo produclion aroa
4. Iroigll cosls for producls Ioaving llo pIanl
5. IacIaging
6. SaIos commissions
700.6 CapiIal SIrucIure MahagemehI 84
CAßM ModuIe 700 Fihahce
|ixed cosls
units produced and soId
figure 6.2 Fixed-CosI 8ehavior over RelevahI Rahge o! OuIpuI
More on ßehavior o! Costs
No ono roaIIy boIiovos llal c|| cosls bolavo as noalIy as vo lavo iIIuslralod llo fixod
and variabIo cosls in Iiguros 6.2 and 6.3. Nor doos any Iav or accounling principIo dic-
lalo llal a corlain oIomonl of llo firm's lolaI cosls aIvays viII bo cIassifiod as fixod or
variabIo. Tlis doponds on oacl firm's spocific circumslancos. In ono firm, onorgy cosls
may bo prodominanlIy fixod, vloroas in anollor lloy may vary vill oulpul.
Iurllormoro, somo cosls may bo fixod for a vliIo, llon riso slarpIy lo a liglor
IovoI as a liglor oulpul is roaclod, romain fixod, and llon riso again vill furllor
incroasos in produclion. Sucl cosls may bo lormod oillor (1) scmitcric||c or (2) scmi|ixc!.
Tlo IaboI is your cloico, bocauso boll aro usod in induslriaI praclico. An oxampIo migll
bo llo saIarios paid lo produclion suporvisors. SlouId oulpul bo cul bacI by 15 porconl
for a slorl poriod, llo managomonl of llo organizalion is nol IiIoIy lo Iay off 15 porconl
of llo suporvisors. SimiIarIy, commissions paid lo saIospoopIo oflon foIIov a slopviso
pallorn ovor vido rangos of succoss. Tlis sorl of cosl bolavior is slovn in Figure 6.4.
To impIomonl llo broaI-ovon modoI and doaI vill sucl a compIox cosl slrucluro,
llo financiaI managor musl (1) idonlify llo mosl roIovanl oulpul rango for pIanning
purposos and llon (2) approximalo llo cosl offocl of somivariabIo iloms ovor llis rango
by sogrogaling a porlion of llom lo fixod cosls and a porlion lo variabIo cosls. In llo
acluaI businoss solling llis procoduro is nol fun. Il is nol unusuaI for llo anaIysl vlo
doaIs vill llo figuros lo spond considorabIy moro limo aIIocaling cosls lo fixod and
variabIo calogorios llan in carrying oul llo acluaI broaI-ovon caIcuIalions.
700.6 CapiIal SIrucIure MahagemehI 85
CAßM ModuIe 700 Fihahce
units produced and soId
figure 6.3 Variable-CosI 8ehavior over RelevahI Rahge o! OuIpuI
units produced and soId
Seuivariable (seuiíixedì cosls
figure 6.4 Semivariable-CosI 8ehavior over Ihe RelevahI Rahge o! OuIpuI
Total Revenue and volume of Output
Bosidos fixod and variabIo cosls, llo ossonliaI oIomonls of llo broaI-ovon modoI
incIudo lolaI rovonuo from saIos and voIumo of oulpul. TntaI revenue moans icic| sc|cs
!c||crs and is oquaI lo llo soIIing prico por unil muIlipIiod by llo quanlily soId. Tlo
vnIume nI nutµut rofors lo llo |irm´s |ctc| c| cpcrciicns and may bo in!iccic! cii|cr cs c
unii ¡ucniiiu cr cs sc|cs !c||crs.
Iinding the 8reak-£ven Point
Iinding llo broaI-ovon poinl in lorms of unils of produclion can bo accompIislod in
sovoraI vays. AII approaclos roquiro llo ossonliaI oIomonls of llo broaI-ovon modoI
jusl doscribod. Tlo broaI-ovon modoI is a simpIo adaplalion of llo firm's incomo slalo-
monl oxprossod in llo foIIoving anaIylicaI formal:
SaIos (lolaI variabIo cosl lolaI fixod cosl) profil (6-1)
On a unils-of-produclion basis, il is nocossary lo inlroduco (1) llo prico al vlicl
oacl unil is soId and (2) llo variabIo cosl por unil of oulpul. Bocauso llo profil ilom
sludiod in broaI-ovon anaIysis is |8|1, vo uso llo acronym insload of llo vord prc|ii.
In lorms of unils, llo incomo slalomonl slovn in oqualion (6-1) bocomos llo broaI-
ovon modoI by solling |8|1 oquaI lo zoro:
Our lasI nov bocomos finding llo numbor of unils llal musl bo producod and
soId in ordor lo salisfy oqualion (6-2)÷llal is, lo arrivo al |8|1 $0. Tlis can bo dono
by (1) conlribulion margin anaIysis or (2) aIgobraic anaIysis. Iacl approacl is iIIus-
lralod using llo samo sol of circumslancos.
Contribution-Margin Analysis
Tlo conlribulion-margin loclniquo pormils dirocl compulalion of llo broaI-ovon
quanlily of oulpul. Tlo cnntributinn margin is llo !i||crcncc |ciuccn i|c unii sc||inv
pricc cn! unii tcric||c ccsis, as foIIovs:
uhiI sales price
- uhiI variable cosI
= uhiI cohIribuIioh margih
Tlo uso of llo vord ccniri|uiicn in llo prosonl conloxl moans conlribulion lo llo
covorago of fixod oporaling cosls. Ior Iiorco Grain Company, llo unil conlribulion
margin is
uhiI sales price $10
uhiI variable cosI - 6
uhiI cohIribuIioh margih $ 4
If llo annuaI fixod cosls of $100,000 aro dividod by llo unil conlribulion margin of
$4, vo find llo broaI-ovon quanlily of oulpul for Iiorco Grain is 25,000 unils.
Figure 6.5 porlrays llo conlribulion-margin loclniquo for finding llo broaI-ovon
SaIos prico
por unil

rriabIo cosl
por unil

lolaI fixod
$ = = |8|1 0
700.6 CapiIal SIrucIure MahagemehI 86
CAßM ModuIe 700 Fihahce
AIgebraic AnaIysis
To oxpIain llo aIgobraic mollod for finding llo broaI-ovon oulpul IovoI, vo nood lo
adopl somo nolalion.
Q llo numbor of unils soId
llo broaI-ovon IovoI of Q
P llo unil saIos prico
I lolaI fixod cosls anlicipalod ovor llo pIanning poriod
V llo unil variabIo cosl
Iqualion (6-2), llo broaI-ovon modoI, is ropoalod on llo foIIoving pagos as oqua-
lion (6-3), vill llo modoI symboIs usod in pIaco of vords. Tlo broaI-ovon modoI is
llon soIvod for Q, llo numbor of unils llal musl bo soId so llal |8|1 oquaIs $0. Wo
IaboI llo broaI-ovon poinl quanlily Q
Obsorvo llal oqualion (6-4) says: Divido lolaI fixod oporaling cosls, I, by llo unil
conlribulion margin, P V, and llo broaI-ovon IovoI of oulpul, Q
, viII bo oblainod.
Tlo conlribulion margin anaIysis is nolling moro llan oqualion (6-4) in difforonl garb.
AppIicalion of oqualion (6-4) pormils dirocl caIcuIalion of Iiorco Grain's broaI-
ovon poinl, as foIIovs:
8reak-£ven Point in Sales Dollars
In doaIing vill llo muIliproducl firm, il is convonionl lo compulo llo broaI-ovon
poinl in lorms of saIos doIIars rallor llan unils of oulpul. SaIos, in offocl, bocomo a
common donominalor associalod vill a parlicuIar producl mix. Iurllormoro, an oul-
sido anaIysl may nol lavo accoss lo inlornaI unil cosl dala. Ho or slo may, lovovor, bo
abIo lo oblain annuaI roporls for llo firm. If llo anaIysl can soparalo llo firm's lolaI
= = =
 
$ $
100 000
10 6
25 000

( ) |( ) ( )] $
( ) ( ) $
P Q V Q I |8|1
= =
PP V I  ) =
700.6 CapiIal SIrucIure MahagemehI 87
CAßM ModuIe 700 Fihahce
Jolal íixed cosls
Exauple. $100,000
divided by lhe
uuil coulribuliou uargiu,
which equals sales price
uiuus uuil variable cosl
Exauple. $10 - $6 = $4 per uuil
Exauple. 2S,000 uuils
figure 6.5 CohIribuIioh-Margih Approach Io 8reak-Lveh Ahalysis
cosls as idonlifiod from ils annuaI roporls inlo lloir fixod and variabIo compononls, lo
or slo can caIcuIalo a gonoraI broaI-ovon poinl in saIos doIIars.
Wo iIIuslralo llis procoduro using Iiorco Grain Company's cosl slrucluro. Supposo
llal llo roporlod financiaI informalion is arrangod in llo formal slovn in TabIe 6.1.
Wo rofor lo llis lypo of financiaI slalomonl as an cnc|uiicc| inccmc sicicmcni. Tlis dislin-
guislos il from audilod incomo slalomonls pubIislod, for oxampIo, in llo annuaI
roporls of pubIic corporalions. If vo aro avaro of llo simpIo mallomalicaI roIalion-
slips on vlicl cosl-voIumo-profil anaIysis is basod, vo can uso TabIo 6.1 lo find llo
broaI-ovon poinl in saIos doIIars for Iiorco Grain Company.
Iirsl, Iol us oxpIoro llo Iogic of llo procoss. RocaII from oqualion (6-1) llal
SaIos (lolaI variabIo cosl lolaI fixod cosl) |8|1
If vo Iol lolaI saIos S, lolaI variabIo cosl VC, and lolaI fixod cosl I, llo pro-
coding roIalionslip bocomos
S (VC I) |8|1
Bocauso variabIo cosl por unil of oulpul and soIIing prico por unil aro cssumc! con-
slanl ovor llo roIovanl oulpul rango in broaI-ovon anaIysis, llo ralio of lolaI variabIo
cosls lo saIos, VC/S, is a conslanl for any IovoI of saIos. Tlis pormils us lo rovrilo llo
provious oxprossion as
Al llo broaI-ovon poinl, lovovor, |8|1 0, and llo corrosponding broaI-ovon
IovoI of saIos can bo roprosonlod as S´. Al llo broaI-ovon IovoI of saIos, vo lavo
´ =
1 
I ´ 1  =
I ´ 1 0   =
I |8|1 1   =
S I |8|1   =
700.6 CapiIal SIrucIure MahagemehI 88
CAßM ModuIe 700 Fihahce
TabIe 6.1 Pierce Graih Compahy AhalyIical Ihcome SIaIemehI
Sales $300,000
Less: 1oIal variable cosIs 180,000
Revehue be!ore !ixed cosIs $120,000
Less: 1oIal !ixed cosIs 100,000
L8lJ $ 20,000
Tlo appIicalion of oqualion (6-5) lo Iiorco Grain's anaIylicaI incomo slalomonl
in TabIo 6.1 pormils llo broaI-ovon saIos IovoI for llo firm lo bo diroclIy compulod, as
700.6.2 CaIcuIate a !irm's degree o! operating Ieverage,
!inanciaI Ieverage, and combined (totaI) Ieverage,
incIuding the !inancing mix
If |ixc! oporaling cosls aro prosonl in llo firm's cosl slrucluro, so is oporaling Iovorago.
Iixod oporaling cosls do nci incIudo inlorosl clargos incurrod from llo firm's uso of
dobl financing. Tloso cosls viII bo incorporalod inlo llo anaIysis vlon financiaI Iovor-
ago is discussod.
So oporaling Iovorago arisos from llo firm's uso of fixod oporaling cosls. Bul
vlal is oporaling Iovorago` Opcrciinv |ctcrcvc is llo rosponsivonoss of llo firm's
|8|1 lo fIuclualions in saIos. By conlinuing lo drav on our dala for Iiorco Grain
Company, vo can iIIuslralo llo concopl of oporaling Iovorago. TabIe 6.2 conlains
dala for a sludy of a possibIo fIuclualion in llo firm's saIos IovoI. Il is assumod llal
Iiorco Grain is curronlIy oporaling al an annuaI saIos IovoI of $300,000. Tlis is
roforrod lo in llo labuIalion as llo baso saIos IovoI al i (limo poriod zoro). Tlo quos-
lion is, Hov viII Iiorco Grain's |8|1 IovoI rospond lo a posilivo 20 porconl clango in
saIos` A saIos voIumo of $360,000, roforrod lo as llo forocasl saIos IovoI al i 1,
rofIocls llo 20 porconl saIos riso anlicipalod ovor llo pIanning poriod. Assumo llal
llo pIanning poriod is 1 yoar.
Oporaling Iovorago roIalionslips aro dorivod villin llo mallomalicaI assump-
lions of cosl-voIumo-profil anaIysis. In llo prosonl oxampIo, llis moans llal Iiorco
Grain's variabIo-cosl-lo-saIos ralio of .6 viII conlinuo lo loId during limo poriod i 1,
and llo fixod cosls viII loId sloady al $100,000.
Givon llo forocaslod saIos IovoI for Iiorco Grain and ils cosl slrucluro, vo can
moasuro llo rosponsivonoss of |8|1 lo llo upsving in voIumo. Nolico in TabIo 6.2 llal

100 000
180 000
300 000
100 000
1 60

== $250 000 ,
700.6 CapiIal SIrucIure MahagemehI 89
CAßM ModuIe 700 Fihahce
TabIe 6.2 CohcepI o! OperaIihg Leverage: Ihcrease ih Pierce Graih Compahy Sales
Item ßase 5aIes LeveI, t forecast 5aIes LeveI, t + 1
Sales $300,000 $360,000
Less: 1oIal variable cosIs 180,000 216,000
Revehue be!ore !ixed cosIs $120,000 $144,000
Less: 1oIal !ixed cosIs 100,000 100,000
L8lJ $ 20,000 $ 44,000
|8|1 is oxpoclod lo bo $44,000 al llo ond of llo pIanning poriod. Tlo porconlago
clango in |8|1 from i lo i 1 can bo moasurod as foIIovs:
Wo Inov llal llo projoclod fIuclualion in saIos amounls lo 20 porconl of llo baso
poriod, i, saIos IovoI. Tlis is vorifiod loro:
By roIaling llo porconlago fIuclualion in |8|1 lo llo porconlago fIuclualion in
saIos, vo can caIcuIalo a spocific moasuro of oporaling Iovorago. Tlus, vo lavo
AppIying oqualion (6-6) lo our Iiorco Grain dala givos
UnIoss vo undorsland vlal llo spocific moasuros of oporaling Iovorago loII us, llo
facl llal vo may Inov il is oquaI lo six limos is nolling moro llan sloriIo informalion.
Ior Iiorco Grain, llo inforonco is llal for cnu porconlago fIuclualion in saIos from llo
baso IovoI, llo porconlago fIuclualion in |8|1 viII bo six limos as groal. If Iiorco Grain
oxpoclod onIy a 5 porconl riso in saIos ovor llo coming poriod, a 30 porconl riso in |8|1
vouId bo anlicipalod as foIIovs:
(Iorconlago clango in saIos) (DOI
) porconlago clango in |8|1
(5°) (6) 30°
Wo viII nov rolurn lo llo posluIalod 20 porconl clango in saIos. Wlal if llo diroc-
lion of llo fIuclualion is oxpoclod lo bo nogalivo rallor llan posilivo` Wlal is in sloro
for Iiorco Grain` UnforlunaloIy for Iiorco Grain, bul forlunaloIy for llo anaIylicaI
procoss, vo viII soo llal llo oporaling Iovorago moasuro loIds in llo nogalivo diroc-
lion as voII. Tlis silualion is dispIayod in TabIe 6.3.
300 000
= =
Dogroo of oporaling
from llo baso saIIos IovoI(s)
porconlago clango in
= = DOI
porconlago clango in saIos
Iorconlago clango in saIos
$ $
360 000 300
i 
 ,,
300 000
60 000
300 000
Iorconlago clango in
$ $
44 000 20 00
, ,

 00
20 000
24 000
20 000
700.6 CapiIal SIrucIure MahagemehI 90
CAßM ModuIe 700 Fihahce
TabIe 6.3 CohcepI o! OperaIihg Leverage: Decrease ih Pierce Graih Compahy Sales
Item ßase 5aIes LeveI, t forecast 5aIes LeveI, t + 1
Sales $300,000 $240,000
Less: 1oIal variable cosIs 180,000 144,000
Revehue be!ore !ixed cosIs $120,000 $ 96,000
Less: 1oIal !ixed cosIs 100,000 100,000
L8lJ $ 20,000 $ -4,000
Al llo $240,000 saIos IovoI, vlicl roprosonls llo 20 porconl docroaso from llo baso
poriod, Iiorco Grain's |8|1 is oxpoclod lo bo $4,000. Hov sonsilivo is |8|1 lo llis
saIos clango` Tlo magniludo of llo |8|1 fIuclualion is caIcuIalod as
MaIing uso of our InovIodgo llal llo saIos clango vas oquaI lo 20 porconl por-
mils us lo compulo llo spocific moasuro of oporaling Iovorago as
Wlal vo lavo soon, llon, is llal llo dogroo of oporaling Iovorago moasuro vorIs in
llo posilivo or nogalivo diroclion. A nogalivo clango in produclion voIumo and saIos
can bo magnifiod sovoraIfoId vlon llo offocl on |8|1 is caIcuIalod.
To llis poinl our caIcuIalions of llo dogroo of oporaling Iovorago lavo roquirod
lvo anaIylicaI incomo slalomonls: ono for llo baso poriod and a socond for llo subso-
quonl poriod llal incorporalos llo possibIo saIos aIloralion. Tlis cumborsomo procoss
can bo simpIifiod. If unil cosl dala aro avaiIabIo lo llo financiaI managor, llo roIalion-
slip can bo oxprossod diroclIy in llo foIIoving mannor:
Obsorvo in oqualion (6-7) llal llo variabIos voro aII proviousIy dofinod in our
aIgobraic anaIysis of llo broaI-ovon modoI. RocaII llal Iiorco soIIs ils producl al $10
por unil, llo unil variabIo cosl is $6, and lolaI fixod cosls ovor llo pIanning lorizon aro
$100,000. SliII assuming llal Iiorco is oporaling al a $300,000 saIos voIumo, vlicl
moans oulpul (Q) is 30,000 unils, vo can find llo dogroo of oporaling Iovorago by
appIicalion of oqualion (6-7):
Wloroas oqualion (6-7) roquiros us lo Inov unil cosl dala lo carry oul llo compu-
lalions, llo noxl formuIalion vo oxamino doos nol. If vo lavo an anaIylicaI incomo
slalomonl for llo baso poriod, llon oqualion (6-8) can bo ompIoyod lo find llo firm's
dogroo of oporaling Iovorago:
Using oqualion (6-8) in conjunclion vill llo baso poriod dala for Iiorco Grain
slovn in TabIo 6.3 givos
Tlo llroo vorsions of llo oporaling Iovorago moasuro aII produco llo samo rosuIl.
Dala avaiIabiIily viII somolimos diclalo vlicl formuIalion can bo appIiod. Tlo cruciaI
considoralion, llougl, is llal you grasp vlal llo moasuromonl loIIs you. Ior Iiorco
Grain, a 1 porconl clango in saIos viII produco a 6 porconl clango in |8|1.
Boforo vo compIolo llis discussion of oporaling Iovorago and movo on lo llo sub-
jocl of financiaI Iovorago, asI yoursoIf, ¨Wlicl lypo of Iovorago is moro undor llo con-
lroI of managomonl`¨ You viII probabIy (and corroclIy) como lo llo concIusion llal
llo firm's managors lavo Ioss conlroI ovor llo oporaling cosl slrucluro and aImosl
300 000
120 000
20 000
= =
= =
rovonuo boforo fixod cosls 
 CC I 
($ $ )
($ $ ) $
300 000
30 000 10 6
30 000 10 6 1

  000 000
120 000
20 000
= =
( )
( )

 
300 000
= =

Iorconlago clango in
$ $
 

4 000 20 00
, , 00
20 000
24 000
20 000

700.6 CapiIal SIrucIure MahagemehI 91
CAßM ModuIe 700 Fihahce
compIolo conlroI ovor ils financiaI slrucluro. Wlal llo firm acluaIIy producos, for
oxampIo, viII dolormino lo a significanl dogroo llo division bolvoon fixod and vari-
abIo cosls. Tloro is moro room for subslilulion among llo various sourcos of financiaI
capilaI llan lloro is among llo Iabor and roaI capilaI inpuls llal onabIo llo firm lo
mool ils produclion roquiromonls. Tlus, you can anlicipalo moro argumonls ovor llo
cloico lo uso a givon dogroo of financiaI Iovorago llan llo corrosponding cloico ovor
oporaling Iovorago uso.
As llo firm's scaIo of oporalions movos in a favorabIo mannor abovo llo broaI-ovon
poinl, llo dogroo of oporaling Iovorago al oacl subsoquonl (liglor) saIos baso viII
docIino. In slorl, llo groalor llo saIos IovoI, llo Iovor llo dogroo of oporaling Iovorago.
As Iong as somo fixod oporaling cosls aro prosonl in llo firm's cosl slrucluro, lovovor,
oporaling Iovorago oxisls, and llo dogroo of oporaling Iovorago (DOI
) viII oxcood 1.00.
Oporaling Iovorago is prosonl, llon, vlonovor llo firm facos llo foIIoving silualion:
Tlo groalor llo firm's dogroo of oporaling Iovorago, llo moro ils profils viII vary
vill a givon porconlago clango in saIos. Tlus, oporaling Iovorago is dofiniloIy an
allribulo of llo businoss risI llal confronls llo company. Wo Inov llal llo dogroo of
oporaling Iovorago faIIs as saIos incroaso pasl llo firm's broaI-ovon poinl. Tlo sloor
sizo and oporaling profilabiIily of llo firm, lloroforo, affocl and can Iosson ils businoss
risI oxposuro.
Tlo managor considoring an aIloralion in llo firm's cosl slrucluro viII bonofil from
an undorslanding of llo oporaling Iovorago concopl. Il migll bo possibIo lo ropIaco
parl of llo Iabor forco vill capilaI oquipmonl (maclinory). A possibIo rosuIl is an
incroaso in fixod cosls associalod vill llo nov maclinory and a roduclion in variabIo
cosls allribulabIo lo a Iovor Iabor biII. Tlis concoivabIy couId raiso llo firm's dogroo of
oporaling Iovorago al a spocific saIos baso. If llo prospocls for fuluro saIos incroasos aro
ligl, llon incroasing llo dogroo of oporaling Iovorago migll bo a prudonl docision.
Tlo opposilo concIusion viII bo roaclod if saIos prospocls aro unallraclivo.
Wo lavo dofinod |incncic| |ctcrcvc as llo praclico of financing a porlion of llo firm's
assols vill socurilios boaring a fixod ralo of rolurn in lopos of incroasing llo uIlimalo
rolurn lo llo common slaroloIdors. In llo prosonl discussion vo focus on llo rospon-
sivonoss of llo company's oarnings por slaro lo clangos in ils |8|1. Ior llo limo
boing, llon, llo rolurn lo llo common slocIloIdor boing conconlralod on is oarnings
por slaro. Wo aro nci saying llal oarnings por slaro is llo approprialo crilorion for aII
financing docisions. In facl, llo voaInoss of sucl a conlonlion is oxaminod Ialor.
Rallor, llo uso of financiaI Iovorago producos a corlain lypo of c||cci. Tlis offocl can bo
iIIuslralod cIoarIy by conconlraling on an oarnings-por-slaro crilorion.
Iol us assumo llal Iiorco Grain Company is in llo procoss of golling slarlod as a
going concorn. Tlo firm's polonliaI ovnors lavo caIcuIalod llal $200,000 is noodod lo
purclaso llo nocossary assols lo conducl llo businoss. Tlroo possibIo financing pIans
lavo boon idonlifiod for raising llo $200,000, lloy aro prosonlod in TabIe 6.4. In pIan A
no financiaI risI is assumod: Tlo onliro $200,000 is raisod by soIIing 2,000 common
slaros, oacl vill a $100 par vaIuo. In pIan B a modoralo amounl of financiaI risI is
assumod: 25 porconl of llo assols aro financod vill a dobl issuo llal carrios an 8 por-
conl annuaI inlorosl ralo. IIan C vouId uso llo mosl financiaI Iovorago: 40 porconl of
llo assols vouId bo financod vill a dobl issuo cosling 8 porconl.
Iorconlago clango in
porconlago clango
iin saIos
> 1 00 .
700.6 CapiIal SIrucIure MahagemehI 92
CAßM ModuIe 700 Fihahce
TabIe 6.5 prosonls llo impacl of financiaI Iovorago on oarnings por slaro associ-
alod vill oacl fund-raising aIlornalivo. If |8|1 slouId incroaso from $20,000 lo
$40,000, llon oarnings por slaro vouId riso by 100 porconl undor pIan A. Tlo samo
posilivo fIuclualion in |8|1 vouId occasion an oarnings-por-slaro riso of 125 porconl
undor pIan B, and 147 porconl undor pIan C. In pIans B and C, llo 100 porconl incroaso
in |8|1 (from $20,000 lo $40,000) is magnifiod lo a groalor llan 100 porconl incroaso in
oarnings por slaro. Tlo firm is ompIoying financiaI Iovorago and oxposing ils ovnors
lo financiaI risI vlon llo foIIoving silualion oxisls:
By foIIoving llo samo gonoraI procoduros llal aIIovod us lo anaIyzo llo firm's
uso of oporaling Iovorago, vo can Iay oul a prociso moasuro of financiaI Iovorago. Sucl
a moasuro doaIs vill llo sonsilivily of oarnings por slaro lo |8|1 fIuclualions. Tlo
roIalionslip can bo oxprossod as
Using oqualion (6-9) vill oacl of llo financing cloicos oulIinod for Iiorco Grain
yioIds llo foIIoving. Tlo baso |8|1 IovoI is $20,000 in oacl caso.
IiIo oporaling Iovorago, llo !cvrcc c| |incncic| |ctcrcvc concopl porforms in llo
nogalivo diroclion as voII as llo posilivo. SlouId |8|1 faII by 10 porconl, Iiorco Grain
Company vouId suffor a 12.5 porconl docIino in oarnings por slaro undor pIan B. If
IIan A: limo
IIan B:
20 000
1 00
. = =
IIan C:
20 000
1 25
. = =
00 000
1 47
. = = limos
Dogroo of financiaI
Iovorago ( ) from
porconlago clango
in oar
= =
nnings por slaro
porconlago clango in |8|1
Iorconlago clango in oarnings por slaro
porcoonlago clango in |8|1
> 1 00 .
700.6 CapiIal SIrucIure MahagemehI 93
CAßM ModuIe 700 Fihahce
TabIe 6.4 Pierce Graih Compahy Possible CapiIal SIrucIures
PIan A. 0% Debt
1oIal debI $ 0
Commoh equiIy 200,000
1oIal asseIs $200,000 1oIal liabiliIies ahd equiIy $200,000
PIan ß. 25% Debt at 8% Interest ßate
1oIal debI $ 50,000
Commoh equiIy 150,000
1oIal asseIs $200,000 1oIal liabiliIies ahd equiIy $200,000
PIan C. 40% Debt at 8% Interest ßate
1oIal debI $ 80,000
Commoh equiIy 120,000
1oIal asseIs $200,000 1oIal liabiliIies ahd equiIy $200,000
2,000 common shares oulslanding.
!,500 common shares oulslanding.
!,200 common shares
pIan C voro closon lo raiso llo nocossary financiaI capilaI, llo docIino in oarnings
vouId bo 14.7 porconl. Obsorvo llal llo groalor llo DII, llo groalor llo fIuclualions
(posilivo or nogalivo) in oarnings por slaro. Tlo common slaroloIdor is roquirod lo
onduro groalor varialions in rolurns vlon llo firm's managomonl cloosos lo uso
moro financiaI Iovorago rallor llan Ioss. Tlo DII moasuro aIIovs llo varialion lo bo
Rallor llan laIo llo limo lo compulo porconlago clangos in |8|1 and oarnings por
slaro, llo DII can bo found diroclIy, as foIIovs:
In oqualion (6-10) llo variabIo | roprosonls llo lolaI inlorosl oxponso incurrod on c||
llo firm's conlracluaI dobl obIigalions. If six bonds aro oulslanding, | is llo sum of llo
inlorosl oxponso on aII six bonds. If llo firm las proforrod slocI in ils financiaI slruc-
luro, llo dividond on sucl issuos musl bo infIalod lo a boforo-lax basis and incIudod in
llo compulalion of |. In llis Iallor inslanco, | is in roaIily llo sum of aII fixod financing
|8|1 |

700.6 CapiIal SIrucIure MahagemehI 94
CAßM ModuIe 700 Fihahce
TabIe 6.5 Pierce Graih Compahy Ahalysis o! Fihahcial Leverage aI Di!!erehI
L8lJ Levels
(1) (2) (3) = (1) - (2) (4) = (3) .5 (5) = (3) - (4) (6)
Net Income Earnings
£8lT Interest £8T Taxes to Common per 5hare
PIan A. 0% Debt, $200,000 Common Equity, 2,000 5hares
$ 0 $ 0 $ 0 $ 0 $ 0 $ 0
20,000 0 $20,000 10,000 10,000 5.00
40,000 0 40,000 20,000 20,000 10.00
60,000 0 60,000 30,000 30,000 15.00
80,000 0 80,000 40,000 40,000 20.00
PIan ß. 25% Debt, 8% Interest ßate, $150,000 Common Equity, 1,500 5hares
$ 0 $4,000 $(4,000) $(2,000)
$(2,000) $ (1.33)
20,000 4,000 16,000 8,000 8,000 5.33
40,000 4,000 36,000 18,000 18,000 12.00
60,000 4,000 56,000 28,000 28,000 18.67
80,000 4,000 76,000 38,000 38,000 25.33
PIan C. 40% Debt, 8% Interest ßate, $120,000 Common Equity, 1,200 5hares
$ 0 $6,400 $(6,400) $(3,200)
$(3,200) $ (2.67)
20,000 6,400 13,600 6,800 6,800 5.67
40,000 6,400 33,600 16,800 16,800 14.00
60,000 6,400 53,600 26,800 26,800 22.33
80,000 6,400 73,600 36,800 36,800 30.67
The negalive lax bill recognizes lhe credil arising lrom lhe carryback and carrylorward provision ol lhe lax
Iqualion (6-10) las boon appIiod lo oacl of Iiorco Grain's financing pIans
(TabIo 6.5) al a baso |8|1 IovoI of $20,000. Tlo rosuIls aro as foIIovs:
As you probabIy suspoclod, llo moasuros of financiaI Iovorago slovn proviousIy
aro idonlicaI lo lloso oblainod by uso of oqualion (6-10). Tlis viII aIvays bo llo caso.
Clangos in saIos rovonuos causo groalor clangos in |8|1. AddilionaIIy, clangos in
|8|1 lransIalo inlo Iargor varialions in boll oarnings por slaro (|PS) and lolaI oarn-
ings avaiIabIo lo llo common slaroloIdors (|AC), if llo firm cloosos lo uso financiaI
Iovorago. Il slouId bo no surpriso, llon, lo find oul llal combining oporaling and
financiaI Iovorago causos rallor Iargo varialions in oarnings por slaro. Tlis onliro
procoss is visuaIIy dispIayod in Figure 6.6.
Bocauso llo risI associalod vill possibIo oarnings por slaro is affoclod by llo uso
of combinod or lolaI Iovorago, il is usofuI lo quanlify llo offocl. To iIIuslralo, vo rofor
onco moro lo Iiorco Grain Company. Tlo cosl slrucluro idonlifiod for Iiorco Grain in
our discussion of broaI-ovon anaIysis sliII loIds. Iurllormoro, assumo llal pIan B,
vlicl carriod a 25 porconl dobl ralio, vas closon lo financo llo company's assols.
Turn your allonlion lo TabIe 6.6.
In TabIo 6.6 an incroaso in oulpul for Iiorco Grain from 30,000 lo 36,000 unils is
anaIyzod. Tlis incroaso roprosonls a 20 porconl riso in saIos rovonuos. Irom our oarIior
discussion of oporaling Iovorago and llo dala in TabIo 6.6, vo can soo llal llis 20 por-
conl incroaso in saIos is magnifiod inlo a 120 porconl riso in |8|1. Irom llis baso saIos
IovoI of $300,000 llo dogroo of oporaling Iovorago is 6 limos.
Tlo 120 porconl riso in |8|1 inducos a clango in oarnings por slaro and oarnings
avaiIabIo lo llo common slaroloIdors of 150 porconl. Tlo dogroo of financiaI Iovorago
is lloroforo 1.25 limos.
Tlo upslol of llo anaIysis is llal llo 20 porconl riso in saIos las boon magnifiod lo
150 porconl, as rofIoclod by llo porconlago clango in oarnings por slaro. Tlo formaI
moasuro of combinod Iovorago can bo oxprossod as foIIovs:
Dogroo of combinod
Iovorago from llo
baso saIoos IovoI
porconlago clango
= = DCI
ooarnings por slaro
porconlago clango in saIoos
IIan A:
20 000
20 000
20 000 0
1 00
. = =

IIan B:
$ $
20 000
20 000
20 000 4 000
, ,
= =

20 000
20 000
20 000
IIan C:
 $$
6 400
1 47
. =
700.6 CapiIal SIrucIure MahagemehI 95
CAßM ModuIe 700 Fihahce
Coubiued leverage
0peraliug leverage |iuaucial leverage
EB|J Sales EPS (E^Cì % % %
figure 6.6 Leverage ahd Larhihgs FlucIuaIiohs
Tlis oqualion vas usod in llo bollom porlion of TabIo 6.6 lo dolormino llal llo
dogroo of combinod Iovorago from llo baso saIos IovoI of $300,000 is 7.50 limos. Iiorco
Grain's uso of boll oporaling and financiaI Iovorago viII causo any porconlago clango
in saIos (from llo spocific baso IovoI) lo bo magnifiod by a faclor of 7.50 vlon llo offocl
on oarnings por slaro is compulod. A 1 porconl clango in saIos, for oxampIo, viII
rosuIl in a 7.50 porconl clango in oarnings por slaro.
Nolico llal llo dogroo of combinod Iovorago is acluaIIy llo producl (nol llo simpIo
sum) of llo lvo indopondonl Iovorago moasuros. Tlus, vo lavo
) (DII
(6) (1.25) 7.50 limos
Il is possibIo lo ascorlain llo dogroo of combinod Iovorago in a dirocl faslion, vill-
oul dolormining any porconlago fIuclualions or llo soparalo Iovorago vaIuos. Wo nood
onIy subslilulo llo approprialo vaIuos inlo oqualion (6-13):
(6-13) DCI
Q P V I |
( )
( )

  
700.6 CapiIal SIrucIure MahagemehI 96
CAßM ModuIe 700 Fihahce
TabIe 6.6 Pierce Graih Compahy Combihed Leverage Ahalysis
forecast 5eIected
ßase 5aIes 5aIes LeveI, Percentage
Item LeveI, t t + 1 Changes
Sales $300,000 $360,000 + 20
Less: 1oIal variable cosIs 180,000 216,000
Revehue be!ore !ixed cosIs $120,000 $144,000
Less: 1oIal !ixed cosIs 100,000 100,000
L8lJ $ 20,000 $ 44,000 +120
Less: IhIeresI expehse 4,000 4,000
Larhihgs be!ore Iaxes (L8J ) $ 16,000 $ 40,000
Less: 1axes aI 50% 8,000 20,000
NeI ihcome $ 8,000 $ 20,000 +150
Less: Pre!erred dividehds 0 0
Larhihgs available Io commoh (LAC) $ 8,000 $ 20,000 +150
Number o! commoh shares 1,500 1,500
Larhihgs per share (LPS) $ 5.33 $ 13.33 +150
Degree o! operaIihg leverage DCL
6 Iimes
Degree o! !ihahcial leverage DFL
1.25 Iimes
Degree o! combihed leverage DCL
7.50 Iimes
Tlo variabIo dofinilions in oqualion (6-13) aro llo samo onos llal lavo boon
ompIoyod llrougloul llis soclion. Uso of oqualion (6-13) vill llo informalion in
TabIo 6.6 givos
Tlo lolaI risI oxposuro llo firm assumos can bo managod by combining oporaling and
financiaI Iovorago in difforonl dogroos. KnovIodgo of llo various Iovorago moasuros
loIps llo financiaI officor dolormino llo propor IovoI of ovoraII risI llal slouId bo
accoplod. If a ligl dogroo of businoss risI is inloronl in llo spocific Iino of commorciaI
aclivily, llon a Iov posluro rogarding financiaI risI vouId minimizo addilionaI oarn-
ings fIuclualions slomming from saIos clangos. ConvorsoIy, llo firm llal by ils vory
naluro incurs a Iov IovoI of fixod oporaling cosls migll clooso lo uso a ligl dogroo of
financiaI Iovorago in llo lopo of incroasing oarnings por slaro and llo ralo of rolurn
on llo common oquily invoslmonl. TabIe 6.7 summarizos llo saIionl concopls and caI-
cuIalion formals discussod llus far in llis soclion.
($ $ )
($ $ ) $
300 000
30 000 10 6
30 000 10 6 1

  000 000 4 000
120 000
16 000
, ,
 $
7.5 limos
700.6 CapiIal SIrucIure MahagemehI 97
CAßM ModuIe 700 Fihahce
TabIe 6.7 Summary o! Leverage CohcepIs ahd CalculaIiohs
Technique Description or Concept CaIcuIation Text ße!erence
ßreak-Even AnaIysis
1. 8reak-eveh poihI quahIiIy 1oIal !ixed cosIs divided by Ihe uhiI (6-4)
cohIribuIioh margih
2. 8reak-eveh sales level 1oIal !ixed cosIs divided by 1 mihus Ihe (6-5)
raIio o! IoIal variable cosIs Io Ihe
associaIed level o! sales
Operating Leverage
3. Degree o! operaIihg leverage PercehIage chahge ih L8lJ divided by Ihe (6-7)
percehIage chahge ih sales, or revehue
be!ore !ixed cosIs divided by revehue
a!Ier !ixed cosIs
financiaI Leverage
4. Degree o! !ihahcial leverage PercehIage chahge ih earhihgs per share (6-10)
divided by Ihe percehIage chahge ih L8lJ.
or L8lJ divided by L8J
Combined Leverage
5. Degree o! combihed leverage PercehIage chahge ih earhihgs per share (6-13)
divided by Ihe percehIage chahge ih
sales, or revehue be!ore !ixed cosIs
divided by L8J
The use ol |b1 here presumes no prelerred dividend paymenls. ln lhe presence ol prelerred dividend paymenls, replace |b1 wilh earnings available lo
common slock (|AC).



 
( )
( )
L8lJ l

C P V F l

  
( )
( )
Givon our undorslanding of boll oporaling and financiaI Iovorago, vo nov dirocl our
allonlion lo llo dolorminalion of an approprialo financing mix for llo firm. Iirsl, vo
musl dislinguisl bolvoon financiaI slrucluro and capilaI slrucluro. FinanciaI structure
is llo mix c| c|| iicms i|ci cppccr cn i|c riv|i-|cn! si!c c| i|c ccmpcnu´s |c|cncc s|cci.
CaµitaI structure is llo mix c| i|c |cnv-icrm scurccs c| |un!s usc! |u i|c |irm. Tlo roIalion-
slip bolvoon financiaI and capilaI slrucluros can bo oxprossod in oqualion form:
(IinanciaI slrucluro) (curronl IiabiIilios) capilaI slrucluro (6-14)
Irudonl financiaI slrucluro dosign roquiros ansvors lo lloso lvo quoslions:
1. Wlal slouId bo llo malurily composilion of llo firm's sourcos of funds, in
ollor vords, lov slouId a firm bosl divido ils lolaI fund sourcos bolvoon
slorl- and Iong-lorm compononls`
2. In vlal proporlions roIalivo lo llo lolaI slouId llo various forms of
pormanonl financing bo uliIizod`
Tlo major infIuonco on llo malurily slrucluro of llo financing pIans is llo naluro
of llo assols ovnod by llo firm. A company loaviIy commillod lo roaI capilaI invosl-
monl, roprosonlod primariIy by fixod assols on ils baIanco slool, slouId financo lloso
assols vill pormanonl (Iong-lorm) lypos of financiaI capilaI. Iurllormoro, llo porma-
nonl porlion of llo firm's invoslmonl in curronl assols slouId IiIoviso bo financod
vill pormanonl capilaI. AIlornalivoIy, assols loId on a lomporary basis aro lo bo
financod vill lomporary sourcos. Tlo prosonl discussion assumos llal llo buII of llo
company's curronl IiabiIilios aro comprisod of lomporary capilaI.
AccordingIy, our focus in llis soclion is on ansvoring llo socond of llo lvo quos-
lions nolod proviousIy÷llis procoss is usuaIIy caIIod ccpiic| siruciurc mcncvcmcni.
Tlo objoclivo of capilaI slrucluro managomonl is lo mix llo pormanonl sourcos of
funds usod by llo firm in a mannor llal viII maximizo llo company's common slocI
prico. AIlornalivoIy, llis objoclivo may bo viovod as a soarcl for llo |un!s mix i|ci ui||
minimizc i|c |irm´s ccmpcsiic ccsi c| ccpiic|. Wo can caII llis propor mix of funds sourcos
llo nµtimaI caµitaI structure.
TabIe 6.8 IooIs al oqualion (6-14) in lorms of a simpIifiod baIanco slool formal. Il
loIps us visuaIizo llo ovorriding probIom of capilaI slrucluro managomonl. Tlo
sourcos of funds llal givo riso lo financing fixod cosls (Iong-lorm dobl and proforrod
oquily) musl bo combinod vill common oquily in llo proporlions mosl suilabIo lo llo
invoslmonl marIolpIaco. If llal mix can bo found, llon loIding aII ollor faclors con-
slanl, llo firm's common slocI prico viII bo maximizod.
AIllougl oqualion (6-14) quilo accuraloIy indicalos llal llo corporalo capilaI
slrucluro may bo viovod as an absoIulo doIIar amounl, llo roaI capilaI slrucluro
probIom is ono of baIancing llo array of funds sourcos in a propor mannor. Our uso
of llo lorm ccpiic| siruciurc omplasizos llis Iallor probIom of roIalivo magniludo, or
700.6 CapiIal SIrucIure MahagemehI 98
CAßM ModuIe 700 Fihahce
TabIe 6.8 8alahce SheeI
CurrehI liabiliIies
NohcurrehI liabiliIies
(i.e., lohg-Ierm debI)
CapiIal Fihahcial
sIrucIure sIrucIure
Pre!erred equiIy
Commoh equiIy
1oIal 1oIal
Il pays lo undorsland llo ossonliaI compononls of capilaI slrucluro lloory. Tlo
assumplion of oxcossivo financiaI risI can pul llo firm inlo banIruplcy procoodings.
Somo arguo llal llo docision lo uso IillIo financiaI Iovorago rosuIls in an undorvaIua-
lion of llo firm's slaros in llo marIolpIaco. Tlo offoclivo financiaI managor musl
Inov lov lo find llo aroa of oplimum financiaI Iovorago uso÷llis viII onlanco slaro
vaIuo, aII ollor considoralions loId conslanl. Tlus, grasping llo lloory viII maIo you
bollor abIo lo formuIalo a sound financiaI slrucluro poIicy.
700.6.3 Learn hov to use the basic tooIs
o! capitaI structure management
RocaII from our oarIior vorI llal llo uso of financiaI Iovorago las lvo offocls on llo
oarnings slroam fIoving lo llo firm's common slocIloIdors. Tlroo possibIo financing
mixos for Iiorco Grain Company aro conlainod in TabIe 6.9, and an anaIysis for llo
corrosponding financiaI-Iovorago offocls is dispIayod in TabIe 6.10.
Tlo firsl financiaI-Iovorago offocl is llo addod variabiIily in llo oarnings-por-slaro
slroam llal accompanios llo uso of fixod-clargo socurilios in llo company's capilaI
slrucluro. By moans of llo dogroo-of-financiaI-Iovorago moasuro ( DII
), vo
oxpIainod lov llis variabiIily can bo quanlifiod. Tlo firm llal usos moro financiaI
Iovorago (rallor llan Ioss) viII oxporionco Iargor roIalivo clangos in ils oarnings por
slaro (rallor llan smaIIor) aflor |8|1 fIuclualions. Assumo llal Iiorco Grain oIoclod
financing pIan C rallor llan pIan A. IIan C is liglIy Iovorod and pIan A is unIovorod.
A 100 porconl incroaso in |8|1 from $20,000 lo $40,000 vouId causo oarnings por slaro
lo riso by 147 porconl undor pIan C bul onIy 100 porconl undor pIan A. UnforlunaloIy,
llo offocl vouId oporalo in llo nogalivo diroclion as voII. A givon clango in |8|1 is
mcvni|ic! by llo uso of financiaI Iovorago. Tlis magnificalion is rofIoclod in llo vari-
abiIily of llo firm's oarnings por slaro.
700.6 CapiIal SIrucIure MahagemehI 99
CAßM ModuIe 700 Fihahce
TabIe 6.9 Pierce Graih Compahy Possible CapiIal SIrucIures
PIan A. 0% Debt
1oIal debI $ 0
Commoh equiIy 200,000
1oIal asseIs $200,000 1oIal liabiliIies ahd equiIy $200,000
PIan ß. 25% Debt at 8% Interest ßate
1oIal debI $ 50,000
Commoh equiIy 150,000
1oIal asseIs $200,000 1oIal liabiliIies ahd equiIy $200,000
PIan C. 40% Debt at 8% Interest ßate
1oIal debI $ 80,000
Commoh equiIy 120,000
1oIal asseIs $200,000 1oIal liabiliIies ahd equiIy $200,000
2,000 common shares oulslanding.
!,500 common shares oulslanding.
!,200 common shares
Tlo socond financiaI-Iovorago offocl concorns llo IovoI of oarnings por slaro al a
givon |8|1 undor a givon capilaI slrucluro. Rofor lo TabIo 6.10. Al llo |8|1 IovoI of
$20,000, oarnings por slaro vouId bo $5, $5.33, and $5.67 undor financing arrango-
monls A, B, and C, rospoclivoIy. Abovo a crilicaI IovoI of |8|1, llo firm's oarnings por
slaro viII bo liglor if groalor dogroos of financiaI Iovorago aro ompIoyod. ConvorsoIy,
boIov somo crilicaI IovoI of |8|1, oarnings por slaro viII suffor al groalor dogroos of
financiaI Iovorago. Wloroas llo firsl financiaI-Iovorago offocl is quanlifiod by llo
dogroo-of-financiaI Iovorago moasuro (DII
), llo socond is quanlifiod by vlal is
gonoraIIy roforrod lo as |8|1-|PS anaIysis. (|PS rofors, of courso, lo oarnings por
slaro.) Tlo ralionaIo undorIying llis sorl of anaIysis is simpIo. Iarnings is ono of llo
Ioy variabIos llal infIuonco llo marIol vaIuo of llo firm's common slocI. Tlo offocl of
a financing docision on |PS, llon, slouId bo undorslood bocauso llo docision viII
probabIy affocl llo vaIuo of llo slocIloIdor's invoslmonl.
EßIT-EP5 Analysis
Graphic AnaIysis
Tlo |8|1-|PS anaIysis clarl aIIovs llo docision maIor lo visuaIizo llo impacl of dif-
foronl financing pIans on IIS ovor a rango of |8|1 IovoIs. Tlo roIalionslip bolvoon
IIS and |8|1 is Iinoar. AII vo nood, lloroforo, lo conslrucl llo clarl is lvo poinls for
oacl aIlornalivo. Iarl B of TabIe 6.11 aIroady providos us vill ono of lloso poinls. Tlo
ansvor lo llo foIIoving quoslion for oacl cloico givos us llo socond poinl: Al vlal
|8|1 IovoI viII llo |PS for llo pIan bo oxaclIy zoro` If llo |8|1 IovoI jusi cctcrs llo
700.6 CapiIal SIrucIure MahagemehI 100
CAßM ModuIe 700 Fihahce
TabIe 6.10 Pierce Graih Compahy Ahalysis o! Fihahcial Leverage aI Di!!erehI
L8lJ Levels
(1) (2) (3) = (1) - (2) (4) = (3) .5 (5) = (3) - (4) (6)
Net Income Earnings
£8lT Interest £8T Taxes to Common per 5hare
PIan A. 0% Debt, $200,000 Common Equity, 2,000 5hares
$ 0 $ 0 $ 0 $ 0 $ 0 $ 0
20,000 0 20,000 10,000 10,000 5.00
40,000 0 40,000 20,000 20,000 10.00
60,000 0 60,000 30,000 30,000 15.00
80,000 0 80,000 40,000 40,000 20.00
PIan ß. 25% Debt, 8% Interest ßate, $150,000 Common Equity, 1,500 5hares
$ 0 $4,000 $(4,000) $(2,000)
$(2,000) $ (1.33)
20,000 4,000 16,000 8,000 8,000 5.33
40,000 4,000 36,000 18,000 18,000 12.00
60,000 4,000 56,000 28,000 28,000 18.67
80,000 4,000 76,000 38,000 38,000 25.33
PIan C. 40% Debt, 8% Interest ßate, $120,000 Common Equity, 1,200 5hares
$ 0 $6,400 $(6,400) $(3,200)
$(3,200) $ (2.67)
20,000 6,400 13,600 6,800 6,800 5.67
40,000 6,400 33,600 16,800 16,800 14.00
60,000 6,400 53,600 26,800 26,800 22.33
80,000 6,400 73,600 36,800 36,800 30.67
The negalive lax bill recognizes lhe credil arising lrom lhe carryback and carrylorward provision ol lhe lax
700.6 CapiIal SIrucIure MahagemehI 101
CAßM ModuIe 700 Fihahce
Assume lhal plan 8 in Table 6.!0 is lhe exisling capilal slruclure lor lhe Pierce Crain Company. lurlhermore, lhe assel
slruclure ol lhe lirm is such lhal |b|1 is expecled lo be S20,000 per year lor a very long lime. A capilal inveslmenl is avail-
able lo Pierce Crain lhal will cosl S50,000. Acquisilion ol lhis assel is expecled lo raise lhe projecled |b|1 level lo S30,000,
permanenlly. The lirm can raise lhe needed cash by (!) selling 500 shares ol common slock al S!00 each or (2) selling new
bonds lhal will nel lhe lirm S50,000 and carry an inleresl rale ol 8.5 percenl. These capilal slruclures and corresponding
||5 amounls are summarized in Table 6.!!.
Al lhe projecled |b|1 level ol S30,000, lhe ||5 lor lhe common slock and debl allernalives are S6.50 and S7.25, respec-
lively. 8olh are considerably above lhe S5.33 lhal would occur il lhe new projecl were rejecled and lhe addilional linancial
capilal were nol raised. 8ased on a crilerion ol selecling lhe linancing plan lhal will provide lhe highesl ||5. lhe bond aller-
nalive is lavored. 8ul whal il lhe basic business risk lo which lhe lirm is exposed causes lhe |b|1 level lo vary over a consid-
erable range? Can we be sure lhal lhe bond allernalive will a|wav: have lhe higher ||5 associaled wilh il? The answer, ol
course, is no. When lhe |b|1 level is subjecl lo uncerlainly, a graphic analysis ol lhe proposed linancing plans can provide
uselul inlormalion lo lhe linancial manager.
TabIe 6.11 Pierce Graih Compahy Ahalysis o! Fihahcihg Choices
Part A. CapitaI 5tructures
Existing CapitaI With Nev Common With Nev
5tructure 5tock financing Debt financing
Lohg-Ierm debI aI 8% $ 50,000 Lohg-Ierm debI aI 8% $ 50,000 Lohg-Ierm debI aI 8% $ 50,000
Commoh sIock 150,000 Commoh sIock 200,000 Lohg-Ierm debI aI 8.5% 50,000
Commoh sIock 150,000
1oIal liabiliIies ahd equiIy $200,000 1oIal liabiliIies ahd equiIy $250,000 1oIal liabiliIies ahd equiIy $250,000
Commoh shares Commoh shares Commoh shares
ouIsIahdihg 1,500 ouIsIahdihg 2,000 ouIsIahdihg 1,500
Part ß. Projected £PS LeveIs
Existing With Nev With Nev
CapitaI Common 5tock Debt
5tructure financing financing
L8lJ $20,000 $30,000 $30,000
Less: IhIeresI expehse 4,000 4,000 8,250
Larhihgs be!ore Iaxes (L8J ) $16,000 $26,000 $21,750
Less: 1axes aI 50% 8,000 13,000 10,875
NeI ihcome $ 8,000 $13,000 $10,875
Less: Pre!erred dividehds 0 0 0
Larhihgs available Io commoh $ 8,000 $13,000 $10,875
LPS $ 5.33 $ 6.50 $ 7.25
pIan's financing cosls (on a boforo-lax basis), llon |PS viII bo zoro. Ior llo slocI pIan,
an |PS of zoro is associalod vill an |8|1 of $4,000. Tlo $4,000 is llo inlorosl oxponso
incurrod undor llo oxisling capilaI slrucluro. If llo bond pIan is oIoclod, llo inlorosl
cosls viII bo llo prosonl $4,000 pIus $4,250 por yoar arising from llo nov dobl issuo.
An |8|1 IovoI of $8,250, llon, is nocossary lo provido a zoro |PS vill llo bond pIan.
Tlo |8|1-|PS anaIysis clarl roprosonling llo financing cloicos avaiIabIo lo llo
Iiorco Grain Company is slovn as Figure 6.7. |8|1 is clarlod on llo lorizonlaI axis
and |PS on llo vorlicaI axis. Tlo inlorcopls on llo lorizonlaI axis roprosonl llo boforo-
lax oquivaIonl financing clargos roIalod lo oacl pIan. Tlo slraigll Iinos for oacl pIan
loII us llo |PS amounls llal viII occur al difforonl |8|1 amounls.
Nolico llal llo bond-pIan Iino las a siccpcr s|cpc llan llo slocI-pIan Iino. Tlis
onsuros llal llo Iinos for oacl financing cloico viII inicrscci. Abovo llo inlorsoclion
poinl, |PS for llo pIan vill groalor Iovorago viII oxcood llal for llo pIan vill Iossor
Iovorago. Tlo inlorsoclion poinl, oncircIod in Iiguro 6.7, occurs al an |8|1 IovoI of
$21,000 and producos |PS of $4.25 for oacl pIan. Wlon |8|1 is $30,000, nolico llal llo
bond pIan producos |PS of $7.25, and llo slocI pIan, $6.50. BoIov llo inlorsoclion
poinl, |PS vill llo slocI pIan viII cxccc! llal vill llo moro liglIy Iovoragod bond
pIan. Tlo sloopor sIopo of llo bond-pIan Iino indicalos llal vill groalor Iovorago, |PS
is moro sonsilivo lo |8|1 clangos.
Computing Indi!!erence Points
Tlo poinl of inlorsoclion in Iiguro 6.7 is caIIod llo  indiIIerence µnint. Il
idonlifios llo |8|1 |ctc| ci u|ic| i|c |PS ui|| |c i|c scmc rcvcr!|css c| i|c |incncinv p|cn
c|cscn |u i|c |incncic| mcncvcr. Tlis indifforonco poinl, somolimos caIIod llo broaI-ovon
poinl, las major impIicalions for financiaI pIanning. Al |8|1 amounls in oxcoss of llo
|8|1 indifforonco IovoI, llo moro loaviIy Iovorod financing pIan viII gonoralo a liglor
|PS. Al |8|1 amounls boIov llo |8|1 indifforonco IovoI, llo financing pIan invoIving
Ioss Iovorago viII gonoralo a liglor |PS. Il is imporlanl, llon, lo Inov llo |8|1 indif-
foronco IovoI.
700.6 CapiIal SIrucIure MahagemehI 102
CAßM ModuIe 700 Fihahce
L8I1 ($000)
Couuou slock
Boud plau
10 20 30 40 S0
figure 6.7 L8lJ-LPS Ahalysis CharI
Wo can find il graplicaIIy, as in Iiguro 6.7. Al limos il may bo moro officionl,
llougl, lo caIcuIalo llo indifforonco poinl diroclIy. Tlis can bo dono by using llo foI-
Ioving oqualion:
 Stnck PIan  Bnnd PIan
vloro S
and S
aro llo numbor of common slaros oulslanding undor llo slocI and
bond pIans, rospoclivoIy, | is inlorosl oxponso, i is llo firm's incomo lax ralo, and P is
proforrod dividonds paid. In llo prosonl caso P is zoro, bocauso lloro is no proforrod
slocI oulslanding. If proforrod slocI is associalod vill ono of llo financing aIlornalivos,
Ioop in mind llal llo proforrod dividonds, P, aro nol lax doduclibIo. Iqualion (6-15)
doos laIo llis facl inlo considoralion.
Ior llo prosonl oxampIo, vo caIcuIalo llo indifforonco IovoI of |8|1 as
Wlon llo oxprossion abovo is soIvod for |8|1, vo oblain $21,000. If |8|1 lurns oul
lo bo $21,000, llon |PS viII bo $4.25 undor boll pIans.
Word o! Caution
Abovo llo |8|1-|PS indifforonco poinl, a moro loaviIy Iovorod financiaI pIan prom-
isos lo doIivor a Iargor |PS. Slricl appIicalion of llo crilorion of soIocling llo financing
pIan llal producos llo liglosl |PS migll lavo llo firm issuing dobl mosl of llo limo
il raisod oxlornaI capilaI. Our discussion of capilaI slrucluro lloory laugll us llo dan-
gors of llal sorl of aclion.
Tlo primary voaInoss of |8|1-|PS anaIysis is llal il disrogards llo impIicil cosls
of dobl financing. Tlo offocl of llo spocific financing docision on llo firm's cosl of
common oquily capilaI is lolaIIy ignorod. Invoslors slouId bo concornod vill boll llo
IovoI and variabiIily of llo firm's oxpoclod oarnings slroam. |8|1-|PS anaIysis consid-
ors onIy llo IovoI of llo oarnings slroam and ignoros llo variabiIily (risIinoss) inloronl
in il. Tlus, llis lypo of anaIysis musl bo usod in conjunclion vill ollor basic looIs in
roacling llo objoclivo of capilaI slrucluro managomonl.
Comparative Leverage Ratios
Wo omplasizo loro llal llo compulalion of Iovorago ralios is ono of llo basic looIs of
capilaI slrucluro managomonl.
Tvo lypos of Iovorago ralios musl bo compulod vlon a financing docision facos
llo firm. Wo caII lloso |c|cncc-s|cci |ctcrcvc rciics and cctcrcvc rciics. Tlo firm's baIanco
slool suppIios inpuls for compuling llo baIanco-slool Iovorago ralios. In various forms
lloso baIanco-slool molrics comparo llo firm's uso of funds suppIiod by crodilors vill
lloso suppIiod by ovnors.
Inpuls lo llo covorago ralios gonoraIIy como from llo firm's incomo slalomonl. Al
limos llo oxlornaI anaIysl may lavo lo consuIl baIanco-slool informalion lo conslrucl
somo of lloso noodod oslimalos. On a privaloIy pIacod dobl issuo, for oxampIo, somo
fraclion of llo curronl porlion of llo firm's Iong-lorm dobl migll lavo lo bo usod as an
oslimalo of llal issuo's sinIing fund. Covorago ralios provido oslimalos of llo firm's
abiIily lo sorvico ils financing conlracls. Higl covorago ralios, comparod vill a slan-
dard, impIy unusod dobl capacily.
In roaIily vo Inov llal |8|1 migll bo oxpoclod lo vary ovor a considorabIo rango
of oulcomos. Ior llis roason llo covorago ralios slouId bo caIcuIalod sovoraI limos,
oacl al a difforonl IovoI of |8|1. If llis is accompIislod ovor aII possibIo vaIuos of
|8|1, a probabiIily dislribulion for oacl covorago ralio can bo conslruclod. Tlis pro-
vidos llo financiaI managor vill mucl moro informalion llan simpIy caIcuIaling llo
covorago ralios basod on llo oxpoclod vaIuo of |8|1.
( $ )( ) ( $ )( |8|1 |8|1     4 000 1 0 5 0
2 000
8 250 1 , .
  0 5 0
1 500
( )( ) ( )( ) |8|1 | i P
|8|1 | i P
s |
      1 1
700.6 CapiIal SIrucIure MahagemehI 103
CAßM ModuIe 700 Fihahce
lndustry Norms
Tlo comparalivo Iovorago ralios caIcuIalod lavo addilionaI uliIily lo llo docision
maIor if lloy can bo comparod vill somo slandard. GonoraIIy, corporalo financiaI
anaIysls, invoslmonl banIors, commorciaI banI Ioan officors, and bond-raling agoncios
roIy on induslry cIassos from vlicl lo compulo ¨normaI¨ ralios. AIllougl induslry
groupings may acluaIIy conlain firms vloso basic businoss-risI oxposuro diffors
vidoIy, llo praclico is onlronclod in Amorican businoss bolavior. Al llo vory Ioasl,
llon, llo financiaI officor musl bo inloroslod in induslry slandards bocauso aImosl
ovorybody oIso is.
SovoraI pubIislod sludios indicalo llal capilaI slrucluro ralios vary in a significanl
mannor among induslry cIassos. Ior oxampIo, random sampIings of llo common
oquily ralios of Iargo rolaiI firms soom lo diffor slalislicaIIy from lloso of major slooI
producors. Tlo major slooI producors uso financiaI Iovorago lo a Iossor dogroo llon do
llo Iargo rolaiI organizalions. On llo vloIo, firms oporaling in llo scmc induslry lond
lo oxlibil capilaI slrucluro ralios llal cIuslor around a conlraI vaIuo llal vo caII a
norm. Businoss risI varios from induslry lo induslry. As a consoquonco, llo capilaI
slrucluro norms vary from induslry lo induslry.
Tlis is nol lo say llal aII companios in llo induslry viII mainlain Iovorago ralios
¨cIoso¨ lo llo norm. Ior inslanco, firms llal aro vory profilabIo may dispIay ligl cov-
orago ralios and ligl baIanco-slool Iovorago ralios. Tlo modoraloIy profilabIo firm,
llougl, migll find sucl a posluro unduIy risIy. Horo llo usofuInoss of induslry-
normaI Iovorago ralios is cIoar. If llo firm cloosos lo dovialo in a maloriaI mannor from
llo accoplod vaIuos for llo Ioy ralios, il musl lavo a sound roason.
700.6 CapiIal SIrucIure MahagemehI 104
CAßM ModuIe 700 Fihahce
700.7 Dividehd Policy 105
700.7.1 Doscribo llo lrado-off bolvoon paying dividonds and rolaining profils
and oxpIain llo roIalionslip bolvoon a dividond poIicy and llo marIol prico of a
common slocI
700.7.2 Doscribo llo praclicaI docisions roIalod lo dividonds, aIlornalivo dividond
poIicios, and llo acluaI dividond paymonl procoduros
700.7.3 Undorsland llo circumslancos Ioading lo docIaring slocI dividonds, slocI
spIils, and slocI ropurclasos
700.7 Dividend Policy
700.7.1 Describe the trade-o!! betveen paying
dividends and retaining pro!its and expIain
the reIationship betveen a dividend poIicy
and the market price o! a common stock
Boforo laIing up llo parlicuIar issuos roIaling lo dividond poIicy, vo musl undorsland
sovoraI Ioy lorms and inlorroIalionslips.
A firm's dividond poIicy incIudos lvo basic compononls. Iirsl, llo dividend µav-
nut ratin indicalos llo cmcuni c| !iti!cn!s pci! rc|ciitc ic i|c ccmpcnu´s ccrninvs. Ior
inslanco, if llo dividond por slaro is $2 and llo oarnings por slaro aro $4, llo payoul
ralio is 50 porconl ($2/$4). Tlo socond compononl is llo slabiIily of llo dividonds ovor
limo. As vo obsorvo Ialor in llo soclion, dividond slabiIily may bo aImosl as imporlanl
lo llo invoslor as llo amounl of dividonds rocoivod.
In formuIaling a dividond poIicy, llo financiaI managor facos lrado-offs. Assuming
llal managomonl las aIroady docidod lov mucl lo invosl and las closon ils
dobl÷oquily mix for financing lloso invoslmonls, llo docision lo pay a Iargo dividond
moans simuIlanoousIy dociding lo rolain IillIo, if any, profils, llis in lurn rosuIls in a
groalor roIianco on oxlornaI oquily financing. ConvorsoIy, givon llo firm's invoslmonl
and financing docisions, a smaII dividond paymonl corrosponds lo ligl profil rolon-
lion, vill Ioss nood for oxlornaIIy gonoralod oquily funds. Tloso lrado-offs, vlicl aro
fundamonlaI lo our discussion, aro iIIuslralod in Figure 7.1.
Tlo fundamonlaI quoslion lo bo rosoIvod in our sludy of llo firm's dividond poIicy
may bo slalod simpIy as, Wlal is a sound ralionaIo or molivalion for dividond pay-
monls` If vo boIiovo our objoclivo slouId bo lo maximizo llo vaIuo of llo common
slocI, vo may roslalo llo quoslion as, Givon llo firm's capilaI-budgoling and borrov-
ing docisions, vlal is llo offocl of llo firm's dividond poIicios on llo slocI prico` Dccs
c |iv| !iti!cn! pcumcni !ccrccsc sicc| tc|uc, incrccsc ii, cr mc|c nc rcc| !i||crcncc?
Al firsl gIanco, vo migll roasonabIy concIudo llal a firm's dividond poIicy is
imporlanl. Wo lavo aIroady dofinod llo vaIuo of a slocI lo bo oquaI lo llo prosonl
vaIuo of fuluro dividonds. Hov can vo nov suggosl llal dividonds aro nol impor-
lanl` Wly do so many companios pay dividonds, and vly is a pago in 1|c Wc|| Sircci
jcurnc| dovolod lo dividond announcomonls` Basod on inluilion, vo couId quicIIy
700.7 Dividehd Policy 106
CAßM ModuIe 700 Fihahce
Civeu lhe íiru's iuveslueul decisious aud
debl-equily uix, lheu il's a
choice belweeu
Large divideud
Low proíil
heavy exlerual
equily íiuauciug
Suall divideud
high proíil
Negligible exlerual
equily íiuauciug
figure 7.1 Dividehd versus ReIehIioh/Fihahcihg 1rade-O!!s
concIudo llal dividond poIicy is imporlanl. Hovovor, vo migll bo surprisod lo Ioarn
llal llo dividond quoslion las boon a conlrovorsiaI issuo for voII moro llan llroo
Three 8asic views
Somo vouId arguo llal llo amounl of dividond is irroIovanl and any limo sponl on llo
docision is a vaslo of onorgy. Ollors conlond llal a ligl dividond rosuIls in a ligl
slocI prico. SliII ollors laIo llo viov llal dividonds acluaIIy lurl llo slocI vaIuo. Iol
us IooI al lloso llroo viovs in lurn.
Viev 1. Dividend PoIicy Is IrreIevant
Mucl of llo conlrovorsy aboul llo dividond issuo is basod in limo-lonorod disagroo-
monls bolvoon llo acadomic and profossionaI communilios. Ixporioncod praclilionors
porcoivo slocI prico clangos as rosuIling from dividond announcomonls and, lloro-
foro, soo dividonds as imporlanl. Irofossors vlo arguo llal dividonds aro irroIovanl soo
a faiIuro lo carofuIIy dofino dividond poIicy and arguo llal llo roIalionslip bolvoon
dividonds and slocI prico may bo an iIIusion.
Tlo posilion llal dividonds aro nol imporlanl rosls on lvo procondilions. Iirsl, vo
assumo llal invoslmonl and borroving docisions lavo aIroady boon mado and llal
lloso docisions viII nol bo aIlorod by llo amounl of any dividond paymonls. Socond,
µerIect caµitaI markets aro assumod lo oxisl, vlicl moans llal (1) intcsicrs ccn |uu
cn! sc|| sicc|s uii|cui incurrinv cnu ircnscciicn ccsis, suc| cs |rc|crcvc ccmmissicns,
(2) ccmpcnics ccn issuc sicc|s uii|cui cnu ccsi c| !cinv sc, (3) i|crc crc nc ccrpcrcic cr pcr-
scnc| icxcs, (4) ccmp|cic in|crmciicn c|cui i|c |irm is rcc!i|u ctci|c||c, (5) i|crc crc nc ccn-
||icis c| inicrcsi |ciuccn mcncvcmcni cn! sicc||c|!crs, cn! (6) |incncic| !isircss cn! |cn|-
rupicu ccsis crc ncncxisicni.
Tlo firsl assumplion÷llal vo lavo aIroady mado llo invoslmonl and financing
docisions÷simpIy Ioops us from confusing llo issuos. Wo vanl lo Inov llo offocl of
dividond docisions on a sland-aIono basis, villoul mixing in ollor docisions. Tlo soc-
ond assumplion, llal of porfocl marIols, aIso aIIovs us lo sludy llo offocl of dividond
docisions in isoIalion, mucl as a plysicisl sludios molion in a vacuum lo avoid llo
infIuonco of friclion.
Givon lloso assumplions, llo offocl of a dividond docision on slaro prico may bo
slalod unoquivocaIIy: 1|crc is nc rc|ciicns|ip |ciuccn !iti!cn! pc|icu cn! sicc| tc|uc. Ono
dividond poIicy is as good as anollor. In llo aggrogalo, invoslors aro concornod onIy
vill icic| rolurns from invoslmonl docisions, lloy aro indifforonl vlollor lloso
rolurns como from capilaI gains or dividond incomo. Tloy aIso rocognizo llal llo div-
idond docision, givon llo invoslmonl poIicy, is roaIIy a cloico of financing slralogy.
Tlal is, lo financo grovll, llo firm (a) may clooso lo issuo slocI, aIIoving inlornaIIy
gonoralod funds (profils) lo bo usod lo pay dividonds, or (b) il may uso inlornaIIy
gonoralod funds lo financo ils grovll, vliIo paying Ioss in dividonds bul nol laving
lo issuo slocI. In llo firsl caso, slaroloIdors rocoivo dividond incomo, in llo socond
caso, llo vaIuo of lloir slocI slouId incroaso, providing capilaI gains. Tlo naluro of
llo rolurn is llo onIy difforonco, lolaI rolurns slouId bo aboul llo samo. Tlus, lo
arguo llal paying dividonds can maIo slaroloIdors bollor off is lo arguo llal paying
oul casl vill ono land and laIing il bacI vill llo ollor is a vorllvliIo aclivily for
Tlo firm's dividond payoul couId affocl slocI prico if llo slaroloIdor las no ollor
vay lo rocoivo incomo from llo invoslmonl. Hovovor, assuming llo capilaI marIols
aro roIalivoIy officionl, a slocIloIdor vlo noods curronl incomo couId aIvays soII
slaros. If llo firm pays a dividond, llo invoslor couId oIiminalo any dividond
rocoivod, in vloIo or in parl, by using llo dividond lo purclaso slocI. Tlo invoslor
can, llus, porsonaIIy croalo any dosirod dividond slroam, no mallor vlal dividond
poIicy is in offocl.
700.7 Dividehd Policy 107
CAßM ModuIe 700 Fihahce
Viev 2. High Dividends Increase 5tock VaIue
Tlo boIiof llal a firm's dividond poIicy is unimporlanl impIicilIy assumos llal an
invoslor is indifforonl aboul vlollor incomo comos llrougl capilaI gains or llrougl
dividonds. Hovovor, dividonds aro moro prodiclabIo llan capilaI gains, managomonl
can conlroI dividonds, bul il cannol diclalo llo prico of llo slocI. Invoslors aro Ioss cor-
lain of rocoiving incomo from capilaI gains llan from dividonds. Tlo incromonlaI risI
associalod vill capilaI gains roIalivo lo dividond incomo impIios a liglor roquirod
ralo for discounling a doIIar of capilaI gains llan for discounling a doIIar of dividonds.
In ollor vords, vo vouId vaIuo a doIIar of oxpoclod dividonds moro liglIy llan a
doIIar of oxpoclod capilaI gains. Wo migll, for oxampIo, roquiro a 14 porconl ralo of
rolurn for a slocI llal pays ils onliro rolurn from dividonds, bul a 20 porconl rolurn for
a ligl-grovll slocI llal pays no dividond. In so doing, vo vouId givo a liglor vaIuo
lo llo dividond incomo llan vo vouId lo llo capilaI gains. Tlis viov, vlicl says
!iti!cn!s crc mcrc ccricin i|cn ccpiic| vcins, las boon caIIod llo bird-in-the-hand divi-
dend thenrv.
Tlo posilion llal dividonds aro Ioss risIy llan capilaI gains, and slouId, lloroforo,
bo vaIuod difforonlIy, is nol villoul ils crilics. If vo loId lo our basic docision nol lo
Iol llo firm's dividond poIicy infIuonco ils invoslmonl and capilaI-mix docisions, llo
company's oporaling casl fIovs, in boll oxpoclod amounl and variabiIily, aro unaf-
foclod by ils dividond poIicy. Bocauso llo dividond poIicy las no impacl on llo voIaliI-
ily of llo company's ovoraII casl fIovs, il las no impacl on llo risIinoss of llo firm.
Incroasing a firm's dividond doos nol roduco llo basic risIinoss of llo slocI,
rallor, if a dividond paymonl roquiros managomonl lo issuo nov slocI, il onIy lrans-
fors risI cn! ovnorslip from llo curronl ovnors lo nov ovnors. Wo vouId lavo lo
acInovIodgo llal llo curronl invoslors vlo rocoivo llo dividond lrado an uncorlain
capilaI gain for a ¨safo¨ assol (llo casl dividond). Hovovor, if risI roduclion is llo
onIy goaI, llo invoslor couId lavo Iopl llo monoy in llo banI and nol bougll llo
slocI in llo firsl pIaco.
Wo migll find fauIl vill llis bird-in-llo-land dividond lloory, bul lloro is sliII a
slrong porcoplion among many invoslors and profossionaI invoslmonl advisors llal
dividonds aro imporlanl.
The previous discussion specilying lhe "bird-in-lhe-hand" lheory belween lhe relalionship ol
slock price and lhe lirm's dividend policy relales direclly lo PrincipIe 2. The Time VaIue o!
Money-A DoIIar ßeceived Today Is Worth More Than a DoIIar ßeceived in the
future. This lheory suggesls lhal because lhe dollar ol dividends is received loday il should
be valued more highly lhan an uncerlain capilal gain lhal mighl be received in lhe lulure.
The lundamenlal premise ol lhis posilion is lhal lhe cash dividend in your hand (placed lhere
loday by lhe lirm's payoul policy) is more cerlain (less risky) lhan a possible capilal gain.
Many praclilioners adhere lo lhis lheory, bul many also adhere lo lhe lheory lhal is advanced
in lhe nexl seclion. ll nolhing else, because il is conlroversial, dividend policy is imporlanl lo
lhe lirm and ils slockholders. And, in realily, many companies do pay cash dividends. Cash
dividends are ubiquilous, so lhey are discussed in deplh.
Viev 3. Lov Dividends Increase 5tock VaIue
Tlo llird viov of lov dividonds affocl slocI prico arguos llal dividonds acluaIIy lurl
llo invoslors. Tlis boIiof las IargoIy boon basod on llo difforonco in lax lroalmonl for
dividond incomo and capilaI gains. Conlrary lo llo porfocl-marIols assumplion of no
laxos, mosl invoslors do pay incomo laxos. Ior lloso laxpayors, llo objoclivo is lo maxi-
mizo llo c|icr-icx rolurn on invoslmonl roIalivo lo llo risI assumod. Tlis objoclivo is roaI-
izod by minimizinv llo offoclivo lax ralo on llo incomo and, vlonovor possibIo, by
!c|crrinv llo paymonl of laxos.
700.7 Dividehd Policy 108
CAßM ModuIe 700 Fihahce
IiIo mosl lax codo compIoxilios, Congross ovor llo yoars las aIlorod llo oulcomo
of vlollor capilaI gains aro laxod al oillor (1) a Iovor or (2) simiIar ralo as ¨oarnod
incomo.¨ TlinI of a valor faucol boing randomIy lurnod on and llon off. Irom 1987
llrougl 1992, no fodoraI lax advanlago vas providod for capilaI gains incomo roIalivo
lo dividond incomo. A rovision in llo lax codo llal looI offocl boginning in 1993 did
provido a proforonco for capilaI gains incomo. Tlon llo Taxpayor RoIiof Acl of 1997
mado llo difforonco (proforonco) ovon moro favorabIo for capilaI gains as opposod lo
casl dividond incomo.
In a nulsloII llis 2003 acl Iovorod llo lop lax ralo on dividond incomo lo 15 por-
conl from a provious lop ralo of 38.6 porconl and aIso Iovorod llo lop ralo paid on
roaIizod Iong-lorm capilaI gains lo llo samo 15 porconl from a provious 20 porconl.
Tlus, you can soo llal llo so-caIIod invoslmonl pIaying fioId vas (moslIy) IovoIod for
dividond incomo roIalivo lo quaIifying capilaI gains. Tlis rallor dramalic clango in
llo lax codo viII immodialoIy romind you of PrinciµIe 8: Taxes Bias Business Deci-
sinns. In offocl, a major porlion of llo provious bias againsl paying casl dividonds lo
invoslors vas miligalod. Bul, nol aII of il, as is poinlod oul noxl.
AcluaIIy a difforonl bonofil oxisls for capilaI gains rolurns roIalivo lo dividond
incomo. Taxos on dividond incomo aro paid vlon llo dividond is rocoivod, vloroas
laxos on prico approcialion (capilaI gains) aro doforrod unliI llo slocI is acluaIIy soId.
Tlus, vlon il comos lo lax considoralions, many invoslors profor llo rolonlion of a
firm's oarnings÷in oxpoclalion of a Ialor capilaI gain÷as opposod lo llo noar-lorm
paymonl of casl dividonds. Again, if oarnings aro rolainod villin llo firm, lopofuIIy
llo slocI prico incroasos, bul llo incroaso is nol laxod unliI llo slocI is soId.
AIllougl llo majorily of invoslors aro subjocl lo laxos, corlain invoslmonl compa-
nios, lrusls, and ponsion pIans aro oxompl on lloir dividond incomo. AIso, for lax pur-
posos, a corporalion may gonoraIIy oxcIudo 70 porconl of llo dividond incomo
rocoivod from anollor corporalion. In lloso casos, and unIiIo llo abovo silualions,
invoslors may profor dividonds ovor capilaI gains.
To summarizo, vlon il comos lo laxos, vo vanl lo maximizo our c|icr-lax rolurn,
as opposod lo llo |c|crc-lax rolurn. Invoslors lry lo dofor laxos vlonovor possibIo.
SlocIs llal aIIov lax doforraI (Iov dividonds÷ligl capilaI gains) viII possibIy soII al a
promium roIalivo lo slocIs llal roquiro curronl laxalion (ligl dividonds÷Iov capilaI
gains). In llis vay, llo lvo slocIs may provido comparabIo c|icr-icx rolurns. Tlis sug-
gosls llal a poIicy of paying Iov dividonds viII rosuIl in a liglor slocI prico. Tlal is,
ligl dividonds lurl invoslors, vloroas Iov dividonds and ligl rolonlion loIp
invoslors. Tlis is llo Iogic of llo advocalos of llo Iov-dividond poIicy. Il doos pro-
sumo llal llo firm's managomonl las a roslor of posilivo nol prosonl vaIuo projocls
llal viII pul llo doIIars rolainod lo produclivo uso. As poinlod oul, llo 2003 acl
roducod llo vaIuo of llis Iogic and pIacod moro omplasis on dividonds paid lo
lmproving Our Thinking
Wo lavo nov IooIod al llroo viovs on dividond poIicy. Wlicl is rigll` Tlo argumonl
llal dividonds aro irroIovanl is difficuIl lo rofulo, givon llo porfocl marIol assump-
lions. Hovovor, in llo roaI vorId, il is nol aIvays oasy lo fooI comforlabIo vill sucl
an argumonl. ConvorsoIy, llo ligl-dividond pliIosoply, vlicl moasuros risI by lov
vo spIil llo firm's casl fIovs bolvoon dividonds and rolonlion, is nol parlicuIarIy
appoaIing vlon sludiod carofuIIy. Tlo llird viov, vlicl is ossonliaIIy a lax argumonl
againsl ligl dividonds, is porsuasivo. Ivon loday, aIllougl llo proforonliaI lax ralo
for capilaI gains is Iimilod, ils ¨doforraI advanlago¨ is sliII aIivo and voII. Hovovor, if
Iov dividonds aro so advanlagoous and gonorous dividonds aro so lurlfuI, vly do
companios conlinuo lo pay dividonds` Il is difficuIl lo boIiovo llal managors vouId
forgo sucl an oasy opporlunily lo bonofil lloir slocIloIdors. Wlal aro vo missing`
Tlo nood lo find llo missing oIomonls in our ¨dividond puzzIo¨ las nol boon
ignorod. Wlon vo nood lo bollor undorsland an issuo or plonomonon, vo can oillor
700.7 Dividehd Policy 109
CAßM ModuIe 700 Fihahce
improvo our llinIing or gallor moro ovidonco aboul llo lopic. ScloIars and pracli-
lionors lavo laIon boll approaclos. AIllougl no singIo dofinilivo ansvor las yol boon
found llal is accoplabIo lo aII, sovoraI pIausibIo oxlonsions lavo boon dovoIopod. Somo
of llo moro popuIar addilions incIudo (1) llo rosiduaI dividond lloory, (2) llo cIionloIo
offocl, (3) llo informalion offocl, (4) agoncy cosls, and (5) oxpoclalions lloory.
The ßesiduaI Dividend Theory
In porfocl marIols, vo assumo lloro is no cosl lo llo firm vlon il issuos nov socuri-
lios. Hovovor, in roaIily llo procoss is quilo oxponsivo, and llo fIolalion cosls asso-
cialod vill a nov offoring may bo as mucl as 20 porconl of llo doIIar issuo sizo.
Tlus, if managomonl cloosos lo issuo slocI rallor llan rolain profils lo financo nov
invoslmonls, a Iargor amounl of socurilios is roquirod lo rocoivo llo amounl noodod
for llo invoslmonl. Ior oxampIo, if $300,000 is noodod lo financo proposod invosl-
monls, an amounl oxcooding llo $300,000 viII lavo lo bo issuod lo offsol fIolalion
cosls incurrod in llo saIo of llo nov slocI issuo. Tlis moans, vory simpIy, llal nov
oquily capilaI raisod llrougl llo saIo of common slocI viII bo moro oxponsivo llan
capilaI raisod llrougl llo rolonlion of oarnings.
In offocl, fIolalion cosls oIiminalo our indifforonco bolvoon financing by inlornaI
capilaI and by nov common slocI. Givon lloso cosls, !iti!cn!s ucu|! |c pci! cn|u i|
prc|iis crc nci ccmp|cic|u usc! |cr intcsimcni purpcscs, llal is, onIy vlon lloro aro
¨rosiduaI oarnings¨ aflor llo financing of nov invoslmonls. Tlis poIicy is caIIod llo
residuaI dividend thenrv, vlicl is consislonl vill llo ¨pocIing ordor¨ lloory of
Givon llo oxislonco of fIolalion cosls, llo firm's dividond poIicy slouId nov bo
as foIIovs:
1. Accopl an invoslmonl if llo NPV is posilivo, llal is, if llo oxpoclod ralo of
rolurn oxcoods llo cosl of capilaI.
2. Iinanco llo oquily porlion of nov invoslmonls |irsi by inlornaIIy gonoralod
funds. OnIy aflor llis capilaI is fuIIy uliIizod slouId llo firm issuo nov
common slaros.
3. If any inlornaIIy gonoralod funds sliII romain aflor maIing aII invoslmonls,
pay dividonds lo llo invoslors. Hovovor, if aII inlornaI capilaI is noodod for
financing llo oquily porlion of proposod invoslmonls, pay no dividond.
Tlus, dividond poIicy is infIuoncod by (1) llo company's invoslmonl opporluni-
lios and (2) llo avaiIabiIily of inlornaIIy gonoralod capilaI, vlon dividonds aro paid
cn|u aflor aII accoplabIo invoslmonls lavo boon financod. According lo llis concopl,
dividond poIicy is lolaIIy passivo in naluro, laving by ilsoIf no dirocl infIuonco on
llo marIol prico of llo common slocI.
The CIienteIe E!!ect
Wlal if llo invoslors do nol IiIo llo dividond poIicy closon by managomonl` In
porfocl marIols, in vlicl vo lavo no cosls in buying or soIIing slocI, lloro is no
probIom. Tlo invoslors may simpIy salisfy lloir porsonaI incomo proforoncos by
purclasing or soIIing socurilios vlon llo dividonds rocoivod do nol salisfy lloir
curronl noods for incomo. If an invoslor doos nol viov llo dividonds rocoivod in
any givon yoar lo bo sufficionl, lo or slo can simpIy soII a porlion of slocI, lloroby
¨croaling a dividond.¨ In addilion, if llo dividond is Iargor llan llo invoslor
dosirod, lo or slo viII purclaso slocI vill llo ¨oxcoss casl¨ croalod by llo divi-
dond. Hovovor, onco vo romovo llo assumplion of porfocl marIols, vo find llal
buying or soIIing slocI is nol cosl froo. BroIorago foos aro incurrod, ranging approx-
imaloIy from 1 porconl lo 10 porconl. Ivon moro coslIy is llal llo invoslor vlo buys
llo slocI vill casl rocoivod from a dividond viII lavo lo pay laxos boforo roinvosl-
ing llo casl. And vlon a slocI is bougll or soId, il musl firsl bo roovaIualod.
Acquisilion of llo informalion for docision maIing aIso may bo limo-consuming
700.7 Dividehd Policy 110
CAßM ModuIe 700 Fihahce
and coslIy. IinaIIy, asido from llo cosl of buying or soIIing parl of llo slocI, somo
inslilulionaI invoslors, sucl as univorsily ondovmonl funds, aro procIudod from
soIIing slocI and ¨sponding¨ llo procoods.
As a rosuIl of lloso considoralions, invoslors may nol bo loo incIinod lo buy slocIs
llal roquiro llom lo ¨croalo¨ a dividond slroam moro suilabIo lo lloir purposos.
Rallor, if invoslors do in facl lavo a proforonco bolvoon dividonds and capilaI gains,
vo couId oxpocl llom lo sooI firms llal lavo a dividond poIicy consislonl vill lloso
proforoncos. Tloy vouId, in ossonco, ¨sorl llomsoIvos oul¨ by buying slocIs llal sal-
isfy lloir proforoncos for dividonds and capilaI gains. IndividuaIs and inslilulions llal
nood curronl incomo vouId bo dravn lo companios llal lavo ligl-dividond payouls.
Ollor invoslors, sucl as voaIlly individuaIs, vouId mucl profor lo avoid laxos by
loIding socurilios llal offor no or smaII dividond incomo bul Iargo capilaI gains. In
ollor vords, lloro vouId bo a cIienteIe eIIect: Iirms !rcu c vitcn c|icnic|c, vitcn i|cir
sicic! !iti!cn! pc|icu.
Tlo possibiIily llal cIionloIos of invoslors oxisl migll Ioad us lo boIiovo llal llo
firm's dividond poIicy mallors. Hovovor, unIoss lloro is a groalor aggrogalo domand
for a parlicuIar poIicy llan llo marIol can salisfy, dividond poIicy is sliII unimporlanl,
ono poIicy is as good as llo ollor. Tlo cIionloIo offocl onIy varns firms lo avoid maI-
ing capricious clangos in lloir dividond poIicy. Givon llal llo firm's invoslmonl doci-
sions aro aIroady mado, llo IovoI of llo dividond is sliII unimporlanl. Tlo clango in
llo poIicy mallors onIy vlon il roquiros cIionloIo lo slifl lo anollor company.
The In!ormation E!!ect
Tlo invoslor in llo vorId of porfocl marIols vouId arguo vill considorabIo porsua-
sion llal a firm's vaIuo is dolorminod slriclIy by ils invoslmonl and financing docisions
and llal llo dividond poIicy las no impacl on vaIuo. Yol vo Inov from oxporionco
llal a Iargo, unoxpoclod clango in dividonds can lavo a significanl impacl on llo
slocI prico. Ior inslanco, in Novombor 1990, OccidonlaI IolroIoum cul ils dividond
from $2 lo $1. In rosponso, llo firm's slocI prico vonl from aboul $32 lo $17. Hov can
vo suggosl llal dividond poIicy mallors IillIo, vlon vo can cilo numorous sucl oxam-
pIos of a clango in dividond affocling llo slocI prico, ospociaIIy vlon llo clango is
Dospilo sucl ¨ovidonco,¨ vo aro nol IooIing al llo roaI causo and offocl. Il may bo
llal invoslors uso a clango in dividond poIicy as a sivnc| aboul llo firm's financiaI
condilion, ospociaIIy ils oarning povor. Tlus, a dividond incroaso llal is Iargor llan
oxpoclod migll signaI lo invoslors llal managomonl oxpocls significanlIy liglor oarn-
ings in llo fuluro. ConvorsoIy, a dividond docroaso, or ovon a Ioss-llan-oxpoclod
incroaso, migll signaI llal managomonl is forocasling Ioss-favorabIo fuluro oarnings.
Somo vouId cIaim llal managomonl froquonlIy las insido informalion aboul llo
firm llal il cannol maIo avaiIabIo lo invoslors. Tlis !i||crcncc in ccccssi|i|iiu ic in|crmc-
iicn |ciuccn mcncvcmcni cn! intcsicrs, caIIod inInrmatinn asvmmetrv, mcu rcsu|i in c
|cucr sicc| pricc i|cn ucu|! cccur un!cr ccn!iiicns c| ccriciniu. Tlis roasoning says llal, by
roguIarIy incroasing dividonds, managomonl is maIing a commilmonl lo conlinuo
lloso casl fIovs lo llo slocIloIdors for llo forosooabIo fuluro. So in a risIy marIol-
pIaco, dividonds bocomo a moans lo minimizo any ¨drag¨ on llo slocI prico llal migll
como from difforoncos in llo IovoI of informalion avaiIabIo lo managors and invoslors.
Dividonds may, lloroforo, bo imporlanl onIy as a communicalion looI, manago-
monl may lavo no ollor crodibIo vay lo inform invoslors aboul fuluro oarnings, or al
Ioasl no convincing vay llal is Ioss coslIy.
Agency Costs
Up lo llis poinl, vo lavo nol aIIovod for soparalion bolvoon managomonl and ovnors.
Hovovor, vill onIy a suporficiaI IooI al llo roaI vorId, vo Inov llal managors and
invoslors aro lypicaIIy nol llo samo poopIo. Moroovor, lloy do nol lavo accoss lo llo
samo informalion aboul llo firm, al limos lloy do nol ovon lavo llo samo inconlivos.
700.7 Dividehd Policy 111
CAßM ModuIe 700 Fihahce
If llo lvo groups aro nol llo samo, vo musl llon assumo llal managomonl is dod-
icalod lo llo samo goaIs as ils ovnors. Tlal is, vo aro maIing a prosupposilion llal llo
bolavior of companios vill soparalo ovnors and managors viII nol diffor from llo
bolavior of ovnor-managod firms.
PrincipIe 7 warned us lhere may be a conllicl belween managemenl and owners, especially
in large lirms in which managers and owners have dillerenl incenlives. Thal is, Managers
Won't Work !or the Ovners UnIess It Is in Their ßest Interest lo do so. As we shall see
in lhis seclion, lhe dividend policy may be one way lo reduce lhis problem.
In roaIily, lovovor, confIicls may sliII oxisl, and llo slocI prico of a company
ovnod by invoslors vlo aro soparalo from managomonl may bo Ioss llan llo slocI
vaIuo of a cIosoIy loId firm. Tlis polonliaI difforonco in prico is llo ccsi c| i|c ccn||ici ic
i|c cuncrs, vlicl las como lo bo caIIod agencv cnsts.
Rocognizing llo possibIo probIom, managomonl, acling indopondonlIy or al llo
insislonco of llo board of diroclors, froquonlIy laIos aclion lo minimizo llo cosl associ-
alod vill llo soparalion of ovnorslip and managomonl conlroI. Sucl aclion, vlicl in
ilsoIf is coslIy, incIudos audiling by indopondonl accounlanls, assigning suporvisory
funclions lo llo company's board of diroclors, croaling covonanls in Ionding agroo-
monls llal roslricl managomonl's povors, and providing inconlivo componsalion
pIans for managomonl llal loIp ¨bond¨ managomonl vill llo ovnors.
A firm's dividond poIicy may bo porcoivod by ovnors as a looI lo minimizo
agoncy cosls. Assuming llal llo paymonl of a dividond roquiros managomonl lo issuo
slocI lo financo nov invoslmonls, nov invoslors may bo allraclod lo llo company onIy
if managomonl providos convincing informalion llal llo capilaI viII bo usod prof-
ilabIy. Tlus, llo paymonl of dividonds indiroclIy rosuIls in a cIosor moniloring of
managomonl's invoslmonl aclivilios. In llis caso, dividonds may maIo a moaningfuI
conlribulion lo llo vaIuo of llo firm.
Expectations Theory
A common llroad llrougl mucl of our discussion of dividond poIicy, parlicuIarIy as
il roIalos lo informalion offocls, is llo vord cxpccic!. Wo slouId nol ovorIooI llo sig-
nificanco of llis vord vlon vo aro maIing any financiaI docision villin llo firm. Nc
mciicr u|ci i|c !ccisicn crcc, |cu i|c mcr|ci pricc rcspcn!s ic mcncvcmcni´s cciicns is nci
!cicrminc! cniirc|u |u i|c cciicn iisc||, ii is c|sc c||ccic! |u intcsicrs´ cxpcciciicns c|cui i|c
u|iimcic !ccisicn ic |c mc!c |u mcncvcmcni. Tlis concopl or idoa is caIIod llo
exµectatinns thenrv.
As llo limo approaclos for managomonl lo announco llo amounl of llo noxl divi-
dond, invoslors form oxpoclalions aboul lov mucl llal dividond viII bo. Tloso
oxpoclalions aro basod on sovoraI faclors inlornaI lo llo firm, sucl as pasl dividond
docisions, curronl and oxpoclod oarnings, invoslmonl slralogios, and financing doci-
sions. Tloy aIso considor sucl llings as llo condilion of llo gonoraI oconomy, llo
slrongll or voaInoss of llo induslry al llo limo, and possibIo clangos in govornmonl
Wlon llo acluaI dividond docision is announcod, llo invoslor comparos llo
acluaI docision vill llo oxpoclod docision. If llo amounl of llo dividond is as
oxpoclod, ovon if il roprosonls an incroaso from prior yoars, llo marIol prico of llo
slocI viII romain unclangod. Hovovor, if llo dividond is liglor or Iovor llan
oxpoclod, invoslors viII roassoss lloir porcoplions of llo firm. Tloy viII quoslion llo
moaning of llo uncxpccic! clango in llo dividond. Tloy may uso llo unoxpoclod divi-
dond docision as a cIuo aboul unoxpoclod clangos in oarnings, llal is, llo unoxpoclod
700.7 Dividehd Policy 112
CAßM ModuIe 700 Fihahce
dividond clango las informalion conlonl aboul llo firm's oarnings and ollor impor-
lanl faclors. In slorl, managomonl's acluaI docision aboul llo firm's dividond poIicy
may nol bo lorribIy significanl, unIoss il doparls from invoslors' oxpoclalions. If lloro
is a difforonco bolvoon acluaI and oxpoclod dividonds, vo viII moro llan IiIoIy soo a
movomonl in llo slocI prico.
The £mpirical £vidence
Our soarcl for an ansvor lo llo quoslion of dividond roIovanco las boon Ioss llan
succossfuI. Wo lavo givon il our bosl llinIing, bul sliII no singIo dofinilivo posilion
las omorgod. Maybo vo couId gallor ovidonco lo slov llo roIalionslip bolvoon
dividond praclicos and socurily pricos. Wo migll aIso inquiro inlo llo porcoplions of
financiaI managors vlo maIo docisions aboul dividond poIicios, vill llo idoa llal
lloir boIiofs affocl lloir docision maIing. Tlon vo couId lruIy Inov llal dividond
poIicy is imporlanl or llal il doos nol mallor.
SovoraI roasons may bo givon for our inabiIily lo arrivo al concIusivo rosuIls aboul
llo roIalionslip bolvoon dividond paymonls and socurily pricos. Iirsl, lo bo accuralo,
vo vouId nood lo Inov llo amounl of dividonds invoslors cxpccic! lo rocoivo. Bocauso
lloso oxpoclalions cannol bo obsorvod, vo can onIy uso lisloricaI dala, vlicl may or
may nol roIalo lo curronl oxpoclalions. Socond, mosl ompiricaI sludios lavo assumod a
Iinoar roIalionslip bolvoon dividond paymonls and slocI pricos. Tlo acluaI roIalion-
slip may bo nonIinoar, possibIy ovon disconlinuous. Wlalovor llo roasons, llo ovi-
donco lo dalo is inconcIusivo and llo jury is sliII oul.
Bocauso our slalislicaI provoss doos nol provido any concIusivo ovidonco, Iol's
lurn lo our Iasl lopo. Wlal do llo financiaI managors of llo vorId boIiovo aboul llo
roIovanco of dividond poIicy` AIllougl vo may nol concIudo llal a managor's opin-
ion is nocossariIy llo ¨finaI vord on llo mallor,¨ laving lloso insiglls is loIpfuI. If
financiaI managors boIiovo llal dividonds mallor and acl consislonlIy in accordanco
vill llal conviclion, lloy couId infIuonco llo roIalionslip bolvoon slocI vaIuo and
dividond poIicy.
What Are We to Conclude7
Wo lavo nov IooIod carofuIIy al llo imporlanco of a firm's dividond poIicy as man-
agomonl sooIs lo incroaso llo slaroloIdors' voaIll. Wo lavo gono lo groal Ionglls lo
gain insigll and undorslanding from our bosl llinIing. Wo lavo ovon dravn from llo
ompiricaI ovidonco on land lo soo vlal llo findings suggosl.
A roasonabIo porson cannol roacl a dofinilivo concIusion, novorlloIoss, manago-
monl is Iofl vill no cloico. A firm musl dovoIop a dividond poIicy, basod, il is lopod,
on llo bosl avaiIabIo InovIodgo. AIllougl vo can givo advico vill somo rosorvalion,
llo foIIoving concIusions vouId appoar roasonabIo:
1. As a firm's invoslmonl opporlunilios incroaso, llo dividond payoul ralio
slouId docroaso. In ollor vords, an invorso roIalionslip slouId oxisl bolvoon
llo amounl of invoslmonls vill oxpoclod ralos of rolurn llal oxcood llo cosl
of capilaI (posilivo NPVs) and llo dividonds romillod lo invoslors. Bocauso of
fIolalion cosls associalod vill raising oxlornaI capilaI, llo rolonlion of
inlornaIIy gonoralod oquily financing is proforabIo lo soIIing slocI (in lorms of
llo voaIll of llo curronl common slaroloIdors).
2. Tlo firm's dividond poIicy appoars lo bo imporlanl, lovovor, appoarancos
may bo docoplivo. Tlo roaI issuo may bo llo firm's cxpccic! oarning povor
and llo risIinoss of lloso oarnings. Invoslors may bo using llo dividond
paymonl as a sourco of informalion aboul llo company's cxpccic! oarnings.
Managomonl's aclions rogarding dividonds may carry groalor voigll llan a
slalomonl by managomonl llal oarnings viII bo incroasing.
700.7 Dividehd Policy 113
CAßM ModuIe 700 Fihahce
3. If dividonds infIuonco slocI prico, llis is probabIy basod on llo invoslor's
dosiro lo minimizo and dofor laxos and on llo roIo of dividonds in minimizing
agoncy cosls.
4. If llo oxpoclalions lloory las moril, vlicl vo boIiovo il doos, managomonl
slouId avoid surprising invoslors vlon il comos lo llo firm's dividond
docision. Tlo firm's dividond poIicy migll offoclivoIy bo lroalod as a |cnv-icrm
rcsi!uc|. Rallor llan projocl invoslmonl roquiromonls for a singIo yoar,
managomonl couId anlicipalo financing noods for sovoraI yoars. Basod on llo
oxpoclod invoslmonl opporlunilios during llo pIanning lorizon, llo firm's
dobl÷oquily mix, and llo funds gonoralod from oporalions, a icrvci dividond
payoul ralio couId bo oslabIislod. If inlornaI funds romainod aflor projoclion
of llo nocossary oquily financing, dividonds vouId bo paid. Hovovor, llo
pIannod dividond slroam slouId dislribulo rosiduaI capilaI ovonIy lo invoslors
ovor llo pIanning poriod. ConvorsoIy, if ovor llo Iong lorm llo onliro amounl
of inlornaIIy gonoralod capilaI is noodod for roinvoslmonl in llo company,
llon no dividond slouId bo paid.
700.7.2 Describe the practicaI decisions reIated
to dividends, aIternative dividend poIicies,
and the actuaI dividend payment procedures
In solling a firm's dividond poIicy, financiaI managors musl vorI in llo vorId of roaIily
vill llo concopls vo lavo sol forll so far in llis soclion. Again, aIllougl lloso concopls
do nol provido an oqualion llal oxpIains llo Ioy roIalionslips, lloy corlainIy givo us a
moro compIolo viov of llo financo vorId, vlicl can onIy loIp us maIo bollor docisions.
Ollor considoralions of a moro praclicaI naluro aIso appoar as parl of llo firm's docision
maIing aboul ils dividond poIicy.
Other Practical Considerations
Many considoralions may infIuonco a firm's docision aboul ils dividonds, somo of
llom uniquo lo llal company. Somo of llo moro gonoraI considoralions aro givon loro.
LegaI ßestrictions
Corlain IogaI roslriclions may Iimil llo amounl of dividonds a firm may pay. Tloso
IogaI conslrainls faII inlo lvo calogorios. Iirsl, siciuicru rcsiriciicns may provonl a com-
pany from paying dividonds. AIllougl spocific Iimilalions vary by slalo, gonoraIIy a
corporalion may nol pay a dividond (1) if llo firm's IiabiIilios oxcood ils assols, (2) if
llo amounl of llo dividond oxcoods llo accumuIalod profils (rolainod oarnings), and
(3) if llo dividond is boing paid from capilaI invoslod in llo firm.
Tlo socond lypo of IogaI roslriclion is uniquo lo oacl firm and rosuIls from roslric-
lions in dobl and proforrod slocI conlracls. To minimizo lloir risI, invoslors froquonlIy
imposo roslriclivo provisions on managomonl as a condilion lo lloir invoslmonl in llo
company. Tloso conslrainls may incIudo llo provision llal dividonds may nol bo
docIarod boforo llo dobl is ropaid. AIso, llo corporalion may bo roquirod lo mainlain a
givon amounl of vorIing capilaI. Iroforrod slocIloIdors may slipuIalo llal common
dividonds may nol bo paid vlon any proforrod dividonds aro doIinquonl.
Liquidity Position
Conlrary lo common opinion, llo moro facl llal a company slovs a Iargo amounl of
rolainod oarnings in llo baIanco slool doos nol indicalo llal casl is avaiIabIo for llo pay-
monl of dividonds. Tlo firm's curronl posilion in Iiquid assols, incIuding casl, is basi-
caIIy indopondonl of llo rolainod oarnings accounl. HisloricaIIy, a company vill sizabIo
700.7 Dividehd Policy 114
CAßM ModuIe 700 Fihahce
rolainod oarnings las boon succossfuI in gonoraling casl from oporalions. Yol lloso
funds lypicaIIy aro oillor roinvoslod in llo company villin a slorl poriod or aro usod lo
pay maluring dobl. Tlus, a firm may bo oxlromoIy profilabIo and sliII bo ccs| pccr.
Bocauso dividonds aro paid vill casl, cn! nci uii| rcicinc! ccrninvs, llo firm musl lavo
casl avaiIabIo for dividonds lo bo paid. Honco, llo firm's Iiquidily posilion las a dirocl
boaring on ils abiIily lo pay dividonds.
Absence or Lack o! Other 5ources o! financing
As aIroady nolod, a firm may (1) rolain profils for roinvoslmonl purposos or (2) pay
dividonds and issuo nov dobl or oquily socurilios lo financo invoslmonls. Ior many
smaII or nov companios, llis socond oplion is nol roaIislic. Tloso firms do nol lavo
accoss lo llo capilaI marIols, so lloy musl roIy moro loaviIy on inlornaIIy gonoralod
funds. As a consoquonco, llo dividond payoul ralio is gonoraIIy mucl Iovor for a
smaII or novIy oslabIislod firm llan for a Iargo, pubIicIy ovnod corporalion.
Earnings PredictabiIity
A company's dividond payoul ralio doponds lo somo oxlonl on llo prodiclabiIily of a
firm's profils ovor limo. If oarnings fIuclualo significanlIy, managomonl cannol roIy on
inlornaIIy gonoralod funds lo mool fuluro noods. Wlon profils aro roaIizod, llo firm
may rolain Iargor amounls lo onsuro llal monoy is avaiIabIo vlon noodod. Con-
vorsoIy, a firm vill a slabIo oarnings lrond viII lypicaIIy pay oul a Iargor porlion of ils
oarnings in dividonds. Tlis company las Ioss concorn aboul llo avaiIabiIily of profils
lo mool fuluro capilaI roquiromonls.
Ovnership ControI
Ior many Iargo corporalions, conlroI llrougl llo ovnorslip of common slocI is nol an
issuo. Hovovor, for many smaII and modium-sizod companios, mainlaining voling con-
lroI laIos a ligl priorily. If llo curronl common slocIloIdors aro unabIo lo parlicipalo in
a nov offoring, issuing nov slocI is unallraclivo, in llal llo conlroI of llo curronl slocI-
loIdor is diIulod. Tlo ovnors migll profor llal managomonl financo nov invoslmonls
vill dobl and llrougl profils rallor llan by issuing nov common slocI. Tlis firm's
grovll is llon conslrainod by llo amounl of dobl capilaI avaiIabIo and by llo com-
pany's abiIily lo gonoralo profils.
Boforo llo Ialo 1970s, infIalionary prossuros lad nol boon a significanl probIom for
oillor consumors or businossos. Hovovor, during mucl of llo 1980s, llo dolorioralion
of llo doIIar's purclasing povor lad a dirocl impacl on llo ropIacomonl of fixod
assols. In a poriod of infIalion, as fixod assols bocomo vorn and obsoIolo, llo funds
gonoralod from llo doprocialion lax slioId idoaIIy aro usod lo financo llo ropIaco-
monls. As llo cosl of oquivaIonl oquipmonl conlinuos lo incroaso, llo doprocialion
funds bocomo insufficionl. Tlis roquiros a groalor rolonlion of profils, vlicl impIios
llal dividonds lavo lo bo advorsoIy affoclod.
RogardIoss of a firm's Iong-lorm dividond poIicy, mosl firms clooso ono of sovoraI
yoar-lo-yoar dividond paymonl pallorns.
1. Cnnstant dividend µavnut ratin. In llis poIicy, llo pcrccnicvc c| ccrninvs pci!
cui in !iti!cn!s is |c|! ccnsicni. AIllougl llo dividond-lo-oarnings ralio is
slabIo, llo doIIar amounl of llo dividond naluraIIy fIuclualos from yoar lo
yoar as profils vary.
2. StabIe dnIIar dividend µer share. Tlis poIicy mcinicins c rc|ciitc|u sic||c !c||cr
!iti!cn! ctcr iimc. An incroaso in llo doIIar dividond usuaIIy doos nol occur
700.7 Dividehd Policy 115
CAßM ModuIe 700 Fihahce
unliI managomonl is convincod llal llo liglor dividond IovoI can bo
mainlainod in llo fuluro. Managomonl aIso viII nol roduco llo doIIar
dividond unliI llo ovidonco cIoarIy indicalos llal a conlinualion of llo curronl
dividond cannol bo supporlod.
3. SmaII, reguIar dividend µIus a vear-end extra. A corporalion foIIoving llis
poIicy pcus c smc||, rcvu|cr !c||cr !iti!cn! p|us c uccr-cn! cxirc !iti!cn! in
prcspcrcus uccrs. Tlo oxlra dividond is docIarod lovard llo ond of llo fiscaI
yoar, vlon llo company's profils for llo poriod can bo oslimalod.
Managomonl's objoclivo is ic ctci! i|c ccnnciciicn c| c pcrmcncni !iti!cn!.
Hovovor, llis purposo may bo dofoalod if rccurrinv oxlra dividonds como lo
bo oxpoclod by invoslors.
Of llo llroo dividond poIicios, llo slabIo doIIar dividond is by far llo mosl common.
Ono oxpIanalion for llo slabIo dividond is llo increasing-stream hvµnthesis nI dividend
µnIicv, vlicl suggosls llal !iti!cn! sic|i|iiu is csscniic||u c smcci|inv c| i|c !iti!cn! sirccm
ic minimizc i|c c||cci c| ci|cr iupcs c| ccmpcnu rctcrsc|s. Tlus, corporalo managors maIo
ovory offorl lo avoid a dividond cul, allompling insload lo dovoIop a graduaIIy incroasing
dividond sorios ovor llo Iong-lorm fuluro. Hovovor, if a dividond roduclion is absoIuloIy
nocossary, llo cul slouId bo Iargo onougl lo roduco llo probabiIily of fuluro culs.
Dividend Policy and Corporate Strategy: Things Will Change-
£ven Dividend Policy
Tlo rocossions of 1990 lo 1991 and 2001 inducod a Iargo numbor of Amorican corpora-
lions lo rovisil lloir broadosl corporalo slralogios llal diroclIy impacl slaroloIdor
voaIll. Today, llo rosuIls of llal ¨rollinIing¨ aro ovidonl in many aspocls of corpo-
ralo bolavior, incIuding adjuslod dividond poIicios.
Ono firm llal aIlorod ils dividond poIicy in rosponso lo nov slralogios vas
W.R. Graco & Co., loadquarlorod in CoIumbia, MaryIand. Tlo firm's coro busi-
nossos incIudo pacIaging, calaIysls and siIica producls, and conslruclion prod-
ucls. W.R. Graco & Co. ranIod numbor 271 villin llo 1997 Icriunc 500 Iisl of llo
Iargosl U.S. corporalions vill saIos of $5.26 biIIion. Tlo nov corporalo pIans
invoIvod (1) divosling or disconlinuing sovoraI producl Iinos and (2) inilialing a
significanl ropurclaso program of ils ovn common slocI. (SlocI ropurclaso pro-
grams aro discussod in dopll Ialor in llis soclion.)
As a rosuIl, boll llo firm's payoul ralio and acluaI casl dividond paid por slaro
docIinod in significanl faslion. Tlo clango in obsorvod dividond poIicy is ovidonl in
TabIe 7.1. Nolico llal ovor llo 1992 lo 1994 poriod, W.R. Graco & Co. providod a good
oxampIo of vlal vo lavo caIIod a ¨slabIo dividond poIicy.¨ During llis poriod llo
firm mainlainod a slabIo doIIar dividond of $1.40 por slaro, vloroas llo payoul ralio
variod from 80.5 porconl lo 100.7 porconl.
700.7 Dividehd Policy 116
CAßM ModuIe 700 Fihahce
TabIe 7.1 Larhihgs per Share, Dividehds per Share, ahd Ihe Dividehd PayouI
RaIio: W.R. Grace & Compahy, 1992 Io 1996
Year Earnings per 5hare
Dividends per 5hare Payout ßatio
1992 $1.70 $1.40 82.3%
1993 1.39 1.40 100.7
1994 1.74 1.40 80.5
1995 2.14 1.175 54.9
1996 2.41 0.50 20.7
This series represenls earnings lrom conlinuing operalions bul belore special ilems.
5ource. 8asic dala lrom W.P. Crace & Co., Annua| |eoor|. !996, p. 55.
Bul vlon company poIicios clangod dramalicaIIy, so did llo associalod dividond
variabIos. Tlo absoIulo doIIar amounl of llo casl dividond por slaro vas Iovorod lo
$0.50 in 1996, and llo accompanying payoul ralio foII lo 20.7 porconl. ImporlanlIy, llo
firm's lolaI rolurn lo invoslors vas a robusl 30.9 porconl during 1996, comparod vill
ils 10-yoar avorago of 16.4 porconl. Tlo marIol IiIod llo clango in dividond poIicy. So,
aIllougl firms may bo roIuclanl lo clango lloir dividond poIicios, il is possibIo vill
good pIanning and propor informalion dissominalion lo convinco llo financiaI mar-
Iols llal sucl a nov diroclion migll bo good for invoslors.
Aflor llo firm's dividond poIicy las boon slruclurod, sovoraI procoduraI dolaiIs musl
bo arrangod. Ior inslanco, lov froquonlIy aro dividond paymonls lo bo mado` If a
slocIloIdor soIIs llo slaros during llo yoar, vlo is onlilIod lo llo dividond` To
ansvor lloso quoslions, vo nood lo undorsland dividond paymonl procoduros.
GonoraIIy, companios pay dividonds on a quarlorIy basis. To iIIuslralo, GonoraI
IIoclric pays $6.72 por slaro in annuaI dividonds. Hovovor, llo firm acluaIIy issuos a
$1.68 quarlorIy dividond for a lolaI yoarIy dividond of $6.72 ($1.68 4 quarlors).
Tlo finaI approvaI of a dividond paymonl comos from llo board of diroclors. As an
oxampIo, Imorson IIoclric on Augusl 5, 1996, announcod llal loIdors of rocord as of
Augusl 16 vouId rocoivo a $0.49 dividond. Tlo dividond paymonl vas lo bo mado on
Soplombor 10. Augusl 5 is llo decIaratinn date÷llo !cic u|cn i|c !iti!cn! is |crmc||u
!cc|crc! |u i|c |ccr! c| !irccicrs. Tlo date nI recnrd, Augusl 16, dosignalos u|cn i|c sicc|
ircns|cr |cc|s crc ic |c c|csc!. Invoslors slovn lo ovn llo slocI on llis dalo rocoivo llo
dividond. If a nolificalion of a lransfor is rocordod subsoquonl lo Augusl 16, llo nov
ovnor is nol onlilIod lo llo dividond. Hovovor, a probIom couId dovoIop if llo slocI
voro soId on Augusl 15, ono day prior lo llo rocord dalo. Timo vouId nol pormil llo
saIo lo bo rofIoclod on llo slocIloIdor Iisl by llo Augusl 16 dalo of rocord. To avoid llis
probIom, sicc| |rc|crcvc ccmpcnics |ctc uni|crm|u !cci!c! ic icrmincic i|c riv|i c| cuncrs|ip
ic i|c !iti!cn! 2 ucr|inv !cus |c|crc i|c !cic c| rcccr!. Tlis prior dalo is llo ex-dividend
date. Tloroforo, any acquiror of Imorson IIoclric slocI on Augusl 14 or lloroaflor doos
nol rocoivo llo dividond. IinaIIy, llo ccmpcnu mci|s i|c !iti!cn! c|cc| ic ccc| intcsicr on
Soplombor 10, llo µavment date. Tloso ovonls may bo diagrammod as foIIovs:
700.7 Dividehd Policy 117
CAßM ModuIe 700 Fihahce
0eclaraliou dale 0ale oí record Payueul dale
^ugusl S ^ugusl 16
^ugusl 14
Ex·divideud dale
Sepleuber 10
700.7.3 Understand the circumstances Ieading
to decIaring stock dividends, stock spIits,
and stock repurchases
An inlograI parl of dividond poIicy is llo uso of slocI dividonds and slocI spIils. Boll
invoIvo issuing nov slaros of slocI on a pro rala basis lo llo curronl slaroloIdors, vliIo
llo firm's assols, ils oarnings, llo risI assumod, and llo invoslors' porconlago of ovnor-
slip in llo company romain unclangod. Tlo onIy dofinilo rosuIl from oillor a slocI divi-
dond or a slocI spIil is llo incroaso in llo numbor of slaros of slocI oulslanding.
To iIIuslralo llo offocl of a slocI dividond, assumo llal llo Kalio Corporalion las
100,000 slaros oulslanding. Tlo firm's aflor-lax profils aro $500,000, or $5 in oarnings
por slaro. CurronlIy, llo company's slocI is soIIing al a prico÷oarnings muIlipIo of 10,
or $50 por slaro. Managomonl is pIanning lo issuo a 20 porconl slocI dividond, so a
slocIloIdor ovning 10 slaros vouId rocoivo lvo addilionaI slaros. Wo migll immo-
dialoIy concIudo llal llis invoslor is boing givon an assol (lvo slaros of slocI) vorll
$100, consoquonlIy, lis or lor porsonaI vorll slouId incroaso by $100. Tlis concIu-
sion is orronoous. Tlo firm viII bo issuing 20,000 nov slaros (100,000 slaros 20 por-
conl). Bocauso llo $500,000 in aflor-lax profils doos nol clango, llo nov oarnings por
slaro viII bo $4.167 ($500,000/120,000 slaros). If llo prico÷oarnings muIlipIo romains
al 10, llo marIol prico of llo slocI aflor llo dividond slouId faII lo $41.67 ($4.167
oarnings por slaro 10). Tlo invoslor nov ovns 12 slaros vorll $41.67, vlicl pro-
vidos a $500 lolaI vaIuo, llus, lo or slo is noillor bollor nor vorso off llan boforo llo
slocI dividond.
Tlis oxampIo may maIo us vondor vly a corporalion vouId ovon bollor vill a
slocI dividond or slocI spIil if no ono bonofils. Hovovor, boforo vo sludy llo ralionaIo
for sucl dislribulions, vo slouId undorsland llo difforoncos bolvoon a slocI spIil and a
slocI dividond.
Stock Dividend versus Split
Tlo onIy difforonco bolvoon a slocI dividond and a slocI spIil roIalos lo lloir rospoc-
livo accounling lroalmonl. Slalod difforonlIy, i|crc is c|sc|uic|u nc !i||crcncc cn cn ccc-
ncmic |csis |ciuccn c sicc| !iti!cn! cn! c sicc| sp|ii. Boll roprosonl a proporlionalo dis-
lribulion of addilionaI slaros lo llo curronl slocIloIdors. Hovovor, |cr ccccuniinv
purpcscs llo stnck sµIit las boon dofinod as a sicc| !iti!cn! cxccc!inv 25 pcrccni. Tlus,
a stnck dividend is convonlionaIIy dofinod as a !isiri|uiicn c| s|crcs up ic 25 pcrccni c|
i|c num|cr c| s|crcs currcni|u cuisicn!inv.
Tlo accounling lroalmonl for a slocI dividond roquiros llo issuing firms lo capi-
laIizo llo ¨marIol vaIuo¨ of llo dividond. In ollor vords, llo doIIar amounl of llo
dividond is lransforrod from rolainod oarnings lo llo capilaI accounls (par and paid-in
capilaI). Tlis procoduro may bosl bo oxpIainod by an oxampIo. Assumo llal llo
I. Bornard Corporalion is proparing lo issuo a 15 porconl slocI dividond. TabIe 7.2
prosonls llo oquily porlion of llo firm's baIanco slool boforo llo dislribulion. Tlo mar-
Iol prico for llo slocI las boon $14. Tlus, llo 15 porconl slocI dividond incroasos llo
700.7 Dividehd Policy 118
CAßM ModuIe 700 Fihahce
TabIe 7.2 L. 8erhard CorporaIioh 8alahce SheeI 8e!ore SIock Dividehd
Commoh SIock
Par value (1,000,000 shares ouIsIahdihg, $2 par value) $ 2,000,000
Paid-ih capiIal 8,000,000
ReIaihed earhihgs 15,000,000
1oIal equiIy $25,000,000
numbor of slaros by 150,000 (1,000,000 slaros 15 porconl). Tlo ¨marIol vaIuo¨ of
llis incroaso is $2,100,000 (150,000 slaros $14 marIol prico). To rocord llis lransac-
lion, $2,100,000 vouId bo lransforrod from rolainod oarnings, rosuIling in a $300,000
incroaso in lolaI par vaIuo (150,000 slaros $2 par vaIuo) and a $1,800,000 incromonl
lo paid-in capilaI. Tlo $1,800,000 is llo rosiduaI difforonco bolvoon $2,100,000 and
$300,000. TabIe 7.3 slovs llo rovisod baIanco slool.
Wlal if llo managomonl of I. Bornard Corporalion clangod llo pIan and docidod
lo spIil llo slocI lvo for ono` In ollor vords, a 100 porconl incroaso in llo numbor of
slaros vouId rosuIl. In accounling for llo spIil, llo clangos lo bo rocordod aro (1) an
incroaso in llo numbor of slaros and (2) a docroaso in llo por-slaro par vaIuo from
$2 lo $1. Tlo doIIar amounls of oacl accounl do nol clango. TabIe 7.4 rovoaIs llo nov
baIanco slool.
Tlus, for a slocI dividond, an amounl oquaI lo llo marIol vaIuo of llo slocI divi-
dond is lransforrod from rolainod oarnings lo llo capilaI slocI accounls. Wlon slocI is
spIil, onIy llo numbor of slaros clangos, and llo par vaIuo of oacl slaro is docroasod
proporlionaloIy. Dospilo llis dissimiIarily in accounling lroalmonl, romombor llal no
roaI oconomic difforonco oxisls bolvoon a spIil and a dividond.
Rationale for a Stock Dividend or Split
AIllougl sicc| dividonds and spIils occur far Ioss froquonlIy llan ccs| dividonds, a
significanl numbor of companios clooso lo uso lloso slaro dislribulions oillor vill
or in Iiou of casl dividonds. Tlo oxlonl of slocI spIils and slocI dividonds ovor llo
yoars can bo mado cIoar by a IillIo prico comparison. In 1926, a licIol lo llo movios
cosl 25¢÷and ovon mucl Ioss in llo ruraI communilios. Al llo samo limo, llo avorago
slaro prico on llo Nov YorI SlocI Ixclango vas $35. Today, if vo vanl lo go lo a
nov movio, vo can pay $7 or moro. Hovovor, llo avorago slaro prico is sliII aboul
$35. Tlo roIalivoIy conslanl slaro prico is llo rosuIl of llo slaros boing spIil ovor and
ovor again. Wo can onIy concIudo llal invoslors apparonlIy IiIo il llal vay. Bul vly
do lloy, if no oconomic bonofil rosuIls lo llo invoslor from doing so`
Iropononls of slocI dividonds and spIils froquonlIy mainlain llal slocIloIdors
rocoivo a Ioy bonofil bocauso llo prico of llo slocI viII nol faII procisoIy in proporlion
lo llo slaro incroaso. Ior a lvo-for-ono spIil, llo prico of llo slocI migll nol docroaso
a fuII 50 porconl, and llo slocIloIdor is Iofl vill a liglor lolaI vaIuo. Tloro aro lvo
roasons for llis disoquiIibrium. Iirsl, many financiaI oxoculivos boIiovo llal an oplimaI
700.7 Dividehd Policy 119
CAßM ModuIe 700 Fihahce
TabIe 7.3 L. 8erhard CorporaIioh 8alahce SheeI A!Ier SIock Dividehd
Commoh SIock
Par value (1,150,000 shares ouIsIahdihg, $2 par value) $ 2,300,000
Paid-ih capiIal 9,800,000
ReIaihed earhihgs 12,900,000
1oIal equiIy $25,000,000
TabIe 7.4 L. 8erhard CorporaIioh 8alahce SheeI A!Ier SIock SpliI
Commoh SIock
Par value (2,000,000 shares ouIsIahdihg, $1 par value) $ 2,000,000
Paid-ih capiIal 8,000,000
ReIaihed earhihgs 15,000,000
1oIal equiIy $25,000,000
prico rango oxisls. Willin llis rango, llo lolaI marIol vaIuo of llo common slocIloId-
ors is llougll lo bo maximizod. As llo prico oxcoods llis rango, fovor invoslors can
purclaso llo slocI, lloroby roslraining llo domand. ConsoquonlIy, dovnvard pros-
suro is pIacod on ils prico. Ior inslanco, Horsloy Ioods Corporalion in 1996
announcod a lvo-for-ono spIil on ils slaros, vlicl voro lrading for $80. Tlo roason
givon: Tlo spIil vouId pul il ¨in a moro popuIar prico rango and slouId onlanco lrad-
ing Iiquidily.¨ (Ii¡ui!iiu in llis conloxl moans llal moro slaros vouId bo bougll and
soId by invoslors.)
Tlo socond oxpIanalion roIalos lo llo in|crmciicnc| ccnicni of llo dividond-spIil
announcomonl. SlocI dividonds and spIils lavo gonoraIIy boon associalod vill com-
panios vill groving oarnings. Tlo announcomonl of a slocI dividond or spIil las
lloroforo boon porcoivod as favorabIo novs. Tlo ompiricaI ovidonco, lovovor, faiIs lo
vorify lloso concIusions. Wo slouId bo suspicious of llo assorlion llal a slocI divi-
dond or spIil can loIp incroaso invoslors' nol vorll.
A socond roason for slocI dividonds or spIils is llo consorvalion of corporalo casl.
If a company is oncounloring casl probIoms, il may subslilulo a slocI dividond for a
casl dividond. Hovovor, as boforo, invoslors viII probabIy IooI boyond llo dividond
lo ascorlain llo undorIying roason for consorving casl. If llo slocI dividond is an
offorl lo consorvo casl for allraclivo invoslmonl opporlunilios, llo slaroloIdor may
bid up llo slocI prico. If llo movo lo consorvo casl roIalos lo financiaI difficuIlios
villin llo firm, llo marIol prico viII mosl IiIoIy roacl advorsoIy.
A stnck reµurchase (stnck buvback) is vlon a |irm rcpurc|cscs iis cun sicc|, rcsu|iinv in
c rc!uciicn in i|c num|cr c| s|crcs cuisicn!inv. Ior voII ovor llroo docados, corporalo
managomonls lavo boon aclivo in ropurclasing lloir ovn oquily socurilios. Ior oxam-
pIo, llo Iord Molor Company on Soplombor 14, 2000, announcod in a pross roIoaso
llal il pIannod lo buy bacI up lo a fuII $5 biIIion of ils slocI. ImmodialoIy aflor llo
pubIic announcomonl of llis pIan, slaros of Iord common slocI roso by 2.2 porconl in
llo financiaI marIols. Nov, a Ioy vord in sucl announcomonls is llo vord p|cn. Com-
panios givo llomsoIvos room across limo lo oxoculo lloso buybacIs. And, Iord, al llo
limo, vas mirod in a major-Ioaguo liro-quaIily probIom on somo of ils bosl-soIIing
volicIos, so nol aII financiaI anaIysls and marIol valclors voro suro vlon llo acluaI
ropurclasos vouId commonco.
AIso, if you voro lo IooI al llo baIanco slool of a firm sucl as llo McDonaId's Cor-
poralion, you vouId soo llal llo firm's lroasury slocI÷llo amounl paid for ropurclas-
ing ils ovn slocI÷is sovoraIfoId llo amounl of llo lolaI amounl originaIIy invoslod by
llo slocIloIdors. Tlis silualion is nol unusuaI for many Iargo companios. SovoraI roa-
sons lavo boon givon for sicc| rcpurc|cscs. IxampIos of sucl bonofils incIudo
1. Moans for providing an inlornaI invoslmonl opporlunily
2. Approacl for modifying llo firm's capilaI slrucluro
3. IavorabIo impacl on oarnings por slaro
4. IIiminalion of a minorily ovnorslip group of slocIloIdors
5. Minimizalion of llo diIulion in oarnings por slaro associalod vill morgors
6. Roduclion in llo firm's cosls associalod vill sorvicing smaII slocIloIdors
AIso, from llo slaroloIdors' porspoclivo, a slocI ropurclaso, as opposod lo a casl div-
idond, las a polonliaI lax advanlago.
Share Repurchase as a Dividend Decision
CIoarIy, llo paymonl of a common slocI dividond is llo convonlionaI mollod for dis-
lribuling a firm's profils lo ils ovnors. Hovovor, il nood nol bo llo onIy vay. Anollor
approacl is lo ropurclaso llo firm's slocI. Tlo concopl may bosl bo oxpIainod by an
700.7 Dividehd Policy 120
CAßM ModuIe 700 Fihahce
The lnvestor's Choice
Givon llo cloico bolvoon a slocI ropurclaso and a dividond paymonl, vlicl vouId
an invoslor profor` In porfocl marIols, in vlicl lloro aro no laxos, no commissions
vlon buying and soIIing slocI, and no informalionaI conlonl assignod lo a dividond,
llo invoslor vouId bo indifforonl vill rogard lo llo cloicos. Tlo invoslor couId croalo
a dividond slroam by soIIing slocI vlon incomo is noodod.
If marIol imporfoclions oxisl, llo invoslor may lavo a proforonco for ono of llo
lvo mollods of dislribuling llo corporalo incomo. Iirsl, llo firm may lavo lo pay loo
ligl a prico for llo ropurclasod slocI, vlicl is lo llo dolrimonl of llo romaining
slocIloIdors. If a roIalivoIy Iargo numbor of slaros aro boing bougll, llo prico may bo
bid up loo ligl, onIy lo faII aflor llo ropurclaso oporalion. Socond, as a rosuIl of llo
700.7 Dividehd Policy 121
CAßM ModuIe 700 Fihahce
Telink, lnc. is planning lo pay S4 million (S4 per share) in dividends lo ils common slockholders. The lollowing earnings and
markel price inlormalion is provided lor Telink.
Nel income S7,500,000
Number ol shares !,000,000
Larnings per share S7.50
Priceearnings ralio 8
Lxpecled markel price per share aller dividend paymenl S60
ln a recenl meeling, several board members, who are also major slockholders, queslion lhe need lor a dividend paymenl.
They mainlain lhal lhey do nol need lhe income, so why nol allow lhe lirm lo relain lhe lunds lor lulure inveslmenls? ln
response, managemenl conlends lhal lhe available inveslmenls are nol sullicienlly prolilable lo juslily relenlion ol lhe
income. Thal is, lhe inveslors' required rales ol relurn exceed lhe expecled rales ol relurn lhal could be earned wilh lhe
addilional S4 million in inveslmenls.
8ecause managemenl opposes lhe idea ol relaining lhe prolils lor inveslmenl purposes, one ol lhe lirm's direclors has sug-
gesled lhal lhe S4 million be used lo repurchase lhe company's slock. ln lhis way, lhe value ol lhe slock should increase.
This resull may be demonslraled as lollows.
1. Assume lhal shares are repurchased by lhe lirm al lhe S60 markel price (ex-dividend price) plus lhe conlemplaled
S4 dividend per share, or lor S64 per share.
2. Civen a S64 price, 62,500 shares would be repurchased (S4 million S64 price).
3. ll nel income is nol reduced bul lhe number ol shares declines as a resull ol lhe share repurchase, earnings per share
would increase lrom S7.50 lo S8, compuled as lollows.
Larnings per share nel income/oulslanding shares
(belore repurchase) S7,500,000/!,000,000
(aller repurchase) S7,500,000/(!,000,000 62,500)
4. Assuming lhal lhe priceearnings ralio remains al 8, lhe new price aller lhe repurchase would be S64, up lrom S60,
where lhe increase exaclly equals lhe amounl ol lhe lorgone dividend.
ln lhis example, Telink's slockholders are essenlially provided lhe same value, whelher a dividend is paid or slock is repur-
chased. ll managemenl pays a dividend, lhe inveslor will have a slock valued al S60 plus S4 received lrom lhe dividend.
Conversely, il slock is repurchased in lieu ol lhe dividend, lhe slock will be worlh S64. These resulls were based on assum-
ing (!) lhe slock is being repurchased al lhe exacl S64 price, (2) lhe S7,500,000 nel income is unallecled by lhe repur-
chase, and (3) lhe priceearnings ralio ol 8 does nol change aller lhe repurchase. Civen lhese assumplions, however, lhe
slock repurchase serves as a perlecl subslilule lor lhe dividend paymenl lo lhe slockholders.
ropurclaso, llo marIol may porcoivo llo risIinoss of llo corporalion as incroasing,
vlicl vouId Iovor llo prico÷oarnings ralio and llo vaIuo of llo slocI.
Iinancing or lnvestment Decision
Ropurclasing slocI vlon llo firm las oxcoss casl may bo rogardod as a dividond
docision. Hovovor, a slocI ropurclaso may aIso bo viovod as a financing docision.
By issuing dobl and llon ropurclasing slocI, a firm can immodialoIy aIlor ils
dobl÷oquily mix lovard a liglor proporlion of dobl. Rallor llan clooso lov lo dis-
lribulo casl lo llo slocIloIdors, managomonl is using slocI ropurclaso as a moans
lo clango llo corporalion's capilaI slrucluro.
In addilion lo dividond and financing docisions, many managors considor slocI
ropurclaso as an invoslmonl docision. Wlon oquily pricos aro doprossod in llo mar-
IolpIaco, managomonl may viov llo firm's ovn slocI as boing maloriaIIy undorvaI-
uod and roprosonling a good invoslmonl opporlunily. AIllougl llo firm's manago-
monl may bo viso lo ropurclaso slocI al unusuaIIy Iov pricos, llis docision cannol
and slouId nol bo viovod in llo conloxl of an invoslmonl docision. Buying ils ovn
slocI cannol provido oxpoclod rolurns as ollor invoslmonls do. No company can sur-
vivo, mucl Ioss prospor, by invosling onIy in ils ovn slocI.
The Repurchase Procedure
If managomonl inlonds lo ropurclaso a bIocI of llo firm's oulslanding slaros, il
slouId maIo llis informalion pubIic. AII invoslors slouId bo givon llo opporlunily lo
vorI vill compIolo informalion. Tloy slouId bo loId llo purposo of llo ropurclaso,
as voII as llo mollod lo bo usod lo acquiro llo slocI.
Tlroo mollods for slocI ropurclaso aro avaiIabIo. Iirsl, llo slaros couId bo bougll
in llo opon marIol. Horo llo firm acquiros llo slocI llrougl a slocIbroIor al llo
going marIol prico. Tlis approacl may pIaco upvard prossuro on llo slocI prico unliI
llo slocI is acquirod. AIso, commissions musl bo paid lo llo slocIbroIors as a foo for
lloir sorvicos.
Tlo socond mollod is lo maIo a londor offor lo llo firm's slaroloIdors. A tender
nIIer is a |crmc| c||cr |u i|c ccmpcnu ic |uu c spcci|ic! num|cr c| s|crcs ci c prc!cicrminc!
cn! sicic! pricc. 1|c icn!cr pricc is sci c|ctc i|c currcni mcr|ci pricc in cr!cr ic ciircci
sc||crs. A londor offor is bosl vlon a roIalivoIy Iargo numbor of slaros aro lo bo bougll
bocauso llo company's inlonlions aro cIoarIy Inovn and oacl slaroloIdor las llo
opporlunily lo soII llo slocI al llo londorod prico.
Tlo llird and finaI mollod for ropurclasing slocI onlaiIs llo purclaso of llo slocI
from ono or moro major slocIloIdors. Tloso purclasos aro mado on a nogolialod basis.
Caro slouId bo laIon lo onsuro a fair and oquilabIo prico. Ollorviso, llo romaining
slocIloIdors may bo lurl as a rosuIl of llo saIo.
700.7 Dividehd Policy 122
CAßM ModuIe 700 Fihahce
700.8 Fihahcial ForecasIihg, Plahhihg, ahd CohIrol 123
700.8.1 Undorsland llo variabIos in financiaI forocasling and Ioarn lov lo uso llo
porconl of saIos forocasl mollod and caIcuIalo a firm's suslainabIo ralo of grovll
700.8.2 Doscribo llo Iimilalions of llo porconl of saIos forocasl mollod and
proparo a casl budgol for dolormining a firm's financing noods
700.8 Financial Forecasting,
Planning, and Control
700.8.1 Understand the variabIes in !inanciaI
!orecasting and Iearn hov to use the percent
o! saIes !orecast method and caIcuIate a !irm's
sustainabIe rate o! grovth
IinanciaI forocasling is llo procoss of allompling lo oslimalo a firm's fuluro financing
roquiromonls. Tlo basic slops invoIvod in prodicling lloso financing noods aro llo
Slop 1: Irojocl llo firm's saIos rovonuos and oxponsos ovor llo pIanning poriod.
Slop 2: Islimalo llo IovoIs of invoslmonl in curronl and fixod assols llal aro
noodod lo supporl llo projoclod saIos.
Slop 3: Dolormino llo firm's financing noods llrougloul llo pIanning poriod.
linancing decisions are made loday in lighl ol our expeclalions ol an uncerlain lulure.
linancial lorecasling involves making eslimales ol lhe lulure linancing requiremenls
ol lhe lirm. PrincipIe 3. Cash-Not Pro!its-Is King speaks direclly lo lhis problem.
Pemember lhal elleclive linancial managemenl requires lhal consideralion
be given lo cash llow and when il is received or disbursed.
Sales Iorecast
Tlo Ioy ingrodionl in llo firm's pIanning procoss is llo saIos forocasl. Tlis projoclion
is gonoraIIy dorivod using informalion from a numbor of sourcos. Al a minimum, llo
saIos forocasl for llo coming yoar vouId rofIocl (1) any pasl lrond in saIos llal is
oxpoclod lo carry llrougl inlo llo nov yoar and (2) llo infIuonco of any anlicipalod
ovonls llal migll maloriaIIy affocl llal lrond. An oxampIo of llo Iallor is llo inilialion
of a major advorlising campaign or a clango in llo firm's pricing poIicy.
Iorecasting Iinancial variables
TradilionaI financiaI forocasling laIos llo saIos forocasl as a givon and maIos projoc-
lions of ils impacl on llo firm's various oxponsos, assols, and IiabiIilios. Tlo mosl com-
monIy usod mollod for maIing lloso projoclions is llo porconl of saIos mollod.
Percent of Sales Method of Iinancial Iorecasting
Tlo µercent nI saIes methnd invoIvos csiimciinv i|c |ctc| c| cn cxpcnsc, cssci, cr |ic|i|iiu |cr c
|uiurc pcric! cs c pcrccnicvc c| i|c sc|cs |crcccsi. Tlo porconlago usod can como from llo mosl
roconl financiaI slalomonl ilom as a porconlago of curronl saIos, from an avorago compulod
ovor sovoraI yoars, from llo judgmonl of llo anaIysl, or from somo combinalion of lloso
TabIe 8.1 prosonls a compIolo oxampIo llal usos llo porconl of saIos mollod of
financiaI forocasling for Drov, Inc. In llis oxampIo oacl ilom in llo firm's baIanco
slool llal varios vill saIos is convorlod lo a porconlago of 2005 saIos of $10 miIIion.
Tlo forocasl of llo nov baIanco for oacl ilom is llon caIcuIalod by muIlipIying llis
porconlago limos llo $12 miIIion in projoclod saIos for llo 2006 pIanning poriod. Tlis
mollod offors a roIalivoIy Iov-cosl and oasy-lo-uso vay lo oslimalo llo firm's fuluro
financing noods.
700.8 Fihahcial ForecasIihg, Plahhihg, ahd CohIrol 124
CAßM ModuIe 700 Fihahce
Nolo llal in llo oxampIo in TabIo 8.1, boll curronl and fixod assols aro assumod lo
vary vill llo IovoI of firm saIos. Tlis moans llal llo firm doos nol lavo sufficionl produc-
livo capacily lo absorb a projoclod incroaso in saIos. Tlus, if saIos voro lo riso by $1, fixod
assols vouId riso by $0.40, or 40 porconl of llo projoclod incroaso in saIos. If llo fixod assols
llo firm curronlIy ovns aro sufficionl lo supporl llo projoclod IovoI of saIos, llon fixod
assols viII nol bo convorlod lo a porconlago of saIos and viII bo projoclod lo romain
unclangod for llo poriod boing forocasl.
AIso, nolo llal accounls payabIo and accruod oxponsos aro llo onIy IiabiIilios
aIIovod lo vary vill saIos. Boll lloso IiabiIily accounls migll roasonabIy bo oxpoclod
lo riso and faII vill llo IovoI of firm saIos, lonco, llo uso of llo porconl of saIos foro-
casl. Bocauso lloso lvo calogorios of curronl IiabiIilios normaIIy vary diroclIy vill llo
IovoI of saIos, lloy aro oflon roforrod lo as sourcos of sµnntanenus Iinancing, vlicl
incIudo i|c irc!c crc!ii cn! ci|cr ccccunis pcuc||c i|ci crisc spcnicnccus|u in i|c |irm´s !cu-
ic-!cu cpcrciicns. Nolos payabIo, Iong-lorm dobl, common slocI, and paid-in capilaI aro
nol assumod lo vary diroclIy vill llo IovoI of firm saIos. Tloso sourcos of financing aro
lormod discretinnarv Iinancing, u|ic| rc¡uirc cn cxp|icii !ccisicn cn i|c pcri c| i|c |irm´s
mcncvcmcni ctcru iimc |un!s crc rcisc!. An cxcmp|c is c |cn| ncic i|ci rc¡uircs i|ci ncvciic-
iicns |c un!cric|cn cn! cn cvrccmcni sivnc! sciiinv |cri| i|c icrms cn! ccn!iiicns |cr i|c
|incncinv. IinaIIy, nolo llal llo IovoI of rolainod oarnings doos vary vill oslimalod
saIos. Tlo prodiclod clango in llo IovoI of rolainod oarnings oquaIs llo oslimalod aflor-
lax profils (projoclod nol incomo) oquaI lo 5 porconl of saIos, or $600,000, Ioss llo com-
mon slocI dividonds of $300,000.
700.8 Fihahcial ForecasIihg, Plahhihg, ahd CohIrol 125
CAßM ModuIe 700 Fihahce
TabIe 8.1 Usihg Ihe PercehI o! Sales MeIhod Io ForecasI Drew, Ihc.'s Fihahcihg RequiremehIs !or 2006
700.8 Fihahcial ForecasIihg, Plahhihg, ahd CohIrol 126
CAßM ModuIe 700 Fihahce
In llo Drov, Inc., oxampIo found in TabIo 8.1, vo oslimalo llal firm saIos viII
incroaso from $10 miIIion lo $12 miIIion, vlicl viII causo llo firm's nood for lolaI
assols lo riso lo $7.2 miIIion. Tloso assols viII llon bo financod by $4.9 miIIion in oxisl-
ing IiabiIilios pIus sponlanoous IiabiIilios, $1.8 miIIion in ovnor funds, incIuding an
addilionaI $300,000 in rolainod oarnings from noxl yoar's saIos, and finaIIy, $500,000 in
discrolionary financing, vlicl can bo raisod by issuing nolos payabIo, soIIing bonds,
offoring an issuo of slocI, or somo combinalion of lloso sourcos.
In summary, vo can oslimalo llo firm's discrolionary financing noods (DIN),
using llo porconl of saIos mollod of financiaI forocasling, by foIIoving a four-slop
5tep 1 Convorl oacl assol and IiabiIily accounl llal varios diroclIy vill firm saIos
lo a porconlago of llo curronl yoar's saIos.
Currenl assels
or 20' = =
2 .
5tep 2 Irojocl llo IovoI of oacl assol and IiabiIily accounl in llo baIanco slool
using ils porconlago of saIos muIlipIiod by projoclod saIos or by Ioaving
llo accounl baIanco unclangod vlon llo accounl doos nol vary vill llo
IovoI of saIos.
Projecled currenl assels projecled sales
= 
rrrenl assels
S M S M = !2 2 2 4   . .
Projecled addilion
lo relained earnings
pro = jjecled sales
nel income
cash divide
   !
nel income
S M ( ) S    = = !2 05 ! 5 300 0 . . , 000
5tep 3 Irojocl llo addilion lo rolainod oarnings avaiIabIo lo loIp financo llo
firm's oporalions. Tlis oquaIs projoclod nol incomo for llo poriod Ioss
pIannod common slocI dividonds.
5tep 4 Irojocl llo firm's DIN as llo projoclod IovoI of lolaI assols Ioss projoclod
IiabiIilios and ovnors' oquily.
700.8 Fihahcial ForecasIihg, Plahhihg, ahd CohIrol 127
CAßM ModuIe 700 Fihahce
Analyzing the £ffects of Profitability and Dividend Policy on DfN
Irojocling discrolionary financing noodod, vo can quicIIy and oasiIy ovaIualo llo son-
silivily of our projoclod financing roquiromonls lo clangos in Ioy variabIos. Ior oxam-
pIo, using llo informalion from llo procoding oxampIo, vo ovaIualo llo offocl of nol
profil margins (NPMs) oquaI lo 1 porconl, 5 porconl, and 10 porconl in combinalion
vill dividond payoul ralios of 30 porconl, 50 porconl, and 70 porconl, as foIIovs:
DiscreIiohary Fihahcihg Needed !or Various NeI Pro!iI Margihs
ahd Dividehd PayouI RaIios
Dividend Payout ßatios = Dividends ÷ Net Income
Net Pro!it Margin 30% 50% 70%
1% $716,000 $740,000 $764,000
5% 380,000 500,000 620,000
10% (40,000) 200,000 440,000
If lloso NPMs aro roasonabIo oslimalos of llo possibIo rangos of vaIuos llo firm migll
oxporionco, and if llo firm is considoring dividond payouls ranging from 30 porconl lo
70 porconl, llon vo oslimalo llal llo firm's financing roquiromonls viII rango from
($40,000), vlicl roprosonls a surpIus of $40,000, lo a silualion in vlicl il vouId nood lo
acquiro $764,000. Iovor NPMs moan liglor funds roquiromonls. AIso, liglor dividond
payoul porconlagos, ollor llings romaining conslanl, Ioad lo a nood for moro discro-
lionary financing. Tlis is a dirocl rosuIl of llo facl llal a ligl-dividond-paying firm
rolains Ioss of ils oarnings.
Analyzing the £ffects of Sales Growth on a Iirm's DfN
In Figure 8.1 vo anaIyzod llo DIN for Drov, Inc., vloso saIos voro oxpoclod lo grov
from $10 miIIion lo $12 miIIion during llo coming yoar. RocaII llal llo 20 porconl oxpoclod
incroaso in saIos Iod lo an incroaso in llo firm's noods for financing in llo amounl of
$500,000. Wo roforrod lo llis addod financing roquiromonl as llo firm's DIN bocauso aII
lloso funds musl bo raisod from sourcos, sucl as banI borroving or a nov oquily issuo,
llal roquiro llal managomonl oxorciso ils discrolion in soIocling llo sourco. In llis soclion
vo vanl lo invosligalo lov a firm's DIN varios vill difforonl ralos of anlicipalod grovll
in saIos.
TabIe 8.2 conlains an oxpansion of llo financiaI forocasl found in TabIo 8.1. Spocif-
icaIIy, vo uso llo samo assumplions and prodiclion mollods llal undorIio TabIo 8.1
bul appIy llom lo saIos grovll ralos of 0 porconl, 20 porconl, and 40 porconl. Tlo DIN
for lloso saIos grovll ralos rangos from ($250,000) lo $1,250,000. Wlon DIN is noga-
livo, llis moans llal llo firm las moro monoy llan il noods lo financo llo assols usod
Discrolionary financing noodod
projoclod lolaI assols  projoclod lolaI IiabiIilios  projoclod ovnor's oquily
$7.2M  4.9M  $1.8M $500,000
700.8 Fihahcial ForecasIihg, Plahhihg, ahd CohIrol 128
CAßM ModuIe 700 Fihahce
40% 30% 20% 10% 0%
SaIes growth rate
|í íiru's sales grow al 6.667%, lheu all oí ils íiuauciug
ueeds will be supplied by lhe releuliou oí earuiugs
aud spoulaueous sources oí íiuauciug (i.e.,  = 0ì.
|í íiru sales grow al 20%, lheu lhe íiru will have a
 oí $S00,000 above aud beyoud ils releuliou
oí earuiugs aud spoulaueous sources oí íiuauciug.
S0% -10%
figure 8.1 Sales GrowIh ahd Ihe DiscreIiohary Fihahcihg Needs o! Ihe Firm
TabIe 8.2 DiscreIiohary Fihahcihg Needs () ahd Ihe GrowIh RaIe ih Sales
lo gonoralo llo projoclod saIos. AIlornalivoIy, vlon DIN is posilivo, llis moans llal
llo firm musl raiso addilionaI funds in llis amounl, by oillor borroving or issuing
slocI. Wo can caIcuIalo DIN using llo foIIoving roIalionslip:
prodiclod clango
prodiclod clango
prodiclod clango
in lolaI assols in sponlanoous IiabiIilios in rolainod oarnings
Nolico llal in dofining DIN vo onIy considor clangos in sponlanoous IiabiIilios,
vlicl you viII rocaII aro lloso IiabiIilios llal ariso moro or Ioss aulomalicaIIy in llo
courso of doing businoss (oxampIos incIudo accruod oxponsos and accounls payabIo).
In TabIo 8.1 llo onIy IiabiIilios llal aro aIIovod lo clango vill saIos aro sponlanoous
IiabiIilios, so vo can caIcuIalo llo clango in sponlanoous IiabiIilios simpIy by compar-
ing lolaI IiabiIilios al llo curronl saIos IovoI vill lolaI IiabiIilios for llo prodiclod saIos
Iqualion (8-1) can bo usod lo oslimalo llo DIN numbors found in TabIo 8.2. Ior
oxampIo, vlon saIos aro oxpoclod lo grov al a ralo of 10 porconl (i.o., v oquaIs 10 por-
conl), DIN can bo caIcuIalod as foIIovs:
DIN(v 10°) ($6,600,000 ÷ 6,000,000) ÷ ($4,700,000 ÷ 4,500,000)
÷ ($1,475,000 ÷ 1,200,000) $125,000
Somolimos anaIysls profor lo caIcuIalo a firm's externaI Iinancing needs (|IN),
vlicl incIudo c|| i|c |irm´s ncc!s |cr |incncinv |cucn! i|c |un!s prcti!c! inicrnc||u i|rcuv|
i|c rcicniicn c| ccrninvs. Tlus,
|IN prodiclod clango in lolaI assols  clango in rolainod oarnings (8-2)
Ior an anlicipalod grovll in saIos of 10 porconl, |IN oquaIs $325,000. Tlo difforonco
bolvoon |IN and DIN oquaIs llo $200,000 in addod sponlanoous financing llal llo
firm anlicipalos rocoiving vlon ils saIos riso from $10 miIIion lo $11 miIIion. Wo profor
lo uso llo DIN concopl bocauso il focusos llo anaIysl's allonlion on llo amounl of
funds llal llo firm musl aclivoIy sooI lo mool llo firm's financing roquiromonls.
Iiguro 8.1 conlains a graplic roprosonlalion of llo roIalionslip bolvoon grovll
ralos for saIos and DIN. Tlo slraigll Iino in llo grapl dopicls llo IovoI of DIN for oacl
of llo difforonl ralos of grovll in firm saIos. Ior oxampIo, if saIos grov by 20 porconl,
llon llo firm projocls a DIN of $500,000, vlicl musl bo raisod oxlornaIIy by borroving
or a nov oquily offoring. Nolo llal vlon firm saIos grov al 6.667 porconl, llo firm's
DIN viII bo oxaclIy zoro. Ior firms llal lavo Iimilod sourcos of oxlornaI financing or
llal clooso lo grov llrougl inlornaI financing pIus sponlanoous financing, il is impor-
lanl llal lloy bo abIo lo oslimalo llo saIos grovll ralo llal lloy can ¨afford,¨ vlicl in
llis caso is 6.667 porconl.
Tlo sustainabIe rate nI grnwth (v¯) roprosonls i|c rcic ci u|ic| c |irm´s sc|cs ccn vrcu i|
ii ucnis ic mcinicin iis prcscni |incncic| rciics cn! !ccs nci ucni ic rcscri ic i|c sc|c c| ncu
c¡uiiu s|crcs. A simpIo formuIa can bo dorivod for v¯ in vlicl vo assumo llal a firm's
assols and IiabiIilios aII grov al llo samo ralo as ils saIos, llal is,
SuslainabIo ralo of grovll (v´) RO| (1  |) (8-3)
RO| is llo firm's rolurn on oquily dofinod as foIIovs:
and | is llo firm's dividond payoul ralio, llal is, . Tlo lorm (1  |) is somolimos
roforrod lo as llo µInwback ratin bocauso il indicalos i|c |rcciicn c| ccrninvs i|ci is
nol incomo
RO| =
nol incomo
common oquily
700.8 Fihahcial ForecasIihg, Plahhihg, ahd CohIrol 129
CAßM ModuIe 700 Fihahce
rcintcsic! cr p|cuc! |cc| inic i|c |irm. Iqualion (8-3) is docoplivoIy simpIo. RocaII llal
RO| can aIso bo vrillon as foIIovs:
ConsoquonlIy, a firm's suslainabIo ralo of grovll is dolorminod by ils RO| (i.o., ils
anlicipalod NPM, assol lurnovor, and capilaI slrucluro), as voII as ils dividond poIicy.
700.8.2 Describe the Iimitations o! the percent
o! saIes !orecast method and prepare a cash budget
!or determining a !irm's !inancing needs
Tlo porconl of saIos mollod of financiaI forocasling providos roasonabIo oslimalos of a
firm's financing roquiromonls onIy vlon assol roquiromonls and financing sourcos can
RO| =
nol incomo
 
lolaI assols
common oquily
700.8 Fihahcial ForecasIihg, Plahhihg, ahd CohIrol 130
CAßM ModuIe 700 Fihahce
Consider lhe lhree lirms lound here.
Net Pro!it Asset Leverage PIovback 5ustainabIe Grovth
firm Margin Turnover (Assets + Equity) ßatio ßate (g*)
A 15% 1.00 1.2 50% 9.0%
8 15% 1.00 1.2 100% 18.0%
C 15% 1.00 1.5 100% 22.5%
Comparing lirms A and 8, we see lhal lhe only dillerence is lhal lirm A pays oul hall ils earnings in common dividends
(i.e., plows back hall ils earnings), whereas lirm 8 relains or plows back all ol ils earnings. The nel resull is lhal lirm 8 wilh
ils added source ol inlernal equily linancing can grow al lwice lhe rale ol lirm A (!8 percenl compared wilh only 9 per-
cenl). Similarly, comparing lirms 8 and C, we nole lhal lhey diller only in lhal lirm 8 uses less debl linancing lhan lirm C.
The resull is lhal lirm C's suslainable rale ol growlh is 22.5 percenl, compared wilh only !8 percenl lor lirm 8.
8elore leaving our discussion ol lhe suslainable rale ol growlh concepl, il is imporlanl lhal we slress lhe underlying
assumplions behind equalion (8-3). lor lhis equalion lo accuralely depicl a lirm's suslainable rale ol growlh, lhe lollowing
assumplions musl hold.
lirsl, lhe lirm's assels musl vary as a conslanl percenlage ol sales (i.e., even lixed assels expand and conlracl direclly
wilh lhe level ol lirm sales).
Second, lhe lirm's liabililies musl all vary direclly wilh lirm sales. This means lhal lhe lirm's managemenl will expand ils
borrowing (bolh sponlaneous and discrelionary) in direcl proporlion wilh sales lo mainlain ils presenl ralio ol debl lo
Third, lhe lirm pays oul a conslanl proporlion ol ils earnings in common slock dividends regardless ol lhe level ol lirm
8ecause all lhree ol lhese assumplions are only rough approximalions lo lhe way lhal lirms aclually behave, equalion (8-3)
provides a crude approximalion ol lhe lirm's aclual suslainable rale ol growlh. However, an eslimale ol * using equalion
(8-3) can be a very uselul lirsl slep in lhe lirm's linancial planning process.
bo accuraloIy forocasl as a conslanl porconl of saIos. Ior oxampIo, prodicling invonlo-
rios using llo porconl of saIos mollod invoIvos llo foIIoving prodiclivo oqualion,
vloro llo subscripl i rofors lo llo poriod llal is boing forocasl.
Figure 8.2a dopicls llis prodiclivo roIalionslip. Nolo llal llo porconl of saIos pro-
diclivo modoI is simpIy a slraigll Iino llal passos llrougl llo origin (i.o., las a zoro
inlorcopl). Tloro aro somo fairIy common inslancos in vlicl llis lypo of roIalionslip
faiIs lo doscribo llo roIalionslip bolvoon an assol calogory and saIos. Tvo sucl oxam-
pIos invoIvo assols for vlicl lloro aro scaIo oconomios and assols llal musl bo pur-
clasod in discrolo quanlilios (¨Iumpy assols¨).
Iconomios of scaIo aro somolimos roaIizod from invosling in corlain lypos of
assols. Ior oxampIo, a nov compulor syslom may supporl a firm's oporalions ovor a
vido rango of firm saIos. Tlis moans llal lloso assols do nol incroaso in dirocl pro-
porlion lo saIos. Figure 8.2b rofIocls ono inslanco in vlicl llo firm roaIizos
oconomios of scaIo from ils invoslmonl in invonlory. Nolo llal invonlorios as a por-
conlago of saIos docIino from 120 porconl of saIos, or $120 vlon saIos aro $100, lo 30
porconl of saIos, or $300 vlon saIos oquaI $1,000. Tlis rofIocls llo facl llal lloro is a
fixod compononl of invonlorios (in llis caso $100) llal llo firm musl lavo on land
rogardIoss of llo IovoI of saIos, pIus a variabIo compononl (20 porconl of saIos). In
llis inslanco llo prodiclivo oqualion for invonlorios is as foIIovs:
c  | saIos
In llis oxampIo, c is oquaI lo 100 and | oquaIs .20.

700.8 Fihahcial ForecasIihg, Plahhihg, ahd CohIrol 131
CAßM ModuIe 700 Fihahce
0 S00 1,000
|uveulories = .2Sales
Nole lhal lhe perceul oí sales íorecasl liue
passes lhrough lhe origiu (i.e., wheu sales
are zero so are iuveuloriesì.
0 S00 1,000
|uveulories = 100 + .2Sales
Nole lhal a íixed auouul oí iuveulory
($100ì is required lo do busiuess. however,
as sales grow lhe ueed íor iuveulory does
uol grow as íasl as iu |igure 8.2a.
figure 8.2a PercehI o! Sales ForecasI
figure 8.2b Lcohomies o! Scale
Figure 8.2c is an oxampIo of |umpu csscis, llal is, assols llal musl bo purclasod in
Iargo, nondivisibIo compononls. Ior oxampIo, if llo firm sponds $500 on pIanl and
oquipmonl, il can produco up lo $100 in saIos por yoar. If il sponds anollor $500 (for a
lolaI of $1,000), llon il can supporl saIos of $200 por yoar, and so forll. Nolo llal vlon
a bIocI of assols is purclasod, il croalos oxcoss capacily unliI saIos grov lo llo poinl al
vlicl llo capacily is fuIIy usod. Tlo rosuIl is a slop funclion IiIo llo ono dopiclod in
Iiguro 8.2c. Tlus, if llo firm doos nol oxpocl saIos lo oxcood llo curronl capacily of ils
pIanl and oquipmonl, lloro vouId bo no projoclod nood for addod pIanl and oquip-
monl capacily.
As vo nolod oarIior, llo principaI virluo of llo porconl of saIos mollod of financiaI
forocasling is ils simpIicily. To oblain a moro prociso oslimalo of llo amounl and
liming of llo firm's fuluro financing noods, vo roquiro a casl budgol. Tlo porconl of
saIos mollod of financiaI forocasling providos a vory usofuI, Iov-cosl fororunnor lo
llo dovoIopmonl of llo moro dolaiIod casl budgol, vlicl llo firm viII uIlimaloIy
uso lo oslimalo ils financing noods.
8udgels have many imporlanl uses, however, lheir use as a lool ol managerial
conlrol is crilically imporlanl and ollen overlooked in lhe sludy ol linancial managemenl.
PrincipIe 7. Agency ProbIems-Managers Won't Work !or Ovners UnIess It's
in Their ßest Interest speaks lo lhe rool source ol lhe problem, and budgels
provide one lool lor allempling lo deal wilh il. Specilically, budgels provide
managemenl wilh a lool lor evalualing perlormance and, consequenlly, mainlaining
a degree ol conlrol over employee aclions.
8udget Iunctions
A budget is simpIy c |crcccsi c| |uiurc ctcnis. Ior oxampIo, sludonls proparing for finaI
oxams maIo uso of limo budgols lo loIp llom aIIocalo lloir Iimilod proparalion limo
among lloir coursos. Sludonls aIso musl budgol lloir financiaI rosourcos among com-
poling usos, sucl as booIs, luilion, food, ronl, cIollos, and oxlracurricuIar aclivilios.
Budgols porform llroo basic funclions for a firm.
Iirsl, lloy indicalo llo amounl and liming of llo firm's noods for fuluro
Socond, lloy provido llo basis for laIing corroclivo aclion in llo ovonl budgolod
figuros do nol malcl acluaI or roaIizod figuros.
700.8 Fihahcial ForecasIihg, Plahhihg, ahd CohIrol 132
CAßM ModuIe 700 Fihahce
^s sales grow lhe íiru's ueed íor plaul aud
equipueul also grows. however, plaul aud
equipueul are purchased iu "luups."
0 200 400
600 100 300 S00
figure 8.2c Lcohomies o! Scale wiIh Lumpy IhvesImehIs
700.8 Fihahcial ForecasIihg, Plahhihg, ahd CohIrol 133
CAßM ModuIe 700 Fihahce
To demonslrale lhe conslruclion and use ol lhe cash budgel, consider Salco lurnilure Company, lnc., a regional dislribulor
ol household lurnilure. Managemenl is in lhe process ol preparing a monlhly cash budgel lor lhe upcoming 6 monlhs
(January lhrough June 2006). Salco's sales are highly seasonal, peaking in lhe monlhs ol March lhrough May. Poughly
30 percenl ol Salco's sales are collecled ! monlh aller lhe sale, 50 percenl 2 monlhs aller lhe sale, and lhe remainder dur-
ing lhe lhird monlh lollowing lhe sale.
Salco allempls lo pace ils purchases wilh ils lorecasl ol lulure sales. Purchases generally equal 75 percenl ol sales and are
made 2 monlhs in advance ol anlicipaled sales. Paymenls are made in lhe monlh lollowing purchases. lor example, June
sales are eslimaled al S!00,000, lhus, April purchases are .75 S!00,000 S75,000. Correspondingly, paymenls lor pur-
chases in May equal S75,000. Wages, salaries, renl, and olher cash expenses are recorded in Table 8.3, which gives Salco's
cash budgel lor lhe 6-monlh period ended in June 2006. Addilional expendilures are recorded in lhe cash budgel relaled
lo lhe purchase ol equipmenl in lhe amounl ol S!4,000 during lebruary and lhe repaymenl ol a S!2,000 loan in May. ln
June, Salco will pay S7,500 inleresl on ils S!50,000 in long-lerm debl lor lhe period ol January lo June 2006. lnleresl on
lhe S!2,000 shorl-lerm nole repaid in May lor lhe period January lhrough May equals S600 and is paid in May.
Tlird, budgols provido llo basis for porformanco ovaIualion and conlroI. IIans
aro carriod oul by poopIo, and budgols provido bonclmarIs llal managomonl
can uso lo ovaIualo llo porformanco of lloso rosponsibIo for carrying oul lloso
pIans and, in lurn, lo conlroI lloir aclions.
The Cash 8udget
Tlo cash budget roprosonls a !cici|c! p|cn c| |uiurc ccs| ||cus and is composod of four
oIomonls: casl rocoipls, casl disbursomonls, nol clango in casl for llo poriod, and
nov financing noodod.
SaIco curronlIy las a casl baIanco of $20,000 and vanls lo mainlain a minimum
baIanco of $10,000. AddilionaI borroving nocossary lo mainlain llal minimum baIanco
is oslimalod in llo finaI soclion of TabIe 8.3. Borroving laIos pIaco al llo boginning of
llo monll in vlicl llo funds aro noodod. Inlorosl on borrovod funds oquaIs 12 por-
conl por annum, or 1 porconl por monll, and is paid in llo monll foIIoving llo ono in
vlicl funds aro borrovod. Tlus, inlorosl on funds borrovod in Ianuary viII bo paid
in Iobruary oquaI lo 1 porconl of llo Ioan amounl oulslanding during Ianuary.
Tlo financing-noodod Iino in SaIco's casl budgol dolorminos llal llo firm's cumu-
Ialivo slorl-lorm borroving viII bo $36,350 in Iobruary, $65,874 in Marcl, $86,633 in
ApriI, and $97,599 in May. In Iuno llo firm viII bo abIo lo roduco ils borroving lo
$79,875. Nolo llal llo casl budgol indicalos nol onIy llo amounl of financing noodod
during llo poriod bul aIso vlon llo funds viII bo noodod.
700.8 Fihahcial ForecasIihg, Plahhihg, ahd CohIrol 134
CAßM ModuIe 700 Fihahce
TabIe 8.3 Salco FurhiIure Co., Ihc. Cash 8udgeI !or Ihe 6 MohIhs Lhded 1uhe 30, 2006
700.9 CapiIal ValuaIioh 1echhiques 135
700.9.1 Undorsland llo various lypos and foaluros of bonds
700.9.2 Dofino llo lorm ¨vaIuo¨ and idonlify llo faclors llal dolormino ¨vaIuo¨
and doscribo llo basic procoss for vaIuing assols
700.9.3 Ioarn lov lo oslimalo llo vaIuo of a bond, compulo a bondloIdor's
oxpoclod ralo of rolurn (yioId lo malurily), and oxpIain llo imporlanl
roIalionslips llal oxisl in bond vaIualion
700.9.4 Dofino proforrod slocI vill ils foaluros and Ioarn lov lo vaIuo a
proforrod slocI
700.9.5 Dofino common slocI vill ils foaluros and Ioarn lov lo vaIuo common
700.9.6 CaIcuIalo a slocI's oxpoclod ralo of rolurn from a slocIloIdor's viovpoinl
700.9 Capital Valuation Iechniques
700.9.1 Understand the various types and !eatures
o! bonds
A bnnd is a iupc c| !c|i cr |cnv-icrm prcmisscru ncic, issuc! |u i|c |crrcucr, prcmisinv ic
pcu iis |c|!cr c prc!cicrminc! cn! |ixc! cmcuni c| inicrcsi pcr uccr cn! i|c |ccc tc|uc c| i|c
|cn! ci mciuriiu. Hovovor, lloro is a vido varioly of sucl croaluros. Iusl lo monlion a
fov, vo lavo
Dobonluros Iurobonds
Subordinalod dobonluros Zoro and vory Iov coupon bonds
Morlgago bonds IunI bonds
Tlo foIIoving soclions briofIy oxpIain oacl of lloso lypos of bonds.
Tlo lorm debenture appIios lo cnu unsccurc! |cnv-icrm !c|i. Bocauso lloso bonds aro
unsocurod, llo oarning abiIily of llo issuing corporalion is of groal concorn lo llo
bondloIdor. Tloy aro aIso viovod as boing moro risIy llan socurod bonds and as a
rosuIl musl provido invoslors vill a liglor yioId llan socurod bonds provido. Oflon
llo issuing firm allompls lo provido somo proloclion lo llo loIdor of llo bond by pro-
libiling il from issuing moro socurod Iong-lorm dobl llal vouId furllor lio up llo
firm's assols and Ioavo llo bondloIdors Ioss proloclod. To llo issuing firm, llo major
advanlago of dobonluros is llal no proporly las lo bo socurod by llom. Tlis aIIovs llo
firm lo issuo dobl and sliII prosorvo somo fuluro borroving povor.
Subordinated Debentures
Many firms lavo moro llan ono issuo of dobonluros oulslanding. In llis caso a lior-
arcly may bo spocifiod, in vlicl somo dobonluros aro givon su|cr!incic! sicn!inv in
ccsc c| insc|tcncu. Tlo cIaims of llo subnrdinated debentures aro lonorod onIy aflor
llo cIaims of socurod dobl and unsubordinalod dobonluros lavo boon salisfiod.
Mortgage 8onds
A mnrtgage bnnd is a |cn! sccurc! |u c |icn cn rcc| prcpcriu. TypicaIIy, llo vaIuo of llo
roaI proporly is groalor llan llal of llo morlgago bonds issuod. Tlis providos llo morl-
gago bondloIdors vill a margin of safoly in llo ovonl llo marIol vaIuo of llo socurod
proporly docIinos. In llo caso of forocIosuro, llo lrusloos lavo llo povor lo soII llo
socurod proporly and uso llo procoods lo pay llo bondloIdors. In llo ovonl llal llo pro-
coods from llis saIo do nol covor llo bonds, llo bondloIdors bocomo gonoraI crodilors,
simiIar lo dobonluro bondloIdors, for llo unpaid porlion of llo dobl.
Eurnbnnds aro nol so mucl a difforonl lypo of socurily. Tloy aro simpIy socurilios,
in llis caso |cn!s, issuc! in c ccuniru !i||crcni |rcm i|c cnc in u|csc currcncu i|c |cn! is
!cncmincic!. Ior oxampIo, a bond llal is issuod in Iuropo or in Asia by an Amorican
company and llal pays inlorosl and principaI lo llo Iondor in U.S. doIIars vouId bo
considorod a Iurobond. Tlus, ovon if llo bond is nol issuod in Iuropo, il moroIy
noods lo bo soId in a counlry difforonl from llo ono in vloso curroncy il is donomi-
nalod lo bo considorod a Iurobond.
Tlo primary allraclions of Iurobonds lo borrovors, asido from favorabIo ralos, aro
llo roIalivo IacI of roguIalion (Iurobonds aro nol rogislorod vill llo Socurilios and
Ixclango Commission |SIC]), Ioss-rigorous discIosuro roquiromonls llan lloso of llo
700.9 CapiIal ValuaIioh 1echhiques 136
CAßM ModuIe 700 Fihahce
SIC, and llo spood vill vlicl lloy can bo issuod. InloroslingIy, nol onIy aro
Iurobonds nol rogislorod vill llo SIC, bul lloy may nol bo offorod lo U.S. cilizons
and rosidonls.
Zero and very Low Coupon 8onds
Zern and verv Inw cnuµnn bnnds aIIov llo issuing firm lo issuo |cn!s ci c su|sicniic|
!isccuni |rcm i|cir S1,000 |ccc tc|uc uii| c zcrc cr tcru |cu ccupcn rcic. Tlo invoslor
rocoivos a Iargo parl (or aII vill zoro coupon bonds) of llo rolurn from llo approcia-
lion of llo bonds. Ior oxampIo, in 2005, Amorican Music, an onIino music providor,
issuod $250 miIIion of dobl maluring in 2015 vill a zoro coupon ralo. In 2005, lloso
bonds soId al a 60 porconl discounl from lloir par vaIuo, llal is, invoslors paid onIy
$400 for a bond vill a $1,000 par vaIuo. Invoslors vlo purclasod lloso bonds for $400
and loId llom unliI lloy maluro in 2015 viII rocoivo an offoclivo inlorosl ralo of 9.6
porconl, vill aII of llis rolurn coming from approcialion of llo bond. Iurllormoro, llo
firm viII lavo no casl oulfIovs unliI lloso bonds maluro, lovovor, al llal limo il viII
lavo lo pay bacI $250 miIIion, ovon llougl il onIy rocoivod approximaloIy $100 miI-
Iion vlon llo bonds voro issuod.
As vill any form of financing, lloro aro boll advanlagos and disadvanlagos of issu-
ing zoro or vory Iov coupon bonds. As aIroady monlionod, ono disadvanlago is, vlon
llo bonds maluro, Amorican Music viII faco an oxlromoIy Iargo casl oulfIov, mucl
groalor llan llo casl infIov il oxporioncod vlon llo bonds voro issuod. Tloro aro sovoraI
advanlagos of zoro and Iov coupon bonds from llo issuing firm's porspoclivo. Iirsl, llo
annuaI casl oulfIovs associalod vill inlorosl paymonls do nol occur vill zoro coupon
bonds and aro al a roIalivoIy Iov IovoI vill Iov coupon bonds. Socond, bocauso lloro is
roIalivoIy slrong invoslor domand for llis lypo of dobl, llo invoslors viII froquonlIy
accopl a Iovor offoclivo inlorosl ralo. Ior inslanco, Amorican Music vas abIo lo issuo zoro
coupon bonds al aboul laIf a porconl Ioss llan il vouId lavo boon if lloy lad boon lradi-
lionaI inlorosl-paying bonds. IinaIIy, llo firm is abIo lo doducl llo annuaI amorlizalion of
llo discounl from laxabIo incomo, vlicl viII provido a posilivo annuaI casl fIov lo
Amorican Music.
1unk 8onds (High-¥ield 8onds)
Junk bnnds aro ligl-risI dobl vill rciinvs c| 88 cr |c|cu by Moody's and Slandard &
Ioor's. Tlo Iovor llo raling, llo liglor llo clanco of dofauIl, llo Iovosl cIass is CC for
Slandard & Ioor's and Ca for Moody's. OriginaIIy, llo lorm ¨junI bonds¨ vas usod lo
doscribo bonds issuod by ¨faIIon angoIs,¨ llal is, firms vill sound financiaI lislorios
llal voro facing sovoro financiaI probIoms and sufforing from poor crodil ralings.
IunI bonds aro aIso caIIod high-vieId bnnds for llo ligl inlorosl ralos lloy pay
llo invoslor, lypicaIIy laving an inlorosl ralo of bolvoon 3 and 5 porconl moro llan
AAA-grado Iong-lorm dobl.
IunI bonds conlinuo lo bo a sourco of financing for a numbor of companios pro-
viding liglor polonliaI rolurns for invoslors÷bul vill groalor risI as voII.
Some have lhoughl junk bonds were lundamenlally dillerenl lrom olher securilies,
bul lhey are nol. They are bonds wilh a greal amounl ol risk and, lherelore, promise high
expecled relurns. Thus, PrincipIe 1. The ßisk-ßeturn Trade-O!!-We Won't Take
on AdditionaI ßisk UnIess We Expect to ße Compensated vith AdditionaI ßeturn.
Nov llal you lavo an undorslanding of llo Iinds of bonds firms migll issuo, Iol's
IooI al somo of llo claraclorislics and lorminoIogy of bonds.
700.9 CapiIal ValuaIioh 1echhiques 137
CAßM ModuIe 700 Fihahce
Boforo vaIuing bonds, vo firsl nood lo undorsland llo lorminoIogy roIalod lo bonds.
Tlon vo viII bo bollor proparod lo dolormino llo vaIuo of a bond.
Wlon a firm or nonprofil inslilulion noods financing, ono sourco is |cn!s. As
aIroady nolod, llis lypo of financing inslrumonl is simpIy a Iong-lorm promissory
nolo, issuod by llo borrovor, promising lo pay ils loIdor a prodolorminod and fixod
amounl of inlorosl oacl yoar. Somo of llo moro imporlanl lorms and claraclorislics
llal you migll loar aboul bonds aro as foIIovs:
CIaims on assols and incomo ConvorlibiIily
Iar vaIuo CaII provision
Coupon inlorosl ralo Indonluro
Malurily Bond ralings
Iol's considor oacl in lurn.
Claims on Assets and lncome
In llo caso of insoIvoncy, cIaims of dobl, incIuding bonds, aro gonoraIIy lonorod
boforo lloso of boll common slocI and proforrod slocI. Hovovor, difforonl lypos of
dobl may aIso lavo a liorarcly among llomsoIvos as lo llo ordor of lloir cIaim on
Bonds aIso lavo a cIaim on incomo llal comos aload of common and proforrod
slocI. In gonoraI if inlorosl on bonds is nol paid, llo bond lrusloos can cIassify llo firm
as insoIvonl and forco il inlo banIruplcy. Tlus, llo bondloIdors' cIaim on incomo is
moro IiIoIy lo bo lonorod llan llal of common slocIloIdors, vloso dividonds aro
paid al llo discrolion of llo firm's managomonl.
Par value
Tlo µar vaIue nI a bnnd is ils |ccc tc|uc, u|ic| is rciurnc! ic i|c |cn!|c|!cr ci mciuriiu. In
gonoraI, corporalo bonds aro issuod in donominalions of $1,000, aIllougl lloro aro
somo oxcoplions lo llis ruIo. AIso, vlon bond pricos aro quolod, oillor by financiaI
managors or in llo financiaI pross, pricos aro gonoraIIy oxprossod as a porconlago of
llo bond's par vaIuo. Ior oxampIo, a Timo-Warnor bond vas roconlIy quolod as soIIing
for 113.68. Tlal doos nol moan you can buy llo bond for $113.68. Il moans llal llis
bond is soIIing for 113.68 porconl of ils par vaIuo of $1,000. Honco, llo marIol prico of
llis bond is acluaIIy $1,136.80. Al malurily in 2028 llo bondloIdor viII rocoivo $1,000.
Coupon lnterest Rate
Tlo cnuµnn interest rate on a bond indicalos llo pcrccnicvc c| i|c pcr tc|uc c| i|c |cn! i|ci
ui|| |c pci! cui cnnuc||u in i|c |crm c| inicrcsi. Tlus, rogardIoss of vlal lappons lo llo prico
of a bond vill an 8 porconl coupon inlorosl ralo and a $1,000 par vaIuo, il viII pay oul $80
annuaIIy in inlorosl unliI malurily (.08  $1,000 $80). Hovovor, as vo viII obsorvo Ialor,
llo inlorosl may bo paid somiannuaIIy, IiIo in Iuno and Docombor. In llo forogoing oxam-
pIo, llo inlorosl vouId bo $40 somiannuaIIy, bul llo coupon ralo is sliII caIcuIalod on llo
annuaI inlorosl of $80.
Tlo maturitv of a bond indicalos i|c |cnvi| c| iimc unii| i|c |cn! issucr rciurns i|c pcr
tc|uc ic i|c |cn!|c|!cr cn! icrmincics cr rc!ccms i|c |cn!.
A cnnvertibIe bnnd may aIIov llo invoslor lo oxclango llo bond for a prodolorminod
numbor of llo firm's slaros of common slocI. Ior inslanco, TiVo, a firm llal dovoIopod
llo TiVo rocordor for loIovision, issuod $51.8 miIIion of 7 porconl convorlibIo dobl. Tlo
700.9 CapiIal ValuaIioh 1echhiques 138
CAßM ModuIe 700 Fihahce
bonds aro convorlibIo al any limo inlo TiVo common slocI al a convorsion prico of $6.73
por slaro. Sinco llo par vaIuo for oacl bond is $1,000, a bondloIdor can convorl ono bond
inlo 148.59 slaros (148.59 slaros $1,000 $6.73 prico por slaro). Tlis oplion aIIovs llo
invoslor lo bo ropaid llo $1,000 par vaIuo or lo convorl inlo slocI if llo vaIuo of llo slocI
is groalor llan $1,000.
Call Provision
If a company issuos bonds and llon Ialor llo provaiIing inlorosl ralo docIinos, llo firm
may vanl lo pay off llo bonds oarIy and llon issuo nov bonds vill a Iovor inlorosl
ralo. To do so, llo bond musl bo caIIabIe or redeemabIe, ollorviso, llo firm cannol
forco llo bondloIdor lo accopl oarIy paymonl. Tlo issuor, lovovor, usuaIIy musl pay
llo bondloIdors a promium, sucl as ono yoar's inlorosl. AIso, lloro froquonlIy is a caII
µrntectinn µerind vloro llo firm cannol caII llo bond for a prospocifiod limo poriod.
An indenture is llo |cvc| cvrccmcni |ciuccn i|c |irm issuinv i|c |cn!s cn! i|c irusicc u|c
rcprcscnis i|c |cn!|c|!crs. Tlo indonluro providos llo spocific lorms of llo Ioan agroo-
monl, incIuding a doscriplion of llo bonds, llo riglls of llo bondloIdors, llo riglls of
llo issuing firm, and llo rosponsibiIilios of llo lrusloo. Tlis IogaI documonl may run
100 pagos or moro in Iongll, vill llo majorily of il dovolod lo dofining proloclivo pro-
visions for llo bondloIdor. Tlo bond lrusloo, usuaIIy a banIing inslilulion or lrusl
company, is llon assignod llo lasI of ovorsooing llo roIalionslip bolvoon llo bond-
loIdor and llo issuing firm, prolocling llo bondloIdor, and sooing llal llo lorms of
llo indonluro aro carriod oul.
TypicaIIy, llo roslriclivo provisions incIudod in llo indonluro allompl lo prolocl
llo bondloIdors' financiaI posilion roIalivo lo llal of ollor oulslanding socurilios.
Common provisions invoIvo (1) prolibiling llo saIo of accounls rocoivabIo, (2) Iimiling
common slocI dividonds, (3) roslricling llo purclaso or saIo of fixod assols, and
(4) solling Iimils on addilionaI borroving. Nol aIIoving llo saIo of accounls rocoivabIo
is spocifiod bocauso sucl saIos vouId bonofil llo firm's slorl-run Iiquidily posilion al
llo oxponso of ils fuluro Iiquidily posilion. Common slocI dividonds may nol bo
aIIovod if llo firm's Iiquidily faIIs boIov a spocifiod IovoI, or llo maximum dividond
payoul may bo Iimilod lo somo fraclion, say, 50 porconl or 60 porconl of oarnings
undor any circumslanco. Iixod-assol roslriclions gonoraIIy roquiro Iondor pormission
boforo llo Iiquidalion of any fixod assol or prolibil llo uso of any oxisling fixod assol
as coIIaloraI on nov Ioans. Conslrainls on addilionaI borroving usuaIIy invoIvo Iimil-
ing llo amounl and lypo of addilionaI Iong-lorm dobl llal can bo issuod. AII lloso
roslriclions lavo ono lling in common: Tloy allompl lo prolibil aclions llal vouId
improvo llo slalus of ollor socurilios al llo oxponso of bonds and lo prolocl llo slalus
of bonds from boing voaIonod by any managoriaI aclion.
8ond Ratings
Ioln Moody firsl bogan lo ralo bonds in 1909, sinco llal limo llroo raling agoncios÷
Moody's, Slandard & Ioor's, and Iilcl Invoslor Sorvicos÷lavo providod ralings on
corporalo bonds. Tloso ralings invoIvo a judgmonl aboul llo fuluro risI polonliaI of
llo bond. AIllougl lloy doaI vill oxpoclalions, sovoraI lisloricaI faclors soom lo pIay
a significanl roIo in lloir dolorminalion. Bond ralings aro favorabIy affoclod by (1) a
groalor roIianco on oquily as opposod lo dobl in financing llo firm, (2) profilabIo opor-
alions, (3) a Iov variabiIily in pasl oarnings, (4) Iargo firm sizo, and (5) IillIo uso of sub-
ordinalod dobl. In lurn, llo raling a bond rocoivos affocls llo inlorosl ralo domandod
on llo bond by llo invoslors. Tlo pooror llo bond raling, llo liglor llo inlorosl ralo
domandod by invoslors. TabIe 9.1 providos an oxampIo and doscriplion of lloso ral-
ings. Tlus, bond ralings aro oxlromoIy imporlanl for llo financiaI managor. Tloy pro-
vido an indicalor of dofauIl risI llal in lurn affocls llo inlorosl ralo llal musl bo paid
on borrovod funds.
700.9 CapiIal ValuaIioh 1echhiques 139
CAßM ModuIe 700 Fihahce
When we say lhal a lower bond raling means a higher inleresl rale charged by lhe
inveslors (bondholders), we are observing an applicalion ol PrincipIe 1. The ßisk-ßeturn
Trade-O!!-We Won't Take on AdditionaI ßisk UnIess We Expect
to ße Compensated vith AdditionaI ßeturn.
700.9.2 De!ine the term "vaIue" and identi!y the
!actors that determine "vaIue" and describe the basic
process !or vaIuing assets
Tlo lorm tc|uc is oflon usod in difforonl conloxls, doponding on ils appIicalion. Ixam-
pIos of difforonl usos of llis lorm incIudo llo foIIoving:
Bnnk vaIue is llo tc|uc c| cn cssci cs s|cun cn c |irm´s |c|cncc s|cci. Il roprosonls llo
lisloricaI cosl of llo assol rallor llan ils curronl vorll. Ior inslanco, llo booI vaIuo of
a company's common slocI is llo amounl llo invoslors originaIIy paid for llo slocI
and, lloroforo, llo amounl llo firm rocoivod vlon llo slocI vas issuod.
700.9 CapiIal ValuaIioh 1echhiques 140
CAßM ModuIe 700 Fihahce
TabIe 9.1 SIahdard & Poor's CorporaIe 8ohd RaIihgs
AAA 1his is Ihe highesI raIihg assighed by SIahdard & Poor's !or debI obligaIioh ahd
ihdicaIes ah exIremely sIrohg capaciIy Io pay prihcipal ahd ihIeresI.
AA 8ohds raIed AA also quali!y as high-qualiIy debI obligaIiohs. 1heir capaciIy Io
pay prihcipal ahd ihIeresI is very sIrohg, ahd ih Ihe maioriIy o! ihsIahces, Ihey
di!!er !rom AAA issues ohly ih small degree.
A 8ohds raIed A have a sIrohg capaciIy Io pay prihcipal ahd ihIeresI, alIhough
Ihey are somewhaI more suscepIible Io Ihe adverse e!!ecIs o! chahges ih
circumsIahces ahd ecohomic cohdiIiohs.
888 8ohds raIed 888 are regarded as havihg ah adequaIe capaciIy Io pay prihcipal
ahd ihIeresI. Whereas Ihey hormally exhibiI adequaIe proIecIioh parameIers,
adverse ecohomic cohdiIiohs or chahgihg circumsIahces are more likely Io lead
Io a weakehed capaciIy Io pay prihcipal ahd ihIeresI !or bohds ih Ihis caIegory
Ihah !or bohds ih Ihe A caIegory.
88 8ohds raIed 88, 8, CCC, ahd CC are regarded, oh balahce, as predomihaIely
8 speculaIive wiIh respecI Io Ihe issuer's capaciIy Io pay ihIeresI ahd repay
CCC ih accordahce wiIh Ihe Ierms o! Ihe obligaIioh.
CC 88 ihdicaIes Ihe lowesI degree o! speculaIioh ahd CC Ihe highesI. AlIhough
such bohds will likely have some qualiIy ahd proIecIive characIerisIics, Ihese are
ouIweighed by large uhcerIaihIies or maior risk exposures Io adverse
C 1he raIihg C is reserved !or ihcome bohds oh which ho ihIeresI is beihg paid.
D 8ohds raIed D are ih de!aulI, ahd paymehI o! prihcipal ahd/or ihIeresI is ih
Plus (+) or Mihus (-): 1o provide more deIailed ihdicaIiohs o! crediI qualiIy, Ihe raIihgs
!rom AA Io 88 may be modi!ied by Ihe addiIioh o! a plus or mihus sigh Io show
relaIive sIahdihg wiIhih Ihe maior raIihg caIegories.
5ource. Adapled lrom, December 2004.
Liquidatinn vaIue is llo !c||cr sum i|ci ccu|! |c rcc|izc! i| cn cssci ucrc sc|! in!iti!u-
c||u cn! nci cs pcri c| c vcinv ccnccrn. Ior oxampIo, if a firm's oporalions voro disconlin-
uod and ils assols voro dividod up and soId, llo saIos prico vouId roprosonl llo assol's
Iiquidalion vaIuo.
Tlo market vaIue of an assol is llo c|scrtc! tc|uc |cr i|c cssci in i|c mcr|cip|ccc.
Tlis vaIuo is dolorminod by suppIy and domand forcos vorIing logollor in llo mar-
IolpIaco, vloro buyors and soIIors nogolialo a muluaIIy accoplabIo prico for llo
assol. Ior inslanco, llo marIol prico for Iord's common slocI on Docombor 14, 2004,
vas $15.12 por slaro. Tlis prico vas roaclod by a Iargo numbor of buyors and soIIors
vorIing llrougl llo Nov YorI SlocI Ixclango. In lloory, a marIol prico oxisls for
aII assols. Hovovor, many assols lavo no roadiIy obsorvabIo marIol prico bocauso
lrading soIdom occurs. Ior inslanco, llo marIol prico for llo common slocI of Vision
Rosoarcl Organizalion, a roconl slarl-up firm in Il. IaudordaIo, IIorida, vouId bo
moro difficuIl lo oslabIisl llan llo marIol vaIuo of Iord's common slocI.
Tlo intrinsic nr ecnnnmic vaIue of an assol÷aIso caIIod llo Iair vaIue÷is llo
prcscni tc|uc c| i|c cssci´s cxpccic! |uiurc ccs| ||cus. Tlis vaIuo is llo amounl an invoslor
slouId bo viIIing lo pay, givon llo amounl, liming, and risIinoss of fuluro casl fIovs.
Onco llo invoslor las oslimalod llo inlrinsic vaIuo of a socurily, llis vaIuo couId bo
comparod vill ils marIol vaIuo vlon avaiIabIo. If llo inlrinsic vaIuo is groalor llan
llo marIol vaIuo, llon llo socurily is undorvaIuod in llo oyos of llo invoslor. SlouId
llo marIol vaIuo oxcood llo invoslor's inlrinsic vaIuo, llon llo socurily is ovorvaIuod.
Wo laslon lo add llal if llo socurilios marIol is vorIing officionlIy, llo marIol
vaIuo and llo inlrinsic vaIuo of a socurily viII bo oquaI. Wlonovor a socurily's inlrinsic
vaIuo diffors from ils curronl marIol prico, llo compolilion among invoslors sooIing
opporlunilios lo maIo a profil viII quicIIy drivo llo marIol prico bacI lo ils inlrinsic
vaIuo. Tlus, vo may dofino an eIIicient market as cnc in u|ic| i|c tc|ucs c| c|| sccuriiics
ci cnu insicni |u||u rc||cci c|| ctci|c||c pu||ic in|crmciicn, u|ic| rcsu|is in i|c mcr|ci tc|uc
cn! i|c inirinsic tc|uc |cinv i|c scmc. If llo marIols aro officionl, il is oxlromoIy difficuIl
for an invoslor lo maIo oxlra profils from an abiIily lo prodicl pricos.
The lacl lhal inveslors have dillicully idenlilying slocks lhal are undervalued relales
lo PrincipIe 6. E!!icient CapitaI Markets-The Markets Are Ouick and the
Prices Are ßight. ln an ellicienl markel, lhe price rellecls all available public inlormalion
aboul lhe securily and, lherelore, il is priced lairly.
Tlo idoa of marIol officioncy las boon llo bacIdrop for an inlonso ballIo bolvoon
profossionaI invoslors and univorsily profossors. Tlo acadomic communily las con-
londod llal somoono llroving darls al llo Iisl of socurilios in 1|c Wc|| Sircci jcurnc|
couId do as voII as a profossionaI monoy managor. MarIol profossionaIs rolorl llal
acadomicians aro grossIy mislaIon in llis viov. Tlo var las boon inlonso bul aIso ono
llal llo sludonl of financo slouId find inlriguing.
Ior our purposos, i|c tc|uc c| cn cssci is iis inirinsic tc|uc cr i|c prcscni tc|uc c| iis
cxpccic! |uiurc ccs| ||cus, vlon lloso casl fIovs aro discounlod bacI lo llo prosonl
using llo invoslor's roquirod ralo of rolurn. Tlis slalomonl is lruo for vaIuing aII assols,
and il sorvos as llo basis of aImosl aII llal vo do in financo. Tlus, vaIuo is affoclod by
llroo oIomonls:
1. Tlo amounl and liming of llo assol's oxpoclod casl fIovs
2. Tlo risIinoss of lloso casl fIovs
3. Tlo invoslor's roquirod ralo of rolurn for undorlaIing llo invoslmonl
700.9 CapiIal ValuaIioh 1echhiques 141
CAßM ModuIe 700 Fihahce
Tlo firsl lvo faclors aro claraclorislics of llo assol, llo llird ono, llo roquirod ralo
of rolurn, is llo minimum ralo of rolurn nocossary lo allracl an invoslor lo purclaso or
loId a socurily, vlicl is dolorminod by i|c rcics c| rciurn ctci|c||c cn simi|cr
intcsimcnis, or vlal is caIIod llo nµµnrtunitv cnst nI Iunds. Tlis ralo musl bo ligl
onougl lo componsalo llo invoslor for llo risI porcoivod in llo assol's fuluro casl
Our discussions should remind us ol lhree ol our principles lhal help us undersland linance.
PrincipIe 1. The ßisk-ßeturn Trade-O!!-We Won't Take on AdditionaI ßisk UnIess
We Expect to ße Compensated vith AdditionaI ßeturn.
PrincipIe 2. The Time VaIue o! Money-A DoIIar ßeceived Today Is Worth
More than a DoIIar ßeceived in the future.
PrincipIe 3. Cash-Not Pro!its-Is King.
Delermining lhe economic worlh or value ol an assel always relies on lhese lhree principles.
Wilhoul lhem, we would have no basis lor explaining value. Wilh lhem, we can know
lhal lhe amounl and liming ol cash, nol earnings, drive value. Also, we musl
be rewarded lor laking risk, olherwise, we will nol invesl.
Figure 9.1 dopicls llo basic faclors invoIvod in vaIualion. As llo figuro slovs,
finding llo vaIuo of an assol invoIvos llo foIIoving slops:
1. Assossing llo assol's claraclorislics, vlicl incIudo llo amounl and liming of
llo oxpoclod casl fIovs and llo risIinoss of lloso casl fIovs
2. Dolormining llo invoslor's roquirod ralo of rolurn, vlicl ombodios llo
invoslor's alliludo aboul assuming risI and llo invoslor's porcoplion of llo
risIinoss of llo assol
3. Discounling llo oxpoclod casl fIovs bacI lo llo prosonl, using llo invoslor's
roquirod ralo of rolurn as llo discounl ralo
Tlus, inlrinsic vaIuo is a funclion of llo casl fIovs yol lo bo rocoivod, llo risIinoss of
lloso casl fIovs, and llo invoslor's roquirod ralo of rolurn.
Tlo vaIualion procoss can bo doscribod as foIIovs: Il is assigning vaIuo lo an assol by
caIcuIaling llo prosonl vaIuo of ils oxpoclod fuluro casl fIovs using llo invoslor's
700.9 CapiIal ValuaIioh 1echhiques 142
CAßM ModuIe 700 Fihahce
Investor attributes
Investor's required rate of return
Asset characteristics
^uouul oí expecled cash ílows
^ssel value = Preseul value oí expecled
cash ílows discouuled usiug lhe
iuveslor's required rale oí reluru
Jiuiug oí expecled cash ílows
Riskiuess oí expecled cash ílows
|uveslor's assessueul oí lhe
riskiuess oí lhe assel's cash ílows
|uveslor's williuguess lo bear risk
figure 9.1 8asic FacIors DeIermihihg ah AsseI's Value
roquirod ralo of rolurn as llo discounl ralo. Tlo invoslor's roquirod ralo of rolurn, |, is
dolorminod by llo IovoI of llo risI-froo ralo of inlorosl and risI promium llal llo
invoslor fooIs is nocossary lo componsalo for llo risIs assumod in ovning llo assol.
Tloroforo, a basic assol vaIualion modoI can bo dofinod mallomalicaIIy as foIIovs:
vloro V llo inlrinsic vaIuo or prosonl vaIuo of an assol producing oxpoclod
fuluro casl fIovs, C
, in yoars 1 llrougl n
casl fIov lo bo rocoivod al limo i
| llo invoslor's roquirod ralo of rolurn
Using oqualion (9-1), lloro aro llroo basic slops in llo vaIualion procoss:
5tep 1 Islimalo llo C
in oqualion (9-1), vlicl is llo amounl and liming of llo
fuluro casl fIovs llo socurily is oxpoclod lo provido.
5tep 2 Dolormino |, llo invoslor's roquirod ralo of rolurn.
5tep 3 CaIcuIalo llo inlrinsic vaIuo, V, as llo prosonl vaIuo of oxpoclod fuluro
casl fIovs discounlod al llo invoslor's roquirod ralo of rolurn.
Iqualion (9-1), vlicl moasuros llo prosonl vaIuo of fuluro casl fIovs, is llo basis
of llo vaIualion procoss. If vo undorsland oqualion (9-1), aII llo vaIualion vorI vo
do, and a losl of ollor lopics as voII, viII bo mucl cIoaror in our minds.
You purchased an assel lhal is expecled lo provide S5,000 cash llow per year lor lour years.
ll you have a !2 percenl required rale ol relurn, whal is lhe value ol lhe assel lor you?
The value ol an assel generaling S5,000 per year lor lour years, given a !2 percenl required rale
ol relurn, would be S!5,!86.75 using a Tl 8A ll plus calculalor, we lind lhe answer as lollows.
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
-15,186.75 CP1 PV

         

700.9 CapiIal ValuaIioh 1echhiques 143
CAßM ModuIe 700 Fihahce
700.9.3 Learn hov to estimate the vaIue o! a bond,
compute a bondhoIder's expected rate o! return (yieId
to maturity), and expIain the important reIationships
that exist in bond vaIuation
Tlo vaIuo of a bond is llo prosonl vaIuo of boll fuluro inlorosl lo bo rocoivod and llo
par or malurily vaIuo of llo bond. Il's llal simpIo.
Tlo procoss for vaIuing a bond, as dopiclod in Figure 9.2, roquiros Inoving llroo
ossonliaI oIomonls: (1) llo amounl and liming of llo casl fIovs lo bo rocoivod by llo
invoslor, (2) llo limo lo malurily of llo bond, and (3) llo invoslor's roquirod ralo of rolurn.
Tlo amounl of casl fIovs is diclalod by llo poriodic inlorosl lo bo rocoivod and by llo par
vaIuo lo bo paid al malurily. Givon lloso oIomonls, vo can compulo llo vaIuo of llo bond,
or llo prosonl vaIuo.
Nolico llal oqualion (9-2b) is a roslalomonl of oqualion (9-1), vloro nov llo casl
fIovs aro roprosonlod by llo inlorosl rocoivod oacl poriod and llo par vaIuo of llo bond
vlon il maluros. In oillor oqualion, llo vaIuo of an assol is llo prosonl vaIuo of ils fuluro
casl fIovs.
Tlo oqualion for finding llo vaIuo of llo Toyola bonds vouId bo as foIIovs:
Iinding llo vaIuo of llo Toyola bonds may bo roprosonlod graplicaIIy as foIIovs:
Using a TI BA II IIus financiaI caIcuIalor, vo find llo vaIuo of llo bond lo bo
$1,069.62, as caIcuIalod on pago 145. Tlus, if invoslors considor 3.6 porconl lo bo an
approprialo roquirod ralo of rolurn in viov of llo risI IovoI associalod vill Toyola
bonds, paying a prico of $1,069.62 vouId salisfy lloir rolurn roquiromonl.
¥ £k8 0 1 2 3 4
0ollars received S66 S66 S66 S66
al end of vear  S1,000
Presenl value S10ß0.ß2
( )
( )
( )
1 0 036
1 0 036
1 0 036
1 2

 . . .
33 4 4
1 0 036
1 000
1 0 036

( )
( ) .
700.9 CapiIal ValuaIioh 1echhiques 144
CAßM ModuIe 700 Fihahce
(^ì Cash ílow iuíorualiou
(Bì Jeru lo ualurily
(Cì |uveslor's required rale oí reluru
Periodic iuleresl payueuls
|or exauple, $6S per year
Priucipal auouul or par value
|or exauple, $1,000
|or exauple, 12 years
|or exauple, 8%
figure 9.2 DaIa RequiremehIs !or 8ohd ValuaIioh
700.9 CapiIal ValuaIioh 1echhiques 145
CAßM ModuIe 700 Fihahce
Consider a bond issued by Toyola wilh a malurily dale ol 2008 and a slaled annual coupon rale ol 5.5 percenl. ln Decem-
ber 2004, wilh 4 years lell lo malurily, inveslors owning lhe bonds are requiring a 3.6 percenl rale ol relurn. We can cal-
culale lhe value ol lhe bonds lo lhese inveslors using lhe lollowing lhree-slep valualion procedure.
5tep 1 Lslimale lhe amounl and liming ol lhe expecled lulure cash llows. Two lypes ol cash llows are received by lhe
a) Annual inleresl paymenls equal lo lhe coupon rale ol inleresl limes lhe lace value ol lhe bond. ln lhis exam-
ple, lhe bond's coupon inleresl rale is 5.5 percenl, lhus, lhe annual inleresl paymenl is S55 .055 S!,000.
Assuming lhal 2004 inleresl paymenls have already been made, lhese cash llows will be received by lhe bond-
holder in each ol lhe 4 years belore lhe bond malures (2005 lhrough 2008 4 years).
b) The lace value ol S!,000 lo be received in 2008.
To summarize, lhe cash llows received by lhe bondholder are as lollows.
Years 1 2 3 4
$55 $55 $55 $ 55
+ $1,000
5tep 2 Delermine lhe inveslor's required rale ol relurn by evalualing lhe riskiness ol lhe bond's lulure cash llows. A
3.6 percenl required rale ol relurn lor lhe bondholders is given. However, an inveslor's required rale ol relurn
is equal lo a rale earned on a risk-lree securily plus a risk premium lor assuming risk.
5tep 3 Calculale lhe inlrinsic value ol lhe bond as lhe presenl value ol lhe expecled lulure inleresl and principal pay-
menls discounled al lhe inveslor's required rale ol relurn.
ln general, lhe presenl value ol a bond is lound as lollows.
Using |
lo represenl lhe inleresl paymenl in year |. | lo represenl lhe bond's malurily (or par) value, and |
lo equal lhe
bondholder's required rale ol relurn, we may express lhe value ol a bond maluring in year n as lollows.
o o o
( )
( )
( )
! ! ! 

  
!! ! 

 |
( )
8ond value
S inleresl in year !
( requir
= = v
! eed rale ol relurn)
S inleresl in year 2


required rale ol relurn)
S inleresl in year 3
( required rale ol relurn)
S i

nnleresl in year
( required rale ol relur
! nn)
S malurily value ol bond
( required r

 ! aale ol relurn)
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
Wo can aIso soIvo for llo vaIuo of Toyola's bonds using a sproadslool. Tlo soIu-
lion using IxcoI appoars as foIIovs:
700.9 CapiIal ValuaIioh 1echhiques 146
CAßM ModuIe 700 Fihahce
Semiannual lnterest Payments
In llo procoding Toyola iIIuslralion, llo inlorosl paymonls voro assumod lo bo paid
annuaIIy. Hovovor, companios lypicaIIy pay inlorosl lo bondloIdors somiannuaIIy.
Ior oxampIo, Toyola acluaIIy pays a lolaI of $55 por yoar, bul disbursos llo inlorosl
somiannuaIIy ($27.50 oacl Iuno 15 and Docombor 15).
SovoraI slops aro invoIvod in adapling oqualion (9-2b) for somiannuaI inlorosl pay-
monls. Iirsl, llinIing in lorms of pcric!s insload of yoars, a bond vill a Iifo of n yoars pay-
ing inlorosl somiannuaIIy las a Iifo of 2n poriods. In ollor vords, a 5-yoar bond (n 5)
llal romils ils inlorosl on a somiannuaI basis acluaIIy maIos 10 paymonls. AIllougl llo
numbor of poriods las doubIod, llo !c||cr amounl of inlorosl boing sonl lo llo invoslors
for oacl poriod and llo bondloIdors' roquirod ralo of rolurn aro laIf of llo oquivaIonl
annuaI figuros. |
bocomos |
/2 and |
is clangod lo |
/2, llus, for somiannuaI com-
pounding, oqualion (9-2b) bocomos
Wo can nov compulo llo vaIuo of llo Toyola bonds, rocognizing llal inlorosl is
boing paid somiannuaIIy. Wo simpIy clango llo numbor of poriods from 4 yoars lo
8 somiannuaI poriods and llo roquirod ralo of rolurn from 3.6 porconl annuaIIy lo
1.8 porconl por somiannuaI poriod. Tlo vaIuo of llo bond vouId nov bo $1,070.20.
| |
$ $ $
/ / /


 


$ $ /
CaIcuIator 5oIution
Data Input function Key
2 2 4 8
3.6 ÷ 2 18
$55.00 ÷ 2 27.50
function Key Ansver
Tlis soIulion can bo found using a caIcuIalor as slovn abovo or a sproadslool llal
vouId IooI as foIIovs:
700.9 CapiIal ValuaIioh 1echhiques 147
CAßM ModuIe 700 Fihahce
La liesla Peslauranls issued bonds lhal have a 6 percenl coupon inleresl rale.
lnleresl is paid annually. The bonds malure in !2 years. ll your required rale ol relurn
is 8 percenl, whal is lhe value ol a bond lo you?
A bond wilh a 6 percenl coupon rale pays S60 in inleresl per year (S60 0.06 coupon
rale S!,000 par value). Thus, you would receive S60 per year lor !2 years plus
lhe S!,000 in par value in year !2. Assuming an 8 percenl required rale ol relurn,
lhe value ol lhe bond would be S849.28.
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
Nov llal vo Inov lov lo vaIuo a bond, vo viII noxl oxamino a bondloIdor's ralo
of rolurn from invosling in a bond, or vlal is caIIod bond yioIds.
8ond ¥ields
Tloro aro lvo caIcuIalions llal aro usod lo moasuro llo ralo of rolurn a bondloIdor is
rocoiving from ovning a bond: llo yioId lo malurily and llo curronl yioId.
TloorolicaIIy, oacl bondloIdor couId lavo a difforonl roquirod ralo of rolurn for a parlic-
uIar bond. Hovovor, llo financiaI managor is onIy inloroslod in llo oxpoclod ralo of
rolurn llal is impIiod by llo marIol pricos of llo firm's bonds or vlal vo caII llo yioId
lo malurily.
To moasuro llo bondloIdor's exµected rate nI return, , vo vouId find llo
!isccuni rcic i|ci c¡ucics i|c prcscni tc|uc c| i|c |uiurc ccs| ||cus (inicrcsi cn! mciuriiu
tc|uc) uii| i|c currcni mcr|ci pricc c| i|c |cn!. Il is aIso llo rcic c| rciurn i|c intcsicr ui||
ccrn i| i|c |cn! is |c|! ic mciuriiu, llus llo namo vieId tn maturitv. So, vlon roforring
lo bonds, llo lorms cxpccic! rcic c| rciurn and uic|! ic mciuriiu aro oflon usod
To iIIuslralo llis concopl, considor llo Brislor Corporalion's bonds, vlicl aro soII-
ing for $1,100. Tlo bonds carry a coupon inlorosl ralo of 9 porconl and maluro in 10
yoars. (Romombor, llo coupon ralo dolorminos llo inlorosl paymonl÷coupon ralo 
par vaIuo.)
In dolormining llo oxpoclod ralo of rolurn ( ), impIicil in llo curronl marIol
prico, vo nood lo find llo ralo llal discounls llo anlicipalod casl fIovs bacI lo a pros-
onl vaIuo of $1,100, llo curronl marIol prico (P
) for llo bond.
Tlo oxpoclod rolurn for llo Brislor Corporalion bondloIdors is 7.54 porconl, vlicl
may bo found by using llo TI BA II IIus caIcuIalor, or by using a compulor sproad-
slool, as foIIovs:
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
Current ¥ield
Tlo current vieId on a bond rofors lo llo rciic c| i|c cnnuc| inicrcsi pcumcni ic i|c |cn!´s
currcni mcr|ci pricc. If, for oxampIo, vo lavo a bond vill an 8 porconl coupon inlorosl
700.9 CapiIal ValuaIioh 1echhiques 148
CAßM ModuIe 700 Fihahce
/ PM1
/ FV
ralo, a par vaIuo of $1,000, and a marIol prico of $700, il vouId lavo a curronl yioId of
11.4 porconl:
Wo slouId undorsland llal llo curronl yioId, aIllougl froquonlIy quolod in llo popu-
Iar pross, is an incompIolo picluro of llo oxpoclod ralo of rolurn from loIding a bond.
Tlo curronl yioId indicalos llo casl incomo llal rosuIls from loIding a bond in a givon
yoar, bul il faiIs lo rocognizo llo capilaI gain or Ioss llal viII occur if llo bond is loId
lo malurily. As sucl, il is nol an accuralo moasuro of llo bondloIdor's oxpoclod ralo
of rolurn.
The Argon Corporalion bonds are selling lor S925. They have a 5 percenl coupon inleresl
rale paid annually and malure in 8 years. Whal is lhe yield lo malurily lor lhe bonds
il an inveslor buys lhem al lhe S925 markel price? Whal is lhe currenl yield?
The Argon bonds pay S50 in inleresl per year (S50 0.05 coupon rale S!,000 par value)
lor lhe duralion ol lhe bond, or lor 8 years. The inveslor will lhen receive S!,000 al lhe
bond's malurily. Civen a markel price ol S925, lhe yield lo malurily would be 6.2 percenl.
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
Wo lavo nov Ioarnod lo find llo vaIuo of a bond (V
), givon (1) llo amounl of inlorosl
paymonls (|
), (2) llo malurily vaIuo (M), (3) llo Iongll of limo lo malurily (n poriods),
and (4) llo invoslor's roquirod ralo of rolurn, |
. Wo aIso Inov lov lo compulo llo
oxpoclod ralo of rolurn ( ), vlicl aIso lappons lo bo llo curronl inlorosl ralo on llo
bond, givon (1) llo curronl marIol vaIuo (P
), (2) llo amounl of inlorosl paymonls (|
(3) llo malurily vaIuo (M), and (4) llo Iongll of limo lo malurily (n poriods). Wo nov
Currenl yield
annual inleresl paymenl
ll markel price ol lhe bond
= = =
0 054! . 5 5 4! . '
+/- FV
+/- PM1
Curronl yioId
annuaI inlorosl paymonl
ll marIol prico of llo bond
0 08 1 000
. , 
== = =
0 114 11 4 . .
700.9 CapiIal ValuaIioh 1echhiques 149
CAßM ModuIe 700 Fihahce
lavo llo basics. Bul Iol's go furllor in our undorslanding of bond vaIualion by sludying
sovoraI imporlanl roIalionslips.
Iirst Relationship
1|c tc|uc c| c |cn! is intcrsc|u rc|cic! ic c|cnvcs in i|c intcsicr´s prcscni rc¡uirc! rcic c|
rciurn. |n ci|cr ucr!s, cs inicrcsi rcics incrccsc (!ccrccsc), i|c tc|uc c| i|c |cn! !ccrccscs
To iIIuslralo, assumo llal an invoslor's roquirod ralo of rolurn for a givon bond is
12 porconl. Tlo bond las a par vaIuo of $1,000 and annuaI inlorosl paymonls of $120,
indicaling a 12 porconl coupon inlorosl ralo ($120  $1,000 12°). Assuming a 5-yoar
malurily dalo, llo bond vouId bo vorll $1,000, compulod as foIIovs:
Using a caIcuIalor, vo find llo vaIuo of llo bond lo bo $1,000.
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
If, lovovor, llo invoslor's roquirod ralo of rolurn incroasos from 12 porconl lo 15 por-
conl, llo vaIuo of llo bond vouId docroaso lo $899.44, compulod as foIIovs:
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
On llo ollor land, if llo invoslors' roquirod ralo of rolurn docroasos lo 9 porconl, llo
bond vouId incroaso in vaIuo lo $1,116.69.
( )
( )
1 1 1

 


0 12
1 0 12
1 0 12
1 2 3
. . . )
( )
( )
( 

 0 12
1 0 12
1 000
1 0 12
4 5 5
. .
. )
( )
( )
700.9 CapiIal ValuaIioh 1echhiques 150
CAßM ModuIe 700 Fihahce
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
Tlis invorso roIalionslip bolvoon llo invoslor's roquirod ralo of rolurn and llo
vaIuo of a bond is prosonlod in Figure 9.3. CIoarIy, as an invoslor domands a liglor
ralo of rolurn, llo vaIuo of llo bond docroasos. Tlo liglor ralo of rolurn llo invoslor
dosiros can bo acliovod onIy by paying Ioss for llo bond. ConvorsoIy, a Iovor roquirod
ralo of rolurn yioIds a liglor marIol vaIuo for llo bond.
Clangos in bond pricos roprosonl an oIomonl of uncorlainly for llo bond invoslor.
If llo curronl inlorosl ralo (roquirod ralo of rolurn) clangos, llo prico of llo bond aIso
fIuclualos. An incroaso in inlorosl ralos causos llo bondloIdor lo incur a Ioss in marIol
vaIuo. Bocauso fuluro inlorosl ralos and llo rosuIling bond vaIuo cannol bo prodiclod
vill corlainly, a bond invoslor is oxposod lo llo ris| c| c|cnvinv tc|ucs cs inicrcsi rcics
tcru. Tlis risI las como lo bo Inovn as interest rate risk.
Second Relationship
1|c mcr|ci tc|uc c| c |cn! ui|| |c |css i|cn i|c pcr tc|uc i| i|c intcsicr´s rc¡uirc! rcic c|
rciurn is c|ctc i|c ccupcn inicrcsi rcic, |ui ii ui|| |c tc|uc! c|ctc pcr tc|uc i| i|c intcsicr´s
rc¡uirc! rcic c| rciurn is |c|cu i|c ccupcn inicrcsi rcic.
700.9 CapiIal ValuaIioh 1echhiques 151
CAßM ModuIe 700 Fihahce
kequired rates of return (%)
6 8 10 12 14
figure 9.3 Value ahd Required RaIes !or a 5-Year 8ohd aI a 12 PercehI
Coupoh RaIe
Using llo provious oxampIo, vo obsorvod llal
1. Tlo bond las a mcr|ci tc|uc of $1,000, oquaI lo llo par or malurily vaIuo, vlon
llo invoslor's roquirod ralo of rolurn oquaIs llo 12 porconl coupon inlorosl
ralo. In ollor vords, if
rc¡uirc! rcic ccupcn rcic, llon mcr|ci tc|uc pcr tc|uc
12° 12°, llon $1,000 $1,000
2. Wlon llo roquirod ralo is 15 porconl, vlicl oxcoods llo 12 porconl coupon
ralo, llo marIol vaIuo faIIs boIov par vaIuo lo $899.44, llal is, if
rc¡uirc! rcic ccupcn rcic, llon mcr|ci tc|uc pcr tc|uc
15° 12°, llon $899.44 $1,000
In llis caso llo |cn! sc||s ci c !isccuni |c|cu pcr tc|uc, llus, il is caIIod a
discnunt bnnd.
3. Wlon llo roquirod ralo is 9 porconl, or Ioss llan llo 12 porconl coupon ralo,
llo marIol vaIuo, $1,116.69, oxcoods llo bond's par vaIuo. In llis inslanco, if
rc¡uirc! rcic ccupcn rcic, llon mcr|ci tc|uc pcr tc|uc
9° 12°, llon $1,116.69 $1,000
Tlo |cn! is ncu sc||inv ci c prcmium c|ctc pcr tc|uc, llus, il is a µremium bnnd.
Third Relationship
Icnv-icrm |cn!s |ctc vrccicr inicrcsi rcic ris| i|cn !c s|cri-icrm |cn!s.
As aIroady nolod, a clango in curronl inlorosl ralos (roquirod ralo of rolurn) causos
an invorso clango in llo marIol vaIuo of a bond. Hovovor, llo impacl on vaIuo is
groalor for Iong-lorm bonds llan il is for slorl-lorm bonds.
In Iiguro 9.3 vo obsorvod llo offocl of inlorosl ralo clangos on a 5-yoar bond pay-
ing a 12 porconl coupon inlorosl ralo. Wlal if llo bond did nol maluro unliI 10 yoars
from loday insload of 5 yoars` WouId llo clangos in marIol vaIuo bo llo samo`
AbsoIuloIy nol. Tlo clangos in vaIuo vouId bo moro significanl for llo 10-yoar bond.
Ior oxampIo, if vo vary llo curronl inlorosl ralos (llo bondloIdor's roquirod ralo of
rolurn) from 9 porconl lo 12 porconl and llon lo 15 porconl, as vo did oarIior vill llo
5-yoar bond, llo vaIuos for boll llo 5-yoar and llo 10-yoar bonds aro slovn loro.
Market VaIue !or a 12% Coupon-ßate ßond Maturing in
ßequired ßate 5 Years 10 Years
9% $1,116.69 $1,192.53
12% 1,000.00 1,000.00
15% 899.44 849.44
Using lloso vaIuos and llo roquirod ralos, vo can grapl llo clangos in vaIuos for llo
lvo bonds roIalivo lo difforonl inlorosl ralos. Tloso comparisons aro providod in
Figure 9.4. Tlo figuro cIoarIy iIIuslralos llal llo prico of a Iong-lorm bond (say, 10 yoars)
is moro rosponsivo or sonsilivo lo inlorosl ralo clangos llan llo prico of a slorl-lorm bond
(say, 5 yoars).
Tlo roason Iong-lorm bond pricos fIuclualo moro llan slorl-lorm bond pricos in
rosponso lo inlorosl ralo clangos is simpIo. Assumo an invoslor bougll a 10-yoar bond
yioIding a 12 porconl inlorosl ralo. If llo curronl inlorosl ralo for bonds of simiIar risI
incroasod lo 15 porconl, llo invoslor vouId bo IocIod inlo llo Iovor ralo for 10 yoars. If, on
llo ollor land, a slorlor-lorm bond lad boon purclasod÷say, ono maluring in 2 yoars÷
llo invoslor vouId lavo lo accopl llo Iovor rolurn for onIy 2 yoars and nol llo fuII 10
yoars. Al llo ond of yoar 2, llo invoslor vouId rocoivo llo malurily vaIuo of $1,000 and
couId buy a bond offoring llo liglor 15 porconl ralo for llo romaining 8 yoars. Tlus, inlor-
700.9 CapiIal ValuaIioh 1echhiques 152
CAßM ModuIe 700 Fihahce
osl ralo risI is dolorminod, al Ioasl in parl, by llo Iongll of limo an invoslor is roquirod lo
commil lo an invoslmonl. Hovovor, llo loIdor of a Iong-lorm bond may laIo somo com-
forl from llo facl llal Iong-lorm inlorosl ralos aro usuaIIy nol as voIaliIo as slorl-lorm
ralos. If llo slorl-lorm ralo clangod 1 porconlago poinl, for oxampIo, il vouId nol bo
unusuaI for llo Iong-lorm ralo lo clango onIy .3 porconlago poinls.
700.9.4 De!ine pre!erred stock vith its !eatures
and Iearn hov to vaIue a pre!erred stock
PreIerred stnck is oflon roforrod lo as a |u|ri! sccuriiu bocauso il las mcnu c|crccicris-
iics c| |ci| ccmmcn sicc| cn! |cn!s. Iroforrod slocI is simiIar lo common slocI in llal
(1) il las no fixod malurily dalo, (2) faiIuro lo pay dividonds doos nol bring on banI-
ruplcy, and (3) dividonds aro nol doduclibIo for lax purposos. On llo ollor land, pro-
forrod slocI is simiIar lo bonds in llal dividonds aro fixod in amounl.
Tlo amounl of llo proforrod slocI dividond is gonoraIIy fixod oillor as a doIIar
amounl or as a porconlago of llo par vaIuo. Ior oxampIo, Toxas UliIily IIoclric (TXU)
las proforrod slocI oulslanding llal pays an annuaI dividond of $1.81, vliIo AT&T las
somo 8.25 porconl proforrod slocI oulslanding. Tlo AT&T proforrod slocI las a par
vaIuo of $25, lonco, oacl slaro pays 8.25 porconl  $25, or $2.06 in dividonds annuaIIy.
To bogin, vo firsl discuss sovoraI foaluros associalod vill aImosl aII proforrod
slocI. Tlon vo laIo a briof IooI al mollods of roliring proforrod slocI. Wo cIoso by
Ioarning lov lo vaIuo proforrod slocI.
Ieatures of Preferred Stock
AIllougl oacl issuo of proforrod slocI is uniquo, a numbor of claraclorislics aro com-
mon lo aImosl aII issuos. Somo of lloso moro froquonl lrails incIudo
MuIlipIo sorios of proforrod slocI
Iroforrod slocI's cIaim on assols and incomo
700.9 CapiIal ValuaIioh 1echhiques 153
CAßM ModuIe 700 Fihahce
kequired rates of return (%)
6 8 10 12 14
S·year boud
10·year boud
figure 9.4 MarkeI Values o! a 5-Year ahd a 10-Year 8ohd aI Di!!erehI
Required RaIes o! ReIurh
CumuIalivo dividonds
Iroloclivo provisions
Roliromonl foaluros
AII lloso foaluros aro prosonlod in llo discussion llal foIIovs.
MuItipIe 5eries
If a company dosiros, il can issuo moro llan ono sorios of proforrod slocI, and oacl
sorios can lavo difforonl claraclorislics. In facl, il is quilo common for firms llal issuo
proforrod slocI lo issuo moro llan ono sorios. Tloso issuos can bo difforonlialod in llal
somo aro convorlibIo inlo common slocI and ollors aro nol, and lloy lavo varying
proloclivo provisions in llo ovonl of banIruplcy. Ior inslanco, llo Xorox Corporalion
las a Sorios B and Sorios C proforrod slocI.
CIaim on Assets and Income
Iroforrod slocI las priorily ovor common slocI vill rogard lo cIaims on assols in llo
caso of banIruplcy. Tlo proforrod slocI cIaim is lonorod aflor llal of bonds and
boforo llal of common slocI. MuIlipIo issuos of proforrod slocI may bo givon an ordor
of priorily. Iroforrod slocI aIso las a cIaim on incomo boforo common slocI. Tlal is,
llo firm musl pay ils proforrod slocI dividonds boforo il pays common slocI divi-
donds. Tlus, in lorms of risI, proforrod slocI is safor llan common slocI bocauso il
las a prior cIaim on assols and incomo. Hovovor, il is risIior llan Iong-lorm dobl
bocauso ils cIaims on assols and incomo como aflor lloso of bonds.
CumuIative Dividends
Mosl proforrod slocIs carry a cumuIative Ieature llal rc¡uircs c|| pcsi, unpci! prc|crrc!
sicc| !iti!cn!s |c pci! |c|crc cnu ccmmcn sicc| !iti!cn!s crc !cc|crc!. Tlo purposo is lo
provido somo dogroo of proloclion for llo proforrod slaroloIdor. Willoul a cumuIa-
livo foaluro, lloro vouId bo no roason vly proforrod slocI dividonds vouId nol bo
omillod or passod vlon common slocI dividonds voro passod.
Protective Provisions
In addilion lo llo cumuIalivo foaluro, proloclivo provisions aro common lo proforrod
slocI. Tloso µrntective µrnvisinns gonoraIIy c||cu |cr tciinv riv|is in i|c ctcni c| ncnpcu-
mcni c| !iti!cn!s, cr i|cu rcsirici i|c pcumcni c| ccmmcn sicc| !iti!cn!s i| i|c prc|crrc! sicc|
sin|inv-|un! pcumcnis crc nci mci cr i| i|c |irm is in |incncic| !i||icu|iu. Ior oxampIo, con-
sidor Tonnoco Corporalion and RoynoIds MolaIs proforrod slocIs. Tlo Tonnoco pro-
forrod slocI las a proloclivo provision llal providos proforrod slocIloIdors vill voling
riglls vlonovor six quarlorIy dividonds aro in arroars. Al llal poinl llo proforrod slaro-
loIdors aro givon llo povor lo oIocl a majorily of llo board of diroclors. Tlo RoynoIds
MolaIs proforrod slocI incIudos a proloclivo provision llal procIudos llo paymonl of
common slocI dividonds during any poriod in vlicl llo proforrod slocI sinIing fund is
in dofauIl. Boll provisions, vlicl givo proloclion boyond llal providod by llo cumuIa-
livo provision and lloroby roduco llo proforrod slaroloIdors' risI, aro dosirabIo.
Bocauso of lloso proloclivo provisions, invoslors do nol roquiro as ligl a ralo of rolurn.
Tlal is, lloy viII accopl a Iovor dividond paymonl.
Mucl of llo proforrod slocI llal is issuod loday is cnnvertibIe µreIerred stnck, llal is,
ci i|c !iscrciicn c| i|c |c|!cr, i|c sicc| ccn |c ccntcric! inic c prc!cicrminc! num|cr c| s|crcs
c| ccmmcn sicc|. In facl, loday aboul ono-llird of aII proforrod slocI issuod las a con-
vorlibiIily foaluro. Tlo convorlibiIily foaluro is, of courso, dosirabIo lo llo invoslor and,
llus, roducos llo cosl of llo proforrod slocI lo llo issuor.
700.9 CapiIal ValuaIioh 1echhiques 154
CAßM ModuIe 700 Fihahce
ßetirement features
AIllougl proforrod slocI doos nol lavo a sol malurily dalo associalod vill il, issuing
firms gonoraIIy provido for somo mollod of roliring llo slocI, usuaIIy in llo form of a
caII provision or a llinIing fund.
CaIIabIe PreIerred. Mosl proforrod slocI las somo lypo of caII µrnvisinn associalod
vill il. A caII provision cniii|cs c ccmpcnu ic rcpurc|csc iis prc|crrc! sicc| |rcm i|cir |c|!-
crs ci sicic! priccs ctcr c vitcn iimc pcric!. In facl, llo Socurilios and Ixclango Commis-
sion discouragos firms from issuing proforrod slocI villoul somo caII provision. Ior
oxampIo, on Ianuary 3, 2005, IIorida Iovor and Iigll rodoomod (caIIod) ils Sorios V
proforrod slocI.
Tlo caII foaluro on proforrod slocI usuaIIy invoIvos an iniliaI promium of approxi-
maloIy 10 porconl abovo llo par vaIuo or issuing prico of llo proforrod slocI. Tlon,
ovor limo, llo caII promium gonoraIIy faIIs. By solling llo iniliaI caII prico abovo llo
iniliaI issuo prico and aIIoving il lo docIino sIovIy ovor limo, llo firm prolocls llo
invoslor from an oarIy caII llal carrios no promium. A caII provision aIso aIIovs llo
issuing firm lo pIan llo roliromonl of ils proforrod slocI al prodolorminod pricos.
Sinking-Fund Prnvisinn. A sinking-Iund µrnvisinn rc¡uircs i|c |irm pcric!icc||u ic sci
csi!c cn cmcuni c| mcncu |cr i|c rciircmcni c| iis prc|crrc! sicc|. Tlis monoy is llon usod
lo purclaso llo proforrod slocI in llo opon marIol or lo caII llo slocI, vliclovor
mollod is cloapor. AIllougl proforrod slocI doos nol lavo a malurily dalo associalod
vill il, llo uso of a caII provision in addilion lo a sinIing fund can offoclivoIy croalo a
malurily dalo. Ior inslanco, Xorox Corporalion las lvo proforrod slocI issuos, ono llal
las a 7-yoar sinIing-fund provision and anollor vill a 17-yoar sinIing fund. Anollor
firm, SCANA Corporalion, a $4.5 biIIion onorgy-basod loIding company in Soull Car-
oIina, lad proforrod slocI oulslanding llal boll vas caIIabIo and lad a sinIing-fund
provision. By llo lorms of llo issuo, llo slocI's caII promium abovo ils par vaIuo vas
nol lo oxcood llo amounl of llo annuaI dividond, and llo firm vas lo roliro $2.4 miI-
Iion of slocI por yoar from 1996 llrougl 2000.
valuing Preferred Stock
As aIroady oxpIainod, llo ovnor of proforrod slocI gonoraIIy rocoivos a conslanl divi-
dond from llo invoslmonl in oacl poriod. In addilion, mosl proforrod slocIs aro porpo-
luilios (nonmaluring). In llis inslanco, finding llo vaIuo (prosonl vaIuo) of proforrod
slocI, V
, vill a IovoI casl-fIov slroam conlinuing indofiniloIy, may bosl bo oxpIainod
by an oxampIo.
700.9 CapiIal ValuaIioh 1echhiques 155
CAßM ModuIe 700 Fihahce
Consider Xerox's Series C prelerred slock issue. ln similar lashion lo valuing bonds, we use a lhree-slep valualion procedure.
5tep 1 Lslimale lhe amounl and liming ol lhe receipl ol lhe lulure cash llows lhe prelerred slock is expecled lo provide.
Xerox's prelerred slock pays an annual dividend ol S6.25. The shares do nol have a malurily dale, lhal is, lhey are
a perpeluily.
5tep 2 Lvaluale lhe riskiness ol lhe prelerred slock's lulure dividends and delermine lhe inveslor's required rale ol relurn.
The inveslor's required rale ol relurn is assumed lo equal 5 percenl lor lhe Xerox prelerred slock.
5tep 3 Calculale lhe economic or inlrinsic value ol lhe Xerox share ol prelerred slock, which is lhe presenl value ol lhe
expecled dividends discounled al lhe inveslor's required rale ol relurn. The valualion model lor a share ol pre-
lerred slock, v
, is, lherelore, delined as lollows.
In summary, llo vaIuo of a proforrod slocI is llo prosonl vaIuo of aII fuluro divi-
donds. Bul bocauso mosl proforrod slocIs aro nonmaluring÷llo dividonds conlinuo
lo infinily÷vo, lloroforo, roIy on a slorlcul for finding vaIuo as roprosonlod by oqua-
lion (9-7).
Valuing prelerred slock relies on lhree ol our principles, namely.
PrincipIe 1. The ßisk-ßeturn Trade-O!!-We Won't Take on AdditionaI ßisk UnIess
We Expect to ße Compensated vith AdditionaI ßeturn.
PrincipIe 2. The Time VaIue o! Money-A DoIIar ßeceived Today
Is Worth More than a DoIIar ßeceived in the future.
PrincipIe 3. Cash-Not Pro!its-Is King.
Delermining lhe economic worlh or value ol an assel always relies on lhese lhree
principles. Wilhoul lhem, we would have no basis lor explaining value. Wilh lhem,
we can know lhal lhe amounl and liming ol cash, nol earnings, drive value.
Also, we musl be rewarded lor laking risk, olherwise, we will nol invesl.
ll a prelerred slock pays 4 percenl on ils par or slaled value ol S!00 and your required
rale ol relurn is 7 percenl, whal is lhe slock worlh lo you?
700.9 CapiIal ValuaIioh 1echhiques 156
CAßM ModuIe 700 Fihahce
Nolice lhal equalion (9-6) is a reslalemenl in a slighlly dillerenl lorm ol equalion (9-!). Pecall lhal equalion (9-!) slales
lhal lhe value ol an assel is lhe presenl value ol lulure cash llows lo be received by lhe inveslor.
8ecause lhe dividends in each period are equal lor prelerred slock, equalion (9-6) can be reduced lo lhe lollowing
Lqualion (9-7) represenls lhe presenl value ol an inlinile slream ol cash llows, when lhe cash llows are lhe same each
year. We can delermine lhe value ol lhe Xerox prelerred slock, using equalion (9-7), as lollows.
= = =
6 25
0 05
!25 00
= =
annual dividend
required rale ol relurn
dividend in year !
( required rale ol r ! eelurn)
dividend in year 2
( required rale

 ! ol relurn)
dividend in inlinily
( requ
 

! iired rale ol relurn)
( ) ( ) 

o: o:
! !
 

( )
The value ol lhe prelerred slock would be S57.!4.
700.9.5 De!ine common stock vith its !eatures
and Iearn hov to vaIue common stock
Cnmmnn stnck is c ccrii|iccic i|ci in!iccics cuncrs|ip in c ccrpcrciicn. In offocl, bond-
loIdors and proforrod slocIloIdors can bo viovod as crodilors, vloroas llo common
slocIloIdors aro llo lruo ovnors of llo firm. Common slocI doos nol lavo a malu-
rily dalo bul oxisls as Iong as llo firm doos. Nor doos common slocI lavo an uppor
Iimil on ils dividond paymonls. Dividond paymonls musl bo docIarod oacl poriod
(usuaIIy quarlorIy) by llo firm's board of diroclors. In llo ovonl of banIruplcy, llo
common slocIloIdors, as ovnors of llo corporalion, viII nol rocoivo any paymonl
unliI llo firm's crodilors, incIuding llo bondloIdors and proforrod slaroloIdors,
lavo boon salisfiod.
In oxamining common slocI, vo firsl IooI al sovoraI of ils foaluros or claracloris-
lics. Tlon vo focus on vaIuing common slocI.
Ieatures or Characteristics of Common Stock
Wo nov oxamino common slocI's cIaim on incomo and assols, slocIloIdor voling riglls,
proomplivo riglls, and llo moaning and imporlanco of ils Iimilod-IiabiIily foaluro.
CIaim on Income
As llo ovnors of a corporalion, llo common slaroloIdors lavo llo rigll lo llo
rosiduaI incomo aflor bondloIdors and proforrod slocIloIdors lavo boon paid. Tlis
incomo may bo paid diroclIy lo llo slaroloIdors in llo form of dividonds or rolainod
villin llo firm and roinvoslod in llo businoss. AIllougl il is obvious llo slaro-
loIdor bonofils immodialoIy from llo dislribulion of incomo in llo form of divi-
donds, llo roinvoslmonl of oarnings aIso bonofils llo slaroloIdor. IIoving bacI
oarnings inlo llo firm slouId rosuIl in an incroaso in llo vaIuo of llo firm, in ils
oarning povor, and in ils fuluro dividonds. Tlis aclion, in lurn, slouId rosuIl in an
incroaso in llo vaIuo of llo slocI. In offocl, rosiduaI incomo is dislribulod diroclIy lo
slaroloIdors in llo form of dividonds or indiroclIy in llo form of capilaI gains on
lloir common slocI.
Tlo rigll lo rosiduaI incomo las advanlagos and disadvanlagos for llo common
slocIloIdor. Tlo advanlago is llal llo polonliaI rolurn is IimilIoss. Onco llo cIaims of
llo mosl sonior socurilios (bonds and proforrod slocI) lavo boon salisfiod, llo romain-
ing incomo fIovs lo llo common slocIloIdors in llo form of dividonds or capilaI
gains. Tlo disadvanlago is llal if llo bond and proforrod slocI cIaims on incomo
lolaIIy absorb oarnings, common slaroloIdors rocoivo nolling. In yoars vlon oarnings
faII, il is llo common slaroloIdor vlo suffors firsl.
CIaim nn Assets. Iusl as common slocI las a rosiduaI cIaim on incomo, il aIso las a
rosiduaI cIaim on assols in llo caso of Iiquidalion. OnIy aflor llo cIaims of dobl loIdors
and proforrod slocIloIdors lavo boon salisfiod do llo cIaims of common slaroloIdors
rocoivo any considoralion. UnforlunaloIy, vlon banIruplcy doos occur, llo cIaims of
llo common slaroloIdors gonoraIIy go unsalisfiod. Tlis rosiduaI cIaim on assols adds
required rale ol relurn
= =
. 0 04  SS S
0 07
0 07
57 !4
. .
. = =
700.9 CapiIal ValuaIioh 1echhiques 157
CAßM ModuIe 700 Fihahce
lo llo risI of common slocI. Tlus, aIllougl common slocI las lisloricaIIy providod a
Iargo rolurn, avoraging 12 porconl annuaIIy sinco llo Ialo 1920s, il aIso las liglor risI
associalod vill il.
Vnting Rights. Tlo common slocI slaroloIdors aro onlilIod lo oIocl llo board of
diroclors and aro, in gonoraI, llo onIy socurily loIdors givon a volo. Will llo morgor
boom of llo 1980s, duaI cIassos of common slocI vill difforonl voling riglls omorgod
as a dofonsivo laclic usod lo provonl laIoovors. Hovovor, vill llo incroasod aclivism
of slaroloIdors, ospociaIIy Iargo inslilulionaI slaroloIdors during roconl yoars, duaI
cIassos of slocI lavo boon discouragod.
Common slaroloIdors lavo llo rigll nol onIy lo oIocl llo board of diroclors bul
aIso lo approvo any clango in llo corporalo clarlor. A lypicaI clango migll invoIvo
llo aullorizalion lo issuo nov slocI or lo accopl a morgor proposaI.
Voling for diroclors and clarlor clangos occurs al llo corporalion's annuaI mool-
ing. AIllougl slaroloIdors may volo in porson, llo majorily gonoraIIy volo by proxy.
A µrnxv vitcs c !csivncic! pcriu i|c icmpcrcru pcucr c| ciicrncu ic tcic |cr i|c sivncc ci i|c
ccrpcrciicn´s cnnuc| mcciinv. Tlo firm's managomonl gonoraIIy soIicils proxy volos
and, if llo slaroloIdors aro salisfiod vill llo firm's porformanco, managomonl las
IillIo probIom socuring llom. Hovovor, in limos of financiaI dislross or vlon man-
agomonl laIoovors aro llroalonod, µrnxv Iights÷|cii|cs |ciuccn ritc| vrcups |cr prcxu
AIllougl oacl slaro of slocI carrios llo samo numbor of volos, llo voling proco-
duro is nol aIvays llo samo from company lo company. Tlo lvo procoduros com-
monIy usod aro majorily and cumuIalivo voling. Undor majnritv vnting, ccc| s|crc c|
sicc| c||cus i|c s|crc|c|!cr cnc tcic, cn! ccc| pcsiiicn cn i|c |ccr! c| !irccicrs is tcic! cn
scpcrcic|u. Bocauso oacl mombor of llo board of diroclors is oIoclod by a simpIo major-
ily, a majorily of slaros las llo povor lo oIocl llo onliro board of diroclors.
Will cumuIative vnting, ccc| s|crc c| sicc| c||cus i|c sicc||c|!cr c num|cr c| tcics
c¡uc| ic i|c num|cr c| !irccicrs |cinv c|ccic!. Tlo slaroloIdor can llon casl aII of lis or
lor volos for a singIo candidalo or spIil llom among llo various candidalos. Tlo
advanlago of a cumuIalivo voling procoduro is llal il givos minorily slaroloIdors llo
povor lo oIocl a diroclor.
In lloory, llo slaroloIdors picI llo corporalo board of diroclors, gonoraIIy
llrougl proxy voling, and llo board of diroclors, in lurn, picIs llo managomonl. In
roaIily, slaroloIdors aro offorod a sIalo of nominoos soIoclod by managomonl from
vlicl lo clooso. Tlo ond rosuIl is llal managomonl offoclivoIy soIocls llo diroclors,
vlo llon may lavo moro aIIogianco lo llo managors llan lo llo slaroloIdors. Tlis
sols up llo polonliaI for agoncy probIoms in vlicl a divorgonco of inlorosls bolvoon
managors and slaroloIdors is aIIovod lo oxisl, vill llo board of diroclors nol moni-
loring llo managors on bolaIf of llo slaroloIdors as lloy slouId.
Preemptive ßights
Tlo µreemµtive right cniii|cs i|c ccmmcn s|crc|c|!cr ic mcinicin c prcpcriicncic s|crc c|
cuncrs|ip in i|c |irm. Wlon nov slaros aro issuod, common slaroloIdors lavo llo
firsl rigll of rofusaI. If a slaroloIdor ovns 25 porconl of llo corporalion's slocI, llon
lo or slo is onlilIod lo purclaso 25 porconl of llo nov slaros. Ccrii|iccics issuc! ic i|c
s|crc|c|!crs vitinv i|cm cn cpiicn ic purc|csc c sicic! num|cr c| ncu s|crcs c| sicc| ci c
spcci|ic! pricc !urinv c 2- ic 10-ucc| pcric! aro caIIod rights. Tloso riglls can bo oxor-
cisod (gonoraIIy al a prico sol by managomonl boIov llo common slocI's curronl
marIol prico), aIIovod lo oxpiro, or soId in llo opon marIol.
Limited LiabiIity
AIllougl llo common slaroloIdors aro llo acluaI ovnors of llo corporalion, lloir
|ic|i|iiu in i|c ccsc c| |cn|rupicu is |imiic! ic i|c cmcuni c| i|cir intcsimcni. Tlo advanlago
is llal invoslors vlo migll nol ollorviso invosl lloir funds in llo firm bocomo viIIing
lo do so. Tlis Iimited IiabiIitv foaluro aids llo firm in raising funds.
700.9 CapiIal ValuaIioh 1echhiques 158
CAßM ModuIe 700 Fihahce
valuing Common Stock
IiIo bonds and proforrod slocI, a common slocI's vaIuo is oquaI lo llo prosonl vaIuo
of aII fuluro casl fIovs oxpoclod lo bo rocoivod by llo slocIloIdor. Hovovor, in con-
lrasl lo bonds, common slocI doos nol promiso ils ovnors inlorosl incomo or a malu-
rily paymonl al somo spocifiod limo in llo fuluro. Givon llo uniquonoss of common
slocI, comparod vill bonds and proforrod slocI, vo viII considor lvo approaclos lo
vaIuing common slocI:
1. Tlo vaIuo of a common slocI is oquaI lo llo prosonl vaIuo of aII fuluro
dividonds÷llo samo approacl jusl usod in vaIuing proforrod slocI, bul vill
somo lvisls and lurns, as vo viII soo.
2. Tlo vaIuo of a common slocI is oquaI lo llo lolaI firm or onlorpriso vaIuo Ioss llo
firm's oulslanding dobl, vloro llo firm vaIuo is oquaI lo llo prosonl vaIuo of llo
firm's |rcc ccs| ||cus.
Iacl of lloso approaclos viII nov bo oxpIainod.
Common Stock value: The Present value of Iuture Dividends
In conlrasl lo proforrod slocI dividonds, common slocI doos nol provido llo invoslor vill
a prodolorminod, conslanl dividond. Ior common slocI, llo dividond is basod on llo prof-
ilabiIily of llo firm and on managomonl's docision lo pay dividonds or lo rolain llo profils
for roinvoslmonl. As a consoquonco, dividond slroams lond lo incroaso vill llo grovll in
corporalo oarnings. Tlus, llo grovll of fuluro dividonds is a primo dislinguisling foaluro
of common slocI.
700.9 CapiIal ValuaIioh 1echhiques 159
CAßM ModuIe 700 Fihahce
To illuslrale lhe nalure ol inlernal growlh, assume lhal lhe relurn on equily lor PepsiCo is !6 percenl. The relurn on equily
is lhe accounling rale ol relurn on lhe common shareholders' inveslmenl in lhe company and is compuled as lollows.
ll PepsiCo's managemenl decides lo pay all lhe prolils oul in dividends lo ils slockholders, lhe lirm will experience no
growlh inlernally. ll mighl become larger by borrowing more money or issuing new slock, bul inlernal growlh will come
only lhrough lhe relenlion ol prolils. ll, on lhe olher hand, PepsiCo relained all lhe prolils, lhe slockholders' inveslmenl in
lhe lirm would grow by lhe amounl ol prolils relained, or by !6 percenl. ll, however, managemenl kepl only 50 percenl ol
lhe prolils lor reinveslmenl, lhe common shareholders' inveslmenl would increase only by hall ol lhe !6 percenl relurn on
equily, or by 8 percenl. We can express lhis relalionship by lhe lollowing equalion.
q |C| r
where q lhe growlh rale ol lulure earnings and lhe growlh in lhe common slockholders' inveslmenl in lhe lirm
|C| lhe relurn on equily (nel income/common book value)
r |he comoanv´: oercen|aqe o| oro|||: re|a|ned, called lhe pro!it-retention rate. The relenlion rale is also equal
lo (! lhe percenlage ol prolils paid oul in dividends). 1he oercen|aqe o| oro|||: oa|d ou| |n d|v|dend: is ollen
called lhe dividend-payout ratio.
Therelore, il only 25 percenl ol lhe prolils were relained by PepsiCo, we would expecl lhe common slockholders' invesl-
menl in lhe lirm and lhe value ol lhe slock price lo increase or grow by 4 percenl, lhal is,
q !6' 0.25 4'
Pelurn on equily
nel income
(common slock re
 llained earnings)
The Grovth factor in VaIuing Common 5tock
Wlal is moanl by llo lorm vrcui| vlon usod in llo conloxl of vaIuing common slocI`
A company can grov in a varioly of vays. Il can bocomo Iargor by borroving monoy
lo invosl in nov projocls. IiIoviso, il can issuo nov slocI for oxpansion. Managomonl
can aIso acquiro anollor company lo morgo vill llo oxisling firm, vlicl vouId
incroaso llo firm's assols. In aII lloso casos, llo firm is groving llrougl llo uso of nov
financing, by issuing dobl or common slocI. AIllougl managomonl can accuraloIy say
llal llo firm las grovn, llo originaI slocIloIdors may or may nol parlicipalo in llis
grovll. Grovll is roaIizod llrougl llo infusion of nov capilaI. Tlo firm sizo cIoarIy
incroasos, bul unIoss llo originaI invoslors incroaso lloir invoslmonl in llo firm, lloy
viII ovn a smaIIor porlion of llo oxpandod businoss.
Anollor moans of groving is internaI grnwth, vlicl roquiros llal mcncvcmcni
rcicin scmc cr c|| c| i|c |irm´s prc|iis |cr rcintcsimcni in i|c |irm, rosuIling in llo grovll of
fuluro oarnings and, lopofuIIy, llo vaIuo of llo common slocI. Tlis procoss undorIios
llo ossonco of polonliaI grovll for llo firm's curronl slocIloIdors and is llo onIy roIo-
vanl grovll for our purposos in vaIuing a firm's common slaros. Wo aro nol arguing
llal llo oxisling common slocIloIdors novor bonofil from llo uso of oxlornaI financ-
ing, lovovor, sucl bonofil is nominaI if capilaI marIols aro officionl.
In summary, common slocIloIdors froquonlIy roIy on an incroaso in llo slocI
prico as a sourco of rolurn. If llo company is rolaining a porlion of ils oarnings for
roinvoslmonl, fuluro profils and dividonds slouId grov. Tlis grovll slouId bo
rofIoclod in an incroasod marIol prico of llo common slocI in fuluro poriods, providod
llal llo rolurn on llo funds roinvoslod oxcoods llo invoslor's roquirod ralo of rolurn.
Tloroforo, boll lypos of rolurn (dividonds and prico approcialion) musl bo rocognizod
in vaIuing common slocI.
ln 2003, Microsoll had a relurn on equily ol !2 percenl. The lirm's earnings per share
was S0.74, and lhe lirm paid S0.32 in dividends per share. ll lhese relalionships
hold in lhe lulure, whal will be lhe lirm's inlernal growlh rale?
Microsoll's inlernal growlh rale would be 6.8! percenl. Microsoll is paying oul
43.24 percenl ol ils earnings in dividends (43.24' S0.32 dividends per share S0.74
earnings per share), which means lhal lhe lirm is relaining 56.76 percenl ol ils earnings
(56.76' !00' 43.24'). Civen lhal lhe lirm has a !2 percenl relurn on equily,
ils inlernal growlh rale would be 8.!! percenl (6.8!' !2' relurn on equily
0.5676 earnings relained per dollar ol earnings).
Dividend valuation Model
Tlo vaIuo of a common slocI vlon dofining vaIuo as llo prosonl vaIuo of fuluro divi-
donds roIios on llo samo basic oqualion llal vo usod vill proforrod slocI |oqualion
(9-6)], vill llo oxcoplion llal vo aro using llo roquirod ralo of rolurn of common
slocIloIdors, |
. Tlal is,
Iqualion (9-9) indicalos llal vo aro discounling llo dividond al llo ond of llo firsl
yoar, D
, bacI 1 yoar, llo dividond in llo socond yoar, D
, bacI 2 yoars, llo dividond in
llo nll yoar bacI n yoars, and llo dividond in infinily bacI an infinilo numbor of
cs cs
1 1 1 ( ) ( ) ( ) 

 

   
(( ) 1  |
700.9 CapiIal ValuaIioh 1echhiques 160
CAßM ModuIe 700 Fihahce
yoars. Tlo roquirod ralo of rolurn is |
. In using oqualion (9-9), nolo llal llo vaIuo of
llo slocI is oslabIislod al llo boginning of llo yoar, say Ianuary 1, 2006. Tlo mosl
roconl pasl dividond, D
, vouId lavo boon paid llo provious day, Docombor 31, 2005.
Tlus, if vo purclasod llo slocI on Ianuary 1, llo firsl dividond vouId bo rocoivod in
12 monlls, on Docombor 31, 2006, vlicl is roprosonlod by D
IorlunaloIy, oqualion (9-9) can bo roducod lo a mucl moro managoabIo form if
dividonds grov oacl yoar al a conslanl ralo, v. Tlo conslanl-grovll common-slocI
vaIualion oqualion may bo prosonlod as foIIovs:
ConsoquonlIy, llo inlrinsic vaIuo (prosonl vaIuo) of a slaro of common slocI
vloso dividonds grov al a conslanl annuaI ralo can bo caIcuIalod using oqualion (9-9).
AIllougl llo inlorprolalion of llis oqualion may nol bo inluilivoIy obvious, simpIy
romombor llal il soIvos for llo prosonl vaIuo of llo fuluro dividond slroam groving al
a ralo, v, lo infinily, assuming llal |
is groalor llan v.
Valuing common slock is no dillerenl lrom valuing prelerred slock, only lhe pallern ol lhe
cash llows changes. Thus, lhe valualion ol common slock relies on lhe same lhree principles
lhal were used in valuing prelerred slock.
PrincipIe 1. The ßisk-ßeturn Trade-O!!-We Won't Take on AdditionaI ßisk
UnIess We Expect to ße Compensated vith AdditionaI ßeturn.
PrincipIe 2. The Time VaIue o! Money-A DoIIar ßeceived Today Is Worth
More than a DoIIar ßeceived in the future.
PrincipIe 3. Cash-Not Pro!its-Is King.
Delermining lhe economic worlh or value ol an assel always relies on lhese lhree principles.
Wilhoul lhem, we would have no basis lor explaining value. Wilh lhem, we can know
lhal lhe amounl and liming ol cash, nol earnings, drives value. Also, we musl be rewarded
lor laking risk, olherwise, we will nol invesl.
Wo lavo arguod llal llo vaIuo of a common slocI is oquaI lo llo prosonl vaIuo of aII
fuluro dividonds, vlicl is villoul quoslion a fundamonlaI promiso of financo. In prac-
lico, lovovor, managors, aIong vill many socurily anaIysls, oflon laII aboul llo roIalion-
slip bolvoon slocI vaIuo and oarnings, rallor llan dividonds. Wo vouId oncourago you
lo bo vory caulious in using oarnings lo vaIuo a slocI. Ivon llougl il may bo a popuIar
praclico, significanl ovidonco avaiIabIo suggosls llal invoslors IooI lo llo casl fIovs gon-
oralod by llo firm, nol llo oarnings, for vaIuo. A firm's vaIuo lruIy is llo prosonl vaIuo of
llo casl fIovs il producos.
Wo nov lurn lo our socond approacl for oslimaling llo vaIuo of a common
slocI÷llo prosonl vaIuo of froo casl fIovs.
The Abraham Corporalion paid S!.32 in dividends per share |a:| vear. The lirm's projecled
growlh rale is 6 percenl lor lhe loreseeable lulure. ll an inveslor's required rale ol relurn lor
a lirm wilh Abraham's level ol risk is !0 percenl, whal is lhe value ol lhe slock?
Common slocI vaIuo
dividond in yoar
dd ralo of rolurn grovll ralo 

| v
700.9 CapiIal ValuaIioh 1echhiques 161
CAßM ModuIe 700 Fihahce
Abraham's slock value would be S35.
Common Stock value: The Present value
of Iree Cash Ilows
Iroo casl fIov vaIualion dofinos llo vaIuo of a firm as llo prosonl vaIuo of ils oxpoclod
fuluro casl fIovs. Moro spocificaIIy, a firm's cccncmic or inirinsic vaIuo is oquaI lo llo
prosonl vaIuo of ils fuluro Iree cash IInws discounlod al llo company's cosl of capilaI÷
llo roquirod ralo of rolurn of llo firm's invoslors. Wo llon compulo slaroloIdor vaIuo
as llo firm vaIuo Ioss llo vaIuo of oulslanding inlorosl-boaring dobl, sucl as bonds and
banI nolos.
Wo Ioarnod llal a firm's lisloricaI froo casl fIovs aro dolorminod as foIIovs:
dividend year
required rale ol relur
nn growlh rale
S ( ) S

 

= =
! 32 ! 06
0 !0 0 06
! 40 . .
. .
00 04
= S
700.9 CapiIal ValuaIioh 1echhiques 162
CAßM ModuIe 700 Fihahce
Consider lhe valualion ol a share ol common slock lhal paid a S2 dividend al lhe end ol lhe lasl year and is expecled lo
pay a cash dividend every year lrom now lo inlinily. Lach year lhe dividends are expecled lo grow al a rale ol !0 percenl.
8ased on an assessmenl ol lhe riskiness ol lhe common slock, lhe inveslor's required rale ol relurn is !5 percenl. Using
lhis inlormalion, we would compule lhe value ol lhe common slock as lollows.
1. 8ecause lhe S2 dividend was paid lasl year (aclually, yeslerday), we musl compule lhe nexl dividend lo be received, lhal
is, |
, where
(! + q)
S2(! + .!0)
2. Now, using equalion (9-9),
| q
2 20
!5 !0

. .
Operating income
+ deprecialion and amorlizalion
lax expense
aller-lax cash llows lrom operalions
lhe inveslmenl (increase) in lhe lirm's assels, bolh nel working capilal and capilal
expendilures in planl and equipmenl
lree cash llows
Hovovor, vo aro inloroslod in prodicling llo firm's |uiurc, rallor llan ils |isicricc|,
froo casl fIovs and llon finding llo prosonl vaIuo of lloso casl fIovs as a moasuro of
firm vaIuo.
700.9.6 CaIcuIate a stock's expected rate o! return
!rom a stockhoIder's vievpoint
As slalod, llo oxpoclod ralo of rolurn, or yioId lo malurily, on a bond is llo rolurn llo
bondloIdor oxpocls lo rocoivo on llo invoslmonl by paying llo oxisling marIol prico
for llo socurily. Tlis ralo of rolurn is of inlorosl lo llo financiaI managor bocauso il
loIIs llo managor aboul llo invoslor's oxpoclalions. Tlo samo can bo said for llo finan-
ciaI managor nooding lo Inov llo oxpoclod ralo of rolurn of llo firm's slocIloIdors,
vlicl is llo lopic of llis soclion.
The Preferred Stockholder's £xpected Rate of Return
In compuling llo proforrod slocIloIdor's oxpoclod ralo of rolurn, vo uso llo vaIualion
oqualion for proforrod slocI. IarIior, oqualion (9-7) spocifiod llo vaIuo of a proforrod
slocI, V
, as
SoIving oqualion (9-7) for |
, vo lavo
Tlus, a proforrod slocIloIdor's rc¡uirc! ralo of rolurn simpIy oquaIs llo slocI's annuaI
dividond dividod by llo inlrinsic vaIuo. Wo may aIso soIvo for a proforrod slocI's
cxpccic! ralo of rolurn,
, as foIIovs. Wo viII uso lo roprosonl a socurily's cxpccic!
ralo of rolurn vorsus | for llo invoslor's rc¡uirc! ralo of rolurn.
Nolo llal vo lavo moroIy subslilulod llo curronl marIol prico, P
, for llo inlrinsic
vaIuo, V
. Tlo oxpoclod ralo of rolurn,
, lloroforo, oquaIs llo annuaI dividond roIalivo |
|ps =
annuaI dividond
proforrod slocI marIol prrico
| |
= =
annuaI dividond
proforrod slocI vaIuo
= =
annuaI dividond
roquirod ralo of rolurn
700.9 CapiIal ValuaIioh 1echhiques 163
CAßM ModuIe 700 Fihahce
lo llo prico llo slocI is curronlIy soIIing for P
. Tlus, llo exµected rate nI return,
, is
i|c rcic c| rciurn i|c intcsicr ccn cxpcci ic ccrn |rcm i|c intcsimcni i| |cuv|i ci i|c currcni
mcr|ci pricc. Ior oxampIo, if llo prosonl marIol prico of proforrod slocI is $50 and il
pays a $3.64 annuaI dividond, llo oxpoclod ralo of rolurn impIicil in llo prosonl marIol
prico is
Tloroforo, invoslors (vlo pay $50 por slaro for a proforrod socurily llal is paying
$3.64 in annuaI dividonds) aro oxpocling a 7.28 porconl ralo of rolurn.
= = =
3 64
7 28
. °
The Common Stockholder's £xpected Rate of Return
Tlo vaIualion oqualion for common slocI vas dofinod oarIior in oqualion (9-9) as
Oving lo llo difficuIly of discounling lo infinily, vo mado llo Ioy assumplion
llal llo dividonds, D
, incroaso al a conslanl annuaI compound grovll ralo of v. If llis
assumplion is vaIid, oqualion (9-9) vas slovn lo bo oquivaIonl lo
Tlus, V
roprosonls llo maximum vaIuo llal an invoslor laving a roquirod ralo of
rolurn of |
vouId pay for a socurily laving an anlicipalod dividond in yoar 1 of D
llal is oxpoclod lo grov in fuluro yoars al ralo v. Al limos llo oxpoclod dividond al
yoar-ond (D
) is nol givon. Insload, vo migll onIy Inov llo mosl roconl dividond
(paid yoslorday), llal is, D
. If so, oqualion (9-9) musl bo roslalod as foIIovs:
SoIving oqualion (9-9) for |
, vo can compulo llo common slocIloIdor's roquirod ralo
of rolurn as foIIovs:
Irom llis oqualion, llo common slocIloIdor's roquirod ralo of rolurn is oquaI lo llo div-
idond yioId pIus a grovll faclor. AIllougl llo grovll ralo, v, appIios lo llo grovll in
llo company's dividonds, givon our assumplions llo slocI's vaIuo may aIso bo oxpoclod
lo incroaso al llo samo ralo. Ior llis roason, v roprosonls llo annuaI porconlago grovll
in llo slocI vaIuo. In ollor vords, llo invoslor's roquirod ralo of rolurn is salisfiod by
rocoiving dividonds and capilaI gains, as rofIoclod by llo oxpoclod porconlago grovll
ralo in llo slocI prico.
As vas dono for proforrod slocI oarIior, vo may roviso oqualion (9-12) lo moasuro
a common slocI's cxpccic! ralo of rolurn, RopIacing llo inlrinsic vaIuo, V
, in
oqualion (9-12) vill llo slocI's curronl marIol prico, P
, vo may oxpross llo slocI's
oxpoclod ralo of rolurn as foIIovs:
Mosl of llo rolurns on slocIs como from prico approcialion, or capilaI gains, vill
a smaIIor parl of llo rolurn coming from dividonds. Tlo Slandard & Ioor's 500 Indox,
for oxampIo, rolurnod a 12 porconl annuaI rolurn on avorago ovor llo pasl 10 yoars.
Tlo dividond yioId (dividond  slocI prico) accounlod for aboul 2 porconl of llo
rolurn, vill llo romaining 10 porconl rosuIling from prico approcialion.
|cs =
dividond in yoar 1
marIol prico


|cs .
growlh rale
| v
D v
| v
cs cs
= =
1 0
( )
( )
( ) 

Common slocI vaIuo
dividond in yoar 1
ood ralo of rolurn grovll ralo 

| v
Common slocI vaIuo
dividond in yoar 1
( roq
1  uuirod ralo of rolurn)
dividond in yoar 2

11 
 
roquirod ralo of rolurn)
dividond in

yyoar infinily
( roquirod ralo of rolurn) 1 
cs cs cs
1 1 1 ( ) ( ) ( ) 

 

700.9 CapiIal ValuaIioh 1echhiques 164
CAßM ModuIe 700 Fihahce
Calculale lhe expecled rale ol relurn lor lhe lwo lollowing slocks.
Prelerred slock. The slock is selling lor S80 and pays a 5 percenl dividend
on ils S!00 par or slaled value.
Common slock. The slock paid a dividend ol S4 lasl year and is expecled lo increase each
year al a 5 percenl growlh rale. The slock sells lor S75.
Prelerred slock.
Common slock.
Lxpecled relurn
slock price
growlh =  rrale
S ( )
' '
= =
4 ! 0 05
4 20
5 6 5
 
 

. .
. ==!0 6 . '
Lxpecled relurn
slock price
= = =
0.. . 0625 6 25 or '
700.9 CapiIal ValuaIioh 1echhiques 165
CAßM ModuIe 700 Fihahce
As an example ol compuling lhe expecled rale ol relurn lor a common slock when dividends are anlicipaled lo grow al a
conslanl rale lo inlinily, assume lhal a lirm's common slock has a currenl markel price ol S44. ll lhe expecled dividend al
lhe conclusion ol lhis year is S2.20 and dividends and earnings are growing al a !0 percenl annual rale (lasl year's dividend
was S2), lhe expecled rale ol relurn implicil in lhe S44 slock price is as lollows.
|c: = =
' '
2 20
!0 !5

We have jusl learned lhal on average, lhe expecled relurn will be equal lo lhe inveslor's
required rale ol relurn. This equilibrium condilion is achieved by inveslors paying
lor an assel only lhe amounl lhal will exaclly salisly lheir required rale ol relurn.
Thus, linding lhe expecled rale ol relurn based on lhe currenl markel price
lor lhe securily relies on lwo ol lhe principles given.
PrincipIe 1. The ßisk-ßeturn Trade-O!!-We Won't Take on AdditionaI ßisk UnIess
We Expect to ße Compensated vith AdditionaI ßeturn.
PrincipIe 2. The Time VaIue o! Money-A DoIIar ßeceived Today Is Worth
More than a DoIIar ßeceived in the future.
As a finaI nolo, vo slouId undorsland llal llo cxpccic! ralo of rolurn impIiod by a
givon marIol prico oquaIs llo rc¡uirc! ralo of rolurn for invoslors al llo margin. Ior
lloso invoslors, llo oxpoclod ralo of rolurn is jusl oquaI lo lloir roquirod ralo of rolurn
and, lloroforo, lloy aro viIIing lo pay llo curronl marIol prico for llo socurily. Tloso
invoslors' roquirod ralo of rolurn is of parlicuIar significanco lo llo financiaI managor
bocauso il roprosonls llo cosl of nov financing lo llo firm.
700.10 CapiIal 8udgeIihg 166
700.10.1 Ioarn lov lo find profilabIo projocls for invoslmonl and dolormino
vlollor a nov invoslmonl projocl slouId bo accoplod or rojoclod using llo
paybacI poriod, llo nol prosonl vaIuo, llo profilabiIily indox, and llo inlornaI ralo
of rolurn mollod
700.10.2 Dofino llo concopl of capilaI ralioning and discuss llo probIoms
oncounlorod in ranIing invoslmonl projocls
700.10.3 Undorsland llo guidoIinos for capilaI budgoling and for moasuring llo
casl fIovs and Ioarn lov lo caIcuIalo a projocl's froo casl fIovs
700.10.4 Discuss llo various oplions avaiIabIo in capilaI budgoling
700.10.5 Ioarn lov lo moasuro and incorporalo risI inlo capilaI budgoling and
Ioarn lov lo oxamino a projocl's risI llrougl simuIalion and sonsilivily anaIysis
700.10 Capital Budgeting
700.10.1 Learn hov to !ind pro!itabIe projects
!or investment and determine vhether a nev
investment project shouId be accepted or rejected
using the payback period, the net present vaIue,
the pro!itabiIity index, and the internaI rate
o! return method
Willoul quoslion il is oasior lo ctc|ucic prc|iic||c prcjccis cr intcsimcni in |ixc! csscis, a
procoss roforrod lo as caµitaI budgeting, llan il is lo find llom. In compolilivo mar-
Iols, gonoraling idoas for profilabIo projocls is oxlromoIy difficuIl. Tlo compolilion is
brisI for nov profilabIo projocls, and onco lloy lavo boon uncovorod, compolilors
gonoraIIy rusl in, pusling dovn pricos and profils. Ior llis roason a firm musl lavo a
syslomalic slralogy for gonoraling capilaI-budgoling projocls. Willoul llis fIov of nov
projocls and idoas, llo firm cannol grov or ovon survivo for Iong, boing forcod lo Iivo
off llo profils from oxisling projocls vill Iimilod Iivos. So vloro do lloso idoas como
from for nov producls, or for vays lo improvo oxisling producls or maIo llom moro
profilabIo` Tlo ansvor is from insido llo firm÷from ovoryvloro insido llo firm.
The lacl lhal prolilable projecls are dillicull lo lind relales direclly lo PrincipIe 5. The Curse
o! Competitive Markets-Why It's Hard to find ExceptionaIIy Pro!itabIe Projects.
When we inlroduced lhal principle, we slaled lhal successlul inveslmenls involve
lhe reduclion ol compelilion by crealing barriers lo enlry lhrough eilher producl
dillerenlialion or cosl advanlages. The key lo localing prolilable projecls is lo undersland
how and where lhey exisl.
TypicaIIy, a firm las a rosoarcl and dovoIopmonl (R&D) doparlmonl llal soarclos
for vays of improving oxisling producls or finding nov producls. Tloso idoas may
como from villin llo R&D doparlmonl or may bo basod on roforraI idoas from oxocu-
livos, saIos porsonnoI, anyono in llo firm, or ovon cuslomors.
In dociding vlollor lo accopl a nov projocl, vo focus on casl fIovs. Casl fIovs ropro-
sonl llo bonofils gonoralod from accopling a capilaI-budgoling proposaI. In llis soclion
vo assumo a givon casl fIov is gonoralod by a projocl and vorI on dolormining
vlollor llal projocl slouId bo accoplod.
Wo considor four commonIy usod criloria for dolormining accoplabiIily of
invoslmonl proposaIs. Tlo firsl ono is llo Ioasl soplislicalod, in llal il doos nol
incorporalo llo limo vaIuo of monoy inlo ils caIcuIalions, llo ollor llroo do laIo il
inlo accounl. Ior llo limo boing, llo probIom of incorporaling risI inlo llo capilaI-
budgoling docision is ignorod. In addilion, vo assumo llal llo approprialo discounl
ralo, roquirod ralo of rolurn, or cosl of capilaI is givon.
Payback Period
Tlo µavback µerind is llo num|cr c| uccrs ncc!c! ic rccctcr i|c iniiic| ccs| cui|cu. Bocauso
llis crilorion moasuros lov quicIIy llo projocl viII rolurn ils originaI invoslmonl, il
doaIs vill froo casl fIovs, vlicl moasuro llo lruo liming of llo bonofils, rallor llan
accounling profils. UnforlunaloIy, il aIso ignoros llo limo vaIuo of monoy and doos nol
discounl lloso froo casl fIovs bacI lo llo prosonl. Tlo accopl/rojocl crilorion conlors on
700.10 CapiIal 8udgeIihg 167
CAßM ModuIe 700 Fihahce
vlollor llo projocl's paybacI poriod is Ioss llan or oquaI lo llo firm's maximum
dosirod paybacI poriod. Ior oxampIo, if a firm's maximum dosirod paybacI poriod is
3 yoars and an invoslmonl proposaI roquiros an iniliaI casl oulIay of $10,000 and
yioIds llo foIIoving sol of annuaI casl fIovs, vlal is ils paybacI poriod` SlouId llo
projocl bo accoplod`
Year free Cash fIov
1 $2,000
2 4,000
3 3,000
4 3,000
5 1,000
In llis caso, aflor 3 yoars llo firm viII lavo rocaplurod $9,000 on an iniliaI
invoslmonl of $10,000, Ioaving $1,000 of llo iniliaI invoslmonl lo bo rocoupod. Dur-
ing llo fourll yoar a lolaI of $3,000 viII bo rolurnod from llis invoslmonl, and,
assuming il viII fIov inlo llo firm al a conslanl ralo ovor llo yoar, il viII laIo ono-
llird of llo yoar ($1,000/$3,000) lo rocapluro llo romaining $1,000. Tlus, llo pay-
bacI poriod on llis projocl is yoars, vlicl is moro llan llo dosirod paybacI
poriod. Using llo paybacI poriod crilorion, llo firm vouId rojocl llis projocl villoul
ovon considoring llo $1,000 casl fIov in yoar 5.
AIllougl llo paybacI poriod is usod froquonlIy, il doos lavo somo rallor obvious
dravbacIs llal aro bosl domonslralod llrougl llo uso of an oxampIo. Considor lvo
invoslmonl projocls, A and B, vlicl invoIvo an iniliaI casl oulIay of $10,000 oacl and
produco llo annuaI casl fIovs slovn in TabIe 10.1. Boll projocls lavo a paybacI
poriod of 2 yoars, lloroforo, in lorms of llo paybacI crilorion boll aro oquaIIy accopl-
abIo. Hovovor, if vo lad our cloico, il is cIoar vo vouId soIocl A ovor B, for al Ioasl
lvo roasons. Iirsl, rogardIoss of vlal lappons aflor llo paybacI poriod, projocl A
rolurns our iniliaI invoslmonl lo us oarIior villin llo paybacI poriod. Tlus, bocauso
lloro is a limo vaIuo of monoy, llo casl fIovs occurring villin llo paybacI poriod
slouId nol bo voigllod oquaIIy, as lloy aro. In addilion, aII casl fIovs llal occur aflor
llo paybacI poriod aro ignorod. Tlis vioIalos llo principIo llal invoslors dosiro moro
in llo vay of bonofils rallor llan Ioss÷a principIo llal is difficuIl lo dony, ospociaIIy
vlon vo aro laIIing aboul monoy.
AIllougl lloso doficioncios Iimil llo vaIuo of llo paybacI poriod as a looI for
invoslmonl ovaIualion, llo paybacI poriod las sovoraI posilivo foaluros. Iirsl, il doaIs
vill casl fIovs, as opposod lo accounling profils, and lloroforo focusos on llo lruo
liming of llo projocl's bonofils and cosls, ovon llougl il doos nol adjusl llo casl
700.10 CapiIal 8udgeIihg 168
CAßM ModuIe 700 Fihahce
TabIe 10.1 Payback Period Lxample
A ß
IhiIial cash ouIlay $10,000 $10,000
Ahhual !ree cash ih!lows
Year 1 $6,000 $5,000
2 4,000 5,000
3 3,000 0
4 2,000 0
5 1,000 0
fIovs for llo limo vaIuo of monoy. Socond, il is oasy lo visuaIizo, quicIIy undorslood,
and oasy lo caIcuIalo. Tlird, llo paybacI poriod may maIo sonso for llo capilaI-
conslrainod firm, llal is, llo firm llal noods funds and is laving probIoms raising
addilionaI invoslmonl funds. Tloso firms nood casl fIovs oarIy on lo aIIov llom lo
conlinuo in businoss and lo laIo advanlago of fuluro invoslmonls. IinaIIy, aIllougl
llo paybacI poriod las sorious doficioncios, il is oflon usod as a rougl scrooning
dovico lo oIiminalo projocls vloso rolurns do nol maloriaIizo unliI Ialor yoars. Tlis
mollod omplasizos llo oarIiosl rolurns, vlicl in aII IiIoIilood aro Ioss uncorlain, and
providos for llo Iiquidily noods of llo firm. AIllougl ils advanlagos aro corlainIy sig-
nificanl, ils disadvanlagos sovoroIy Iimil ils vaIuo as a discriminaling capilaI-budgoling
Net Present value
Tlo net µresent vaIue (NPV) of an invoslmonl proposaI is oquaI lo llo prcscni tc|uc c|
iis cnnuc| |rcc ccs| ||cus |css i|c intcsimcni´s iniiic| cui|cu. Tlo nol prosonl vaIuo can bo
oxprossod as foIIovs:
The linal lhree capilal-budgeling crileria all incorporale PrincipIe 2. The Time VaIue o!
Money-A DoIIar ßeceived Today Is Worth More than a DoIIar ßeceived in the future
in lheir calculalions. ll we are al all lo make ralional business decisions, we musl recognize
lhal money has a lime value. ln examining lhe lollowing lhree capilal-budgeling lechniques,
you will nolice lhal lhis principle is lhe driving lorce behind each ol lhem.
NPV prosonl vaIuo of aII llo fuluro annuaI froo casl fIovs llo iniliaI casl oulIay
|°, 1 yr
|°, 2 yr
|°, n yr
) |O (10-1)
vloro ICI
llo annuaI froo casl fIov in limo poriod i (llis can laIo on oillor
posilivo or nogalivo vaIuos)
| llo approprialo discounl ralo, llal is, llo roquirod ralo of rolurn or
cosl of capilaI
|O llo iniliaI casl oulIay
n llo projocl's oxpoclod Iifo
|°, n yr
llo prosonl vaIuo inlorosl faclor al |° and n yoars
Tlo projocl's NPV givos a moasuromonl of llo nol vaIuo of an invoslmonl proposaI
in lorms of loday's doIIars. Bocauso aII casl fIovs aro discounlod bacI lo llo prosonl,
comparing llo difforonco bolvoon llo prosonl vaIuo of llo annuaI casl fIovs and llo
invoslmonl oulIay doos nol vioIalo llo limo vaIuo of monoy assumplion. Tlo diffor-
onco bolvoon llo prosonl vaIuo of llo annuaI casl fIovs and llo iniliaI oulIay dolor-
minos llo nol vaIuo of accopling llo invoslmonl proposaI in lorms of loday's doIIars.
Wlonovor llo projocl's NPV is groalor llan or oquaI lo zoro, vo viII accopl llo projocl,
vlonovor llo NPV is nogalivo, vo viII rojocl llo projocl. If llo projocl's NPV is zoro,
llon il rolurns llo roquirod ralo of rolurn and slouId bo accoplod. Tlis accopl/rojocl
crilorion is iIIuslralod loro:
NPV 0.0: accopl
NPV 0.0: rojocl
Tlo foIIoving oxampIo iIIuslralos llo uso of NPV as a capilaI-budgoling crilorion.
700.10 CapiIal 8udgeIihg 169
CAßM ModuIe 700 Fihahce
Nolo in llo SIi-Doo oxampIo llal llo vorll of llo NPV caIcuIalion is a funclion of
llo accuracy of llo casl fIov prodiclions.
Tlo NPV crilorion is llo capilaI-budgoling docision looI vo find mosl favorabIo for
sovoraI roasons. Iirsl of aII, il doaIs vill froo casl fIovs rallor llan accounling profils.
In llis rogard il is sonsilivo lo llo lruo liming of llo bonofils rosuIling from llo projocl.
Moroovor, rocognizing llo limo vaIuo of monoy aIIovs comparison of llo bonofils and
cosls in a IogicaI mannor. IinaIIy, bocauso projocls aro accoplod onIy if a posilivo NPV
is associalod vill llom, llo accoplanco of a projocl using llis crilorion viII incroaso
llo vaIuo of llo firm, vlicl is consislonl vill llo goaI of maximizing llo slaroloId-
ors' voaIll.
Tlo disadvanlago of llo NPV mollod sloms from llo nood for dolaiIod, Iong-lorm
forocasls of froo casl fIovs accruing from llo projocl's accoplanco. Dospilo llis drav-
bacI, llo NPV is llo mosl lloorolicaIIy corrocl crilorion llal vo viII oxamino. Tlo foI-
Ioving oxampIo providos an addilionaI iIIuslralion of ils appIicalion.
700.10 CapiIal 8udgeIihg 170
CAßM ModuIe 700 Fihahce
Ski-Doo is considering new machinery lhal would reduce manulacluring cosls associaled wilh ils Mach Z snowmobile lor
which lhe lree cash llows are shown in TabIe 10.2. ll lhe lirm has a !2 percenl required rale ol relurn, lhe presenl value ol
lhe lree cash llow is S47,678, as calculaled in TabIe 10.3. Sublracling lhe S40,000 inilial oullay leaves an  ol S7,678.
8ecause lhis value is grealer lhan zero, lhe  crilerion indicales lhal lhe projecl should be accepled.
TabIe 10.2 NPV IllusIraIioh o! Ski-Doo's IhvesImehI ih New Machihery
free Cash fIov
IhiIial ouIlay $40,000
Ih!low year 1 15,000
Ih!low year 2 14,000
Ih!low year 3 13,000
Ih!low year 4 12,000
Ih!low year 5 11,000
TabIe 10.3 CalculaIioh !or NPV IllusIraIioh o! IhvesImehI ih New Machihery
Present VaIue Present
free Cash fIov factor at 12 Percent VaIue
Ih!low year 1 $15,000 .893 $13,395
Ih!low year 2 14,000 .797 11,158
Ih!low year 3 13,000 .712 9,256
Ih!low year 4 12,000 .636 7,632
Ih!low year 5 11,000 .567 6,237
PresehI value o! !ree cash !lows $47,678
IhiIial ouIlay 40,000
NeI presehI value $ 7,678
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
NPV $37,303 $30,000 $7,303
Profitability lndex (8enefit-Cost Ratio)
Tlo µrnIitabiIitv index (PI), or beneIit÷cnst ratin, is llo rciic c| i|c prcscni tc|uc c| i|c
|uiurc |rcc ccs| ||cus ic i|c iniiic| cui|cu. AIllougl llo NPV invoslmonl crilorion givos a
moasuro of llo absoIulo doIIar dosirabiIily of a projocl, llo profilabiIily indox providos
a roIalivo moasuro of an invoslmonl proposaI's dosirabiIily÷llal is, llo ralio of llo
prosonl vaIuo of ils fuluro nol bonofils lo ils iniliaI cosl. Tlo profilabiIily indox can bo
oxprossod as foIIovs:
(10-2) P| =
prosonl vaIuo of
aII llo fuluro annuaI
frooo casl fIovs
iniliaI casl oulIay
| 1 °°, 1 yr °, 2 yr °,
) ( ) (    ICI PV|I ICI PV|I
| n | 2

700.10 CapiIal 8udgeIihg 171
CAßM ModuIe 700 Fihahce
A lirm is considering lhe purchase ol a new compuler syslem, which will cosl S30,000 inilially, lo aid in credil billing and
invenlory managemenl. The lree cash llows resulling lrom lhis projecl are provided in TabIe 10.4. The required rale ol
relurn demanded by lhe lirm is !0 percenl. To delermine lhe syslem's , lhe 3-year S!5,000 cash llow annuily is lirsl
discounled back lo lhe presenl al !0 percenl. lrom lhe presenl value lable, we lind lhal 
!0', 3 yr
is 2.487. Thus, lhe
presenl value ol lhis S!5,000 annuily is S37,305.
Seeing lhal lhe cash inllows have been discounled back lo lhe presenl, lhey can now be compared wilh lhe inilial oullay
because bolh ol lhe llows are now slaled in lerms ol loday's dollars. Sublracling lhe inilial oullay (S30,000) lrom lhe pres-
enl value ol lhe cash inllows (S37,305), we lind lhal lhe syslem's  is S7,305. 8ecause lhe  on lhis projecl is posi-
live, lhe projecl should be accepled.
TabIe 10.4 NPV Lxample Problem o! CompuIer SysIem
free Cash fIov
IhiIial ouIlay $30,000
Ih!low year 1 15,000
Ih!low year 2 15,000
Ih!low year 3 15,000
vloro ICI
llo annuaI froo casl fIov in limo poriod i (llis can laIo on oillor
posilivo or nogalivo vaIuos)
| llo approprialo discounl ralo, llal is, llo roquirod ralo of rolurn or
cosl of capilaI
|O llo iniliaI casl oulIay
n llo projocl's oxpoclod Iifo
|°, n yr
llo prosonl vaIuo inlorosl faclor al |° and n yoars
Tlo docision crilorion is accopl llo projocl if llo P| is groalor llan or oquaI lo 1.00
and rojocl llo projocl if llo P| is Ioss llan 1.00.
P| 1.0: accopl
P| 1.0: rojocl
IooIing cIosoIy al llis crilorion, vo soo llal il yioIds llo samo accopl/rojocl doci-
sion as llo NPV crilorion. Wlonovor llo prosonl vaIuo of llo projocl's froo casl fIovs
is groalor llan ils iniliaI casl oulIay, llo projocl's NPV viII bo posilivo, signaIing a
docision lo accopl. Wlon llis is lruo, llon llo projocl's P| viII aIso bo groalor llan 1
bocauso llo prosonl vaIuo of llo froo casl fIovs (llo P|'s numoralor) is groalor llan ils
iniliaI oulIay (llo P|'s donominalor). Tlus, lloso lvo docision criloria viII aIvays yioId
llo samo docision, aIllougl lloy viII nol nocossariIy ranI accoplabIo projocls in llo
samo ordor. Tlis probIom of confIicling ranIing is doaIl vill al a Ialor poinl.
Bocauso llo NPV and P| criloria aro ossonliaIIy llo samo, lloy lavo llo samo
advanlagos ovor llo ollor criloria oxaminod. Boll ompIoy froo casl fIovs, rocognizo
llo liming of llo casl fIovs, and aro consislonl vill llo goaI of maximizalion of slaro-
loIdors' voaIll. Tlo major disadvanlago of llo P| crilorion, simiIar lo llo NPV crilo-
rion, is llal il roquiros Iong, dolaiIod froo casl fIov forocasls.
lnternal Rate of Return
Tlo internaI rate nI return (IRR) allompls lo ansvor llo quoslion, vlal ralo of rolurn
doos llis projocl oarn` Ior compulalionaI purposos, llo inlornaI ralo of rolurn is
dofinod as i|c !isccuni rcic i|ci c¡ucics i|c prcscni tc|uc c| i|c prcjcci´s |rcc ccs| ||cus uii|
i|c prcjcci´s iniiic| ccs| cui|cu. MallomalicaIIy, llo inlornaI ralo of rolurn is dofinod as
llo vaIuo |RR in llo foIIoving oqualion:
|RR llo ralo of rolurn llal oqualos llo prosonl vaIuo of llo projocl's froo casl
fIovs vill llo iniliaI oulIay
|RR°, 1 yr
|RR°, 2 yr
|RR°, n yr
) (10-3)
vloro ICI
llo annuaI froo casl fIov in limo poriod i (llis can laIo on oillor
posilivo or nogalivo vaIuos)
|O llo iniliaI casl oulIay
n llo projocl's oxpoclod Iifo
|RR llo projocl's inlornaI ralo of rolurn
|°, n yr
llo prosonl vaIuo inlorosl faclor al |° and n yoars
700.10 CapiIal 8udgeIihg 172
CAßM ModuIe 700 Fihahce
A lirm wilh a !0 percenl required rale ol relurn is considering invesling in a new machine wilh an expecled lile ol 6 years. The
lree cash llows resulling lrom lhis inveslmenl are given in TabIe 10.5. Discounling lhe projecl's lulure nel lree cash llows
back lo lhe presenl yields a presenl value ol S53,667, dividing lhis value by lhe inilial oullay ol S50,000 gives a prolilabilily
index ol !.0733, as shown in TabIe 10.6. This lells us lhal lhe presenl value ol lhe lulure benelils accruing lrom lhis projecl is
!.0733 limes lhe level ol lhe inilial oullay. 8ecause lhe prolilabilily index is grealer lhan !.0, lhe projecl should be accepled.
In offocl, llo |RR is anaIogous lo llo concopl of llo yioId lo malurily for bonds. In
ollor vords, a projocl's |RR is simpIy llo ralo of rolurn llal llo projocl oarns.
Tlo docision crilorion is lo accopl llo projocl if llo |RR is groalor llan or oquaI lo
llo roquirod ralo of rolurn. Wo rojocl llo projocl if ils |RR is Ioss llan llo roquirod ralo
of rolurn. Tlis accopl/rojocl crilorion can bo slalod as
|RR roquirod ralo of rolurn: accopl
|RR roquirod ralo of rolurn: rojocl
If llo |RR on a projocl is oquaI lo llo slaroloIdors' roquirod ralo of rolurn, llon llo
projocl slouId bo accoplod bocauso llo firm is oarning llo ralo llal ils slaroloIdors aro
roquiring. Hovovor, llo accoplanco of a projocl vill an |RR boIov llo invoslors'
roquirod ralo of rolurn viII docroaso llo firm's slocI prico.
If llo NPV is posilivo, llon llo |RR musl bo groalor llan llo roquirod ralo of
rolurn, |. Tlus, aII llo discounlod casl fIov criloria aro consislonl and viII givo simiIar
accopl/rojocl docisions. Ono ollor disadvanlago of llo |RR roIalivo lo llo NPV doaIs
vill llo impIiod roinvoslmonl ralo assumplions mado by lloso lvo mollods. Tlo NPV
assumos llal casl fIovs ovor llo Iifo of llo projocl aro roinvoslod bacI in projocls llal
oarn llo roquirod ralo of rolurn. Tlal is, if vo lavo a mining projocl vill a 10-yoar
oxpoclod Iifo llal producos a $100,000 casl fIov al llo ond of llo socond yoar, llo NPV
loclniquo assumos llal llis $100,000 is roinvoslod ovor yoars 3 llougl 10 al llo
roquirod ralo of rolurn. Tlo uso of llo |RR, lovovor, impIios llal casl fIovs ovor llo
700.10 CapiIal 8udgeIihg 173
CAßM ModuIe 700 Fihahce
TabIe 10.5 Pl IllusIraIioh o! IhvesImehI ih New Machihery
free Cash fIov
IhiIial ouIlay $50,000
Ih!low year 1 15,000
Ih!low year 2 8,000
Ih!low year 3 10,000
Ih!low year 4 12,000
Ih!low year 5 14,000
Ih!low year 6 16,000
TabIe 10.6 CalculaIioh !or Pl IllusIraIioh o! IhvesImehI ih New Machihery
Present VaIue
free factor at Present
Cash fIov 10 Percent VaIue
IhiIial ouIlay $50,000 1.000 $50,000
Ih!low year 1 15,000 0.909 13,635
Ih!low year 2 8,000 0.826 6,608
Ih!low year 3 10,000 0.751 7,510
Ih!low year 4 12,000 0.683 8,196
Ih!low year 5 14,000 0.621 8,694
Ih!low year 6 16,000 0.564 9,024
k k n
1 2
( ) ( )
%, 1yr %, 2 yr
  

$ $ $ $
%, yr
k n
, , ,
13 635 6 608 7 510 8    ,, , ,
196 8 694 9 024
50 000
53 667
50 00
  $ $
1 0733 . =
Iifo of llo projocl can bo roinvoslod al llo |RR. Tlus, if llo mining projocl vo jusl
IooIod al las a 40 porconl |RR, llo uso of llo |RR impIios llal llo $100,000 casl fIov
llal is rocoivod al llo ond of yoar 2 couId bo roinvoslod al 40 porconl ovor llo romain-
ing Iifo of llo projocl. In offocl, i|c NPV mci|c! imp|icii|u cssumcs i|ci ccs| ||cus ctcr i|c
|i|c c| i|c prcjcci ccn |c rcintcsic! ci i|c prcjcci´s rc¡uirc! rcic c| rciurn, u|crccs i|c usc c| i|c
|RR mci|c! imp|ics i|ci i|csc ccs| ||cus ccu|! |c rcintcsic! ci i|c |RR. Tlo bollor assump-
lion is llo ono mado by llo NPV, llal casl fIovs couId bo roinvoslod al llo roquirod
ralo of rolurn, bocauso casl fIovs couId oillor bo (1) rolurnod in llo form of dividonds
lo slaroloIdors vlo domand llo roquirod ralo of rolurn on lloir invoslmonls, or
(2) roinvoslod in a nov invoslmonl projocl. If lloso casl fIovs aro invoslod in a nov
projocl, llon lloy aro simpIy subsliluling for oxlornaI funding on vlicl llo roquirod
ralo of rolurn is domandod. Tlus, llo opporlunily cosl of lloso funds is llo roquirod
ralo of rolurn. Tlo bollom Iino lo aII llis is llal llo NPV mollod maIos llo bosl roin-
voslmonl ralo assumplion, and, as sucl, is suporior lo llo |RR mollod. Wly slouId vo
caro vlicl mollod is usod if boll mollods givo simiIar accopl/rojocl docisions` Tlo
ansvor, as vo viII soo, is llal aIllougl lloy may givo llo samo accopl/rojocl docision,
lloy may ranI projocls difforonlIy in lorms of dosirabiIily.
Computing the lRR !or Even Cash fIovs Using the TVM TabIes
In llis soclion vo aro going lo pul our caIcuIalors asido and oblain a bollor undor-
slanding of llo |RR by oxamining llo mallomalicaI procoss of caIcuIaling inlornaI
ralos of rolurn.
Tlo caIcuIalion of a projocl's |RR can bo oillor vory simpIo or roIalivoIy compIi-
calod. As an oxampIo of a slraigllforvard soIulion, assumo llal a firm vill a roquirod
ralo of rolurn of 10 porconl is considoring a projocl llal invoIvos an iniliaI oulIay of
$45,555. If llo invoslmonl is laIon, llo froo casl fIovs aro oxpoclod lo bo $15,000 por
annum ovor llo projocl's 4-yoar Iifo. In llis caso, llo inlornaI ralo of rolurn is oquaI lo
|RR in llo foIIoving oqualion:
Irom our discussion of llo prosonl vaIuo of an annuily, vo Inov llal llis oqua-
lion can bo roducod lo
$45,555 $15,000 (PV|IA
i, 4 yr
vlicl can bo soIvod using vaIuos for llo PV|IA
i, n
for various combinalions of i and n.
Dividing boll sidos by $15,000, llis bocomos
3.037 PV|IA
i, 4 yr
Honco, vo aro IooIing for PV|IA
i, 4 yr
of 3.037 in llo 4-yoar rov of llo prosonl
vaIuo labIos. Tlis vaIuo occurs vlon i oquaIs 12 porconl, vlicl moans llal 12 porconl
is llo |RR for llo invoslmonl. Tloroforo, bocauso 12 porconl is groalor llan llo 10 por-
conl roquirod rolurn, llo projocl slouId bo accoplod.
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
12.01 I/Y
( )
( )
45 555
15 000
15 000
1 2
, ,

,, , 000
15 000
3 4
( )
( ) 

 |RR |RR
700.10 CapiIal 8udgeIihg 174
CAßM ModuIe 700 Fihahce
Computing the lRR !or Uneven Cash fIovs
UnforlunaloIy, aIllougl soIving for llo |RR is quilo oasy vlon using a financiaI caI-
cuIalor or sproadslool, il can bo soIvod diroclIy in llo labIos onIy vlon llo fuluro
froo casl fIovs aro in llo form of an annuily or a singIo paymonl. Will a caIcuIalor
llo procoss is simpIo: Ono nood onIy Ioy in llo iniliaI casl oulIay, llo casl fIovs,
and lloir liming, and pross llo ¨IRR¨ bullon. Iol's laIo a IooI al lov you migll
soIvo a probIom vill unovon casl fIovs using a financiaI caIcuIalor. Ivory caIcuIalor
vorIs a bil difforonlIy, so you'II vanl lo bo famiIiar vill lov lo inpul dala inlo
yours, bul llal boing said, lloy aII vorI ossonliaIIy llo samo vay. As you'd oxpocl,
you viII onlor aII llo casl fIovs, llon soIvo for llo projocl's |RR. Will a Toxas
Inslrumonls BA II IIus caIcuIalor, CIo indicalos llo iniliaI oulIay, vlicl you'II vanl
lo givo a nogalivo vaIuo, C01 is llo firsl froo casl fIov, and I01 is llo numbor of
yoars llal llo firsl froo casl fIov appoars. Tlus, if llo froo casl fIovs in yoars 1, 2,
and 3 aro aII $1,000, llon I01 3. C02 llon bocomos llo socond froo casl fIov, and
I02 is llo numbor of yoars llal llo socond froo casl fIov appoars. You'II nolico llal
you movo bolvoon llo difforonl casl fIovs using llo dovn arrov ( ) Iocalod on llo
lop rov of your caIcuIalor. Onco you lavo inpullod llo iniliaI oulIay and aII llo froo
casl fIovs you llon caIcuIalo llo projocl's |RR by lilling llo ¨IRR¨ bullon foIIovod
by ¨CIT,¨ llo compulo bullon. Iol's IooI al a quicI oxampIo. Considor llo foIIoving
invoslmonl proposaI:
IniliaI OulIay $5,000
ICI in yoar 1 2,000
ICI in yoar 2 2,000
ICI in yoar 3 3,000
CaIcuIator 5oIution
(Using a Texas Instruments ßA II PIus).
Data and Key Input DispIay
, 5,000, CIo 5,000.00
, 2,000, C01 2,000.00
, 2, I01 2.00
, 3,000, C02 3,000.00
, 1, I02 1.00
, IRR 17.50°
Tlus, llo |RR on llis projocl is 17.50 porconl. Wlon a financiaI caIcuIalor is nol avaiI-
abIo and lloso fIovs aro in llo form of an unovon sorios of fIovs, a lriaI-and-orror
approacl is nocossary. To do llis, vo firsl dolormino llo prosonl vaIuo of llo fuluro
froo casl fIovs using an arbilrary discounl ralo. If llo prosonl vaIuo of llo fuluro casl
fIovs al llis discounl ralo is Iargor llan llo iniliaI oulIay, llo ralo is incroasod, if il is
smaIIor llan llo iniliaI oulIay, llo discounl ralo is Iovorod and llo procoss bogins
again. Tlis soarcl roulino is conlinuod unliI llo prosonl vaIuo of llo fuluro froo casl
fIovs is oquaI lo llo iniliaI oulIay. In offocl, sinco llo prosonl vaIuo of llo froo casl
infIovs is oquaI lo llo iniliaI oulIay, llo NPV musl oquaI zoro al llis poinl. Tlo inlor-
osl ralo llal croalos llis silualion is llo |RR. Tlis is llo samo basic procoss llal a finan-
ciaI caIcuIalor usos lo caIcuIalo an |RR.
700.10 CapiIal 8udgeIihg 175
CAßM ModuIe 700 Fihahce
viewing the NPV-Ißß Relationship: The Net Present value Profile
Iorlaps llo oasiosl vay lo undorsland llo roIalionslip bolvoon llo |RR and llo NPV
vaIuo is lo viov il graplicaIIy llrougl llo uso of a net µresent vaIue µrnIiIe. A nol
prosonl vaIuo profiIo is simpIy c vrcp| s|cuinv |cu c prcjcci´s NPV c|cnvcs cs i|c !is-
ccuni rcic c|cnvcs. To grapl a projocl's nol prosonl vaIuo profiIo, you simpIy nood lo
dolormino llo projocl's NPV, firsl using a 0 porconl discounl ralo, llon sIovIy incroas-
ing llo discounl ralo unliI a roprosonlalivo curvo las boon pIollod. Hov doos llo |RR
700.10 CapiIal 8udgeIihg 176
CAßM ModuIe 700 Fihahce
Consider lhe lollowing inveslmenl proposal.
lnilial Oullay S!0,0!0
 in year ! !,000
 in year 2 3,000
 in year 3 6,000
 in year 4 7,000
CaIcuIator 5oIution
(Using a Texas Instruments ßA II PIus)
Data and Key Input DispIay
, 10,010, CI0 10,010.00
, 1,000, C01 1,000.00
, 1, I01 1.00
, 3,000, C02 3,000.00
, 1, I02 1.00
, 6,000, C03 6,000.00
, 1, I03 1.00
, 7,000, C04 7,000.00
, 1, I04 1.00
, IRR 19.00°
Try dillerenl discounl rales. The one lhal makes lhe presenl value ol lhe lree cash inllows equal lo lhe inilial oullay (i.e.,
makes lhe  equal lo zero) is lhe .
Discount ßate Guesses NPv
15% $1,075
20% $ 245
19% $ 0
Thus, !9 percenl is lhe projecl's .
onlor inlo llo nol prosonl vaIuo profiIo` Tlo |RR is llo discounl ralo al vlicl llo NPV
is zoro.
Iol's IooI al an oxampIo of a projocl llal invoIvos an aflor-lax iniliaI oulIay of
$105,517 vill froo casl fIovs oxpoclod lo bo $30,000 por yoar ovor llo projocl's 5-yoar
Iifo. CaIcuIaling llo NPV of llis projocl al sovoraI difforonl discounl ralos rosuIls in llo
Discount ßate Project's NPv
0% $44,483
5% $24,367
10% $28,207
13% $28,200
15% $24,952
20% $15,798
25% $24,839
IIolling lloso vaIuos yioIds llo nol prosonl vaIuo profiIo in Figure 10.1.
Wloro is llo |RR in llis figuro` RocaII llal llo |RR is llo discounl ralo llal oqualos
llo prosonl vaIuo of llo infIovs vill llo prosonl vaIuo of llo oulfIovs, llus, llo |RR is
llo poinl al vlicl llo NPV is oquaI lo zoro÷in llis caso, 13 porconl. Tlis is oxaclIy llo
procoss llal vo uso in compuling llo |RR for a sorios of unovon casl fIovs÷vo sim-
pIy caIcuIalo llo projocl's NPV using difforonl discounl ralos and llo discounl ralo llal
maIos llo NPV oquaI lo zoro is llo projocl's |RR.
Irom llo nol prosonl vaIuo profiIo you can oasiIy soo lov a projocl's NPV varios
invorsoIy vill llo discounl ralo÷as llo discounl ralo is raisod, llo NPV drops. By
anaIyzing a projocl's nol prosonl vaIuo profiIo, you can aIso soo lov sonsilivo llo proj-
ocl is lo your soIoclion of llo discounl ralo. Tlo moro sonsilivo llo NPV is lo llo dis-
counl ralo, llo moro imporlanl il is llal you uso llo corrocl ono in your caIcuIalions.
700.10 CapiIal 8udgeIihg 177
CAßM ModuIe 700 Fihahce
ßiscount rate
2S% 20%
10% S%
lRR = 13%
NPV < 0
NPV > 0
figure 10.1 NeI PresehI Value Pro!ile
700.10.2 De!ine the concept o! capitaI rationing
and discuss the probIems encountered in ranking
investment projects
Tlo uso of our capilaI-budgoling docision ruIos dovoIopod in llis soclion impIios llal
llo sizo of llo capilaI budgol is dolorminod by llo avaiIabiIily of accoplabIo invosl-
monl proposaIs. Hovovor, a firm may p|ccc c |imii cn i|c !c||cr sizc c| i|c ccpiic| |u!vci.
Tlis silualion is caIIod caµitaI ratinning. As vo viII soo, an oxaminalion of capilaI
ralioning nol onIy bollor onabIos us lo doaI vill compIoxilios of llo roaI vorId bul aIso
sorvos lo domonslralo llo suporiorily of llo NPV mollod ovor llo |RR mollod for cap-
ilaI budgoling.
Using llo |RR as llo firm's docision ruIo, a firm accopls aII projocls vill an |RR
groalor llan llo firm's roquirod ralo of rolurn. Tlis ruIo is iIIuslralod in Figure 10.2,
vloro projocls A llrougl I vouId bo closon. Hovovor, vlon capilaI ralioning is
imposod, llo doIIar sizo of llo lolaI invoslmonl is Iimilod by llo budgol conslrainl. In
Iiguro 10.2, llo budgol conslrainl of $X procIudos llo accoplanco of an allraclivo
invoslmonl, projocl I. Tlis silualion obviousIy conlradicls prior docision ruIos. Moro-
ovor, llo soIulion of cloosing llo projocls vill llo liglosl |RR is compIicalod by llo
facl llal somo projocls may bo indivisibIo, for oxampIo, il is moaningIoss lo rocom-
mond llal laIf of projocl D bo acquirod.
Rationale for Capital Rationing
Wo firsl asI vly capilaI ralioning oxisls and vlollor il is ralionaI. In gonoraI, llroo
principaI roasons aro givon for imposing a capilaI-ralioning conslrainl. Iirsl, manago-
monl may llinI marIol condilions aro lomporariIy advorso. In llo poriod surrounding
llo dovnlurn in llo oconomy in llo oarIy 2000s, llis roason vas froquonlIy givon. Al
llal limo slocI pricos voro doprossod, vlicl mado llo cosl of funding projocls ligl.
Socond, lloro may bo a slorlago of quaIifiod managors lo dirocl nov projocls, llis can
lappon vlon projocls aro of a liglIy loclnicaI naluro. Tlird, lloro may bo inlangibIo
considoralions. Ior oxampIo, managomonl may simpIy foar dobl, visling lo avoid
inlorosl paymonls al any cosl. Or porlaps issuanco of common slocI may bo Iimilod lo
mainlain a slabIo dividond poIicy.
Dospilo slrong ovidonco llal capilaI ralioning oxisls in praclico, llo quoslion romains
as lo ils offocl on llo firm. In briof, llo offocl is nogalivo, and lo vlal dogroo doponds on
llo sovorily of llo ralioning. If llo ralioning is minor and slorl-Iivod, llo firm's slaro
prico viII nol suffor lo any groal oxlonl. In llis caso, capilaI ralioning can probabIy bo
oxcusod, aIllougl il slouId bo nolod llal any capilaI ralioning llal rojocls projocls vill
posilivo NPVs is conlrary lo llo firm's goaI of maximizalion of slaroloIdors' voaIll. If
llo capilaI ralioning is a rosuIl of llo firm's docision lo Iimil dramalicaIIy llo numbor of
700.10 CapiIal 8udgeIihg 178
CAßM ModuIe 700 Fihahce
$X 0ollars
0ollar budgel couslraiul
(culoíí crileriou uuder capilal raliouiugì
Required rale oí reluru
(culoíí crileriou wilhoul
capilal raliouiugì
figure 10.2 ProiecIs Rahked by lRR
nov projocls or lo Iimil lolaI invoslmonl lo inlornaIIy gonoralod funds, llon llis poIicy
viII ovonluaIIy lavo a significanlIy nogalivo offocl on llo firm's slaro prico. Ior oxam-
pIo, a Iovor slaro prico viII ovonluaIIy rosuIl from Iosl compolilivo advanlago if,
bocauso of a docision lo arbilrariIy Iimil ils capilaI budgol, a firm faiIs lo upgrado ils
producls and manufacluring procossos.
Capital Rationing and Project Selection
If a firm docidos lo imposo a capilaI conslrainl on invoslmonl projocls, llo approprialo
docision crilorion is lo soIocl llo sol of projocls vill llo liglosl NPV subjocl lo llo cap-
ilaI conslrainl. In offocl, vo aro soIocling llo projocls llal incroaso slaroloIdors' voaIll
llo mosl, bocauso llo NPV is llo amounl of voaIll llal is croalod vlon a projocl is
accoplod. Tlis guidoIino may procIudo moroIy laIing llo liglosl-ranIod projocls in
lorms of llo P| or llo |RR. If llo projocls slovn in Iiguro 10.2 aro divisibIo, llo Iasl
projocl accoplod may bo onIy parliaIIy accoplod. AIllougl parliaI accoplanco may bo
possibIo in somo casos, llo indivisibiIily of mosl capilaI invoslmonls provonls il. If a
projocl is a saIos oulIol or a lrucI, il may bo moaningIoss lo purclaso laIf a saIos oulIol
or laIf a lrucI.
To iIIuslralo llis procoduro, considor a firm vill a budgol conslrainl of $1 miI-
Iion and fivo indivisibIo projocls avaiIabIo lo il, as givon in TabIe 10.7. If llo liglosl-
ranIod projocls voro laIon, projocls A and B vouId bo laIon firsl. Al llal poinl lloro
vouId nol bo onougl funds avaiIabIo lo laIo projocl C, lonco, projocls D and I
vouId bo laIon. Hovovor, a liglor lolaI NPV is providod by llo combinalion of
projocls A and C. Tlus, projocls A and C slouId bo soIoclod from llo sol of projocls
avaiIabIo. Tlis iIIuslralos our guidoIino: lo soIocl llo sol of projocls llal maximizos
llo firm's NPV.
Project Ranking
In llo pasl, vo lavo proposod llal aII projocls vill a posilivo NPV, a P| groalor llan
1.0, or an |RR groalor llan llo roquirod ralo of rolurn bo accoplod, assuming lloro is no
capilaI ralioning. Hovovor, llis accoplanco is nol aIvays possibIo. In somo casos,
vlon lvo projocls aro judgod accoplabIo by llo discounlod casl fIov criloria, il may
bo nocossary lo soIocl onIy ono of llom bocauso lloy aro muluaIIy oxcIusivo. MutuaIIv
excIusive µrnjects occur vlon a sci c| intcsimcni prcpcsc|s pcr|crm csscniic||u i|c scmc
ics|, ccccpicncc c| cnc ui|| ncccsscri|u mccn rcjcciicn c| i|c ci|crs. Ior oxampIo, a company
considoring llo inslaIIalion of a compulor syslom may ovaIualo llroo or four sysloms,
aII of vlicl may lavo posilivo NPVs, lovovor, llo accoplanco of ono syslom aulomal-
icaIIy moans rojoclion of llo ollors. In gonoraI, lo doaI vill muluaIIy oxcIusivo proj-
ocls, vo simpIy ranI llom by moans of llo discounlod casl fIov criloria and soIocl llo
projocl vill llo liglosl ranIing. On occasion, lovovor, probIoms of confIicling ranI-
ing may ariso. As vo viII soo, in gonoraI llo NPV mollod is llo proforrod docision-
maIing looI bocauso il Ioads lo llo soIoclion of llo projocl llal incroasos slaroloIdor
voaIll llo mosl.
700.10 CapiIal 8udgeIihg 179
CAßM ModuIe 700 Fihahce
TabIe 10.7 CapiIal-RaIiohihg Lxample o! Five Ihdivisible ProiecIs
Pro!itabiIity Net Present
Project InitiaI OutIay Index VaIue
A $200,000 2.4 $280,000
8 200,000 2.3 260,000
C 800,000 1.7 560,000
D 300,000 1.3 90,000
L 300,000 1.2 60,000
Tloro aro llroo gonoraI lypos of ranIing probIoms: llo sizo disparily probIom, llo limo dis-
parily probIom, and llo unoquaI Iivos probIom. Iacl invoIvos llo possibiIily of confIicl in
llo ranIs yioIdod by llo various discounlod casl fIov capilaI-budgoling criloria. As nolod
proviousIy, vlon ono discounlod casl fIov crilorion givos an accopl signaI, lloy viII aII
givo an accopl signaI, bul lloy viII nol nocossariIy ranI aII projocls in llo samo ordor. In
mosl casos llis disparily is nol crilicaI, lovovor, for muluaIIy oxcIusivo projocls llo ranI-
ing ordor is imporlanl.
Size Disparity
Tlo sizo disparily probIom occurs vlon muluaIIy oxcIusivo projocls of unoquaI sizo
aro oxaminod. Tlis probIom is mosl oasiIy cIarifiod vill an oxampIo.
In summary, vlonovor llo sizo disparily probIom rosuIls in confIicling ranIings
bolvoon muluaIIy oxcIusivo projocls, llo projocl vill llo Iargosl NPV viII bo soIoclod,
providod lloro is no capilaI ralioning. Wlon capilaI ralioning oxisls, llo firm slouId
soIocl llo sol of projocls vill llo Iargosl NPV.
700.10 CapiIal 8udgeIihg 180
CAßM ModuIe 700 Fihahce
Suppose a lirm is considering lwo mulually exclusive projecls, A and 8, bolh have required rales ol relurn ol !0 percenl.
Projecl A involves a S200 inilial oullay and a cash inllow ol S300 al lhe end ol ! year, whereas projecl 8 involves an inilial
oullay ol S!,500 and a cash inllow ol S!,900 al lhe end ol ! year. The nel presenl values, prolilabilily indexes, and inlernal
rales ol relurn lor lhese projecls are given in TabIe 10.8.
ln lhis case, il lhe  crilerion is used, projecl 8 should be accepled, whereas il lhe  or  crilerion is used, projecl A
should be chosen. The queslion now becomes, which projecl is beller? The answer depends on whelher capilal ralioning
exisls. Wilhoul capilal ralioning, projecl 8 is beller because il provides lhe largesl increase in shareholders' weallh, lhal is,
il has a larger . ll lhere is a capilal conslrainl, lhe problem lhen locuses on whal can be done wilh lhe addilional
S!,300 lhal is lreed il projecl A is chosen (cosling S200, as opposed lo S!,500). ll lhe lirm can earn more on projecl A plus
lhe projecl linanced wilh lhe addilional S!,300 lhan il can on projecl 8, lhen projecl A and lhe marginal projecl should be
accepled. ln ellecl, we are allempling lo selecl lhe sel ol projecls lhal maximizes lhe lirm's . Thus, il lhe marginal proj-
ecl has an  grealer lhan S!54.40 (S227.!0 S72.70), selecling il plus projecl A wilh an  ol S72.70 will provide an
 grealer lhan S227.!0, lhe  lor projecl 8.
TabIe 10.8 Size DispariIy Rahkihg Problem
F80J £0 I k F80J£ 0 I 8
linflowì S800 linflowì S1,000
1 vear 1 vear
S200 loulflowì S1,600 loulflowì
 S72.70  S227.10
 1.8ß  1.16
 60%  27%
Time Disparity
Tlo limo disparily probIom and llo confIicling ranIings llal accompany il rosuIl from
llo difforing roinvoslmonl assumplions mado by llo nol prosonl vaIuo and inlornaI ralo
of rolurn docision criloria. Tlo NPV crilorion assumos llal casl fIovs ovor llo Iifo of llo
projocl can bo roinvoslod al llo roquirod ralo of rolurn or cosl of capilaI, vloroas llo |RR
crilorion impIicilIy assumos llal llo casl fIovs ovor llo Iifo of llo projocl can bo roin-
voslod al llo |RR. Again, llis probIom may bo iIIuslralod llrougl llo uso of an oxampIo.
Unequal Lives
Tlo finaI ranIing probIom lo bo oxaminod conlors on llo quoslion of vlollor il is
approprialo lo comparo muluaIIy oxcIusivo projocls vill difforonl Iifo spans.
Tloro aro sovoraI mollods lo doaI vill llis silualion. Tlo firsl oplion is lo assumo
llal llo casl infIovs from llo slorlor-Iivod invoslmonl viII bo roinvoslod al llo roquirod
ralo of rolurn unliI llo lorminalion of llo Iongor-Iivod assol. AIllougl llis approacl is llo
simpIosl, moroIy caIcuIaling llo NPV, il acluaIIy ignoros llo probIom al land÷llal of
aIIoving for parlicipalion in anollor ropIacomonl opporlunily vill a posilivo NPV. Tlo
propor soIulion, llus, bocomos llo projoclion of roinvoslmonl opporlunilios inlo llo
fuluro÷llal is, maIing assumplions aboul possibIo fuluro invoslmonl opporlunilios.
UnforlunaloIy, vloroas llo firsl mollod is loo simpIislic lo bo of any vaIuo, llo socond is
oxlromoIy difficuIl, roquiring oxlonsivo casl fIov forocasls. Tlo finaI loclniquo for con-
fronling llo probIom is lo assumo llal roinvoslmonl opporlunilios in llo fuluro viII bo
simiIar lo llo curronl onos. Tlo lvo mosl common vays of doing llis aro by croaling a
ropIacomonl clain lo oquaIizo Iifo spans or by caIcuIaling llo projocl's equivaIent annuaI
annuitv (EAA). A projocl's |AA is simpIy an cnnuiiu ccs| ||cu i|ci uic|!s i|c scmc prcs-
cni tc|uc cs i|c prcjcci´s NPV.
700.10 CapiIal 8udgeIihg 181
CAßM ModuIe 700 Fihahce
Suppose a lirm wilh a required rale ol relurn or cosl ol capilal ol !0 percenl and wilh no capilal conslrainl is considering
lhe lwo mulually exclusive projecls illuslraled in TabIe 10.9. The  and  indicale lhal projecl A is lhe beller ol lhe lwo,
whereas lhe  indicales lhal projecl 8 is lhe beller. Projecl 8 receives ils cash llows earlier lhan projecl A, and lhe diller-
enl assumplions made aboul how lhese llows can be reinvesled resull in lhe dillerence in rankings. Which crilerion would
be lollowed depends on which reinveslmenl assumplion is used. The  crilerion is prelerred in lhis case because il
makes lhe mosl acceplable assumplion lor lhe weallh-maximizing lirm. ll is cerlainly lhe mosl conservalive assumplion
lhal can be made, because lhe required rale ol relurn is lhe lowesl possible reinveslmenl rale. Moreover, as we have
already noled, lhe  melhod maximizes lhe value ol lhe lirm and lhe shareholders' weallh.
TabIe 10.9 1ime DispariIy Rahkihg Problem
F80J £0 I k F80J £0 I 8
S100 S200 S2,000 Sß60 Sß60 Sß60
1 2 8 vears 1 2 8 vears
S1,000 S1,000
 S768.10  Sß1ß.66
 1.768  1.ß17
 86%  48%
700.10.3 Understand the guideIines !or capitaI
budgeting and !or measuring the cash !Iovs and Iearn
hov to caIcuIate a project's !ree cash !Iovs
To ovaIualo invoslmonl proposaIs, vo musl firsl sol guidoIinos by vlicl vo moasuro
llo vaIuo of oacl proposaI. In offocl, vo aro dociding vlal is and vlal isn'l a roIovanl
casl fIov.
Use Iree Cash Ilows Rather Than Accounting Profits
Wo uso froo casl fIovs, nol accounling profils, as our moasuromonl looI. Tlo firm rocoivos
and is abIo lo roinvosl froo casl fIovs, vloroas accounling profils aro slovn vlon lloy
aro oarnod rallor llan vlon llo monoy is acluaIIy in land. UnforlunaloIy, a firm's
accounling profils and froo casl fIovs may nol bo limod lo occur logollor. Ior oxampIo,
capilaI oxponsos, sucl as volicIos and pIanl and oquipmonl, aro doprocialod ovor sovoraI
yoars, vill lloir annuaI doprocialion sublraclod from profils. Iroo casl fIovs corroclIy
rofIocl llo liming of bonofils and cosls÷ llal is, vlon llo monoy is rocoivod, vlon il can
bo roinvoslod, and vlon il musl bo paid oul.
ll we are lo make inlelligenl capilal-budgeling decisions, we musl accuralely measure lhe
liming ol lhe benelils and cosls, lhal is, when we receive money and when il leaves our
hands. PrincipIe 3. Cash-Not Pro!its-Is King speaks direclly lo lhis. Pemember, il is cash
inllows lhal can be reinvesled and cash oulllows lhal involve paying oul money.
Think lncrementally
UnforlunaloIy, caIcuIaling froo casl fIovs from a projocl may nol bo onougl. Docision
maIors musl asI, W|ci ncu |rcc ccs| ||cus ui|| i|c ccmpcnu cs c u|c|c rcccitc i| i|c ccmpcnu
ic|cs cn c vitcn prcjcci? Wlal if llo company doos nol laIo on llo projocl` InloroslingIy,
vo may find llal nol aII casl fIovs a firm oxpocls from an invoslmonl proposaI aro incro-
monlaI in naluro. In moasuring froo casl fIovs, lovovor, llo lricI is lo llinI incromon-
laIIy. In doing so, vo viII soo llal onIy incrementaI aIter-tax Iree cash IInws mallor. As
sucl, our guiding ruIo in dociding if a froo casl fIov is incromonlaI is lo IooI al llo com-
pany vill, vorsus villoul, llo nov producl. As you viII soo in llo upcoming soclions,
llis may bo oasior said llan dono.
ln order lo measure lhe lrue ellecls ol our decisions, we analyze lhe benelils and cosls ol
projecls on an incremenlal basis, which relales direclly lo PrincipIe 4. IncrementaI Cash
fIovs-It's OnIy What Changes That Counts. ln ellecl, we ask ourselves whal lhe cash
llows will be il lhe projecl is laken on versus whal lhey will be il lhe projecl is nol laken on.
8eware of Cash Ilows Diverted from £xisting Products
Assumo for a momonl llal vo aro managors of a firm considoring a nov producl Iino
llal migll compolo vill ono of our oxisling producls and possibIy roduco ils saIos. In
dolormining llo froo casl fIovs associalod vill llo proposod projocl, vo slouId con-
sidor onIy llo incromonlaI saIos brougll lo llo company as a vloIo. Nov-producl saIos
acliovod al llo cosl of Iosing saIos of ollor producls in our Iino aro nol considorod a bon-
ofil of adopling llo nov producl.
700.10 CapiIal 8udgeIihg 182
CAßM ModuIe 700 Fihahce
Romombor llal vo aro onIy inloroslod in llo saIos doIIars lo llo firm if llo projocl
is accoplod, as opposod lo vlal llo saIos doIIars vouId bo if llo projocl voro rojoclod.
Iusl moving saIos from ono producl Iino lo a nov producl Iino doos nol bring anylling
nov inlo llo company, bul if saIos aro caplurod from compolilors or if saIos llal
vouId lavo boon Iosl lo nov compoling producls aro rolainod, llon lloso aro roIovanl
incromonlaI froo casl fIovs. In oacl caso lloso aro llo incromonlaI froo casl fIovs lo
llo firm÷IooIing al llo firm as a vloIo, vill llo nov producl vorsus villoul llo
nov producl.
Look for lncidental or Synergistic £ffects
AIllougl in somo casos a nov projocl may laIo saIos avay from a firm's curronl proj-
ocls, in ollor casos a nov offorl may acluaIIy bring nov saIos lo llo oxisling Iino.
Work in Working-Capital Requirements
Many limos a nov projocl invoIvos addilionaI invoslmonl in vorIing capilaI. Tlis
may laIo llo form of nov invonlory lo slocI a saIos oulIol, addilionaI invoslmonl
in accounls rocoivabIo rosuIling from addilionaI crodil saIos, or incroasod invosl-
monl in froo casl lo oporalo casl rogislors, and moro. WorIing-capilaI roquiro-
monls aro considorod a froo casl fIov ovon llougl lloy do nol Ioavo llo company.
Hov can invoslmonl in invonlory bo considorod a froo casl oulfIov vlon llo
goods aro sliII in llo sloro` Bocauso llo firm doos nol lavo accoss lo llo invon-
lory's casl vaIuo, llo firm cannol uso llo monoy for ollor invoslmonls. GonoraIIy,
vorIing-capilaI roquiromonls aro liod up ovor llo Iifo of llo projocl. Wlon llo
projocl lorminalos, lloro is usuaIIy an offsolling casl infIov as llo vorIing capilaI
is rocovorod, aIllougl llis offsol is nol porfocl bocauso of llo limo vaIuo of monoy.
Consider lncremental £xpenses
Iusl as casl infIovs from a nov projocl aro moasurod on an incromonlaI basis,
oxponsos slouId aIso bo moasurod on an incromonlaI basis. Ior oxampIo, if inlroduc-
ing a nov producl Iino nocossilalos lraining llo saIos slaff, llo aflor-lax casl fIov
associalod vill llo lraining program musl bo considorod a casl oulfIov and
clargod againsl llo projocl. If accopling a nov projocl diclalos llal a produclion
faciIily bo roonginoorod, llo casl fIovs associalod vill llal capilaI invoslmonl
slouId bo clargod againsl llo projocl, and lloy viII llon bo doprocialod ovor llo Iifo
of llo projocl. Again, any incromonlaI aflor-lax casl fIov affocling llo company as a
vloIo is a roIovanl casl fIov, vlollor il is fIoving in or fIoving oul.
Remember That Sunk Costs Are Not lncremental Cash Ilows
OnIy casl fIovs llal aro affoclod by llo docision maIing al llo momonl aro roIovanl in
capilaI budgoling. Tlo managor asIs lvo quoslions: (1) WiII llis casl fIov occur if llo
projocl is accoplod` (2) WiII llis casl fIov occur if llo projocl is rojoclod` Yos lo llo firsl
quoslion and no lo llo socond oquaIs an incromonlaI casl fIov. Ior oxampIo, Iol's assumo
you aro considoring inlroducing a nov laslo lroal caIIod Iuddin' in a Sloo. You vouId
IiIo lo do somo losl-marIoling boforo produclion. If you aro considoring llo docision lo
losl-marIol and lavo nol yol dono so, llo cosls associalod vill llo losl-marIoling aro roI-
ovanl casl fIovs. ConvorsoIy, if you lavo aIroady losl-marIolod, llo casl fIovs invoIvod
in losling-marIoling aro no Iongor roIovanl in projocl ovaIualion. Il's a mallor of liming.
RogardIoss of vlal you migll docido aboul fuluro produclion, llo casl fIovs aIIocalod lo
marIoling lavo aIroady occurrod. Casl fIovs llal lavo aIroady laIon pIaco aro oflon
roforrod lo as ¨sunI cosls¨ bocauso lloy lavo boon sunI inlo llo projocl and cannol bo
undono. As a ruIo, any casl fIovs llal aro nol affoclod by llo accopl/rojocl crilorion
slouId nol bo incIudod in capilaI-budgoling anaIysis.
700.10 CapiIal 8udgeIihg 183
CAßM ModuIe 700 Fihahce
Account for Opportunity Costs
Nov vo viII focus on llo casl fIovs llal aro Iosl bocauso a givon projocl consumos scarco
rosourcos llal vouId lavo producod casl fIovs if llal projocl lad boon rojoclod. Tlis is
llo opporlunily cosl of doing businoss. Ior oxampIo, a producl may uso vaIuabIo fIoor
spaco in a produclion faciIily. AIllougl llo casl fIov is nol obvious, llo roaI quoslion
romains: Wlal oIso couId bo dono vill llis spaco` Tlo spaco couId lavo boon ronlod oul,
or anollor producl couId lavo boon slorod lloro. Tlo Ioy poinl is llal opporlunily-cosl
casl fIovs slouId rofIocl nol casl fIovs llal vouId lavo boon rocoivod if llo projocl undor
considoralion voro rojoclod. Again, vo aro anaIyzing llo casl fIovs lo llo company as a
vloIo, vill or villoul llo projocl.
Decide lf Overhead Costs Are Truly lncremental Cash Ilows
AIllougl vo corlainIy vanl lo incIudo any incromonlaI casl fIovs rosuIling in
clangos from ovorload oxponsos sucl as uliIilios and saIarios, vo aIso vanl lo maIo
suro llal lloso aro lruIy incromonlaI casl fIovs. Many limos, ovorload oxponsos÷
loal, Iigll, ronl÷vouId occur vlollor a givon projocl voro accoplod or rojoclod.
Tloro is oflon nol a singIo spocific projocl lo vlicl lloso oxponsos can bo aIIocalod.
Tlus, llo quoslion is nol vlollor llo projocl bonofils from ovorload iloms bul
vlollor llo ovorload cosls aro incromonlaI casl fIovs associalod vill llo projocl and
roIovanl lo capilaI budgoling.
lgnore lnterest Payments and Iinancing Ilows
In ovaIualing nov projocls and dolormining casl fIovs, vo musl soparalo llo invosl-
monl docision from llo financing docision. Inlorosl paymonls and ollor financing casl
fIovs llal migll rosuIl from raising funds lo financo a projocl slouId nol bo considorod
incromonlaI casl fIovs. If accopling a projocl moans vo lavo lo raiso nov funds by issu-
ing bonds, llo inlorosl clargos associalod vill raising funds aro nol a roIovanl casl oul-
fIov. Wlon vo discounl llo incromonlaI casl fIovs bacI lo llo prosonl al llo roquirod
ralo of rolurn, vo aro impIicilIy accounling for llo cosl of raising funds lo financo llo
nov projocl. In ossonco, llo roquirod ralo of rolurn rofIocls llo cosl of llo funds noodod
lo supporl llo projocl. Managors firsl dolormino llo dosirabiIily of llo projocl and llon
dolormino lov bosl lo financo il.
In moasuring casl fIovs, vo viII bo inloroslod onIy in llo incromonlaI, or difforonliaI, aflor-
lax casl fIovs llal can bo allribulod lo llo proposaI boing ovaIualod. Tlal is, vo viII focus
our allonlion on llo difforonco in llo firm's aflor-lax casl fIovs uii| vorsus uii|cui llo
projocl÷llo projocl's |rcc ccs| ||cus. Tlo vorll of our docision doponds on llo accuracy of
our casl fIov oslimalos. Ior llis roason, vo firsl oxaminod llo quoslion of vlal casl fIovs
aro roIovanl. Nov vo viII soo llal, in gonoraI, a projocl's froo casl fIovs viII faII inlo ono of
llroo calogorios: (1) llo iniliaI oulIay, (2) llo difforonliaI fIovs ovor llo projocl's Iifo, and
(3) llo lorminaI casl fIov. Onco vo lavo laIon a IooI al lloso calogorios, vo viII laIo on
llo lasI of moasuring lloso froo casl fIovs.
lnitial Outlay
Tlo initiaI nutIav invoIvos llo immodialo casl oulfIov nocossary lo purclaso llo assol
and pul il in oporaling ordor. Tlis amounl incIudos llo cosl of inslaIIing llo assol (llo
assol's purclaso prico pIus any oxponsos associalod vill slipping or inslaIIalion) and
any nonoxponso casl oulIays, sucl as incroasod vorIing-capilaI roquiromonls. If vo
aro considoring a nov saIos oulIol, lloro migll bo addilionaI casl fIovs associalod
vill nol invoslmonl in vorIing capilaI in llo form of incroasod invonlory and casl
nocossary lo oporalo llo saIos oulIol. AIllougl lloso casl fIovs aro nol incIudod in llo
700.10 CapiIal 8udgeIihg 184
CAßM ModuIe 700 Fihahce
cosl of llo assol or ovon oxponsod on llo booIs, lloy musl bo incIudod in our anaIysis.
Tlo aflor-lax cosl of oxponso iloms incurrod as a rosuIl of nov invoslmonl musl aIso bo
incIudod as casl oulfIovs÷for oxampIo, any lraining oxponsos llal vouId nol lavo
boon incurrod ollorviso.
IinaIIy, if llo invoslmonl docision is a ropIacomonl docision, llo casl infIov asso-
cialod vill llo soIIing prico of llo oId assol, in addilion lo any lax offocls rosuIling
from ils saIo, musl bo incIudod. Il slouId bo slrossod llal llo incromonlaI naluro of llo
casl fIov is of groal imporlanco. In many casos, if llo projocl is nol accoplod, llon sla-
lus quo for llo firm viII simpIy nol conlinuo. In caIcuIaling incromonlaI casl fIovs, vo
musl bo roaIislic in oslimaling vlal llo casl fIovs lo llo company vouId bo if llo
nov projocl voro nol accoplod.
Tax E!!ects-5aIe o! OId Machine
IolonliaIIy, ono of llo mosl confusing iniliaI oulIay caIcuIalions is for a ropIacomonl
projocl invoIving llo incromonlaI lax paymonl associalod vill llo saIo of an oId
maclino. Tloro aro llroo possibIo lax silualions doaIing vill llo saIo of an oId assol:
1. Tlo oId assol is soId for a prico abovo llo doprocialod vaIuo. Horo llo
difforonco bolvoon llo oId maclino's soIIing prico and ils doprocialod vaIuo is
considorod a laxabIo gain and is laxod al llo marginaI corporalo lax ralo. If, for
oxampIo, llo oId maclino vas originaIIy purclasod for $15,000, lad a booI
vaIuo of $10,000, and vas soId for $17,000, assuming llo firm's marginaI
corporalo lax ralo is 34 porconl, llo laxos duo from llo gain vouId bo
($17,000 $10,000) (.34), or $2,380.
2. Tlo oId assol is soId for ils doprocialod vaIuo. In llis caso, no laxos rosuIl,
bocauso lloro is noillor a gain nor a Ioss in llo assol's saIo.
3. Tlo oId assol is soId for Ioss llan ils doprocialod vaIuo. In llis caso, llo
difforonco bolvoon llo doprocialod booI vaIuo and llo saIvago vaIuo of llo
assol is a laxabIo Ioss and may bo usod lo offsol capilaI gains and llus rosuIls
in lax savings. Ior oxampIo, if llo doprocialod booI vaIuo of llo assol is
$10,000 and il is soId for $7,000, vo lavo a $3,000 Ioss. Assuming llo firm's
marginaI corporalo lax ralo is 34 porconl, llo casl infIov from lax savings is
($10,000 $7,000) (.34), or $1,020.
Annual Iree Cash Ilows over the Project's Life
AnnuaI froo casl fIovs como from oporaling casl fIovs (llal is, vlal you'vo mado as
a rosuIl of laIing on llo projocl), clangos in vorIing capilaI, and any capilaI sponding
llal migll laIo pIaco. In our caIcuIalions vo'II bogin vill our pro forma slalomonls
and vorI from lloro. Wo viII lavo lo maIo adjuslmonls for inlorosl, doprocialion, and
vorIing capilaI, aIong vill any capilaI oxpondiluros llal migll occur.
Boforo vo IooI al llo caIcuIalions, Iol's IooI al llo lypos of adjuslmonls llal vo'ro
going lo lavo lo maIo lo go from oporaling casl fIovs lo froo casl fIovs. To do llis
vo'II lavo lo maIo adjuslmonls for:
Deµreciatinn and Taxes. Wlon accounlanls caIcuIalo a firm's nol incomo, ono of
llo oxponsos lloy sublracl oul is doprocialion. Hovovor, doprocialion is a
non÷casl fIov oxponso. If you llinI aboul il, doprocialion occurs bocauso you
bougll a fixod assol (for oxampIo, you buiIl a pIanl) in an oarIior poriod, and
nov, llrougl doprocialion, you'ro oxponsing il ovor limo÷bul doprocialion
doos nol invoIvo a casl fIov. Tlal moans nol incomo undorslalos casl fIovs by
llis amounl. Tloroforo, vo'II vanl lo componsalo for llis by adding
doprocialion bacI in lo our moasuro of accounling incomo vlon caIcuIaling
casl fIovs.
In addilion, aIllougl doprocialion is nol a casl fIov ilom, il Iovors profils,
vlicl in lurn Iovors laxos. Ior sludonls dovoIoping a foundalion in corporalo
financo, il is llo concopl of doprocialion, nol llo caIcuIalion of il, llal is
700.10 CapiIal 8udgeIihg 185
CAßM ModuIe 700 Fihahce
imporlanl. Tlo roason llo caIcuIalion of doprocialion is doomplasizod is llal il
is oxlromoIy compIicalod, and ils caIcuIalion clangos ovory fov yoars as
Congross onacls nov lax Iavs. Tlrougl aII llis, boar in mind llal aIllougl
doprocialion is nol a casl fIov ilom, il doos affocl casl fIovs by Iovoring llo
IovoI of profils on vlicl laxos aro caIcuIalod.
Ior our purposos, doprocialion is caIcuIalod using a simpIifiod slraigll-Iino
mollod. Tlis simpIifiod procoss ignoros llo laIf-yoar convonlion llal aIIovs
onIy a laIf-yoar's doduclion in llo yoar llo projocl is pIacod in sorvico and a
laIf-yoar's doduclion in llo firsl yoar aflor llo rocovory poriod. By ignoring llo
laIf-yoar convonlion and assuming a zoro saIvago vaIuo, vo aro abIo lo caIcuIalo
annuaI doprocialion by laIing llo projocl's iniliaI doprociabIo vaIuo and
dividing by ils doprociabIo Iifo as foIIovs:
Tlo iniliaI doprociabIo vaIuo is oquaI lo llo cosl of llo assol pIus any
oxponsos nocossary lo gol llo nov assol inlo oporaling ordor.
Tlis is nol lov doprocialion vouId acluaIIy bo caIcuIalod. Tlo roason vo
lavo simpIifiod llo caIcuIalion is lo aIIov you lo focus diroclIy on vlal slouId
and slouId nol bo incIudod in llo casl fIov caIcuIalions. Moroovor, bocauso llo
lax Iavs clango rallor froquonlIy, vo aro moro inloroslod in rocognizing llo lax
impIicalions of doprocialion llan in undorslanding llo spocific doprocialion
provisions of llo curronl lax Iavs.
Our concorn vill doprocialion is lo liglIigll ils imporlanco in gonoraling
casl fIov oslimalos and lo indicalo llal llo financiaI managor musl bo avaro of
llo curronl lax provisions vlon ovaIualing capilaI-budgoling proposaIs.
Interest Exµenses. Tloro's no quoslion llal if you laIo on a nov projocl, you'II
lavo lo pay for il somolov÷llrougl oillor inlornaI casl fIov or soIIing nov
slocIs or bonds. In ollor vords, lloro's a cosl lo llal monoy. Wo rocognizo llis
principIo vlon vo discounl fuluro casl fIovs bacI lo llo prosonl al llo roquirod
ralo of rolurn. Romombor, llo projocl's roquirod ralo of rolurn is llo ralo of
rolurn llal you musl oarn lo juslify laIing on llo projocl. Il rocognizos llo risI
of llo projocl and llo facl llal lloro is an opporlunily cosl of monoy. If vo
discounlod llo fuluro casl fIovs bacI lo llo prosonl and aIso sublraclod oul
inlorosl oxponsos, llon vo'd bo doubIo counlod for llo cosl of monoy÷
accounling for llo cosl of monoy onco vlon vo sublraclod oul inlorosl oxponsos
and onco vlon vo discounlod llo casl fIovs bacI lo llo prosonl. Tloroforo, vo
vanl lo maIo suro inlorosl oxponsos aron'l sublraclod oul. Tlal moans vo'II
vanl lo maIo suro llal financing fIovs aro nol incIudod.
Changes in Wnrking CaµitaI. Many projocls roquiro an incroasod invoslmonl in
vorIing capilaI. Ior oxampIo, somo of llo nov saIos may bo crodil saIos
rosuIling in an incroasod invoslmonl in accounls rocoivabIo. AIso, in ordor lo
produco and soII llo producl, llo firm may lavo lo incroaso ils invoslmonl in
invonlory. On llo ollor land, somo of llis incroasod vorIing-capilaI
invoslmonl may bo financod by an incroaso in accounls payabIo. Sinco aII lloso
polonliaI clangos aro clangos in assols and IiabiIilios, lloy don'l affocl
accounling incomo. Tlo bollom Iino loro is llal if llis projocl brings vill il a
posilivo clango in nol vorIing capilaI, llon il moans monoy is going lo bo liod
up in incroasod vorIing capilaI, and llis vouId bo a casl oulfIov. Tlal moans
vo'II lavo lo maIo suro vo accounl for any clangos in vorIing capilaI llal
migll occur.
Changes in CaµitaI Sµending. Irom an accounling porspoclivo, llo casl fIov
associalod vill llo purclaso of a fixod assol is nol an oxponso. Tlal moans llal
vlon Marrioll sponds $50 miIIion on buiIding a nov loloI rosorl, aIllougl
lloro is a significanl casl oulfIov, lloro is no accompanying oxponso. Insload,
AnnuaI doprocialion using llo
simpIifiod slraaigll-Iino mollod
iniliaI doprociabIo vaIu
doprociabIo Iifo
700.10 CapiIal 8udgeIihg 186
CAßM ModuIe 700 Fihahce
llo $50 miIIion casl oulfIov croalos an annuaI doprocialion oxponso ovor llo Iifo
of llo loloI. Wo'II vanl lo maIo suro vo incIudo any clangos in capilaI
sponding in our casl fIov caIcuIalions.
Terminal Cash Ilow
Tlo caIcuIalion of llo lorminaI casl fIov is in gonoraI quilo a bil simpIor llan llo pro-
coding lvo caIcuIalions. IIovs associalod vill llo projocl's lorminalion may incIudo
llo saIvago vaIuo of llo projocl pIus or minus any laxabIo gains or Iossos associalod
vill ils saIo.
Undor llo curronl lax Iavs, in mosl casos lloro viII bo lax paymonls associalod
vill llo saIvago vaIuo al lorminalion. Tlis is bocauso llo curronl Iavs aIIov aII proj-
ocls lo bo doprocialod lo zoro, and if a projocl las a booI vaIuo of zoro al lorminalion
and a posilivo saIvago vaIuo, llon llal saIvago vaIuo viII bo laxod. Tlo lax offocls asso-
cialod vill llo saIvago vaIuo of llo projocl al lorminalion aro dolorminod oxaclIy IiIo
llo lax offocls on llo saIo of llo oId maclino associalod vill llo iniliaI oulIay. Tlo saI-
vago vaIuo procoods aro comparod vill llo doprocialod vaIuo, in llis caso zoro, lo
dolormino llo lax.
In addilion lo llo saIvago vaIuo, lloro may bo a casl oulIay associalod vill llo
projocl lorminalion. Ior oxampIo, al llo cIoso of a slrip-mining oporalion, llo mino
musl bo rofiIIod in an ocoIogicaIIy accoplabIo mannor.
Nov Iol's pul llis aII logollor and moasuro llo projocl's froo casl fIovs.
Measuring the Iree Cash Ilows
Iroo casl fIov caIcuIalions can bo broIon dovn inlo llroo basic parls: casl fIovs from
oporalions, casl fIovs associalod vill vorIing-capilaI roquiromonls, and capilaI-
sponding casl fIovs. Iol's bogin our discussion by IooIing al lov lo moasuro casl
fIovs from oporalions and llon movo on lo discuss moasuring casl fIovs from
vorIing-capilaI roquiromonls and capilaI sponding.
5tep 1 Mccsurc i|c prcjcci´s c|cnvc in cpcrciinv ccs| ||cus. An oasy vay lo caIcuIalo
oporaling casl fIovs is lo laIo llo informalion providod on a pro forma
slalomonl and simpIy convorl llo accounling informalion inlo casl fIov
informalion. To do llis vo laIo advanlago of llo facl llal llo difforonco
bolvoon llo clango in saIos and llo clango in cosls slouId bo oquaI lo llo
clango in oarnings boforo inlorosl and laxos (IBIT) pIus doprocialion.
Undor llis mollod, llo caIcuIalion of a projocl's oporaling casl fIov
invoIvos llroo slops. Iirsl, vo dolormino llo company's ccrninvs |c|crc inicrcsi
cn! icxcs (|8|1 ) vill and villoul llis projocl. Socond, vo sublracl oul llo
clango in laxos. Koop in mind llal in caIcuIaling llo clango in laxos, vo viII
ignoro any inlorosl oxponsos. Tlird, vo adjusl llis vaIuo for llo facl llal
doprocialion, a non÷casl fIov ilom, las boon sublraclod oul in llo caIcuIalion
of IBIT. Wo do llis by adding bacI doprocialion. Tlus, oporaling casl fIovs
aro caIcuIalod as foIIovs:
Oporaling casl fIovs clango in oarnings boforo inlorosl and laxos
clango in laxos clango in doprocialion
700.10 CapiIal 8udgeIihg 187
CAßM ModuIe 700 Fihahce
5tep 2 Cc|cu|cic i|c ccs| ||cus |rcm i|c c|cnvc in nci ucr|inv ccpiic|. As vo monlionod oar-
Iior in llis soclion, many limos a nov projocl viII invoIvo addilionaI invosl-
monl in vorIing capilaI÷porlaps nov invonlory lo slocI a nov saIos oulIol or
simpIy addilionaI invoslmonl in accounls rocoivabIo. Tloro aIso may bo somo
sponlanoous slorl-lorm financing÷for oxampIo, incroasos in accounls
payabIo÷llal rosuIl from llo nov projocl. Tlus, llo clango in nol vorIing
capilaI is llo addilionaI invoslmonl in curronl assols minus any addilionaI
slorl-lorm IiabiIilios llal voro gonoralod.
5tep 3 Dcicrminc i|c ccs| ||cus |rcm i|c c|cnvc in ccpiic| spcn!inv. AIllougl lloro is
gonoraIIy a Iargo casl oulfIov associalod vill a projocl's iniliaI oulIay,
lloro may aIso bo addilionaI capilaI-sponding roquiromonls ovor llo Iifo of
llo projocl. Ior oxampIo, you may Inov aload of limo llal llo pIanl viII
nood somo minor rolooIing in llo socond yoar of llo projocl in ordor lo
Ioop llo projocl abroasl of nov loclnoIogicaI clangos llal aro oxpoclod lo
laIo pIaco. In offocl, vo viII IooI al llo company vill and villoul llo
nov projocl, and any clangos in capilaI sponding llal occur aro roIovanl.
5tep 4 Puiiinv ii icvci|cr. cc|cu|ciinv c prcjcci´s |rcc ccs| ||cus. Tlus, a projocl's froo
casl fIovs aro:
Irojocl's froo casl fIovs clango in oarnings boforo inlorosl and laxos
clango in laxos clango in doprocialion
clango in nol vorIing capilaI
clango in capilaI sponding
To oslimalo llo clangos in IBIT, laxos, doprocialion, nol vorIing cap-
ilaI, and capilaI sponding vo slarl vill oslimalos of lov many unils vo
oxpocl lo soII, vlal llo cosls÷boll fixod and variabIo÷viII bo, vlal llo
soIIing prico viII bo, and vlal llo roquirod capilaI invoslmonl viII bo.
Irom lloro vo can pul logollor a pro forma slalomonl llal slouId provido
us vill llo dala vo nood lo oslimalo llo projocl's froo casl fIovs. Hov-
ovor, you musl Ioop in mind llal our capilaI-budgoling docision viII onIy
700.10 CapiIal 8udgeIihg 188
CAßM ModuIe 700 Fihahce
Lel's look al an example lo show lhe calculalion ol operaling cash llows. Assume lhal
a new projecl will annually generale revenues ol S!,000,000 and cash expenses
including bolh lixed and variable cosls ol S500,000, while increasing deprecialion by
S!50,000 per year. ln addilion, lel's assume lhal lhe lirm's marginal lax rale is 34 per-
cenl. Civen lhis, lhe lirm's nel prolil aller lax operaling cash llows can be calcu-
laled as.
Pevenue S!,000,000
Cash expenses 500,000
Deprecialion !50,000
L8lT S 350,000
Taxes (34') !!9,000
Nel income S 23!,000
Operaling cash llows change in earnings belore inleresl and laxes
change in laxes change in deprecialion
S350,000 S!!9,000 S!50,000 S38!,000
bo as good as our oslimalos of llo cosls and fuluro domand. In facl, mosl
capilaI-budgoling docisions llal lurn oul lo bo bad docisions aro nol so
bocauso of using a bad docision ruIo bul bocauso llo oslimalos of fuluro
domand and cosls voro inaccuralo.
700.10.4 Discuss the various options avaiIabIe
in capitaI budgeting
Tlo uso of our discounlod casl fIov docision criloria, sucl as llo NPV mollod, pro-
vidos an oxcoIIonl framovorI villin vlicl lo ovaIualo projocls. Hovovor, vlal lap-
pons if llo projocl boing anaIyzod las llo polonliaI lo bo modifiod aflor somo fuluro
uncorlainly las boon rosoIvod` Ior oxampIo, if a projocl llal lad an oxpoclod Iifo of
10 yoars lurns oul lo bo bollor llan anlicipalod, il may bo oxpandod or conlinuod pasl
10 yoars, porlaps going for 20 yoars. On llo ollor land, if ils casl fIovs do nol mool
oxpoclalions, il may nol Iasl a fuII 10 yoars, il migll bo scaIod bacI, abandonod, or
soId. In addilion, il migll bo doIayod for a yoar or lvo. Tlis fIoxibiIily is somolling
llal llo NPV and our ollor docision criloria lad a difficuIl limo doaIing vill. In facl,
llo NPV may acluaIIy undorslalo llo vaIuo of llo projocl bocauso llo fuluro opporlu-
nilios associalod vill llo possibiIily of modifying llo projocl may lavo a posilivo
vaIuo. Il is llis vaIuo of fIoxibiIily llal vo viII bo oxamining using oplions.
Tlroo of llo mosl common oplion lypos llal can add vaIuo lo a capilaI-budgoling
projocl aro (1) llo oplion lo doIay a projocl unliI llo fuluro casl fIovs aro moro favorabIo÷
llis oplion is common vlon llo firm las oxcIusivo riglls, porlaps a palonl, lo a
producl or loclnoIogy, (2) llo oplion lo oxpand a projocl, porlaps in sizo or ovon lo
nov producls llal vouId nol lavo ollorviso boon foasibIo, and (3) llo oplion lo
abandon a projocl if llo fuluro casl fIovs faII slorl of oxpoclalions.
The Option to Delay a Project
Tloro is no quoslion llal llo oslimalod casl fIovs associalod vill a projocl can clango
ovor limo. In facl, as a rosuIl of clanging oxpoclod casl fIovs, a projocl llal curronlIy
las a nogalivo nol prosonl vaIuo may lavo a posilivo nol prosonl vaIuo in llo fuluro.
Iol's assumo llal you'vo dovoIopod a ligl-voIlago nicIoI-molaI lydrido ballory llal
couId bo usod lo incroaso llo miIoago on lybrid cars up lo 150 miIos por gaIIon. Hov-
ovor, as you oxamino llo cosls of producing llis nov ballory, you roaIizo llal il is sliII
roIalivoIy oxponsivo lo manufacluro and llal, givon llo cosls, llo marIol for a car using
llis ballory is quilo smaII rigll nov. Doos llal moan llal llo riglls lo llo ligl-voIlago
nicIoI-molaI lydrido ballory lavo no vaIuo` No, lloy lavo vaIuo bocauso you may bo
abIo lo improvo on llis loclnoIogy in llo fuluro and maIo llo ballory ovon moro offi-
cionl and Ioss oxponsivo. Tloy aIso lavo vaIuo bocauso oiI pricos may riso ovon furllor,
vlicl vouId Ioad lo a biggor marIol for supor fuoI-officionl cars. In offocl, llo abiIily
lo doIay llis projocl vill llo lopo llal loclnoIogicaI and marIol condilions viII
clango, maIing llis projocl profilabIo, Ionds vaIuo lo llis projocl.
Anollor oxampIo of llo oplion lo doIay a projocl unliI llo fuluro casl fIovs aro
moro favorabIo invoIvos a firm llal ovns llo oiI riglls lo somo oiI-ricl Iand and is con-
sidoring an oiI-driIIing projocl. Aflor aII of llo cosls and llo oxpoclod oiI oulpul aro con-
sidorod, llis projocl may lavo a nogalivo nol prosonl vaIuo. Doos llal moan llo firm
slouId givo avay ils oiI riglls or llal lloso oiI riglls lavo no vaIuo` CorlainIy nol, lloro
is a clanco llal in llo fuluro oiI pricos couId riso lo llo poinl llal llis nogalivo NPV proj-
ocl couId bocomo a posilivo NPV projocl. Il is llis abiIily lo doIay dovoIopmonl llal pro-
vidos vaIuo. Tlus, llo vaIuo in llis soomingIy nogalivo NPV projocl is providod by llo
oplion lo doIay llo projocl unliI llo fuluro casl fIovs aro moro favorabIo.
700.10 CapiIal 8udgeIihg 189
CAßM ModuIe 700 Fihahce
The Option to £xpand a Project
Iusl as vo sav vill llo oplion lo doIay a projocl, llo oslimalod casl fIovs associalod
vill a projocl can clango ovor limo, maIing il vaIuabIo lo oxpand a projocl. Again, llis
fIoxibiIily lo adjusl produclion lo domand las vaIuo. Ior oxampIo, a firm may buiId a
produclion pIanl vill oxcoss capacily so llal if llo producl las moro llan anlicipalod
domand, il can simpIy incroaso produclion. AIlornalivoIy, laIing on llis projocl may
provido llo firm vill a foolloId in a nov induslry and Ioad lo ollor producls llal
vouId nol lavo ollorviso boon foasibIo. Tlis roasoning las Iod many firms lo oxpand
inlo o-businossos, loping lo gain Inov-lov and oxporliso llal viII Ioad lo ollor prof-
ilabIo projocls dovn llo Iino. Il aIso providos somo of llo ralionaIo for rosoarcl and
dovoIopmonl oxpondiluros in vlicl llo fuluro projocl is nol voII dofinod.
The Option to Abandon a Project
Tlo oplion lo abandon a projocl as llo oslimalod casl fIovs associalod vill a projocl
can clango ovor limo aIso las vaIuo. Again, il is llis fIoxibiIily lo adjusl lo nov infor-
malion llal providos llo vaIuo. Ior oxampIo, a projocl's saIos in llo firsl yoar or lvo
may nol Iivo up lo oxpoclalions, vill llo projocl boing baroIy profilabIo. Tlo firm may
llon docido lo Iiquidalo llo projocl and soII llo pIanl and aII of llo oquipmonl, and
llal Iiquidalod vaIuo may bo moro llan llo vaIuo of Iooping llo projocl going.
Again, Iol's go bacI lo our oxampIo of llo gas-oIoclric lybrid car and, llis limo,
oxamino llo oplion lo abandon llal projocl. If aflor a fov yoars llo cosl of gas faIIs dra-
malicaIIy vliIo llo cosl of loclnoIogy romains ligl, llo gas-oIoclric lybrid car may nol
bocomo profilabIo. Al llal poinl llo manufacluror may docido lo abandon llo projocl
and soII llo loclnoIogy, incIuding aII llo palonl riglls il las dovoIopod. In offocl, llo
originaI projocl, llo gas-oIoclric lybrid car, may nol bo of vaIuo, bul llo loclnoIogy llal
las boon dovoIopod may bo. In offocl, llo vaIuo of abandoning llo projocl and soIIing
llo loclnoIogy may bo moro llan llo vaIuo of Iooping llo projocl running. Again, il is
llo vaIuo of fIoxibiIily associalod vill llo possibiIily of modifying llo projocl in llo
fuluro÷in llis caso abandoning llo projocl÷llal can produco posilivo vaIuo.
Options in Capital 8udgeting: The 8ottom Line
Bocauso of llo polonliaI lo bo modifiod in llo fuluro aflor somo fuluro uncorlainly las
boon rosoIvod, vo may find llal a projocl vill a nogalivo nol prosonl vaIuo basod
upon ils oxpoclod froo casl fIovs is a ¨good¨ projocl and slouId bo accoplod÷llis
domonslralos llo vaIuo of oplions. In addilion, vo may find llal a projocl vill a posi-
livo nol prosonl vaIuo may bo of moro vaIuo if ils accoplanco is doIayod. Oplions aIso
oxpIain llo Iogic llal drivos firms lo laIo on nogalivo NPV projocls llal aIIov llom lo
onlor nov marIols. Tlo oplion lo abandon a projocl oxpIains vly firms liro ompIoy-
oos on a lomporary basis rallor llan pormanonlIy, vly lloy may Ioaso rallor llan buy
oquipmonl, and vly lloy may onlor inlo conlracls vill suppIiors on an annuaI basis
rallor llan Iong lorm.
700.10.5 Learn hov to measure and incorporate risk
into capitaI budgeting and Iearn hov to examine
a project's risk through simuIation and sensitivity
Up lo llis poinl vo lavo ignorod risI in capilaI budgoling, llal is, vo lavo discounlod
oxpoclod casl fIovs bacI lo llo prosonl and ignorod any uncorlainly llal lloro migll
bo surrounding llal oslimalo. In roaIily llo fuluro casl fIovs associalod vill llo inlro-
duclion of a nov saIos oulIol or a nov producl aro oslimalos of vlal is cxpccic! lo
700.10 CapiIal 8udgeIihg 190
CAßM ModuIe 700 Fihahce
lappon in llo fuluro, nol nocossariIy vlal viII lappon in llo fuluro. Ior oxampIo,
vlon Coca-CoIa docidod lo ropIaco CIassic CoIo vill ils ¨Nov CoIo,¨ you can bol
llal llo oxpoclod casl fIovs il basod ils docision on voro nolling IiIo llo casl fIovs il
roaIizod. As a rosuIl, il didn'l laIo Coca-CoIa Iong lo roinlroduco CIassic CoIo. Tlo
casl fIovs vo lavo discounlod bacI lo llo prosonl lavo onIy boon our bosl oslimalo of
llo oxpoclod fuluro casl fIovs. A casl fIov diagram basod on llo possibIo oulcomos
of an invoslmonl proposaI rallor llan llo oxpoclod vaIuos of lloso oulcomos appoars
in Figure 10.3.
In llis soclion, vo assumo llal undor condilions of risI vo do nol Inov boforo-
land vlal casl fIovs viII acluaIIy rosuIl from a nov projocl. Hovovor, vo do lavo
oxpoclalions concorning llo possibIo oulcomos and aro abIo lo assign probabiIilios lo
lloso oulcomos. Slalod anollor vay, aIllougl vo do nol Inov vlal llo casl fIovs
rosuIling from llo accoplanco of a nov projocl viII bo, vo can formuIalo llo probabiI-
ily dislribulions from vlicl llo fIovs viII bo dravn. RisI occurs vlon lloro is somo
quoslion aboul llo fuluro oulcomo of an ovonl.
Wo assumo llal aIllougl fuluro casl fIovs aro nol Inovn vill corlainly, llo
probabiIily dislribulion from vlicl lloy como can bo oslimalod. AIso, bocauso vo
lavo iIIuslralod llal llo disporsion of possibIo oulcomos rofIocls risI, vo aro proparod
lo uso a moasuro of disporsion or variabiIily vlon vo quanlify risI.
Romombor llal lloro aro onIy lvo basic issuos llal vo addross: (1) Wlal is risI in
lorms of capilaI-budgoling docisions, and lov slouId il bo moasurod` (2) Hov slouId
risI bo incorporalod inlo capilaI-budgoling anaIysis`
What Measure of Risk ls Relevant in Capital 8udgeting7
Boforo vo bogin our discussion of lov lo adjusl for risI, il is imporlanl lo dolormino
jusl vlal lypo of risI vo aro lo adjusl for. In capilaI budgoling, a projocl's risI can bo
IooIod al on llroo IovoIs. Iirsl, lloro is llo µrnject standing aInne risk, vlicl is a
prcjcci´s ris| ivncrinv i|c |cci i|ci muc| c| i|is ris| ui|| |c !itcrsi|ic! cucu cs i|c prcjcci is
ccm|inc! uii| i|c |irm´s ci|cr prcjccis cn! csscis. Socond, vo lavo llo projocl's
cnntributinn-tn-Iirm risk, vlicl is llo cmcuni c| ris| i|ci i|c prcjcci ccniri|uics ic i|c
|irm cs c u|c|c, i|is mccsurc ccnsi!crs i|c |cci i|ci scmc c| i|c prcjcci´s ris| ui|| |c !itcrsi|ic!
cucu cs i|c prcjcci is ccm|inc! uii| i|c |irm´s ci|cr prcjccis cn! csscis, |ui ivncrcs i|c c||ccis
c| !itcrsi|icciicn c| i|c |irm´s s|crc|c|!crs. IinaIIy, lloro is svstematic risk, vlicl is llo
ris| c| i|c prcjcci |rcm i|c ticupcini c| c uc||-!itcrsi|ic! s|crc|c|!cr, i|is mccsurc ic|cs inic
ccccuni i|ci scmc c| c prcjcci´s ris| ui|| |c !itcrsi|ic! cucu cs i|c prcjcci is ccm|inc! uii| i|c
|irm´s ci|cr prcjccis, cn!, in c!!iiicn, scmc c| i|c rcmcininv ris| ui|| |c !itcrsi|ic! cucu |u
s|crc|c|!crs cs i|cu ccm|inc i|is sicc| uii| ci|cr sicc|s in i|cir pcri|c|ics. GraplicaIIy, llis
is slovn in Figure 10.4.
SlouId vo bo inloroslod in llo projocl slanding aIono risI` Tlo ansvor is no. In
slorl, bocauso mucl of a projocl's risI is divorsifiod avay villin llo firm, llo projocl
700.10 CapiIal 8udgeIihg 191
CAßM ModuIe 700 Fihahce
0iííereulial cash ílows Jeruiual
cash ílow
figure 10.3 Lxample Cash Flow Diagram 8ased oh Possible OuIcomes
slanding aIono risI is an inapproprialo moasuro of llo moaningfuI IovoI of risI of a
capilaI-budgoling projocl.
SlouId vo bo inloroslod in llo projocl's conlribulion-lo-firm risI` Onco again, al
Ioasl in lloory llo ansvor is no, providod invoslors aro voII divorsifiod and lloro is no
clanco of banIruplcy. Irom our oarIior discussion of risI, vo sav llal as slaroloIdors,
if vo combinod an individuaI socurily vill ollor socurilios lo form a divorsifiod porl-
foIio, mucl of llo risI of llo individuaI socurily vouId bo divorsifiod avay. In slorl,
aII llal affocls llo slaroloIdors is llo syslomalic risI of llo projocl and, as sucl, is aII
llal is lloorolicaIIy roIovanl for capilaI budgoling.
Measuring Risk for Capital-8udgeting Purposes with a Dose
of Reality-ls Systematic Risk All There ls7
According lo llo capilaI assol pricing modoI (CAIM), syslomalic risI is llo onIy roIo-
vanl risI for capilaI-budgoling purposos, lovovor, roaIily compIicalos llis somovlal.
In many inslancos a firm viII lavo undivorsifiod slaroloIdors, incIuding ovnors of
smaII corporalions. Bocauso lloy aro nol divorsifiod, for lloso slaroloIdors llo roIo-
vanl moasuro of risI is llo projocl's conlribulion-lo-firm risI.
Tlo possibiIily of banIruplcy aIso affocls our viov of vlal moasuro of risI is roIo-
vanl. As you rocaII in dovoIoping llo CAIM, vo mado llo assumplion llal banI-
ruplcy cosls voro zoro. Bocauso llo projocl's conlribulion-lo-firm risI can affocl llo
possibiIily of banIruplcy, llis may bo an approprialo moasuro of risI if lloro aro cosls
associalod vill banIruplcy. Ouilo obviousIy, in llo roaI vorId lloro is a cosl associ-
alod vill banIruplcy. Iirsl, if a firm faiIs, ils assols, in gonoraI, cannol bo soId for lloir
lruo oconomic vaIuo. Moroovor, llo amounl of monoy acluaIIy avaiIabIo for dislribu-
lion lo slocIloIdors is furllor roducod by Iiquidalion and IogaI foos llal musl bo paid.
IinaIIy, llo opporlunily cosl associalod vill llo doIays roIalod lo llo IogaI procoss fur-
llor roducos llo funds avaiIabIo lo llo slaroloIdor. Tloroforo, bocauso cosls aro asso-
cialod vill banIruplcy, roduclion of llo clanco of banIruplcy las a vory roaI vaIuo
associalod vill il.
700.10 CapiIal 8udgeIihg 192
CAßM ModuIe 700 Fihahce
Measures of kisk kisk 1hat Is
ßiversified Away
Projecl slaudiug aloue. |guores diversiíicaliou
wilhiu lhe íiru aud wilhiu lhe shareholder's
Projecl írou lhe coupauy's perspeclive.
|guores diversiíicaliou wilhiu lhe
shareholder's porlíolio, bul allows íor
diversiíicaliou wilhiu lhe íiru.
Projecl írou lhe shareholder's perspeclive.
^llows íor diversiíicaliou wilhiu lhe íiru
aud wilhiu lhe shareholder's porlíolio.
Sysleualic risk
Projecl's coulribuliou·
lo·íiru risk
Projecl's slaudiug
aloue risk
Risk diversiíied away
wilhiu íiru as lhis
projecl is coubiued
wilh íiru's olher
projecls aud assels
Risk diversiíied
away by shareholders as
securilies are coubiued
lo íoru diversiíied
porlíolio, also called
uusysleualic risk
figure 10.4 Lookihg aI 1hree Measures o! a ProiecI's Risk
Indirocl cosls of banIruplcy aIso affocl ollor aroas of llo firm, incIuding produc-
lion, saIos, and llo quaIily and officioncy of managomonl. Ior oxampIo, firms vill a
liglor probabiIily of banIruplcy may lavo a moro difficuIl limo rocruiling and rolain-
ing quaIily managors bocauso jobs vill llal firm aro viovod as boing Ioss socuro. Sup-
pIiors aIso may bo Ioss viIIing lo soII on crodil. IinaIIy, cuslomors may Ioso confidonco
and foar llal llo firm may nol bo around lo lonor llo varranly or lo suppIy sparo
parls for llo producl in llo fuluro. As a rosuIl, as llo probabiIily of banIruplcy
incroasos, llo ovonluaI banIruplcy may bocomo soIf-fuIfiIIing as polonliaI cuslomors
and suppIiors fIoo. Tlo ond rosuIl is llal bocauso llo projocl's conlribulion-lo-firm risI
affocls llo probabiIily of banIruplcy for llo firm, il is a roIovanl risI moasuro for capi-
laI budgoling.
IinaIIy, probIoms in moasuring a projocl's syslomalic risI maIo ils impIomonla-
lion oxlromoIy difficuIl. Il is mucl oasior laIIing aboul a projocl's syslomalic risI llan
moasuring il.
Givon aII llis, vlal do vo uso` Tlo ansvor is llal vo viII givo considoralion lo
boll moasuros. Wo Inov in lloory syslomalic risI is corrocl. Wo aIso Inov llal banI-
ruplcy cosls and undivorsifiod slaroloIdors vioIalo llo assumplions of llo lloory,
vlicl brings us bacI lo llo concopl of a projocl's conlribulion-lo-firm risI. SliII, llo
concopl of syslomalic risI loIds vaIuo for capilaI-budgoling docisions, bocauso llal is
llo risI llal slaroloIdors aro componsalod for assuming. Tloroforo, vo viII concorn
oursoIvos vill boll llo projocl's conlribulion-lo-firm risI and llo projocl's syslomalic
risI and nol lry lo maIo any spocific aIIocalion of imporlanco bolvoon llo lvo for cap-
ilaI-budgoling purposos.
Wo ignorod any risI difforoncos bolvoon projocls. Tlis approacl is simpIo bul nol
vaIid, difforonl invoslmonl projocls do in facl conlain difforonl IovoIs of risI. Wo nov
IooI al llo risI-adjuslod discounl ralo, vlicl is basod on llo nolion llal invoslors
roquiro liglor ralos of rolurn on moro risIy projocls.
All lhe melhods used lo compensale lor risk in capilal budgeling lind lheir rools in
PrincipIe 1. The ßisk-ßeturn Trade-O!!-We Won't Take On AdditionaI ßisk UnIess
We Expect to ße Compensated vith AdditionaI ßeturn. ln lacl, lhe risk-adjusled
discounl melhod puls lhis concepl direclly inlo play.
Risk-Adjusted Discount Rates
Tlo uso of risk-adjusted discnunt rates is basod on llo concopl llal invoslors domand
liglor rolurns for moro risIy projocls. Tlis is llo basic principIo bolind PrinciµIe 1 and
llo CAIM, and llis roIalionslip bolvoon risI and rolurn is iIIuslralod graplicaIIy in
Figure 10.5.
As vo Inov from PrinciµIe 1, llo oxpoclod ralo of rolurn on any invoslmonl
slouId incIudo componsalion for doIaying consumplion oquaI lo llo risI-froo ralo of
rolurn, pIus componsalion for any risI laIon on. Undor llo risI-adjuslod discounl ralo
approacl, if llo risI associalod vill llo invoslmonl is groalor llan llo risI invoIvod in
a lypicaI ondoavor, llo discounl ralo is adjuslod upvard lo componsalo for llis addod
risI. Onco llo firm dolorminos llo approprialo roquirod ralo of rolurn for a projocl vill
a givon IovoI of risI, llo casl fIovs aro discounlod bacI lo llo prosonl al llo risI-
adjuslod discounl ralo. Tlon llo normaI capilaI-budgoling criloria aro appIiod, oxcopl in
700.10 CapiIal 8udgeIihg 193
CAßM ModuIe 700 Fihahce
llo caso of llo |RR. Ior llo |RR, llo lurdIo ralo vill vlicl llo projocl's |RR is com-
parod nov bocomos llo risI-adjuslod discounl ralo. Ixprossod mallomalicaIIy, llo
NPV using llo risI-adjuslod discounl ralo bocomos
NPV prosonl vaIuo of aII llo
fuluro annuaI froo casl
fIovs discounlod bacI llo iniliaI casl oulIay (10-4)
lo prosonl al llo risI-adjuslod
ralo of rolurn
|´°, 1 yr
|´°, 2 yr
|´°, n yr
) |O
vloro ICI
llo annuaI froo casl fIov oxpoclod in limo poriod i
|O llo iniliaI casl oulIay
|¯ llo risI-adjuslod discounl ralo
n llo projocl's oxpoclod Iifo
|°, n yr
llo prosonl vaIuo inlorosl faclor for |° and n yoars
Tlo Iogic bolind llo risI-adjuslod discounl ralo sloms from llo idoa llal if llo
IovoI of risI in a projocl is difforonl from llal of llo lypicaI firm projocl, llon manago-
monl musl incorporalo llo slaroloIdors' probabIo roaclion lo llis nov ondoavor inlo
llo docision-maIing procoss. If llo projocl las moro risI llan a lypicaI projocl, llon a
liglor roquirod ralo of rolurn slouId appIy. Ollorviso, marginaI projocls viII Iovor
llo firm's slaro prico÷llal is, roduco slaroloIdors' voaIll. Tlis viII occur as llo mar-
Iol raisos ils roquirod ralo of rolurn on llo firm lo rofIocl llo addilion of a moro risIy
projocl, vloroas llo incromonlaI casl fIovs rosuIling from llo accoplanco of llo nov
projocl aro nol Iargo onougl lo offsol llis clango fuIIy. By llo samo Iogic, if llo projocl
las Ioss llan normaI risI, a roduclion in llo roquirod ralo of rolurn is approprialo.
Tlus, llo risI-adjuslod discounl mollod allompls lo appIy moro slringonl slandards÷
llal is, roquiro a liglor ralo of rolurn÷lo projocls llal viII incroaso llo firm's risI
IovoI. Tlis is bocauso lloso projocls viII Ioad slaroloIdors lo domand a liglor
roquirod ralo of rolurn lo componsalo llom for llo liglor risI IovoI of llo firm. If llis
adjuslmonl is nol mado, llo marginaI projocls conlaining abovo-avorago risI couId
acluaIIy Iovor llo firm's slaro prico.
700.10 CapiIal 8udgeIihg 194
CAßM ModuIe 700 Fihahce
Expecled reluru
íor lakiug ou
added risk
Expecled reluru
íor delayed
fIgure 10.5 Risk-ReIurh RelaIiohship
In praclico, vlon llo risI-adjuslod discounl ralo is usod, projocls aro gonoraIIy
groupod according lo purposo, or risI cIass, llon llo discounl ralo proassignod lo llal
purposo or risI cIass is usod. Ior oxampIo, a firm vill a roquirod ralo of rolurn of
12 porconl migll uso llo foIIoving ralo-of-rolurn calogorizalion:
ßequired ßate
Project o! ßeturn (%)
ReplacemehI decisioh 12
Modi!icaIioh or expahsioh o! exisIihg producI lihe 15
ProiecI uhrelaIed Io currehI operaIiohs 18
Research ahd developmehI operaIiohs 25
Tlo purposo of llis calogorizalion of projocls is lo maIo lloir ovaIualion oasior,
bul il aIso inlroducos a sonso of arbilrarinoss inlo llo caIcuIalions llal maIos llo ovaI-
ualion Ioss moaningfuI. Tlo lrado-offs invoIvod in llo procoding cIassificalion aro
obvious, limo and offorl aro minimizod bul onIy al llo cosl of procision.
Risk-Adjusted Discount Rate and Measurement
of a Project's Systematic Risk
Wlon vo iniliaIIy laIIod aboul syslomalic risI or llo bola, vo voro laIIing aboul moas-
uring il for llo onliro firm. As you rocaII, aIllougl vo couId oslimalo a firm's bola
using lisloricaI dala, vo did nol lavo compIolo confidonco in our rosuIls. As vo viII
soo, oslimaling llo approprialo IovoI of syslomalic risI for a singIo projocl is ovon moro
fraugll vill difficuIlios. To lruIy undorsland vlal il is vo aro lrying lo do and llo dif-
ficuIlios vo viII oncounlor, Iol us slop bacI a bil and oxamino syslomalic risI and llo
risI adjuslmonl for a projocl.
700.10 CapiIal 8udgeIihg 195
CAßM ModuIe 700 Fihahce
A loy manulaclurer is considering lhe inlroduclion ol a line ol lishing equipmenl wilh an expecled lile ol 5 years. ln lhe
pasl, lhis lirm has been quile conservalive in ils inveslmenl in new producls, slicking primarily lo slandard loys. ln lhis con-
lexl, lhe inlroduclion ol a line ol lishing equipmenl is considered an abnormally risky projecl. Managemenl lhinks lhal lhe
normal required rale ol relurn lor lhe lirm ol !0 percenl is nol sullicienl. lnslead, lhe minimum acceplable rale ol relurn
on lhis projecl should be !5 percenl. The inilial oullay would be S!!0,000, and lhe expecled cash llows lrom lhis projecl
are given in lhe lollowing lable.
Year Expected free Cash fIov
1 $30,000
2 30,000
3 30,000
4 30,000
5 30,000
Discounling lhis annuily back lo lhe presenl al !5 percenl yields a presenl value ol lhe lulure lree cash llows ol S!00,560.
8ecause lhe inilial oullay on lhis projecl is S!!0,000, lhe  becomes S9,440, and lhe projecl should be rejecled. ll lhe
normal required rale ol relurn ol !0 percenl had been used as lhe discounl rale, lhe projecl would have been accepled
wilh a  ol S3,730.
Wlal vo aro lrying lo do is uso llo CAIM lo dolormino llo IovoI of risI and llo
approprialo risI÷rolurn lrado-offs for a parlicuIar projocl. Wo llon laIo llo oxpoclod
rolurn on llis projocl and comparo il lo llo roquirod rolurn suggoslod by llo CAIM lo
dolormino vlollor llo projocl slouId bo accoplod. If llo projocl appoars lo bo a lypicaI
ono for llo firm, using llo CAIM lo dolormino llo approprialo risI÷rolurn lrado-offs and
llon judging llo projocl againsl llom may bo a varranlod approacl. Bul if llo projocl is
nol a lypicaI projocl, vlal do vo do` HisloricaI dala gonoraIIy do nol oxisl for a nov
projocl. In facl, for somo capilaI invoslmonls÷for oxampIo, a lrucI or a nov buiIding÷
lisloricaI dala vouId nol lavo mucl moaning. Wlal vo nood lo do is maIo llo bosl of a
bad silualion. Wo oillor (1) faIo il÷llal is, uso lisloricaI accounling dala, if avaiIabIo, lo
subslilulo for lisloricaI prico dala in oslimaling syslomalic risI÷or (2) vo allompl lo find
a subslilulo firm in llo samo induslry as llo capilaI-budgoling projocl and uso llo subsli-
lulo firm's oslimalod syslomalic risI as a proxy for llo projocl's syslomalic risI.
8eta £stimation Using Accounting Data
Wlon vo aro doaIing vill a projocl llal is idonlicaI lo llo firm's ollor projocls, vo
nood onIy oslimalo llo IovoI of syslomalic risI for llo firm and uso llal oslimalo as a
proxy for llo projocl's risI. UnforlunaloIy, vlon projocls aro nol lypicaI of llo firm,
llis approacl doos nol vorI. Ior oxampIo, vlon R. I. RoynoIds inlroducos a nov food
llrougl ono of ils food producls divisions, llis nov producl mosl IiIoIy carrios vill il
a difforonl IovoI of syslomalic risI from vlal is lypicaI for RoynoIds as a vloIo.
To gol a bollor approximalion of llo syslomalic risI IovoI on llis projocl, vo oslimalo
llo IovoI of syslomalic risI for llo food division and uso llal as a proxy for llo projocl's
syslomalic risI. UnforlunaloIy, lisloricaI slocI prico dala aro avaiIabIo onIy for llo com-
pany as a vloIo, and as you rocaII, lisloricaI slocI rolurn dala aro gonoraIIy usod lo osli-
malo a firm's bola. Tlus, vo aro forcod lo uso accounling rolurn dala rallor llan lisloricaI
slocI rolurn dala for llo division lo oslimalo llo division's syslomalic risI. To oslimalo a
projocl's bola using accounling dala vo nood onIy run a limo-sorios rogrossion of llo divi-
sion's rolurn on assols (nol incomo/lolaI assols) on llo marIol indox (llo S&I 500). Tlo
rogrossion coofficionl from llis oqualion vouId bo llo projocl's accounling bola and vouId
sorvo as an approximalion for llo projocl's lruo bola, or moasuro of syslomalic risI. AIlor-
nalivoIy, a muIlipIo rogrossion modoI basod on accounling dala couId bo dovoIopod lo
oxpIain bolas. Tlo rosuIls of llis modoI couId llon bo appIiod lo firms llal aro nol pubIicIy
lradod lo oslimalo lloir bolas.
Hov good is llo accounling bola loclniquo` Il corlainIy is nol as good as a dirocl
caIcuIalion of llo bola. In facl, llo corroIalion bolvoon llo accounling bola and llo
bola caIcuIalod on lisloricaI slocI rolurn dala is onIy aboul 0.6, lovovor, bollor IucI
las boon oxporioncod vill muIlipIo rogrossion modoIs usod lo prodicl bolas. Unforlu-
naloIy, in many casos lloro may nol bo any roaIislic aIlornalivo lo llo caIcuIalion of llo
accounling bola. Oving lo llo imporlanco of adjusling for a projocl's risI, llo accounl-
ing bola mollod is mucl proforrod lo doing nolling.
The Pure PIay Method !or Estimating a Project's ßeta
Wloroas llo accounling bola mollod allompls lo diroclIy oslimalo a projocl or divi-
sion's bola, llo µure µIav methnd allompls lo idonlify pubIicIy lradod firms llal aro
ongagod soIoIy in llo samo businoss as llo projocl or division. Onco llo proxy or puro
pIay firm is idonlifiod, ils syslomalic risI is dolorminod and llon usod as a proxy for
llo projocl's or division's IovoI of syslomalic risI. Wlal vo aro doing is |cc|inv |cr c
pu||ic|u irc!c! |irm cn i|c cuisi!c i|ci |cc|s |i|c cur prcjcci cn! usinv i|ci |irm´s rc¡uirc!
rcic c| rciurn ic ju!vc cur prcjcci. In doing so vo aro prosuming llal llo syslomalic risI
and llo capilaI slrucluro of llo proxy firm aro idonlicaI lo lloso of llo projocl.
In using llo puro pIay mollod il slouId bo nolod llal a firm's capilaI slrucluro is
rofIoclod in ils bola. Wlon llo capilaI slrucluro of llo proxy firm is difforonl from llal of
llo projocl's firm, somo adjuslmonl musl bo mado for llis difforonco. AIllougl nol a
porfocl approacl, il doos provido somo insiglls aboul llo IovoI of syslomalic risI a proj-
ocl migll lavo.
700.10 CapiIal 8udgeIihg 196
CAßM ModuIe 700 Fihahce
Simulation: £xplained and lllustrated
Anollor mollod for ovaIualing risI in llo invoslmonl docision is llrougl llo uso of
simuIatinn. Tlo risI-adjuslod discounl ralo approacl providod us vill a singIo vaIuo
for llo risI-adjuslod NPV, vloroas a simuIalion approacl givos us a probabiIily dislri-
bulion for llo invoslmonl's NPV or |RR. SimuIalion intc|tcs i|c prcccss c| imiiciinv i|c
pcr|crmcncc c| i|c prcjcci un!cr ctc|uciicn. 1|is is !cnc |u rcn!cm|u sc|cciinv c|scrtciicns
|rcm ccc| c| i|c !isiri|uiicns i|ci c||cci i|c cuiccmc c| i|c prcjcci, cn! ccniinuinv uii| i|is
prcccss unii| c rcprcscniciitc rcccr! c| i|c prcjcci´s prc|c||c cuiccmc is csscm||c!.
Tlo oasiosl vay lo dovoIop an undorslanding of llo compulor simuIalion procoss is
lo foIIov llrougl an oxampIo simuIalion for an invoslmonl projocl ovaIualion. Supposo
a clomicaI producor is considoring an oxlonsion lo ils procossing pIanl. Tlo simuIalion
procoss is porlrayod in Figure 10.6. Iirsl, llo probabiIily dislribulions aro dolorminod for
aII llo faclors llal affocl llo projocl's rolurns, in llis caso, Iol us assumo lloro aro nino
sucl variabIos:
1. MarIol sizo
2. SoIIing prico
3. MarIol grovll ralo
4. Slaro of marIol (vlicl rosuIls in plysicaI saIos voIumo)
5. Invoslmonl roquirod
6. RosiduaI vaIuo of invoslmonl
7. Oporaling cosls
8. Iixod cosls
9. UsofuI Iifo of faciIilios
Tlon llo compulor randomIy soIocls ono obsorvalion from oacl of llo probabiI-
ily dislribulions, according lo ils clanco of acluaIIy occurring in llo fuluro. Tloso
nino obsorvalions aro combinod, and an NPV or |RR figuro is caIcuIalod. Tlis
procoss is ropoalod as many limos as dosirod, unliI a roprosonlalivo dislribulion of
possibIo fuluro oulcomos is assombIod. Tlus, llo inpuls lo a simuIalion incIudo aII
llo principaI faclors affocling llo projocl's profilabiIily, and llo simuIalion oulpul is
a probabiIily dislribulion of nol prosonl vaIuos or inlornaI ralos of rolurn for llo proj-
ocl. Tlo docision maIor basos llo docision on llo fuII rango of possibIo oulcomos.
Tlo projocl is accoplod if llo docision maIor fooIs llal onougl of llo dislribulion Iios
abovo llo normaI culoff criloria (NPV 0, |RR roquirod ralo of rolurn).
Supposo llo oulpul from llo simuIalion of a clomicaI producor's projocl is as
slovn in Figure 10.7. Tlis oulpul providos llo docision maIor vill llo probabiIily of
difforonl oulcomos occurring in addilion lo llo rango of possibIo oulcomos. Somolimos
caIIod scenarin anaIvsis, llis cxcminciicn i!cnii|ics i|c rcnvc c| pcssi||c cuiccmcs un!cr i|c
ucrsi, |csi, cn! mcsi |i|c|u ccscs. Tlo firm's managomonl oxaminos llo dislribulion lo
dolormino llo projocl's IovoI of risI and llon maIos llo approprialo adjuslmonl.
You'II nolico llal aIllougl llo simuIalion approacl loIps us lo dolormino llo
amounl of lolaI risI a projocl las, il doos nol difforonlialo bolvoon syslomalic and
unsyslomalic risI. Bocauso syslomalic risI cannol bo divorsifiod avay for froo, llo
simuIalion approacl doos nol provido a compIolo mollod of risI assossmonl.
Hovovor, il doos provido imporlanl insiglls aboul llo lolaI risI IovoI of a givon
invoslmonl projocl. Nov vo viII IooI briofIy al lov llo simuIalion approacl can
bo usod lo porform sonsilivily anaIysis.
700.10 CapiIal 8udgeIihg 197
CAßM ModuIe 700 Fihahce
700.10 CapiIal 8udgeIihg 198
CAßM ModuIe 700 Fihahce
Step 2: Raudouly selecl
values írou lhese
Step 1: 0evelop probabilily dislribulious íor key íaclors.
Step 4: Couliuue lo repeal lhis process uulil a clear
porlrail oí lhe resulls is oblaiued.
Step 3: Coubiue lhese íaclors aud deleruiue au iulerual rale oí reluru.
Step 5: Evaluale lhe resullaul probabilily dislribuliou.
\alue rauge
value oí
Share oí
useíul liíe
oí íacililies
|ulerual rale oí reluru
figure 10.6 CapiIal-8udgeIihg SimulaIioh
Sensitivity Analysis Through Simulation Approach
Sensitivitv anaIvsis invoIvos !cicrmininv |cu i|c !isiri|uiicn c| pcssi||c nci prcscni tc|-
ucs cr inicrnc| rcics c| rciurn |cr c pcriicu|cr prcjcci is c||ccic! |u c c|cnvc in cnc pcriicu|cr
inpui tcric||c. Tlis is dono by clanging llo vaIuo of ono inpul variabIo vliIo loIding
aII ollor inpul variabIos conslanl. Tlo dislribulion of possibIo nol prosonl vaIuos or
inlornaI ralos of rolurn llal is gonoralod is llon comparod vill llo dislribulion of pos-
sibIo rolurns gonoralod boforo llo clango vas mado lo dolormino llo offocl of llo
clango. Ior llis roason sonsilivily anaIysis is commonIy caIIod u|ci-i| cnc|usis.
Ior oxampIo, llo clomicaI producor llal is considoring a possibIo oxpansion lo ils
pIanl may visl lo dolormino llo offocl of a moro possimislic forocasl of llo anlicipalod
marIol grovll ralo. Aflor llo moro possimislic forocasl ropIacos llo originaI forocasl
in llo modoI, llo simuIalion is rorun. Tlo lvo oulpuls aro llon comparod lo dolormino
lov sonsilivo llo rosuIls aro lo llo rovisod oslimalo of llo marIol grovll ralo.
700.10 CapiIal 8udgeIihg 199
CAßM ModuIe 700 Fihahce
InternaI rate of return (%)
0 1S 30
figure 10.7 OuIpuI !rom SimulaIioh
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 200
700.11.1 Undorsland lov a financiaI managor raisos funds oillor inlornaIIy or
oxlornaIIy and undorsland llo ralo-of-rolurn roIalionslips among various cIassos
of financing inslrumonls avaiIabIo in llo financiaI marIols
700.11.2 Undorsland llo compononls of llo U.S. financiaI marIol syslom
700.11.3 Undorsland llo roIo of llo invoslmonl banIor and privalo pIacomonls
and Ioarn aboul llo fIolalion cosls in raising llo Iong-lorm capilaI
700.11.4 Undorsland llo roIo of llo roguIalions in financiaI marIols
700.11 Financial lnstitutions
and Narkets
700.11.1 Understand hov a !inanciaI manager
raises !unds either internaIIy or externaIIy and
understand the rate-o!-return reIationships among
various cIasses o! !inancing instruments avaiIabIe
in the !inanciaI markets
Al limos, inlornaIIy gonoralod funds viII nol bo sufficionl lo financo aII of llo firm's
proposod oxpondiluros. In lloso silualions, llo corporalion may find il nocossary lo
allracl Iargo amounls of financiaI capilaI oxlornaIIy or ollorviso forgo projocls llal aro
forocasl lo bo profilabIo. By cxicrnc||u vcncrcic!, vo moan llal llo funds aro oblainod
by moans ci|cr i|cn llrougl rolonlions or doprocialion. Iunds from lloso Iallor lvo
sourcos aro commonIy caIIod inicrnc||u vcncrcic! |un!s. Businoss firms in llo nonfinan-
ciaI corporalo soclor of llo U.S. oconomy roIy loaviIy on llo nalion's financiaI marIol
syslom lo raiso casl.
Tlo financiaI oxoculivo is porpoluaIIy on lis or lor loos rogarding marIol condi-
lions. Clangos in marIol condilions infIuonco llo prociso vay corporalo funds aro
raisod. Higl roIalivo inlorosl ralos, for inslanco, viII dolor llo uso of dobl inslrumonls
by llo financiaI managor.
Tlo financiaI marIol syslom musl bo boll organizod and rosiIionl. Ioriods of oco-
nomic rocossion, for inslanco, losl llo financiaI marIols and lloso firms llal conlinu-
aIIy uso llo marIols. Iconomic conlraclions aro ospociaIIy claIIonging lo financiaI
docision maIors bocauso aII rocossions aro uniquo. Tlis forcos financing poIicios lo
bocomo uniquo.
Corporalo profilabiIily aIso pIays a cruciaI roIo in llo dolorminalion of llo
inlornaI÷oxlornaI financing cloico.
Tlo coIIoclivo bolavior of companios llal rosuIls in firms rolaining inlornaIIy gon-
oralod casl rallor llan paying il lo slocIloIdors as dividonds or lo crodilors (bond-
loIdors) as inlorosl is roforrod lo by financiaI oconomisls and anaIysls as llo inicrnc|
ccpiic| mcr|ci. Tlis is bocauso llo firm aIIocalos llo casl fIovs lo nov projocls. On llo
ollor land, if llo casl paymonls voro mado diroclIy lo slocIloIdors and crodilors, llo
funds vouId uIlimaloIy bo aIIocalod lo nov projocls llrougl llo oxlornaI capilaI
As Figure 11.1 slovs, llo inlornaI capilaI marIol accounlod for 72.3 porconl of
nonfinanciaI corporalions' sourcos of funds ovor llo 1981÷2000 poriod. Clanging oco-
nomic condilions causo llis roIalionslip lo conlinuaIIy slifl bocauso oxoculivos conlin-
uaIIy adjusl lo llo nov informalion llal oncompassos llo businoss cycIo, inlorosl ralos,
and slocI pricos.
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 201
CAßM ModuIe 700 Fihahce
InternaI funds
LxternaI funds
figure 11.1 Noh!ihahcial CorporaIe 8usihess Sources o! Fuhds, 1981 Io 2000
Wlon corporalions docido lo raiso casl in llo capilaI marIol, vlal lypo of financing
volicIo is mosl favorod` Many individuaI invoslors llinI llal common slocI is llo
ansvor lo llis quoslion. Tlis is undorslandabIo, givon llo covorago of llo IovoI of com-
mon slocI pricos by llo popuIar novs modia. AII llo major loIovision nolvorIs, for
inslanco, quolo llo cIosing prico of llo Dov Ionos InduslriaI Avorago on lloir nigllIy
novs broadcasls. Common slocI, llougl, is nol llo financing mollod corporalions
mosl roIy on, rallor, lloy uso ccrpcrcic |cn!s. 1|c ccrpcrcic !c|i mcr|cis c|ccr|u !cmincic
i|c ccrpcrcic c¡uiiu mcr|cis u|cn ncu |un!s crc |cinv rcisc!. Tlis is a Iong-lorm
roIalionslip÷il occurs yoar aflor yoar.
Wo Ioarn from our discussions of llo cosl of capilaI and pIanning llo firm's financ-
ing mix llal llo U.S. lax syslom inloronlIy favors dobl as a moans of raising capilaI.
Ouilo simpIy, inlorosl oxponso is doduclibIo from ollor incomo vlon compuling llo
firm's fodoraI lax IiabiIily, vloroas llo dividonds paid on boll proforrod and common
slocI aro nol.
IinanciaI oxoculivos rosponsibIo for raising corporalo casl Inov llis. Wlon lloy
lavo a cloico bolvoon marIoling nov bonds and marIoling nov proforrod slocI, llo
oulcomo is usuaIIy in favor of bonds. Tlo aflor-lax cosl of capilaI on dobl is Ioss llan
llal incurrod on proforrod slocI. IiIoviso, if llo firm las unusod dobl capacily and
llo gonoraI IovoI of oquily pricos is doprossod, financiaI oxoculivos favor llo issuanco
of dobl socurilios ovor llo issuanco of nov common slocI.
Our previous discussion on lhe linancing prelerences ol corporale execulives provides
langible evidence ol Principle 8: Taxes 8ias 8usiness Decisions. The U.S. lax code allows
corporalions lo deducl lhe inleresl expense associaled wilh debl conlracls lrom lhe income
levels lhal are laxed. On lhe olher hand, common and prelerred slock cash dividend
paymenls lo inveslors are nol lax deduclible. Thus, lhe logical choice made by execulives on
behall ol lheir lirms and shareholders is lo linance lhe nexl dollar ol exlernally raised capilal
by means ol some debl conlracl such as bonds and noles. This decision saves lhe lirm cash
llows because lhe lax bill is lower. And, we remember. Principle J: Cash-Not Profits-ls
King. You see how il all lies logelher. The lirm would ralher have more cash, inslead ol less
cash, and so would ils slockholders.
FinanciaI markets aro insiiiuiicns cn! prccc!urcs i|ci |cci|iicic ircnscciicns in c|| iupcs c|
|incncic| c|cims. Tlo purclaso of your lomo, llo common slocI you may ovn, and
your Iifo insuranco poIicy aII looI pIaco in somo lypo of financiaI marIol. Wly do
financiaI marIols oxisl` Wlal vouId llo oconomy Ioso if our compIox syslom of finan-
ciaI marIols voro nol dovoIopod` Wo viII addross lloso quoslions loro.
Somo cccncmic uniis, sucl as lousoloIds, firms, or govornmonls, spond moro
during a givon poriod llan lloy oarn. Ollor oconomic unils spond Ioss on curronl
consumplion llan lloy oarn. Ior oxampIo, businoss firms in llo aggrogalo usuaIIy
spond moro during a spocific poriod llan lloy oarn. HousoloIds in llo aggrogalo
spond Ioss on curronl consumplion llan lloy oarn. As a rosuIl, somo moclanism is
noodod lo faciIilalo llo lransfor of savings from lloso oconomic unils vill a surpIus
lo lloso vill a doficil. Tlal is procisoIy llo funclion of financiaI marIols. IinanciaI
marIols oxisl in ordor lo aIIocalo llo suppIy of savings in llo oconomy lo llo doman-
dors of lloso savings. Tlo conlraI claraclorislic of a financiaI marIol is llal il acls as
llo volicIo llrougl vlicl llo forcos of domand and suppIy for a spocific lypo of
financiaI cIaim (sucl as a corporalo bond) aro brougll logollor.
Nov, vly vouId llo oconomy suffor villoul a dovoIopod financiaI marIol sys-
lom` Tlo ansvor is llal llo voaIll of llo oconomy vouId bo Ioss villoul llo financiaI
marIols. Tlo ralo of capilaI formalion vouId nol bo as ligl if financiaI marIols did
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 202
CAßM ModuIe 700 Fihahce
nol oxisl. Tlis moans llal llo nol addilions during a spocific poriod lo llo slocIs of
(1) dvoIIings, (2) produclivo pIanl and oquipmonl, (3) invonlory, and (4) consumor
durabIos vouId occur al Iovor ralos. Figure 11.2 loIps cIarify llo ralionaIo bolind llis
assorlion. Tlo abbrovialod baIanco slools in llo figuro rofor lo firms or any ollor lypo
of oconomic unils llal oporalo in llo privalo, as opposod lo govornmonlaI, soclors of
llo oconomy. Tlis moans llal sucl unils cannol issuo monoy lo financo lloir ovn
Al slago 1 in Iiguro 11.2, onIy roaI assols oxisl in llo lypollolicaI oconomy. ReaI
assets aro icnvi||c csscis suc| cs |cuscs, c¡uipmcni, cn! intcnicrics. Tloy aro dislin-
guislod from IinanciaI assets, vlicl roprosonl c|cims |cr |uiurc pcumcni cn ci|cr ccc-
ncmic uniis. Common and proforrod slocIs, bonds, biIIs, and nolos aII aro lypos of
financiaI assols. If onIy roaI assols oxisl, llon savings for a givon oconomic unil, sucl as
a firm, musl bo accumuIalod in llo form of roaI assols. If llo firm las a groal idoa for a
nov producl, llal nov producl can bo dovoIopod, producod, and dislribulod onIy oul
of company savings (rolainod oarnings). Iurllormoro, aII invoslmonl in llo nov prod-
ucl musl occur simuIlanoousIy as llo savings aro gonoralod. If you lavo llo idoa, and
vo lavo llo savings, lloro is no moclanism lo lransfor our savings lo you. Tlis is nol
a good silualion.
Al slago 2, papor monoy (casl) comos inlo oxislonco in llo oconomy. Horo, al Ioasl,
you can sicrc your ovn savings in llo form of monoy. Tlus, you can financo your
groal idoa by draving dovn your casl baIancos. Tlis is an improvomonl ovor slago 1,
bul lloro is sliII no offoclivo moclanism lo lransfor our savings lo you. You soo, vo
von'l jusl land you our doIIar biIIs÷vo'II vanl a rocoipl.
Tlo concopl of a rocoipl llal roprosonls llo lransfor of savings from ono oconomic
unil lo anollor is a monumonlaI advancomonl. Tlo oconomic unil vill oxcoss savings
can Iond llo savings lo an oconomic unil llal noods llom. To llo Ionding unil, lloso
rocoipls aro idonlifiod as ¨ollor financiaI assols¨ in slago 3 of Iiguro 11.2. To llo borrov-
ing unil, llo issuanco of financiaI cIaims (rocoipls) slovs up as ¨financiaI IiabiIilios¨ on
llo slago 3 baIanco slool. Tlo oconomic unil vill surpIus savings oarns a ralo of rolurn
on lloso funds. Tlo borroving unil musl pay llal ralo of rolurn, bul il las boon abIo lo
financo ils groal idoa.
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 203
CAßM ModuIe 700 Fihahce
Balauce sheel
Slage 1.
Jolal = Jolal
Balauce sheel
Slage 2.
Jolal = Jolal
Slage 4.
Slage S.
Balauce sheel
Slage 3.
Jolal = Jolal
Real assels Nel worlh
Real assels
Nel worlh
Jhe addiliou oí (1ì loau brokers, (2ì securily uuderwrilers, aud (3ì secoudary uarkels
Jhe addiliou oí íiuaucial iuleruediaries
0lher íiuaucial assels
Real assels
|iuaucial liabililies
Nel worlh
figure 11.2 DevelopmehI o! a Fihahcial MarkeI SysIem
In slago 4 llo financiaI marIol syslom movos furllor lovard fuII dovoIopmonl.
Ioan broIors como inlo oxislonco. Tloso broIors loIp Iocalo pocIols of oxcoss savings
and clannoI sucl savings lo oconomic unils nooding llo funds. Somo oconomic unils
acluaIIy purclaso llo financiaI cIaims of borroving unils and soII llom al a liglor
prico lo ollor invoslors, llis procoss is caIIod un!cruriiinv. Undorvriling is discussod
in moro dolaiI Ialor in llis soclion. In addilion, secnndarv markets dovoIop. Socondary
marIols simpIy roprosonl irc!inv in c|rcc!u cxisiinv |incncic| c|cims. If you buy your
brollor's GonoraI Molors common slocI, you lavo mado a socondary marIol lransac-
lion. Socondary marIols roduco llo risI of invosling in financiaI cIaims. SlouId you
nood casl, you can Iiquidalo your cIaims in llo socondary marIol. Tlis inducos savors
lo invosl in socurilios.
Tlo progrossion lovard a dovoIopod and compIox syslom of financiaI marIols
onds vill slago 5. Horo, financiaI inlormodiarios como inlo oxislonco. You can llinI of
financiaI inlormodiarios as llo major financiaI inslilulions you'ro usod lo doaIing vill.
Tloso incIudo commorciaI banIs, savings and Ioan associalions, crodil unions, Iifo
insuranco companios, and muluaI funds. IinanciaI inlormodiarios slaro a common
claraclorislic: Tloy offor i|cir cun |incncic| c|cims, caIIod indirect securities, lo oco-
nomic unils vill oxcoss savings. Tlo procoods from soIIing lloir indirocl socurilios aro
llon usod lo purclaso llo |incncic| c|cims c| ci|cr cccncmic uniis. Tloso Iallor cIaims can
bo caIIod direct securities. Tlus, a muluaI fund migll soII muluaI fund slaros (lloir
indirocl socurily) and purclaso llo common slocIs (dirocl socurilios) of somo major
corporalions. A Iifo insuranco company soIIs Iifo insuranco poIicios and purclasos
lugo quanlilios of corporalo bonds. IinanciaI inlormodiarios lloroby invoIvo many
smaII savors in llo procoss of capilaI formalion. Tlis moans lloro aro moro ¨good
llings¨ for ovorybody lo buy.
A dovoIopod financiaI marIol syslom providos for a groalor IovoI of voaIll in llo
oconomy. In llo absonco of financiaI marIols, savings aro nol lransforrod lo llo oconomic
unils mosl in nood of lloso funds. Il is difficuIl, aflor aII, for a lousoloId lo buiId ils ovn
aulomobiIo. Tlo financiaI marIol syslom maIos il oasior for llo oconomy lo buiId aulo-
mobiIos and aII llo ollor goods llal oconomic unils IiIo lo accumuIalo.
Tlo movomonl of financiaI capilaI (funds) llrougloul llo oconomy jusl moans llo
movomonl of savings lo llo uIlimalo usor of lloso savings. Somo soclors of llo ocon-
omy savo moro llan ollor soclors. As a rosuIl, lloso savings aro movod lo a produclivo
uso÷say, lo manufacluro llal Corvollo you vanl lo buy.
Tlo prico of using somoono oIso's savings is oxprossod in lorms of inlorosl ralos.
Tlo financiaI marIol syslom loIps lo movo funds lo llo mosl produclivo ond uso.
Tloso oconomic unils vill llo mosl promising projocls slouId bo viIIing lo bid llo
liglosl (in lorms of ralos) lo oblain llo savings. Tlo concopls of financing and moving
savings from ono oconomic unil lo anollor aro oxpIorod in llis soclion.
The Iinancing Process
Wo nov undorsland llo cruciaI roIo llal financiaI marIols pIay in a capilaIisl ocon-
omy. Al llis poinl vo laIo a briof IooI al lov funds fIov across somo soIoclod soclors
of llo U.S. oconomy. In addilion, vo focus a IillIo moro cIosoIy on llo procoss of finan-
ciaI inlormodialion llal vas inlroducod in llo procoding soclion. Somo acluaI dala aro
usod lo slarpon our InovIodgo of llo financing procoss. Wo viII soo llal financiaI
inslilulions pIay a major roIo in bridging llo gap bolvoon savors and borrovors in llo
oconomy. NonfinanciaI corporalions, vo aIroady Inov, aro significanl borrovors of
financiaI capilaI.
Wo lavo soon loro llal llo financiaI marIol syslom musl oxisl lo faciIilalo llo
ordorIy and officionl fIov of savings from llo surpIus soclors lo llo doficil soclors of
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 204
CAßM ModuIe 700 Fihahce
llo oconomy. Ovor Iong poriods, llo nonfinanciaI businoss soclor is lypicaIIy dopon-
donl on llo lousoloId soclor lo financo ils invoslmonl noods. Ioroign financing aIso
pIays an imporlanl roIo in llo U.S. oconomy.
Movement of Savings
Figure 11.3 providos a usofuI vay lo summarizo our discussion of (1) vly financiaI
marIols oxisl and (2) llo movomonl of funds llrougl llo oconomy. Il aIso sorvos as an
inlroduclion lo llo roIo of llo invoslmonl banIor.
Wo soo llal savings aro uIlimaloIy lransforrod lo llo businoss firm in nood of casl
in llroo vays.
1. The direct transIer nI Iunds. Horo llo firm sooIing casl soIIs ils socurilios
diroclIy lo savors (invoslors) vlo aro viIIing lo purclaso llom in lopos of
oarning a roasonabIo ralo of rolurn. Nov businoss formalion is a good oxampIo
of llis procoss al vorI. Tlo nov businoss may go diroclIy lo a savor or group
of savors caIIod vonluro capilaIisls. Tlo vonluro capilaIisls Iond funds lo llo
firm or laIo an oquily posilion in llo firm if lloy fooI llo producl or sorvico
llo nov firm lopos lo marIol viII bo succossfuI.
2. Indirect transIer using the investment banker. In a common arrangomonl
undor llis syslom, llo managing invoslmonl-banIing louso forms a syndicalo
of sovoraI invoslmonl banIors. Tlo syndicalo buys llo onliro issuo of socurilios
from llo firm llal is in nood of financiaI capilaI. Tlo syndicalo llon soIIs llo
socurilios al a liglor prico llan il paid for llom lo llo invosling pubIic (llo
savors). SaIomon Smill Barnoy and GoIdman Sacls aro oxampIos of
invoslmonl-banIing firms. Tloy lond lo bo caIIod ¨lousos¨ by lloso vlo vorI
in llo financiaI communily. Nolico llal undor llis socond mollod of
lransforring savings, llo socurilios boing issuod jusl pass llrougl llo
invoslmonl-banIing firm. Tloy aro nol lransformod inlo a difforonl lypo of
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 205
CAßM ModuIe 700 Fihahce
ßirect transfer of funds
Indirect transfer using the
investment banker
Indirect transfer using the
financiaI intermediary
Jhe busiuess íiru
(a saviugs·deíicil uuilì
Jhe busiuess íiru
(a saviugs·deíicil uuilì
Jhe busiuess íiru
(a saviugs·deíicil uuilì
baukiug íiru
Savers (saviugs·
surplus uuilsì
Savers (saviugs·
surplus uuilsì
Savers (saviugs·
surplus uuilsì
figure 11.3 1hree Ways Io 1rahs!er Fihahcial CapiIal ih Ihe Lcohomy
3. Indirect transIer using the IinanciaI intermediarv. Tlis is llo lypo of syslom
Iifo insuranco companios and ponsion funds oporalo villin. Tlo financiaI
inlormodiary coIIocls llo savings of individuaIs and issuos ils ovn (indirocl)
socurilios in oxclango for lloso savings. Tlo inlormodiary llon usos llo funds
coIIoclod from llo individuaI savors lo acquiro llo businoss firm's (dirocl)
socurilios, sucl as slocIs and bonds.
Wo aII bonofil from llo llroo lransfor moclanisms dispIayod in Iiguro 11.3. Capi-
laI formalion and oconomic voaIll aro groalor llan lloy vouId bo in llo absonco of
llis financiaI marIol syslom.
In discussing ¨llo financing procoss¨ vo nolod llal nol usors of funds (savings-doficil
oconomic unils) musl compolo vill ono anollor for llo funds suppIiod by nol savors
(savings-surpIus oconomic unils). ConsoquonlIy, lo oblain financing for projocls llal
viII bonofil llo firm's slocIloIdors, llo firm musl offor llo suppIior (savings-surpIus
unil) a ralo of rolurn ccmpciiiitc vill llo noxl bosl invoslmonl aIlornalivo avaiIabIo lo
llal savor (invoslor). Tlis rcic c| rciurn cn i|c ncxi |csi intcsimcni c|icrnciitc ic i|c sctcr
is Inovn as llo suppIior's nµµnrtunitv cnst nI Iunds. Tlo opporlunily cosl concopl is
cruciaI in financiaI managomonl and is roforrod loo oflon.
700.11.2 Understand the components o! the
U.5. !inanciaI market system
Numorous approaclos oxisl for cIassifying llo socurilios marIols. Al limos, llo array
can bo confusing. An oxaminalion of four sols of diclolomous lorms can loIp provido
a basic undorslanding of llo slrucluro of llo U.S. financiaI marIols.
Public Offerings and Private Placements
Wlon a corporalion docidos lo raiso oxlornaI capilaI, lloso funds can bo oblainod by
maIing a pubIic offoring or a privalo pIacomonl. In a µubIic nIIering |ci| in!iti!uc|
cn! insiiiuiicnc| intcsicrs |ctc i|c cppcriuniiu ic purc|csc i|c sccuriiics. Tlo socurilios aro
usuaIIy mado avaiIabIo lo llo pubIic al Iargo by a managing invoslmonl-banIing firm
and ils undorvriling (risI-laIing) syndicalo. Tlo firm doos nol mool llo uIlimalo pur-
clasors of llo socurilios in llo pubIic offoring. Tlo pubIic marIol is an imporsonaI
In a µrivate µIacement, aIso caIIod a direct µIacement, llo socurilios aro offorod
and soId lo a |imiic! num|cr c| intcsicrs. Tlo firm viII usuaIIy lammor oul, on a faco-
lo-faco basis vill llo prospoclivo buyors, llo dolaiIs of llo offoring. In llis solling llo
invoslmonl-banIing firm may acl as a findor by bringing logollor polonliaI Iondors
and borrovors. Tlo privalo pIacomonl marIol is a moro porsonaI marIol llan ils pub-
Iic counlorparl.
Primary Markets and Secondary Markets
Primarv markets aro i|csc in u|ic| sccuriiics crc c||crc! |cr i|c |irsi iimc ic pcicniic|
intcsicrs. A nov issuo of common slocI by AT&T is a primary marIol lransaclion. Tlis
lypo of lransaclion incroasos llo lolaI slocI of financiaI assols oulslanding in llo
As monlionod in our discussion of llo dovoIopmonl of llo financiaI marIol sys-
lom, scccn!cru mcr|cis roprosonl lransaclions in curronlIy oulslanding socurilios. If llo
firsl buyor of llo AT&T slocI subsoquonlIy soIIs il, lo or slo doos so in llo socondary
marIol. AII lransaclions aflor llo iniliaI purclaso laIo pIaco in llo socondary marIol.
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 206
CAßM ModuIe 700 Fihahce
Tlo saIos do nci affocl llo lolaI slocI of financiaI assols llal oxisls in llo oconomy.
Boll llo monoy marIol and llo capilaI marIol, doscribod noxl, lavo primary and soc-
ondary sidos.
Money Market and Capital Market
Money Market
Tlo Ioy dislinguisling foaluro bolvoon llo monoy and capilaI marIols is llo malurily
poriod of llo socurilios lradod in llom. Tlo mnnev market rofors lo c|| insiiiuiicns cn!
prccc!urcs i|ci prcti!c |cr ircnscciicns in s|cri-icrm !c|i insirumcnis gonoraIIy issuod by
borrovors vill vory ligl crodil ralings. By financiaI convonlion, s|cri-icrm moans
malurily poriods of 1 yoar or Ioss. Nolico llal oquily inslrumonls, oillor common or
proforrod, aro nol lradod in llo monoy marIol. Tlo major inslrumonls issuod and
lradod aro U.S. Troasury biIIs, various fodoraI agoncy socurilios, banIors' accoplancos,
nogoliabIo corlificalos of doposil, and commorciaI papor. Koop in mind llal llo monoy
marIol is an inlangibIo marIol. You do nol vaII inlo a buiIding on WaII Slrool llal las
llo vords ¨Monoy MarIol¨ olclod in slono ovor ils arclos. Rallor, llo monoy marIol
is primariIy a loIoplono and compulor marIol.
CapitaI Market
Tlo caµitaI market rofors lo c|| insiiiuiicns cn! prccc!urcs i|ci prcti!c |cr ircnscciicns in
|cnv-icrm |incncic| insirumcnis. Icnv-icrm loro moans laving malurily poriods llal
oxlond boyond ono yoar. In llo broad sonso llis oncompassos lorm Ioans and financiaI
Ioasos, corporalo oquilios, and bonds. Tlo funds llal compriso llo firm's capilaI slruc-
luro aro raisod in llo capilaI marIol. Imporlanl oIomonls of llo capilaI marIol aro llo
organizod socurily oxclangos and llo ovor-llo-counlor marIols.
Organized Security £xchanges and Over-the-Counter Markets
Organized securitv exchanges aro icnvi||c cniiiics, lloy plysicaIIy occupy spaco (sucl
as a buiIding or a parl of a buiIding), and |incncic| insirumcnis crc irc!c! cn i|cir prcm-
iscs. Tlo nver-the-cnunter markets incIudo c|| sccuriiu mcr|cis cxccpi i|c crvcnizc!
cxc|cnvcs. Tlo monoy marIol, llon, is an ovor-llo-counlor marIol. Bocauso boll mar-
Iols aro imporlanl lo financiaI officors concornod vill raising |cnv-icrm ccpiic|, somo
addilionaI discussion is varranlod.
Organized 5ecurity Exchanges
Ior praclicaI purposos lloro aro sovon major socurily oxclangos in llo Unilod Slalos:
(1) Nov YorI SlocI Ixclango, (2) Amorican SlocI Ixclango, (3) Clicago SlocI
Ixclango, (4) Iacific SlocI Ixclango, (5) IliIadoIplia SlocI Ixclango, (6) Boslon
SlocI Ixclango, and (7) Cincinnali SlocI Ixclango. Tlo Nov YorI SlocI Ixclango
(NYSI) and llo Amorican SlocI Ixclango (AMIX) aro caIIod nciicnc| oxclangos,
vloroas llo ollors aro IoosoIy doscribod as rcvicnc|s. AII sovon of lloso aclivo
oxclangos aro rogislorod vill llo Socurilios and Ixclango Commission (SIC). Iirms
vloso socurilios aro lradod on llo rogislorod oxclangos musl compIy vill roporling
roquiromonls of boll llo spocific oxclango and llo SIC.
Stnck Exchange BeneIits. Boll corporalions and invoslors onjoy sovoraI bonofils pro-
vidod by llo oxislonco of organizod socurily oxclangos. Tloso incIudo
1. Prnviding a cnntinunus market. Tlis may bo llo mosl imporlanl funclion of an
organizod socurily oxclango. A conlinuous marIol providos a sorios of conlinuous
socurily pricos. Irico clangos from lrado lo lrado lond lo bo smaIIor llan lloy
vouId bo in llo absonco of organizod marIols bocauso lloro is a roIalivoIy Iargo
saIos voIumo in oacl socurily, lrading ordors aro oxoculod quicIIy, and llo rango
bolvoon llo prico asIod for a socurily and llo offorod prico londs lo bo narrov.
Tlo rosuIl is llal prico voIaliIily is roducod.
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 207
CAßM ModuIe 700 Fihahce
2. EstabIishing and µubIicizing Iair securitv µrices. An organizod oxclango
pormils socurily pricos lo bo sol by compolilivo forcos. Tloy aro nol sol by
nogolialions off llo fIoor of llo oxclango, vloro ono parly migll lavo a
bargaining advanlago. Tlo bidding procoss fIovs from llo suppIy and
domand undorIying oacl socurily. Tlis moans llo spocific prico of a socurily is
dolorminod in llo mannor of an auclion. In addilion, llo socurily pricos
dolorminod al oacl oxclango aro vidoIy pubIicizod.
3. HeIµing business raise new caµitaI. Bocauso a conlinuous socondary marIol
oxisls vloro pricos aro compolilivoIy dolorminod, il is oasior for firms lo fIoal
nov socurily offorings succossfuIIy. Tlis conlinuous pricing moclanism aIso
faciIilalos llo dolorminalion of llo offoring prico of a nov issuo. Tlis moans llal
comparalivo vaIuos aro oasiIy obsorvod.
Listing Requirements. To rocoivo llo bonofils providod by an organizod oxclango,
llo firm musl sooI lo lavo ils socurilios Iislod on llo oxclango. An appIicalion for Iisl-
ing musl bo fiIod and a foo paid. Tlo roquiromonls for Iisling vary from oxclango lo
oxclango, lloso of llo NYSI aro llo mosl slringonl. Tlo gonoraI criloria for Iisling faII
inlo lloso calogorios: (1) profilabiIily, (2) sizo, (3) marIol vaIuo, and (4) pubIic ovnor-
slip. To givo you llo fIavor of an acluaI sol of Iisling roquiromonls, lloso sol forll by
llo NYSI aro dispIayod in TabIe 11.1.
Over-the-Counter Markets
Many pubIicIy loId firms do nol mool llo Iisling roquiromonls of major slocI
oxclangos. Ollors may vanl lo avoid llo roporling roquiromonls and foos roquirod lo
mainlain Iisling. As an aIlornalivo lloir socurilios may lrado in llo ovor-llo-counlor
marIols. On llo basis of sloor numbors (nol doIIar voIumo), moro slocIs aro lradod
ovor llo counlor llan on organizod oxclangos. As far as socondary lrading in corpo-
ralo bonds is concornod, llo ovor-llo-counlor marIols aro vloro llo aclion is. In a lyp-
icaI yoar, moro llan 90 porconl of corporalo bond businoss laIos pIaco ovor llo
Mosl ovor-llo-counlor lransaclions aro dono llrougl a Iooso nolvorI of socurily
lradors vlo aro Inovn as broIor-doaIors and broIors. BroIors do nol purclaso socuri-
lios for lloir ovn accounl, vloroas broIor-doaIors do. BroIor-doaIors sland roady lo
buy and soII spocific socurilios al soIoclod pricos. Tloy aro said lo ¨maIo a marIol¨ in
lloso socurilios. Tloir profil is llo sproad or difforonco bolvoon llo prico lloy pay for
a socurily (bid prico) and llo prico al vlicl lloy soII llo socurily (asIod prico).
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 208
CAßM ModuIe 700 Fihahce
TabIe 11.1 A Sample o! NYSL LisIihg RequiremehIs !or DomesIic (U.S.)
Pro!itabiIity (Earnings)
Larhihgs be!ore Iaxes (L81) !or Ihe mosI recehI year musI be aI leasI $2.5 millioh.
For Ihe 2 years precedihg IhaI, L81 musI be aI leasI $2.0 millioh.
Market VaIue (GIobaI Market CapitaIization)
Revehues !or Ihe mosI recehI !iscal year musI be aI leasI $100.0 millioh, ahd average
(lasI six mohIhs) global markeI capiIalizaIioh musI be $1.0 billioh.
PubIic Ovnership (Distribution Criteria)
1here musI be aI leasI 1.1 millioh publicly held commoh shares.
1here musI be aI leasI 2,000 holders o! 100 shares or more.
5ource. New York Slock Lxchange, 2004 |ac| boo| Cn||ne (New York, 2004),
Price Ouotes and the NA5DAO
Tlo avaiIabiIily of pricos is nol as conlinuous in llo ovor-llo-counlor marIol as il is on
an organizod oxclango. Sinco Iobruary 8, 1971, lovovor, vlon a compulorizod nolvorI
caIIod NASDAO camo inlo oxislonco, llo avaiIabiIily of pricos in llis marIol las
improvod subslanliaIIy. NASDAO slands for NalionaI Associalion of Socurily DoaIors
Aulomalod Ouolalion syslom. Il is a loIocommunicalions syslom llal providos a
nalionaI informalion IinI among llo broIors and doaIors oporaling in llo ovor-llo-
counlor marIols. Subscribing lradors lavo a lorminaI llal aIIovs llom lo oblain ropro-
sonlalivo bids and asI pricos for llousands of socurilios lradod ovor llo counlor.
NASDAO is a quolalion syslom, nol a lransaclions syslom. Tlo finaI lrado is sliII con-
summalod by dirocl nogolialion bolvoon lradors.
Tlo NASDAO syslom las bocomo an incroasingIy imporlanl oIomonl of llo U.S.
financiaI marIol syslom in roconl yoars. Il providos a nalionvido communicalions oIo-
monl llal vas IacIing in llo ovor-llo-counlor sido of llo socurilios marIols.
Tlo Nasdaq SlocI MarIol, Inc., doscribos ilsoIf as a ¨scroon-basod, fIoorIoss mar-
Iol.¨ Il las bocomo liglIy popuIar as llo lrading moclanism of cloico of sovoraI fasl-
grovll soclors in llo Unilod Slalos, incIuding llo ligl-loclnoIogy soclor. Tlo com-
mon slocI of compulor clip maIor InloI Corporalion, for oxampIo, is lradod via llo
NASDAO as is llal of DoII and SlarbucIs. Aboul 3,300 companios aro Iislod.
NASDAO prico quolos for many slocIs aro pubIislod daiIy in 1|c Wc|| Sircci jcur-
nc|. Tlis samo financiaI novspapor aIso pubIislos pricos on lundrods of ollor slocIs
lradod ovor llo counlor. IocaI papors suppIy pricos on slocIs of rogionaI inlorosl.
700.11.3 Understand the roIe o! the investment banker
and private pIacements and Iearn about the !Iotation
costs in raising the Iong-term capitaI
Tlo invoslmonl banIor is lo bo dislinguislod from llo commorciaI banIor in llal llo for-
mor's organizalion is nol a pormanonl doposilory for funds. Ior llo momonl, il is impor-
lanl for you lo Ioarn aboul llo roIo of llo invoslmonl banIor in llo funding of commorciaI
aclivily bocauso of llo imporlanco of llis inslilulion villin llo financiaI marIol syslom.
Mosl corporalions do nol raiso Iong-lorm capilaI froquonlIy. Tlo aclivilios of
vorIing-capilaI managomonl go on daiIy, bul allracling Iong-lorm capilaI is, by compari-
son, opisodic. Tlo sums invoIvod can bo lugo, so lloso silualions aro considorod of groal
imporlanco lo financiaI managors. Bocauso mosl managors aro unfamiIiar vill llo sub-
lIolios of raising Iong-lorm funds, lloy onIisl llo loIp of an oxporl. Tlal oxporl is an
invoslmonl banIor.
Tlo investment banker is c |incncic| spccic|isi intc|tc! cs cn inicrmc!icru in i|c mcrc|cn-
!isinv c| sccuriiics. Ho or slo acls as a ¨middIo porson¨ by faciIilaling llo fIov of sav-
ings from lloso oconomic unils llal vanl lo invosl lo lloso unils llal vanl lo raiso
funds. Wo uso llo lorm intcsimcni |cn|cr lo rofor boll lo a givon individuaI and lo llo
organizalion for vlicl sucl a porson vorIs, variousIy Inovn as an invoslmonl-
banIing firm or an invoslmonl-banIing louso. AIllougl lloso firms aro caIIod invosl-
monl banIors, lloy porform no doposilory or Ionding funclions. Tlo aclivilios of com-
morciaI banIing and invoslmonl banIing as vo Inov llom loday voro soparalod by
llo BanIing Acl of 1933 (aIso Inovn as llo GIass-SloagaII Acl of 1933). Tlon, aflor con-
sidorabIo poIilicaI dobalo, llo IinanciaI Modornizalion Acl vas passod by llo U.S.
Congross on Novombor 12, 1999. Tlis roconl IogisIalion is aIso roforrod lo as llo
Gramm-Ioacl-BIiIoy Acl of 1999, in lonor of ils congrossionaI sponsors. Tlo acl aclu-
aIIy ropoaIod llo doprossion-ora GIass-SloagaII Acl and is aimod al incroasing
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 209
CAßM ModuIe 700 Fihahce
compolilivonoss among modorn financiaI sorvicos companios. Tlrougl llo croalion of
oporaling subsidiarios, llo acl providos for businoss combinalions among banIs,
undorvrilors of financiaI socurilios (invoslmonl banIors), insuranco firms, and socuri-
lios broIors. Horo vo focus on invoslmonl banIing and ils imporlanl inlormodiary
roIo. Tlis is mosl oasiIy undorslood in lorms of llo basic funclions of invoslmonl
Tlo invoslmonl banIor porforms llroo basic funclions: (1) undorvriling, (2) dislribul-
ing, and (3) advising.
Tlo lorm underwriting is borrovod from llo fioId of insuranco. Il moans cssuminv c ris|.
Tlo invoslmonl banIor assumos llo risI of soIIing a socurily issuo al a salisfaclory prico.
A salisfaclory prico is ono llal gonoralos a profil for llo invoslmonl-banIing louso.
Tlo procoduro goos IiIo llis. Tlo managing invoslmonl banIor and ils syndicalo
viII buy llo socurily issuo from llo corporalion in nood of funds. Tlo svndicate is c
vrcup c| ci|cr intcsimcni |cn|crs i|ci is intiic! ic |c|p |uu cn! rcsc|| i|c issuc. Tlo managing
louso is llo invoslmonl-banIing firm llal originalod llo businoss bocauso ils corporalo
cIionl docidod lo raiso oxlornaI funds. On a spocific day, llo firm llal is raising capilaI is
prosonlod vill a clocI in oxclango for llo socurilios boing issuod. Al llis poinl llo
invoslmonl-banIing syndicalo ovns llo socurilios. Tlo corporalion las ils casl and can
procood lo uso il. Tlo firm is nov immuno from llo possibiIily llal llo socurily marIols
migll lurn sour. If llo prico of llo novIy issuod socurily faIIs boIov llal paid lo llo firm
by llo syndicalo, llo syndicalo viII suffor a Ioss. Tlo syndicalo, of courso, lopos llal llo
opposilo silualion viII rosuIl. Ils objoclivo is lo soII llo nov issuo lo llo invosling pubIic
al a prico por socurily groalor llan ils cosl.
Onco llo syndicalo ovns llo nov socurilios, il musl gol llom inlo llo lands of llo uIli-
malo invoslors. Tlis is llo dislribulion or soIIing funclion of invoslmonl banIing. Tlo
invoslmonl banIor may lavo brancl officos across llo Unilod Slalos, or il may lavo an
informaI arrangomonl vill sovoraI socurily doaIors vlo roguIarIy buy a porlion of
oacl nov offoring for finaI saIo. Il is nol unusuaI lo lavo 300 lo 400 doaIors invoIvod in
llo soIIing offorl. Tlo syndicalo can proporIy bo viovod as llo socurily vloIosaIor, and
llo doaIor organizalion can bo viovod as llo socurily rolaiIor.
Tlo invoslmonl banIor is an oxporl in llo issuanco and marIoling of socurilios. A
sound invoslmonl-banIing louso viII bo avaro of provaiIing marIol condilions and
can roIalo lloso condilions lo llo parlicuIar lypo of socurily llal slouId bo soId al a
givon limo. Businoss condilions may bo poinling lo a fuluro incroaso in inlorosl ralos.
Tlo invoslmonl banIor migll adviso llo firm lo issuo ils bonds in a limoIy faslion lo
avoid llo liglor yioIds llal aro forllcoming. Tlo banIor can anaIyzo llo firm's capilaI
slrucluro and maIo rocommondalions aboul vlal gonoraI sourco of capilaI slouId bo
issuod. In many inslancos llo firm viII invilo ils invoslmonl banIor lo sil on llo board
of diroclors. Tlis pormils llo banIor lo obsorvo corporalo aclivily and maIo rocom-
mondalions on a roguIar basis.
Distribution Methods
SovoraI mollods aro avaiIabIo lo llo corporalion for pIacing nov socurily offorings in
llo lands of finaI invoslors. Tlo invoslmonl banIor's roIo is difforonl in oacl of lloso.
Somolimos, in facl, il is possibIo lo bypass llo invoslmonl banIor. Tloso mollods aro
doscribod in llis soclion. Irivalo pIacomonls, bocauso of lloir imporlanco, aro lroalod
soparaloIy Ialor in llo soclion.
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 210
CAßM ModuIe 700 Fihahce
Negotiated Purchase
In a nogolialod undorvriling, llo firm llal noods funds maIos conlacl vill an invosl-
monl banIor, and doIiboralions concorning llo nov issuo bogin. If aII goos voII, a
mci|c! is nogolialod for dolormining llo prico llo invoslmonl banIor and llo syndicalo
viII pay for llo socurilios. Ior oxampIo, llo agroomonl migll slalo llal llo syndicalo
viII pay $2 Ioss llan llo cIosing prico of llo firm's common slocI on llo day boforo llo
offoring dalo of a nov slocI issuo. Tlo nogolialod purclaso is llo mosl provaIonl
mollod of socurilios dislribulion in llo privalo soclor. Il is gonoraIIy llougll lo bo llo
mosl profilabIo loclniquo as far as invoslmonl banIors aro concornod.
Competitive ßid Purchase
Tlo mollod by vlicl llo undorvriling group is dolorminod dislinguislos llo com-
polilivo bid purclaso from llo nogolialod purclaso. In a compolilivo undorvriling,
sovoraI undorvriling groups bid for llo rigll lo purclaso llo nov issuo from llo cor-
poralion llal is raising funds. Tlo firm doos nol diroclIy soIocl llo invoslmonl banIor.
Tlo invoslmonl banIor llal undorvrilos and dislribulos llo issuo is closon by an auc-
lion procoss. Tlo syndicalo viIIing lo pay llo groalosl doIIar amounl por nov socurily
viII vin llo compolilivo bid.
Mosl compolilivo bid purclasos aro confinod lo llroo silualions, compoIIod by
IogaI roguIalions: (1) raiIroad issuos, (2) pubIic uliIily issuos, and (3) slalo and munici-
paI bond issuos. Tlo argumonl in favor of compolilivo bids is llal any unduo infIuonco
of llo invoslmonl banIor ovor llo firm is miligalod and llo prico rocoivod by llo firm
for oacl socurily slouId bo liglor. Tlus, vo vouId inluilivoIy suspocl llal llo cosl of
capilaI in a compolilivo bid silualion vouId bo Ioss llan in a nogolialod purclaso silu-
alion. Ividonco on llis quoslion, lovovor, is mixod. Ono probIom vill llo compoli-
livo bid purclaso as far as llo fund-raising firm is concornod is llal llo bonofils gainod
from llo advisory funclion of llo invoslmonl banIor aro Iosl. Il may bo nocossary lo
uso an invoslmonl banIor for advisory purposos and llon by Iav oxcIudo llo banIor
from llo compolilivo bid procoss.
Commission or ßest-E!!orts ßasis
Horo, llo invoslmonl banIor acls as an agonl rallor llan as a principaI in llo dislribulion
procoss. Tlo socurilios aro nci undorvrillon. Tlo invoslmonl banIor allompls lo soII llo
issuo in rolurn for a fixod commission on oacl socurily acluaIIy soId. UnsoId socurilios
aro rolurnod lo llo corporalion. Tlis arrangomonl is lypicaIIy usod for moro spocuIalivo
issuos. Tlo issuing firm may bo smaIIor or Ioss oslabIislod llan llo banIor vouId IiIo.
Bocauso llo undorvriling risI is nol passod on lo llo invoslmonl banIor, llis dislribu-
lion mollod is Ioss coslIy lo llo issuor llan a nogolialod or compolilivo bid purclaso. On
llo ollor land, llo invoslmonl banIor onIy las lo givo il lis or lor ¨bosl offorl.¨ A suc-
cossfuI saIo is nol guaranlood.
PriviIeged 5ubscription
OccasionaIIy, llo firm may fooI llal a dislincl marIol aIroady oxisls for ils nov socuri-
lios. Wlon a ncu issuc is mcr|cic! ic c !c|iniic cn! sc|cci vrcup c| intcsicrs, il is caIIod a
µriviIeged subscriµtinn. Tlroo largol marIols aro lypicaIIy invoIvod: (1) curronl slocI-
loIdors, (2) ompIoyoos, or (3) cuslomors. Of lloso, dislribulions diroclod al curronl
slocIloIdors aro llo mosl provaIonl. Sucl offorings aro caIIod riv|is c||crinvs. In a privi-
Iogod subscriplion llo invoslmonl banIor may acl onIy as a soIIing agonl. Il is aIso pos-
sibIo llal llo issuing firm and llo invoslmonl banIor migll sign a sicn!|u cvrccmcni,
vlicl vouId obIigalo llo invoslmonl banIor lo undorvrilo llo socurilios llal aro nol
accoplod by llo priviIogod invoslors.
Direct 5aIe
In a direct saIe i|c issuinv |irm sc||s i|c sccuriiics !ircci|u ic i|c intcsiinv pu||ic uii|cui
intc|tinv cn intcsimcni |cn|cr. Ivon among oslabIislod corporalo gianls, llis
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 211
CAßM ModuIe 700 Fihahce
procoduro is roIalivoIy raro. A varialion of llo dirocl saIo, llougl, vas usod moro fro-
quonlIy in llo 1970s llan in provious docados. Tlis invoIvos llo privalo pIacomonl of a
nov issuo by llo fund-raising corporalion uii|cui llo uso of an invoslmonl banIor as
an inlormodiary. Toxaco, MobiI OiI, and InlornalionaI Harvoslor (nov Navislar) aro
oxampIos of Iargo firms llal lavo foIIovod llis procoduro.
Private Placements
Irivalo pIacomonls aro an aIlornalivo lo llo saIo of socurilios lo llo pubIic or lo a roslriclod
group of invoslors llrougl a priviIogod subscriplion. Any lypo of socurily can bo pri-
valoIy pIacod (diroclIy pIacod). Tlis marIol, lovovor, is cIoarIy dominalod by dobl issuos.
Tlus, vo roslricl llis discussion lo dobl socurilios. Irom yoar lo yoar llo voIumo of pri-
valo pIacomonls varios groalIy. Hovovor, llo privalo pIacomonl marIol is aIvays a signifi-
canl porlion of llo U.S. capilaI marIol. In facl, according lo llo IodoraI Rosorvo, bonds
and nolos mado up 35.5 porconl of privalo socurilios offorod for casl ovor llo 1997÷1999
poriod. Tlo privalo pIacomonl marIol is nol Iimilod lo fixod-incomo socurilios. Tloro
oxisls in llo Unilod Slalos an oxlonsivo, organizod, privalo oquily marIol llal is oxlon-
sivoIy parlicipalod in by vonluro capilaIisls. Irom llo fund-raising porspoclivo, llo privalo
pIacomonl marIol is ospociaIIy appoaIing lo nov, smaII, and modium-sizod companios.
Sucl firms aro llo provinco of llo vonluro capilaIisls.
Tlo major invoslors in privalo pIacomonls aro sliII Iargo financiaI inslilulions.
Basod on llo voIumo of socurilios purclasod, llo llroo mosl imporlanl invoslor
groups aro (1) Iifo insuranco companios, (2) slalo and IocaI roliromonl funds, and
(3) privalo ponsion funds.
In arranging a privalo pIacomonl, llo firm may (1) avoid llo uso of an invoslmonl
banIor and vorI diroclIy vill llo invosling inslilulions or (2) ongago llo sorvicos of
an invoslmonl banIor. If llo firm doos nol uso an invoslmonl banIor, of courso, il doos
nol lavo lo pay a foo. ConvorsoIy, invoslmonl banIors can provido vaIuabIo advico in
llo privalo pIacomonl procoss. Tloy aro usuaIIy in conlacl vill sovoraI major inslilu-
lionaI invoslors, llus, lloy viII Inov if a firm is in a posilion lo invosl in ils proposod
offoring, and lloy can loIp llo firm ovaIualo llo lorms of llo nov issuo.
Irivalo pIacomonls lavo advanlagos and disadvanlagos comparod vill pubIic
offorings. Tlo financiaI managor musl carofuIIy ovaIualo boll sidos of llo quoslion.
Tlo advanlagos associalod vill privalo pIacomonls aro lloso:
1. Sµeed. Tlo firm usuaIIy oblains funds moro quicIIy llrougl a privalo
pIacomonl llan a pubIic offoring. Tlo major roason is llal rogislralion of llo
issuo vill llo SIC is nol roquirod.
2. Reduced IIntatinn cnsts. Tloso savings rosuIl bocauso llo Ionglly rogislralion
slalomonl for llo SIC doos nol lavo lo bo proparod, and llo invoslmonl-
banIing undorvriling and dislribulion cosls do nol lavo lo bo absorbod.
3. Financing IIexibiIitv. In a privalo pIacomonl llo firm doaIs on a faco-lo-faco
basis vill a smaII numbor of invoslors. Tlis moans llal llo lorms of llo issuo
can bo laiIorod lo mool llo spocific noods of llo company. Ior oxampIo, aII of
llo funds nood nol bo laIon by llo firm al onco. In oxclango for a commilmonl
foo, llo firm can ¨drav dovn¨ againsl llo oslabIislod amounl of crodil vill
llo invoslors. Tlis providos somo insuranco againsl capilaI marIol
uncorlainlios, and llo firm doos nol lavo lo borrov llo funds if llo nood doos
nol ariso. Tloro is aIso llo possibiIily of ronogolialion. Tlo lorms of llo dobl
issuo can bo aIlorod. Tlo lorm lo malurily, llo inlorosl ralo, or any roslriclivo
covonanls can bo discussod among llo affoclod parlios.
Tlo foIIoving disadvanlagos of privalo pIacomonls musl bo ovaIualod:
1. Interest cnsts. Il is gonoraIIy concodod llal inlorosl cosls on privalo
pIacomonls oxcood lloso of pubIic issuos. Wlollor llis disadvanlago is
onougl lo offsol llo roducod fIolalion cosls associalod vill a privalo
pIacomonl is a dolorminalion llo financiaI managor musl maIo. Tloro is somo
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 212
CAßM ModuIe 700 Fihahce
ovidonco llal on smaIIor issuos, say $500,000 as opposod lo $30 miIIion, llo
privalo pIacomonl aIlornalivo vouId bo proforabIo.
2. Restrictive cnvenants. Dividond poIicy, vorIing-capilaI IovoIs, and llo
raising of addilionaI dobl capilaI may aII bo affoclod by provisions in llo
privalo-pIacomonl dobl conlracl. Tlis is nol lo say llal sucl roslriclions aro
aIvays absonl in pubIic dobl conlracls. Rallor, llo financiaI officor musl bo
aIorl lo llo londoncy for lloso covonanls lo bo ospociaIIy burdonsomo in
privalo conlracls.
3. The µnssibiIitv nI Iuture SEC registratinn. If llo Iondor (invoslor) slouId
docido lo soII llo issuo lo a pubIic buyor boforo malurily, llo issuo musl bo
rogislorod vill llo SIC. Somo Iondors, llon, roquiro llal llo issuing firm agroo lo
a fuluro rogislralion al lloir oplion.
Tlo firm raising Iong-lorm capilaI incurs lvo lypos of IIntatinn cnsts: (1) i|c un!cr-
uriicr´s sprcc! and (2) issuinv ccsis. Of lloso lvo cosls, llo undorvrilor's sproad is llo
Iargor. Tlo un!cruriicr´s sprcc! is simpIy llo difforonco bolvoon llo gross and nol pro-
coods from a givon socurily issuo oxprossod as a porconl of llo gross procoods. Tlo
issuc ccsis incIudo (1) prinling and ongraving, (2) IogaI foos, (3) accounling foos,
(4) lrusloo foos, and (5) sovoraI ollor miscoIIanoous compononls. Tlo lvo mosl signifi-
canl issuo cosls aro prinling and ongraving and IogaI foos.
Dala pubIislod by llo SIC lavo consislonlIy rovoaIod lvo roIalionslips aboul
fIolalion cosls. Iirsl, llo cosls associalod vill issuing common slocI aro nolabIy
groalor llan llo cosls associalod vill proforrod slocI offorings. In lurn, proforrod
slocI cosls oxcood lloso of bonds. Socond, fIolalion cosls (oxprossod as a porconlago of
gross procoods) docroaso as llo sizo of llo socurily issuo incroasos.
In llo firsl inslanco, llo slalod roIalionslip rofIocls llo facl llal issuo cosls aro sonsi-
livo lo llo risIs invoIvod in succossfuIIy dislribuling a socurily issuo. Common slocI is
risIior lo ovn llan corporalo bonds. Undorvriling risI is, lloroforo, groalor vill com-
mon slocI llan vill bonds. Tlus, fIolalion cosls jusl mirror lloso risI roIalionslips. In
llo socond caso, a porlion of llo issuo cosls is fixod. IogaI foos and accounling cosls aro
good oxampIos. So, as llo sizo of llo socurily issuo risos, llo fixod compononl is sproad
ovor a Iargor gross procoods baso. As a consoquonco, avorago fIolalion cosls vary
invorsoIy vill llo sizo of llo issuo.
700.11.4 Understand the roIe o! the reguIations
in !inanciaI markets
Sinco Ialo 1986, pubIic inlorosl las boon ronovod in llo roguIalion of llo counlry's
financiaI marIols. Tlo Ioy ovonl vas a massivo insidor lrading scandaI llal mado llo
namo Ivan I. BoosIy ono of aImosl univorsaI rocognilion÷bul, unforlunaloIy, in a
nogalivo sonso. Tlis vas foIIovod by llo Oclobor 19, 1987, crasl of llo oquily marIols.
Moro roconlIy, in oarIy 1990, llo invosling communily (boll inslilulionaI and individ-
uaI) bocamo incroasingIy concornod ovor a voaIoning in llo so-caIIod junI bond mar-
Iol. Tlon sovoraI financiaI faiIuros and broaIdovns in corporalo govornanco and
domocracy mado firms sucl as Inron, WorIdCom, GIobaI Crossing, AdoIplia, Tyco,
Arllur Andorson, and HoaIllSoull lousoloId namos in a nogalivo conloxl in llo vory
roconl 2001÷2003 limo framo. Tlo accompanying nolorioly associalod vill lloso firms
and lloir Ioy managomonl porsonnoI Iod Congross lo pass llo Sarbanos-OxIoy Acl of
2002. Tlis roconl acl is roviovod Ialor in llis soclion. Tlo upslol of aII of llis onlancod
avaronoss is a nov approcialion of llo cruciaI roIo llal roguIalion pIays in llo finan-
ciaI syslom.
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 213
CAßM ModuIe 700 Fihahce
IoIIoving llo sovoro oconomic dovnlurn of 1929÷1932, congrossionaI aclion vas
laIon lo provido for fodoraI roguIalion of llo socurilios marIols. Slalo slalulos (bIuo
sIy Iavs) aIso govorn llo socurilios marIols vloro appIicabIo, bul llo fodoraI roguIa-
lions aro cIoarIy moro prossing and imporlanl. Tlo major fodoraI roguIalions aro
roviovod loro.
Primary Market Regulations
Tlo nov issuos marIol is govornod by llo Socurilios Acl of 1933. Tlo inlonl of llo acl is
imporlanl. Il aims lo provido polonliaI invoslors vill accuralo, lrullfuI discIosuro aboul
llo firm and llo nov socurilios boing offorod lo llo pubIic. Tlis doos nci provonl firms
from issuing liglIy spocuIalivo socurilios. Tlo SIC says nolling vlalsoovor aboul llo
possibIo invoslmonl vorll of a givon offoring. Il is up lo llo invoslor lo soparalo llo junI
from llo jovoIs. Tlo SIC doos lavo llo IogaI povor and rosponsibiIily lo onforco llo
1933 acl.
IuII pubIic discIosuro is acliovod by llo roquiromonl llal llo issuing firm fiIo a rogis-
lralion slalomonl vill llo SIC conlaining roquisilo informalion. Tlo slalomonl dolaiIs
parlicuIars aboul llo firm and llo nov socurily boing issuod. During a minimum 20-day
vailing poriod, llo SIC oxaminos llo submillod documonl. In numorous inslancos llo
20-day vail las boon oxlondod by sovoraI vooIs. Tlo SIC can asI for addilionaI informa-
lion llal vas omillod in ordor lo cIarify llo originaI documonl. Tlo SIC can aIso ordor
llo offoring lo bo sloppod.
During llo rogislralion procoss, a proIiminary prospoclus (llo rod lorring) may bo
dislribulod lo polonliaI invoslors. Wlon llo rogislralion is approvod, llo finaI prospoc-
lus musl bo mado avaiIabIo lo llo prospoclivo invoslors. Tlo prospoclus is acluaIIy a
condonsod vorsion of llo fuII rogislralion slalomonl. If, al a Ialor dalo, llo informalion
in llo rogislralion slalomonl and llo prospoclus is found lo bo IacIing, purclasors of
llo nov issuo vlo incurrod a Ioss can suo for damagos. Officors of llo issuing firm
and ollors vlo looI parl in llo rogislralion and marIoling of llo issuo may suffor
boll civiI and criminaI ponaIlios.
GonoraIIy, llo SIC dofinos pubIic issuos as lloso llal aro soId lo moro llan 25
invoslors. Somo pubIic issuos nood nol bo rogislorod. Tloso incIudo llo foIIoving:
1. RoIalivoIy smaII issuos for vlicl llo firm soIIs Ioss llan $1.5 miIIion of nov
socurilios por yoar. Sucl issuos of Ioss llan $1.5 miIIion aro nol onliroIy
roguIalion froo. Tloy aro monilorod llrougl vlal is usuaIIy caIIod llo smc||-
issucs cxcmpiicn. Tloso smaII issuos, llon, faII undor llo auspicos of RoguIalion
A, vlicl is jusl a vory slorl offoring slalomonl comparod lo llo fuII-bIovn
rogislralion slalomonl.
2. Issuos llal aro soId onliroIy inlraslalo.
3. Issuos llal aro basicaIIy slorl-lorm inslrumonls. Tlis lransIalos inlo malurily
poriods of 270 days or Ioss.
4. Issuos llal aro aIroady roguIalod or conlroIIod by somo ollor fodoraI agoncy.
IxampIos incIudo llo IodoraI Iovor Commission (pubIic uliIilios) and llo
Inlorslalo Commorco Commission (raiIroads).
Secondary Market Regulations
Socondary marIol lrading is roguIalod by llo Socurilios Ixclango Acl of 1934. Tlis acl
croalod llo SIC lo onforco fodoraI socurilios Iavs. Tlo IodoraI Trado Commission
onforcod llo 1933 acl for 1 yoar. Tlo major aspocls of llo 1934 acl can bosl bo pro-
sonlod in oulIino form:
1. Major socurily oxclangos musl rogislor vill llo SIC. Tlis roguIalos llo
oxclangos and pIacos roporling roquiromonls on llo firms vloso socurilios aro
Iislod on llom.
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 214
CAßM ModuIe 700 Fihahce
2. Insidor lrading is roguIalod. Insidors can bo officors, diroclors, ompIoyoos,
roIalivos, major invoslors, or anyono laving informalion aboul llo oporalion
of llo firm llal is nol pubIic InovIodgo. If an invoslor purclasos llo socurily
of llo firm in vlicl llo invoslor is an insidor, lo or slo musl loId il for al
Ioasl 6 monlls boforo disposing of il. Ollorviso, profils mado from lrading llo
slocI villin a poriod of Ioss llan 6 monlls musl bo rolurnod lo llo firm.
Iurllormoro, insidors musl fiIo vill llo SIC a monllIy slalomonl of loIdings
and lransaclions in llo slocI of lloir corporalion.
3. ManipuIalivo lrading of socurilios by invoslors lo affocl slocI pricos is
4. Tlo SIC is givon conlroI ovor proxy procoduros.
5. Tlo Board of Govornors of llo IodoraI Rosorvo Syslom is givon rosponsibiIily
for solling margin roquiromonls. Tlis affocls llo fIov of crodil inlo llo
socurilios marIols. Buying socurilios on margin simpIy moans using crodil lo
acquiro a porlion of llo subjocl financiaI inslrumonls.
ln recenl years a number ol linancial inlermediaries, including Drexel 8urnham Lamberl and
Salomon 8rolhers, have been rocked by elhical scandals. 8ecause linancial dealings demand
lrusl, lhese elhical scandals closed Drexel 8urnham Lamberl and almosl did lhe same lo
Salomon 8rolhers. Once again, lhis demonslrales lhe imporlance ol Principle 10: £thical
8ehavior ls Doing the Right Thing, and £thical Dilemmas Are £verywhere in Iinance.
The Securities Acts Amendments of 1975
Tlo Socurilios Acls Amondmonls of 1975 louclod on llroo imporlanl issuos. Iirsl,
Congross mandalod llo croalion of a nalionaI marIol syslom (NMS). OnIy broad
goaIs for llis nalionaI oxclango voro idonlifiod by Congross. ImpIomonlalion
dolaiIs voro Iofl lo llo SIC and, lo a mucl Iossor oxlonl, llo socurilios induslry in
gonoraI. Congross vas roaIIy oxprossing ils dosiro for (1) vidosproad appIicalion of
auclion-marIol lrading principIos, (2) a ligl dogroo of compolilion across marIols,
and (3) llo uso of modorn oIoclronic communicalion sysloms lo IinI llo fragmonlod
marIols in llo counlry inlo a lruo NMS. Tlo NMS is sliII a goaI lovard vlicl llo
SIC and llo socurilios induslry aro moving. Agroomonl as lo ils finaI form and an
impIomonlalion dalo las nol occurrod.
A socond major aIloralion in llo labils of llo socurilios induslry aIso looI pIaco in
1975. Tlis vas llo oIiminalion of fixod commissions (fixod broIorago ralos) on pubIic
lransaclions in socurilios. Tlis vas cIosoIy liod lo llo dosiro for an NMS in llal fixod
broIorago foos providod no inconlivo for compolilion among broIors. A llird consid-
oralion of llo 1975 amondmonls focusod on sucl financiaI inslilulions as commorciaI
banIs and insuranco firms. Tloso financiaI inslilulions voro prolibilod from acquiring
momborslip on slocI oxclangos in ordor lo roduco or savo commissions on lloir ovn
Shelf Registration
On Marcl 16, 1982, llo SIC bogan a nov procoduro for rogisloring nov issuos of socu-
rilios. IormaIIy il is caIIod SIC RuIo 415, informaIIy llo procoss is Inovn as a sheII
registratinn, or a sheII nIIering. Tlo ossonco of llo procoss is rallor simpIo. Rallor
llan go llrougl llo Ionglly, fuII rogislralion procoss oacl limo llo firm pIans an offor-
ing of socurilios, il can gol a bIanIol ordor approvod by llo SIC. A mcsicr rcvisirciicn
sicicmcni i|ci cctcrs i|c |incncinv p|cns c| i|c |irm ctcr i|c ccminv 2 uccrs is |i|c! uii| i|c
S|C. On approvaI, llo firm can marIol somo or aII of llo socurilios ovor llis 2-yoar
poriod. Tlo socurilios aro soId in a piocomoaI faslion, or ¨off llo sloIf.¨ Boforo oacl
spocific offoring, a slorl slalomonl aboul llo issuo is fiIod vill llo SIC.
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 215
CAßM ModuIe 700 Fihahce
Corporalions raising funds approvo of llis procoduro. Tlo lodious, fuII rogislra-
lion procoss is avoidod vill oacl offoring puIIod off llo sloIf. Tlis slouId rosuIl in a
saving of foos paid lo invoslmonl banIors. Moroovor, an issuo can moro quicIIy bo
brougll lo llo marIol. AIso, if marIol condilions clango, an issuo can oasiIy bo
rodosignod lo fil llo spocific condilions of llo momonl.
As is aIvays llo caso, lloro is anollor sido lo llo slory. RocaII llal llo roason for
llo rogislralion procoss in llo firsl pIaco is lo givo invoslors usofuI informalion aboul
llo firm and llo socurilios boing offorod. Undor llo sloIf rogislralion procoduro somo
of llo informalion aboul llo issuing firm bocomos oId as llo 2-yoar lorizon unfoIds.
Somo invoslmonl banIors fooI lloy do nol lavo llo propor amounl of limo lo sludy llo
firm vlon a sloIf offoring laIos pIaco.
Sarbanes-Oxley Act of 2002
As monlionod proviousIy, sovoraI disappoinling Iapsos in corporalo bolavior bocamo
pubIic informalion aflor llo yoar 2000. Numorous unfIalloring inslancos of poor judg-
monl occurrod invoIving llo major fundamonlaI buiIding bIocIs of Woslorn capilaI-
ism. Tloso incIudod llo (a) pubIic accounling induslry, (b) IogaI induslry, (c) invosl-
monl-banIing induslry, (d) socurily anaIysls' induslry, and (o) subjocl firms
llomsoIvos, ovon invoIving lloir oIoclod boards of diroclors. Boll individuaI invoslors
and somo inslilulionaI invoslors Iosl lugoIy significanl amounls of invoslod capilaI as
a rosuIl of llis monumonlaI broaIdovn in corporalo moraIily.
Ono gIaring oxampIo invoIvod llo board of diroclors of llo onorgy-soclor company
Inron Corporalion. Inron faiIod financiaIIy in Docombor 2001. Irior lo llal formaI
faiIuro (banIruplcy), llo firm's board of diroclors ovorlIy volod on lvo occasions lo
lomporariIy suspond ils ovn codo of ollics lo pormil ils CIO lo ongago in risIy por-
sonaI financiaI vonluros llal invoIvod llo financiaI slrucluro and casl fIov slroams of
Inron. Tlis slouId romind you of our PrinciµIe 10: EthicaI Behavinr Is Dning the
Right Thing, and EthicaI DiIemmas Are Evervwhere in Finance.
Undor inlonso pubIic scruliny rosuIling from a Iargo sorios of corporalo indiscro-
lions IiIo lloso nolod oarIior, Congross passod in IuIy 2002 llo IubIic Company
Accounling Roform and Invoslor Iroloclion Acl. Tlo slorl namo for llo acl bocamo
llo Sarbanos-OxIoy Acl of 2002. Tlo acl conlains 11 ¨lilIos,¨ vlicl aro dispIayod in
TabIe 11.2. Tloso 11 lilIos provido llo fIavor of llo acl, vlicl ligllonod significanlIy
llo Ialiludo givon corporalo advisors (sucl as accounlanls, Iavyors, company officors,
and boards of diroclors) vlo lavo accoss lo or infIuonco company docisions.
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 216
CAßM ModuIe 700 Fihahce
TabIe 11.2 Sarbahes-Oxley AcI o! 2002, Key LlemehIs
TitIe Area o! Emphasis
I Public Compahy AccouhIihg OversighI 8oard
II AudiIor Ihdepehdehce
III CorporaIe RespohsibiliIy
IV Lhhahced Fihahcial Disclosures
V AhalysI Coh!licIs o! IhIeresI
VI Commissioh Resources ahd AuIhoriIy
VII SIudies ahd ReporIs
VIII CorporaIe ahd Crimihal Fraud AccouhIabiliIy
IX WhiIe-Collar Crime PehalIy LhhahcemehIs
X CorporaIe 1ax ReIurhs
XI CorporaIe Fraud ahd AccouhIabiliIy
5ource. U.S. Congress, H.P. 3763. Passed by lhe !07lh Congress ol lhe U.S. on July 25, 2002, signed by
Presidenl 8ush on July 30, 2002.
In offocl, sucl advisors aro nov loId slriclIy accounlabIo by Iav for any inslancos
of misconducl. Tlo acl vory simpIy and diroclIy idonlifiod ils purposo as boing ¨lo
prolocl invoslors by improving llo accuracy and roIiabiIily of corporalo discIosuros
mado pursuanl lo llo socurilios Iavs, and for ollor purposos.¨
As ovidoncod by ils boing llo iniliaI lilIo of llo acl, a crilicaI parl of llis Iav vas
llo croalion of llo IubIic Company Accounling Ovorsigll Board. Tlis board's pur-
poso is lo roguIalo llo accounling induslry roIalivo lo pubIic companios llal accounl-
ing firms audil. TabIe 11.3 liglIiglls llo composilion of llo board's momborslip and
ils dulios.
700.11 Fihahcial IhsIiIuIiohs ahd MarkeIs 217
CAßM ModuIe 700 Fihahce
TabIe 11.3 Public Compahy AccouhIihg OversighI 8oard
I. The ßoard. EstabIishment o! an Independent Oversight ßoard !or Auditors
1he 8oard cohsisIs o! !ive !ihahcially-liIeraIe members, appoihIed !or !ive-year Ierms.
1wo o! Ihe members musI be or have beeh CerIi!ied Public AccouhIahIs (CPAs), ahd Ihe
remaihihg members musI hoI be hor have ever beeh CPAs. Members cahhoI share ih Ihe
pro!iIs or receive paymehIs !rom a public accouhIihg !irm (oIher Ihah !ixed cohIihuihg
paymehIs such as reIiremehI behe!iIs). Members are appoihIed by Ihe SLC, a!Ier
cohsulIaIioh wiIh Ihe chairmah o! Ihe Federal Reserve 8oard ahd Ihe SecreIary o! Ihe
1reasury. Members cah be removed !rom Ihe board by Ihe SLC !or good cause.
II. ßoard Duties
1. RegisIer public accouhIihg !irms.
2. LsIablish or adopI, by rule, audiIihg, qualiIy cohIrol, eIhics, ihdepehdehce, ahd oIher
sIahdards relaIihg Io Ihe preparaIioh o! audiI reporIs !or issuers.
3. CohducI ihspecIiohs o! audiI !irms.
4. CohducI ihvesIigaIiohs ahd disciplihary proceedihgs, ahd impose appropriaIe
5. CohducI such oIher duIies or !uhcIiohs as hecessary ahd appropriaIe.
6. Lh!orce compliahce wiIh Ihe AcI, Ihe rules o! Ihe 8oard, pro!essiohal sIahdards, ahd
Ihe securiIies laws relaIihg Io Ihe preparaIioh ahd issuahce o! audiI reporIs ahd Ihe
obligaIiohs ahd liabiliIies o! accouhIahIs wiIh respecI IhereIo.
7. SeI Ihe budgeI ahd mahage Ihe operaIiohs o! Ihe 8oard ahd iIs sIa!!.
5ource. Sarbanes-Oxley Acl ol 2002.
700.12 Fihahcial Risk MahagemehI 218
700.12.1 Dofino compound inlorosl and fuluro vaIuo of monoy
700.12.2 Ioarn lov lo caIcuIalo llo limo vaIuo of monoy
700.12.3 Dofino prosonl vaIuo of monoy
700.12.4 Difforonlialo bolvoon ordinary annuilios and annuilios duo mollods
700.12.5 IxpIain llo concopl of Ioan amorlizalion
700.12.6 CaIcuIalo llo compound inlorosl vill nonannuaI poriods
700.12.7 CaIcuIalo llo prosonl vaIuo of an unovon slroam of paymonls
and dolormino llo prosonl vaIuo of a porpoluily
700.12.8 Dofino and moasuro llo oxpoclod ralo of rolurn of an individuaI
invoslmonl and llo risIinoss of an individuaI invoslmonl
700.12.9 IxpIain lov divorsifying invoslmonls affocls llo risIinoss and oxpoclod
ralo of rolurn of a porlfoIio of assol
700.12.10 IxpIain llo roIalionslip bolvoon an invoslor's roquirod ralo of rolurn
on an invoslmonl and llo risIinoss of llo invoslmonl
700.12 Financial Risk Nanagement
700.12.1 De!ine compound interest and !uture vaIue
o! money
Mosl of us oncounlor llo concopl of compound inlorosl al an oarIy ago. Anyono vlo
las ovor lad a savings accounl or purclasod a govornmonl savings bond las rocoivod
compound inlorosl. Cnmµnund interest occurs vlon inicrcsi pci! cn i|c intcsimcni !ur-
inv i|c |irsi pcric! is c!!c! ic i|c principc|, i|cn, !urinv i|c scccn! pcric!, inicrcsi is ccrnc!
cn i|is ncu sum.
ln lhis seclion we develop lhe lools lo incorporale PrincipIe 2. The Time VaIue
o! Money-A DoIIar ßeceived Today Is Worth More than a DoIIar ßeceived
in the future inlo our calculalions. We use lhis principle lo measure value by
bringing lhe benelils and cosls lrom a projecl back lo lhe presenl.
Ior oxampIo, supposo vo pIaco $100 in a savings accounl llal pays 6 porconl inlor-
osl, compoundod annuaIIy. Hov viII our savings grov` Al llo ond of llo firsl yoar vo
lavo oarnod 6 porconl, or $6 on our iniliaI doposil of $100, giving us a lolaI of $106 in
our savings accounl. Tlo mallomalicaI formuIa iIIuslraling llis plonomonon is
PV(1  i) (12-1)
vloro IV
llo fuluro vaIuo of llo invoslmonl al llo ond of ono yoar
i llo annuaI inlorosl (or discounl) ralo
PV llo prosonl vaIuo, or originaI amounl invoslod al llo boginning of
llo firsl yoar
In our oxampIo
PV(1  i)
$100(1  .06)
Carrying lloso caIcuIalions ono poriod furllor, vo find llal vo nov oarn llo
6 porconl inlorosl on a principaI of $106, vlicl moans vo oarn $6.36 in inlorosl
during llo socond yoar. Wly do vo oarn moro inlorosl during llo socond yoar llan
vo did during llo firsl` SimpIy bocauso vo nov oarn inlorosl on llo sum of llo orig-
inaI principaI, or prosonl vaIuo, and llo inlorosl vo oarnod in llo firsl yoar. In offocl
vo aro nov oarning inlorosl on inlorosl, llis is llo concopl of compound inlorosl.
Ixamining llo mallomalicaI formuIa iIIuslraling llo oarning of inlorosl in llo soc-
ond yoar, vo find
(1  i) (12-2)
vlicl, for our oxampIo, givos
IooIing bacI al oqualion (12-1), vo can soo llal IV
, or $106, is acluaIIy oquaI lo
PV(1  i), or $100(1  .06). If vo subslilulo lloso vaIuos inlo oqualion (12-2), vo gol
PV(1  i)(1  i)
PV(1  i)
700.12 Fihahcial Risk MahagemehI 219
CAßM ModuIe 700 Fihahce
Carrying llis forvard inlo llo llird yoar, vo find llal vo onlor llo yoar vill
$112.36 and vo oarn 6 porconl, or $6.74 in inlorosl, giving us a lolaI of $119.10 in our
savings accounl. Ixprossing llis mallomalicaIIy:
(1  i)
$112.36(1.06) (12-4)
If vo subslilulo llo vaIuo in oqualion (12-3) for IV
inlo oqualion (12-4), vo find
PV(1  i)(1  i)(1  i)
PV(1  i)
By nov a pallorn is bocoming apparonl. Wo can gonoraIizo llis formuIa lo iIIus-
lralo llo vaIuo of our invoslmonl if il is compoundod annuaIIy al a ralo of i for n yoars
lo bo
PV(1  i)
vloro IV
llo fuluro vaIuo of llo invoslmonl al llo ond of n yoars
n llo numbor of yoars during vlicl llo compounding occurs
i llo annuaI inlorosl (or discounl) ralo
PV llo prosonl vaIuo or originaI amounl invoslod al llo boginning of llo
firsl yoar
TabIe 12.1 iIIuslralos lov llis invoslmonl of $100 vouId conlinuo lo grov for llo
firsl 10 yoars al a compound inlorosl ralo of 6 porconl. Nolico lov llo amounl of inlor-
osl oarnod annuaIIy incroasos oacl yoar. Again, llo roason is llal oacl yoar inlorosl is
rocoivod on llo sum of llo originaI invoslmonl pIus any inlorosl oarnod in llo pasl.
Wlon vo oxamino llo roIalionslip bolvoon llo numbor of yoars an iniliaI invosl-
monl is compoundod for and ils fuluro vaIuo as slovn graplicaIIy in Figure 12.1, vo
soo llal vo can incroaso llo fuluro vaIuo of an invoslmonl by oillor incroasing llo
numbor of yoars for vlicl vo Iol il compound or by compounding il al a liglor inlor-
osl ralo. Wo can aIso soo llis from oqualion (12-6) bocauso an incroaso in oillor i or n
vliIo PV is loId conslanl rosuIls in an incroaso in IV
700.12 Fihahcial Risk MahagemehI 220
CAßM ModuIe 700 Fihahce
TabIe 12.1 IllusIraIioh o! Compouhd IhIeresI CalculaIiohs
Year ßeginning VaIue Interest Earned Ending VaIue
1 $100.00 $16.00 $106.00
2 106.00 6.36 112.36
3 112.36 6.74 119.10
4 119.10 7.15 126.25
5 126.25 7.57 133.82
6 133.82 8.03 141.85
7 141.85 8.51 150.36
8 150.36 9.02 159.38
9 159.38 9.57 168.95
10 168.95 10.13 179.08
700.12.2 Learn hov to caIcuIate the time vaIue
o! money
Tloro aro llroo difforonl approaclos llal you can uso lo soIvo a limo vaIuo of monoy
probIom. Tlo firsl is lo uso llo limo vaIuo of monoy labIos. Tloso labIos do mucl of
llo mall for you and soIvo for llo prosonl or fuluro vaIuo of $1 for a rango of vaIuos of
i and n. IinanciaI caIcuIalors aro a socond aIlornalivo, and lloro aro a numbor of llom
llal do a good job of soIving limo vaIuo of monoy probIoms. Basod on many yoars of
oxporionco, llo Toxas Inslrumonls BA II IIus caIcuIalor vouId bo an oxcoIIonl cloico.
IinaIIy, sproadslools can movo monoy llrougl limo, and in llo roaI vorId, lloy aro
villoul quoslion llo looI of cloico. Nov Iol's laIo a IooI al aII llroo aIlornalivos.
700.12 Fihahcial Risk MahagemehI 221
CAßM ModuIe 700 Fihahce
ll we place S!,000 in a savings accounl paying 5 percenl inleresl compounded annually, how much will our accounl accrue
lo in !0 years? Subsliluling |v S!,000, | 5 percenl, and n !0 years inlo equalion (!2-6), we gel
PV(! + | )
S!,000(! + .05)
Thus, al lhe end ol !0 years we will have S!,628.89 in our savings accounl.
humber of years
2 4 6 8 10 12 14 16 18
figure 12.1 FuIure Value o! $100 IhiIially DeposiIed ahd Compouhded
aI 0, 5, 10, ahd 15 PercehI
Time value of Money (TvM) Tables Solution
Bocauso dolormining fuluro vaIuo can bo quilo limo-consuming vlon an invoslmonl is
loId for a numbor of yoars, llo Iuture-vaIue interest Iactnr for i and n (
 
), dofinod
as (1  i)
, las boon compiIod for various vaIuos of i and n. An abbrovialod compound
inlorosl or fuluro-vaIuo inlorosl faclor labIo appoars in TabIe 12.2. AIlornalivoIy, llo
i, n
vaIuos couId oasiIy bo dolorminod using a caIcuIalor. Nolo llal llo com-
pounding faclors givon in lloso labIos roprosonl llo vaIuo of $1 compoundod al ralo
i al llo cn! of llo nll yoar. Tlus, lo caIcuIalo llo fuluro vaIuo of an iniliaI invosl-
monl, vo nood onIy lo dolormino llo IV|I
i, n
using a caIcuIalor or llo labIos and
muIlipIy llis limos llo iniliaI invoslmonl. In offocl, vo can rovrilo oqualion (12-6)
as foIIovs:
i, n
) (12-6a)
700.12 Fihahcial Risk MahagemehI 222
CAßM ModuIe 700 Fihahce
TabIe 12.2 FVlF
, or Ihe Compouhd Sum o! $1
N 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.100
2 1.020 1.040 1.061 1.082 1.102 1.124 1.145 1.166 1.188 1.210
3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295 1.331
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611
6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144
9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358
10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.594
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.853
12 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2.518 2.813 3.138
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452
14 1.149 1.319 1.513 1.732 1.980 2.261 2.579 2.937 3.342 3.797
15 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177
ll we invesl S500 in a bank where il will earn 8 percenl compounded annually, how much will il be worlh al lhe end ol
7 years? Looking al Table !2.2 in lhe row n 7 and column | 8 percenl, we lind lhal |v||
8', 7 yr
has a value ol !.7!4.
Subsliluling lhis inlo equalion (!2-6a), we lind
8', 7 yr
Thus, we will have S857 al lhe end ol 7 years.
We will lind several uses lor equalion (!2-6a), nol only can we lind lhe lulure value ol an inveslmenl, bul we can also solve
lor |v. |. or n. ln any case, you will be given lhree ol lhe lour variables and will have lo solve lor lhe lourlh.
700.12 Fihahcial Risk MahagemehI 223
CAßM ModuIe 700 Fihahce
Lel's assume lhal lhe DaimlerChrysler Corporalion has guaranleed lhal lhe price ol a new Jeep will always be S20,000,
and you'd like lo buy one bul currenlly have only S7,752. How many years will il lake lor your inilial inveslmenl ol S7,752
lo grow lo S20,000 il il is invesled al 9 percenl compounded annually? We can use equalion (!2-6a) lo solve lor lhis prob-
lem as well. Subsliluling lhe known values in equalion (!2-6a), you lind
Thus, you are looking lor a value ol 2.58 in lhe |v||
|. n
lables, and you know il musl be in lhe 9' column. To linish solving
lhe problem, look down lhe 9' column lor lhe value closesl lo 2.58. You lind lhal il occurs in lhe n !! row. Thus il will
lake !! years lor an inilial inveslmenl ol S7,752 lo grow lo S20,000 il il is invesled al 9 percenl compounded annually.
|v |v |v||
n | n
( )
S S ( )
9', yr
, , 20 000 7 752
200 000
7 752
7 752
7 752
2 58
S ( )
9', yr
n 9' yr ,
Now lel's solve lor lhe compound annual growlh rale, and lel's go back lo lhal Jeep lhal always cosls S20,000. ln !0 years,
you'd really like lo have S20,000 lo buy a new Jeep, bul you only have S!!,!67. Al whal rale musl your S!!,!67 be com-
pounded annually lor il lo grow lo S20,000 in !0 years? Subsliluling lhe known variables inlo equalion (!2-6a), you gel
You know lo look in lhe n !0 row ol lhe |v||
|. n
lables lor a value ol !.79!, and you lind lhis in lhe | 6' column.
Thus, il you wanl your inilial inveslmenl ol S!!,!67 lo grow lo S20,000 in !0 years, you musl invesl il al 6 percenl.
|v |v |v||
n | n
( )
S S ( )
, !0 yr
, , 20 000 !!!67
220 000
S ( )
, !0 yr
779!= |v||
| , !0 yr
Iinancial Calculator Solution
Timo vaIuo of monoy caIcuIalions can bo mado simpIo vill llo aid of a |incncic| cc|cu-
|cicr. In soIving limo vaIuo of monoy probIoms vill a financiaI caIcuIalor, you viII bo
givon llroo of four variabIos and viII lavo lo soIvo for llo fourll. Boforo prosonling
any soIulions using a financiaI caIcuIalor, vo inlroduco llo caIcuIalor's fivo mosl com-
mon Ioys. (In mosl limo vaIuo of monoy probIoms, onIy four of lloso Ioys aro roIo-
vanl.) Tloso Ioys aro
Sloros (or caIcuIalos) llo lolaI numbor of paymonls or compounding
Sloros (or caIcuIalos) llo inlorosl or discounl ralo.
Sloros (or caIcuIalos) llo prosonl vaIuo of a casl fIov or sorios of casl
Sloros (or caIcuIalos) llo fuluro vaIuo, llal is, llo doIIar amounl of a finaI
casl fIov or llo compound vaIuo of a singIo fIov or sorios of casl fIovs.
Sloros (or caIcuIalos) llo doIIar amounl of oacl annuily paymonl doposilod
or rocoivod al llo ond of oacl yoar.
Wlon you uso a financiaI caIcuIalor, romombor llal oulfIovs gonoraIIy lavo lo bo
onlorod as nogalivo numbors. In gonoraI, oacl probIom viII lavo lvo casl fIovs: ono
an oulfIov vill a nogalivo vaIuo, and ono an infIov vill a posilivo vaIuo. Tlo idoa is
llal you doposil monoy in llo banI al somo poinl in limo (an oulfIov), and al somo
ollor poinl in limo you laIo monoy oul of llo banI (an infIov). AIso, ovory caIcuIalor
oporalos a bil difforonlIy vill rospocl lo onloring variabIos. NoodIoss lo say, il is a
good idoa lo famiIiarizo yoursoIf vill oxaclIy lov your caIcuIalor funclions.
700.12 Fihahcial Risk MahagemehI 224
CAßM ModuIe 700 Fihahce
Al whal rale musl S!00 be compounded annually lor il lo grow lo S!79.!0 in !0 years? ln lhis case we know lhe inilial
inveslmenl, |v S!00, lhe lulure value ol lhis inveslmenl al lhe end ol n years, |v
S!79.!0, and lhe number ol years
lhal lhe inilial inveslmenl will compound lor, n !0 years. Subsliluling inlo equalion (!2-6), we gel
PV(! + | )
S!79.!0 S!00(! + | )
!.79! (! + | )
We know lo look in lhe n !0 row ol lhe |v||
|. n
lable lor a value ol !.79!, and we lind lhis in lhe | 6 percenl column.
Thus, il we wanl our inilial inveslmenl ol S!00 lo accrue lo S!79.!0 in !0 years, we musl invesl il al 6 percenl.
Jusl how powerlul is lhe lime value ol money? Manhallan lsland was purchased by Peler Minuil lrom lhe lndians in !626
lor S24 in "knickknacks" and jewelry. ll al lhe end ol !626 lhe lndians had invesled lheir S24 al 8 percenl compounded
annually, il would be worlh over S!!! lrillion loday (by lhe end ol 2005, 379 years laler). Thal's cerlainly enough lo buy
back all ol Manhallanin lacl, wilh S!!! lrillion in lhe bank, lhe S80 billion lo S90 billion you'd have lo pay lo buy back
all ol Manhallan would seem like pockel change. This slory illuslrales lhe incredible power ol lime in compounding. There
simply is no subslilule lor il.
As proviousIy slalod, in any probIom you viII bo givon llroo of four variabIos. Tloso
four variabIos viII aIvays incIudo N and |/Y, in addilion, lvo oul of llo finaI llroo
variabIos÷PV, IV, and PM1÷viII aIso bo incIudod. To soIvo a limo vaIuo of monoy
probIom using a financiaI caIcuIalor, aII you nood lo do is onlor llo approprialo numbors
for llroo of llo four variabIos and llon pross llo Ioy of llo finaI variabIo lo caIcuIalo ils
vaIuo. Il is aIso a good idoa lo onlor zoro for any of llo fivo variabIos nol incIudod in llo
probIom in ordor lo cIoar llal variabIo.
Nov Iol's soIvo llo provious oxampIo using a financiaI caIcuIalor. Wo voro lrying
lo find al vlal ralo $100 musl bo compoundod annuaIIy for il lo grov lo $179.10 in
10 yoars. Tlo soIulion using a financiaI caIcuIalor vouId bo as foIIovs:
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
Any of llo probIoms in llis soclion can oasiIy bo soIvod using a financiaI caIcuIa-
lor, and llo soIulions lo many oxampIos using a Toxas Inslrumonls BA II IIus financiaI
caIcuIalor aro providod in llo margins. If you aro using llo TI BA II IIus, maIo suro
llal you lavo soIoclod boll llo ¨IND MODI¨ and ¨ono paymonl por yoar¨ (P/Y 1).
Tlis sols llo paymonl condilions lo a maximum of ono paymonl por poriod occurring
al llo ond of llo poriod. Ono finaI poinl, you viII nolico llal soIulions using llo
prosonl-vaIuo labIos vorsus soIulions using a caIcuIalor may vary sIigllIy÷a rosuIl of
rounding orrors in llo labIos.
ObviousIy, llo cloico of llo inlorosl ralo pIays a crilicaI roIo in lov mucl an invosl-
monl grovs, bul do smaII clangos in llo inlorosl ralo lavo mucl of an impacl on fuluro
vaIuos` To ansvor llis quoslion, Iol's IooI bacI al Iolor Minuil's purclaso of Manlallan.
If llo Indians lad invoslod lloir $24 al 10 porconl rallor llan 8 porconl compoundod
annuaIIy al llo ond of 1626, lloy vouId lavo ovor $116 quadriIIion by llo ond of 2005
(379 yoars Ialor). Tlal is 116 foIIovod by 15 zoros, or $116,000,000,000,000,000. AcluaIIy,
llal is onougl lo buy bacI nol onIy Manlallan IsIand bul aIso llo onliro vorId and sliII
lavo pIonly Iofl ovor! Nov Iol's assumo a Iovor inlorosl ralo÷say 6 porconl. In llal caso
llo $24 vouId lavo onIy grovn lo a moro $93.6 biIIion÷Ioss llan ono ono-llousandll of
vlal il grov lo al 8 porconl, and Ioss llan ono-miIIionll of vlal il vouId lavo grovn lo
al 10 porconl. Will loday's roaI oslalo pricos, you'd lavo a lougl limo buying Manlal-
lan, and if you did, you probabIy couIdn'l pay your laxos! To say llo Ioasl, llo inlorosl
ralo is oxlromoIy imporlanl in invosling.
Spreadsheet Solution
Willoul quoslion, in llo roaI vorId mosl caIcuIalions invoIving moving monoy
llrougl limo viII bo carriod oul vill llo loIp of a sproadslool. AIllougl lloro aro
sovoraI compoling sproadslools, llo mosl popuIar ono is Microsofl IxcoI. Iusl as vill
llo IoyslroIo caIcuIalions on a financiaI caIcuIalor, a sproadslool can maIo oasy vorI
700.12 Fihahcial Risk MahagemehI 225
CAßM ModuIe 700 Fihahce
of mosl common financiaI caIcuIalions. Iislod loro aro somo of llo mosl common
funclions usod vill IxcoI vlon moving monoy llrougl limo:
CaIcuIation formuIa
PresehI Value PV(raIe,humber o! periods,paymehI,!uIure value,Iype)
FuIure Value FV(raIe,humber o! periods,paymehI,presehI value,Iype)
PaymehI PMJ(raIe,humber o! periods,presehI value,!uIure
Number o! Periods NPLR(raIe,paymehI,presehI value,!uIure value,Iype)
IhIeresI RaIe RAJL(humber o! periods,paymehI,presehI value,!uIure
value,Iype, guess)
where: raIe i, Ihe ihIeresI raIe or discouhI raIe
humber o! periods n, Ihe humber o! years or periods
paymehI PMJ, Ihe ahhuiIy paymehI deposiIed or received aI Ihe
ehd o! each period
!uIure value FV, Ihe !uIure value o! Ihe ihvesImehI aI Ihe ehd o! n
periods or years
presehI value PV, Ihe presehI value o! Ihe !uIure sum o! mohey
Iype wheh Ihe paymehI is made (0 i! omiIIed)
0 aI ehd o! period
1 aI begihhihg o! period
guess a sIarIihg poihI wheh calculaIihg Ihe ihIeresI raIe,
i! omiIIed, Ihe calculaIiohs begih wiIh a value o! 0.1
or 10%
Iusl IiIo vill a financiaI caIcuIalor, llo oulfIovs lavo lo bo onlorod as nogalivo
numbors. In gonoraI, oacl probIom viII lavo lvo casl fIovs: ono posilivo and ono
nogalivo. Tlo idoa is llal you doposil monoy al somo poinl in limo (an oulfIov or nog-
alivo vaIuo), and al somo poinl Ialor in limo, you villdrav your monoy (an infIov or
posilivo vaIuo).
700.12 Fihahcial Risk MahagemehI 226
CAßM ModuIe 700 Fihahce
Entered values in cell d13:
700.12.3 De!ine present vaIue o! money
Up lo llis poinl vo lavo boon moving monoy forvard in limo, llal is, vo Inov lov
mucl vo lavo lo bogin vill and aro lrying lo dolormino lov mucl llal sum viII grov in
a corlain numbor of yoars vlon compoundod al a spocific ralo. Wo aro nov going lo IooI
al llo rovorso quoslion: Wlal is llo vaIuo in loday's doIIars of a sum of monoy lo bo
rocoivod in llo fuluro` Tlo ansvor lo llis quoslion viII loIp us dolormino llo dosirabiIily
of invoslmonl projocls in capilaI budgoling. Wo viII dolormino llo µresent vaIue of a Iump
sum, vlicl in simpIo lorms is llo currcni tc|uc c| c |uiurc pcumcni. In facl, vo viII bo doing
nolling ollor llan invorso compounding. Tlo difforoncos in lloso loclniquos como aboul
moroIy from llo invoslor's poinl of viov. In compounding, vo laIIod aboul llo compound
inlorosl ralo and llo iniliaI invoslmonl, in dolormining llo prosonl vaIuo, vo viII laII aboul
llo discounl ralo and prosonl vaIuo of fuluro casl fIovs. Dolorminalion of llo discounl
ralo can bo dofinod as llo ralo of rolurn avaiIabIo on an invoslmonl of oquaI risI lo vlal is
boing discounlod. Ollor llan llal, llo loclniquo and llo lorminoIogy romain llo samo,
and llo mallomalics aro simpIy rovorsod. In oqualion (12-6) vo voro allompling lo dolor-
mino llo fuluro vaIuo of an iniliaI invoslmonl. Wo nov vanl lo dolormino llo iniliaI
invoslmonl or prosonl vaIuo. By dividing boll sidos of oqualion (12-6) by (1  i)
, vo gol
vloro IV
llo fuluro vaIuo of llo invoslmonl al llo ond of n yoars
n llo numbor of yoars unliI llo paymonl viII bo rocoivod
i llo annuaI discounl (or inlorosl) ralo
PV llo prosonl vaIuo of llo fuluro sum of monoy
Bocauso llo mallomalicaI procoduro for dolormining llo prosonl vaIuo is oxaclIy llo
invorso of dolormining llo fuluro vaIuo, vo aIso find llal llo roIalionslips among n, i,
and PV aro jusl llo opposilo of lloso vo obsorvod in fuluro vaIuo. Tlo prosonl vaIuo of a
fuluro sum of monoy is invorsoIy roIalod lo boll llo numbor of yoars unliI llo paymonl
viII bo rocoivod and llo discounl ralo. Tlis roIalionslip is slovn in Figure 12.2.
n n
1 ( ) 
700.12 Fihahcial Risk MahagemehI 227
CAßM ModuIe 700 Fihahce
Entered values in cell d15:
700.12 Fihahcial Risk MahagemehI 228
CAßM ModuIe 700 Fihahce
humber of years
2 4 6 8 10 12 14 16 18
figure 12.2 PresehI Value o! $100 Io 8e Received aI a FuIure DaIe
ahd DiscouhIed 8ack Io Ihe PresehI aI 0, 5, 10, ahd 15 PercehI
Whal is lhe presenl value ol S500 lo be received !0 years lrom loday il our discounl rale is 6 percenl? Subsliluling
S500, n !0, and | 6 percenl inlo equalion (!2-7), we lind
Thus, lhe presenl value ol lhe S500 lo be received in !0 years is S279.
|v =
( )
! 06
! 79!
000 558
( )
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
700.12 Fihahcial Risk MahagemehI 229
CAßM ModuIe 700 Fihahce
TabIe 12.3 FVlF
, or Ihe Compouhd Sum o! $1
N 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 .990 .980 .971 .962 .952 .943 .935 .926 .917 .909
2 .980 .961 .943 .925 .907 .890 .873 .857 .842 .826
3 .971 .942 .915 .889 .864 .840 .816 .794 .772 .751
4 .961 .924 .888 .855 .823 .792 .763 .735 .708 .683
5 .951 .906 .863 .822 .784 .747 .713 .681 .650 .621
6 .942 .888 .837 .790 .746 .705 .666 .630 .596 .564
7 .933 .871 .813 .760 .711 .655 .623 .583 .547 .513
8 .923 .853 .789 .731 .677 .627 .582 .540 .502 .467
9 .914 .837 .766 .703 .645 .592 .544 .500 .460 .424
10 .905 .820 .744 .676 .614 .558 .508 .463 .422 .386
11 .896 .804 .722 .650 .585 .527 .475 .429 .388 .350
12 .887 .789 .701 .625 .557 .497 .444 .397 .356 .319
13 .879 .773 .681 .601 .530 .469 .415 .368 .326 .290
14 .870 .758 .661 .577 .505 .442 .388 .340 .299 .263
15 .861 .743 .642 .555 .481 .417 .362 .315 .275 .239
To aid in llo compulalion of prosonl vaIuos, llo µresent-vaIue interest Iactnr for i
and n (
 
), dofinod as |1/(1  i)
], las boon compiIod for various combinalions of i
and n and an abbrovialod vorsion appoars in TabIe 12.3. A cIoso oxaminalion slovs
llal llo vaIuos in TabIo 12.3 aro moroIy llo invorso of lloso found in TabIo 12.2. Nov,
lo dolormino llo prosonl vaIuo of a sum of monoy lo bo rocoivod al somo fuluro dalo,
vo nood onIy dolormino llo vaIuo of llo approprialo PV|I
i, n
, by oillor using a caIcuIa-
lor or consuIling llo labIos, and muIlipIy il by llo fuluro vaIuo. In offocl vo can uso
our nov nolalion and rovrilo oqualion (12-7) as foIIovs:
i, n
) (12-7a)
You're on vacalion in a ralher remole parl ol llorida and see an adverlisemenl slaling lhal il you lake a sales lour ol some
condominiums "you will be given S!00 jusl lor laking lhe lour." However, lhe S!00 lhal you gel is in lhe lorm ol a savings
bond lhal will nol pay you lhe S!00 lor !0 years. Whal is lhe presenl value ol S!00 lo be received !0 years lrom loday il
your discounl rale is 6 percenl? 8y looking al lhe n !0 row and | 6' column ol Table !2-3, you lind lhe |v||
6', !0 yr
.558. Subsliluling |v
S!00 and |v||
6', !0 yr
.558 inlo equalion (!2-7a), you lind
|v S!00(|v||
6', !0 yr
Thus, lhe value in loday's dollars ol lhal S!00 savings bond is only S55.80.
700.12 Fihahcial Risk MahagemehI 230
CAßM ModuIe 700 Fihahce
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
Whal is lhe presenl value ol an inveslmenl lhal yields S500 lo be received in 5 years and S!,000 lo be received in !0 years
il lhe discounl rale is 4 percenl? Subsliluling lhe values ol n 5, | 4 percenl, and |v
S500, and n !0, | 4 percenl,
and |v
S!,000 inlo equalion (!2-7) and adding lhese values logelher, we lind
Again, presenl values are comparable because lhey are measured in lhe same lime period's dollars.
Wilh a linancial calculalor, lhis becomes a lhree-slep solulion. lirsl, you'll solve lor lhe presenl value ol lhe S500 received
al lhe end ol 5 years, lhen you'll solve lor lhe presenl value ol lhe S!,000 received al lhe end ol !0 years, and linally, you'll
add lhe lwo presenl values logelher. Pemember, once you've lound lhe presenl value ol lhose lulure cash llows you can
add lhem logelher because lhey're measured in lhe same period's dollars.
|v = S
( )
( )
! 04
! 04
5 !0

 .
 = S ( ) S (
', 5 yr ', !0 yr
500 !000
4 4
|v|| |v|| , ))
S ( ) S ( )
500 822 !000 676
4!! 676
. , .

Dealing with Multiple Uneven Cash Ilows
Again, vo onIy lavo ono prosonl-vaIuo÷fuluro-vaIuo oqualion, llal is, oqualions
(12-6) and (12-7) aro idonlicaI. Wo lavo inlroducod llom as soparalo oqualions lo sim-
pIify our caIcuIalions, in ono caso vo aro dolormining llo vaIuo in fuluro doIIars, and
in llo ollor caso llo vaIuo in loday's doIIars. In oillor caso llo roason is llo samo: lo
comparo vaIuos on aIlornalivo invoslmonls and lo rocognizo llal llo vaIuo of a doIIar
rocoivod loday is nol llo samo as llal of a doIIar rocoivod al somo fuluro dalo. Wo
musl moasuro llo doIIar vaIuos in doIIars of llo samo limo poriod. Ior oxampIo, if vo
IooIod al lloso projocls÷ono llal promisod $1,000 in 1 yoar, ono llal promisod
$1,500 in 5 yoars, and ono llal promisod $2,500 in 10 yoars÷llo concopl of prosonl
vaIuo aIIovs us lo bring lloir fIovs bacI lo llo prosonl and maIo lloso projocls com-
parabIo. Moroovor, bocauso aII prosonl vaIuos aro comparabIo (lloy aro aII moasurod
in doIIars of llo samo limo poriod), vo can add and sublracl llo prosonl vaIuo of
infIovs and oulfIovs lo dolormino llo prosonl vaIuo of an invoslmonl. Iol's nov IooI
al an oxampIo of an invoslmonl llal las lvo casl fIovs in difforonl limo poriods and
dolormino llo prosonl vaIuo of llis invoslmonl.
700.12 Fihahcial Risk MahagemehI 231
CAßM ModuIe 700 Fihahce
5tep 1
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
5tep 2
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
5tep 3 Add lhe lwo presenl values lhal you jusl calculaled logelher.
700.12.4 Di!!erentiate betveen ordinary annuities
and annuities due method
An annuitv is a scrics c| c¡uc| !c||cr pcumcnis |cr c spcci|ic! num|cr c| uccrs. Wlon vo laII
aboul annuilios, vo aro roforring lo nrdinarv annuities unIoss ollorviso nolod. Will an
ordinary annuily i|c pcumcnis cccur ci i|c cn! c| ccc| pcric!. Bocauso annuilios occur fro-
quonlIy in financo÷for oxampIo, as bond inlorosl paymonls÷vo lroal llom spociaIIy.
AIllougl compounding and dolormining llo prosonl vaIuo of an annuily can bo doaIl
vill using llo mollods vo lavo jusl doscribod, lloso procossos can bo limo-consuming,
ospociaIIy for Iargor annuilios. Tlus, vo lavo modifiod llo formuIas lo doaI diroclIy
vill annuilios.
Compound Annuities
A cnmµnund annuitv invoIvos !cpcsiiinv cr intcsiinv cn c¡uc| sum c| mcncu ci i|c cn! c|
ccc| uccr |cr c ccricin num|cr c| uccrs cn! c||cuinv ii ic vrcu. Iorlaps vo aro saving
monoy for oducalion, a nov car, or a vacalion lomo. In any caso vo vanl lo Inov
lov mucl our savings viII lavo grovn by somo poinl in llo fuluro.
AcluaIIy, vo can find llo ansvor by using oqualion (12-6), our compounding
oqualion, and compounding oacl of llo individuaI doposils lo ils fuluro vaIuo. Ior
oxampIo, if lo provido for a coIIogo oducalion vo aro going lo doposil $500 al llo ond
of oacl yoar for llo noxl 5 yoars in a banI vloro il viII oarn 6 porconl inlorosl, lov
mucl viII vo lavo al llo ond of 5 yoars` Compounding oacl of lloso vaIuos using
oqualion (12-6), vo find llal vo viII lavo $2,818.50 al llo ond of 5 yoars.
$500(1  0.6)
 $500(1  0.6)
 $500(1  0.6)
 $500(1  0.6)  $500
$500(1.262)  $500(1.191)  $500(1.124)
 $500(1.060)  $500
$631.00  $595.50  $562.00  $530.00  $500.00
Irom oxamining llo mallomalics invoIvod and llo grapl of llo movomonl of
monoy llrougl limo in TabIe 12.4, vo can soo llal aII vo aro roaIIy doing is adding up
llo fuluro vaIuos of difforonl casl fIovs llal iniliaIIy occurrod in difforonl limo pori-
ods. IorlunaloIy, lloro is aIso an oqualion llal loIps us caIcuIalo llo fuluro vaIuo of an
of an annuily PM1 (12-8)
PM1 (12-8a)
vloro IV
llo fuluro vaIuo of llo annuily al llo ond of llo nll yoar
PM1 llo annuily paymonl doposilod or rocoivod al llo ond of oacl yoar
i llo annuaI inlorosl (or discounl) ralo
n llo numbor of yoars for vlicl llo annuily viII Iasl
To simpIify our discussion, vo viII rofor lo llo vaIuo in paronllosos in
oqualion (12-8a) as llo Iuture-vaIue interest Iactnr Inr an annuitv for i and n (
 
dofinod as , and providod for various combinalions of n and i, an abbro-
vialod vorsion is slovn in TabIe 12.5.
( ) 1 1   i
( ) 1 1   i
i n ,
 1
700.12 Fihahcial Risk MahagemehI 232
CAßM ModuIe 700 Fihahce
TabIe 12.4 IllusIraIioh o! a 5-Year $500 AhhuiIy Compouhded aI 6 PercehI
¥ £k8 0 1 2 3 4 5
0ollar dcposìIs aI cnd oI vcar 600 600 600 600 600
S 600.00
FuIurc valuc oI Ihc annuìIv S2,818.60
Using llis nov nolalion, vo can rovrilo oqualion (12-8) as foIIovs:
i, n
) (12-8b)
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
Rooxamining llo provious oxampIo, in vlicl vo dolorminod llo vaIuo aflor 5 yoars
of $500 doposilod in llo banI al 6 porconl al llo ond of oacl of llo noxl 5 yoars, vo
vouId IooI in llo i 6 porconl coIumn and n 5 rov and find llo vaIuo of llo
6°, 5 yr
lo bo 5.637. Subsliluling llis vaIuo inlo oqualion (12-8b), vo gol
Tlis is llo samo ansvor vo oblainod oarIior using oqualion (12-6).
700.12 Fihahcial Risk MahagemehI 233
CAßM ModuIe 700 Fihahce
TabIe 12.5 FVlF
, or Ihe Sum o! ah AhhuiIy o! $1 !or n Years
N 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.010 2.020 2.030 2.040 2.050 2.060 2.070 2.080 2.090 2.100
3 3.030 3.060 3.091 3.122 3.152 3.184 3.215 3.246 3.278 3.310
4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4.506 4.573 4.641
5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105
6 6.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716
7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487
8 8.286 8.583 8.892 9.214 9.549 9.897 10.260 10.637 11.028 11.436
9 9.368 9.755 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579
10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531
12 12.682 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523
14 14.947 15.974 17.086 18.292 19.598 21.015 22.550 24.215 26.019 27.975
15 16.097 17.293 18.599 20.023 21.578 23.276 25.129 27.152 29.361 31.772
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
Rallor llan asI lov mucl vo viII accumuIalo if vo doposil an oquaI sum in a
savings accounl oacl yoar, a moro common quoslion is lov mucl vo musl doposil
oacl yoar lo accumuIalo a corlain amounl of savings. Tlis probIom froquonlIy occurs
vill rospocl lo saving for Iargo oxpondiluros and ponsion funding obIigalions.
Ior oxampIo, vo may Inov llal vo nood $10,000 for oducalion in 8 yoars, lov
mucl musl vo doposil in llo banI al llo ond of oacl yoar al 6 porconl inlorosl lo
lavo llo coIIogo monoy roady` In llis caso vo Inov llo vaIuos of n, i, and IV
oqualion (12-8b), vlal vo do nol Inov is llo vaIuo of PM1. Subsliluling lloso
oxampIo vaIuos in oqualion (12-8b), vo find
Tlus, vo musl doposil $1,010.41 in llo banI al llo ond of oacl yoar for 8 yoars al
6 porconl inlorosl lo accumuIalo $10,000 al llo ond of 8 yoars.
$ ( )
$ (
6°, 8 yr
10 000
10 000 9 897
, .
PM1 ))
10 000
9 897
1 010 41
, .
700.12 Fihahcial Risk MahagemehI 234
CAßM ModuIe 700 Fihahce
How much musl we deposil in an 8 percenl savings accounl al lhe end ol each year lo accumulale S5,000 al lhe end ol
!0 years? Subsliluling lhe values |v
S5,000, n !0, and | 8 percenl inlo equalion (!2-8b), we lind
Thus, we musl deposil S345.!4 per year lor !0 years al 8 percenl lo accumulale S5,000.
S ( )
S (
8', !0 yr
5 000
5 000 !4 487
, .
||1 |v||A
||1 ))
5 000
!4 487
345 !4
Present value of an Annuity
Ionsion funds, insuranco obIigalions, and inlorosl rocoivod from bonds aII invoIvo
annuilios. To comparo llom, vo nood lo Inov llo prosonl vaIuo of oacl. AIllougl
vo can find llis by using llo prosonl-vaIuo labIo, llis can bo limo consuming, parlic-
uIarIy vlon llo annuily Iasls for sovoraI yoars. Ior oxampIo, if vo visl lo Inov vlal
$500 rocoivod al llo ond of oacl of llo noxl 5 yoars is vorll lo us givon llo appropri-
alo discounl ralo of 6 porconl, vo can simpIy subslilulo llo approprialo vaIuos inlo
oqualion (12-7), sucl llal
Tlus, llo prosonl vaIuo of llis annuily is $2,106.00. Irom oxamining llo mallo-
malics invoIvod and llo grapl of llo movomonl of monoy llrougl limo in TabIe 12.6,
vo can soo llal aII vo aro roaIIy doing is adding up llo prosonl vaIuos of difforonl casl
fIovs llal iniliaIIy occurrod in difforonl limo poriods. IorlunaloIy, lloro is aIso an
oqualion llal loIps us caIcuIalo llo prosonl vaIuo of an annuily:
PV of an annuily PM1 (12-9)
PM1 (12-9a)
vloro PM1 llo annuily paymonl doposilod or rocoivod al llo ond of oacl yoar
i llo annuaI discounl (or inlorosl) ralo
PV llo prosonl vaIuo of llo fuluro annuily
n llo numbor of yoars for vlicl llo annuily viII Iasl
To simpIify our discussion, vo viII rofor lo llo vaIuo in llo paronllosos in oqua-
lion (12-9a) as llo µresent-vaIue interest Iactnr Inr an annuitv for i and n (
dofinod as , vlicl las boon compiIod for various combinalions of i and n,
vill an abbrovialod vorsion providod in TabIe 12.7.
1 ( )  

1 i
1 ( )  

1 i
1  PV|I
i n ,
PV = $
( )
( )
$ 500
1 06
1 06

. .
1 06
1 06
( )
( )

( )
$ ( ) $ ( )
1 06
500 943 500 890

 
. . = $$ ( ) $ ( ) $ ( )
500 840 500 792 500 747
2 106
. . .
 
700.12 Fihahcial Risk MahagemehI 235
CAßM ModuIe 700 Fihahce
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
Using llis nov nolalion vo can rovrilo oqualion (12-9) as foIIovs:
) (12-9b)
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
-2,106.18 PV
700.12 Fihahcial Risk MahagemehI 236
CAßM ModuIe 700 Fihahce
TabIe 12.7 PVlFA
. or Ihe PresehI Value o! ah AhhuiIy o! $1
N 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.326 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.746 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.560 8.061 7.606
TabIe 12.6 IllusIraIioh o! a 5-Year $500 AhhuiIy DiscouhIed Io Ihe PresehI
aI 6 PercehI
¥ £k8 0 1 2 3 4 5
0ollars rcccìvcd aI cnd oI vcar 600 600 600 600 600
S 471.60
PrcscnI valuc oI Ihc annuìIv S2,10ß.00
SoIving llo provious oxampIo lo find llo prosonl vaIuo of $500 rocoivod al llo ond
of oacl of llo noxl 5 yoars discounlod bacI lo llo prosonl al 6 porconl, vo IooI in llo
i 6 porconl coIumn and n 5 rov and find llo PV|IA
6°, 5 yr
lo bo 4.212. Subsliluling
llo approprialo vaIuos inlo oqualion (12-9b), vo find
PV $500(4.212)
Tlis, of courso, is llo samo ansvor vo caIcuIalod vlon vo individuaIIy dis-
counlod oacl casl fIov lo llo prosonl. Tlo roason is llal vo roaIIy onIy lavo cnc labIo,
llo TabIo 12.7 vaIuo for an n-yoar annuily for any discounl ralo i is moroIy llo sum of
llo firsl n vaIuos in TabIo 12.3. Wo can soo llis by comparing llo vaIuo in llo prosonl-
vaIuo-of-an-annuily labIo (TabIo 12.7) for i 8 porconl and n 6 yoars, vlicl is 4.623,
vill llo sum of llo vaIuos in llo i 8 porconl coIumn and n 1, . . . , 6 rovs of llo
prosonl-vaIuo labIo (TabIo 12.3), vlicl is oquaI lo 4.623, as slovn in TabIe 12.8.
700.12 Fihahcial Risk MahagemehI 237
CAßM ModuIe 700 Fihahce
Whal is lhe presenl value ol a !0-year S!,000 annuily discounled back lo lhe presenl al 5 percenl? Subsliluling n
!0 years, | 5 percenl, and ||1 S!,000 inlo equalion (!2-9b), we lind
|v S!,000(|v||A
5', !0 yr
Delermining lhe value lor lhe |v||A
5', !0 yr
lrom Table !2.7, row n !0, column | 5 percenl, and subsliluling il in,
we gel
|v S!,000(7.722)
Thus, lhe presenl value ol lhis annuily is S7,722.
TabIe 12.8 PresehI Value o! a 6-Year AhhuiIy DiscouhIed aI 8 PercehI
0ne dollar received 1 2 8 4 6 ß
al lhe end of vear
Presenl value
4.ß28 Presenl value of lhe annuilv
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
As vill our ollor compounding and prosonl-vaIuo labIos, givon any llroo of llo
four unInovns in oqualion (12-9b), vo can soIvo for llo fourll. In llo caso of llo
prosonl-vaIuo-of-an-annuily labIo, vo may bo inloroslod in soIving for PM1, if vo
Inov i, n, and PV. Tlo financiaI inlorprolalion of llis aclion vouId bo: Hov mucl can
bo villdravn, porlaps as a ponsion or lo maIo Ioan paymonls, from an accounl llal
oarns i porconl compoundod annuaIIy for oacl of llo noxl n yoars if vo visl lo lavo
nolling Iofl al llo ond of n yoars` Ior oxampIo, if vo lavo $5,000 in an accounl oarning
8 porconl inlorosl, lov Iargo an annuily can vo drav oul oacl yoar if vo vanl nolling
Iofl al llo ond of 5 yoars` In llis caso llo prosonl vaIuo, PV, of llo annuily is $5,000,
n 5 yoars, i 8 porconl, and PM1 is unInovn. Subsliluli ng lli s i nlo
oqualion (12-9b), vo find
$5,000 PM1(3.993)
$1,252.19 PM1
Tlus, llis accounl viII faII lo zoro al llo ond of 5 yoars if vo villdrav $1,252.19 al
llo ond of oacl yoar.
Bocauso annuities due aro roaIIy jusl cr!incru cnnuiiics in u|ic| c|| i|c cnnuiiu pcumcnis
|ctc |ccn s|i|ic! |crucr! |u 1 uccr, compounding llom and dolormining lloir prosonl
vaIuo is acluaIIy quilo simpIo. Romombor, vill an annuily duo, oacl annuily paymonl
occurs al llo boginning of oacl poriod rallor llan al llo ond of llo poriod. Iol's firsl
IooI al lov llis affocls our compounding caIcuIalions.
Bocauso an annuily duo moroIy slifls llo paymonls from llo ond of llo yoar lo llo
boginning of llo yoar, vo nov compound llo casl fIovs for ono addilionaI yoar.
Tloroforo, llo compound sum of an annuily duo is simpIy
(annuily duo) PM1(IV|IA
i, n
)(1  i) (12-10)
Ior oxampIo, oarIior vo caIcuIalod llo vaIuo of a 5-yoar ordinary annuily of $500
invoslod in llo banI al 6 porconl lo bo $2,818.50. If vo nov assumo llis lo bo a 5-yoar
annuily duo, ils fuluro vaIuo incroasos from $2,818.50 lo $2,987.61.
6°, 5 yr
)(1  .06)
IiIoviso, vill llo prosonl vaIuo of an annuily duo, vo simpIy rocoivo oacl casl
fIov 1 yoar oarIior÷llal is, vo rocoivo il al llo boginning of oacl yoar rallor llan al
llo ond of oacl yoar. Tlus, bocauso oacl casl fIov is rocoivod 1 yoar oarIior, il is dis-
counlod bacI for ono Ioss poriod. To dolormino llo prosonl vaIuo of an annuily duo,
vo moroIy nood lo find llo prosonl vaIuo of an ordinary annuily and muIlipIy llal by
(1  i), vlicl in offocl cancoIs oul 1 yoar's discounling.
PV(annuily duo) PM1(PV|IA
i, n
)(1  i) (12-11)
Rooxamining llo oarIior oxampIo in vlicl vo caIcuIalod llo prosonl vaIuo of a
5-yoar ordinary annuily of $500 givon an approprialo discounl ralo of 6 porconl, vo
nov find llal if il is an annuily duo rallor llan an ordinary annuily, llo prosonl vaIuo
incroasos from $2,106 lo $2,232.36,
PV $500(PV|IA
6°, 5 yr
)(1  .06)
Will a financiaI caIcuIalor, you lavo lvo cloicos. Iirsl, you can rosol your financiaI
caIcuIalor lo ¨Boginning Modo.¨ Iusl as oasy is lo approacl llis as a lvo-slop probIom.
700.12 Fihahcial Risk MahagemehI 238
CAßM ModuIe 700 Fihahce
Iirsl, lroal il as if il voro an ordinary annuily and find llo prosonl vaIuo. Tlon muIli-
pIy llo prosonl vaIuo limos (1  i), in llis caso limos 1.06, llis is slovn boIov.
Present vaIue o! an annuity due.
5tep 1
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
5tep 2
Tlo rosuIl of aII llis is llal boll llo fuluro and prosonl vaIuos of an annuily duo
aro Iargor llan lloso of an ordinary annuily bocauso in oacl caso aII paymonls aro
rocoivod oarIior. Tlus, vlon ccmpcun!inv an annuily duo, il compounds for ono addi-
lionaI yoar, vloroas vlon !isccuniinv an annuily duo, llo casl fIovs aro discounlod
for ono Ioss yoar. AIllougl annuilios duo aro usod vill somo froquoncy in accounling,
lloir usago is quilo Iimilod in financo. Tloroforo, in llo romaindor of llis loxl, vlon-
ovor llo lorm cnnuiiu is usod, you slouId assumo llal vo aro roforring lo an ordinary
700.12 Fihahcial Risk MahagemehI 239
CAßM ModuIe 700 Fihahce
The Virginia Slale Lollery runs like mosl olher slale lolleries. You musl selecl 6 oul ol 44 numbers correclly in order lo win
lhe jackpol. ll you come close, lhere are some signilicanlly lesser prizes, which we ignore lor now. lor each million dollars
in lhe lollery jackpol you receive S50,000 per year lor 20 years, and your chance ol winning is ! in 7.! million. A recenl
adverlisemenl lor lhe Virginia Slale Lollery wenl as lollows. "Okay, you gol lwo kinds ol people. You've gol lhe kind who
play Lollo all lhe lime, and lhe kind who play Lollo some ol lhe lime. You know, like only on a Salurday when lhey slop in
al lhe slore on lhe corner lor some peanul buller cups and diel soda and lhe jackpol happens lo be really big. l mean, my
lriend Ned? He's like "Hey, il's only S2 million lhis week." Well, hellloooo, anybody home? l mean, l don'l know aboul
you, bul l wouldn'l mind having a measly 2 mill coming mv way. . . ."
Whal is lhe presenl value ol lhese paymenls? The answer lo lhis queslion depends on whal assumplion you make aboul
lhe lime value ol money. ln lhis case, lel's assume lhal your required rale ol relurn on an inveslmenl wilh lhis level ol risk
700.12 Fihahcial Risk MahagemehI 240
CAßM ModuIe 700 Fihahce
is !0 percenl. Keeping in mind lhal lhe Lollo is an annuily duelhal is, on a S2 million lollery you would gel S!00,000
immedialely and S!00,000 al lhe end ol each ol lhe nexl !9 years. Thus, lhe presenl value ol lhis 20-year annuily due dis-
counled back lo presenl al !0 percenl becomes
|v(annuily due) ||1(|v||A
|', n yr
)(!  |)
!0', 20 yr
)(!  .!0)
Jusl as belore, you can eilher resel your linancial calculalor lo "8eginning Mode" or use lhe lwo-slep process. Wilh lhe
lwo-slep process, in slep !, you lreal il as il il were an ordinary annuily and lind lhe presenl value. Then mulliply lhe pres-
enl value limes (!  |), in lhis case limes !.!0, lhis is shown below. You'll nolice lhis answer is a bil dillerenl lrom lhe
answer you gol using lhe lables. Thal's because ol rounding error in lhe lables.
Thus, lhe presenl value ol lhe S2 million Lollo jackpol is less lhan S! million il !0 percenl is lhe appropriale discounl rale.
Moreover, because lhe chance ol winning is only ! in 7.! million, lhe expecled value ol each dollar "invesled" in lhe lol-
lery is only (!/7.! million )  (S936,540) !3.!9c. Thal is, lor every dollar you spend on lhe lollery you should expecl lo
gel, on averaqe, aboul !3 cenls backnol a parlicularly good deal. Allhough lhis ignores lhe minor paymenls lor coming
close, il also ignores laxes. ln lhis case, il looks like "my lriend Ned" is doing lhe righl lhing by slaying clear ol lhe lollery.
Obviously, lhe main value ol lhe lollery is enlerlainmenl. Unlorlunalely, wilhoul an underslanding ol lhe lime value ol
money, il can sound like a good inveslmenl.
700.12.5 ExpIain the concept o! Ioan amortization
Amortized Loans
Tlis procoduro of soIving for PM1, llo annuily paymonl vaIuo vlon i, n, and PV aro
Inovn, is aIso usod lo dolormino vlal paymonls aro associalod vill paying off a Ioan
in oquaI inslaIImonls ovor limo. Iccns i|ci crc pci! c|| i|is ucu, in c¡uc| pcric!ic pcumcnis,
aro caIIod amnrtized Inans. AcluaIIy, llo vord cmcriizciicn comos from llo Ialin vord
moaning ¨aboul lo dio.¨ Wlon you pay off a Ioan using roguIar, fixod paymonls, llal
Ioan is amorlizod. AIllougl llo paymonls aro fixod, difforonl amounls of oacl paymonl
Present vaIue o! an annuity due.
5tep 1
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
5tep 2
aro appIiod lovard llo principaI and llo inlorosl. Will oacl paymonl you ovo a bil Ioss
lovard llo principaI. As a rosuIl, llo amounl llal las lo go lovard llo inlorosl pay-
monl docIinos vill oacl paymonl vloroas llo porlion of oacl paymonl llal goos
lovard llo principaI incroasos. Figure 12.3 iIIuslralos llo procoss of amorlizalion.
Ior oxampIo, supposo a firm vanls lo purclaso a pioco of maclinory. To do llis, il
borrovs $6,000 lo bo ropaid in four oquaI paymonls al llo ond of oacl of llo noxl
4 yoars, and llo inlorosl ralo llal is paid lo llo Iondor is 15 porconl on llo oulslanding
porlion of llo Ioan. To dolormino vlal llo annuaI paymonls associalod vill llo
ropaymonl of llis dobl viII bo, vo simpIy uso oqualion (12-9b) and soIvo for llo vaIuo
of PM1, llo annuaI annuily. Again vo Inov llroo of llo four vaIuos in llal oqualion:
PV, i, and n. PV, llo prosonl vaIuo of llo fuluro annuily, is $6,000, i, llo annuaI inlorosl
ralo, is 15 porconl, and n, llo numbor of yoars for vlicl llo annuily viII Iasl, is 4 yoars.
PM1, llo annuily paymonl rocoivod (by llo Iondor and paid by llo firm) al llo ond of
oacl yoar, is unInovn. Subsliluling lloso vaIuos inlo oqualion (12-9b), vo find
$6,000 PM1(PV|IA
15°, 4 yr
$6,000 PM1(2.855)
$2,101.58 PM1
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
To ropay llo principaI and inlorosl on llo oulslanding Ioan in 4 yoars, llo annuaI
paymonls vouId bo $2,101.58. Tlo broaIdovn of inlorosl and principaI paymonls is
givon in llo |ccn cmcriizciicn sc|c!u|c in TabIe 12.9, vill vory minor rounding orror. As
you can soo, llo inlorosl porlion of llo paymonl docIinos oacl yoar as llo Ioan oulsland-
ing baIanco docIinos.
700.12 Fihahcial Risk MahagemehI 241
CAßM ModuIe 700 Fihahce
Parl oí each
payueul relaled
lo priucipal
Parl oí each
payueul relaled
lo iuleresl
|ixed payueul
humber of payments
1 2 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . n
figure 12.3 1he AmorIizaIioh Process
700.12.6 CaIcuIate the compound interest
vith nonannuaI periods
UnliI nov vo lavo assumod llal llo compounding or discounling poriod is aIvays
annuaI, lovovor, il nood nol bo, as ovidoncod by savings and Ioan associalions and
commorciaI banIs llal compound on a quarlorIy, daiIy, and in somo casos conlinuous
basis. IorlunaloIy, llis adjuslmonl of llo compounding poriod foIIovs llo samo for-
mal as llal usod for annuaI compounding. If vo invosl our monoy for 5 yoars al 8 por-
conl inlorosl compoundod somiannuaIIy, vo aro roaIIy invosling our monoy for 10 six-
monll poriods during vlicl vo rocoivo 4 porconl inlorosl oacl poriod. If il is
compoundod quarlorIy, vo rocoivo 2 porconl inlorosl por poriod for 20 llroo-monll
poriods. Tlis procoss can oasiIy bo gonoraIizod, giving us llo foIIoving formuIa for
finding llo fuluro vaIuo of an invoslmonl for vlicl inlorosl is compoundod in nonan-
nuaI poriods:
vloro IV
llo fuluro vaIuo of llo invoslmonl al llo ond of n yoars
n llo numbor of yoars during vlicl llo compounding occurs
i annuaI inlorosl (or discounl) ralo
PV llo prosonl vaIuo or originaI amounl invoslod al llo boginning of llo
firsl yoar
m llo numbor of limos compounding occurs during llo yoar
Wo can soo llo vaIuo of inlrayoar compounding by oxamining TabIe 12.10. Bocauso
inlorosl is oarnod on inlorosl moro froquonlIy as llo Iongll of llo compounding poriod
docIinos, lloro is an invorso roIalionslip bolvoon llo Iongll of llo compounding
poriod and llo offoclivo annuaI inlorosl ralo.
= 1 
700.12 Fihahcial Risk MahagemehI 242
CAßM ModuIe 700 Fihahce
TabIe 12.9 Loah AmorIizaIioh Schedule Ihvolvihg a $6,000 Loah aI 15 PercehI
Io 8e Repaid ih 4 Years
ßepayment o! Loan ßaIance
Interest Portion the PrincipaI a!ter the
o! the Portion o! Annuity
Year Annuity Annuity
the Annuity
0 0 0 0 $6,000
1 $2,101.58 $900.00 $1,201.58 4,798.42
2 2,101.58 719.76 1,381.82 3,416.60
3 2,101.58 512.49 1,589.09 1,827.51
4 2,101.58 274.07 1,827.51
The inleresl porlion ol lhe annuily is calculaled by mulliplying lhe oulslanding loan balance al lhe beginning
ol lhe year by lhe inleresl rale ol !5 percenl. Thus, lor year ! il was S6,000 .!5 S900.00, lor year 2 il
was S4,798.42 .!5 S7!9.76, and so on.
Pepaymenl ol lhe principal porlion ol lhe annuily was calculaled by sublracling lhe inleresl porlion ol lhe
annuily (column 2) lrom lhe annuily (column !).
Iinancial Calculator Solution to Nonannual Periods
Will a financiaI caIcuIalor, llo oasiosl vay lo soIvo a probIom invoIving nonannuaI
poriods is lo rosol llo ¨paymonls por yoar¨ or foaluro on your caIcuIalor lo malcl
llo probIom. WliIo you'II vanl lo maIo suro you undorsland lov your financiaI caIcu-
Ialor vorIs, you slouId Ioop in mind llal on mosl financiaI caIcuIalors is llo
numbor of compounding poriods. Tlus, for probIoms vill annuaI compounding,
slouId bo sol lo 1, and for probIoms vill monllIy compounding, slouId bo
sol lo 12. If you lavo a TI BA II IIus caIcuIalor, lo rosol llo foaluro you musl firsl
lil llo bullon, llon llo bullon (you'II nolico jusl abovo llo bullon
is Iislod). Irom lloro, you onlor 12, llon lil llo bullon on llo lop rov,
and finaIIy lil llo llon again÷lilling llo bullon lvico sorvos lo
cIoar llo dispIay. Onco again, onco you'vo gol llo ¨paymonls por yoar¨ bullon sol,
bocomos llo numbor of compounding poriods, so if your probIom invoIvos 10 yoars
of monllIy compounding, llon oquaIs 120, llo numbor of monlls in 10 yoars. N
PY I/Y I/Y 2
700.12 Fihahcial Risk MahagemehI 243
CAßM ModuIe 700 Fihahce
TabIe 12.10 1he Value o! $100 Compouhded aI Various IhIervals
for 1 Year at i Percent
i = 2% 5% 10% 15%
Compouhded ahhually $102.00 $105.00 $110.00 $115.00
Compouhded semiahhually 102.01 105.06 110.25 115.56
Compouhded quarIerly 102.02 105.09 110.38 115.87
Compouhded mohIhly 102.02 105.12 110.47 116.08
Compouhded weekly (52) 102.02 105.12 110.51 116.16
Compouhded daily (365) 102.02 105.13 110.52 116.18
for 10 Years at i Percent
i = 2% 5% 10% 15%
Compouhded ahhually $121.90 $162.89 $259.37 $404.56
Compouhded semiahhually 122.02 163.86 265.33 424.79
Compouhded quarIerly 122.08 164.36 268.51 436.04
Compouhded mohIhly 122.12 164.70 270.70 444.02
Compouhded weekly (52) 122.14 164.83 271.57 447.20
Compouhded daily (365) 122.14 164.87 271.79 448.03
lirsl lel's solve lhis problem wilhoul reselling lhe "paymenls per year" or lealure on your calculalor. ll we place S!00
in a savings accounl lhal yields !2 percenl compounded quarlerly, whal will our inveslmenl grow lo al lhe end ol 5 years?
Subsliluling n 5, m 4, | !2 percenl, and |v S!00 inlo equalion (!2-!2), we lind
Thus, we will have S!80.60 al lhe end ol 5 years. Nolice lhal lhe calculalor solulion is slighlly dillerenl because ol round-
ing errors in lhe lables, and il also lakes on a negalive value. Also nolice lhal while becomes lhe number ol quarlers in
5 years, remains lhe annual inleresl rale. I/Y
4 5
!00 !
!00! 03
S ( )
S (

!! 806
!80 60
S =
700.12 Fihahcial Risk MahagemehI 244
CAßM ModuIe 700 Fihahce
CaIcuIator 5oIution
first, 5ET PlY 4
Data Input function Key
function Key Ansver
ln 2004 lhe average U.S. household owed S8,400 in credil card debl, and lhe average inleresl rale on credil card debl was
!8.9 percenl. On many credil cards lhe minimum monlhly paymenl is 2 percenl ol lhe debl balance. ll lhe average house-
hold paid oll 2 percenl ol lhe inilial amounl owed each monlh, lhal is, made paymenls ol S!68 each monlh, how many
monlhs would il lake lo repay lhis credil card debl? Use a linancial calculalor lo solve lhis problem.
You'll nolice in lhe solulion lhal appears below lhal lhe value lor ||1 goes in as a negalive. The answer is 99 monlhs.
Over lhal period you'll be paying jusl aboul as much in inleresl as you will in repaymenl ol principal!
CaIcuIator 5oIution
first, 5ET PlY 12
Data Input function Key
function Key Ansver
700.12.7 CaIcuIate the present vaIue o! an uneven
stream o! payments and determine the present vaIue
o! a perpetuity
AIllougl somo projocls viII invoIvo a singIo casl fIov and somo annuilios, many proj-
ocls viII invoIvo unovon casl fIovs ovor sovoraI yoars. Tloro vo viII bo comparing nol
onIy llo prosonl vaIuo of casl fIovs bolvoon projocls bul aIso llo casl infIovs and
oulfIovs villin a parlicuIar projocl, lrying lo dolormino llal projocl's prosonl vaIuo.
Hovovor, llis viII nol bo difficuIl bocauso llo prosonl vaIuo of any casl fIov is moas-
urod in loday's doIIars and llus can bo comparod, llrougl addilion for infIovs and
sublraclion for oulfIovs, lo llo prosonl vaIuo of any ollor casl fIov aIso moasurod in
loday's doIIars. Ior oxampIo, if vo vislod lo find llo prosonl vaIuo of llo foIIoving
casl fIovs
Year Cash fIov Year Cash fIov
1 $ 0 6 500
2 200 7 500
3 -400 8 500
4 500 9 500
5 500 10 500
givon a 6 porconl discounl ralo, vo vouId moroIy discounl llo fIovs bacI lo llo prosonl
and lolaI llom by adding in llo posilivo fIovs and sublracling llo nogalivo onos. Hovovor,
llis probIom is compIicalod by llo annuily of $500 llal runs from yoars 4 llrougl 10. To
accommodalo llis, vo can firsl discounl llo annuily bacI lo llo boginning of poriod 4 (or
ond of poriod 3) by muIlipIying il by llo vaIuo of PV|IA
6°, 7 yr
and gol ils prosonl vaIuo al
llal poinl in limo. Wo llon muIlipIy llis vaIuo limos llo PV|I
6°, 3 yr
in ordor lo bring llis
singIo casl fIov (vlicl is llo prosonl vaIuo of llo 7-yoar annuily) bacI lo llo prosonl. In
offocl vo discounl lvico, firsl bacI lo llo ond of poriod 3, llon bacI lo llo prosonl. Tlis is
slovn graplicaIIy in TabIe 12.11 and numoricaIIy in TabIe 12.12. Tlus, llo prosonl vaIuo
of llis unovon slroam of casl fIovs is $2,186.44.
Romombor, onco llo casl fIovs from an invoslmonl lavo boon brougll bacI lo llo
prosonl, lloy can bo combinod by adding and sublracling lo dolormino llo projocl's lolaI
prosonl vaIuo.
5tep 1 Bring llo $200 al llo ond of yoar 2 bacI lo prosonl.
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
-178.00 PV
700.12 Fihahcial Risk MahagemehI 245
CAßM ModuIe 700 Fihahce
TabIe 12.11 IllusIraIioh o! ah Lxample o! PresehI Value o! ah Uheveh SIream
Ihvolvihg Ohe AhhuiIy DiscouhIed Io Ihe PresehI aI 6 PercehI
¥ £k8 0 1 2 3 4 5 6 7 8 9 1 0
0ollars rcccìvcd 0 200 400 600 600 600 600 600 600 600
aI cnd oI vcar
S 178.00
]oIal prcscnI valuc S2,18ß.44
5tep 2 Bring llo nogalivo $400 al llo ond of yoar 3 bacI lo prosonl.
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
5tep 3 Bring llo 7-yoar, $500 annuily boginning al llo ond of yoar 4 bacI lo llo
boginning of yoar 4, vlicl is llo samo as llo ond of yoar 3.
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
-2,791.19 PV
700.12 Fihahcial Risk MahagemehI 246
CAßM ModuIe 700 Fihahce
TabIe 12.12 DeIermihaIioh o! Ihe PresehI Value o! ah Lxample wiIh Uheveh
SIream Ihvolvihg Ohe AhhuiIy DiscouhIed Io Ihe PresehI aI 6 PercehI
1. PresehI value o! $200 received aI Ihe ehd o! 2 years $200(.890) $ 178.00
2. PresehI value o! a $400 ouI!low aI Ihe ehd o! 3 years -400(.840) -336.00
3. (a) Value ehd o! year 3 o! a $500 ahhuiIy, years 4-10
$500(5.582) $2,791.00
(b) PresehI value o! $2,791.00 received aI Ihe ehd o! year 3 $2,791(.840) 2,344.44
4. 1oIal presehI value $2,186.44
5tep 4 Bring llo vaIuo vo jusl caIcuIalod, vlicl is llo vaIuo of llo 7-yoar annuily
of $500 al llo ond of yoar 3, bacI lo prosonl.
CaIcuIator 5oIution
Data Input function Key
function Key Ansver
5tep 5 Add llo prosonl vaIuo of llo casl infIovs and sublracl llo prosonl vaIuo
of llo casl oulfIov (llo $400 from llo ond of yoar 3) caIcuIalod in slops 1,
2, and 4:
$ 178.00
$ 2,185.69
A µerµetuitv is cn cnnuiiu i|ci ccniinucs |crctcr, llal is, ovory yoar from ils oslabIislmonl
llis invoslmonl pays llo samo doIIar amounl. An oxampIo of a porpoluily is proforrod
slocI llal pays a conslanl doIIar dividond infiniloIy. Dolormining llo prosonl vaIuo of a
porpoluily is doIigllfuIIy simpIo, vo moroIy nood lo divido llo conslanl fIov by llo dis-
counl ralo. Ior oxampIo, llo prosonl vaIuo of a $100 porpoluily discounlod bacI lo llo
prosonl al 5 porconl is $100/.05 $2,000. Tlus, llo oqualion roprosonling llo prosonl
vaIuo of a porpoluily is
vloro PV llo prosonl vaIuo of llo porpoluily
PP llo conslanl doIIar amounl providod by llo porpoluily
i llo annuaI inlorosl (or discounl) ralo
700.12 Fihahcial Risk MahagemehI 247
CAßM ModuIe 700 Fihahce
Whal is lhe presenl value ol a S500 perpeluily discounled back lo lhe presenl al 8 percenl? Subsliluling || S500 and
| .08 inlo equalion (!2-!3), we lind
Thus, lhe presenl value ol lhis perpeluily is S6,250.
|v = =
6 250
700.12.8 De!ine and measure the expected rate o!
return o! an individuaI investment and the riskiness
o! an individuaI investment
Tlo oxpoclod bonofils or rolurns an invoslmonl gonoralos como in llo form of casl
fIovs. Casl fIovs, nol accounling profils, is llo roIovanl variabIo llo financiaI man-
agor usos lo moasuro rolurns. Tlis principIo loIds lruo rogardIoss of llo lypo of socu-
rily, vlollor il is a dobl inslrumonl, proforrod slocI, common slocI, or any mixluro of
lloso (sucl as convorlibIo bonds).
This seclion has one primary objeclive, lhal ol helping us undersland
PrincipIe 1. The ßisk-ßeturn Trade-o!!-We Won't Take on AdditionaI ßisk UnIess
We Expect to ße Compensated vith AdditionaI ßeturn.
Pemember lhal lulure cash llows, nol lhe reporled earnings ligure, delermine lhe inveslor's
rale ol relurn. Thal is, PrincipIe 3. Cash-Not Pro!its-Is King.
AccuraloIy moasuring oxpoclod fuluro casl fIovs is nol oasy in a vorId of uncor-
lainly. To iIIuslralo, assumo you aro considoring an invoslmonl cosling $10,000, for
vlicl llo fuluro casl fIovs from ovning llo socurily dopond on llo slalo of llo ocon-
omy, as oslimalod in TabIe 12.13.
In any givon yoar, llo invoslmonl couId produco any ono of llroo possibIo casl
fIovs, doponding on llo parlicuIar slalo of llo oconomy. Will llis informalion, lov
slouId vo soIocl llo casl fIov oslimalo llal moans llo mosl for moasuring llo invosl-
monl's oxpoclod ralo of rolurn` Ono approacl is lo caIcuIalo an cxpccic! casl fIov. Tlo
oxpoclod casl fIov is simpIy llo voigllod avorago of llo pcssi||c casl fIov oulcomos
sucl llal llo voiglls aro llo probabiIilios of llo occurronco of llo various slalos of llo
oconomy. Iol X
dosignalo llo ill possibIo casl fIov, n rofIocl llo numbor of possibIo
slalos of llo oconomy, and P(X
) indicalo llo probabiIily llal llo ill casl fIov or slalo
of oconomy viII occur. Tlo oxpoclod casl fIov, , may llon bo caIcuIalod as foIIovs:
Ior llo prosonl iIIuslralion:
X = = . , . , . , 2 1 000 3 1 200 5 1 400 1   $ $ $ $ ,, 260
n n
1 1 2 2
 

700.12 Fihahcial Risk MahagemehI 248
CAßM ModuIe 700 Fihahce
TabIe 12.13 Measurihg Ihe LxpecIed ReIurh
ProbabiIity Cash fIovs Percentage ßeturns
5tate o! o! the !rom the (Cash fIov
the Economy 5tates
Investment Investment Cost)
Lcohomic recessioh 20% $1,000 10% ($1,000 ÷ $10,000)
ModeraIe ecohomic 30% 1,200 12% ($1,200 ÷ $10,000)
SIrohg ecohomic growIh 50% 1,400 14% ($1,400 ÷ $10,000)
The probabililies assigned lo lhe lhree possible economic condilions have lo be delermined subjeclively,
which requires managemenl lo have a lhorough underslanding ol bolh lhe inveslmenl cash llows and lhe
general economy.
In addilion lo compuling an oxpoclod doIIar rolurn from an invoslmonl, vo can
aIso caIcuIalo an exµected rate nI return oarnod on llo $10,000 invoslmonl. SimiIar lo
llo oxpoclod casl fIov, llo oxpoclod ralo of rolurn is c uciv|ic! ctcrcvc c| c|| i|c pcssi-
||c rciurns, uciv|ic! |u i|c prc|c|i|iiu i|ci ccc| rciurn ui|| cccur. As llo Iasl coIumn in
TabIo 12.13 slovs, llo $1,400 casl infIov, assuming slrong oconomic grovll, ropro-
sonls a 14 porconl rolurn ($1,400  $10,000). SimiIarIy, llo $1,200 and $1,000 casl
fIovs rosuIl in 12 porconl and 10 porconl rolurns, rospoclivoIy. Using lloso porconlago
rolurns in pIaco of llo doIIar amounls, llo oxpoclod ralo of rolurn, can bo
oxprossod as foIIovs:
In our oxampIo:
Will our concopl and moasuromonl of oxpoclod rolurns, Iol's considor llo ollor
sido of llo invoslmonl coin: risI.
You are conlemplaling making a S5,000 inveslmenl lhal would have lhe lollowing
possible oulcomes in cash llow each year. Whal are lhe expecled value ol lhe
lulure cash llows and lhe expecled rale ol relurn?
ProbabiIity Cash fIov
0.30 $350
0.50 625
0.20 900
PossibIe Expected
ProbabiIity Cash fIov ßeturn Cash fIov ßeturn
0.30 $350 7.0% $105.00 2.1%
0.50 625 12.5% 312.50 6.3%
0.20 900 18.0% 180.00 3.6%
LxpecIed cash !low ahd
raIe o! reIurh $597.50 12.0%
The possible relurns are equal lo lhe possible cash llows divided by lhe S5,000 inveslmenl.
The expecled cash llow and relurn are equal lo lhe possible cash llows
and possible relurns mulliplied by lhe probabililies.
Bocauso vo Iivo in a vorId vloro ovonls aro uncorlain, llo vay vo soo risI is vilaIIy
imporlanl in aImosl aII dimonsions of our Iifo.
In our sludy of risI, vo vanl lo considor lloso quoslions:
1. Wlal is risI`
2. Hov do vo Inov llo amounl of risI associalod vill a givon invoslmonl, llal
is, lov do vo moasuro risI`
| = = . . . . 2 10 3 12 5 14 12 6   ° ° ° °
| P | | P | | P | |
n n
1 1 2 2
 

700.12 Fihahcial Risk MahagemehI 249
CAßM ModuIe 700 Fihahce
3. If vo clooso lo divorsify our invoslmonls by ovning moro llan ono assol, as
mosl of us do, viII sucl divorsificalion roduco llo risIinoss of our combinod
porlfoIio of invoslmonls`
What ls Risk7
Willoul inlonding lo bo lrilo, risI moans difforonl llings lo difforonl poopIo, dopond-
ing on llo conloxl and on lov lloy fooI aboul laIing clancos. Ior llo sludonl, risI is
llo possibiIily of faiIing an oxam or llo clanco of nol maIing lis or lor bosl grados.
Ior llo coaI minor or llo oiI fioId vorIor, risI is llo clanco of an oxpIosion in llo mino
or al llo voII silo. Ior llo rolirod porson, risI moans porlaps nol boing abIo lo Iivo
comforlabIy on a fixod incomo. Ior llo onlropronour, risI is llo clanco llal a nov von-
luro viII faiI.
WliIo corlainIy acInovIodging lloso difforonl Iinds of risI, vo Iimil our allonlion
lo llo risI inloronl in an invoslmonl. In llis conloxl, risk is llo pcicniic| tcric|i|iiu in
|uiurc ccs| ||cus. Tlo vidor llo rango of possibIo ovonls llal can occur, llo groalor llo
risI. If vo llinI aboul il, llis is a roIalivoIy inluilivo concopl.
To loIp us grasp llo fundamonlaI moaning of risI villin llis conloxl, considor
lvo possibIo invoslmonls:
1. Tlo firsl invoslmonl is a U.S. Troasury biII, a govornmonl socurily llal maluros
in 90 days and promisos lo pay an annuaI rolurn of 6 porconl. If vo purclaso
and loId llis socurily for 90 days, vo aro virluaIIy assurod of rocoiving no moro
and no Ioss llan 6 porconl on an annuaIizod basis. Ior aII praclicaI purposos, llo
risI of Ioss is nonoxislonl.
2. Tlo socond invoslmonl invoIvos llo purclaso of llo slocI of a IocaI pubIisling
company. IooIing al llo pasl rolurns of llo firm's slocI, vo lavo mado llo
foIIoving oslimalo of llo annuaI rolurns from llo invoslmonl:
Chance o! Occurrence ßate o! ßeturn on Investment
1 chahce ih 10 (10%) 0%
2 chahces ih 10 (20%) 5%
4 chahces ih 10 (40%) 15%
2 chahces ih 10 (20%) 25%
1 chahce ih 10 (10%) 30%
Invosling in llo pubIisling company couId concoivabIy provido a rolurn as ligl as
30 porconl if aII goos voII, or no rolurn (0 porconl) if ovorylling goos againsl llo firm.
Hovovor, in fuluro yoars, boll good and bad, vo couId oxpocl a 15 porconl rolurn on
Comparing llo Troasury biII invoslmonl vill llo pubIisling company invosl-
monl, vo soo llal llo Troasury biII offors an oxpoclod 6 porconl annuaIizod ralo of
rolurn, vloroas llo pubIisling company las an oxpoclod ralo of rolurn of 15 porconl.
Hovovor, our invoslmonl in llo pubIisling firm is cIoarIy moro ¨risIy¨÷llal is,
lloro is groalor uncorlainly aboul llo finaI oulcomo. Slalod somovlal difforonlIy,
lloro is a groalor varialion or disporsion of possibIo rolurns, vlicl in lurn impIios
groalor risI. Figure 12.4 slovs lloso difforoncos graplicaIIy in llo form of discrolo
probabiIily dislribulions.
AIllougl llo rolurn from invosling in llo pubIisling firm is cIoarIy Ioss corlain
llan for Troasury biIIs, quanlilalivo moasuros of risI aro usofuI vlon llo difforonco
bolvoon lvo invoslmonls is nol so ovidonl. Tlo slandard dovialion ( ) is sucl a
| = . . . . 10 0 20 5 40 15 20 25    ° ° ° °  .10 30 15 ° ° =
700.12 Fihahcial Risk MahagemehI 250
CAßM ModuIe 700 Fihahce
moasuro. Tlo standard deviatinn is simpIy llo squaro rool of llo uciv|ic! ctcrcvc
s¡ucrc! !cticiicn c| ccc| pcssi||c rciurn |rcm i|c cxpccic! rciurn, llal is,
vloro n llo numbor of possibIo oulcomos or difforonl ralos of rolurn on llo
llo vaIuo of llo ill possibIo ralo of rolurn
) llo clanco or probabiIily llal llo ill oulcomo or rolurn viII occur
llo oxpoclod vaIuo of llo ralos of rolurn
Ior llo pubIisling company, llo slandard dovialion vouId bo 9.22 porconl, dolor-
minod as foIIovs:
AIllougl llo slandard dovialion of rolurns providos us vill a quanlilalivo
moasuro of an assol's risIinoss, lov slouId vo inlorprol llo rosuIl` Wlal doos il
moan` Is llo 9.22 porconl slandard dovialion for llo pubIisling company invosl-
monl good or bad` Iirsl, vo slouId romombor llal slalislicians loII us llal lvo-
llirds of llo limo, an ovonl viII faII villin ono slandard dovialion of llo oxpoclod
vaIuo (assuming llo dislribulion is normaIIy dislribulod, llal is, il is slapod IiIo a
boII). Tlus, givon a 15 porconl oxpoclod rolurn and a slandard dovialion of 9.22 por-
conl for llo pubIisling company invoslmonl, vo may roasonabIy anlicipalo llal llo
acluaI rolurns viII faII bolvoon 5.78 porconl and 24.22 porconl (15°  9.22°) lvo-
llirds of llo limo÷nol mucl corlainly vill llis invoslmonl.
A socond vay of ansvoring llo quoslion aboul llo moaning of llo slandard
dovialion comos by comparing llo invoslmonl in llo pubIisling firm againsl ollor
invoslmonls. Tlo allraclivonoss of a socurily vill rospocl lo ils rolurn and risI can-
nol bo dolorminod in isoIalion. OnIy by oxamining ollor avaiIabIo aIlornalivos can
vo roacl a concIusion aboul a parlicuIar invoslmonl's risI. Ior oxampIo, if anollor
invoslmonl, say, an invoslmonl in a firm llal ovns a IocaI radio slalion, las llo
samo oxpoclod rolurn as llo pubIisling company, 15 porconl, bul vill a slandard
dovialion of 7 porconl, vo vouId considor llo risI associalod vill llo pubIisling
firm, 9.22 porconl, lo bo oxcossivo. In llo loclnicaI jargon of modorn porlfoIio llo-
ory, llo radio slalion invoslmonl is said lo ¨dominalo¨ llo pubIisling firm
( ° °) ( ) ( ° °) ( )
( ° °
0 15 10 5 15 20
15 15
2 2
  
 
. .
)) ( ) ( ° °) ( )
( ° °) ( )
2 2
40 25 15 20
30 15 10
. .
 
 
85 9 22 = = ° ° .
( ) ( ) | | P |

700.12 Fihahcial Risk MahagemehI 251
CAßM ModuIe 700 Fihahce
figure 12.4 ProbabiliIy DisIribuIioh o! ReIurhs
1reasury biII
PossibIe returns (%)
3 6 9 12
PossibIe returns (%)
0 S 1S 2S 30
PubIishing company
invoslmonl. In common sonso lorms, llis moans llal llo radio slalion invoslmonl
las llo samo oxpoclod rolurn as llo pubIisling company invoslmonl bul is Ioss
Wlal if vo comparo llo invoslmonl in llo pubIisling company vill ono in a
quicI oiI-clango francliso, an invoslmonl in vlicl llo oxpoclod ralo of rolurn is an
allraclivo 24 porconl bul llo slandard dovialion is oslimalod al 13 porconl` Nov
vlal slouId vo do` CIoarIy, llo oiI-clango francliso las a liglor oxpoclod ralo of
rolurn, bul il aIso las a Iargor slandard dovialion. In llis oxampIo, vo soo llal llo
roaI claIIongo in soIocling llo bollor invoslmonl comos vlon ono invoslmonl las a
liglor oxpoclod ralo of rolurn bul aIso oxlibils groalor risI. Hcrc i|c |inc| c|cicc is
!cicrminc! |u cur ciiiiu!c icucr! ris|, cn! i|crc is nc sinv|c riv|i cnsucr. You migll
soIocl llo pubIisling company, vloroas I migll clooso llo oiI-clango invoslmonl,
and noillor of us vouId bo vrong. Wo vouId simpIy bo oxprossing our laslos and
proforoncos aboul risI and rolurn.
ln lhe preceding problem check, we compuled lhe expecled cash llow ol S597.50 and lhe
expecled relurn ol !2 percenl on a S5,000 inveslmenl. Now lel's calculale lhe slandard
devialion ol lhe relurns. The probabililies ol possible relurns are given as lollows.
ProbabiIity ßeturns
0.30 7.0%
0.50 12.5%
0.20 18.0%
Deviation (PossibIe ßeturn - Deviation ProbabiIity
12% Expected ßeturn) 5quared ProbabiIity Deviation 5quared
-5.0% 25.00% 0.30 7.500%
0.5% 0.25% 0.50 0.125%
6.0% 36.00% 0.20 7.200%
Sum o! squared deviaIiohs
probabiliIy 14.825%
SIahdard deviaIioh 3.850%
700.12.9 ExpIain hov diversi!ying investments a!!ects
the riskiness and expected rate o! return o! a port!oIio
o! asset
Wo can dofino risI as llo variabiIily of anlicipalod rolurns, as moasurod by llo slan-
dard dovialion. Hovovor, moro can bo said aboul risI, ospociaIIy aboul ils naluro,
vlon vo ovn moro llan ono assol in our invoslmonl porlfoIio. Iol's considor for llo
momonl lov risI is affoclod if vo divorsify our invoslmonl by loIding a varioly of
700.12 Fihahcial Risk MahagemehI 252
CAßM ModuIe 700 Fihahce
Diversifying Away the Risk
If vo divorsify our invoslmonls across difforonl socurilios rallor llan invosl in onIy
ono slocI, llo variabiIily in llo rolurns of our porlfoIio slouId docIino. Tlo roduclion
in risI viII occur if llo slocI rolurns villin our porlfoIio do nol movo procisoIy
logollor ovor limo÷llal is, if lloy aro nol porfoclIy corroIalod. Iiguro 12.5 slovs
graplicaIIy vlal vo couId oxpocl lo lappon lo llo variabiIily of rolurns as vo add
addilionaI slocIs lo llo porlfoIio. Tlo roduclion occurs bocauso somo of llo voIaliIily
in rolurns of a slocI aro uniquo lo llal socurily. Tlo uniquo variabiIily of a singIo slocI
londs lo bo counlorod by llo uniquonoss of anollor socurily. Hovovor, vo slouId nol
oxpocl lo oIiminalo aII risI from our porlfoIio. In praclico, il vouId bo rallor difficuIl
lo cancoI aII llo varialions in rolurns of a porlfoIio, bocauso slocI pricos lavo somo
londoncy lo movo logollor. Tlus, vo can divido llo lolaI risI (lolaI variabiIily) of our
porlfoIio inlo lvo lypos of risI: (1) cnmµanv-unique risk, or unsvstematic risk, and
(2) market risk, or svstematic risk. Company-uniquo risI migll aIso bo caIIod
diversiIiabIe risk, in llal il ccn |c !itcrsi|ic! cucu. MarIol risI is nnndiversiIiabIe risk,
il ccnnci |c c|imincic! i|rcuv| rcn!cm !itcrsi|icciicn. Tloso lvo lypos of risI aro slovn
graplicaIIy in Figure 12.5. TolaI risI docIinos unliI vo lavo approximaloIy 20 socuri-
lios, and llon llo docIino bocomos vory sIigll.
Tlo romaining risI, vlicl vouId lypicaIIy bo aboul 40 porconl of llo lolaI risI, is llo
porlfoIio's syslomalic or marIol risI. Al llis poinl, our porlfoIio is liglIy corroIalod vill
aII socurilios in llo marIolpIaco. Ivonls llal affocl our porlfoIio nov aro nol so mucl
uniquo ovonls as clangos in llo gonoraI oconomy, major poIilicaI ovonls, and socioIogicaI
clangos. IxampIos incIudo clangos in inlorosl ralos in llo oconomy, clangos in lax Iogis-
Ialion llal affocl aII companios, or incroasing pubIic concorn aboul llo offocl of businoss
praclicos on llo onvironmonl.
Bocauso vo can romovo llo company-uniquo or unsyslomalic risI, lloro is no
roason lo boIiovo llo marIol viII rovard us vill addilionaI rolurns for assuming
risI llal couId bo avoidod by simpIy divorsifying. Our moasuro of risI slouId,
lloroforo, moasuro lov rosponsivo a slocI or porlfoIio is lo clangos in a marIol
porlfoIio, sucl as llo Nov YorI SlocI Ixclango or llo S&I 500 Indox. Tlo Nov
YorI SlocI Ixclango Indox is an indox llal rofIocls llo porformanco of aII slocIs
Iislod on llo Nov YorI SlocI Ixclango. Tlo Slandard & Ioor's (S&I) 500 Indox is
simiIarIy an indox llal moasuros llo combinod slocI-prico porformanco of llo com-
panios llal conslilulo llo 500 Iargosl companios in llo Unilod Slalos, as dosignalod
by Slandard & Ioor's.
700.12 Fihahcial Risk MahagemehI 253
CAßM ModuIe 700 Fihahce
humber of stocks in portfoIio
uusysleualic or diversiíiable
risk (relaled lo coupauy·uuique eveulsì
1 10 20 25
Sysleualic or uoudiversiíiable
risk (resull oí geueral
uarkel iuílueucesì
figure 12.5 VariabiliIy o! ReIurhs Compared wiIh Size o! PorI!olio
Tlo marIol rovards divorsificalion. Wo can indood Iovor risI villoul sacrificing
oxpoclod rolurns, and/or vo can incroaso oxpoclod rolurns villoul laving lo assumo
moro risI by divorsifying our invoslmonls.
Nolo llo divorsificalion across difforonl assol lypos÷Troasury biIIs vorsus Iong-
lorm govornmonl bonds vorsus common slocIs. Ditcrsi|uinv cmcnv !i||crcni |in!s c|
csscis is caIIod asset aIIncatinn, comparod vill divorsificalion villin llo difforonl
assol cIassos. Tlo bonofil vo rocoivo from divorsifying is far groalor llrougl offoclivo
assol aIIocalion llan from asluloIy soIocling individuaI slocIs lo incIudo villin an
assol calogory. Tlo poinl is invoslors in llo capilaI marIols slouId focus moro allon-
lion on assol aIIocalion llan on soIocling individuaI socurilios.
700.12.10 ExpIain the reIationship betveen an
investor's required rate o! return on an investment
and the riskiness o! the investment
In llis soclion, vo oxamino llo concopl of llo invoslor's roquirod ralo of rolurn, ospo-
ciaIIy as il roIalos lo llo risIinoss of an assol, and llon vo soo lov llo roquirod ralo of
rolurn migll bo moasurod.
The Required Rate of Return Concept
An invoslor's required rate nI return can bo dofinod as llo minimum rcic c| rciurn ncc-
csscru ic ciircci cn intcsicr ic purc|csc cr |c|! c sccuriiu. Tlis dofinilion considors llo
invoslor's nµµnrtunitv cnst nI Iunds of maIing an invoslmonl in i|c ncxi-|csi intcsi-
mcni. Tlis forgono rolurn is an opporlunily cosl of undorlaIing llo invoslmonl and
consoquonlIy is llo invoslor's roquirod ralo of rolurn. In ollor vords, vo invosl vill
llo inlonlion of aclioving a ralo of rolurn sufficionl lo varranl maIing llo invoslmonl.
Tlo invoslmonl viII bo mado onIy if llo purclaso prico is Iov onougl roIalivo lo
oxpoclod fuluro casl fIovs lo provido a ralo of rolurn groalor llan or oquaI lo our
roquirod ralo of rolurn.
To loIp us bollor undorsland llo naluro of an invoslor's roquirod ralo of rolurn, vo
can soparalo llo rolurn inlo ils basic compononls: llo risI-froo ralo of rolurn pIus a risI
promium. Ixprossod as an oqualion:
| |
 |
vloro | llo invoslor's roquirod ralo of rolurn
llo risI-froo ralo of rolurn
llo risI promium
Tlo risI-froo ralo of rolurn rovards us for doforring consumplion, nol for assum-
ing risI, llal is, llo risI-froo rolurn rofIocls llo basic facl llal vo invosl loday so llal
vo can consumo moro Ialor. By ilsoIf, llo risk-Iree rate nI return is llo rc¡uirc! rcic c|
rciurn, cr !isccuni rcic, |cr ris||css intcsimcnis. TypicaIIy, our moasuro for llo risI-froo
ralo of rolurn is llo U.S. Troasury biII ralo.
Tlo risk µremium, |
, is llo c!!iiicnc| rciurn uc musi cxpcci ic rcccitc |cr cssuminv
ris|. As llo IovoI of risI incroasos, vo viII domand addilionaI oxpoclod rolurns. Ivon
llougl vo may or may nol acluaIIy rocoivo llis incromonlaI rolurn, vo musl lavo roa-
son lo oxpocl il, ollorviso, vly oxposo oursoIvos lo llo clanco of Iosing aII or parl of
our monoy`
700.12 Fihahcial Risk MahagemehI 254
CAßM ModuIe 700 Fihahce
Measuring the Required Rate of Return
Wo lavo soon llal (1) syslomalic risI is llo onIy roIovanl risI÷llo rosl can bo divor-
sifiod avay, and (2) llo roquirod ralo of rolurn, |, oquaIs llo risI-froo ralo, |
, pIus a
risI promium, |
. Wo viII nov oxamino lov vo may oslimalo an invoslors'
roquirod ralos of rolurn.
Tlo financo profossion las lad difficuIly in dovoIoping a praclicaI approacl lo
moasuro an invoslor's roquirod ralo of rolurn, lovovor, financiaI managors oflon uso a
mollod caIIod llo caµitaI asset µricing mndeI (CAPM). Tlo capilaI assol pricing
modoI is cn c¡uciicn i|ci c¡ucics i|c cxpccic! rcic c| rciurn cn c sicc| ic i|c ris|-|rcc rcic
p|us c ris| prcmium |cr i|c sicc|´s susicmciic ris|. AIllougl corlainIy nol villoul ils cril-
ics, llo CAIM providos an inluilivo approacl for llinIing aboul llo rolurn llal an
invoslor slouId roquiro on an invoslmonl, givon llo assol's syslomalic or marIol risI.
Iqualion (12-17) on llo prior pago providos llo naluraI slarling poinl for moasur-
ing llo invoslor's roquirod ralo of rolurn and sols us up for using llo CAIM. Roar-
ranging llis oqualion lo soIvo for llo risI promium (|
), vo lavo
|  |
vlicl simpIy says llal llo risI promium for a socurily, |
, oquaIs llo roquirod rolurn, |,
Ioss llo risI-froo ralo oxisling in llo marIol, |
. Ior oxampIo, if llo roquirod rolurn is
15 porconl and llo risI-froo ralo is 5 porconl, llo risI promium is 10 porconl. AIso, if llo
roquirod rolurn for llo marIol porlfoIio, |
, is 12 porconl, and llo risI-froo ralo, |
, is
5 porconl, llo risI promium, |
, for llo marIol vouId bo 7 porconl. Tlis 7 porconl risI
promium vouId appIy lo any socurily laving syslomalic (nondivorsifiabIo) risI oquivaIonl
lo llo gonoraI marIol, or a bola of 1.
In llis samo marIol, a socurily vill a bola ( ) of 2 slouId provido a risI promium of
14 porconl, or lvico llo 7 porconl risI promium oxisling for llo marIol as a vloIo. Honco,
in gonoraI, llo approprialo roquirod ralo of rolurn for llo jll socurily, |
, slouId bo dolor-
minod by
r| j
 |
) (12-19)
Iqualion (12-19) is llo CAIM. Tlis oqualion dosignalos llo risI÷rolurn lrado-off
oxisling in llo marIol, vloro risI is moasurod in lorms of bola. Figure 12.6 grapls llo
CAIM as llo securitv market Iine. Tlo socurily marIol Iino is i|c vrcp|ic rcprcscniciicn
c| i|c CAPM, u|crc i|c |inc s|cus i|c cpprcpricic rc¡uirc! rcic c| rciurn vitcn c sicc|´s sus-
icmciic ris|. As prosonlod in llis figuro, socurilios vill bolas oquaI lo 0, 1, and 2 slouId
lavo roquirod ralos of rolurn as foIIovs:
0: |
5°  0(12°  5°) 5°
1: |
5°  1(12°  5°) 12°
2: |
5°  2(12°  5°) 19°
vloro llo risI-froo ralo, |
, is 5 porconl and llo roquirod rolurn for llo marIol porlfo-
Iio, |
, is 12 porconl.
700.12 Fihahcial Risk MahagemehI 255
CAßM ModuIe 700 Fihahce
Assume you are considering lhe purchase ol a slock lhal you believe will provide a !4 percenl relurn over lhe nexl year. ll
lhe expecled risk-lree rale ol relurn, such as lhe rale ol relurn lor 90-day Treasury bills, is 5 percenl, lhen lhe risk premium
you are demanding lo assume lhe addilional risk is 9 percenl (!4' 5').
The conclusion ol lhe maller is lhal PrincipIe 1 is alive and well. ll lells us,
We Won't Take on AdditionaI ßisk UnIess We Expect to ße Compensated
vith AdditionaI ßeturn. Thal is, lhere is a riskrelurn lrade-oll in lhe markel.
Delermine a lair expecled or required rale ol relurn lor a slock lhal has a bela ol !.25 when
lhe risk-lree rale is 5 percenl and lhe expecled markel relurn is 9 percenl.
The appropriale rale ol relurn would be.
Lxpecled relurn risk-lree rale  |bela  (markel relurn  risk-lree rale)¦
5'  !.25  9'  5') !0'
700.12 Fihahcial Risk MahagemehI 256
CAßM ModuIe 700 Fihahce
0.S 1.S 1.0 2.0 2.S
figure 12.6 SecuriIy MarkeI Lihe
700.13 Mergers ahd AcquisiIiohs 257
700.13.1 IxpIain llo molivalions bolind morgors and acquisilions (M&A) and
slov lov lloy lavo clangod ovor limo
700.13.2 IxpIain vly M&A is imporlanl lo slralogy
700.13.3 Idonlify llo various lypos of M&A
700.13.4 Undorsland lov llo pricing and promiums of M&A affocl llo roaIizalion
of synorgios
700.13.5 Discuss llo slops in llo M&A procoss
700.13.6 OulIino llo aIlornalivo vays lo inlogralo M&A and oxpIain llo
impIomonlalion procoss
700.13.7 Discuss llo claraclorislics of M&A in difforonl induslry conloxls
700.13 Nergers and Acquisitions
700.13.1 ExpIain the motivations behind mergers
and acquisitions (M&A) and shov hov they have
changed over time
Wly do firms acquiro companios rallor llan onloring nov businossos on lloir ovn or
llrougl aIIiancos` Was oBay's acquisilion of IayIaI a lypicaI acquisilion` Aro mosl
acquisilions succossfuI` Wly do companios oflon pay lugo cosls, sucl as llo
20-porconl promium llal oBay paid for IayIaI, lo acquiro anollor firm` By llo ond of
llis soclion, you slouId bo abIo lo ansvor lloso and ollor quoslions aboul morgors
and acquisilions (M&As). Indood, as you vorI llrougl llo soclion, you'II soo llal our
oponing vignollo on oBay and IayIaI inlroducos many of llo foaluros common lo
Differences between Acquisitions and Mergers
AIllougl il is roguIar praclico lo uso llo lorms mcrvcrs and cc¡uisiiicns logollor, and
somolimos inlorclangoabIy, lloy aron'l llo samo lling. Tlo difforoncos can bo sublIo,
and doponding on vlo's using llo lorms and in vlal counlry, oacl lorm londs lo lavo
difforonl moanings. Dispulos ovor difforoncos in IogaI dofinilions can ond up in courl.
Ior inslanco, ClrysIor invoslor KirI KorIorian suod DaimIorClrysIor in 2001 for biI-
Iions basod on llo argumonl llal llo marriago of DaimIor vill ClrysIor in 1997 vas
acluaIIy an acquisilion by DaimIor and nol a morgor. Wlal vas KorIorian's inlorosl in
llo lransaclion boing IaboIod an acquisilion` An acquisilion vouId rosuIl in mucl
moro monoy boing paid lo ClrysIor slaroloIdors, incIuding KorIorian.
ToclnicaIIy, llo lorm acquisitinn moans llal a lransfor of ovnorslip las laIon
pIaco÷llal ono firm las bougll anollor. A merger is llo consoIidalion or combina-
lion of ono firm vill anollor.
Wlon llo lorm mcrvcr is usod, il oflon rofors lo a cIass
of morgors Inovn as mcrvcrs c| c¡uc|s. Tloso morgors aro lypicaIIy bolvoon firms of
roIalivoIy oquaI sizo and infIuonco llal fuso logollor lo form ono nov Iargor firm.
AIllougl lloro aro many loclnicaI, IogaI, and dolaiIod difforoncos bolvoon morgors
and acquisilions, for our purposos in undorslanding lov lloy sorvo as volicIos of
slralogy, lloy aro moro simiIar llan dissimiIar. ConsoquonlIy, vo viII focus on lov
firms uso M&As lo pursuo lloir objoclivos.
Wo viII omplasizo llo molivos for M&As and llo slralogic impIicalions of lloso
molivos. Tlo molivos bolind M&As faII inlo llroo basic calogorios: mcncvcric| sc||-
inicrcsi, |u|ris, and suncrvu. In llis soclion, vo'II roviov lloso llroo lypos of molivos
and assoss llo offocls of M&As undorlaIon in pursuil of oacl of llom. Bocauso llo firsl
lvo molivos usuaIIy don'l rofIocl slaroloIdors' bosl inlorosls, llo rosl of llo soclion
viII focus on M&As undorlaIon in pursuil of synorgy.
Managerial Self-lnterest
Somolimos sonior managors maIo docisions basod on porsonaI soIf-inlorosl rallor llan
llo bosl inlorosls of slaroloIdors. Wo caII llis bolavior manageriaIism. ConcoivabIy,
managors can maIo acquisilions÷and ovon viIIingIy ovorpay in M&As÷in ordor lo
maximizo lloir ovn inlorosls al llo oxponso of slaroloIdor voaIll. Ixoculivo compon-
salion, for inslanco, londs lo bo IinIod lo firm sizo. Managors migll, lloroforo, onlanco
lloir payclocIs by maIing acquisilions llal accompIisl nolling moro llan onIarging
llo firm.
As you lavo Ioarnod, golling biggor, in and of ilsoIf, doos nol croalo slaro-
loIdor voaIll.
IiIoviso, bocauso yoar-ond bonusos (and job socurily) aro oflon liod lo llo firm's
oarnings, somo managors migll pursuo divorsificalion llrougl M&A in ordor lo slabi-
Iizo annuaI oarnings. Managors couId, lloroforo, maIo acquisilions in ordor lo boosl
oarnings by divorsifying llo firm's rovonuo slroam.
CorlainIy, organic grovll couId
700.13 Mergers ahd AcquisiIiohs 258
CAßM ModuIe 700 Fihahce
acliovo llo samo goaI bul nol as quicIIy. In any caso, divorsificalion of a firm's rov-
onuo slroam croalos IillIo vaIuo for slaroloIdors. Wly` Bocauso, as vo'vo soon, lloy
can divorsify lloir porsonaI socurilios porlfoIios mucl moro cloapIy.
In llo mid-1980s, oconomisl Riclard RoII proposod vlal lo caIIod llo |u|ris |upci|csis
lo oxpIain, al Ioasl in parl, vly acquisilion promiums aro so Iargo and yol acquisilions
romain so common.
Wlon a pubIicIy lradod firm is acquirod by anollor firm, llo purclaso prico aImosl
aIvays oxcoods llo largol firm's marIol vaIuo. Tlo avorago promium÷llo amounl
rocoivod by llo largol firm's slaroloIdors in oxcoss of llo vaIuo of lloir slocI÷vas
bolvoon 30 and 45 porconl during llo 15-yoar poriod bolvoon 1989 and 2004. Wly
vouId anyono pay sucl a gonorous promium` Aflor aII, llo largol firm's marIol vaIuo
prior lo llo acquisilion bid vas llo marIol's bosl oslimalo of llo prosonl vaIuo of largol
firm's fuluro casl fIovs.
According lo RoII, managors nol onIy maIo mislaIon vaIualions bul oflon lavo
unvarranlod confidonco boll in lloir vaIualions and in lloir abiIily lo croalo vaIuo.
Tlis alliludo, says RoII, rofIocls hubris÷a GrooI lorm donoling oxcossivo prido, ovor-
confidonco, or arroganco. Hubrislic managors may ovoroslimalo lloir ovn abiIilios lo
impIomonl polonliaI synorgios.
A finaI vord: AIllougl vo'ro going lo focus on synorgy as a molivalion for acqui-
silions, you slouIdn'l ignoro llo ollor lvo molivalions÷managoriaIism and manago-
riaI lubris÷vlon you'ro ovaIualing M&As. Wlon managoriaIism and lubris aro Iopl
in clocI, acquiring firms aro moro IiIoIy lo roaIizo synorgios and posilivo porformanco
Wlon M&As aro undorlaIon in pursuil of synorgy, managors aro guidod by llo boIiof
llal llo vaIuo of lvo firms combinod can bo groalor llan llo sum vaIuo of llo lvo
firms indopondonlIy. Tlis calogory incIudos aII forms of M&As llal aro molivalod by
vaIuo croalion. Synorgy may dorivo from a numbor of sourcos, incIuding roducod
llroals from suppIiors, incroasod marIol povor, polonliaI cosl savings, suporior finan-
ciaI slrongll, oconomios of scopo and scaIo, and llo slaring and Iovoraging of
ßeducing Threats
Somolimos a suppIior cannol or viII nol maIo an invoslmonl llal's spocific lo an
oxclango vill ono buyor. Wly migll llis silualion ariso` Iorlaps llo invoslmonl
vouId lio llo company loo cIosoIy lo ono buyor, oxposo il lo loo mucl risI, or ovorlax
ils financiaI moans. In sucl casos firms may nood lo inlogralo vorlicaIIy, bacIvard inlo
llo suppIy clain.
Tlo quicIosl vay lo do llis is llrougl an acquisilion. Somo of Cisco
Sysloms' acquisilions of nolvorI svilcl loclnoIogy companios aro oxampIos of llis
lypo of bacIvard inlogralion.
Increasing Market Pover and Access
If a company improvos ils compolilivo posilion by moans of a morgor or acquisilion, il
may bo possibIo lo dorivo polonliaI marIol povor from llo doaI. Iirms lavo marIol
povor vlon lloy can infIuonco pricos, and prico compolilion is roducod significanlIy
vlon rivaIry is roducod. In llo banIing induslry, for oxampIo, somo morgors÷
ospociaIIy lloso invoIving lvo modoralo-sizod banIs÷soom lo lavo boon molivalod by
a dosiro lo improvo marIol povor. Tlus, vlon Iirsl Union purclasod Waclovia, llo
combinod company vauIlod inlo llo numbor-four sIol among U.S. banIs. Wlon DaimIor
morgod vill ClrysIor in an offorl lo oxpIoil polonliaI synorgios, ils slaro in llo gIobaI
aulomolivo marIol incroasod significanlIy. And llo morgor vas dosignod lo improvo
700.13 Mergers ahd AcquisiIiohs 259
CAßM ModuIe 700 Fihahce
marIol accoss for boll companios in goograplic aronas vloro lloy voro voaI bul lloir
morgor parlnor vas slrong. Anollor oxampIo of improvod accoss is providod by
IopsiCo. In 1992, for oxampIo, vlon IopsiCo sliII ovnod Iizza Hul, Taco BoII, and Kon-
lucIy Iriod ClicIon, il purclasod Carls of CoIorado (CC), a smaII food carl (o.g., IiosI)
manufacluror, for $7miIIion, sooing il as llo idoaI moans of inslaIIing nov roslauranls
quicIIy and cloapIy. Nol onIy did llo purclaso givo IopsiCo accoss lo nov carl loclnoI-
ogy, bul il aIso providod il vill an inoxponsivo moans for quicIIy oslabIisling fasl food
oulIols in ligl-lraffic Iocalions. Ono of IopsiCo's firsl succossfuI carl Iocalions vas in
llo Moscov molro syslom.
ßeaIizing Cost 5avings
Cosl savings aro llo mosl common synorgy and llo oasiosl lo oslimalo. IinanciaI mar-
Iols lond lo undorsland and accopl cosl savings as a ralionaIo and aro moro IiIoIy lo
rovard savings-molivalod M&As vill liglor slocI pricos llan ollor forms of syn-
orgy. Rovonuo-onlancomonl opporlunilios, sucl as incroasing lolaI saIos llrougl
cross-soIIing and onlancod dislribulion, aIso roprosonl a significanl upsido in many
M&As. Il's moro difficuIl, lovovor, lo caIcuIalo and impIomonl rovonuo onlancomonl
synorgios (somolimos caIIod sc|i suncrvics) llan cosl-saving synorgios.
Increasing financiaI 5trength
Ollor synorgios can bo croalod by various forms of financiaI onginooring. An acquisi-
lion, for inslanco, can Iovor llo financing cosls of llo largol firm vlon llo lvo firms'
rospoclivo crodil ralings aro marIodIy difforonl and significanl dobl is invoIvod. Sucl
vouId bo llo caso if a company vill AAA-ralod dobl voro lo buy a B-ralod company.
Various lax bonofils aIso provido uniquo financiaI synorgios. If, for oxampIo, llo largol
company las oporaling Ioss carry-forvards (i.o., financiaI Iossos llal llo IRS aIIovs
firms lo appIy lo fuluro yoars' oarnings) llal can'l bo fuIIy uliIizod, llo acquiring com-
pany can uso llom lo roduco llo lax biII of llo combinod firm.
5haring and Leveraging CapabiIities
Transforring bosl praclicos and coro compoloncios can croalo vaIuo. Tlis form of syn-
orgy is imporlanl in llo rosourco-basod viov of compolilivo advanlago. According lo
llis viov, ono roason for acquiring anollor firm vouId bo lo absorb and assimiIalo llo
largol's rosourco, InovIodgo, and capabiIilios÷aII of vlicl may bo primary sourcos of
compolilivo advanlago. Wlon firms combino rosourcos and capabiIilios llrougl
M&As, lloy may bo abIo lo croalo a bundIo of rosourcos llal is unavaiIabIo lo compoli-
lors. If llo combinod rosourcos and capabiIilios aro compIomonlary, llo compolilivo
advanlago may bo Iong-lorm. If llo combinalion is vaIuabIo and raro, llo acquiring
firm may bo abIo lo gonoralo profils groalor llan llo sum of llo lvo firms' individuaI
profils. Boar in mind, lovovor, llal lransforring rosourcos, InovIodgo, or capabiIilios
can croalo Iong-lorm compolilivo advanlago onIy if llo cosl of llo acquisilion doosn'l
oxcood llo cosl lo ollor firms of accumuIaling comparabIo rosourco slocIs.
700.13.2 ExpIain vhy M&A is important to strategy
Tlroo poinls nood lo bo Iopl in mind vlon considoring acquisilions as a parl of a
firm's corporalo slralogy. Iirsl, as vill ollor oIomonls of slralogy, managors nood lo
bo cIoar aboul llo oconomic Iogic: Hov doos llo acquisilion loIp llo firm oarn profils`
Socond, managors nood lo considor aIlornalivos lo llo acquisilion, sucl as dovoIoping
llo nov businoss inlornaIIy rallor llan buying il. Tlird, acquisilions aro fraugll vill
lazards llal can ond up ruining llo projoclod rolurns, and managors nood lo Inov
vlal lloso lazards aro and lov lo navigalo around llom.
700.13 Mergers ahd AcquisiIiohs 260
CAßM ModuIe 700 Fihahce
The vehicle and lts £conomic Logic
Acquisilions onabIo firms lo onlor nov businossos quicIIy, roduco llo limo and risIs
onlaiIod by llo procoss of slarling nov businossos inlornaIIy, and rapidIy roacl mini-
mum officionl scaIo. Rosoarcl slovs, lovovor, llal M&As como vill significanl risIs
and uncorlainlios of lloir ovn. AIllougl somo acquisilions succood, sucl as oBay's
acquisilion of IayIaI, ollors faiI lo produco anlicipalod synorgios, rosuIling in smaII
Iossos, and somo faiI misorabIy, rosuIling in lugo Iossos. oBay, for inslanco, vas forcod
lo soII BullorfioIds al a significanl Ioss in lorms of boll doIIars and managoriaI limo
and allonlion. In llis soclion, vo'II discuss somo of llo Ioys lo maIing acquisilions
sorvo as an offoclivo volicIo for grovll and, al llo samo limo, avoiding common
polonliaI pilfaIIs.
Wlal vas said of aIIiancos aIso loIds lruo for morgors and acquisilions: Tloy aro
nol slralogios in and of llomsoIvos, rallor, as vo'ro romindod in llo slralogy diamond
slovn in Figure 13.1, M&As simpIy roprosonl ono oIomonl of a slralogy. SpocificaIIy,
lloy aro tc|ic|cs for roaIizing a slralogy÷llal is, for onloring or oxiling a businoss.
Hovovor, acquisilions lavo significanl impIicalions for ollor oIomonls of slralogy.
Acquisilions laIo firms inlo nov aronas. Acquisilions llal rosuIl in divorsificalion aro
usod in llo slaging of corporalo slralogios. And finaIIy, acquisilions lavo impIicalions
for llo financiaI succoss of slralogios÷for llo roaIizalion of llo anlicipalod oconomic
Iogic of llo slralogy.
Iorlaps bocauso lloy onabIo companios lo accoIoralo lloir slralogios, acquisilions
aro quilo popuIar. Tlo numbor of acquisilions ovor llo pasl fov docados suggosls llal
lloy conslilulo a fundamonlaI oIomonl of many firms' slralogios.
Rosoarcl suggosls llal firms avorago aboul ono acquisilion por yoar, bul of courso,
lloro's lromondous varianco in firms' proponsily for using acquisilions as a grovll
Nol surprisingIy, llo financiaI succoss of any givon acquisilion doponds on a
numbor of faclors and las a significanl offocl on llo ovoraII oconomic Iogic of a firm's
Dospilo÷and bocauso of÷lloir oconomic consoquoncos, M&As gol a Iol of bad
pross and rocoivo crilicism from scloIars and consuIlanls as voII. Wo can allribulo llis
crilicism÷al Ioasl in parl÷lo llo ligl visibiIily of many spoclacuIar acquisilion
mislaIos. NolabIo acquisilion ¨mislaIos¨ incIudo AT&T's acquisilion of NCR,
OuaIor's acquisilion of SnappIo, and AOI's acquisilion of Timo Warnor. As is llo caso
700.13 Mergers ahd AcquisiIiohs 261
CAßM ModuIe 700 Fihahce
M&A and the Strategy D|amond.
While mergers and acquisitions are
explicitly vehicles of strategy, they
have major implications for arenas,
staging, and economic logic as well.
figure 13.1 1he Place o! AcquisiIiohs ih Ihe SIraIegy Diamohd
of so many acquisilions, llo managors vlo mado lloso doaIs soomod lo bo unabIo lo
maIo llom vorI.
Irom vlal vo'vo soon so far, il's cIoar llal divestiture÷llo soIIing off of a busi-
noss and llo fIip sido of acquisilion÷is aIso a Ioy slralogic volicIo. oBay, AT&T, and
OuaIor aII oxilod businossos by soIIing businoss unils lo compolilors. In llis soclion,
vo focus primariIy on acquisilions as volicIos for onloring or oxpanding businossos,
bul romombor llal cIosoIy roIalod lypos of lransaclions onabIo firms lo oxil businossos
as voII.
Wlon dociding lo onlor a nov businoss, companios lavo aIlornalivo volicIos from
vlicl lo clooso, incIuding inicrnc| !ctc|cpmcni, c||icnccs, and cc¡uisiiicn. Horo, vo'II
oxpIain vly llo lradooffs bolvoon inlornaI dovoIopmonl and acquisilion÷maIo or buy
docisions÷aro imporlanl considoralions vlon dociding vlollor lo onlor a nov businoss
llrougl acquisilion.
8enefits of Acquisition over lnternal Development
Ono of llo primary advanlagos of acquisilion ovor inlornaI dovoIopmonl is spcc!.
AIllougl an acquisilion quicIIy oslabIislos a foolloId in a nov businoss, inlornaI
dovoIopmonl can laIo yoars. A coroIIary bonofil is crilicaI mass. An acquisilion onsuros
llal a firm onlors a nov businoss vill sufficionl sizo and viabIo compolilivo slrongll.
Tlo acquiring firm, for oxampIo, can bo assurod of onloring al minimum officionl scaIo
for cosl purposos. As anollor advanlago, acquisilions can provido accoss lo compIo-
monlary assols and rosourcos. In dovoIoping a nov businoss, a firm invosls ils oxisling
slocI of rosourcos and capabiIilios, and aIllougl il may dovoIop nov rosourcos and
capabiIilios in llo procoss, lloro's aIvays llo clanco llal il may simpIy oxpond oxisl-
ing rosourcos. Will an acquisilion, nov rosourcos and capabiIilios can bo inlogralod
vill lloso of llo buyor, vlo may acluaIIy improvo ils compolilivo posilion in ollor
businossos as voII. IinaIIy, onlry by acquisilion may foslor a Ioss compolilivo onviron-
monl. By acquiring an oxisling firm in a nov businoss, llo buyor oIiminalos a compoli-
lor llal vouId ollorviso romain in llo marIol.
Drawbacks of Acquisition over lnternal Development
ConvorsoIy, firms may find il proforabIo for sovoraI roasons lo onlor nov businossos by
moans of inlornaI dovoIopmonl. Iirsl, acquisilions can bo moro oxponsivo llan inlornaI
dovoIopmonl. Buyors oflon pay sloop promiums for oxisling companios. In many casos,
lloso promiums oulvoigl any polonliaI bonofils of llo acquisilion, and in somo casos,
lloy maIo il oconomicaIIy moro viabIo oillor lo onlor llrougl inlornaI dovoIopmonl or
lo avoid onlry aIlogollor. In slorl, firms may docido againsl onloring nov businossos
bocauso lloy aron'l IiIoIy lo gonoralo sufficionl rolurn on capilaI lo juslify llo pro-
mium cosl. In addilion, llo acquiring firm viII oflon inloril sovoraI unnocossary
adjuncl businossos. As an acquiror, you musl oillor bo viIIing lo run lloso unvanlod
businossos or go llrougl llo adminislralivo lassIo of spinning llom off.
Socond, aIllougl acquisilions roprosonl a major ono-limo commilmonl of
rosourcos, inlornaI dovoIopmonl onlaiIs incromonlaI invoslmonl ovor limo. Tlo inlor-
naI dovoIopmonl procoss, lloroforo, aIIovs for many poinls al vlicl llo projocl can
bo assossod and roovaIualod boforo furllor invoslmonl is mado. If, for oxampIo, oco-
nomic circumslancos clango, a firm can puII llo pIug. Acquisilions, on llo ollor land,
aro lypicaIIy aII-or-nolling proposilions.
IinaIIy, organizalionaI confIicl may omorgo as a polonliaI probIom, llo oruplion of
cu|iurc| c|cs|cs can impodo llo inlogralion of lvo firms. Tlo procoss of inlogralion
roquiros significanl offorl, and firms may oncounlor solbacIs or ovon faiIuro. Bocauso
inlogralion is sucl a major faclor in maIing M&As vorI, vo'II discuss il in groalor
dolaiI Ialor in llis soclion.
As you can soo, many polonliaI roadbIocIs can maIo il difficuIl for firms lo roaI-
izo oconomic gains from acquisilions. And llo groalor llo cosl in capilaI and limo
700.13 Mergers ahd AcquisiIiohs 262
CAßM ModuIe 700 Fihahce
roquirod for inlogralion, llo moro synorgios managors viII lavo lo squoozo oul of
llo doaI.
700.13.3 Identi!y the various types o! M&A
Tloro aro many lypos of M&As, and oacl las a parlicuIar purposo÷a spocific ralion-
aIo for croaling synorgios. In llis soclion, vo'II survoy llo difforonl forms of M&As
and IinI llo oconomic Iogic of oacl form lo firm slralogy.
Bocauso llo Iogic bolind
oacl form varios, so, loo, do llo criloria for lloir succoss.
Types of Acquisitions
Acquisilions can figuro inlo mosl aspocls of businoss slralogy, bul lloy'ro gonoraIIy
rogardod as a moans of managing compolilivo prossuros, uncorlainly, or boll. Tlus,
businoss-slralogy acquisilions, IiIo businoss-slralogy aIIiancos, lond lo bo fundamon-
laIIy roIalod lo llo firm's coro businoss llrougl tcriicc|, |crizcnic|, or ccmp|cmcnicru
A vorlicaI acquisilion las llroo purposos:
To socuro a roIiabIo suppIy
To Iovorago llo rosourcos and capabiIilios of upslroam aclivilios in ordor lo
croalo moro vaIuo for llo ond cuslomor
To roduco lolaI produclion cosls across llo vaIuo clain
Coca-CoIa and Iopsi oacl lavo ongagod in sovoraI vorlicaI acquisilions ovor llo
yoars as lloy lavo purclasod indopondonl bollIing oporalions. Tloso acquisilions aro
dovnslroam vorlicaI acquisilions. RocaII llal CoIo and Iopsi soII mosl of lloir coro
producl (conconlralo) lo bollIors vlo llon mix llo conconlralo vill ollor ingrodionls,
bollIo llo producl, and dislribulo il lo rolaiI oulIols. CoIo and Iopsi voro abIo lo
roduco somo llroals llal voro boginning lo omorgo from Iargo bollIors, as voII as
infuso moro officioncy inlo lloso dovnslroam aclivilios, by consoIidaling bollIing
oporalions inlo moro officionl rogionaI oporalions.
In conlrasl, lorizonlaI acquisilions loIp oxpand llo company's producl offorings.
Tlo Cadbury Sclvoppos purclaso of SnappIo vas a lorizonlaI acquisilion llal loIpod
oxpand llo buyor's bovorago porlfoIio, parlicuIarIy in llo groving juico and loa
A compIomonlary acquisilion invoIvos a compIomonlary businoss÷ono llal
incroasos llo saIo of anollor producl. Bosl Buy's roconl acquisilion of llo GooI Squad,
a compulor-supporl sorvico, is a compIomonlary acquisilion: Wlon compulor-sorvico
capabiIily is bundIod vill rolaiI compulor saIos, oacl businoss polonliaIIy incroasos
saIos of llo ollor's producl.
A CompIete CIassi!ication
Bocauso llis simpIo broaIdovn of acquisilions inlo vorlicaI, lorizonlaI, and compIo-
monlary roIalionslips is a IillIo ovorsimpIifiod, Iol's laIo a IooI al llo lypoIogy pro-
posod by Harvard profossor Iosopl Bovor, iIIuslralod in Figure 13.2. Il viII givo us a
bollor undorslanding of llo slralogic Iogic bolind fivo moro commonIy ompIoyod
forms of acquisilion.
Tlougl dovoIopod llrougl a sludy of oxlromoIy Iargo acquisilions (ovor $500 miI-
Iion), llis scloma providos a usofuI vay of llinIing gonoraIIy aboul M&As.
Prnduct and Market Extensinn. In a prc!uci-cxicnsicn cc¡uisiiicn, llo acquiring com-
pany oxpands ils producl Iino by purclasing anollor company. BasicaIIy, llo buyor
las docidod llal il can roap liglor rovards by buying a company vill an oxisling
700.13 Mergers ahd AcquisiIiohs 263
CAßM ModuIe 700 Fihahce
producl llan by dovoIoping a compolilivo producl inlornaIIy. In a mcr|ci-cxicnsicn
cc¡uisiiicn, ono company buys anollor llal offors ossonliaIIy llo samo producls as llo
buyor bul las a pIalform in a goograplic marIol in vlicl llo buyor las no prosonco.
Tlo journoy of SnappIo llal vo doscribod oarIior in llis soclion is an inlorosling
oxampIo of lvo difforonl companios using llo samo acquirod firm for llo purposo of
producl oxlonsion. ConcoivabIy, OuaIor Oals couId lavo dovoIopod ils ovn Iino of
fruil juicos, Iomonados, and loas. Al llo limo, lovovor, OuaIor managomonl boIiovod
llal an inlornaIIy dovoIopod Iino vouId Iag loo far bolind lloso of incumbonl firms in
llo marIol sogmonl. IiIoviso, Cadbury Sclvoppos corlainIy las llo capabiIily lo
dovoIop nov drinIs inlornaIIy bul closo lo cuIlivalo oxporliso in oxlonding producl
offorings llrougl llo acquisilion of oslabIislod brands.
Gengraµhic RnII-Uµs. A gengraµhic rnII-uµ occurs vlon a firm acquiros sovoraI
firms llal aro in llo samo in!usiru sogmonl bul in many difforonl vccvrcp|ic aronas. Il's
nol llo samo slralogy as marIol oxlonsion. Will a roII-up, llo acquiring company is
lrying lo clango llo naluro of induslry compolilion in a fundamonlaI vay, il sooIs lo
bocomo a Iargo rogionaI, nalionaI, or inlornalionaI pIayor in vlal's probabIy boon a
fragmonlod induslry. Tlo purposo of a roII-up is lo acliovo oconomios of scaIo and
scopo. Irior lo ils morgor vill Iirsl Clicago, for oxampIo, Banc Ono lad grovn from a
smaII rogionaI banI in Olio lo a Iargo nalionaI banI by buying smaIIor IocaI and
rogionaI banIs around llo counlry. (Tlo morgod company is caIIod BanI Ono.) In a
roII-up, llo acquiring company usuaIIy rolains llo rosourcos and managomonl of
acquirod companios bul imposos ils procossos on llom.
Inlropronour BradIoy Iacobs mado a forluno dopIoying llo roII-up slralogy lo
buiId lvo oxlromoIy succossfuI companios in lvo difforonl induslrios. In llo vaslo-
managomonl businoss, Iacobs usod Unilod Waslo Sysloms as a roII-up company lo buy
smaII lrasl-lauIing firms in a fragmonlod induslry. Ho Ialor soId llo company lo USA
Waslo Sorvicos (nov Waslo Managomonl) and usod llo procoods lo Iauncl anollor
slarlup÷ono llal vouId uso llo samo roII-up slralogy lo consoIidalo llo oquipmonl
ronlaI induslry. Ho Iaunclod Unilod RonlaIs by purclasing six loavy-oquipmonl
700.13 Mergers ahd AcquisiIiohs 264
CAßM ModuIe 700 Fihahce
Percent of A||
M&A Dea|s
Extens|on Ro||-up M&A
Eliminating capacity,
gaining market
share, and
more than 100
acquisitions of
funeral homes
Efficiency of
larger operations
(e.g., economies
of scale, superior
acquisition of
Synergy of
similar but
product lines
or geographic
M&A as R&D
lntel's dozens
of acquisitions
of small high-tech
Short cut
innovation by
buying it from
small companies
acquisition of
Anticipation of
new industry
emerging; culling
resources from
firms in multiple
industries whose
boundaries are
figure 13.2 8ower's Classi!icaIioh o! AcquisiIiohs
Ioasing firms and llon procoodod lo buy oquipmonl ronlaI companios aII across llo
counlry. Tlrougl a sorios of moro llan sixly acquisilions in sovon yoars, il las bocomo
llo Iargosl oquipmonl ronlaI company in llo Unilod Slalos.
Wlal's llo ralionaIo bolind a roII-up slralogy` BasicaIIy il's llal a Iargo rogionaI or
nalionaI pIayor can acliovo oconomios of scaIo llal smaIIor IocaI firms can'l. ConlraI-
izod managomonl, for oxampIo, may improvo ovoraII oporalionaI offoclivonoss
llrougl Iargo voIumo suppIy discounls. In addilion, a nalionaI firm may lavo llo
rosourcos lo vin cuslomor accounls llal smaIIor IocaI firms don'l lavo. Unilod
RonlaIs, for inslanco, may bo abIo lo vin oquipmonl ronlaI conlracls vill Iargo cus-
lomors vlo vanl a singIo nalionaI providor for aII of lloir loavy oquipmonl noods.
M&As as R&D. Somo firms uso acquisilions in Iiou of or in addilion lo inlornaI R&D.
UsuaIIy, llo acquiring firm buys anollor company in ordor lo gain ovnorslip of ils
loclnoIogy. Tlo slralogy is common in induslrios in vlicl loclnoIogy advancos rap-
idIy and in vlicl no singIo company can do aII llo innovaling llal il noods lo conlinuo
compoling offoclivoIy.
In llo loIocommunicalions oquipmonl and compulor induslrios, llis slralogy las
boon usod lo good offocl by sucl firms as Cisco, Microsofl, and InloI. Figure 13.3 indi-
calos lov imporlanl acquisilions aro lo lloso companios as R&D volicIos.
Iirsl of aII, boar in mind llal llo avorago U.S. company ongagos in approximaloIy
ono acquisilion por yoar. In llo fivo-yoar poriod bolvoon 1999 and 2003, oacl of lloso
llroo companios avoragod moro llan lon acquisilions por yoar. AII llroo companios
aIIocalo monoy for inlornaI R&D, bul oacl aIso sponds considorabIo sums lo acquiro
nov loclnoIogios by buying slarlups llal lavo mado promising innovalions. Tlo slral-
ogy, of courso, roprosonls a lradooff.
To gol a bollor idoa of vlal llis lradooff onlaiIs, considor llo acquisilion oxponsos
of InloI and AMD. Boll firms dovolo significanl capilaI lo lradilionaI inlornaI R&D
projocls. Hovovor, InloI mado dozons of acquisilions during llo pasl sovoraI yoars,
vloroas AMD mado onIy llroo. Tlis suggosls llal lloso lvo firms in llo samo indus-
lry lavo vory difforonl approaclos lo R&D. InloI apparonlIy usos acquisilions as an
opporlunily lo acquiro polonliaI fuluro innovalions from smaII slarlup companios
vill promising loclnoIogios.
Overcaµacitv M&As. Tlo purposo of an ctcrccpcciiu cc¡uisiiicn is lo roduco llo num-
bor of compolilors in a maluro induslry in vlicl capacily oxcoods docroasing domand.
In ossonco, parlios lo an ovorcapacily acquisilion aro lrying lo consoIidalo llo induslry.
Sucl is llo caso, for inslanco, vlon lvo companios in llo samo induslry morgo (or ono
acquiros anollor) in ordor lo ralionaIizo llo induslry and roduco ovorcapacily. Ovorca-
pacily morgors aro oflon oxpIainod as allompls lo croalo oconomios of scaIo, bul in
700.13 Mergers ahd AcquisiIiohs 265
CAßM ModuIe 700 Fihahce
Microsoft Cisco lntel
M&A as R&D
figure 13.3 M&A as R&D
many casos boll companios aro aIroady Iargo onougl lo bo oporaling al a minimum
officionl scaIo. Improvod officioncios como from roducing rodundanl oporalions and
lrimming llo sizo of combinod unils. Tlis vas llo ralionaIo bolind DaimIor's acquisi-
lion of ClrysIor (DaimIor's roconl saIo of ClrysIor for a significanl Ioss is ovidonco of
llo difficuIly impIomonling Iargo acquisilions). Tlo banIing induslry, in vlicl firms
aro jocIoying for marIol posilion and lrying lo croalo groalor oconomios of scaIo, las
oxporioncod oxlonsivo ovorcapacily-M&A voIumo in llo pasl docado.
Industrv Cnnvergence M&As. Wlon lvo induslrios slarl lo ovorIap and bocomo
liglIy compIomonlary, lloy bogin lo ccntcrvc. Wlon llis lappons, vo soo an incroaso
in llo IovoI of M&As invoIving firms in llo convorging induslrios. In llo modia and
onlorlainmonl induslrios, for oxampIo, Timo Inc. lad an oxlonsivo prinl modia busi-
noss and somo cabIo oporalions (as voII as HBO). Warnor Brollors Inc. lad a biggor
prosonco in cabIo oporalions and a lugo Iibrary of movios. In 1990, llo lvo companios
combinod llrougl Timo's acquisilion of Warnor lo form Timo Warnor (vlicl acquirod
Turnor Broadcasling in 1996 and vlicl vas Ialor acquirod by AOI in 2001) in ordor lo
consoIidalo modia conlonl and dislribulion. In rosponso lo llo AOI÷Timo Warnor
combinalion, Viacom, vloso coro businoss vas cabIo TV produclion and dislribulion,
bougll Iaramounl, a movio and TV producor (1993), BIocIbuslor, a clain of vidoo
oulIols (1994), and llo TV nolvorI CBS (2000). In 1996, Disnoy, aIroady a modia con-
gIomoralo, bougll ABC, incIuding cabIo broadcaslor ISIN (1996). Tlo onlorlainmonl
induslry's Iandscapo conlinuos lo slifl as firms lry lo find llo rigll mix of businossos
lo compolo offoclivoIy in convorging induslrios.
Tlo Iogic bolind M&As in convorging induslrios loIds llal sucl caIcuIalod invosl-
monls viII pul firms in a bollor compolilivo posilion if and vlon induslry boundarios
orodo. Ono can aIso viov acquisilions in llis onvironmonl as allompls by companios lo
acquiro rosourcos llal, aIllougl Ioss vaIuabIo in llo prosonl compolilivo onvironmonl,
viII bo crilicaI in projoclod nov induslry conloxls.
Investnr/HnIding Cnmµanv M&As. AIllougl vo von'l discuss llis calogory in
mucl dolaiI, invoslor loIding company M&A roprosonls a significanl porlion of lolaI
acquisilion aclivily. In invoslor/loIding company lransaclions, indopondonl invoslors
or loIding companios purclaso oxisling firms. Sucl migll bo llo caso vlon an invosl-
monl fund ongagos in a Iovoragod buyoul of a company. Rallor llan morgo llo pur-
clasod company vill ollor firms in ils porlfoIio, llo buyor lrios lo bring somo man-
agomonl, oporaling, and financiaI discipIino lo llo company, inlonding lo soII il Ialor al
a profil. In ollor casos, invoslors (sucl as Warron Buffoll's BorIsliro Hallavay) pur-
claso companios for Iong-lorm ovnorslip and managomonl.
InternationaI Acquisitions
Bovor's cIassificalion doosn'l provido a spocific calogory for inlornalionaI M&As, bul
you Ioarnod llal lloy aro fairIy provaIonl. Our anaIysis of dala compiIod by Tlompson
IinanciaI Sorvicos rovoaIs llal sinco 1990, cross-bordor M&As lavo accounlod for an
incroasing porconlago of aII M&A aclivily. Hovovor, llo issuos confronling firms dur-
ing inlornalionaI acquisilions aro significanl and you may nood lo oxamino llo issuos
of difforing cuIluros, Iavs, and compolilors vory cIosoIy boforo oxoculing an inlorna-
lionaI acquisilion. An inlornalionaI acquisilion can bo of any of llo lypos roviovod
(o.g., R&D, producl/marIol oxlonsion, roII-up, convorgonco, ovorcapacily, loIding
company). ObviousIy, llo uso of acquisilions as a slralogy volicIo by any firm vanling
lo onlor a nov inlornalionaI arona slouId fIov from ils businoss- and corporalo-
slralogy objoclivos, bul firms musl bo avaro llal llo inlornalionaI conloxl inlroducos
significanl compIoxily inlo M&A lransaclions.
700.13 Mergers ahd AcquisiIiohs 266
CAßM ModuIe 700 Fihahce
700.13.4 Understand hov the pricing and premiums
o! M&A a!!ect the reaIization o! synergies
In llis soclion, vo'II roviov somo of llo basic financiaI issuos roIaling lo polonliaI
M&A succoss. Tloso issuos incIudo pricing, promiums, and llo bonofils of oslabIisling
a vaII-avay prico.
Wlal is llo rigll prico lo pay for an acquisilion` You migll imagino sucl an assign-
monl from a fuluro boss (or a financo profossor on an oxam!), lovovor, in llo roaI
vorId lloro roaIIy is no singIo corrocl prico for an acquisilion or morgor. Wly` SimpIy
bocauso llo vaIuo of a largol doponds on lov voII il fils vill llo acquiring company.
A polonliaI acquisilion viII lavo a difforonl vaIuo for difforonl buyors. Tlo uIlimalo
purclaso prico viII dopond on a numbor of spocific faclors, incIuding llo largol's cur-
ronl marIol vaIuo, ils inlrinsic vaIuo, and llo vaIuo lo bo gainod from any polonliaI
synorgios bolvoon llo largol and buyor. Inlrinsic vaIuo and llo vaIuo of polonliaI syn-
orgios cannol bo Inovn vill corlainly, lloso vaIuos aro oslimalod by managors of llo
acquiring firm, invoslmonl banIors, and oulsido anaIysls. Tlo firm conlompIaling an
acquisilion can considor a numbor of faclors vlon dolormining ils offor prico for
anollor firm.
Market and Intrinsic VaIue
Of courso, ono of llo firsl (and oasiosl) llings lo considor vlon ovaIualing a possibIo
acquisilion is llo largol's curronl marIol vaIuo. As llo lorm suggosls, market vaIue is
llo curronl marIol capilaIizalion of a firm, vlicl is lypicaIIy caIcuIalod by muIlipIy-
ing llo numbor of slaros oulslanding by llo firm's slocI prico. Tlis vaIuo is llooroli-
caIIy llo marIol's oslimalos of llo curronl vaIuo of llo firm's fuluro casl fIovs. A
firm's intrinsic vaIue, lovovor, is llo prosonl vaIuo of a company's fuluro casl fIovs
from oxisling assols and businossos for a parlicuIar ovnor or buyor. Il can bo liglor or
Iovor llan a company's marIol vaIuo, vill llo difforonco rofIocling a numbor of fac-
lors. MarIols maIo imporlanl adjuslmonls in llo vaIualion of a firm, ovaIualing fuluro
grovll opporlunilios llal viII rosuIl in producls and gonoralo addilionaI casl fIovs,
assossing discounls for bad managomonl or oxcossivo divorsificalion, or avarding pro-
miums lo firms llal aro IiIoIy lo bocomo llo largols of bidding vars llomsoIvos.
Tlo µurchase µrice is llo vaIuo acluaIIy paid lo llo largol firm's slaroloIdors.
IiIo marIol prico, il may bo oillor liglor or Iovor llan inlrinsic vaIuo, bul il's aImosl
aIvays groalor llan curronl marIol vaIuo. Tlo onIy oxcoplion lo llis ruIo invoIvos lar-
gol firms llal aro in diro financiaI condilion (o.g., DaimIor roconlIy lad lo pay a buyor
lo laIo ClrysIor off ils lands).
Wly vouId a polonliaI acquiror offor lo pay moro llan a firm's marIol prico in an
acquisilion` RocaII llal synorgy is llo oconomic vaIuo croalod by boing abIo lo roduco
cosls or incroaso rovonuos by oporaling in lvo or moro businossos insload of a singIo
businoss. Synorgy is ossonliaIIy anollor vay of saying llal lvo or moro combinod onli-
lios croalo oconomios of scopo and scaIo. If a buyor porcoivos llal an acquisilion viII
offor synorgy polonliaI, il may ralionaIIy pay moro llan llo curronl marIol vaIuo for
anollor firm. Wlon synorgios oxisl, lloy lavo llo offocl of incroasing llo inlrinsic
vaIuo of a largol firm for llal buyor.
Bocauso synorgy is a funclion of llo sircicvic |ii of llo acquiring and llo largol
firms, oacl bidding firm may vaIuo llo largol difforonlIy. In addilion, llo marIol may
roacl difforonlIy in ovaIualing difforonl bidding firms. Wlon, for inslanco, Vodafono
and BoII AlIanlic boll mado bids for AirToucl, BoII AlIanlic's slocI prico droppod
vliIo Vodafono's prico vonl up÷ovon llougl Vodafono onlorod llo bidding vill a
700.13 Mergers ahd AcquisiIiohs 267
CAßM ModuIe 700 Fihahce
liglor offor. Wly` Tlo marIol boIiovod llal Vodafono and AirToucl couId acliovo
groalor synorgios llan BoII AlIanlic and AirToucl.
Tlo difforonco bolvoon curronl marIol vaIuo and llo finaI purclaso prico is caIIod llo
acquisitinn µremium. A promium is vlal inducos slaroloIdors of llo largol lo soII
lloir slaros lo nov ovnors. Our anaIysis of llo acquisilions lracIod by Tlompson
IinanciaI Sorvicos finds llal in llo Unilod Slalos, avorago acquisilion promiums lavo
rangod bolvoon 30 and 45 porconl during oacl of llo pasl fifloon yoars. Ior inslanco, a
firm vill a marIol vaIuo of $100 miIIion vouId normaIIy soII for a purclaso prico of
bolvoon $130 and $145 miIIion.
Iaying promiums for acquisilions, lovovor, prosonls a basic probIom for man-
agors of vouId-bo acquirors. Wlon llo managors of an acquiring firm agroo lo pay a
promium for a largol firm, lloy musl oxpocl llal lloy viII bo abIo lo gonoralo bollor
rolurns by combining llo firms llan llo firms vouId acliovo indopondonlIy. In ollor
vords, lo juslify paying a promium of 30 lo 45 porconl, managors viII nood lo gonoralo
moro nol incomo from llo combinod companios llan llo marIol assumod vouId bo
roaIizod boforo llo announcomonl of llo acquisilion. Wloro is llis incroaso in rolurn
supposod lo como from` ApparonlIy il is from llo synorgios acliovod by llo combinod
firms. Synorgios, lovovor, aro nol guaranlood and lloro aro sovoraI managoriaI lraps
llal can maIo synorgios difficuIl lo acliovo. Somo of llo managoriaI probIoms viII bo
discussod in moro dolaiI Ialor in llo soclion. Iirsl, Iol's considor llo praclicaI impIica-
lion of promiums.
The 5ynergy Trap
In a sludy of acquisilion promiums, MarI Sirovor of llo Boslon ConsuIling Group
(BCG) discussod vlal lo caIIod llo ¨synorgy lrap.¨
Ho arguod llal promiums pro-
sonl lvo probIoms for managors:
1. Iromiums incroaso llo IovoI of rolurns llal musl bo oxlraclod from llo
combinod businossos.
2. Bocauso of llo limo vaIuo of monoy, llo Iongor il laIos lo impIomonl
porformanco improvomonls, llo Iovor llo IiIoIilood llal llo acquisilion viII
bo succossfuI. ConsoquonlIy, any doIays in impIomonling and oxlracling
synorgios incroaso llo anlo on roquirod porformanco improvomonls.
Nol surprisingIy, paying loo mucl for an acquisilion can nol onIy joopardizo llo
succoss of an acquisilion, bul il can aIso causo irroparabIo damago lo llo acquiring
firm. RoguIarIy in lis Iollors lo slaroloIdors, Warron Buffoll las romindod slaroloId-
ors of BorIsliro Hallavay llal paying loo mucl for a company can Ioad lo disaslrous
offocls. Required µerInrmance imµrnvements aro llo annuaI incroasos in casl fIov
llal aro nocossary lo juslify llo IovoI of promium paid. CaIcuIaling roquirod porfor-
manco improvomonls uliIizos simpIo principIos from discounlod casl fIov anaIysis.
ßeaching a WaIk-avay Price
Givon vlal you nov Inov aboul llo synorgy lrap (and porlaps aboul Warron Buf-
foll's slrovdnoss as a slralogic invoslor), il slouIdn'l surpriso you lo Ioarn llal in 2000,
vlon CoIo CIO DougIas Dafl lriod lo buy OuaIor Oals in ordor lo add Galorado lo
llo company's producl Iino, board mombor Buffoll opposod llo idoa. Buffoll arguod
llal llo bidding by CoIo and Iopsi lad drivon llo promium loo ligl and CoIo
slouId vaII avay from llo nogolialions. (Tlo board sidod vill Buffoll and villdrov
from llo bidding.) SimiIarIy, in 2004, cabIo oporalor Comcasl mado a londor offor for
Disnoy of 0.78 slaro of Comcasl CIass A slocI for oacl Disnoy slaro. Tlo slocI marIol
vasn'l ovorIy llriIIod vill llo proposod doaI and Comcasl's slaro prico droppod
vliIo Disnoy's incroasod. Comcasl vas forcod lo villdrav llo offor, lovovor,
700.13 Mergers ahd AcquisiIiohs 268
CAßM ModuIe 700 Fihahce
bocauso llo vaIuo of ils slocI subsoquonlIy droppod loo far: Tloro camo a poinl al
vlicl Comcasl vouId lavo lo pay oul loo many slaros lo roacl llo offorod vaIuo. In
offocl, llal poinl vas Comcasl's ¨vaII-avay prico.¨
EscaIation o! Commitment and the Winner's Curse
IslabIisling a vaII-avay prico is roIalivoIy oasy, slicIing lo il is nol. Ono roason for
llis is llal oxoculivos oscaIalo llo commilmonl lo lloir inilialivo as lloy procood
llrougl a lransaclion. Tlis÷coupIod vill oxcossivo foar of faiIuro÷moans llal bid-
dors aro somolimos soducod inlo maIing quoslionabIo docisions. Biddors vlo aIIov
lloir pricos lo gol carriod avay (or aIIov llomsoIvos lo gol carriod avay vill lloir
bidding) oflon suffor from llo so-caIIod winner's curse. AIllougl llo biddors vin llo
¨prizo,¨ lloy'ro saddIod vill llo consoquoncos of laving paid loo mucl.
700.13.5 Discuss the steps in the M&A process
So far vo'vo focusod moslIy on llo loclnicaI sido of M&As: vlal lloy aro and lov
lloy'ro usod as slralogy volicIos, aIong vill llo roIos of pricing and promiums. Tlo
succoss of M&As as a slralogy volicIo, lovovor, doponds on mucl moro llan llo
cloico of a good largol and paying llo rigll prico. Tlo procoss by vlicl M&As aro
compIolod and largolod firms aro inlogralod inlo acquiring firms can lavo a significanl
boaring on succoss or faiIuro. Indood, somo oxporls say llal llo acquisilion procoss is
llo singIo Iargosl faclor.
Stages of the Acquisition Process
Figure 13.4 summarizos llo four major slagos in an acquisilion: i!cc vcncrciicn,
jusii|icciicn (incIuding duo diIigonco and nogolialion), inicvrciicn, and rcsu|is. As llo
figuro suggosls, llo M&A procoss roaIIy bogins vill llo slralogy bocauso managomonl
las idonlifiod and proparod for M&A as a slralogy volicIo, undorslands vlal slralogic
difforonlialors llo firm viII gain, boIslor, or dovoIop as a rosuIl of M&A, and las
accounlod for aII llo acquisilion procoss slagos in llo slaging and pacing facol of ils
700.13 Mergers ahd AcquisiIiohs 269
CAßM ModuIe 700 Fihahce
process problems
lntegration process problems
A Process Perspect|ve
Due Diligence,
figure 13.4 AcquisiIioh Process SIages
IrobIoms al any of llo firsl llroo slagos can sov llo soods of faiIuro.
Tlis modoI
idonlifios lvo lypos of probIoms: !ccisicn-mc|inv prc||cms and imp|cmcniciicn or
inicvrciicn prc||cms. Docision-maIing probIoms can ariso during llo idoa-gonoralion,
juslificalion, and inlogralion slagos, vloroas impIomonlalion probIoms occur during
llo inlogralion slago. Hovovor, lloso inlogralion probIoms couId lavo lloir rools in an
oarIior slago of llo procoss.
Inlogralion slarls vill llo slralogy ilsoIf, sinco llo slralogy viII lavo forosoon M&A as
a crilicaI volicIo for succoss. Bul onco M&A is parl of llo slralogy, llon llo i!cc is llo
impolus for llo acquisilion. Somo firms lavo voII-arlicuIalod slralogios llal slalo llo
condilions undor vlicl acquisilions viII bo llo volicIo of cloico for impIomonling
slralogic pIans. RocaII, for inslanco, llo caso of Unilod RonlaIs' roII-up slralogy: Acqui-
silions voro a Ioy volicIo in llo firm's slralogy. ConvorsoIy, OuaIor Oals' purclaso of
SnappIo vas an opporlunislic (and iII-considorod) movo. Wloroas somo firms lavo
voII-dofinod slralogios, in lorms of llo roIo of M&A as slralogy volicIos, ollors don'l.
Iirms llal do lavo cIoar concopls aboul llo roIo of M&A in lloir slralogy, and lavo
llo roquisilo M&A capabiIilios, can bo moro opporlunislic in llo uso of acquisilions.
1usti!ication, Due DiIigence, and Negotiation
Tlo major anaIylicaI slago of an acquisilion incIudos llo procossos llal a firm goos
llrougl lo dovoIop llo inlornaI and oxlornaI Iogic for llo acquisilion. Rosoarclors
IliIippo HasposIagl and David Iomison conlond llal sovoraI crilicaI docisions musl
bo mado al llis slago: slralogic assossmonl, dovoIoping a vidoIy slarod viov, a dogroo
of spocificily, organizalionaI condilions, impIomonlalion liming, and a vaII-avay
Sircicvic csscssmcni is llo procoss of dolormining lov an acquisilion viII
conlribulo lo ovoraII slralogy and compolilivo posilion. Il slouId do moro llan
anaIyzo llo largol: Il slouId addross llo issuo of lov llo acquisilion viII affocl
llo acquiring firm's pursuil of ils coro objoclivos. Managors slouId aIso maIo
suro llal lloir assossmonl isn'l loo slalic: Il slouId considor llo firm's fuluro
noods as ils induslry ovoIvos.
Bocauso many poopIo viII bo invoIvod in impIomonling an acquisilion and
inlograling llo largol firm inlo llo paronl, il's imporlanl llal llo purposo and
slralogic Iogic of llo acquisilion bo vidoIy undorslood by mombors of llo
organizalion. Tlo foIIoving is a Iisl of oigll quoslions llal managors slouId asI
al llis slago of an acquisilion:
1. Wlal is llo slralogic Iogic bolind llis acquisilion` Doos il corrospond vill
llo firm's slralogy` Wly llis company`
2. Is llo largol induslry allraclivo` Wlal aro llo Ioy sogmonls` Wlal is llo
prognosis aboul induslry ovoIulion`
3. If llis is an inlornalionaI acquisilion, vlal aro llo Ioy difforoncos bolvoon
llis counlry and our oxporionco` Do lloso difforoncos lavo porformanco
4. Doos an anaIysis of llo largol company (producls and sorvicos, marIol
posilion, cuslomors, suppIiors, dislribulion clannoIs, cosls, olc.) suggosl llal
il is loaIlly and viabIo in llo Iong lorm`
5. Hov voII doos llis company fil vill ours` Wlal aro llo oxpoclod bonofils,
and vlal migll impingo on llo roaIizalion of lloso bonofils`
700.13 Mergers ahd AcquisiIiohs 270
CAßM ModuIe 700 Fihahce
6. Hov viII llo acquisilion bo inlogralod` Wlo viII Ioad llis procoss` Hov viII
vo bo organizod`
7. Havo aIlornalivo sccncrics boon considorod` Wlal is llo oulcomo givon
roasonabIo, oplimislic, basoIino, and possimislic assumplions`
8. Is llo vaIualion roasonabIo` Is llis acquisilion pricod al a promium or
dislross÷pricod` Wlal do aIlornalivo vaIualion mollods concIudo
(accounling-basod, marIol-basod, NIV, oplion)`
Managors slouId bo as spocific as possibIo in idonlifying llo possibIo bonofils
and probIoms of an acquisilion llrougloul llo organizalion. Tlis slop is
imporlanl for lvo roasons:
1. If oporalionaI managors aron'l avaro of llo polonliaI sourcos of synorgios
idonlifiod by uppor managomonl and llo acquisilion loam, lloy'II lavo a
lard limo dolormining vlal's oxpoclod of llom. Moroovor, if lloy
undorsland llal synorgios aro noodod bul lavo IillIo idoa aboul lov lo gain
llom, llo lasI is jusl as daunling. Iol's go bacI lo OuaIor Oals' purclaso of
SnappIo. Iorlaps somo acquisilion managors undorslood SnappIo's
oporalions bul no ono soomod lo undorsland fuIIy llo difforoncos bolvoon
llo lvo induslrios' dislribulion sysloms. Oporaling-IovoI managors voro llus
Iofl lo discovor and doaI vill llom llrougl lriaI and orror. A good doaI of
limo and offorl vas vaslod in lrying lo impIomonl llo acquisilion in vays
llal simpIy voro nol in sync vill OuaIor Oals' businoss modoI.
2. AIllougl idonlifying possibIo probIoms is aIso imporlanl, somo acquisilion
loams lond lo undorslalo llom, usuaIIy bocauso lloy'ro afraid of causing Ioy
docision maIors lo sly avay from llo doaI.
AII in aII, il's mucl bollor for aII
parlios lo Inov vlal llo polonliaI roadbIocIs aro, lloy can bo doaIl vill
moro offoclivoIy if llo acquisilion loam providos somo suggoslod soIulions.
Understand the Cnnditinns Required Inr Creating Svnergies. Managors musl undor-
sland llo organizalionaI faclors on vlicl Ioy synorgios lingo and llo organizalionaI
condilions nocossary lo impIomonl dosirod synorgios. Synorgios in a cross-bordor
acquisilion, for oxampIo, may dopond on llo lransfor of a funclionaI sIiII from ono
company lo anollor. If so, oxoculivos al llo acquiring firm musl idonlify llo managors
and Ioy ompIoyoos vlo aro crilicaI lo llo lransfor. Ivon vlon llo numbors IooI good,
moro and moro firms aro scullIing acquisilions bocauso of a IacI of organizalionaI fil÷
vlicl can undormino possibIo synorgios. Cisco Sysloms is ono of llo mosl succossfuI
ligl-loclnoIogy acquirors, lloir scrooning criloria and moans of aclioving lloso crilo-
ria aro summarizod in Figure 13.5. Cisco roguIarIy usos acquisilions lo suppIomonl
inlornaI R&D. Hovovor, Cisco discovorod llal llo abiIily lo roaIizo synorgios vas lo
manago llo onliro procoss aclivoIy, from scrooning possibIo acquisilions lo diIigonlIy
managing llo inlogralion procoss.
CnntrnI the Timing nI ImµIementatinn and Integratinn. Timing is crilicaI in mosl
acquisilions. Il's imporlanl bocauso of llo limo vaIuo of monoy. In addilion, slocI mar-
Iols can bo voIaliIo, vlicl is imporlanl vlon a firm is paying for an acquisilion vill
ils ovn slocI. Moroovor, liming is crilicaI bocauso acquisilions causo major disruplions
in boll llo largol and acquiring firms. Many organizalionaI probIoms ariso from dis-
ruplion in llo Iivos of affoclod ompIoyoos vlo may bo impaclod by llo acquisilion,
sucl probIoms can bo Iossonod if impIomonlalion and inlogralion aro acliovod
quicIIy. As you Ioarnod from llo synorgy lrap looI, llo moro quicIIy llal synorgios
can bo roaIizod llrougl impIomonlalion and inlogralion moasuros, llo groalor llo pro-
mium a firm can afford lo pay for llo acquisilion.
700.13 Mergers ahd AcquisiIiohs 271
CAßM ModuIe 700 Fihahce
EstabIish a WaIk-awav Price. IinaIIy, managors slouId sollIo on llo maximum prico
llal lloy'ro viIIing lo pay for llo largol firm. As vo'vo aIroady soon, il's viso lo sol a
vaII-avay prico oarIy in llo procoss, boforo rivaI biddors succumb lo cscc|ciicn c| ccm-
miimcni and ovoroslimalo llo vaIuo llal lloy boIiovo viII bo dorivod from llo acquisi-
lion. IolonliaI synorgios aro oflon uncorlain and ambiguous, and lloy'II vary from ono
prospoclivo buyor lo llo noxl. IrobIoms ariso vlon managors mislaIo a rivaI's liglor
bid as a signaI llal lloy'vo ovorIooIod somo allraclivo foaluro of llo doaI, in rospond-
ing vill a moro compolilivo offor, lloy'ro oflon ovorpaying.
Many acquisilions faiI during llo inlogralion slago. Tlo bosl moans of inlograling an
acquisilion varios from caso lo caso, and faiIuro lo idonlify il can cancoI any polonliaI
synorgios llal may lavo boon dorivod from llo doaI. Dolormining llo bosl procoss for
impIomonling and inlograling an acquisilion moans undorslanding polonliaI inlorac-
lions bolvoon llo largol and llo acquiring firm. Bocauso llis slago is so imporlanl,
vo'II dovolo llo noxl soclion lo prosonling a modoI for doaIing vill inlogralion
700.13.6 OutIine the aIternative vays to integrate
M&A and expIain the impIementation process
Wlon ono company acquiros anollor il las sovoraI oplions for lov llo acquirod com-
pany viII bo inlogralod inlo llo firm. Al ono oxlromo, llo acquirod company may bo
granlod noar-compIolo aulonomy. Warron Buffoll's BorIsliro Hallavay oflon lroals
ils acquirod companios llis vay. AIlornalivoIy, llo acquiring company may allompl lo
fuIIy inlogralo llo acquirod firm inlo ils oporalions so llal llo lvo firms aro moIdod
inlo ono.
Hov slouId managors docido vlollor an acquisilion slouId bo lroalod in a rallor
lands-off approacl or bo ligllIy inlogralod` Tvo concopls slouId bo considorod in
maIing llis docision÷llo slralogic inlordopondonco of llo businossos and llo nood for
organizalionaI aulonomy of llo acquirod businoss.
700.13 Mergers ahd AcquisiIiohs 272
CAßM ModuIe 700 Fihahce
Screen|ng Cr|ter|a Means of Ach|ev|ng Cr|ter|a
figure 13.5 OrgahizaIiohal-FiI AcquisiIiohs Screehihg by Cisco SysIems
Strategic lnterdependence
Iol's go bacI lo ono of llo basic principIos idonlifiod in llis soclion: Tlo primary pur-
poso of M&As is lo croalo synorgios÷vaIuo llal can bo croalod by combining lvo
firms llal isn'l avaiIabIo lo llom as slandaIono firms. To vlal oxlonl slouId llo largol
firm and acquiring firm romain slralogicaIIy inlordopondonl` Il doponds on llo lypos
of rosourco slaring and sIiII lransfors anlicipalod by llo lvo firms. Wlon llo Iogic of
llo acquisilion roquiros llal lloy slaro langibIo and inlangibIo rosourcos, llo succoss
of llo doaI usuaIIy roquiros a roIalivoIy ligl IovoI of inlordopondonco. IiIoviso, vlon
llo Iogic of llo doaI caIIs for lransforring poopIo vill difforonl funclionaI sIiIIs in
ordor lo slaro InovIodgo, il onlaiIs moro inlordopondonco bolvoon llo lvo organiza-
lionaI unils llan if il caIIod simpIy for a lransfor of gonoraI managomonl sIiIIs. AIlor-
nalivoIy, vlon llo rosourcos boing lransforrod aro primariIy financiaI (say, borroving
povor or oxcoss casl), vory IillIo inlordopondonco is roquirod. Tlus llo firsl faclor llal
dolorminos lov inlogralion slouId bo landIod is llo IovoI of slralogic inlordopon-
donco bolvoon llo acquiring firm and llo acquirod firm.
Need for Autonomy
Tlo socond faclor llal slouId bo considorod is llo largol's nood for aulonomy. Tlo
vaIuo of somo acquisilions Iios IargoIy in llo rolonlion of Ioy poopIo and lransfors of
capabiIilios. Koy poopIo, lovovor, oflon Ioavo onco lloir firm las boon acquirod÷
ospociaIIy vlon llo acquisilion disrupls lloir oporaling procoduros and lloir aulon-
omy in conducling llom. Iusl lov mucl aulonomy slouId bo granlod an acquirod
firm` Tloro's no singIo ansvor, of courso, bul llo foIIoving is a good ruIo of llumb:
Tlo approprialo amounl of aulonomy doponds on vlollor il is nocossary lo croalo
vaIuo. Granlod, ovon llis rosponso is a IillIo loo simpIo. Iorlaps, for oxampIo, aulon-
omy is nocossary onIy in corlain facols of llo acquirod firm's oporalions, vloroas oll-
ors can bo oasiIy assimiIalod.
Wlon Sviss gianl NoslIó sol oul lo purclaso Brilisl candy maIor Rovnlroo YorI
(maIors of sucl candios as Kil Kal and RoIo) in ordor lo oxlond ils roacl in clocoIalos
and confoclionary marIols, il found llal il couId nol, in accord vill ils usuaI poIicy,
fuIIy inlogralo ils Ialosl acquisilion. Rallor, lo gol llo doaI approvod by Rovnlroo,
NoslIó lad lo aIIov Rovnlroo oxoculivos lo romain in llo Unilod Kingdom and run
llo slralogic offico in clargo of aII confoclionary businossos. Tlus, in llis caso, aulon-
omy vas noodod simpIy lo gol llo managors of llo largol firm lo supporl llo acquisi-
lion and agroo lo llo buyoul. Cisco, llo nolvorI company, las usod acquisilions
oxlonsivoIy as parl of ils slralogy. GonoraIIy, lloy lry lo inlogralo llo largol as soon
aflor llo cIosing as possibIo. Ior inslanco, lloy allompl lo lavo llo largol's producls in
ils saIos poopIos' calaIoguos llo momonl llo acquisilion cIosos. In ordor lo acliovo llis,
lloy nood llo largol firms lo adopl aII of Cisco's sysloms and bo fuIIy inlogralod. Hov-
ovor, poriodicaIIy, Cisco acquiros a largol llal rosisls somo aspocl of Cisco inlogralion.
Tloy cIaim llal lo bo innovalivo, lloy nood somo organizalionaI aulonomy, and llal
lloir onginoors vanl lo vorI for a smaII and dynamic company, nol a big, ¨buroau-
cralic¨ Cisco. ConsoquonlIy, in a fov casos, Cisco las dovialod from lloir normaI inlo-
gralion poIicy in ordor lo compIolo a lransaclion llal lloy doom is of slralogic
The lmplementation Process
No mallor vlal approacl managors laIo÷fosloring inlordopondonco, aulonomy, or
somo combinalion of lloso÷lloy viII bo voII sorvod by rominding llomsoIvos llal
acquisilion inlogralion is a prcccss and nol an ctcni. By anaIogy, llinI of acquisilion
inlogralion as a comma in a sonlonco, nol a poriod. To llis ond vo can Ioarn somo Ios-
sons from so-caIIod seriaI acquirers÷companios llal ongago i n froquonl
acquisilions÷llal viII bo usofuI in undorslanding lov llo procoss can bo landIod
smoollIy and offoclivoIy.
700.13 Mergers ahd AcquisiIiohs 273
CAßM ModuIe 700 Fihahce
It's a ContinuaI Process, Not an Event
Tlo bosl soriaI acquirors slarl llo inlogralion procoss during iniliaI scrooning inlor-
viovs and nogolialions, voII boforo cIosing llo doaI. M&A is aIroady dosignod inlo llo
aronas, difforonlialors, volicIos, slaging and pacing, and oconomic facols of lloir slral-
ogy (nolico lloso compriso c|| fivo facols of llo slralogy diamond). During llis procoss,
caIIod due diIigence, oxoculivos and Iovor-IovoI managors al boll companios bogin lo
pIan for llo posldoaI slrucluro of llo combinod firm. AIllougl somo prolransaclion
discussions can bo avIvard, lloy'ro ossonliaI in idonlifying boll polonliaI obslacIos
and addilionaI opporlunilios. Onco llo doaI is cIosod, spocific docisions musl bo oxo-
culod and proarrangod organizalionaI slrucluros impIomonlod. Tlo Iosson, in slorl, is
llal il's bollor lo maIo lougl docisions oarIy rallor llan doIaying llom. Iirms sucl as
GI CapilaI and Cisco, vlicl lavo succossfuIIy inlogralod many acquisilions (and
somo nol so succossfuIIy), lavo found llal inilialing and pursuing a comprolonsivo
inlogralion and communicalions procoss is llo Iynclpin for succoss.
Integration Management Is a fuII-time 1ob
Many firms maIo llo mislaIo of assuming llal poopIo al aII IovoIs in boll organiza-
lions viII vorI logollor lo maIo llo acquisilion as soamIoss as possibIo. Unforlu-
naloIy, so many organizalionaI issuos aro invoIvod in inlograling an acquirod com-
pany llal Iino managors oflon can'l ovorsoo oporalions cn! manago llo inlogralion
procoss. Many succossfuI acquirors, lloroforo, appoinl an inicvrciicn mcncvcr. IdoaIIy,
llis porson viII bo somoono from llo duo-diIigonco loam vlo undorslands boll com-
panios. Having mol many Iino managors in boll organizalions, llo inlogralion man-
agor spoarloads inlogralion offorls, guiding novIy acquirod managors llrougl llo
mazo of llo nov organizalionaI liorarcly.
Al GI CapilaI, for inslanco, inlogralion managors inlroduco boll oxoculivos and
ompIoyoos of llo acquirod firm lo llo businoss roquiromonls and organizalionaI slan-
dards of llo nov paronl company. Tloy aIso doaI vill a numbor of soomingIy mun-
dano issuos llal lavo boon found lo lampor inlogralion offorls, sucl as communical-
ing informalion aboul bonofils and luman rosourcos poIicios. Tloy oducalo nov
ompIoyoos aboul sucl idiosyncralic foaluros of llo firm as cuIluro, businoss cusloms,
and ovon acronyms. IinaIIy, in ordor lo provonl unnocossary ovorIoad and rodundanl
aclivilios, lloy clannoI informalion roquosls from llo paronl company lo boll nov
managors and lloso vlo aro volorans of llo originaI organizalion.
GI CapilaI las found llal individuaIs vill slrong porsonaI and loclnicaI sIiIIs
maIo llo bosl inlogralion managors and lypicaIIy dravs candidalos from ono of lvo
pooIs. Iirsl, llo company rocruils ¨ligl-polonliaI individuaIs¨÷poopIo vill slrong
funclionaI-aroa managomonl crodonliaIs and Ioadorslip polonliaI. Tloso poopIo func-
lion bosl as inlogralion managors vlon llo inlogralion is liglIy slruclurod and roIa-
livoIy uncompIicalod. Ior moro compIox inlogralions, GI CapilaI roIios on soasonod
volorans vlo Inov llo company voII. Ixporionco las slovn llal lloso individuaIs
can bo dravn from ovory funclionaI aroa.
Key Decisions 5houId ße Made 5vi!tIy
As vo'vo aIroady soon, spood is of llo ossonco in llo acquisilion procoss simpIy
bocauso of llo cosl and llo limo vaIuo of monoy. Corlain organizalionaI faclors aIso
diclalo svifl inlogralion. Ior ono, ompIoyoos÷boll lloso of llo largol firm and lloso
of llo acquiring firm÷aro naluraIIy concornod aboul llo impacl of llo acquisilion on
lloir jobs. As mucl as oxoculivos and managors vouId IiIo ovoryono lo fooI IiIo a
loam pIayor vill a socuro pIaco in llo organizalionaI Iinoup, vlon lloy'ro vorriod
aboul lloir jobs, poopIo succumb lo dislraclions. SuccossfuI acquirors lavo found llal
il's bosl nol lo proIong llo susponso: Docisions aboul managomonl slrucluro, Ioy roIos,
roporling roIalionslips, Iayoffs, roslrucluring, cosl-culling, and ollor caroor-affocling
aspocls of llo acquisilion slouId bo announcod as soon as possibIo÷ovon villin days
of llo acquisilion announcomonl. ToIIing ompIoyoos llal ovorylling viII bo ¨businoss
700.13 Mergers ahd AcquisiIiohs 274
CAßM ModuIe 700 Fihahce
as usuaI¨ is aImosl novor boing lonosl and viII probabIy lampor llo inlogralion
procoss. In addilion, svifl impIomonlalion of llo inlogralion procoss aIIovs llo firm lo
gol on vill ils primary lasI÷croaling vaIuo. Bocauso sIuggisl inlogralion maIos il
moro difficuIl lo focus on llis lasI, il voaIons llo vaIuo-croalion procoss.
Integration 5houId Address TechnicaI and CuIturaI Issues
Wlon inlograling acquisilions, mosl managors lond lo focus on loclnicaI issuos. Al
Cisco, for oxampIo, a Ioy loclnicaI issuo is llo rapid inlogralion of llo largol's prod-
ucls inlo llo Cisco syslom so llal saIos roprosonlalivos can bogin soIIing llo nov prod-
ucl Iino. SuccossfuI inlogralion moans idonlifying and addrossing sucl issuos as oarIy
as possibIo.
Issuos roIalod lo corporalo cuIluro slouId aIso bo addrossod immodialoIy. Somo of
lloso issuos aro as simpIo as mooling and grooling nov ompIoyoos. Tlo cuIluros of any
lvo firms aro bound lo bo difforonl, and llo faslor managors and ompIoyoos can moId
llo lvo organizalions, llo moro smoollIy llo inlogralion viII procood. Ivon vlon
lvo organizalions soom lo lavo a Iol in common, profound cuIluraI difforoncos may
oxisl llal couId llroalon succossfuI inlogralion. Wlon, for inslanco, IranIIin Ouosl
morgod vill Covoy, many obsorvors oxpoclod cuIluraI inlogralion lo bo smooll. Aflor
aII, llo lvo businossos voro liglIy compIomonlary, and bocauso boll firms voro
Iocalod in Ulal, lloy lad simiIar ompIoyoo basos. In addilion, llo lvo CIOs voro
voII acquainlod vill ono anollor. SurprisingIy, lovovor, llo lvo cuIluros voro
liglIy dissimiIar. Ior inslanco, IranIIin Ouosl vas buiIl on a cuIluro of officioncy,
vloroas Covoy osclovod officioncy for offoclivonoss. Ivorylling from producls lo
company vision slalomonls voro liod lo lloso crilicaI undorIying pliIosoplios. During
llo acquisilion procoss, oxoculivos dismissod lloso difforoncos as somanlics, bul dis-
covorod during llo inlogralion plaso llal lloso voro rallor incongruonl pliIosoplios.
In addilion, moro funclionaI llings, sucl as incompalibIo accounling sysloms, aIso
impodod quicI inlogralion. SuccossfuI acquirors idonlify cuIluraI cIaslos oarIy, in facl,
lloy may vaII avay from doaIs vlon llo polonliaI cIaslos aro loo sovoro.
700.13.7 Discuss the characteristics o! M&A
in di!!erent industry contexts
Nol surprisingIy, M&A aclivily varios across induslrios. Il is dolorminod IargoIy by llo
dovoIopmonl plaso in vlicl a givon induslry finds ilsoIf and by llo oxlonl of induslry
dynamism. In addilion, compolilivo condilions viII dolormino vlollor acquisilion is a
suilabIo slralogy volicIo for a firm in a givon induslry and vlal llo mosl viabIo lypo
of acquisilion may bo. In llis soclion, vo'II discuss llo roIo of M&As and induslry con-
loxl in lorms of llo induslry Iifo cycIo and llo IovoI of induslry-vido lurbuIonco.
M&As and lndustry Life Cycle
In llis soclion, vo'II uso llo modoI of induslry Iifo cycIo and induslry dynamics lo
iIIuslralo lov difforonl lypos of acquisilions pIay difforonl roIos in oacl slago.
During llo inlroduclion slago, acquisilions lond lo invoIvo llo purclaso of slarlup
firms by voII-oslabIislod firms in roIalod bul moro maluro induslry sogmonls. Many
parliaI acquisilions may occur, vill oslabIislod companios maIing oquily invoslmonls
in slarlups bul nol acquiring llom oulrigll. Tlus, al llis slago M&As lond lo bo R&D
and producl- and marIol-oxlonsion acquisilions.
700.13 Mergers ahd AcquisiIiohs 275
CAßM ModuIe 700 Fihahce
During llis plaso, vo soo sovoraI lypos of acquisilions. IslabIislod companios from
ono induslry sogmonl may slarl onloring ollor sogmonls vill groalor froquoncy, IooI-
ing moslIy for provon and groving largols. AIllougl somo M&A aclivily may bo for
R&D, mosl of il is IiIoIy lo bo for llo purposo of acquiring producls llal aro provon
and gaining cuslomor accoplanco. Tlo goograplic roII-up aIso bocomos moro com-
mon, ospociaIIy al llo ond of llo grovll slago and llrougl llo malurily slago. In
ligl-voIocily induslrios, induslry-convorgonco acquisilions appoar and conlinuo inlo
llo malurily slago.
Al llis poinl, vo bogin lo soo ovorcapacily acquisilions. Wly` During llo grovll
slago, llo induslry vilnossod llo onlry of nov firms and aggrossivo oxpansion, vill
numorous compolilors jocIoying for compolilivo posilion. Capacily buiIl during llis
poriod oflon oxcoods llo Iong-lorm noods of llo sogmonl, and as domand slarls lo fIal-
lon, companios soo consoIidalion as a vay lo ralionaIizo llo induslry. Ovorcapacily
M&A aclivily conlinuos llrougloul llo docIino slago of llo cycIo.
M&As in Dynamic Contexts
Dynamic conloxls aro oflon lomo lo firms llal ongago in acquisilions al a franlic paco.
Wlal is il aboul dynamic conloxls llal maIos acquisilions sucl popuIar slralogy voli-
cIos` Tloro aro faclors llal can aIlor an induslry Iandscapo, parlicuIarIy disconlinuilios
and gIobaIizalion. Tloso faclors lond lo accoIoralo acquisilions. Nolo llal villin lloso
lvo broad calogorios, many faclors can affocl llo allraclivonoss of acquisilions as slral-
ogy volicIos. Wo'II focus on icc|nc|cvicc| c|cnvc, !cmcvrcp|ic c|cnvc, vccpc|iiicc| c|cnvc,
irc!c |i|crc|izciicn, and !crcvu|ciicn.
TechnoIogicaI Change
In ligl-voIocily induslrios, loclnoIogicaI clango and innovalion can lranspiro al Iigll-
ning spood, and somo firms rospond vill aggrossivo acquisilion campaigns. Boll
Cisco and Microsofl, for oxampIo, uso acquisilions lo onsuro llal innovalion and locl-
noIogicaI clango among compolilors don'l conlribulo lo llo orosion of lloir slrong
compolilivo posilions.
Demographic Change
Domograplic clangos, sucl as llo aging of llo popuIalion and mass omigralion, may
aIlor cuslomor profiIos significanlIy. Spanisl-Ianguago spoaIors, for inslanco, aro an
incroasingIy imporlanl marIol sogmonl for U.S. modia companios. Tlus, vlon llo
Tribuno Company morgod vill Timos-Mirror in 2000, il acquirod Hcu, llo Ioading
Spanisl-Ianguago daiIy in Nov YorI and ono of llo faslosl-groving pubIicalions of
ils Iind. Tlo Tribuno Company las roconlIy Iaunclod odilions in Clicago and Ios
GeopoIiticaI Change
Sucl ovonls as llo faII of llo Iron Curlain, llo omorgonco of llo Iuropoan Union, llo
oponing of Clina, and confIicl in llo MiddIo Iasl aII lavo significanl offocls on llo
oporalions of gIobaI companios. In somo casos, clangos onlanco opporlunilios for
acquiring oslabIislod companios in nov Iocalions. In ollors, lloy foslor divosliluro.
Ior oxampIo, IBM vas abIo lo divosl ils porsonaI compulor division lo llo Clinoso
firm Ionova in 2005 IargoIy bocauso of llo rapid grovll and commorciaIizalion of llo
domoslic Clinoso marIolpIaco, vlicl vas foslorod by llo Ioosoning of somo govorn-
monl inlorvonlions.
700.13 Mergers ahd AcquisiIiohs 276
CAßM ModuIe 700 Fihahce
Trade LiberaIization
Trado IiboraIizalion aIso opons nov opporlunilios for doing businoss. In llo vaIo of
llo Iuropoan Union and llo Norll Amorican Iroo Trado Agroomonl (NAITA), for
oxampIo, cross-bordor acquisilion aclivily incroasod in induslrios conducling businoss
in lloso rogions. WaI-Marl's acquisilion of llo succossfuI Moxican rolaiIing gianl,
Cifra, is a caso in poinl. Goograplic proximily and NAITA maIo il cosl-offoclivo for
WaI-Marl lo slocI ils sloIvos in llo Unilod Slalos vill goods assombIod in Moxico as
voII as provido ollorviso moro oxponsivo U.S.÷mado goods lo Moxican consumors
llrougl Cifra's oulIols. WaI-Marl gainod improvod oconomios of scopo and scaIo as a
rosuIl of NAITA.
IinaIIy, doroguIalion las lad a major impacl on llo voIumo of M&A aclivily in a
numbor of induslrios. Irior lo doroguIalion, for inslanco, llo vavo of M&As llal
svopl llo banIing induslry vouId nol lavo boon possibIo. RoguIalion and doroguIa-
lion lavo aIso affoclod acquisilions and divosliluros in llo loIocommunicalions indus-
lry. AT&T, for oxampIo, vas aIIovod lo oxisl as a virluaI monopoIy unliI 1984, vlon
anlilrusl aclion forcod ils broaIup. Tlo sovon so-caIIod Baby BoIIs dividod up IocaI
sorvico, Ioaving llo paronl company, AT&T, vill Iong-dislanco and loIocom oquip-
monl businossos. IoIIoving subsoquonl doroguIalion, M&A aclivily las pul llo indus-
lry in a slalo of aImosl conslanl clango.
M&As and Coevolution
As vill aIIiancos, llo uso of acquisilions in dynamic conloxls fils inlo llo coovoIulion
modoI of corporalo slralogy. RocaII our dofinilion of coovoIulion as llo orcloslralion
of a vob of slifling IinIagos among ovoIving businossos. In llo caso of acquisilions,
acquisilions can onabIo a firm lo absorb llo capabiIilios of lloir largols in ordor lo
dovoIop spocific dynamic capabiIilios in concorl vill llo bosl rosourcos and capabiIi-
lios avaiIabIo on llo marIol. Iusl as imporlanl, acquisilions (al Ioasl voII-concoivod
onos) supporl a spocific, focusod slralogy. ConsoquonlIy, in Iooping vill llis slralogy,
corlain businossos aro poriodicaIIy parod off llrougl divosliluros and ollors addod
llrougl acquisilions. If, for inslanco, llo firm is pursuing a grovll slralogy, llo
coovoIulion porspoclivo vouId suggosl llal il divosl sIov-grovll businossos and
producls and acquiro firms llal aro oporaling on llo loclnoIogy fronlior or llal offor
somo ollor basis for fuluro compolilivo advanlago.
700.13 Mergers ahd AcquisiIiohs 277
CAßM ModuIe 700 Fihahce
Glossary 278
accounting book vaIue Il roporls assols and IiabiIilios basod on llo lisloricaI
lransaclions rocordod al lloir originaI cosl, nol al llo ropIacomonl cosl or curronl
marIol vaIuo. Tlo booI vaIuo is caIcuIalod as llo doprocialod vaIuo of assols (i.o.,
originaI cosl Ioss accumuIalod doprocialion) minus aII llo oulslanding IiabiIilios. 15
accounts payabIe Il roprosonls a lrado crodil oxlondod by suppIiors lo a firm vlon il
purclasos invonlorios, roprosonling a IiabiIily of a firm. 16
accounts receivabIe Il consisls of paymonls duo from ils cuslomors vlo buy on
crodil, roprosonling an assol of a firm. 14
accrued expenses Il roprosonls slorl-lorm IiabiIilios llal lavo boon incurrod in a
firm's oporalions bul nol yol paid, roprosonling a financiaI obIigalion of llo firm. 16
acquisition Slralogy by vlicl ono firm acquiros anollor llrougl slocI purclaso or
oxclango. 258
acquisition premium Difforonco bolvoon curronl marIol vaIuo of a largol firm
and purclaso prico paid lo induco ils slaroloIdors lo lurn ils conlroI ovor lo nov
ovnors. 268
agency costs Tlo cosls, sucl as a roducod slocI prico, associalod vill polonliaI
confIicl bolvoon managors and invoslors vlon lloso lvo groups aro nol llo
samo. 112
agency probIem IrobIoms and confIicls rosuIling from llo soparalion of llo
managomonl and ovnorslip of llo firm. 7
anticipatory buying Buying in anlicipalion of a prico incroaso lo socuro goods al a
Iovor cosl. 63
baIance sheet A basic accounling slalomonl llal roprosonls llo financiaI posilion of
a firm on a givon dalo. 14
bene!it-cost ratio  µrnIitabiIitv index. 171
bird-in-the-hand dividend theory Tlo viov llal dividonds aro moro corlain llan
capilaI gains. 108
bond A Iong-lorm (10-yoar or moro) promissory nolo issuod by llo borrovor,
promising lo pay llo ovnor of llo socurily a prodolorminod and fixod amounl of
inlorosl oacl yoar. 136
book vaIue (1) Tlo vaIuo of an assol as slovn on llo firm's baIanco slool. Il
roprosonls llo lisloricaI cosl of llo assol rallor llan ils curronl marIol vaIuo or
ropIacomonl cosl. (2) Tlo doprocialod vaIuo of a company's assols (originaI cosl Ioss
accumuIalod doprocialion) Ioss llo oulslanding IiabiIilios. 140
budget Il is a forocasl of fuluro ovonls mainIy consisling of lransaclions llal aro
financiaI in naluro. 132
business risk Tlo roIalivo disporsion or variabiIily in llo firm's oxpoclod oarnings
boforo inlorosl and laxos (IBIT). Tlo naluro of llo firm's oporalions causos ils businoss
risI. Tlis lypo of risI is affoclod by llo firm's cosl slrucluro, producl domand
claraclorislics, and inlra-induslry compolilivo posilion. In capilaI slrucluro lloory,
businoss risI is dislinguislod from financiaI risI. Comparo IinanciaI risk. 82
caII protection period A firm cannol caII a bond for a prospocifiod limo poriod
bocauso llo bond is proloclod from oarIy caIIs. 139
caII provision A provision llal onlilIos llo corporalion lo ropurclaso ils proforrod
slocI from lloir invoslors al slalod pricos ovor spocifiod poriods. 155
caIIabIe bond Bonds musl lavo a caIIabIo or rodoomabIo provision so a firm can pay
off llo curronl bonds issuod al a liglor inlorosl ralo oarIy and llon issuo nov bonds al
a Iovor inlorosl ralo. 139
capitaI asset pricing modeI (CAPM) An oqualion slaling llal llo oxpoclod ralo
of rolurn on a projocl is a funclion of (1) llo risI-froo ralo, (2) llo invoslmonl's
syslomalic risI, and (3) llo oxpoclod risI promium for llo marIol porlfoIio of
aII risIy socurilios. 70
capitaI budgeting Tlo docision-maIing procoss vill rospocl lo invoslmonl in fixod
assols. SpocificaIIy, il invoIvos moasuring llo incromonlaI casl fIovs associalod vill
invoslmonl proposaIs and ovaIualing lloso proposod invoslmonls. 167
capitaI market AII inslilulions and procoduros llal faciIilalo lransaclions in Iong-
lorm financiaI inslrumonls. 207
capitaI rationing Tlo pIacing of a Iimil by llo firm on llo doIIar sizo of llo capilaI
budgol. 178
capitaI structure Tlo mix of Iong-lorm sourcos of funds usod by llo firm. Tlis is aIso
caIIod llo firm's capilaIizalion. Tlo roIalivo lolaI (porconlago) of oacl lypo of fund is
omplasizod. 71, 98
cash budget A dolaiIod pIan of fuluro casl fIovs. Tlis budgol is composod of four
oIomonls: casl rocoipls, casl disbursomonls, nol clango in casl for llo poriod, and
nov financing noodod. 133
chatteI mortgage agreement A Ioan agroomonl in vlicl llo Iondor can incroaso lis
or lor socurily inlorosl by laving spocific iloms of invonlory idonlifiod in llo Ioan
agroomonl. Tlo borrovor rolains lilIo lo llo invonlory bul cannol soII llo iloms
villoul llo Iondor's consonl. 36
cIienteIe e!!ect Tlo boIiof llal individuaIs and inslilulions llal nood curronl incomo
viII invosl in companios llal lavo ligl dividond payouls. Ollor invoslors profor lo
avoid laxos by loIding socurilios llal offor onIy smaII dividond incomo bul Iargo
capilaI gains. Tlus, vo lavo a ¨cIionloIo¨ of invoslors. 111
commerciaI paper Slorl-lorm unsocurod promissory nolos soId by Iargo businossos
in ordor lo raiso casl. UnIiIo mosl ollor monoy-marIol inslrumonls, commorciaI
papor las no dovoIopod socondary marIol. 32
common stock Slaros llal roprosonl llo ovnorslip in a corporalion. 157
common stockhoIders Tloy aro llo rosiduaI ovnors of a businoss and gol paid aflor
llo crodilors and proforrod slocIloIdors aro paid. 16
Glossary 279
CAßM ModuIe 700 Fihahce
compensating baIance A baIanco of a givon amounl llal llo firm mainlains in
ils domand doposil accounl. Il may bo roquirod by oillor a formaI or informaI
agroomonl vill llo firm's commorciaI banI. Sucl baIancos aro usuaIIy roquirod by
llo banI (1) on llo unusod porlion of a Ioan commilmonl, (2) on llo unpaid porlion
of an oulslanding Ioan, or (3) in oxclango for corlain sorvicos providod by llo banI,
sucl as clocI-cIoaring or crodil informalion. Tloso baIancos raiso llo offoclivo ralo
of inlorosl paid on borrovod funds. 31
constant dividend payout ratio A dividond paymonl poIicy in vlicl llo
porconlago of oarnings paid oul in dividonds is loId conslanl. Tlo doIIar amounl
fIuclualos from yoar lo yoar as profils vary. 115
contribution margin Tlo difforonco bolvoon a producl's soIIing prico and ils unil
variabIo cosls. Il is usuaIIy moasurod on a por unil basis. 86
contribution-to-!irm risk Tlo amounl of risI llal a projocl conlribulos lo llo firm as
a vloIo. Tlis moasuro considors llo facl llal somo of llo projocl's risI viII bo
divorsifiod avay as llo projocl is combinod vill llo firm's ollor projocls and assols
bul ignoros llo offocls of divorsificalion of llo firm's slaroloIdors. 191
convertibIe bond Il aIIovs an invoslor lo oxclango lis bond for a prodolorminod
numbor of a firm's slaros of common slocI. 138
convertibIe pre!erred stock SlocI llal aIIovs llo slocIloIdor lo convorl llo
proforrod slocI inlo a prodolorminod numbor of slaros of common slocI, if lo or slo
so cloosos. 154
cost o! goods soId Il roprosonls llo cosl of producing or acquiring llo producl
or sorvico. 12
coupon interest rate Tlo inlorosl lo bo paid annuaIIy on a bond as a porconl of par
vaIuo, vlicl is spocifiod in llo conlracluaI agroomonl. 138
credit scoring Tlo numoricaI ovaIualion of crodil appIicanls vloro llo scoro is
ovaIualod roIalivo lo a prodolorminod slandard. 56
cumuIative !eature A roquiromonl llal aII pasl unpaid proforrod slocI dividonds bo
paid boforo any common slocI dividonds aro docIarod. 154
cumuIative voting Voling in vlicl oacl slaro of slocI aIIovs llo slaroloIdor a
numbor of volos oquaI lo llo numbor of diroclors boing oIoclod. Tlo slaroloIdor can
llon casl aII of lis or lor volos for a singIo candidalo or spIil llom among llo various
candidalos. 158
current assets Assols consisling primariIy of casl, marIolabIo socurilios, accounls
rocoivabIo, invonlorios, and propaid oxponsos. 14
current debt Il roprosonls a slorl-lorm IiabiIily, vlicl incIudos borrovod monoy
llal musl bo ropaid villin llo noxl 12 monlls. 16
current yieId Tlo ralio of llo annuaI inlorosl paymonl lo llo bond's marIol
prico. 148
date o! record Dalo al vlicl llo slocI lransfor booIs aro lo bo cIosod for
dolormining llo invoslor lo rocoivo llo noxl dividond paymonl.  ex-dividend
date. 117
debenture Any unsocurod Iong-lorm dobl. 136
debt IiabiIilios consisling of sucl sourcos as crodil oxlondod by suppIiors or a Ioan
from a banI. 15
debt ratio TolaI IiabiIilios dividod by lolaI assols. A ralio llal moasuros llo oxlonl lo
vlicl a firm las boon financod vill dobl. 18
decIaration date Tlo dalo upon vlicl a dividond is formaIIy docIarod by llo board
of diroclors. 117
deIivery-time stock Tlo invonlory noodod bolvoon llo ordor dalo and llo rocoipl of
llo invonlory ordorod. 62
Glossary 280
CAßM ModuIe 700 Fihahce
direct costs  variabIe cnsts. 84
direct method A formal usod lo moasuro casl fIov from oporalions, by vlicl llo
difforonl casl oulfIovs occurring in roguIar oporalions of a businoss aro sublraclod
from llo casl fIov coIIoclod from cuslomors. 84
direct pIacement  µrivate µIacement. 206
direct saIe Tlo saIo of socurilios by llo corporalion lo llo invosling pubIic villoul
llo sorvicos of an invoslmonl-banIing firm. 211
direct securities Tlo puro financiaI cIaims issuod by oconomic unils lo savors. Tloso
can Ialor bo lransformod inlo indirocl socurilios. 204
discount bond A bond llal soIIs al a discounl boIov par vaIuo. 152
discretionary !inancing Sourcos of financing llal roquiro an oxpIicil docision on llo
parl of llo firm's managomonl ovory limo funds aro raisod. An oxampIo is a banI nolo
llal roquiros llal nogolialions bo undorlaIon and an agroomonl signod solling forll
llo lorms and condilions of llo financing. 125
divestiture Slralogy vloroby a company soIIs off a businoss or division. 262
dividend payout ratio Tlo amounl of dividonds roIalivo lo llo company's nol
incomo or oarnings por slaro. 106
due diIigence IniliaI pro-cIosing scrooning, anaIysis, and nogolialions for an
acquisilion. 274
earnings be!ore taxes Oporaling incomo minus inlorosl oxponso. 12
EßIT-EP5 indi!!erence point Tlo IovoI of oarnings boforo inlorosl and laxos (IBIT)
llal viII oqualo oarnings por slaro (IIS) bolvoon lvo difforonl financing pIans. 102
economic pro!it Il is oquaI lo accounling profil (i.o., nol oporaling profil aflor laxos,
NOIAT) Ioss a clargo for llo uso of capilaI, vloro llo Iallor is caIcuIalod as invoslod
capilaI muIlipIiod by llo cosl of capilaI. 78
e!!icient market A marIol in vlicl llo vaIuos of socurilios al any inslanl in limo
fuIIy rofIocl aII avaiIabIo informalion, vlicl rosuIls in llo marIol vaIuo and llo
inlrinsic vaIuo boing llo samo. 6, 141
equity SlocIloIdor's invoslmonl in llo firm and llo cumuIalivo profils rolainod in
llo businoss up lo llo dalo of llo baIanco slool. 15
Eurobond A bond issuod in a counlry difforonl from llo ono in vloso curroncy llo
bond is donominalod, for oxampIo, a bond issuod in Iuropo or Asia by an Amorican
company llal pays inlorosl and principaI lo llo Iondor in U.S. doIIars. 136
ex-dividend date Tlo dalo upon vlicl slocI broIorago companios lavo uniformIy
docidod lo lorminalo llo rigll of ovnorslip lo llo dividond, vlicl is lvo days prior
lo llo dalo of rocord. 117
expectations theory Tlo concopl llal, no mallor vlal llo docision aroa, lov llo
marIol prico rosponds lo managomonl's aclions is nol dolorminod onliroIy by llo
aclion ilsoIf, il is aIso affoclod by invoslors' oxpoclalions aboul llo uIlimalo docision lo
bo mado by managomonl. 112
expected rate o! return (1) Tlo discounl ralo llal oqualos llo prosonl vaIuo of
llo fuluro casl fIovs (inlorosl and malurily vaIuo) vill llo curronl marIol prico
of a bond. Il is llo ralo of rolurn an invoslor viII oarn if llo bond is loId lo malurily.
(2) Tlo ralo of rolurn llo invoslor oxpocls lo rocoivo on an invoslmonl by paying
llo oxisling marIol prico of llo socurily. (3) Tlo arillmolic moan or avorago of aII
possibIo oulcomos vloro lloso oulcomos aro voigllod by llo probabiIily llal oacl
viII occur. 148, 163
externaI !inancing needs (EfN) Il roprosonls a firm's oxlornaI financing noods going
boyond llo funds gonoralod inlornaIIy llrougl llo rolonlion of oarnings. 129
Glossary 281
CAßM ModuIe 700 Fihahce
!actor A firm llal, in acquiring llo rocoivabIos of ollor firms, boars llo risI of
coIIoclion and, for a foo, sorvicos llo accounls. 35
!actoring accounts receivabIe Tlo oulrigll saIo of a firm's accounls rocoivabIo
lo anollor parly (llo faclor) villoul rocourso. Tlo faclor, in lurn, boars llo risI
of coIIoclion. 35
!air vaIue Tlo prosonl vaIuo of an assol's oxpoclod fuluro casl fIovs. 141
!ieId varehouse-!inancing agreement A socurily agroomonl in vlicl invonlorios
pIodgod as coIIaloraI aro plysicaIIy soparalod from llo firm's ollor invonlorios and
pIacod undor llo conlroI of a llird-parly fioId-varolousing firm. 36
!inanciaI assets CIaims for fuluro paymonl by ono oconomic unil upon
anollor. 203
!inanciaI Ieverage Tlo uso of socurilios boaring a fixod (Iimilod) ralo of rolurn lo
financo a porlion of a firm's assols. IinanciaI Iovorago can ariso from llo uso of oillor
dobl or proforrod slocI financing. Tlo uso of financiaI Iovorago oxposos llo firm lo
financiaI risI. 83
!inanciaI markets Inslilulions and procoduros llal faciIilalo lransaclions in aII lypos
of financiaI cIaims (socurilios). 202
!inanciaI poIicy Tlo firm's poIicios rogarding llo sourcos of financing il pIans lo uso
and llo parlicuIar mix (proporlions) in vlicl lloy viII bo usod. 65
!inanciaI risk Tlo addod variabiIily in oarnings avaiIabIo lo a firm's common
slaroloIdors and llo addod clanco of insoIvoncy causod by llo uso of socurilios
boaring a Iimilod ralo of rolurn in llo firm's financiaI slrucluro. Tlo uso of financiaI
Iovorago givos riso lo financiaI risI. 83
!inanciaI structure Tlo mix of aII funds sourcos llal appoars on llo rigll-land sido
of llo baIanco slool. 98
!inancing cash !Iovs Tloy roprosonl casl fIovs bolvoon invoslors and a firm and
aro caIcuIalod as a clango in Iong-lorm dobl pIus clango in common slocI minus
inlorosl and dividond paymonls. 21
!inancing costs Cosl incurrod by a company llal oflon incIudo inlorosl oxponsos and
proforrod dividonds. 12
!inished-goods inventory Goods on vlicl llo produclion las boon compIolod bul
llal aro nol yol soId. 58
!ixed assets Tloy roprosonl Iong-lorm assols, incIuding maclinory and oquipmonl,
buiIdings, and Iand. 15
!ixed costs Cosls llal do nol vary in lolaI doIIar amounl as saIos voIumo or quanlily
of oulpul clangos. AIso caIIod indirocl cosls. 83
!Ioat Tlo Iongll of limo from vlon a clocI is vrillon unliI llo acluaI rocipionl can
drav upon or uso llo ¨good funds.¨ 41
!Ioating Iien agreement An agroomonl, gonoraIIy associalod vill a Ioan, vloroby
llo borrovor givos llo Iondor a Iion againsl aII ils invonlory. 36
!Iotation costs Tlo lransaclion cosl incurrod vlon a firm raisos funds by issuing a
parlicuIar lypo of socurily. 65, 213
!ree cash !Iovs Tloy roprosonl an amounl of romaining casl fIovs llal aro froo lo
bo dislribulod lo a firm's crodilors and slaroloIdors. Tloy aro caIcuIalod as aflor-lax
casl fIovs from oporalions minus clango in nol vorIing capilaI and minus clango in
gross fixod assols (Iong-lorm assols). 19, 162
geographic roII-up Slralogy vloroby a firm acquiros many ollor firms in llo samo
induslry sogmonl bul in difforonl goograplic aronas in an allompl lo croalo significanl
scaIo and scopo advanlagos. 264
gross pro!it Il is saIos or rovonuo minus llo cosl of goods soId. 12
Glossary 282
CAßM ModuIe 700 Fihahce
hedging principIe A vorIing-capilaI managomonl poIicy vlicl slalos llal llo casl
fIov÷gonoraling claraclorislics of a firm's invoslmonls slouId bo malclod vill llo
casl fIov roquiromonls of llo firm's sourcos of financing. Vory simpIy, slorl-Iivod
assols slouId bo financod vill slorl-lorm sourcos of financing vliIo Iong-Iivod assols
slouId bo financod vill Iong-lorm sourcos of financing. 26
high-yieId bond  junk bnnd. 137
hubris Ixaggoralod soIf-confidonco llal can rosuIl in managors' ovoroslimaling llo
vaIuo of a polonliaI acquisilion, laving unroaIislic assumplions aboul llo abiIily lo
croalo synorgios, and a viIIingnoss lo pay loo mucl for a lransaclion. 259
income statement A basic accounling slalomonl llal moasuros llo rosuIls of a firm's
oporalions ovor a spocifiod poriod, commonIy ono yoar. AIso Inovn as llo profil and
Ioss slalomonl. Tlo bollom Iino of llo incomo slalomonl slovs llo firm's profil or Ioss
for llo poriod. 12
increasing-stream hypothesis o! dividend poIicy Tlo lypollosis llal dividond
slabiIily is ossonliaIIy a smoolling of llo dividond slroam lo minimizo llo offocl of
ollor lypos of company rovorsaIs. Tlus, corporalo managors maIo ovory offorl lo
avoid a dividond cul, allompling insload lo dovoIop a graduaIIy incroasing dividond
sorios ovor llo Iong-lorm fuluro. 116
incrementaI a!ter-tax !ree cash !Iovs Tloy roprosonl addilionaI froo casl fIovs
llal a company can rocoivo if il invosls in a nov projocl. 182
incrementaI cash !Iov Tlo casl fIovs llal rosuIl from llo accoplanco of a capilaI-
budgoling projocl. 5
indenture Tlo IogaI agroomonl bolvoon a firm issuing bonds and llo bond
lrusloo vlo roprosonls llo bondloIdors, providing llo spocific lorms of llo Iong
agroomonl. 139
indirect costs  Iixed cnsts. 83
indirect securities Tlo uniquo financiaI cIaims issuod by financiaI inlormodiarios.
MuluaI fund slaros aro an oxampIo. 204
in!ormation asymmetry Tlo difforonco in accossibiIily lo informalion bolvoon
managors and invoslors, vlicl may rosuIl in a Iovor slocI prico llan vouId bo lruo in
condilions of corlainly. 111
initiaI outIay Tlo immodialo casl oulfIov nocossary lo purclaso an assol and pul il
in oporaling ordor. 184
insoIvency Tlo inabiIily lo mool inlorosl paymonls or lo ropay dobl al malurily. 40
interest rate risk (1) Tlo variabiIily in a bond's vaIuo (risI) causod by clanging
inlorosl. (2) Tlo uncorlainly llal onvoIops llo oxpoclod rolurns from a socurily causod
by clangos in inlorosl ralos. Irico clangos inducod by inlorosl ralo clangos aro groalor
for Iong-lorm llan for slorl-lorm financiaI inslrumonls. 151
internaI grovth A firm's grovll ralo in oarnings rosuIling from roinvosling
company profils rallor llan dislribuling llo oarnings in llo form of dividonds. Tlo
grovll ralo is a funclion of llo amounl rolainod and llo rolurn oarnod on llo rolainod
funds. 160
internaI rate o! return (Ißß) A capilaI-budgoling loclniquo llal rofIocls llo ralo of
rolurn a projocl oarns. MallomalicaIIy, il is llo discounl ralo llal oqualos llo prosonl
vaIuo of llo infIovs vill llo prosonl vaIuo of llo oulfIovs. 172
intrinsic or economic vaIue Tlo prosonl vaIuo of an assol's oxpoclod fuluro casl
fIovs. Tlis vaIuo is llo amounl llo invoslor considors lo bo fair vaIuo, givon llo
amounl, liming, and risIinoss of fuluro casl fIovs. 141
intrinsic vaIue Irosonl vaIuo of a company's fuluro casl fIovs from oxisling assols
and businossos. 267
Glossary 283
CAßM ModuIe 700 Fihahce
inventory Il consisls of rav maloriaIs, vorI-in-procoss, and finislod goods loId by a
firm for ovonluaI saIo, roprosonling an assol of a firm. 14
inventory Ioans Ioans socurod by invonlorios. IxampIos incIudo fIoaling or bIanIol
Iion agroomonls, clalloI morlgago agroomonls, fioId-varolouso rocoipl Ioans, and
lorminaI-varolouso rocoipl Ioans. 36
inventory management Tlo conlroI of assols usod in llo produclion procoss or
producod lo bo soId in llo normaI courso of llo firm's oporalions. 57
investment banker A financiaI spociaIisl vlo undorvrilos and dislribulos nov
socurilios and advisos corporalo cIionls aboul raising nov funds. 209
investor's required rate o! return Tlo minimum ralo of rolurn nocossary lo allracl
an invoslor lo purclaso or loId a socurily. Il is aIso llo discounl ralo llal oqualos llo
prosonl vaIuo of llo casl fIovs vill llo vaIuo of llo socurily. 65
junk bond Any bond ralod BB or boIov. 137
just-in-time inventory controI system A produclion and managomonl syslom in
vlicl invonlory is cul dovn lo a minimum llrougl adjuslmonls lo llo limo and
plysicaI dislanco bolvoon llo various produclion oporalions. Undor llis syslom llo
firm Ioops a minimum IovoI of invonlory on land, roIying upon suppIiors lo furnisl
parls ¨jusl in limo¨ for llom lo bo assombIod. 63
Iimited IiabiIity A proloclivo provision vloroby llo invoslor is nol IiabIo for moro
llan llo amounl invoslod in llo firm. 158
Iine o! credit GonoraIIy an informaI agroomonl or undorslanding bolvoon a
borrovor and a banI as lo llo maximum amounl of crodil llo banI viII provido llo
borrovor al any ono limo. Undor llis lypo of agroomonl lloro is no ¨IogaI¨
commilmonl on llo parl of llo banI lo provido llo slalod crodil. Comparo revnIving
credit agreement. 31
Iiquidation vaIue Tlo doIIar sum llal couId bo roaIizod if an assol voro soId
indopondonlIy of llo going concorn. 141
Iong-term debt Il roprosonls Ioans from banIs or ollor sourcos llal Iond monoy lo a
firm for Iongor llan 12 monlls. 16
majority voting Voling in vlicl oacl slaro of slocI aIIovs llo slaroloIdor ono
volo, and oacl posilion on llo board of diroclors is volod on soparaloIy. As a rosuIl, a
majorily of slaros las llo povor lo oIocl llo onliro board of diroclors. 158
manageriaIism Tondoncy of managors lo maIo docisions basod on porsonaI soIf-
inlorosl rallor llan llo bosl inlorosls of slaroloIdors. 258
market vaIue Tlo vaIuo obsorvod in llo marIolpIaco, vloro buyors and soIIors
nogolialo a muluaIIy accoplabIo prico for llo assol. 141, 267
market vaIue added (MVA) Il roprosonls llo difforonco in llo curronl marIol vaIuo
of a firm and llo sum of aII llo funds llal aro invoslod in llo firm. MVA is caIcuIalod
as lolaI marIol vaIuo of a firm minus invoslod capilaI. 77
maturity Tlo Iongll of limo unliI llo bond issuor rolurns llo par vaIuo lo llo
bondloIdor and lorminalos llo bond. 138
merger ConsoIidalion or combinalion of lvo or moro firms. 258
money market AII inslilulions and procoduros llal faciIilalo lransaclions in slorl-
lorm inslrumonls issuod by borrovors vill vory ligl crodil ralings. 207
mortgage bond A bond socurod by a Iion on roaI proporly. 136
mutuaIIy excIusive projects A sol of projocls llal porform ossonliaIIy llo samo lasI,
so llal accoplanco of ono viII nocossariIy moan rojoclion of llo ollors. 179
Glossary 284
CAßM ModuIe 700 Fihahce
net income A figuro roprosonling a firm's profil or Ioss for llo poriod. Il aIso
roprosonls llo oarnings avaiIabIo lo llo firm's common  proforrod
slocIloIdors. 13
net income avaiIabIe to ovners Il is nol incomo llal couId bo roinvoslod in a firm
or dislribulod lo ils ovnors. 13
net present vaIue (NPV) A capilaI-budgoling concopl dofinod as llo prosonl vaIuo
of llo projocl's annuaI nol casl fIovs aflor lax Ioss llo projocl's iniliaI oulIay. 169
net present vaIue pro!iIe Il slovs llo roIalionslip bolvoon llo inlornaI ralo of
rolurn (IRR) and llo nol prosonl vaIuo (NIV) of an invoslmonl projocl llrougl a grapl
indicaling lov a projocl's NIV clangos as llo discounl ralo clangos. Tlo IRR is llo
discounl ralo al vlicl llo NIV is zoro. 176
net vorking capitaI Tlo difforonco bolvoon llo firm's curronl assols and ils curronl
IiabiIilios. 18
operating expenses Tloy consisl of marIoling and soIIing oxponsos, gonoraI and
adminislralivo oxponsos, and doprocialion oxponsos. 12
operating income  earnings beInre interest and taxes (EBIT). 12
operating Ieverage Tlo incurring of fixod oporaling cosls in a firm's incomo
slroam. 83
opportunity cost o! !unds Tlo noxl-bosl ralo of rolurn avaiIabIo lo llo invoslor for a
givon IovoI of risI. 142, 206
optimaI capitaI structure Tlo capilaI slrucluro llal minimizos llo firm's composilo
cosl of capilaI (maximizos llo common slocI prico) for raising a givon amounl of
funds. 98
order point probIem Dolormining lov Iov invonlory slouId bo dopIolod boforo il
is roordorod. 62
order quantity probIem Dolormining llo oplimaI ordor sizo for an invonlory ilom
givon ils usago, carrying cosls, and ordoring cosls. 59
organized security exchanges IormaI organizalions invoIvod in llo lrading of
socurilios. Sucl oxclangos aro langibIo onlilios llal conducl auclion marIols in Iislod
socurilios. 207
over-the-counter markets AII socurily marIols oxcopl llo organizod oxclangos. Tlo
monoy marIol is an ovor-llo-counlor marIol. Mosl corporalo bonds aIso aro lradod in
llis marIol. 207
par vaIue On llo faco of a bond, llo slalod amounl llal llo firm is lo ropay upon llo
malurily dalo. 138
payabIe-through dra!t (PTD) A IogaI inslrumonl llal las llo plysicaI appoaranco of
an ordinary clocI bul is nol dravn on a banI. A payabIo-llrougl drafl is dravn on
and paid by llo issuing firm. Tlo banI sorvos as a coIIoclion poinl and passos llo drafl
on lo llo firm. 47
payback period A capilaI-budgoling crilorion dofinod as llo numbor of yoars
roquirod lo rocovor llo iniliaI casl invoslmonl. 167
payment date Tlo dalo on vlicl llo company maiIs a dividond clocI lo oacl
invoslor of rocord. 117
percent o! saIes method A mollod of financiaI forocasling llal invoIvos oslimaling
llo IovoI of an oxponso, assol, or IiabiIily for a fuluro poriod as a porconl of llo saIos
forocasl. 124
Glossary 285
CAßM ModuIe 700 Fihahce
per!ect capitaI market An assumplion llal aIIovs ono lo sludy llo offocl of
dividond docisions in isoIalion. Il assumos llal (1) invoslors can buy and soII
slocIs villoul incurring any lransaclion cosls, sucl as broIorago commissions,
(2) companios can issuo slocIs villoul any cosl of doing so, (3) lloro aro no corporalo
or porsonaI laxos, (4) compIolo informalion aboul llo firm is roadiIy avaiIabIo, (5) lloro
aro no confIicls of inlorosl bolvoon managomonl and slocIloIdors, and (6) financiaI
dislross and banIruplcy cosls aro nonoxislonl. 107
permanent investment An invoslmonl llal llo firm oxpocls lo loId Iongor llan
ono yoar. Tlo firm maIos pormanonl invoslmonls in fixod and curronl assols. Comparo
temµnrarv investments. 26
pIedging accounts receivabIe A Ioan llo firm oblains from a commorciaI banI or a
financo company using ils accounls rocoivabIo as coIIaloraI. 34
pIovback ratio Tlo fraclion of oarnings llal aro roinvoslod, or pIovod bacI, inlo llo
firm. 129
preemptive right Tlo rigll onlilIing llo common slaroloIdor lo mainlain lis or lor
proporlionalo slaro of ovnorslip in llo firm. 158
pre!erred stock A lybrid socurily vill claraclorislics of boll common slocI and
bonds. Il is simiIar lo common slocI in llal il las no fixod malurily dalo, llo
nonpaymonl of dividonds doos nol bring on banIruplcy, and dividonds aro nol
doduclibIo for lax purposos. Il is simiIar lo bonds in llal dividonds aro Iimilod in
amounl. 153
pre!erred stockhoIders Tloy rocoivo a dividond llal is fixod in amounl. Tloy aro
paid aflor llo crodilors bul boforo llo common slocIloIdors. 16
premium bond A bond llal is soIIing abovo ils par vaIuo. 152
primary markets Transaclions in socurilios offorod for llo firsl limo lo polonliaI
invoslors. 206
principIe o! seI!-Iiquidating debt  hedging µrinciµIe. 26
private pIacement A socurily offoring Iimilod lo a smaII numbor of polonliaI
invoslors. 206
priviIeged subscription Tlo procoss of marIoling a nov socurily issuo lo a soIocl
group of invoslors. 211
pro!it and Ioss statement Il indicalos llo amounl of profils and Iossos gonoralod by
a firm ovor a givon limo poriod, oflon a yoar, quarlor, or monll. Il is aIso caIIod an
incomo slalomonl and caIcuIalod as saIos or rovonuos minus oxponsos. 12
pro!it margins IinanciaI ralios (somolimos simpIy roforrod lo as margins) llal
rofIocl llo IovoI of firm profils roIalivo lo saIos. IxampIos incIudo llo gross profil
margin (gross profil dividod by saIos), oporaling profil margin (oporaling oarnings
dividod by saIos), and llo nol profil margin (nol profil dividod by saIos). 14
pro!itabiIity index (PI) A capilaI-budgoling crilorion dofinod as llo ralio of llo
prosonl vaIuo of llo fuluro nol casl fIovs lo llo iniliaI oulIay. AIso caIIod beneIit-cnst
ratin. 171
project standing aIone risk Il roprosonls an invoslmonl projocl's risI ignoring llo
facl llal mucl of llis risI viII bo divorsifiod avay as llo projocl is combinod vill a
firm's ollor projocls and assols. 191
protective provisions Irovisions for proforrod slocI incIudod in lorms of llo issuo
lo prolocl llo invoslor's inlorosl. Ior inslanco, provisions gonoraIIy aIIov for voling
in llo ovonl of nonpaymonl of dividonds, or lloy roslricl llo paymonl of common
slocI dividonds if sinIing-fund paymonls aro nol mol or if llo firm is in financiaI
difficuIly. 154
proxy A moans of voling in vlicl a dosignalod parly is providod vill llo
lomporary povor of allornoy lo volo for llo signoo al llo corporalion's annuaI
mooling. 158
proxy !ight A ballIo bolvoon rivaI groups for proxy volos in ordor lo conlroI llo
docisions mado in a slocIloIdors' mooling. 158
Glossary 286
CAßM ModuIe 700 Fihahce
pubIic o!!ering A socurily offoring vloro aII invoslors lavo llo opporlunily lo
acquiro a porlion of llo financiaI cIaims boing soId. 206
purchase price IinaI prico acluaIIy paid lo llo largol firm's slaroloIdors of an
acquirod company. 267
pure pIay method A mollod of oslimaling a projocl's bola llal invoIvos IooIing for
a pubIicIy lradod firm on llo oulsido llal IooIs IiIo llo projocl and using llal oulsido
firm's roquirod ralo of rolurn lo judgo llo projocl. 196
rav-materiaIs inventory Tlo basic maloriaIs purclasod from ollor firms lo bo usod
in llo firm's produclion oporalions. 58
reaI assets TangibIo assols IiIo lousos, oquipmonl, and invonlorios, roaI assols aro
dislinguislod from financiaI assols. 203
redeemabIe bonds Bonds musl lavo a rodoomabIo or caIIabIo provision so a firm
can pay off llo curronl bonds issuod al a liglor inlorosl ralo oarIy and llon issuo nov
bonds al a Iovor inlorosl ralo. 139
remote disbursing A casl managomonl sorvico spocificaIIy dosignod lo oxlond
disbursing fIoal. 47
required per!ormance improvements Tlo incroasos in combinod casl fIov of llo
acquiror and largol llal aro nocossary lo juslify llo acquisilion promium. 268
residuaI dividend theory A lloory llal a company's dividond paymonl slouId
oquaI llo casl Iofl aflor financing aII llo invoslmonls llal lavo posilivo nol prosonl
vaIuos. 110
retained earnings CumuIalivo profils rolainod in a businoss up lo llo dalo of llo
baIanco slool. 16
revoIving credit agreement An undorslanding bolvoon llo borrovor and llo banI
as lo llo amounl of crodil llo banI viII bo IogaIIy obIigalod lo provido llo borrovor.
Comparo Iine nI credit. 31
right A corlificalo issuod lo common slocIloIdors giving llom an oplion lo purclaso
a slalod numbor of nov slaros al a spocifiod prico during a 2- lo 10-vooI poriod. 158
risk IolonliaI variabiIily in fuluro casl fIovs. Tlo IiIoIy variabiIily associalod vill
rovonuo or incomo slroams. Tlis concopl las boon moasurod oporalionaIIy as llo
slandard dovialion or bola. 82
risk-adjusted discount rate A mollod for incorporaling a projocl's IovoI of risI inlo
llo capilaI-budgoling procoss, in vlicl llo discounl ralo is adjuslod upvard lo
componsalo for liglor-llan-normaI risI or dovnvard lo componsalo for Iovor-llan-
normaI risI. 193
sa!ety stock Invonlory loId lo accommodalo any unusuaIIy Iargo and unoxpoclod
usago during doIivory limo. 61
scenario anaIysis SimuIalion anaIysis llal focusos on an oxaminalion of llo rango
of possibIo oulcomos. 197
secondary market Transaclions in curronlIy oulslanding socurilios. Tlis is
dislinguislod from llo nov issuos or primary marIol. 204
secured Ioans Sourcos of crodil llal roquiro socurily in llo form of pIodgod assols. In
llo ovonl llo borrovor dofauIls in paymonl of principaI or inlorosl, llo Iondor can
soizo llo pIodgod assols and soII llom lo sollIo llo dobl. 29
sensitivity anaIysis Tlo procoss of dolormining lov llo dislribulion of possibIo nol
prosonl vaIuos or inlornaI ralos of rolurn for a parlicuIar projocl is affoclod by a clango
in ono parlicuIar inpul variabIo. 199
seriaI acquirers Company llal ongagos in froquonl acquisilions. 273
sheI! o!!ering  sheII registratinn. 215
Glossary 287
CAßM ModuIe 700 Fihahce
sheI! registration A procoduro for issuing nov socurilios vloro llo firm oblains a
maslor rogislralion slalomonl approvod by llo SIC. 215
short-term notes Tloy roprosonl amounls borrovod from a banI or ollor Ionding
sourco llal aro duo and payabIo villin 12 monlls. 16
simuIation Tlo procoss of imilaling llo porformanco of an invoslmonl projocl
llrougl ropoalod ovaIualions, usuaIIy using a compulor. In llo gonoraI caso,
oxporimonlalion upon a mallomalicaI modoI llal las boon dosignod lo capluro llo
crilicaI roaIilios of llo docision-maIing silualion. 197
sinking-!und provision A proloclivo provision llal roquiros llo firm poriodicaIIy lo
sol asido an amounl of monoy for llo roliromonl of ils proforrod slocI. Tlis monoy is
llon usod lo purclaso llo proforrod slocI in llo opon marIol or llrougl llo uso of llo
caII provision, vliclovor mollod is cloapor. 155
smaII, reguIar dividend pIus a year-end extra A corporalo poIicy of paying a smaII
roguIar doIIar dividond pIus a yoar-ond oxlra dividond in prosporous yoars lo avoid
llo connolalion of a pormanonl dividond. 116
spontaneous !inancing Tlo lrado crodil and ollor accounls payabIo llal ariso
¨sponlanoousIy¨ in llo firm's day-lo-day oporalions. 125
stabIe doIIar dividend per share A dividond poIicy llal mainlains a roIalivoIy
slabIo doIIar dividond por slaro ovor limo. 115
stock dividend A dislribulion of slaros of up lo 25 porconl of llo numbor of slaros
curronlIy oulslanding, issuod on a pro rala basis lo llo curronl slocIloIdors. 118
stock repurchase Tlo ropurclaso of common slocI by llo issuing firm for any of a
varioly of roasons, rosuIling in roduclion of slaros oulslanding. AIso caIIod stnck
buvback. 120
stock spIit A slocI dividond oxcooding 25 porconl of llo numbor of slaros curronlIy
oulslanding. 118
subordinated debenture A dobonluro llal is subordinalod lo ollor dobonluros in
boing paid in caso of insoIvoncy. 136
sustainabIe rate o! grovth Tlo ralo al vlicl a firm's saIos can grov if il vanls lo
mainlain ils prosonl financiaI ralios and doos nol vanl lo rosorl lo llo saIo of nov
oquily slaros. 129
syndicate A group of invoslmonl banIors vlo conlracluaIIy assisl in llo buying and
soIIing of a nov socurily issuo. 210
systematic risk (1) Tlo porlion of varialions in invoslmonl rolurns llal cannol bo
oIiminalod llrougl invoslor divorsificalion. Tlis varialion rosuIls from faclors llal
affocl aII slocIs. AIso caIIod market risk or nnndiversiIiabIe risk. (2) Tlo risI of a
projocl from llo viovpoinl of a voII-divorsifiod slaroloIdor. Tlis moasuro laIos inlo
accounl llal somo of llo projocl's risI viII bo divorsifiod avay as llo projocl is
combinod vill llo firm's ollor projocls, and, in addilion, somo of llo romaining risI
viII bo divorsifiod avay by slaroloIdors as lloy combino llis slocI vill ollor slocIs
in lloir porlfoIios. 191
temporary investments A firm's invoslmonls in curronl assols llal viII bo
Iiquidalod and nol ropIacod villin a poriod of ono yoar or Ioss. IxampIos incIudo
soasonaI oxpansions in invonlorios and accounls rocoivabIo. Comparo µermanent
investments. 26
tender o!!er A formaI offor by llo company lo buy a spocifiod numbor of slaros al a
prodolorminod and slalod prico. Tlo londor prico is sol abovo llo curronl marIol prico
in ordor lo allracl soIIors. 122
Glossary 288
CAßM ModuIe 700 Fihahce
terminaI varehouse agreement A socurily agroomonl in vlicl llo invonlorios
pIodgod as coIIaloraI aro lransporlod lo a pubIic varolouso llal is plysicaIIy romovod
from llo borrovor's promisos. Tlis is llo safosl (llougl coslIy) form of financing
socurod by invonlory. 36
terms o! saIe Tlo crodil lorms idonlifying llo possibIo discounl for oarIy
paymonl. 55
totaI revenue TolaI saIos doIIars. 86
trade credit Crodil mado avaiIabIo by a firm's suppIiors in conjunclion vill
llo acquisilion of maloriaIs. Trado crodil appoars on llo baIanco slool as accounls
payabIo. 26
transaction Ioan A Ioan vloro llo procoods aro dosignalod for a spocific purposo÷
for oxampIo, a banI Ioan usod lo financo llo acquisilion of a pioco of oquipmonl. 32
treasury stock Il roprosonls a firm's slocI llal las boon ropurclasod by
llo firm. 16
undervriting Tlo purclaso and subsoquonl rosaIo of a nov socurily issuo. Tlo risI
of soIIing llo nov issuo al a salisfaclory (profilabIo) prico is assumod (undorvrillon)
by llo invoslmonl banIor. 210
unsecured Ioans AII sourcos of crodil llal lavo as lloir socurily onIy llo Iondor's
faill in llo borrovor's abiIily lo ropay llo funds vlon duo. 29
variabIe costs Cosls llal aro fixod por unil of oulpul bul vary in lolaI as oulpul
clangos. AIso caIIod direct cnsts. 84
voIume o! output A firm's IovoI of oporalions oxprossod oillor in saIos doIIars or as
unils of oulpul. 86
veighted average cost o! capitaI Il roprosonls a voigllod avorago of llo aflor-lax
cosls of oacl of llo sourcos of capilaI usod by a firm lo financo a projocl, vloro llo
voiglls rofIocl llo proporlion of lolaI financing raisod from oacl sourco. 65
vinner's curse Silualion in vlicl a vinning M&A biddor musl Iivo vill llo
consoquoncos of paying loo mucl for llo largol. 269
vork-in-process inventory IarliaIIy finislod goods roquiring addilionaI vorI
boforo lloy bocomo finislod goods. 58
yieId to maturity Tlo ralo of rolurn a bondloIdor viII rocoivo if llo bond is loId lo
malurily. (IquivaIonl lo llo oxpoclod ralo of rolurn.) 148
zero and very Iov coupon bond A bond issuod al a subslanliaI discounl from ils
$1,000 faco vaIuo and llal pays IillIo or no inlorosl. 137
zero baIance accounts (ZßAs) A casl managomonl looI llal pormils conlraIizod
conlroI ovor casl oulfIov vliIo mainlaining divisionaI disbursing aullorily.
Objoclivos aro (1) lo acliovo bollor conlroI ovor casl paymonls, (2) lo roduco oxcoss
casl baIancos loId in rogionaI banIs for disbursing purposos, and (3) lo incroaso
disbursing fIoal. 46
Glossary 289
CAßM ModuIe 700 Fihahce
NoIes 290
Nod 700.1
1. Soo, for oxampIo, Roborl S. IindycI and DanioI RubonfioId, Micrccccncmics,
6ll od. (Uppor SaddIo Rivor, NI: Ironlico HaII, 2005).
Nod 700.4
1. Ioln Maynard Koynos, 1|c Gcncrc| 1|ccru c| |mp|cumcni, |nicrcsi, cn! Mcncu
(Nov YorI: Harcourl Braco Iovanovicl, 1936).
Nod 700.13
1. ¨KorIorian IiIos Briofs in Iavsuil AIIoging Docoplion by DaimIor,¨ Wc|| Sircci
jcurnc|, Iuno 19, 2001, A4.
2. Soo R. I. Brunor, App|ic! Mcrvcrs cn! Ac¡uisiiicns (HoboIon, NI: Ioln WiIoy &
Sons, 2004).
3. I. Wrigll, M. KroII, and D. IIonIov, ¨Acquisilion Rolurns, Incroaso in Iirm Sizo,
and Cliof Ixoculivo Officor Componsalion: Tlo Modoraling RoIo of
Moniloring,¨ Acc!cmu c| Mcncvcmcni jcurnc| 45 (2002), 599÷608.
4. Y. Amilud and B. Iov, ¨RisI Roduclion as a ManagoriaI Molivo for
CongIomoralo Acquisilions,¨ 1|c 8c|| jcurnc| c| |ccncmics 12 (1983), 605÷617.
5. R. RoII, ¨Tlo Hubris Hypollosis of Corporalo TaIoovors,¨ jcurnc| c| 8usincss 59
(1986), 197÷216.
6. O. I. WiIIiamson, 1|c |ccncmic |nsiiiuiicns c| Ccpiic|ism (Nov YorI: Iroo Iross,
7. Adaplod from HambricI and IrodricIson, ¨Aro You Suro You Havo a Slralogy`¨
Acc!cmu c| Mcncvcmcni |xccuiitc 15:4 (2001), 48÷59.
8. I. HaunscliId, ¨Hov Mucl Is Tlal Company Worll`: InlororganizalionaI
RoIalionslips, Uncorlainly, and Acquisilion Iromiums,¨ A!minisirciitc Scicncc
Qucricr|u 39 (1994), 391÷411, W. G. Sandors, ¨BolavioraI Rosponsos of CIOs lo
SlocI Ovnorslip and SlocI Oplion Iay,¨ Acc!cmu c| Mcncvcmcni jcurnc| 44
(2001), 477÷492.
9. Iiguro is adaplod. Tlis lypoIogy vas dovoIopod by I. T. Bovor, ¨Nol AII M&As
Aro AIiIo÷and Tlal Mallors,¨ Hcrtcr! 8usincss Rcticu 79:3 (2001), 92÷101.
10. Bovor, ¨Nol AII M&As Aro AIiIo.¨
13. Brunnor, App|ic! Mcrvcrs cn! Ac¡uisiiicns, HasposIagl and Iomison, Mcncvinv
14. HasposIagl and Iomison, Mcncvinv Ac¡uisiiicns, 42.
15. HasposIagl and Iomison, Mcncvinv Ac¡uisiiicns.
16. HasposIagl and Iomison, Mcncvinv Ac¡uisiiicns.
17. Brunnor, App|ic! Mcrvcrs cn! Ac¡uisiiicns, 88.
18. S. I. Brovn and K. M. Iisonlardl, Ccmpciinv cn i|c |!vc. Sircicvu cs Siruciurc!
C|ccs (Boslon: Harvard Businoss SclooI Iross, 1998).
NoIes 291
CAßM ModuIe 700 Fihahce
11. M. I. Sirovor, 1|c Suncrvu 1rcp. Hcu Ccmpcnics Icsc ci i|c Ac¡uisiiicn Gcmc (Nov
YorI: Iroo Iross, 1997).
12. HasposIagl and Iomison, Mcncvinv Ac¡uisiiicns, D. B. Iomison and
S. B. SilIin, ¨Corporalo Acquisilions: A Irocoss Iorspoclivo,¨ Acc!cmu c|
Mcncvcmcni Rcticu 11:1 (1986), 145÷163.

  

    
    

 



   
                                                            

                                                                                                                                                       

 



                                                                          

  
     
                                                                                                      
 



  

   

 

                                      

  
                                                                    

 
                      
 

                                                                                                                                                                                                                                                                                                         .

                                                                                                                                                                                                                                                  .

                                                                                                                                                                                                    