THELEVERAGEFACTOR

:
HowtheInvestorCanProfitfromChangesinCorporate
Risk

ByJ.D.Ardell
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TABLEOFCONTENTS i

1.-Introduction:ATaleofTwoCompanies,orthree,orfour...1

SECTION1:THETHEORYOFCAPITALSTRUCTURE11

2.-Leverage11

BusinessRisk,12
FinancialRisk,13
Leverage:ADefinition,13
BasicRisksandProportions,14
BalancingLeverage,16
TheAnatomyofFinancialLeverage,17
TheAnatomyofOperatingleverage,20
TotalRisk,22
LeverageMeasurement,23
Theoryvs.Reality:FinancialLeverage,24
Theoryvs.Reality:OperatingLeverage,24
TheoryandReality:TotalLeverage,25
LeverageManagement,27
SourcesofVariation,28
ReturnonEquity,30,
TheForcesBehindLeverage,31
Appendix:Streamlining?,33

3.-CapitalStructure35

TheCostofCapital:MarketOrientationandPracticalApplication,36
TheAdvantagesofDebt,38
RiskandDebt,40
MathematicalOptimization:Theoryvs.Reality,43
TheModigliani-MillerPropositions,45
TheOptimizationProblem,46
TheProposedIdealanditsInherentProblems,48
CapitalStructureandtheCostofCapital,50
TheConceptofaWeightedAverageCostofCapital,53
EarningsandCapitalStructure,55
CapitalStructureLogic,56
ChangesinCapitalStructureandStockPrices,57
Four“Postulates”,59
ShareLimitations,60
AdaptedMeasurements,61
Explicitvs.ImplicitCosts,62
TABLEOFCONTENTS ii
ImplicitCostsofDebt,64
TheImplicitCostofEquity,64
TheMomentofTruth,66
Appendix:TheNetOperatingIncomeApproachtoStockValuation,68

4.-TheCostofDebt71

TheProblemofShort-termCredit,71
InterestExpenseInequalities,73
Risk,Return,andtheSignificanceofShort-termCredit,74
TheCorporateCostofDebt,76
TheNominalCostofDebtandtheCostofBankruptcy,78
TheCostofBankruptcy,80
TheProbabilityofDefault,80
CommercialRatingsSystems,82
TypesofBankruptcy,84
TheAmountofLoss,85
TheRoleofDebtinCapitalStructureOptimization,90
TheOptimalAmountofDebt,92
Long-termDebtandtheAmountofLoss,93
GraphicDepiction,93
Appendix:MakingSureThatWhatYouSeeisWhatYouGet,95

5.-TheCostofEquity99

Modifications,100
TheReinvestmentRateandOpportunityCosts,103
EvaluatingtheCostofEquity:Methodology,104
TheCAPMasaBuildingBlockforCapitalStructureAnalysis,110
AnEstimateofRiskandnotPrediction,117
AnomaliesPertainingtotheUseoftheCostofEquityinCapitalStructure,119
AdaptiveExpectationsversusRationalExpectations,120
TheDecompositionofBeta,122
BalancingLeverage,RiskandtheCAPM,127
BetaandLeverage,128
ASimpleEqualizer,129
ConcludingComments,131
Appendix:TheMathematicalRelationshipBetweenLeveredandUnleveredCompaniesin
TermsoftheCAPM,133

6.-TheCapitalDynamicandOtherTools138

ThePercentageTrap,138
TheWeightedAverageCostofCapital,139
TheTheoreticalShapeoftheWeightedAverageCostofCapitalCurve,141
TABLEOFCONTENTS iii
AccelerationRates,142
TheWACCandRisk,143
TheMechanicsoftheWACC:RiskAdjustment,143
CorporateMethod,144
RiskAdjustedMethod,145
TheMarginalCostofCapital,145
DecisionMakingandtheMarginalCostofCapital,147
EconomicProfit,EVA,andtheCapitalDynamic:UtilizingtheOpportunityCost,149
ElementsinanEVACalculation,150
TheCapitalDynamic,151
TheRelationshipbetweenEVAandtheCapitalDynamic,152
EconomicProfitandCorrelation,152
ManagementofEconomicProfit,154
ComponentMovementsoftheCapitalDynamic,157
TheComparativeCapitalDynamic,159
Appendix:TheEfficiencyofEVAversusROE,160
Appendix:TheCostofCapitalandWhatTheInvestorNeedstoKnow,161

7-FundamentalsandCapitalStructure168

DuPontAnalysis,170
ComparingROEComponents,175
ModifyingandEnhancingDuPontAnalysis,181
TheReturnonCapitalRatio,186

8.-CapitalStructureandtheBusinessCycle189

CommonElementsofBusinessCycles,189
TheYieldCurveandInterestRateBehavior,190
GraphsThatUnitetheTwoTheories,192
StrategicConsiderations,198
TheBusinessCycleandtheCostofEquity,200
TheCapitalAssetPricingModelandSensitivityAnalysis,202
CircumventingtheOptimalCapitalStructure,208
TheGameofCapitalStructure“Gothcha”,209
IdealizedTrends,210
SectorRotation,212
SectorLogic,213
IndustryResponsetotheBusinessCycle213
EconomicSignals,217

9.-OperatingRisk219

FixedCostsandEconomics,220
TheCaseofCompaqComputer,223
TABLEOFCONTENTS iv
TheNatureofCostsandMargins,224
FixedCostsandtheBreakevenpointforSales,227
CompaqComputer:TheRestoftheStory,229
OperatingLeverageandPrediction,231
CharacteristicsofOperatingLeverage,232
OperatingTrendsandReversals,235
TheQualityofanOperatingMargin,235
ARiskyProposition:ConfidenceIntervals,237
OperatingBeta,240
TheUnleveredBetaEquation,241
TheArdcoBarbellCompany:AnExampleofUnleveredBeta,241
“MomandPopStore”Betas:CompaniesWhoareNotontheMarket,244
OperationsResearchfortheInvestor,245
TwoMasters:FisherandBuffett,247
ABriefOperatingAnalysisofFed-ExandStaplesfortheYear2000,249
StaplesandFed-ExOperatingHistories:1994-1999
AnalysisandStatistics
TheConfidenceIntervalTool
OperatingMargin

10.-OperatingMomentum258

ReasonsforStudy,259
OperatingMomentumSensitivity,264
Regression,269
TheGeneralElectricSolution,271
ClassicalMicroeconomicsandOperatingMomentum,275

11.StrategicCapitalRequirements279

TheRealitiesofFunding,279
TheProperAmountofCapital,280
TheDebt/EquityTradeoffandEVA,282
EVA/CapitalDynamicBasedImprovement,285
IncrementalEquityImprovement,287
TheIrrationalityofRationingCapital,287
IncrementalDebt,288
DividendsandRetainedEarnings,288
CapitalFundingFromEVA:TwoMethods,288
Method1:SolvingfortheOptimalEquity
Method2:SolvingfortheOptimalNetIncome
DeterminingCapitalProportionsandRequirements,290
ProjectedAnalysis,291
FinancialEngineering:SettingCapitalRequirementsFromEVA,291
ConocoPhillips2005-2006:aRealWorldExample,291
TABLEOFCONTENTS v
Method1:CapitalProportionsfromOptimalEquity
Method2:CapitalProportionsfromOptimalNetIncome
FinancialEngineeringMethod
TheAdditionalFundsNeededEquation,296
TheModifiedAdditionalFundsNeededEquation,299
DegreeofAFNLogic,303
TheNeedforQualitativeAssessment,306
TheProblemwithOptimality,306
MergerMania,308
MergerGrowthIllusionandEVA,311

SECTION2:BUILDINGCAPITALSTRUCTUREMODELS315

12.-TheEconomicProfitLaboratory:ComputerApplications315

SetUp,315
SectionOne,315
SectionTwo,316
SampleData,318
SensitivityversusOptimization,319
ProvingtheCapitalDynamic/EVAHypothesis,320
SettingtheConstraints,320
TriggerPoints,321
SettingtheTriggerPointModule,322
TheEarningsSolution,323
OptimizationandCorrelation,324
RaisingCapitalEffectively,324
TheConnectionBetweenCapital,StockPrice,andEVA,326
SensitivityAnalysis:TheEffectofChangesinOperatingIncomeandCapital,327
EstablishingGuidelines,331
Appendix:SpreadsheetExamples,333

13.-TheMarginalBenefitsEquation:AnExperimentalModel335

TheModeledConcept,336
TheMarginalBenefitsEquation,336
DefaultProbabilityandBankruptcy,338
TheInterestBenefitsMechanism,339
CheckingResultsAgainstaViableStandard,340
DefaultMechanics,340
StrategicImplications:FinancialLeverage,341
StrategicImplications:OperatingRisk,343
SpreadsheetConstants,344
TABLEOFCONTENTS vi
SpreadsheetLogic,346
DynamicVariables,347
ModelSetUp,348
TheProcess:EntryVariables,349
TheProcess:OptimizingwithSolver,350
TheResults:ThreeExamples,350
EVADiscrepancies,354
Appendix:ListofFormulasandSpreadsheetConstruction,355

14.AnIntroductiontoResidualEconomicProfitTheory:Usinga
ConstantDividendDiscountModel359

AnIntroductiontoResidualEconomicProfitTheory,359
OpportunityCost,360
ValuationModels,361
DividendTheory,362
ResidualEconomicProfit,364
TheDividendTrap,365
ModelOptimization,366
ModelBackground,366
ModelSetUp,368
ModelAdaptations,369
TheCaseof:CanYouTopThis?,369
ComparingSpreadsheets,370
Appendix:ThreeSpreadsheets,373

SECTION3:REALWORLDCASES376

15.-AnalyticalTools:PracticalApplication376

TheTolerationofImprecision,376
ErringontheSideofConservatism,378
BriefMethodologiesforDeterminingtheCostofEquity,379
TheHurdleRate,382
TheEVA/CapitalDynamic,383
TheWeightedAverageCostofCapital,383
ComparingRisk:JustificationforTwoCostsofEquity,386
ChangesintheCAPM,386
TheComparativeCapitalDynamic,388
TheMarginalBenefitsEquation,388
LeverageStateAnalysis,391
The“LookAhead”Bias,395
MicroAnalysis:QuarterlyObservation,396
NaiveExtrapolation,397
EarningsPressure,399
TABLEOFCONTENTS vii
Appendix:DividendDiscountModels,402

16.-Kimberly-Clark-”TooMuchofaGoodThing”:Economic
ProfitandMarginalBenefitsAnalysis404

Underpinning1:PositionintheBusinessCycle,404
Underpinnings2,3and4:OpportunitiesforAnalysis,405
TheLeverageState,406
ChangesinEconomicProfit,411
TheExtremeConsensusMethod,411
EconomicProfit,416
TooMuchofaGoodThing,417
MarginalBenefitsAnalysis,418
BasicMethodology,419
TaxBenefitsforKimberly-Clark,420
AmountofLossforKimberly-Clark,420
TheProbabilityofDefault,421
TheCostofBankruptcy,422
MarginalBenefits,423
Confirmation,424
Altman’sZScore:BookValueVersion,424
Kimberly-Clark’sZScore,426
InvestmentConclusion,427
Appendix:ExtrapolatedRisk:When“Normal”isTooRisky,428

17.-“FullSteamAhead”:AnAnalysisofConocoPhillips,2002-
2006431

TheContext,431
TheDecision,434
PricePerformance,435
AnticipatingPerformance:LeverageStates,436
QuarterlyLeverageResults,438
InterpretingRegression,439
EstablishingaComparativeCostofEquity,441
ContrastingtheRequiredReturnwiththeExpectedReturn,445
TheEVA/CapitalDynamic,446
NaiveExtrapolation,448
TheMarginalBenefitsFunction,451
TheComparativeCapitalDynamic,434
EarningsPressure,456
Appendix:SelectedFinancialDataforConocoPhillips,2001–2006,459

TABLEOFCONTENTS viii
18.-MicrosoftVersusConocoPhillips:ComparingCompaniesin
DifferentIndustries460

ApplesandOranges:MicrosoftVersusConocoPhillips,461
CommonGround,463
AMarketDisconnectandEventualReconciliation,467
IndustryCompetition:ChevronandtheComparativeCapitalDynamic,469
PercentageofNewRetainedEarnings,473

SECTION4:CORRELATIONANDPROBABILITYSTUDIES-
475

19.-OperatingIncomeCorrelationStudies475

Name,Premise,DataPointsandStructure,476
Categories,477
CompaniesintheSample,479
FundamentalVariables,479
AllVariables,480
StatisticalResults,481
SpearmanRankCorrelations:NextYear’sMidrangeStockPrice,484
Interpretation,485
MethodologicalCriticism,488

20.-ChangesinCapitalStructureandTheirEffectonStockPrices
-491

TheValidityofLeverageFactors,491
ConnectingtheDots:EarningsandDividendGrowthandtheCostofEquity,492
EarningsAcceleration,493
StatisticalValidity,495
ABriefStudy,496
ThreeAssumptions,498
Expectations,499
InterpretationandResults,500
HypotheticalCausation,502
TheHazardsofPlayingDetective,503
TheArgumentforCapitalRationing,505
SpearmanRankCorrelationandIndividualInterpretation,510

21.-ProbabilityandCapitalStructure518

TABLEOFCONTENTS ix
TheEfficientMarketsHypothesis,519
Screens,519
TheReturnonCapital,520
LeverageStates,521
IndustryAverages:Lemmingsvs.Leaders,522
TheLeverageStateRatios,523
Combinations,524
TheMechanismofLeverageStates,525
MatchingtheLeverageStatetotheBusinessCycle,528
ProbabilityandDiversification,530
SalesandBeta,531
ProbabilityandAnticipation,532
PrincipleComponentsAnalysis,534
Staticvs.Forward-LookingRatios,536
TheQuickPayoff,540
BarrRosenbergandResponseCoefficients,541

22.-TechnicalAnalysisandCapitalStructure544

MajorForces,545
TheBaneofVolatility,547
Self-fulfillingProphecy,548
Ex-PostPerformance,549
StochasticConformance,552
CapitalStructuralism:Quasi-TechnicalAnalysis?,334
FightingWords:“TheEfficientMarketsHypothesis”,555
TheArtandScienceofForecasting,557
MovingAveragestoUseWisely,558
TheExponentialMovingAverage,559
BriefInterpretation,561
PrimaryTrendsandSecondaryTrends,561

23.-StatisticsPrimer563

TheMean,ModeandMedian,564
TheVarianceandAssortedAdaptations,566
TheStandardDeviation,567
TheCovariance,567
DownsideRisk,568
AnnualizedVolatility,569
EstimatedVolatility,570
SampleStandardDeviation,571
TheMean–Variance,571
TheCoefficientofVariation,572
WorstCaseScenarios,572
AccountingforAdditionalRisk:CombiningStandardDeviations,574
TABLEOFCONTENTS x
Prediction,576
ConfidenceIntervals,576
TheNormalDeviate,578
UpdatingtheMeanandStandardDeviation:MovingAverages,580
AccountingforSmallSampleSize:TheStudent“t”Distribution,581
Regression,582
RelationshipsinLinearRegression,584
TheCoefficientofDetermination,585
MakingPredictions,585
GrowthRates,586
GeometricApproximation,589
AccurateGrowthRatesfromLogarithms,588
SpearmanRankCorrelation:NonParametricStatistics,589
SampleSize,592

SELECTEDREFERENCES
1

1
“ATALEOFTWOCOMPANIES”-orthree,orfouror...
ThecomparisonbetweenWallStreetanda“jungle”wasnevervalid.Iflifeina
stateofnaturecanbedescribedas“nasty,brutishandshort”,nowhereistheDarwinian
conceptof“survivalofthefittest”championedmore.Whileconsumptionofsmallfishbya
largeroneseemsanappropriatemetaphor,itistriteandmyopicenoughtodivertour
attentionfromthetruth:theconceptsofmutualbenefitandsharedgainaremore
prominentthananyvestigesofunilateralconquest.
Infact,ifanyallegoryisespeciallyapplicabletocharacterizing“theStreet”,itisthe
BiblicalstoryofJonahandthewhale.Beliefinmiraclesnotwithstanding,“theBigFish”
swallowingasmallercreatureisonlypartofthestory.Jonahturnsthecrisisintoan
opportunity;heis“spat”outontoabeach,andbeginspreachingtothekingdomof
Nineveh,changingtheirmisbegottenways.
Likethewhale,thefinancialcommunitymustcontinuetogrowtoremain
competitive.However,likeJonah,thereislifeafterconsumption.Despiteitsreputation
fora“bottomline”mentality,WallStreetcreatesmutualbenefitsbysharingrisk.When
individualswithsimilartolerancesforriskpooltheirresources,thepotentialreturnrises,
orthechanceforanunacceptableoutcomedecreases,orboth;theembodimentofthis
conceptistheinherentlimitedliabilityofthecorporationitself.This“symbiosis”isthe
productnotofsomehierarchicalstructurethateliminatescompetition,butamathematical
processthatcombinesriskandreturninthemostefficientmannerpossible.
Thefollowingstoryrelatesascenariothatisquitecharacteristicofcompetition
betweenmoderncorporations.Onecompany’srisk-seekingmarketingstrategynarrows
itsfocustoapointwhereitscash-flowiscompromised.Anothercompanywhoserevenue
streamismorediversified,seeksriskinitsmanneroffunding,andendsupborrowing
2

moneytotakeoverthefirstcompany.Thistensionbetweentwotypesofrisk–onethat
affectsrevenuesandonethataffectsfunding–formsthecruxofallcapitalstructure
decisions.Leverageismerelythemeasuredmanipulationoftheserisks,whileanoptimal
capitalstructurepointstotheirsuccessfuluse.Ineffect,corporatesharepriceswill
maximizewhenthesetworisksareperfectlyreconciled.
Liketheproverbial“whale”,largercorporationscanswallow-upsmallerones
becausetheyhaveawiderarrayofoptionswhencombiningrisk.Lessriskintheirrevenue
streamallowsthemtotakemoreriskinotherareas–especiallyintheirsourcesoffunding.
Ontheotherhand,anymiscalculationineitherriskbyasmaller“Jonah–type”company
willhaveafar-reachingimpactbecauseoftherelativesizeofthefirm.Ultimately,larger,
“predator”companiescanexploitanimbalancebetweenrisksinsmallercompanies-
usuallyamatteroftiming.
CurtinMathesonScientificwasaqualitydistributorofscientificproductsforover
twenty-fiveyears.Afterthefamedstatistician,DrW.EdwardsDeming,reportedonthe
precisionqualitycontrolofJapanesefirms,CurtinMatheson’sexecutivesbecamedisciples
ofPhilipCrosby,oneoftheearlyandpremieradherentsoftheconceptofquality
leadership.
Aboomingmarketinhealthcareproductsinthemiddle1980sproducedhigh
profitsandsomepricingpower,andCurtinMathesonshifteditsfocusawayfrom
industriallaboratoryequipmentandtowardtheburgeoningdiagnostictestingfield.The
marketinginitiativewassteadfast:thefirmwouldattempttocarveoutanicheforitself
basedonahighlevelofserviceandfastidiousproductknowledge.Sellingtotherapidly
consolidatingHMOs(healthmaintenanceorganizations)wouldensurecosteffectiveness
andhighprofitability.
Bythetimearecessionhitintheearly1990’s,however,competitionhadalteredthe
healthcarelandscape.Ashifttohighervolumeandlowerpricesnecessitatedtheclosingof
distributioncentersandtheconsolidationofcustomerservice.Cut-backsbecameeven
3

morerampantwhenfearsofnationalizedhealthcaregrippedtheindustry.Pricecontrol
wouldreverttoagovernmententityandsalesrepswouldbecompetingforcontractsthat
wouldyieldalmostnothing.CurtinMathesonScientificbecamevulnerableintheonearea
onwhichtheyconcentrated-healthcare
Healthcareproductdistributionhastwocharacteristicsthatmakeitespecially
attractiveforacquisitionbylargerfirms.Althoughprofitmarginshadbeenshrinking,
significantcash-flowwaschanneledthroughveryhighrevenues;thepriceoftheinventory
wasbuffetedbytechnologicalscarcity-bloodanalyzersthatsoldfor$200,000,forexample.
Moreover,thedemandforhealthcareproductsissteadyenoughtocushionotherrisk
takingventures;eveninadownturn,revenuesarestable.
FisherScientificwasanoldnemesisofCurtinMatheson.WhenCurtinMatheson
beganconcentratingonthehealthcaremarket,Fishermovedintheoppositedirection,
focusingonspecialtychemicalsandindustrialproducts-amovethatlimitedtheir
exposuretoanindustrywithdecliningmargins.Bythemiddle1990s,Fisherspottedan
opportunity;theflounderingCurtinMathesonwasripeforatakeover.Fishergarnereda
loanfromaCanadianbankandpaidCurtinMatheson’sEnglishholdingcompany,
Fisons’,approximately350milliondollars.Managementbecamejitteryaboutlosingthe
companytheyhadsoadeptlybuilt,evenasatelltalesignquashedanyrumorsabout
maintainingtheCurtinMathesonScientific(“CMS”)brandintegrity:theFisherlogo
beganappearingoneveryproduct,fromsharpscontainerstobeakersandtesttubes.
FisherScientificInternationalwaslistedontheNewYorkStockExchange,butthey
werenota“big”playeronWallStreet.Theirstocksoldforaboutelevendollarsashare,
whichwasconsideredpaltryinthehyper-inflatedmarketofthelate90s;therewasnothing
“romantic”aboutspecialtychemicalsandanalystsmaintainedalowkeycoverageonthe
company.However,Fisherhadasolidreputationinthescientificcommunity.Infact,the
firmhadbeenaroundsincethelateindustrialrevolutionofthe1800’s,buildingprofitable
vendorrelationshipsthathadproducedalongtrackrecordofconsistentsales.
4

TheintegrationofCurtinMathesonintoFisherwentsmoothly.Asaninterested
participant,Icouldnothelpbutnoticesomeoddities.Althoughwelaughedathowrapidly
Fisherputtheirbrandnameon“our”products,thereseemedtobesomedisconnect
betweensalesandoperations.WhilethetwoentitieswerecloselyintegratedinCurtin
Matheson,emphasizinganemotional,“Japanese-like”commitmentandunitybetween
teammates,theFisherapproachwasveryclinical,likebrokeringacommodity,whichof
course,healthcareproductshadbecome.ThemainoperationscenterwasinPittsburgh,
butallexecutivedecisionswereconveyedfromasmalltownonthecoastofNew
Hampshire,calledHampton.Thedichotomiesposedmorequestionsthantheydid
answers.
Infact,FisherScientificwasrapidlybecomingastrategically-runfinancial
powerhousethatexpertlynegotiatedrisk.Bytheonsetofthenewmillennium,thefirm
wasextremelywell-diversified,carryingover250,000items.Fisherhaddivisionsinsafety,
healthcare,chemicals,electronicsandevenhadasupplycenterforradioactivematerialat
theLosAlamosnuclearfacilityinNewMexico.CurtinMathesonwasjustoneacquisition
thatfueledthisdiversification,albeitthelargestatthetime.Byhavingatleastonedivision
thatwouldreactfavorablytoachangingeconomyatanyonetime,theriskofFisher’s
cash-flowsweredecreased,anditsrevenuebasewasmaintained.Whilemosthigh-tech
companieswerestrugglingwithrevenuesofapproximately$250,000peremployeebythe
year2000,Fisherhadastreamofabout$340,000inafieldthatwasnotparticularlycapital
intensive-distribution.
Althoughrevenueswerehigh,Fishercouldnotgeneratethetypeofinternalfunding
thatsupportedbothexistingoperationsandaprogramofdiversifiedgrowth
simultaneously;marginswerejusttoolow.Thefundingforacquisitionscamefromdebt-
alotofit.Byearly2001,Fishercarriednegativeequity.Stockwasneverissuedfor
purchases,andretainedearningswereinsubstantial.Ontheotherhand,thevarious
5

integrationsofacquisitionswereexpensiveevenasFisher’slong-termdebttocapitalrate
approachedeighty-fivepercent.
Cash-flow,however,remainedveryhigh,evenduringtherecessionthatbeganin
2001.CreditorstookonelookatthesizeandvariationofFisher’srevenuestreamandgave
themthe“greenlight”.Thefirmrespondedbyrenewingloansatlowerinterestrates,
courtesyoftheFederalReserve.Equitywaskepttoaminimum.
Ultimately,whenacquisitionsbegantopayoff,thestocksoared,butitdidnotmove
onthebasisofsalesorprofits.Thestockbarelymovedatallinfact,exceptforasingle
situation:whenanynewsorrumorofanacquisitionoccurred,thestockwouldjumpoutof
itsusualstabledormancyandtakeofflikearocket.Sincesomesmallacquisitionoccurred
atleasttwiceayear,thestockwasagoodadditiontoanyportfolio;itsonlyvolatilitywas
selfgenerating.Inthemeantime,Fisherbegantoparedownitsdebtandissueequity,
causingthestocktosoarevenhigher.TheyboughtbiotechsuppliersinSwedenandtest
equipmentcompaniesintheUnitedStates.By2006,theyhadmergedwithThermo-
Electron,acompanythathadnolong-termdebtwhatsoever.Theyendedupcalling
themselves,“Thermo-FisherScientific”(TMO).Andinevitably,theyalsohadthelast
laugh-theyseemedpoisedtostartthewhole“process”overagain.
Inanutshell,thestoryofFisherScientificprovidesavaluablelessoninmanaging
capitalstructure.Fisherhadtwotypesofriskthatwereinpotentialconflict:businessrisk
sometimescalledeconomicriskor“operatingrisk”,andfinancialrisk.Businessriskisthe
variationinrevenue,costsandoperatingincomethatstemsfromthetypeofindustry;
someindustriesreacttoinflation,recessions,foreigncompetition,andothereconomic
factorsdifferentlythanothers.Ontheotherhand,financialriskisalmostentirelyself-
generated,andstemsfromthevariationinnetincomefromthedecisiontousedebt.In
essence,financialriskisexpressedasthepotentialfordefaultingoninterestpaymentsand
principal.Itworkstogetherwithbusinessriskthroughthevariabilityofoperatingincome;
6

anadequateandsteadyoperatingincomecankeepfinancialriskverylowbecausethereis
lessprobabilityofdefault.
FisherScientifictreateditsoperatingcash-flowslikeaportfolio,addingand
droppingproductlinesthatwouldmakeitlessrisky.Evenasmarginsdeclined,itsreturn
onequity(ROE)increasedbecauseitneverfundedwithitsownmoney.Byfinancingwith
debt,butsimultaneouslydecreasingtheriskofitsoperatingincome,Fisherconfiguredthe
risk-returntradeoffinitsfavor.Alternatively,thedecisionbyCurtinMathesontofocuson
healthcaretotheexclusionofotherdivisionsmadethecompanyatakeoverprospect.
Withfewbarriersofentry,theindustryinvitedintensecompetition;marginsdeclined,and
thecompanywasleftwithariskieranddepletedcash-flow.
CompanieslikeFisherScientificarequiteordinary.Theyneverhavethetypeof
sensationalresultsthatmakesthemthedarlingsofspeculators.Theyrarelymakethe
eveningnews.Andyet-herewasacompanywhosestockwassellingat$11asharein1997
onlytorisetoapeakof$77eightyearslater.Inthatperiod,itwasonlyabouthalfas
volatileastherestofthemarket.
Onemisconceptionthatstudentsandinvestorssharealikeisthatabusinessis
supposeto“maximize”profits:the“bottomline”mentalityisalmostanendemic
archetypeandyetrarelyoccursineconomicbehavior.ImagineacashflowforCompanyA
of60,70,65,90,and110.NowcompareittothecashflowofCompanyB:60,60,65,75,
and75.Whichwouldyouprefer?Mostpeoplewouldpickthefirstbecausethechanceof
gettingahighnumberisgreater.However,theflowfromCompanyBismuchsteadierand
byseveralmathematicalgaugesofriskhasabetterrisk-returncharacteristicthan
CompanyA’s.Infact,thedifferenceissmall,butmaybecompellingenoughforinvestors
tochooseCompanyBasaninvestment.WhiletheaverageinCompanyAismuchgreater
thanin“B”(79vs.67),theriskisfargreateralso.
Capitalstructuralismisnotaboutdirectlymaximizingprofitsthroughprograms
likeanewmarketingcampaignor“zerobasebudgeting”ortheimplementationofnew
7

technology;ittakesafarmoresubtleapproach.Itchoosesacourseofactionfromseveral
alternativesthatbalancestheriskofdifferenttypesoffundingwithreturnsthatexceed
theircost.Thus,thegoalofminimizingthecostofcapitalisimplementedthroughthe
capitalbudgetingprocess;thecostofthemixtureofdebttoequitywilldeterminethe
plausibilityofeachprojectbecauseofthenecessityofexceedingcapitaloutlayswith
returns.Theloweristhecostofcapital,thegreaterthenumberofprojectsthatwillbe
potentiallyprofitable.
Riskandreturnaresointertwinedthatitispropertorefertothemasastatistical
“distribution”withtwoparameters,ratherthanasseparatecategories.Asanexample,
consideranequityissue,themarketingofmoresharesofstocktoraiseadditionalfunds.
Thecharacteristicsofriskandreturnforsuchanissuearemuchdifferentatthebeginning
ofarecoverythanattheendofabullmarket-forboththeissuingcompanyandthe
investor.Althoughtheinvestorisnotencouragedto“time”investmentsovertheshort
term,someawarenessofthecorrelationbetweensectorperformanceandthebusinesscycle
isessential.Capitalstructureisdependentontherelationshipbetweeninterestratesand
theequitymarket,whicharedependentonthestateoftheeconomy.Therefore,timeisa
unifyingfactorbetweenriskandreturnandencouragestheirinterdependence.The
investorisleftinaprecariousposition.Ontheonehand,heorsheisencouragednotto
timethemarketbecauseitisnotsuccessfullydoneoveralongperiod.Ontheotherhand,
timeistheessentialcomponentinallrisk-returndistributions-frominvestmenthorizons
tothechoiceofwhichinvestmentstomake.Byidentifyingandinvestinginfirmswho
repeatedlymovetowardtheiroptimalcapitalstructures,capitalstructuralismresolves
someofthisconflict.
Whataboutvariation?Randomfluctuationisthebaneofanyanalyst.Nomatter
howpreciselyonemeasuresthedeviationsinpastperformance,currentandfuture
behaviorofaninvestmentseemstodefyformulation.WhileWallStreetprizescertainty,
long-termviabilityisnevercertain.Themarketkeepschangingandtheresponsetoworld
8

eventsisembeddedincorporategainsandlosses.Capitalstructuralismisflexibleenough
toencompasschangebecauseitneverdefinesoptimalityasarigidsetofconditions.Each
industryhasaparticularresponsetoeconomicfactorsthatproducesadifferentoptimum
levelofproportionaldebtandequity.Someindustrieshavebetterrisk-return
characteristicswithoutanydebtatall.Otherscancompetewithfirmsthathavetwoor
threetimesitsprofitmarginssimplybecausetheyknowhowtousedebtjudiciously.Since
capitalstructureisdependentonthebusinesscycle,itrespondstosocietaltrends,
demographicchangesandpoliticalrisksbetterthanthevarious“systems”thathavemade
theirwayintotheinvestmentliterature.Ineffect,capitalstructurereflectsthereasons
whyacertainentityisinbusinessinthefirstplace:togrowandmakeaprofit.
Ultimately,ouranalysisattemptstoputadollarpriceonrisk.Whilethemarket
respondstoinformationinstantaneously,weattempttomeasureitscontentbeforeit
becomesmeaningful.Wecandefinecostinthreedifferentways,allofwhichareusedto
evaluaterisk:
• 1)TheNominalCost-Thisisthe“upfront”,accountingcostofanactionwhichwillbe
reportedinfinancialstatements
• 2)The“Real”Cost-Thisisthecostofanactionwitheconomicconditionsfactoredin.
Ifmynetincomeis$100andtheinflationrateisfivepercent,thenmy“real”net
incomeisprobablyonly$95.IfIhavetax“lookbacks”of$20figuredintothat$100,
thenmyeffectivetaxratewasreducedandIwillhavetomakeamuchgreaternet
incomeinthenextyear.
• 3)TheRiskAdjustedCost-IfIkeepallofmymoneyinacheckingaccountwhenthe
marketisrisingbyfifteenpercentayear,Iwillbepenalizedfornotputtingmore
moneyintothemarket.Theriskadjustedcostisthecomparativecostoftakingone
actionoveranother,creatingeitheragain(opportunitygain)oraloss(opportunity
loss).Itismostrelatedtowhatcanbetermed,“thegoingmarketprice”.Incapital
structure,thisriskadjusted,“opportunitycost”ismoreimportantthananyother
9

becauseitlooksatanarrayofalternativesandchoosesacourseofactionthatattempts
tocreatethelargestpossibleopportunitygain.
Therefore,manyofthecostsweincurincapitalstructurearenotrepresentativeofa
physicalassetandpassedonfromapreviousowner,butaretheresultofachoiceofactions
withwhichwehavecomparativeinformation.
Theintegrativeapproachofthistextistopositiontheanalyst,theinvestorandthe
financialmanagerfromthesameviewpoint:heorshegaugestheriskofoperatingcash
flowsandbalancesthatobservationwiththechoiceofalternativesourcesofcapital,
repeatedlymakingcomparisonsbetweentheindustry,thesector,andthegreatereconomy.
Underthepremisethatcapitalstructureistheinterfacebetweencomparativeaccounting
andthemacroeconomy,thestudentreceivesanoverviewofcorporatefinancethroughthe
attemptedreconciliationofriskandreturn.Ineffect,thedifferencebetweenstudent,
investor,analystandmanageriscloudedbecauseeachperspectiveisdirectedbytheneed
toseekanddiscoveroptimality.
Thetextrequiressomefamiliaritywithstatisticsandcomputerspreadsheetsbutnot
anextensivebackgroundineither.Thereisachapterdedicatedtostatistics,andmost
spreadsheetshavestepbystepinstructions.Theflowofthetextisasfollows:
• 1.TheoreticalBackground:Capitalstructuretheoryisexaminedthroughprevious
researchwithanemphasisonintegratingtheevaluationofriskandreturn.
• 2.ModelBuilding:Amathematicalconceptionofcapitalstructureisbuiltthrough
computermodelsandtheadaptationofexistingformulas.Eachofthespreadsheet
modelshasbeenusedtoevaluatecorporatebehavior.
• 3.CorrelationStudies:Examinationoftherelationshipsbetweenstockpriceand
capitalstructurevariablesgivesinsightintothebehaviorofsomemajorcorporations.
Whilenodefinitiveconclusionsaredrawn,tendenciesthatsupportcapitalstructure
theoryareexaminedusingtheSpearmanrankcorrelation.
10

• 4.CaseStudies:ApplicationofcapitalstructureanalysistoKimberly-Clarkand
ConocoPhillips,aswellasMicrosoftandChevrondisplaytheeffectivenessofthe
techniques.
Oneofthegreatphilosophersoftheearlytwentiethcentury,WilliamJames,might
haveappreciatedthepersonalcomputerrevolution.Hewhochampioned“thecashvalue
ofideas”andthephilosophyofpragmatismmighthavefoundsolaceinamachinethat
testedtheviabilityoftheory.Whileweoftenlackthepoliticalframeworktoimplement
ideas,atleast“theinformationage”hasmadethemavailable,whichiscertainly“halfthe
battle”.
Forstudents,theauthorhopesthatthisbookwillunifyfinancialthoughtintoa
comprehensible“whole”andencouragetheactualizationof“justtheory”.Forinvestors,
theauthorhopesthatthisbookwillhelpthemseebeyondthesuperficialityofconventional
wisdomwiththeknowledgethatthecashvalueofanyideaisalmostalwaysfoundinits
underlyingstructure.Finally,fortheexecutive,theimperativeisplacedoninnovative
thinking:atime-testedsolutionistheoutgrowthofanewperspective.
(BacktoTableofContents)
11

SECTIONI:THETHEORYOFCAPITALSTRUCTURE
2
LEVERAGE
Inafundamentalsbased“bottomup”analysissystem,theincreaseandacceleration
ofsalesisparamount.Theaxiom,“nothinginbusinesshappenswithoutasale”appears
selfevident.However,capitalstructuralismoftenseemstodenytheneedforgreater
returnsbyfocusingonrisk,eventotheexclusionoflarge,unevenstreamsofincomethat
mightupset“corporateequilibrium”.Thisfrictionbetweenmarketingstrategyand
absoluteriskisreconciledbyastrongadherencetotheprinciplesofleverage.
Capitalstructureanalysisadjustsforboththeamountandvariabilityofsalesby
firstevaluatingoperatingincomeasafunctionofsales,andsecondly,bychoosingthe
amountoffundingfromseveralalternativesourcesbasedontheriskofthisevaluation.
Sinceitmakescomparativechoicesfromamacroeconomicperspective,capital
structuralismisa“topdownapproach”;businessriskandcreditavailabilityput
restrictionsonallavailablechoices.Forexample,achoicetoaddanewproductlinemay
notcometoimmediatefruitionforacompanywhopayshighinterestratesandhas
excessivedebtonitsbalancesheet.Whiletheideasthatgeneratehighreturnsoftencome
fromadetailedmarketingplanthatformsafoundationforthebusiness,therisksincurred
bytheplanareoftenimposedfromabove:governmentregulations,competitor’sactions,
andthefluctuationsinherentinatypicalbusinesscycle.Thegistofcapitalstructure
analysisistoresolvethisconflictbetweenwhatcanbeproducedandwhatwillbe
produced,byreconcilingriskwithreturn.Accordingly,thetoolstomanagethisresolution
areencompassedbytwodistinctmeasurements:operatingleverageandfinancialleverage.
12

BUSINESSRISK
Operatingleverageisonemeasureofbusinessriskalsoknownaseconomicrisk.As
anexample,considertheattributesoffarming.Tostayinbusiness,thefarmermustbe
concernedaboutthecostofseed,irrigation,storage,andtransportation.Demandforhis
orhercropisdependentonweather,foreigncompetitionandtheavailabilityofsubstitutes.
Thevariabilityofinputs(costs)andoutputs(demandandquantityproduced)form
economicrisk.Highfluctuationsindemandoftencauselargeswingsinthepricesthata
farmercancharge.Whensuppliers’pricesalsovary,thedoubleedgedswordcreatesan
environmentofhighbusinessriskWithoutanyideaofhowmuchtopayvendorsorhow
muchtochargecustomers,planningmustbetotallycontingentontheunexpected,an
immediatebarter-likenegotiationwhereuncertaintyprevails.Littlegrowthwilloccurin
suchanenvironmentbecausenoinvestorwantstocommitcapitalwithoutconfidenceina
minimumreturn.
Manyeconomistsbelievethatbusinessriskisareflectionoftheleveloftechnology
inanindustry.Becausefixedcostsmustbepaidregardlessofthelevelofdemand,higher
fixedcostsimplythatmorebusinessriskisincurred.Whencompetitivepressuredemands
thatspecificqualitystandardsaremet,thosestandardsareanoutgrowthofthelevelof
technologyrequiredbytheindustry.Fixedassetsthathavelongdepreciablelivesarevery
costly,butnecessarytomeetthesecompetitivepressures.Considerforamoment,the
shrinkwrappingonaCD.WouldacustomerbuyahandwrappedCDwhentheindustry
standardistowrapit“astightasadrum”?Moreover,addingfixedcoststoanyoperation
raisesthebreakevenpointforsales,evenwhenthetotalcostisthesame.Oncethe
percentageoffixedcostsisincreased,moresalesmustbegeneratedtocoverthem.
However,whenanoperationhasahigherproportionoffixedcosts,andsalesareadequate,
moreunitsofproductionwillbespreadamongthesameamountofcosts;theresultisa
higheroperatingprofit.Thissinglekernelofcorporaterisk,affectsallotherelementsin
13

thechain:demandschedules,variabilityofincome,theprobabilityofdefaultandthe
methodsandsourcesoffundingprojects.
FINANCIALRISK
Financialleverageisonemeasureoffinancialrisk,whichistheriskincurredbya
firmforitsdecisiontousedebtfinancing.Companiesfaceachoiceoffundingprojects
withequity(retainedearnings,commonstockandpreferredstock)ordebt(bonds,bank
loans,commercialpaper).Whendecidingtoincreasetheamountofdebt,thefirm
increasestherisktoexistingshareholdersbecauseearningsbecomepartiallychanneled
towardcreditorsintheformofinterestpayments,andawayfromthepotentialforhigher
dividends;thevariabilityofincomeisincreased.Inreturn,shareholdersreceivethe
possiblerewardofhigherearningsonapersharebasisbecausefewershareswillbe
outstandingwhendebtisusedinplaceofequity.Consequently,thefirmincreasesits
chanceofbankruptcywhenitincursmoredebt;itcandefaultoninterestpaymentsif
earningsarenothighenoughtocoverthem.Thisriskcanbedecomposedintotwobasic
elements:1.Theamountofpotentialloss-theclaimsthatcreditorshaveonafirm.2.
Theprobabilityofloss-acomplexinteractionbetweensales,earnings,andliabilitiesthat
determinessolvency.
LEVERAGE:ADEFINITION
Ifthechoicetotakeondebtsoundsdire,thestudent/investorwillturnthisdecision
intoaprofit-makingventurebydeterminingthecrucialdifferencebetweenstrategyand
obligation.Firmsthatareobligedtoincreasefinancialleverageinordertocushionpoor
demandhaveradicallydifferentcharacteristicsfromthosewhooptimizecapitalstructure.
Infact,manywell-runfirmslowertheiroverallriskbecauseofthechoicetousemoredebt;
theriskentailedbythecostofhigherinterestpaymentsismuchlessthantheprobabilityof
newcash-flow.Indeed,the“primerate”issetlowenoughtoattractthebestcustomers
withoutburdeningthemwithworriesofinsolvency.
14

Ifwethinkofleverageasaproportionoftwodifferentcomponentsofthesamerisk,
eachseekingtobalancetheother,wecanformageneraldefinition.Inphysics,asmall
forceappliedatonepointcanbalanceorcontrolamuchlargerforceatanotherpoint.A
child’ssee-sawistheclassicexampleofthisprinciple:whenafiftypoundchildbalancesa
twohundredpoundadultandthenjumpsoff,theadultdropswithathud.Ifweviewthe
smallerforce(thechild’sweight)asthedenominatorofaratio,andthelargerforceasthe
numerator,itissimpletoobservehowachangeinonecomponentaffectsthechangeinthe
other,dependingontheirrelativeamountofassociation.Inafinancialcontext,wespeak
of“leverage”whenasmalleramountofonevariablehasalargereffectontheother.In
mathematicalterms,weputthe“derivedcomponent”inthenumerator,andthe“source
component”inthedenominator,anddeterminethechangeinboth.Inourexample,the
child’sweightwasthesourcecomponent,whichhadanexaggeratedeffect(derived)onthe
adult’sweight.
Ineconomics,weusuallyviewleverageintermsofinputandoutput,butinfinance,
weaddtheelementofconnotativerisk:welookforotherassociationsthatthelevelof
leveragemayaffect.Forexample,ifwediscovera“new”laborsavingmethodinwhich
twopeoplecanaccomplishthesameamountofworkastwenty-two,themethod
undoubtedlyhasalotof“leverage.Ofcourse,leveragealmostalwaysexactsaninherent
“cost”andinourexample,thetwolaborerswouldatleasthaverisingexpectationsabout
wages,ifnotactualdemands.Secondly,sinceeachremainingpersonismoreresponsible
fortotalproduction,moreriskisinvolved;losingonepersonmaycutproductioninhalf.
Therefore,leveragealwaysimpliessomerisk-returntradeoff,whichneedstobeidentified.
Leveragecanonlybeincreasediftheriskshavebeenfullyvetted.
Whilethereareothermeasuresofriskbesidesleverage,fewdisplaytheintegration
ofriskandreturnbetterthanthebalancebetweenfinancialandoperatingleverages.In
fact,capitalstructuretheoryisfoundeduponthisintegration:behindeverystrategic
15

decision,thatchangesthepriceofastock,layssomethreadofleverage.Eachtimethat
capitalisallocatedforanygivenproject,ultimateprofitabilitydependsonleverage.
BASICRISKSANDPROPORTIONS
WallStreetdoesnotlikeuncertainty.Ifthereisonequalitytocultivateintheworld
offinanceitisconsistency;whenamarketiscoherent,thefinancialcommunitycanmake
plansaroundexpectationsandpredictions.Leverage,however,impliesvolatilityanditis
whentwodifferenttypesofvolatilityaremixedthatalevelofreturnisderived.Cash,for
examplehasalmostzerovolatility,andverylittlereturnwhenkeptinthatform.Atthe
otherextremearecertaincommoditiesthatcanskyrocketovernight,onlytoleaveafutures
ownerpoorerafewweeksout.Operatingleverageisconceptuallymeasuredas%∆
OperatingIncome/%∆Salesandimpliestheinherentvolatilityofachangeinsales
creatingachangeinEBIT(earningsbeforeinterestandtaxes).Whenoperatingleverageis
large,moreriskisincurred;thepossibilityofhighprofitsisgreaterinanupturnwhen
salesarelarge,butinadownturn,withlowerdemand,profitsarejeopardized.Lower
operatingleveragecreateslowervolatility,butalsolessprofitwhenapositiveshiftin
demandoccurs.
Thesamethemeofvariabilityappliestothefinancialleverageratio,whichis
theoreticallydefinedas,%∆NetIncome/%∆OperatingIncome(EBIT).The
student/investorwillnotethattheterm“debt”isnowheretobefoundintheratio,butthat
interestpayments,aswellasanytaxadvantagessuchpaymentsentail,areimplicitwhen
operatingincomebecomesnetincome.Again,thederivedcomponent(netincome)is
affectedbyachangeinthesourcecomponent(operatingincome).Bothtaxesandinterest
paymentsmustbedeductedfromEBITbeforeitistermed“earnings”,anditisthe
magnitudeofthesedeductionsthatwillcausevariability.
Areferencethatconfusesbothinvestorsandstudentsalikeisthatsomeacademic
literaturedesignatesseveraldifferentratiosbytheterm,“financialleverage”.Among
thoseproportionsare:Assets/Equity,Long-termdebttocapitalandEBT/EBITwhichis
16

earningsbeforetaxesdividedbyearningsbeforeinterestandtaxes,andisanintegralpart
ofanycapitalstructureanalysissystem.Thecommonpointineachoftheseratiosisthat
theyrepresentsomeformofdebtfinancing,althoughsomespecificallymeasureinterest
expenseandothersmeasureaparticularliabilityorcategorythereof.Weusetheratio,%
∆NetIncome/%∆OperatingIncome(EBIT)becauseitbestexpressestheconceptual
integrationofriskandreturnwhencombinedandbalancedwithoperatingleverage.In
fact,wecanformameasureoftotalriskifwemultiplythetwoleveragestogether,(%∆
OperatingIncome/%∆Sales)x(%∆NetIncome/%∆OperatingIncome),which
convenientlybecomes(%∆NetIncome)/(%∆Sales)Obviously,thepremiumforWall
Streetistohaveashighalevelof(%∆NetIncome)/(%∆Sales)-totalleverage-as
possiblewithouttheinherentvolatilitysuchalevelimplies.
Leverageisalwaysameasureofpotentialvolatility,whichcanbedampenedby
maintainingasteadyleveragefigure.Forexample,ifoperatingleverageisnormally3/1.
whichisconsideredhigh,operatingincomereactsheavilytochangesinsales.However,if
thesamechangeinsalesisenactedyearafteryear,investorswouldbeoverjoyedbythe
stability;theywouldknowexactlywhattoexpectandwhen.Theproblemwithhigh
leverageisitsinabilitytoadjustitselftoachangingeconomy.Demandcyclesinvariably
change,andwhentheydo,thehigherleveragefirmssufferthemost-morefixedcosts
entailthenecessityofhighersalestocoverthem.Whentheeconomylagsandsalesabate,
fixedcostsmuststillbepaiddespiteaslowerproductioncycle.
BALANCINGLEVERAGE
Sinceincurringdebtimpliestheriskofdefault(failuretopayinterestexpenseina
timelymanner),asteadiersourceofincomeallowsafirmtoeitherengagemoredebt,or
maintainitsexistingdebtwithlessrisk.Thesourceofincomeisevaluatedforitsamount
andconsistency,whiledebtisevaluatedforthesizeofinterestpaymentsandtheamountof
principal,especiallyinrelationtoassetsandnetworth.Thebalancebetweenthe
comparativeamountsofincomeanddebtarethengaugedintermsofriskandreturn.
17

Aproperbalanceofleveragewillyieldtaxbenefitsbecauseinterestisatax
deductibleexpense.Secondly,thereisthepotentialforariseinbothearningspershare
andsharepricebecausefundingisachievedwithlesssharesofstockoutstandingthanif
donethroughanequityissue;moreincomeisspreadoverfewershares.Thirdly,debtcan
shiftthebalanceofcontrolawayfromshareholdersandtowardcreditorsinalegalfashion,
i.e.,moredebtcanmakeacompanyprohibitivelyexpensiveforatakeoverandevenshift
controltoasupportiveinvestoror“whiteknight”incaseofahostileattempt.
Themainriskofleverageistheriskofdefault,whichdetractsfromafirm’s
viabilityinseveralways.
• 1)Theprobabilityofdefaultaffectsthecostoffuturefinancingbyincreasingboth
interestratesandthecostoffloatinganequityissue.
• 2)Defaultmayendangerdividends,andrestrictivecovenants(bondcontracts)may
limittheirgrowth.
• 3)Creditorsmayhaveaclaimonassetsandrestrictincomepotential.
• 4)Theprobabilityofdefaultaffectsmarketvolatilityforthestock
Addedtotheriskofcreditdefaultistheriskofincomevariability,whichisafunctionof
payingoutinterestexpense.Thetworisks,businessriskandfinancialrisk,are
inseparable:boththeamountofdebtandthechanceoflossarepredicatedonasteady
operatingincome.Anydownturninsaleswouldbemagnifiedwithahigheroperating
leverage,creatingvolatilityinearningsandmakingthefirmmorelikelytodefaulton
interestpayments.
THEANATOMYOFFINANCIALLEVERAGE
Thevolatilityofnetincomeisanaturaloutgrowthofitsdependenceonboth
operatingincomeandtheamountofinterestexpense.Keepingoperatingincomeconstant
andchanginginterestwillincreasethevolatilityofchangesinnetincome.Whatisnot
apparentfromthefinancialleverageratio,%∆NetIncome/%∆OperatingIncome,is
18

thatEPS(earningspershare)canchangebecauseofexogenousfactors-themanipulation
ofthenumberofsharesoutstandingbyfinancialmanagement.
Ifthemantraoffinancialleverageistodo“morewithless”,itispartiallyachieved
byincreasingthepotentialvalueofeachsharebyissuinglessofthem.Wheninterestand
taxesareheldconstant,thevariabilityofnetincomeremainsconstantaswell.Theability
tolimitsharesaddsanewlevelofvolatilitytofinancialleverage.Ineffect,netincomethat
isnormallyderivedfromthedeductionofinterestandtaxesfromoperatingincome,is
spreadoverfewershares,increasingboththereturnandthevolatilityofthatreturnona
persharebasis.Netincomemaynotvarymorethanitdoeswithoutdebt,butlimitingthe
amountofshareswillmakethepersharefiguremorevolatileandmoreprofitable.
Toillustratethisconcept,considerthefollowingflowsofoperatingincome,thefirst
groupwithnodebt,andthesecondgroupwith$20ofinterestexpense.Taxesare30%in
bothgroups.
Table2-1

NODEBT
EBIT 90 100 110 120 130
TAX 27 30 33 36 39
NET
INCOME
63 70 77 84 91
Table2-2

WITH
DEBT

EBIT 90 100 110 120 130
INTEREST 20 20 20 20 20
TAX 21 24 27 30 33
NET
INCOME
44 56 63 70 77

19

Wenowmeasurethemeanofeachflowandusethesamplestandarddeviationasa
measureofrisk:
Table2-3

ACTUALFLOWOF FLOW1(NODEBT) FLOW2(DEBT)
NETINCOME 63 44
70 56
77 63
84 70
91 77
MEAN 77 63
SAMPLESTD.
DEVIATION
11.07 11.07

Althoughthedebtladenflowhasasmallermean(63)thanthenodebtflow(77),its
essentialriskisthesame-11.07-asanabsolutevaluefornetincome.Itmaybeless
preferablebasedonthecoefficientofvariationwhichmeasuresthestandarddeviation
dividedbythemean(11.07/63)vs.(11.07/77)-thelowerthefigure,thebetter.However,if
weproceedtoobservethefourseparatechangesinnetincomeforeachflow,wefindthat
thedebtladenflowismuchmorevolatile,butgrowsatafasterrate:
Table2-4

YEARTOYEAR
CHANGES
FLOW1(PERCENT) FLOW2(PERCENT)
FLOW1-NODEBT 11.1 14.29
FLOW2-DEBT 10 12.5
9.09 11.1
8.33 10
MEAN 9.63 11.97
SAMPLESTD
DEVIATION
1.194 1.853

Nowassumingthattensharesareoutstandingforthefirstflow,whilefiveareoutstanding
forthesecond,wehaveEPScalculationsforeach:
20

Table2-5

EARNINGSPERSHARE FLOW1(NODEBT) FLOW2(DEBT)
10SHARES-NODEBT 6.3 9.8
5SHARES-DEBT 7 11.2
7.7 12.6
8.4 14
9.1 15.4
MEAN 7.7 12.6
SAMPLESTD
DEVIATION
1.106 2.24

Notethatbothmeanandstandarddeviationincreaseonlessincomeinflow2thaninflow
1.SinceEPSbehaviorisoftenaproxyforsharepricebehavior,thepotentialtoincrease
priceisbalancedbytheriskofvolatilemovementinbothdirections.Anypoorlymanaged
capitalstructurewillhavetoomanysharesoutstandinginadditiontodebt,causinga
higherriskofdefaultanddilutionofEPSatthesametime.Suchacombinationmoves
companiesawayfromtheoptimalproportionofdebttoequity.Sincecreatingequity
reducessomevolatility,manyfirmsadheretothecreedthat“moreisbetter”,especiallyif
theequityisbeingusedasabargainingchipforexecutivecompensationorforacquisitions.
However,theproportionofdebttoequitymustbeidealinorderforthestocktorise,and
manyofthesefirmsissueequitywithoutsuchforesight.
THEANATOMYOFOPERATINGLEVERAGE
Likethefinancialleverageratiowhereavariabilityfactor(interest)causesvolatility
inthenumerator(netincome),operatingleveragealsocarriesanimplicitandundisclosed
variabilityfactor-fixedcosts.Inthedegreeofoperatingleverage,%∆EBIT/%∆Sales,
itisthechangeinfixedcoststhatcontributetoearningsvolatility.Inessence,bymaking
costslessvariablewithsales,afinancialparadoxoccurs:steadier,“fixed”costscontribute
moretovariabilitygiventhesamelevelofsalesandoperatingincome.Higherfixedcosts
requireahigherlevelofsalestobreakeven,butvariablecostsareabsorbedbythesaleof
21

eachadditionalunit.Moreover,anybusinessfluctuationswillhaveanexaggeratedeffect
onthosefirmswithhigherfixedcosts;profitsmaysurgeduringanupswingbutfixedcosts
muststillbepaidduringadownturn,makingitmoresevere.Perhapsthebestexampleof
oversensitivitytothebusinesscycleoccurswithbiotechcompaniesthatspendalotfor
researchanddevelopment,havelittledebt,andseehighprofitsinanexpansionbutnear
insolvencywhenadownturnoccurs.Thevariabilityisasmuchafunctionofthetypeof
costasitisoffluctuatingdemand.
Thefundamentalkeytounderstandingoperatingleverageistorecognizetheeffects
ofincreasingfixedcostsasapercentageofsales.Companiesoftenwanttoautomate
remedialtaskstoreducelaborcostsortoaddaspecialcompetitivequalitytotheproduct.
Besidestheinherentcostofmachinery,someoperatingcostsmustbepaidevenwhen
nothingisproduced(insurance,storage,maintenance).Thus,acompanymustincrease
salesbyaspecificamounttocoverthesecostsevenifthevariablecostperunitof
productionremainsunchanged.Thetrueriskofincreasingoperatingleveragestemsfrom
thepossibilityofnotincreasingthebreakevenpointforsales.Anexampleofhowthis
worksin“breakevennotation”isasfollows:
Table2-6

VARIABLE SYMBOL VALUE
SALES S 1000
PROFIT PFT 300
FIXEDCOSTS FX 100
VARIABLECOST VC 600
BREAKEVEN
EQUATION
PFT=S-VC-FX 300

Inlaterchapters,wewilldecomposesalesintotheproduct,(PricexQuantity).To
illustrateanincreaseinfixedcosts,whilemaintaininga60%variablecostproportion(that
is:VCremains0.6S),wecanpluganincreasedirectlyintothebreakevenequation.We
22

willincreasefixedcoststo200,aonehundredpercentincrease.PFT=S-VC-FXor1000-
600-200=PFT=200.Thesmallerprofitcanberaiseduptoitsoldlevelbyalgebraically
solvingforsales:
X-(.6X)-200=300.Salesisthesymbol“X”and0.6(X)isvariablecosts.SolvingforX,
weobtain1250asthenewlevelofsalesneededtomaintaintheoldprofitlevelof300.A
onehundredpercentincreaseinfixedcostsrequiredatwenty-fivepercentincreaseinsales
toabsorbit.Noticealsothat0.6(1250)=750.A$100increaseinfixedcostsinstigatedan
increaseinvariablecoststo$750,andalsoadecreaseintheratioVC/FXfrom“6”
(600/100)to“3.75”(750/200).
Onamicrocosmicproductionlevel,eachrevenue-generatingprocedureinaplant
hasitsownunit-dependentoperatingleverage.Inthiscase,variablecostsarespreadover
eachunitproduced,andsalesareafunctionofthepriceoftheunitmultipliedbythe
quantityoftheunit.Fixedcosts,however,arenotunitdependent;theyareindependentof
thelevelofproduction.Atthislowestlevel,operatingleverageisrelativelystablebecause
mostprocessesarestandardized.Itisintheraretimeswhenfixedcostschangeasa
percentageofsales(higherrent,moresalariedemployees,etc.)orasnewtechnologyis
added,thatoperatingleveragechanges.
Onamacrocosmiccorporatelevel,operatingleverageismorevolatile.Newproduct
linesandprocessesareconstantlychangingoperatingleverage.Anacquisitionofaservice
typebusiness,forexample,willprobablyloweramanufacturer’srisk.Ontheotherhand,
theswitchfromdistributinganitemtomanufacturingitrequiresanentireshiftfrom
formermethodsoforderingandstorage,aswellasthepurchaseofcapitalequipment.The
higherprofitsthatarecitedwillbeaccompaniedbythehigherriskofmorefixedcosts.
Ultimately,anytimethatasegmentofthebusinessisdiscontinuedorchanged,thereisa
risk-relatedeffectinvolved–somechangeinoperatingleverage.
TOTALRISK
23

Thehigherleveloffixedcostsassociatedwithmoreoperatingleveragerequires
extensivecapitalfunding.Anyprocessthatneedsmoremachineryalsoneedsareliable
sourceofsteadyfinancingtoreplaceandrepairequipmentandfundnecessaryshiftsin
production.However,creditorsdonotwanttoextendloanstocompaniesthatevince
incomevariability.Theydesireacustomerwhohassteadycash-flowandisnotsensitiveto
businesscyclefluctuations.Thus,thereexistssomeleveloftotalrisk,theproductof
operatingandfinancialleveragesthatdeterminesthesourceoffunding.Iftotalriskistoo
high,oroperatingleveragebyitselfishigh,creditorswillonlyextendloansathighinterest
ratesornotatall.Thefirmswiththehighestoperatingleveragesendupfinancingwith
retainedearningsorequityissues,whichputsthemmoreatriskduringadownturn.
Theleveragedbuyoutisperhapsthebestexampleofhowthetwoleveragesinteract.
Theadditionofcompanieswithlessoperatingriskisamethodofdiversificationthatworks
intandemwithfinancialleverage.Iftheriskofdefaultcanbeminimizedbyspreadinga
parentcompany’sfixedcostsovermoreunitsofproduction,moredebtcanbeincurred
(duetolowertotalrisk),andlessequitysharesissued.Theresultwillbeahighershare
priceforthe“merged”company.Inshort,thebrokersofaleveragedbuyoutuselessof
theirowncapital(equity)andallowthecorporationtoassumethe“limitedliability”of
greaterdebt.
LEVERAGEMEASUREMENTS
Usingconventionalmethods,itisdifficulttoobtainarealisticoperatingleverage
figurefromthefinancialstatementsofacompany.Notonlywillproductionchanges
obscurethe“true”number,butaccountantsoftenhavedifficultyattributingfixedand
variablecoststospecificunits:manycostshaveboth“fixed”and“variable”
characteristics.Additionally,thefinancialleverageratioisinherentlyunstablebecause
likeoperatingleverage,wearemeasuringtheratiooftwochanges:meaningful
measurementisdifficultwhenlargevariabilityisincurredthroughtheuseofpercentage
changes.Toanalyzecapitalstructureinthiscontext,weattempttofindaconcreteproxy,
24

afigurethatwillmirrortheanalyticalvalueoffinancialleveragewhileremainingstable
enoughtobufferthevolatilityofchangesinoperatingleverage.
THEORYVS.REALITY:FINANCIALLEVERAGE
Thefinancialleverageratio,%∆NetIncome/%∆EBIT,hasaconcrete
counterpartthatismoreamenabletodirectmeasurementwhichis,EBIT/(EBIT-Interest
Expense).Thestabilityofthisratiomakesitidealforcomparison,anditcaneasilybe
convertedtoatimesinterestearned(TIE)ratiowhichisusedtocalculatedefaultratings
forbonds.
Theuniquecharacteristicofthefinancialleverageratioisitsdualcapacity:itisnot
onlyacomparativeratingtoolfordefault,butitpredictsthepressureonearningsandthe
relationshipbetweennetandoperatingincomes.Wheninterestexpenseremains
unchanged,theconcreteratiopredictstheexactearningsfiguresoneyearhence.Toview
howthisworks,examinethefollowing:
Inyear1,operatingincome(EBIT)is100,interestexpenseis20andthetaxrateis30%.
Thus,thefinancialleverageratiois100/(100-20)=1.25.Toconfigurenetincomeinyear
1,wesubtract20from100=80,whichwemultiplyby(1-taxrate)toobtain56[80(0.7)=
56].Foryear2,wepickatrandomanoperatingincomeincreasefromyear1,say40%,
makingyear2’sEBITequalto140.Thenetincomecalculationis140-20=120,and120x
(1-0.3)=84.Theincreaseinnetincometooperatingincome,%∆NetIncome/%∆
EBITis((84/56)-1)/((140/100)-1)=50%/40%=1.25.Thus,bykeepinginterestexpense
constant,netincomebecomesfullypredictable!
THEORYVS.REALITY:OPERATINGLEVRAGE
Thetheoreticalrelationshipofoperatingleverage,%∆EBIT/%∆Salesalsohasa
concretecounterpartthatiscalculablewhentheanalysthasfullknowledgeofassigned
costs.Theratiois:(Sales-VariableCosts)/(Sales-VariableCosts-FixedCosts).Since
investorsrarelyhaveaccesstosuchspecificcostbreak-downsbetweenfixedandvariable,
itisalmostunusableonthatlevel.However,onacorporate“needtoknow”basis,itcanbe
25

utilizedincombinationwiththefinancialleverageratiotoformameasureoftotalrisk,and
toanticipatechangesinEPS.Thestudent/investorshouldnotethatthenumerator(sales-
variablecosts)isreferredtoasthe“contribution”whilethedenominatorisactuallyEBIT,
restatedwithitscomponentparts.Alsonotethattheonlydifferencebetweennumerator
anddenominatorisin“fixedcosts”.
Besidesmeasuringoperatingrisk,theconcreteversionofoperatingleveragealso
hasapredictivecapacity:giventhatvariablecostsareastablepercentageofsales,and
fixedcostsremainunchanged,theratiowillpredict%∆EBIT/%∆Salesexactlyoneyear
intothefuture.Thefollowingexamplewillexhibitthisrelationship:
Inyear1,theHardseatBicycleCompanyhas1000insales,variablecoststhatare0.6times
salesandfixedcostsof100.Determinenextyear’sEBITiffixedandvariablecostsremain
stable.
Year1OperatingIncome(EBIT)isSales-VariableCosts-FixedCosts=300.Operating
leverageis:(1000-600)/(1000-600-100)=1.33
Year2willyieldachangeofEBIToverthechangeinsalesof1.33,nomatterthelevelof
sales.Ifwepickasalesincreaseatrandom,say67.6%,thefollowingvaluesapply:
Table2-7

YEAR2
SALES=1000(1.676)=1676
VARIABLECOSTS=0.6(1676)=1005.6
FIXEDCOSTS=100
EBIT=S-VC-FX=1676-1005.6-100=570.4
CHANGEINEBIT=(570.4/300)-1=90.1333%
CHANGEINSALES=(1676/1000)-1=67.6%
90.1333/67.6=1.33INOPERATINGLEVERAGE
Thus,byapplyingoperatingleveragetoaknownchangeinsales,operatingincome
becomesfullypredictable!
THEORYANDREALITY:TOTALLEVERAGE
26

Sincerealitydictatesaconstantlychanginginterestexpense,fixedcostpercentage
andvariablecostrate,analystsarehardpressedtomakepredictionsfromleverageratios.
However,eachratioaccuratelypredictsthepressureonearningsifthestatusquois
maintained.Whencomparedtoindustryaverages,theratioscangaugerelativeriskand
exhibitthepressuretoconformtothosestandards.Ifmultipliedtogether,weproduce%
∆NetIncome/%∆Sales,whichappearstobeadynamicversionoftheclassicratio,profit
margin(NetIncome/Sales).Thefullyconvertedequationis:
(EBIT/(EBIT-InterestExpense))x((S-VC)/(S-VC-FX))=
%∆NetIncome/%∆EBIT)x(%∆EBIT/%∆Sales)=
%∆NetIncome/%∆Sales
Indeed,marginsandleveragearecloselyrelatedandmoreleveragewillcontributetoa
largermargin,butthetwoshouldnotbeconfused.Leverageistheprecursortoamargin
becauseitexhibitsthedynamicmovementnecessarytochangeit.Whenmanagement
attemptstohaveacontrollabletotalleverageratio,predictingthenextearningscycle
becomesaremedialequationaslongassalesareforecastcorrectly:
(OldNetIncome)x(1+(TotalLeveragex%∆Sales))=(NewNetIncome).
Conceptually,morenetincomecanarisefrommoreleverageorgreatersales,butthe
leveragecomponentscannotviolateindustrystandardsordysfunctionwilloccurthat
upsetsafirm’sequilibrium-toomuchdebtforthelevelofincome,costoverruns,lackof
capacityutilizationetc.Infact,manystockrun-upswilloccurpreciselybecausea
companyissuccessfullydefyingtheoddsandnotsuccumbingtothenegativeassociations
thatoccurwithtoomuchleverage.Whilemeetingindustrystandardswilldetermine“ball
park”figuresfortheleverageratios,eachmanagementteamhasauniqueflexibilityin
changingthemasaresponsetocompetitivepressure.Forexample,ifindustrystandards
foroperatingleveragearetraditionallyhigh,diversifyingthefirmwithacquisitionsthat
havealoweroperatingleveragewouldbufferthefirmfromaneconomicdownturn.A
firmwhoincreaseditsfinancialleverageatthebeginningofarecoveryandcouldaffordto
27

doso,wouldbetakingadvantageoflowerinterestratesandultimatelyincreasenet
income.Thepremiumistofindacombinationofleveragethatwillimmunizethefirm
frombusinessfluctuations,meetthethresholdsoftheindustry,andyetstrategically
contributetoalargeincreaseinsales.
LEVERAGEMANAGEMENT
Forafirmthatissolvent,fivecomponentsarethekeytocontrollingleverage:fixed
costs,variablecosts,sales,interestexpenseandtaxes.Ofthefive,taxpolicyandinterest
expensearethemostcontrollable;theotherfactorsaregreatlyaffectedbytheindustry,
vendorsandthegeneraleconomy.Whiletaxpolicyandinterestratestrend,theywillnot
surgesuddenlyupordown,causingdysfunction.Ontheotherhand,salesandcostscan
fluctuatewildlydependingonthestateoftheindustryandeconomy.Thus,financial
leverageismuchmoreamenabletomanagementthanoperatingleverage.However,the
risksincurredinmanagingfinancialleveragelieoutsidethecomponentsofthe
measurement;therelationshipbetweeninterestexpenseandoperatingincomeare
determinedbythesometimes“uncontrollable”elementsofoperatingleverage-vendor
prices,afavorableeconomy,andtheleveloftechnologyintheindustry.Inessence,one
cannotmanagefinancialleveragewithoutdeterminingthestabilityofcash-flow,whichis
derivedfromoperatingleverage.Onlywhensalesaresteadycanmanagementuse
financialleverageasastrategictooltoincreasenetincome.Itisthissymbioticrelationship
betweenstablesales,costs,earningsanddebtthatenablesacorporationtolimitthe
amountofsharesissuedandraisethepriceofthestock-anddosowithaminimumofrisk.
Fromamacrostandpoint,financialleveragetrendsmorethanoperatingleverage
becauseitreflectsmanagementstrategyandmustconformtothenecessityofraising
capitalinlargeincrements.Managementwillmatchtheneedforcapitalwithanticipated
cash-flows.Foraprojectthatisexpectedtopayoffthroughanumberofyears,itissimply
morecosteffectivetoraiselargeamountsofdebtwhentheconditionsarerighttodoso-
whenthefirmdoesnotalreadyhaveexcessivedebtandwheninterestratesarerelatively
28

lowcomparedtoothersourcesoffunding.Moreover,thistrendingcharacteristicisaboon
toinvestors.Bywatchingtheflowoffundsintoafirm,theinvestorseesabuild-upofrisk
whichmustbeultimatelyfollowedbyoneoftwoscenarios:eitherthefirmincreases
return,oritwallowsindebt-takingonevenmoredebt,divestingassetsetc.Ineffect,the
objectiveofcapitalstructureanalysisistodiscriminatebetweenthesetwooutcomesand
choosetheformerbeforeitoccurs.
SOURCESOFVARIATION
Variationinsalesisthecommonfactortovariationinbothtypesofleverage.If
salesareespeciallysteady,operatingleveragewillberelativelylowandmorefinancial
leveragecanbeafforded.However,thereisarisk-returntradeoffinanyindustrywith
consistentsales;largerreturnsoftenaccompanymoreriskyoperatingleverageandthose
companieswilltradethebenefitsoffinancialleveragetofundmostlywithequity-retained
earningsandcommonstock.Again,therootofthefunctionliesinfixedcosts:firmswith
higherfixedcostsmustconstantly“uptheante”andincreasesalestocoveradditional
investmentsintechnology.But-thesamehighneedforcapitaltofundfixedassetscreates
pricingpowerinthoseindustriesbecausethelargeinvestmentandaddedexpertiseactas
barriersofentrytotheindustry.Theresultisahigherprofitmarginandalowerasset
turnoverthaninotherindustries.Firmswhomakefifteenandtwentypercentprofit
marginsarenotfundedinthesamemannerasagrocerystorechainmakingtwopercent-
but-thegrocerychainmaybeasuperiorinvestmentifitbalancesriskandreturnmore
adeptly.Moreonthissubjectiscontainedinthechapteronoperatingrisk.
Withinnarrowparameters,therearemyriadmethodsofcombiningoperating
leveragestoreduceriskorincreasereturn:outsourcinganddiversifyingintorelated
productsoftenreducesriskaslongascorecompetenciesremainstrong;manufacturing
insteadofbuyingapartalwaysincreasesbothriskandpotentialreturn;consolidating
processesinonelocationincreasesriskandreturn;diversifyingoneproductlineinto
differentstandardsofqualityappealstoagreatercustomerbase,butoftenreducesrisk.
29

Thisbrieflistoftechniquesisbynomeansexhaustive,andrepresentsjustasmallexample
ofthepossibilitiesavailabletoreducevariationandincreasereturn.
Inthecaseoffinancialleverage,besidesthederivedvariationinoperatingincome
fromsalesandfixedcosts,liesthevariationininterestexpense.Whileinterestexpenseis
partiallycontrollablebytheamountofdebtafirmincursandthetypeandsourceofloans,
itisalsoafunctionofthestateoftheeconomy.WhentheFederalReservecutsoradjusts
boththediscountrateandthefederalfundsrate,thosefirmswhofundwithdebtaremost
affected.Theriskofchangesininterestrateswillaffecttheneedtorefinanceatalower
rate,oralternatively,willaffecttheleveloffundingforfutureprojectsiftherateisgoing
up.Thissensitivitytoboththeinternalriskdynamicsoftheindividualcompanyandthe
stateoftheoveralleconomymakesthefinancialleverageratioaprimebarometerfor
changesinbothcapitalstructureandstockprices.
Thefinancialleverageratiowillnotvarybyarelativelygreatamount.Ifitgoesup
ordownbytentofifteenpercentitisconsideredalargechangeThisrelativestability
makeschangessignificantandallowstheinvestortogaugeriskbyusingitincombination
withmorevolatileratioslikethetheoreticalconstruct,%∆EBIT/%∆Sales.Thislatter
ratioisfullyavailabletoallinvestorsbutsuffersfromlargejumpsinmeasurement,which
makesitlessamenabletointerpretation.Ratherthanseekoutathresholdnumberfor
risk,theinvestorusesthecombinationtolookatchangesinbothratios.Anincreasein%
∆EBIT/%∆Sales,forexample,mayindicateupwardsearningpressureandisusually
accompaniedbyanincreaseinoperatingmargin.Ontheotherhand,anincreaseinthe
financialleverageratiousuallyindicatesthatmoredebthasbeenincurred.Together,the
combinationofchangeswillindicateageneraldirectionforriskandreturninthefirm.
Wheneachratioisbrokenintoitscomponentparts,%∆Salesforexample,theinvestor
startstoseekoutmoredefinitivereasonsforthebehavioroftheratioandthedirectionof
risk.

30

Thevariationininterestandoperatingincometellonlyapartialstory.To
understandfinancialleverage,onemustlookfortheimplicitdynamicsaswellasthe
obviousinteractions.Partofthereasonforfundingwithdebtisderivedfromadesireto
keepthenumberofsharesoutstandingtoaminimum.However,nowhereineither
leverageratioisthisriskdefined.TheriskofdilutingEPSandmarketpriceisespecially
highinthosecompanieswhouseminimaldebtfinancingandneedtoissuestockto
maintainaleveloffixedassets.Thus,anabsoluteleverageratioof3.5,forexample,gives
uslittleinformation.Wenotonlyneedtounderstandthechangesinleverage,wemust
combinethatinformationwithseveralotherindicatorstoformatruepictureofcapital
structure.
Thepremiumincapitalstructureanalysisistodetectmovementtowardanoptimal
proportionofdebttoequity.Ifacompanyfinanceswithnodebtatall,thenthe
managementofincomeandequityformsasimilarrisk/returnimperative.Bycomparing
theindustryaveragesofthelargestcompetitorsoverthespanofabusinesscycle,some
paradigmofanoptimalproportionisformed:usuallyastockwillpeakatleastonce
duringthecycle,yieldingsome“guesstimate”ofoptimalitywhenthatsectorisfavored.
However,relyingonaveragesisrisky:characteristicsofcorporationsandindustries
change,andtheinvestorisencouragedtocoordinateinformationfromseveralsources;
focusingononeconcretenumbercanbemyopicatbestanddisastrousatworst.Thus,the
investorneedsto“diversify”hisorheranalysisandassumea“balancedapproach”by
evaluatingtheriskofearnings.Observingthecomponentpartsofthequotient,Net
Income/Stockholders’Equity,alsoknownasthereturnonequityorROE,isonemethod
ofthistypeofextensiveanalysis.
RETURNONEQUITY
Maximizingthereturnonequityisveryclosetooptimizingcapitalstructure.The
riskcharacteristicsofmaximizingeitherEPSorROE,however,willnotbethesamelevels
31

neededtomaximizethesharepriceofthestock.Tocreateasustainablegaininastock,the
right“infrastructure”needstobeinplace,whichisformedbystrategicmovementtoward
anoptimalproportionofdebttoequity.Thisstrategicmovementisabalancingact
betweenleverageriskandthecostofcapital,butalsoincludesintegrationbetween
scheduleddemandandthebusinesscycle.Ineffect,theriskofmaximizingROEistogrow
attoorapidarate,whicheventuallypropelsthestockdownward,andsocapital
structuralismoptstoachievethehighestlevelofROEwiththeleastamountofrisk.
Thereturnonequityhasasitsfoundation,thesamecomponentsthatformleverage
measurements.InsteadofmeasuringthechangeinsalesandEBIT,theROEequationuses
theabsolutevalueoftheratio,EBIT/Sales,alsoknownas“operatingmargin”.Insteadof
measuringEBIT/EBIT-Interest,theROEequationturnsitupsidedownandmeasures
theinverse,EBT/EBIT.Fixedcostsareoftenmeasuredbytheratio,Assets/Sales,whichis
often,calledthe“capitalintensity”ratio.TheROEequationturnsthisintoanother
inverse,knownastheassetturnoverratio,Sales/Assets.Theseratioswillbeexplainedin
detailinsubsequentchapters.Fornow,thestudent/investorshouldrealizethatriskand
returnarefirmlyinterconnectedonbothconceptualandmathematicallevels.Thevery
sameelementsthatreduceriskwillsometimesincreasereturn;theobjectiveistoitemize
thecharacteristicsofeachcomponentandseeksomecombinationoffactorsthatproduces
anoptimum.
THEFORCESBEHINDLEVERAGE
Inthecontextofcapitalstructure,absolutelevelsofriskandreturnareless
meaningfulthantheintegratedrelationshipbetweenthem.Wegaugethatrelationshipby
observingtheirmovement.Atwentypercentincreaseinnetincomeaccompaniedbya
thirtypercentincreaseinequity,maybemoredeleteriousthanatenpercentincreasein
earningsthatisaccompaniedbylowinterestdebtfunding.Eachchangeincapital
structureneedstobeexaminedinthecontextofchangesintheeconomy,productlines,
industryandinternaldynamicsofthecompany.Sinceleverageisthebackboneof
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corporaterisk,settingupasimplequadrantanalysiswillexhibitthefundamentalforces.
Wewillsubstitutetheterminology“incomerisk”foroperatingleverageandtheterm“debt
risk”forfinancialleverage.Wewillthendelineatetheincreaseordecreasebya“+”ora
“-”respectively.
Table2-8

INCOMERISK
++ --
DEBTRISK (Increasedebtandincome
risks)
(Reducedebtandincome
risks)
+- -+
(Increasedebt,reduce
income)
(Reducedebt,increase
income)

Obviously,the“+-“quadrant-increasingdebtriskswhilereducingincomerisksappears
tobethemostdangerous.Gaugingtheotherthreequadrantsisamatteroffactoring
severalvariables,andobservingthedegreeofrespectiveincrease.Infact,the“+-”
quadrantshouldhaveboththemostriskandmostreturn,becausefinancialleverageisa
functionofoperatingincomewhoseriskisderivedfromtheconsistencyofsales.Bythat
chainoflogic,theleastriskyquadrantwouldbethe“-+”quadrantinthelowerrighthand
corner.Inthisquadrant,defaultrisk(notpayinginterestinatimelymanner)wouldbethe
leastbecauseincomewouldcoverdebtbetter.Thebestchoicefortheinvestormaybethe
firstquadrant(upperleftcorner)becausedefaultriskseemsneutral,buttheeffecton
incomemaybegreater.Noneofthesecombinationsare“setinstone”,andeachmustbe
examinedforindividualrisksandreturns.
(BacktoTableofContents)
33

APPENDIX:STREAMLINING?
Whenmostbusinessesthinkof“streamlining”anoperation,theythinkofreducing
costsandincreasingprofits.Acommonmethodistoconsolidaterepetitivefunctionsand
avoidduplicationbyaddingtechnology-usuallyintheformofamachine.While
"naysayers"decrythedehumanizationofwork,thebusinesspersonmustaskifthereturn
isworththerisk.Thefollowingscenarioshoulddemonstratethateveninthebestof
circumstances,moreefficiencywillleadtogreaterrisk.
TheSkidmarkTireCompanyhas$1000(million)insales,avariablecostrateof0.6
salesandfixedcostsof$100.Theiroperatingleverageandprofitareasfollows:
OPERATINGLEVERAGE)1000-600/1000-600-100=400/300=1.33
OPERATINGINCOME)1000-600-100=300
Anewtypeofrubberisbothlessexpensive,andstronger,butneedstobeappliedwith
machinerycosting$100more.Costsavingswouldbringvariablecostsdownto0.4sales
andimproveoperatingincomeby$100attheexistinglevelofsales.Thenewoperating
leverageis:
NEWOPERATINGLEVERAGE)1000-400/1000-400-200=1.5
NEWOPERATINGINCOME)1000-400-200=400
Whilethisscenariowouldrepresentadreamcometrueforsomeoperations
managers,operatingleverageincreasedto1.5from1.33,indicatingmorerisk.Managers
mightreply,“Butwhere’stherisk?”Infact,withoutathoroughexaminationofsales
volatility,thisprojectshouldnotbeimplemented.Ifsalesdeteriorateonaseasonalbasis
(astheydointhetireindustry),moreoperatingleverageandtemporarycostsavingswould
leadtolessprofitandnotmore;fixedcostsmustbepaidregardlessofthelevelofsales.
Technologyandriskgotogether.Somereadersofthisbookmaybeoldenoughto
rememberwhenentireindustrieswerecomputerizedinthelate1970sandearly80s.While
computersincreasedproductivity,systemswouldgodownfordaysatatimeanditwas
importanttohaveacontingencybackup-a“papertrail”.Anytimeproductiveactivityis
34

centralizedinoneprocessorlocation,moreriskisincurred-eventhoughpotentialprofits
increase.
(BacktoTableofContents)
35

3
CAPITALSTRUCTURE
Economicshasadualisticnature.Whetheritisahumanquestforcertaintyor
simplyaneedtoachievebalance,eachconceptcanbedefinedbyitsopposite:supplyvs.
demand,inflationvs.deflation,Keynesianvs.monetarist,debitvs.creditandultimately,
riskvs.return.Rarelydoesonefinancialthreadweaveitselfthroughtherandomchaosof
opposingideas,andholisticallyembracetheirreconciliation.Thatthreadiscapital
structure.
Studentsoftenleavecollegewithasetofidealsthatreadilyflourishinasanitized,
isolatedlaboratory,onlytofalterwhentestedandstressedbyreal-worldrandomvariation.
Ratherthanabandonthoseideals,moststudentswilladaptthemtothevicissitudesof
modernfinance.Forexample,ifonegraduatedbefore1970,bothhighinflationandhigh
unemploymentoccurringatthesametimewasinconceivable:thePhillipscurveprofessed
atradeoffbetweentheseeconomicstatesanddirectcorrelationwasinfrequent.However,
bythetimetheyear1980rolledaround,inflationandunemploymenthadbeensorampant
thateconomistschangedtheirownconceptofcausation;expectationsofinflationcarriedas
muchmathematical“weight”asanyotherhypothesizedcause.
Whenstudentsbecome“investors”,thereiseventualdisenchantmentwith
“fundamentals”becausestocksseemtohavea”mindoftheirown”andrarelyrespondto
suchanalysis.Investorsbecomediscouragedbecausesome“magic”combinationofsales
andearningsfailstobeatacompetitorwhoisbarelyfunctioning.Often,thefrustration
with“chasingearnings”willturnintoapenchantfortechnicalanalysis,whichatfirst
appearstoyieldlegitimateresults-untiltheinvestorrealizesthatheorsheismerely
followingrandompatternsmadewithinthecontextofarisingmarket.Inthiscase,“the
trendisthefriend”,butthechangesinpatternsandtransitionsareunpredictable.Indeed,
ifthereturnwereashighastoutedbythesoftwaredealerswhosellit,technicalanalysis
36

wouldattractmajorcompanieslikeBoeingandGEwhowouldhappilyforegotheireight
orninepercentprofitmarginsinpursuitof“safe”fortypercentreturns.
Capitalstructureisfirmlyentrenchedinacademictradition,butisflexibleenough
toapplytorealworldsituations;itsstudycanleadtobothrevelationandfinancial
remunerationbecauseitisinteractivewithsomanyeconomicdisciplines.Thebasic
concept,however,isnotsounusual:movementtowardafirm’soptimalproportionofdebt
andequityfundingtendstopropelthestockupward.Whatismoredifficulttograspisthe
balancebetweenriskandreturnthatallowsthistooccur.Theabilitytoforecastisnotas
importantastheabilitytocoordinateinformationandidentifyfirmswhoseleverageis
conducivetogreaterearnings.Ineffect,mostanalysisconcentratesonearningsbecauseit
isthemostcorrelatedfundamentaltostockprice.Alternatively,capitalstructureanalysis
concentratesonthecontextofearningsbecauseitisconcernedwithbothriskand
sustainability;thevariationofthereturnhasasmuchimportasthereturnitself.Without
thisdomainofrisk,profitappreciationcanbebothdeceptiveandtransient,andbeguiling
enoughtolosemoneyover.

THECOSTOFCAPITAL:MARKETORIENTATIONANDPRACTICAL
APPLICATION

Thetraditionaldefinitionofthecostofcapitalisconceptuallyvague.Definedasthe
amountofreturnthatabusinesscouldmakeonalternativeinvestmentsofsimilarrisk,the
costofcapitalencompassesseveralimplicitfactorsthatcomplicateitspracticaluse.
Foremostamongtheseisthegaugingof“similar”risk,andtheneedtopriceallsourcesof
capital–debt,equityandassociatedvariations–atthemarketrate.Secondly,thecostof
capitaldoesnotalwayshavean“upfront”accountingcost.Itisconsideredan
“opportunitycost”thatiscomparativeinnature,anditsonly“cost”maybethegreater
37

risktakentogeneratemoreincome.Comparativeactionsthatarenotpursuedmayhave
asmuchsignificanceastheactualcourseofaction.
Theoretically,allsourcesofcapitalarepricedatwhatthemarketcurrentlydictates
andimplicitintheanalysisofcomparativeinvestmentsisthebreakdownofthesecapital
componentsintorelativepricelevels.Byinterfacingindividualcorporateriskwiththe
pricesconfiguredbythecurrentstateofthecapitalmarkets,aspecific“requiredrateof
return”willbedetermined.Fordebt,thereturnisthemostcurrentinterestratewhichis
multipliedbyareciprocalofthetaxrateandthenbythemarketvalueofafirm’sdebt.
Sincethepriceofafirm’sdebtwillchangeexponentiallydependingontherelativeincrease
ordecreaseinthenewlynegotiatedrate,thescopeofthecalculationisbeyondthepurview
ofmostinvestors.Forequity,investorswillattempttodeterminetheexpected
appreciationofstockswithequalriskandattachthisratetothemarketvalueofthefirm’s
stock.Eachvaluecanbemultipliedbytheproportionofitsrespectivecomponentinthe
capitalstructure.Ifafirmhasa30/70percentdebttoequity,then30%ismultipliedby
themostcurrentinterestrateandthenbytheincurredtaxadvantageof(1–taxrate)to
produceapercentagecostofdebtThisfigureisaddedtotheproductofthepercentage
costofequityandtheproportionofequityinthecapitalstructure(70%inthisexample).
Together,therespectivecostsofequityanddebtareproportionedbytheirrelativeweights
inthecapitalstructuretoformanaggregatecostofcapital.
Problemsarisewhentheinvestorattemptstocorroboratetheorywithreality.
Stockpricescanbequitevolatileandanybodywhofollowsthemarketcantestifytothe
futilityofgaugingacorporation’srequiredamountofequityfrommarketvaluesalone.
Similarly,investorsarenotprivytonegotiationswithcreditorsoverinterestratesnorare
38

marketvaluesofdebtalwaysdeterminable.Moreover,themarketwillfrequentlymisprice
riskovershortperiods.Thus,determiningcapitalproportionsfrommarketvaluescan
evenbedangerouslymisleading.
Whyusemarketratestopricethecostofcapital?Inordertogaugetheriskof
alternativeinvestments,theinvestorneedsacommondenominator.Withmarketrates,a
corporationcanobservethedirectgainsorlossesinfollowingaspecificcourseofaction.If,
forexample,acorporationcanissuestockatahighpricebutchoosestoissuehighcoupon
ratebondsinstead,itmayincurwhatistermedan“opportunityloss”–ameasurable
outlayofinterestexpenseoverandabovethecostofequity.Aslongasadollaramountcan
beattachedtoanystrategicaction,alternativescanbecomparedandthemostcost
effectivepathcanberealized
Whiletheuseofcapitalimplieslong-termplanningandobligation,thevolatilityof
marketratesmakesthecostofcapitalarelativevalue:itcanbedesignatedas“improved”,
or“lower”thancompetitor’srates,butitneedsotherfinancialinformationtocorroborate
it.Todeterminecapitalproportions,forexample,thehistoryoftheindustry,thetypesof
assets,andtheexpectedsizeandstabilityofearningsmustbecounterpoisedtothecurrent
marketcostofcapital.Ineffect,theabsolutesizeofthecostofcapitalislessimportantthan
itsrelationalvalueanditscontext.Therefore,adaptationsofthecostofcapitalare
improvisedthroughoutthistexttoassisttheinvestorinbettergaugingrisk.Anappendix
inchaptersixcoverssomeofthetheoreticalunderpinningsindetermininga“realcostof
capital”,andwhyusingsomebookvalues-suchasinterestexpense–mayoffertheinvestor
apracticalanalog.
THEADVANTAGESOFDEBT
39

Implicitinthedefinitionofdebtisitsinherentadvantage-thereceptionof
immediatefundswithpayment“postponed”untilalaterdate.Anyamountofcash-flowis
morevaluableinthepresentthanitisinthefuturebecauseitcanbeinvestedandearn
interest.Wheneveranaccountreturnsmoreonaloanthanitcosts,anetadvantageoccurs
However,thetimingoftheinflowsisofevengreaterimportance.Notonlyarereturns
greaterwhenthepayofffromaninvestmentoccursfaster,buttheriskoftheloanis
diminishedbecausethefirmhasadequatecashtoserviceinterestpayments.Like“justin
time”inventorysystems,mostbusinessesrecognizetheimportanceofreceivingcash-flows
atthemomentabillisdue.Ineffect,profitsareenhancedandriskisdiminishedif
paymentismadepromptlybutnottoosoon.Whenservicingdebt,profitsreceivedin
JanuaryandFebruaryaremuchmorevaluablethanthesameprofitsreceivedin
NovemberandDecembersimplybecausethe“lagtime”isnotproductive.Duringthislag,
interestmaybedueontheloan,increasingitsrisk;nocashinflowsarebalancingthe
outflows.
Besidesthetimevalueofmoney,debtisevaluatedbycomparisontootherfirms.A
loanthatreturnsmorethanitscostmaybeconsidered“ineffective”,ifafirm’speersare
returningoneandahalftimesasmuch.Thus,industrystandardsareanimportant
elementinevaluatingdebt.Performanceindicatorslikethereturnoncapitalare
significant,butevenmoreindicativearetheaverageratiosofdebttoequity,andthe
amountofinterestexpenserelativetolong-termdebt.Whenbothreturnsandleverage
ratiosarehoveringaroundtheindustrystandard,riskandreturnwillbecommensurate
withafirm’speers.However,whenthesemeasurementsarebelowthatstandard,the
investorcanlookforoneoftwooutcomes:eitheracompensatingbounce(turnaround)
thatlowersriskandpropelsthestockupward,ormaintenanceoftheposition,whichmay
beaccompaniedbyaselloff.Thislatterpositioncanmakeorbreakinvestorsbecause
maintenanceofthepositioncanbeasignofeitherfaithinaninvestmentpayoff,or
40

uncertaintyovertheinevitable“costoverruns”thatmayfurtherscareinvestors.A
numberofmechanismsareinplacethatconfersotheradvantages:
• 1.Interestisataxdeductibleexpense.Interestexpenseisroutinelydeductedfrom
operatingincomebeforetaxableincomeiscalculated.Infact,thetaxsavingsarethe
costofinterestmultipliedbythetaxrate.
• 2.Along-termloan(overoneyear)grantstaxadvantagesuntiltheloanispaidoffand
mayhaveastabilizingeffectonthefirmifcash-flowisespeciallytight.
• 3.Sinceinterestistaxdeductible,thecostofdebtisalmostuniformlylessthanthecost
ofissuingequity,whichcandilutemarketprice.
• 4.Investmentwithdebtmaylimitthenumberofsharesoutstanding;performancecan
beenhancedwithoutburdeningshareholdersifearningspershare(EPS)rise.
• 5.Issuingdebtratherthanequityhelpsmaintainexistingcontrolofthecompany.Less
newsharesrestrictsvotingpowertothelargestcurrentshareholders.Moreover,more
debtonthebookswilllimittakeoverattemptsbecauseprospectivebuyersdonotwant
tobeburdenedwiththeobligationsofleverage,i.e.,interestexpense,restrictive
covenants,sinkingfunds,etc.
Sincealldebtfundsaspecificlevelofassets,takingondebtwillsavethefirman
amountequaltothetaxratemultipliedbytheamountofbonds.Ineffect,thegovernment
conferstaxadvantagestoencourageinvestment,andthenplanstomakeupthedifference
innewincometaxeswhentheinvestmentgeneratesprofits.Withoutthistaxbenefit,the
optimalproportionofdebttoequitywouldbelesssignificant,dependingontheriskof
insolvencyalone.
RISKANDDEBT
Whileitseemsadvantageoustopileupdebtandusethetaxsavingsforother
investments,acorporationwhodoessoflirtswithdefault.Earningsareoftencyclical,but
interestpaymentsmustbetimely,andoncedebtisincurred,theprobabilityofbankruptcy
increasesexponentially.Infact,theamountoffixedcostsinaproductioncycleregulates
41

bothoperatingriskandtheamountoffinancialleveragethatcanbeincurred.Thosefirms
withveryhighfixedcostsmayhaveearningsthatfluctuatemorethanfirmswithlower
fixedcosts,andhaveahigherriskofdefaultduringeconomicdownturns.Theirriskof
bankruptcyishighersimplybecausetheirproductioncyclesaremorereactivetoeconomic
conditions.Thus,thesefirmswithhigh“economic”riskarepoorcandidatesforfinancial
leverage.
Onemajorproblemwithcapitalstructureanalysisisenumeratingthecostof
bankruptcy.Theterm“bankruptcy”hasmanydefinitionsandcoversawidebreadthof
legalstatesandfinancialconditions.Thistextapproachestheconceptfromtheperspective
ofthecorporatecommonshareholderandalwayspresumesthelossofshareholdervalue.
Itdesignatesarelationshipbetweenassets,liabilitiesandmarketvalue,whichbyitsvery
natureisprobabilistic;marketvalueisaffectedbypsychologyasmuchasassetsare
affectedbyinflation.However,themaintenetneedstobeexamined;thereissomecostof
bankruptcythatiscomposedofatleasttwoassociatedelements:someamountoflossand
someprobabilityofdefault.Althoughtheremaybemanyotherfactors,theseformthe
baseofagenericmodel.
Oncethe“genericpremise”isaccepted,thereisconsiderabledifficultyincreatinga
relationshipbetweenfixedcostsandassetstructuretoobtainan“amountofloss”.There
aresomeassetsthatcanbesoldintheeventofliquidationandsomeassetsthatdonot
directlyaffecttheoperatingcapacityofthefirm.Moreover,themarketvalueofthestock
abovethelevelofassetsisbasedontheexpectedabilitytogenerateincomeinthefuture.
Thus,theproperconfluencebetweenseveralassetclassesandtheamountofintrinsic
shareholdervalueformsanamountofloss.
Defaultprobabilitiesarecreatedfromhistoricaldistributions.Whenthe
relationshipbetweentypicalinputtedvariableslikeassetsize,orsalesstabilitychanges,
theprobabilityisnolongervalid.Ineffect,onceadefaultprobabilityisreadyforthe
market,itisnolongeronehundredpercentaccurate.Thefinancialcommunitydevelops
42

limitsoftolerancethatacceptsimprecisionasagivenvariable.Ultimately,capital
structureanalysisrestsuponthistolerancefora“ballparkfigure”,butmusthavedata
thatiscoordinatedtoalerttheanalysttothepresenceofmorerisk.However,thereliance
ondefaultprobabilitiesisinitself“risky”(the2007“creditcrunch”)becausethereisrisk
thatcannotbeenumerateduntiltheeventoccurs.Theeconomicandpoliticalrisksthatare
outlierstoany“system”,areveryillustrativeofthisconcept;theymayaffectafirm’s
performancemorethananyinternallygeneratedvariablelikesalesorassets.Thus,to
forma“genericcostofbankruptcy”,wedependondefaultprobabilitiesandwemultiply
thembyanestimatedamountofloss,buteachcomponentpartishypotheticaland
tentative.
Withanincreaseinbankruptcycostscomesaconcurrentriseinthecostofcapital.
Investmentbanksdemandmoreinterestonbondsandhigherflotationcostsforstocksto
mirrorthegreaterriskinacompany.Thecostofeachsourceoffundingisinterdependent
onthemarketforalternativesources.Infact,proportionalincreasesindebthaveafixed
tendencytoraisethecostofbothequityanddebtasriskbecomeshigher.Thisinteraction
betweenriskandthecostofcapitalisneverstaticandformsthebasisofcapitalstructure
analysis.Whenanoptimalproportionofcapitalsourcesisachieved,cost,risk,andthe
interrelationshipbetweeneconomicoutlookandcorporateperformancewillbebalanced;
thefirm’sstockpricewillbemaximized.
Inevitably,seekinganoptimalcapitalstructureturnsintoagameofstrategicrisk.
Sincethecostofcapitalcutsintoprofitability,firmswithtoomuchdebtareusuallycash-
poor,low-earnerswithdiminishedmarketvalues.Theirinabilitytomaintaincash-flow
perpetuatesachainofloansinwhichoneloanretiresanotherwithlittlepaymentof
principal.However,thosefirmswhohavegreaterresourcescanaffordtousemoredebtin
theircapitalstructureswhichcauseslessstrainonexistingshareholders,enhancing
marketvalue.Thisstrategicuseofleverage,theutilizationofdebtwithrecourse,allows
fewersharestobeissued,contributingtoperformanceonapersharebasis.Whenprojects
43

becomeprofitable,thereislessshareholderinvestmentbutgreaterreturn,andthemarket
priceofthestockincreases.
MATHEMATICALOPTIMIZATION:THEORYVERSUSREALITY
Thetheoryofcapitalstructureispredicatedonthebalancebetweenthetaxbenefits
ofdebtononesideofafunctionandbankruptcycostsontheother.Thisequality
optimizestheproportionofdebttoequityatthepointwherethechangeintaxbenefits
equalsthechangeinbankruptcycosts.Ineffect,wetrytomaximizethefunction(Tax
benefitsofdebt)-(BankruptcyCosts).Ifwecalculatethefirstderivativeofthefunction
andsetittozero,thefunctionisatanoptimumand∆ ∆∆ ∆Taxbenefits=∆ ∆∆ ∆Bankruptcycosts.
Theproblem,however,isnotintheconceptofthefunction,butinthedefinitionof
variablesthatinteract.Aspreviouslymentioned,theterm“bankruptcycosts”isuniqueto
therealmoftheamountofloss;eachcorporateentitylosessomethingdifferent.Moreover,
someofthevariablesdependonprobabilityandsomearedeterministic;theyare
interdependentneverthelessandcreatebothvariationanduncertainty.Toafinancial
executive,themathematicalsituationisakintoforecastingthepathofahurricaneand
decidingtomakepreparations;theeffortsmaybewasted,butthepotentialoutcomeof
inactioncanbedevastating.
Ultimately,theneedformathematicalcertaintyisnotassignificantastheneedto
realisticallygaugeriskandmovethefirmintherightdirection.Infact,thepotentialfor
priceappreciationinastockismuchgreaterwhenafirmisalongdistanceawayfromits
optimalcapitalstructure,butresolutelymovingtowardit.Sinceastockpricemaximizes
whenafirm’scapitalstructureisoptimal,thereislittleroomforittomove-upordown.
Inthiscase,investorsmightevendemandthatthefirmtakemoreriskbymovingaway
fromtherelatively“safe”worldofastockpriceoptimumandengageinmergersand
acquisitions.WallStreetrewardscompanieswho“defytheodds”byoutperformingthe
marketinsomespecialway.Consequently,firmswhoseemladenwithdebtbutbeginto
escalatesalesandearningsaregenerallyobservedtobealongdistancefromanoptimal
44

capitaltarget;theirhigherriskofbankruptcycoupledwithsubsequentimprovement
substantiatesmoreinvestment.
Thetrueoptimalcapitalstructureisinastateofflux.Infact,itrespondstoso
manydifferentvariablesthatitperpetuallychanges-almostinstantaneously.Thereason
behindthisvariationisthatitisdependentonexternalrelationshipsoutsidetheinternal
controlofthefirm.Whileleveragefactorsmaydetermineanestimateoftheamountand
sourcesoffunding,thefoundationofcorporateriskistheinterrelationshipbetweenlong
andshort-terminterestrates,andtheequitymarket.Theserelationshipschangedaily.
Thus,ifafirmwereshutdownforaweekend,itsoptimalcapitalstructurewouldchange
eversoslightly,evendependingontheperformanceofforeignmarkets.
Fortunately,theanalystdoesnotneedamathematicallypreciserenditionofan
optimalcapitalstructuretomakeeffectiverecommendations.Severalusefulindicators
existtoaidindeterminingwhetherthefirmismovinginafavorabledirection.Classic
measurementslikethereturnonequity(ROE),andEVA
®1
(economicvalueadded)canbe
modifiedtoreflectactivitytowardanoptimaltarget.Althoughthestudent/investoris
encouragedtocreateaworkingmodelandobtaina“ballpark”estimate,suchexercises
willbeladenwithatleastthreediscrepancies:1)Alackofadequatevariables2)Artificial
constraintsand3)Toomanyconstants.However,sucheffortscanbeinformative,evenif
imperfect.Theycanhelptheanalysttounderstandthecomponentsofcorporaterisk,and
especiallyanychangesthereof.

1
EVA
®
istheregisteredtrademarkofSternStewart,Inc.
45

THEMODIGLIANI-MILLERPROPOSITIONS
Mostofourpresentknowledgeofcapitalstructureismerelyanextensionofthe
researchdonebytheteamofMertonMillerandFrancoModiglianiinthelate1950s.In
fact,thefunction,(TaxBenefits)-(BankruptcyCosts)issimplyarelaxationofaconstraint
thattheyusedtodeterminetheincrementalvalueofaleveragedfirmoveranunlevered
one.IntheirfamousequationV(l)=V(u)+TB,thevalueofaleveragedfirmwasgreater
thanthevalueofonewithanallequitystructurebyafactorofTB,whichwastheamount
ofthefirm’sbondsmultipliedbytheirtaxrate.Sinceinterestisataxdeductibleexpense,
intheabsenceofbankruptcy,afirmcanincreaseitsvaluesimplybyincurringmoreand
moredebt.Withoutsuchtaxadvantages,thevalueoftheunleveredandleveragedversions
ofafirmwouldbeequal,whichformsthecruxofMiller/Modigliani’sPropositionI:In
theabsenceoftaxesorbankruptcy,thevalueofafirmisindependentofitscapital
structure.
Thesecondproposition,propositionII,provesthatincreasingtheproportional
amountofdebtincreasesthecostofequity.Sincetherealrateofreturnondebtmust
coverinterestpaymentsbeforeitshowsprofitability,itishigherthantherateofreturnon
equitybya“riskpremium”thatpushesthecostofequityupward.Whenthisproposition
isexaminedinaworldoftaxes,wecanconcludethattheoptimalcapitalstructureis
composedofonehundredpercentdebt.Aslongasinterestistaxdeductible,intheabsence
ofbankruptcy,thecostofdebtwouldalwaysbelowerthanthecostofequity;freecash-
flowwouldalwaysbegreaterwiththeuseofdebt.Infact,thisextreme“corner”solution
formsthefoundationforallfurtherextrapolationsofcapitalstructuretheory.Inessence,
werelaxconstraintsandaddvariablestoderivearealistichypothesis.Byadding
bankruptcycosts,forexample,wemerelyregulatethetendencytouselowercostdebt.
ThelogicbehindpropositionIIwasthatthecostofequityreactedtotheincreasein
debtbyrising.This“riskpremium”wasreconciledwithequitybyahigherrequiredrate
ofreturn;thenecessityofcoveringinterestpaymentsincreasedthecostofequity.Without
46

taxesandbankruptcy,thecostofdebtwouldbeahorizontalstraightlinethatfellwell
belowtheangledlineofthecostofequity.
Figure3-1

Eachincrementalunitofdebtpushesupthecostofequitybecauseitincreasestherequired
rateofreturn.Weassumethattheleveredcompanyismakingatleastasmuchasthe
valueofitsinterestpaymentmorethantheunleveredfirm,ortherewouldbenoreasonto
incurdebtinthefirstplace.
THEOPTIMIZATIONPROBLEM
Whiletaxbenefitsarecomposedofasimplelinearfunction(long-termdebt
multipliedbythetaxrate),thecostofbankruptcywilladoptashapethatisdefinedbyits
variables.Insomemodels,withaconstantamountofloss,ittakesontheshapeofthe
defaultprobability.Inothermodels,theshapemaybedefinedbyanexponentially
increasinglossoralineardefaultprobability;eachmanifestationofbankruptcyis
fundamentallyunique.Withoutastandardized“costofbankruptcy”,solvingforan
optimalamountofdebtdependsonthecombinationofvariablesthatmakeupthe
function.
Debt/EquityRatio
Costof
Capital
CostofDebt
AverageCostofDebtandEquity
CostofEquity
47

Attheveryleast,thecostofbankruptcymusthaveaslopethatisgreaterthanTB
(TaxRatexBonds)ortaxbenefitswillexceedbankruptcycostsateverylevelandthe
modelisnotoperable.Secondly,thecurveshouldemulatearisk-returntradeoffand
increaseatanincreasingrateatsomepoint;amodified“S”shapeisidealbecauseitshows
athresholdamountofbankruptcycosts,followedbyarapidincreaseandthenaleveling
offwhenactualbankruptcyoccurs.Lastly,someoftheshapeofthecostofcapitalcurve
shouldbeincorporatedintothecostofbankruptcy.Whilebankruptcycostsdonot
perfectlymirrorthecostofcapital,theyshouldshowincreasingcostsforgreaterriskjust
ascreditorschargehigherinterestratesformoreriskyloans.
ThelinearityoftheassortedcostsofcapitalintheMiller/Modiglianipropositions
wasafunctionoftheconstraints-especiallytheabsenceofbankruptcycosts.Inreality,
thecostofcapitalisregulatedbyseveralrelationshipsthatcreateajaggedcurveandlimit
theamountofdebtthatafirmcanincur.Thecostofcapitalcurvewillatfirstdecreaseas
moredebtcreatesbothtaxbenefitsandalargerEPS,throughfewersharesissued.Itthen
movesrapidlyupwardsasinterestexpensebecomesonerousandthefirmmovescloserto
bankruptcy.Thus,thetheoreticalunderpinningsofthecostofcapitalwillcreateacurve
thatinthelongrun,mimicsthecostofbankruptcycurveascreditorschargemoreinterest
atanincreasingrate;pastaspecificpoint,eachadditionalunitofdebtwillincreaserates
sorapidlythatfinancialleveragewillnolongerbecosteffective.
Thelimitingconstraintinanyoptimizationmodelistheamountofcapital.Whena
modelattemptstooptimizetheamountofdebt,itwillmatchtheamountofcapitalwiththe
boundariesofthedefaultprobability.Thegreatestaccuracyisachievedwithinnarrow
boundsandmaynotincludethegivenamountofcapital.Forexample,manydefault
algorithmswillallowagreateramountofdebtthanthecapitallimitsimplybecausethey
arenotconfiguredforextremevalues:defaultprobabilitiesarecreatedfromaveragesand
maynotbeaccuratewithinthelevelofdebtthatisnormallyusedbythecompany.
48

Somemodelsshelvetheconceptofmarketvaluealtogetherandconcentrateonthe
amountofassetlossthatoccursinatypicalbankruptcywithintheindustry.Fromtwenty
tosixty-fivepercentofassetsisacommonfigure,andthesemodelswillbeconfiguredfor
specificsectors.Defaultalgorithmsmaybe‘customized”tomeettheneedsoffirmswithin
anindustryandwillbemoreaccuratethanthegenericalgorithmsusedinthistext.
Nevertheless,anymodelwillopposethecostsofdebtwithitsbenefits,-aspinoffofthe
originalMiller/Modiglianithesis.
THEPROPOSEDIDEALANDITSINHERENTPROBLEMS
Wecansolvethemarginalbenefitsfunction,∆ ∆∆ ∆Taxbenefits=∆ ∆∆ ∆Bankruptcycosts,.
byfindingaleveloflong-termdebtthatmakesthefunctionequaltozero.Naturally,long-
termdebtwouldbeavariableinbankruptcycosts,andwecansatisfytheequationby
manuallyinputtingeachunitofdebtfromzerotothecapitallimit.Whenthefunction,
(TaxBenefits)-(BankruptcyCosts)nolongerincreases,anoptimumisfound.
Alternatively,wecanusealinearprogrammingmodulelikeExcels“Solver”tomaximize
thefunction.Thegraphicaldisplaywouldbethus:

Figure3-2

DEBT
$COST
TB
CostofBankruptcy
X
49

Inthis“ideal”depiction,theoptimalamountofdebtisatpoint“X”becausethedifference
betweentaxbenefitsandbankruptcycostsareattheirgreatestpoint.Themarginal
benefitsfunction,∆ ∆∆ ∆Taxbenefits=∆ ∆∆ ∆Bankruptcycostsisoperablewhentheslopesofeach
curveareequal.Fromtheperspectiveofcalculus,thefunction,(TaxBenefits)-
(BankruptcyCosts)ismaximizedwhenitsfirstderivativeissettozero.Bylinkingtax
benefitstobankruptcycoststhroughthevariable,“Long-termdebt”,weproducea
differentiatedfunction.Whenwesubtractthisoptimalamountofdebtfromagiven
amountofcapital,weproducetheoptimalamountofequity.
Amongtheseveralproblemsinsuchamodelare:
• 1.Context-Optimizationvariablesarenotformulatedintermsofcorporatepotential,
andyetcapitalallocationdependsonexpectations,judgment,andwisdomgarnered
fromhistoricalobservations.Nooptimizationvariableiscognizant,forexample,ofa
marketingstrategythatwillmakeafirmanindustry“front-runner”.Anotherexample
wouldbetheexpectationofincreasinginterestrates;anoptimizationprogrammight
lockafirmintoalevelofdebtthatisappropriateatalowerrate,butexcessiveifrates
areexpectedtorise.
• 2.Artificiality-Besidestheconstructionofhypotheticalvariables(amountofloss),
somevariablesmustbeheldconstantwheninreality,theywouldchangedynamically
withthelevelofdebt.
• 3.Theassumptionofappropriatecapital.-Fewcompanieshavetheabilitytomatch
theamounttheycanraisewithactualcapitalrequirements.Anyoptimizationmodel
workswithinagivencapitalconstraintwhichmaynotbetheoptimalone.For
example,ifunderperformingitspeersisconsidered“normal”performancefora
company,aprogrammightoptimizedebtunderthepremisethatthefirmisearninga
tenpercentreturnoncapitalandnotthefifteenpercentofitscompetitors.However,a
trueoptimalproportionofdebttoequitywouldbringthereturnoncapital(ROC)up
toindustrystandards.Inthiscase,eithertheamountofcapitalisexcessive,or
50

productionproblemslimittheamountofnetincome-aproblemthatisnotpartofthe
optimizationfunction.
CAPITALSTRUCTUREANDTHECOSTOFCAPITAL
Bothstudentsandinvestorsgetthemisconceptionthattherelationshipbetweenthe
costofcapitalandcapitalstructureisbasedonaffordability-thatthepriceofdebt
(interest)determineshowmuchdebtafirmcanincur.Usingthisfaultylineoflogic,a
companycanhaveafortypercentdebttoequityratiowheninterestratesaredownanda
twentypercentproportionwhentheyrise.Infact,firmsdotakeadvantageofinterestrate
cyclestoincurmoredebtbutdonotmateriallychangetheiroptimalcapitalstructures;
lowerratesbecomeanincentivetotakemoreriskbutarebalancedbythediminished
earningsoutlookthatusuallyaccompaniesaFederalReserveratecut.
Capitalstructurehasaninteractivecauseandeffectrelationshipwiththecostof
capital.Someofthefactorsthatregulatetheproportionofdebttoequityaffectthecostof
capital.Ontheotherhand,themajorportionofthecostofcapitalisconfiguredaway
fromtheinternaldynamicsofthefirmandisdictatedbyaconfluenceoffactorsinthe
greatereconomy.Ineffect,anaggregateofthedemandformoneywilldeterminethe
absolutelevelofinterestrateswhilecompetitiveforceswithinthecompany(salesstability,
earnings,andassets)willdeterminethelimitsoftolerance-comparativelyfavorablerates,
orratesthatareattheuppermostlevels.
Thedecisiontousedebtisnotsoaffectedbythepriceofdebt,asbytheasset
structureofthecompany-theproportionoffixedassets,andhowwelltheassetscanserve
ascollateralforaloan.Forexample,realestatemayserveasbettercollateralforabond
issuethanamorevaluablecommoditylikegoldsimplybecauseitislessvolatile.Thefixed
incomemarketisbasedondependability,whichisactualized,bysteadyearningsand
stableprices;creditorsdemandfromfirms’assetstructures,thesameperformancethat
theyexpectwhenreceivinginterestpayments.Thus,largefirmswithsteadyincomesand
salablecollateralcanseekandincurmoredebtintheircapitalstructures.
51

Threecharacteristicsofafirm’sassetstructureareespeciallysignificant:the
stabilityofsales,operatingleverageandcapitalintensity.Thethirdcharacteristic,capital
intensityismerelytheinverseofthefundamental,assetturnover,whichis:Sales/Assets.
Whenweturnthisaroundto:Assets/Sales,weobtainacomparativeratioofthedegreeof
fixedassetsinacompany.Riskiscreatedbythepropensitytogeneratefixedcosts,and
highercapitalintensitieswillrequirejustthat-morecapitaltopayforoutdated
machinery,managementsalariesandvarious“overheads”.Firmsdesiretomatchthe
timingofcash-flowsfromprojectswiththetypeoffundingbecausesuchastrategy
increasesreturnandreducesrisk.Consequently,firmswithhighercapitalintensitieswill
haveprojectsthatencouragelong-runprofitabilityandrequireextendedfunding.By
itself,capitalintensitywillaffectbothoperatingleverageandsalesstabilityandisvery
dependentonthetypeofindustry.However,withinthoseconfines,thedecisiontofund
withequityordebtstillexists,andisasmuchdependentontheriskofphysicalcollateral
asitisonoperatingrisk-whichoftengo”handinhand”;firmswho,dealwithriskier
assetswilloftenhavethemostoperatingrisk.
ByMiller/ModiglianipropositionII,itisdoubtfulthatthefirmcanobtainalevelof
riskthatpushesthecostofdebtabovethecostofequity.Therefore,bypricealone,the
optimalcapitalstructureismadeupofalldebt.Theinvestorcanverifythisconceptby
observingthedemandforanystockthathasajunkbondstatus;thepriceofthestock
deterioratesasthecostofitsdebtsky-rockets,andthestockbecomesatoolforspeculators.
Theriskofholdingonethousanddollarsworthofstockismuchgreaterthanholdingaone
thousanddollarbondofthesamefirmbecausethebondneedstoberepaidorthestock
willbecomeworthless.
Inthelongrun,ahigherprobabilityofbankruptcywillraisethecostofcapital,a
directcorrelationthatismaintainedatlowerlevelsaswell.Ineffect,thecostofcapital
respondstotheriskofbankruptcyinthecapitalstructureandwilladjusttoreflectthe
stabilityofthecompany.Capitalstructure,however,respondsslightlytochangesinthe
52

costofcapital,mostlyadjustingthroughtheamountofcapitalraised.Wheninterestrates
arehigh,forexample,thecompanymaynotchangeitstargetstructuretoalowerlevelof
debt,butmayadjusttheamountoffundingforallprojectsandmoveslightlypastitstarget
withmoreequityfunding.Whenratesarelower,thefirmbeginstofundwithmoredebt,
movingpastitsoptimaltargetfromtheotherdirection.Onlywhentherehasbeena
systemicshiftthatwillraiseorlowertheinterestratethroughoutanentirebusinesscycle
willtheoptimaltargetchangesubstantially.Suchpatternsoccurredinthelate1970swith
massiveinflationanddoubledigitinterestratesandagainwithnearrecordlowratesin
2002-2003.
Thestudent/investorshouldrecognizethatnolevelofinterestratewillensure
steadyrepaymentofaloanbecauserateschangefrequentlywiththelevelofGDPgrowth.
Forafirmwhofundswithallequity,takingadvantageof“cheapinterest”forashort
amountoftimewillmerelycausethefirmtosuffertheconsequencesofapoordecision;
shareholderswillsellthestockbecausetoomuchriskisincurred.Ontheotherhand,firms
whoseassetstructureshavechangedandaremoreamenabletousingdebt,willreceivean
initialboostupwardsastaxadvantageseclipsethecostofbankruptcy.Forcompanieswho
usedebtonaregularbasis,changesinratesgiveincentivetoraisemorecapitalbutnotto
makemajorchangesincapitalstructure.Ineffect,afavorablechangeinthecostofcapital
isanimpetustomovewellpasttheoptimaltargetoreventemporarilymoveawayfromit
altogetherbecausetheriskofdoingsoisrewardedwithalowercostofcapital.However,
firmsrealizethatsuchconditionsaretemporaryandusuallymovebacktowardthe
optimaltargetassoonaspossible.
Thefollowingchartdelineatesdifferentlevelsofdebttoequityfromtheperspective
ofboththecostofbankruptcyandthecostofcapital.Thecostofdebtisindicatedwith
taxsavingsandriseswithbankruptcycosts.Thecostofequityisabovethecostofdebt
andalsoriseswiththeprobabilityofbankruptcy.However,asindicatedbyasterisks,the
costofbankruptcyisnotalwaysperfectlyalignedwithrisksandcallsforexecutive
53

judgment.Thecalculationsarebasedonalevelofcapitalof$1000andataxrateofthirty
(0.3)percent.Thecostofbankruptcyisatypicalalgorithm.
Table3-1

Percent
D/E
TB Costof
Bankruptcy
TB-Cost Interest
Rate%
AfterTax
Costof
Debt
Costof
Equity%
10 30 20 10 5.5 3.85 7
20 60 30 30 6 4.2 9
30 90 40 50 6.5 4.55 9.5
40 120 55 65* 6.8 4.76 9.5
50 150 90 60 7.4 5.18 10.5
60 180 130 50 8.4 5.88 12
70 210 180 30 9.75 6.85 14
80 240 170 70* 11.75 8.225 17
90 270 1250 -980 14 9.8 20
100 300 1350 -1050 17 11.8 24

Thiscostofbankruptcyfunctionisabimodaldistribution,producingtwoinflectionpoints:
oneatfortypercentdebttoequityandanotherateightypercent.Thejudgmentofthe
analystisparamountanditisobviousthatthemostcosteffectivepathisatfortypercent.
Manybankruptcyalgorithmsareonlyaccurateacrossanarrowrangebecausetheyare
basedonaveragehistoricaldistributions.Thechallengetoanymathematicianisto
produceanalgorithmthatcanmaintainaccuracyoveritsentirerangeandyetbeflexible
enoughtosolveforcapitalstructureinputs.

THECONCEPTOFAWEIGHTEDAVERAGECOSTOFCAPITAL
Thestandarddefinitionof“capital”comprisesseveralcomponentpartsincluding
equity,long-termdebt,preferredstockandsomeshort-termdebtandcapitalleases.When
thepercentageofeachcomponentinthecapitalstructureismultipliedbyitsspecificcost
andthensummedtogether,themeasurementthatisformediscalledtheweightedaverage
costofcapitalorWACC.Inthechartabove,forexample,attwentypercentdebttoequity,
54

wemultiplytheaftertaxcostofdebt(0.042)bythepercentageofdebt(0.2)andsumitwith
theproductofthecostofequity(.09)anditsrespectivepercentage(0.8).Thetotal
expressionis(0.2)(0.042)+(0.8)(0.09)=0.0804or8.04percent.
Inthelongrun,theWACCwillfollowtheprobabilityofdefaulteitherupordown,
butminimizeswhenthecapitalstructureisoptimal-atapointwheretaxbenefitsand
bankruptcycostsareattheirgreatestdistance.Intheshortrun,theremaybeeccentric
movementbecausethemarketdoesnotalwayspriceriskcorrectly.Whenthegovernment
setsinterestrates,itdoessotopreservesystemicequilibrium,abalancebetweengrowth
andinflation.However,afirmdoesnotsetpolicytoconformtoFederalReservedecisions.
Itfundscapitalprojectstomakebackitsinvestmentasrapidlyaspossible.Therefore,
therewillbeperiodswhenthefirmisusingmoreequitywhileinterestratesfordebtare
decreasingandviceversa.Overatwoorthreeyearperiod,theWACCisareliable
indicatorofmovementtowardanoptimalcapitalstructure;anydecreasewouldbeviewed
asfavorable.However,itmayrisefromyeartoyearsimplybecausetherehasbeena
systemicshifttowardcomparativelyhighercapitalcosts.
Byusingtheamountofdebtthatkeepsthecostofbankruptcyatarelative
minimum,butmaximizestaxbenefits,thegreatestamountoftheleastexpensivecapital
componentisused.Forfirmswhofundonlywithequity,theprobabilityofdefaultis
minimizedwiththesameactionsthatwillbooststructuralintegrityanddecreasethecostof
equity-stabilityofsalesandincomeinthedomainofhigherreturns.Thus,anunlevered
firmmustminimizeitsWACCwithouttheluxuryofsubstitutinglowercostdebtfor
equity.However,byminimizingbankruptcycosts-keepingsharestoaminimumand
loweringtheprobabilityofdefault-itwillalsominimizeitsWACC,producinganoptimal
capitalstructure.Inmostcases,thecostofcapitalwillbeuniformlyhigherforallequity
companies,whichtheyneedtoovercomebybothincreasingandstabilizingtheamountof
salesandincome.

55

Figure3-3

EARNINGSANDCAPITALSTRUCTURE
Inthechapteronleveragewementionedthattheamountoffixedassetsinan
industrywilldeterminethestabilityofearningsandthatfinancialleveragecanbe
increasedwhenoperatingleverageislower.However,theamountofearningsisalsoa
majorfactorindeterminingcapitalstructure.Whenearningsarelarge,theycanbe
retained,andoutsidesourcesoffunding(debtandnewsharesofequity)canbeavoided.In
effect,largeamountsofearningstendtobeunstablebecauseoftherisk-returntradeoff,
butenableafirmtobuildstockholders’equitythroughretainedearnings.
Whenearningsareretainedandbecomepartofstockholders’equity,theyincurthe
costofequity.Thefulldevelopmentofthecostofequityislefttoanotherchapter,butletit
bestatedthatthecostofequityisacomparativecostverymuchrelatedtothereturnon
equity,whichistheratio,NetIncome/Stockholders’Equity.Thus,ifthecostofequityis
particularlyhigh,itwillcostthefirmmoretoretainearningsthantodistributethemas
dividendsorbuybacksharesofstock.Inthisregard,dividendpolicyisveryintegrated
withcapitalstructurebecauseitdeterminesretentionandtheultimateWACC.
Debt/Equity
Dollar
Value
WACC
TB-CostofBankruptcy
56

Anothereffectofearningsoncapitalstructureistheminimizationoftheprobability
ofdefault.Mostdefaultalgorithmsexplicitlydefinesomeaspectofearningsasavariable
thatdiminishesthisprobability.Inthemarginalbenefitsequation,asmallerprobabilityof
defaultallowsmoredebtfunding,moreshares,orsomecombinationofboth-capital
appreciationthatleadstoassetgrowth.Inevitably,topreservetaxbenefits,theproportion
ofequitygrowsthroughretainingthesameearningsthatdiminishedtheprobabilityof
default;themarginalbenefitsfunctioncangrowwhenequityisaddedtodebtbutdoesnot
replaceit.Onlywhenthecostofequityisconsideredtoohighwillsharebuybacksand
specialdividendsneedtobeconsideredinlieuofretention.
Thebusinesscycledetermineswhencertainindustrieswillhavefavorablesalesand
earnings.Consequently,anentiresectorwillexhibitsimilarpatternsofmarginalbenefits
andleveragethatwillbedependentontheprobabilityofdefault.Inadownturn,hightax
benefitswillbeaccompaniedbyanevenhigherprobabilityofdefaultbecausefirmsare
generatinglessincome;theymustparedowntheirdebtaboveallelse.Inexpansions,more
incomelowerstheprobabilityofdefaultallowingmoretaxbenefits.Theeffectofan
optimalcapitalstructure,however,istoreducethenegativeeffectsofthebusinesscycle
andtoaccentuatethepositive.Thecostofcapitaliskeptlowenoughduringadownturnso
thatcompetitiveprogresscanbemade.Consequently,duringanexpansion,thecompany
willhavethefinancialflexibilitytotakeonmorerisk,andsometimeseventheluxuryof
movingawayfromthe“safe”environsofanoptimalcapitalstructure.
CAPITALSTRUCTURELOGIC
Capitalstructuretheorydisplaysapatternofalternatingrisksandreturnsthatare
encapsulatedinseveralmeasurements.Eachcategoryofriskstemsfromtheprevious
categoryandhasacorrespondingsetofmeasurements.Inthefollowingchart,togettothe
highestlevel,capitalallocation,theotherriskcategoriesmustbeproperlyassessed.
57

Table3-2

HIERARCHALRISK
RISK/RETURN MEASUREMENT
1)CAPITAL
ALLOCATION
1)COSTOFCAPITAL
a.Proportionofdebtto
equity
a.Costofdebt
b.Projectanalysis b.Costofequity
c.Capitalbudgeting c.Costofvariousother
components
d.CapitalRequirements d.WACC
e.Capitalmarket
conditions
e.ROE,ROC,Economic
Profit

2)BANKRUPTCYRISK 2)COSTOF
BANKRUPTCY
a.Probabilityofdefault a.Measurementsand
risksarethesame.
b.Amountofloss

3)FINANCIALRISK 3)LEVERAGERATIOS
a.Interestexpense a.Financialleverageratio
b.Numberofequity
shares
b.Equitymultiplier=
Assets/Equity
c.TaxBenefits cChangeinNetIncome/
ChangeinOperating
Income
d.Stabilityofnetincome
andoperatingincome
d.TIE(TimesInterest
Earned)

4)ECONOMICRISK 4)OPERATINGRISK
a.Sales a.OperatingLeverage
b.Fixedandvariable
costs
b.CapitalIntensity
c.OperatingIncome c.OperatingMargin

CHANGESINCAPITALSTRUCTUREANDSTOCKPRICES
“Likeamonkeythrowingdarts”,hasbeenacommondescriptionoftherandom
variationthatanalystsfacewhenpickingindividualstocks.Indeed,anysystemthat
58

purportstocomprehendsomeofthemismatchesinriskandreturnthroughouttheyears,
includingcapitalstructuralism,appearstobeablindattempttorationalizechaosbygiving
itmeaning.However,theonetothreeyeartimeframeofcapitalstructureanalysisdoes
giveitsomeperspective.Althoughhistoricalpatternsseemtorepeatthemselves“witha
newtwist”,capitalstructuralismdoesnottrytoforecaststockprices;itonlyattemptsto
identifyanenvironmentconducivetoincreasingthem.Infact,thesamedynamicsthat
provedsuccessfulforIBMinthe1960shavebeenprovensuccessfulforGoogleinthenew
millennium;bothcompanieshaveworkeddiligentlytooptimizetheirrespectivecapital
structures.Whilethe“devilisinthedetails”,thesefirmshaveimprovedstockpriceby
increasingtheflowofearningstowardshareholders-mostlythroughcapitalgains.In
effect,theabilitytokeepearningsexpectationshighhasbeentheprimeingredientinstock
priceappreciation.Bystavingoffbankruptcycostsandkeepingthecostofcapitallow
enough,earningshavebeenmagnifiedincomparisontothecompetition.Neithercompany
worriedaboutthe“clienteleeffect”ofkeepingtheirsharepricestoohighandnotsplitting
them;thepremiumwasplacedonminimizingthenumberofsharesoutstanding.
Mostimprovementinstockpriceshappensconcurrentlywithearnings
improvements.Ifthiswerenotso,“investingafterthefact”wouldbeprofitableand
simple.Althoughsomemoneyismadeoffof“momentum”insomemarkets,WallStreet
triestoseparateinvestorsintotwocategories:thosewhomakegoodjudgmentswellahead
oftime,andtheneveryoneelse.Infact,mostfirmswillreachanoptimalcapitalstructure
sometimeduringabusinesscycleanddosowhentheirentiresectorisdominatingthe
market.Ifthehousingsectorisdominant,forexample,thepaintcompanieswillnotbefar
behind.Itisacycleofmatchingtheopportunitiescreatedbytherelationshipbetween
interestratesandequities,withthestructureofthefirmsthatcanmosttakeadvantageof
it
Asanexampleofaverytypicalscenario,considerthehypotheticalXYZCompany.
Atthetopofabusinesscycle,theyhavenowincreaseddebttoequityfortwoyearsina
59

row,andtheyarewellpasttheiroptimalcapitalstructurewithtoomuchdebt.Their
earningshavebeentepid,butnowtheysensethattheirinvestmentinChinesefurnitureis
goingtobea“cashcow”andpayoff.Inthethirdyearoftheirinvestmentcycle,sales
jumptwenty-fivepercent.Consumershavemoneytospend.Increasedearningsmovethe
stockupthirtypercentandthefirmdecreasesitsdebttoequityratiobypayingoffsomeof
itsloansandretainingearnings.Investorswhoenteredthisgameearlyenoughreceivethe
spoilsofvictory.Aftertwoyearsofdiminishingitsdebt,thefirmmaybepastitsoptimum
intheotherdirection,andinvestorsbeginignoringthestockbecausereturnsarenotas
substantial.Atthispoint,thefirmneedstoregroupandfundnewprojectswithahigher
risk-whichmayagainmeanincreasingitsproportionofdebt.
Dartthrowingmonkeysnotwithstanding,someofthevolatilityinthemarketis
attributabletobusinesscyclefluctuations;thosefirmswiththegreatestoperatingriskcan
onlyperformforabriefamountoftimewhentheirparticularsectorisfavored.The
performanceofsuchfirmsmayentailaneightypercentriseinthestockpriceovertwoor
threeyears,followedbyweakorevennegativeresults.Lowertotalleverage(operating
leveragemultipliedbyfinancialleverage)willbuffersomeoftheeffectofthebusiness
cycle,butevenlow-riskfirmswillhavebriefperiodsofwildprofitabilityfollowedbybelow
averageresults.
Howdoesthebusinesscyclesuddenlymatchafirm’sstructurewiththepatternof
availablefunding?Eachfirmhasanoptimalproportionofdebttoequitythatrespondsto
thelevelofinterestratesandtheirrelationshiptoequity.Firmswhohavelowoperating
risk,forexample,mayusemorefinancialleverageandfundprojectswheninterestrates
arelowatthebeginningofarecovery.Atthispoint,thefirm’searningswillbegintofar
outpacethecostofcapital,anditsstockpricewillsoar.However,thistypeofopportunity
canonlyberealizedwhenthefirmismovingtowarditsoptimalcapitalstructure;the
distancethefirmneedstotravelactuallyaccentuatesboththeriskandthereturn.
FOUR“POSTULATES”
60

Intheworldofequities,hardandfastrules“breakliketwigs”andsowecallthese
observations“postulates”withtheknowledgethateachwillbebrokenatsometimeor
other:
• 1)Allvariablesheldequal,moreearningstendtodecreasetheproportionofdebtto
equity(D/E),becausethefirmwillpayoffsomeloansand/orincreaseretention.
• 2)Companieswhosimultaneouslyandsubstantiallyincreasebothdebtandearnings
maypayoutinincometaxesmuchmorethantheyhavedeductedininteresttax
savings.Itisnocoincidencethatcompaniestimetheirdebtissueswhenearningsare
lower.
• 3)Thegreateststockreturnsoccurwhenearningsareacceleratingupwardwhilethe
costofcapitalisacceleratingdownward.
• 4)Smallblocksofdebtareprohibitivelyexpensivebecausethereareeconomiesofscale
whenbondsareissued.Firmswhogarnerlargeloansusuallydosowithstrategic
purpose.Alternatively,firmswhoincreasedebtbysmallamountsonaconstantbasis
mayhavecostoverrunsorproblemswithremainingsolvent.
SHARELIMITATIONS
Theeffectoffinancialleverageistoreducethepotentialnumberofshares
outstandingbyfundingwithdebtinsteadofequity.Thefirmreceivesatradeoffbetween
thepotentialamountandvariabilityofearningspersharebecausenetincomeandmarket
pricearenotdilutedbymoresharesoutstanding.However,givenachoice,mostfirms
wouldfundwithsufficientretainedearningsaslongasdividendgrowthwereadequate.
Thefactthatafirmneedstomakeachoicebetweenthe“lesseroftwoevils”(debtormore
shares)isindicativeoftheinadequacyofinternallygeneratedfunds.
Thisinsufficiencyisinnowayapejorative.Manyindustriesdonothavethe
earningscapacitytodocontinualinternalfunding.Thesearewell-managedandprofitable
companieswhohappentobeinanindustrythathavehistoricallylowmargins.Infact,
theirabilitytoincreasetheirstockpricerestswholeheartedlyonmanagingacapital
61

structurethathashigheramountsofdebtbecauseoperatingleverageissolow;large
increasesinsaleswilltranslateintosmallincreasesinoperatingincome.Thepremiumis
placedonkeepingshareissuestoaminimum,andevenlimitingretainedearningsby
payingasteadilygrowingdividend.Thistypeofcontrolovercapitalstructureallowsthese
firmstocompeteinmarketsthathaveplayerswithprofitmarginsfivetoseventimesas
much.Infact,anyquickstatisticalsurveywillfindthatindustrieswithmoredebttendto
havelessstockpricevolatility-whichseemstobeananomaly-untiloneconsidersthat
firmswithlessoperatingriskcanincurmorefinancialrisk.
Firmswhoarefundedwithanall-equitystructurefacea‘doubleedgedsword”.On
theonehand,theyareusuallyveryprofitable-periodically-andfundtheirprojects
internallyfromretainedearnings.Ontheotherhand,theneedtocompeteandreplacea
highleveloffixedassetsrequiresaconstantsourceoffundingwhichfurtherrequiresthese
firmstoissuesharesofstock.Sincedebtisunwarrantedgiventhelevelofoperatingrisk,
thesefirmswilldilutetheirEPSandmarketpricewithmoresharesoutstanding.Thus,the
morestableandlargeistheiroperatingincome,thefewersharesneedtobeissued.Those
“diamondsintherough”thatarefortunateenoughtohaveahighoperatingleveragewith
stablesalescanfundalloftheirneedswithinternallygeneratedretainedearnings.
However,thesecompaniesareusuallysmall,andwhenWallStreetrequiresthemtogrow,
therewillbesometradeoffmadebetweenstabilityandthemethodoffinancing,i.e.,more
sharesoutstanding.
ADAPTEDMEASUREMENTS
Thistextaccentuatesthetradeoffbetweenlong-termdebtandcommonequity.It
considersallothersourcesofcapitaltobeadjunctsthatattempttolowerthecostofcapital.
Whileothersourcesoffundingmayslightlychangetheriskprofileoftheentirefirm,the
crucialcomponentsaretheamountoflong-termdebtandcommonequitybecausethese
requirethemostexpenseandobligation.Ourdefinitionofcapitalmayincludeallof
stockholders’equityandallliabilitiesforthepurposeoftheoreticalillustration:indeed,
62

anycorporationmustitemizeeverysourceofcapitalwhenitimplementsaproject.
However,whenwecomparecompaniesandmakeinvestments,weexcludepreferredstock
andinterestbearingdebtoflessthanoneyear’smaturity,becausewedesireastrict,
categoricalriskmeasurementthatisremovedfromcorporateeffortstominimizethecost
ofcapital.

Forboththeinvestorandfinancialmanagement,thefocusneedstobeplacedon
evaluatingthefirmthroughitslong-termcapitalobligationsbecausethesuccessofthe
companyrestsontheirviability.Byeliminatingothervariables(preferredstockandother
interestbearingdebt),weinnowaydiscounttheirimportance:infact,short-termdebtis
viewedasamajorelementintheneedtofundwithlong-termdebt.However,wedowant
indicativemeasurementstofocusonthetradeoffbetweenlong-termdebtandcommon
equityandsoweadaptmeasurementstofitthisurgency.Forexample,insteadofalluding
totheproportionofdebttoequity(D/E),weconcentrateonlong-termdebttocapital
(LTD/CAP)whichismoresensitivetochange(mathematically)andbetterelucidatesthe
tradeoffbetweencapitalobligations.Moreover,weusetheratio,returnoncapital(ROC)
morethantheratio,returnonequity(ROE),simplybecauseinourmorenarrowdefinition
ofcapital,thefigureismoreresistanttofalseinterpretation.Anotherexampleappliesto
theweightedaveragecostofcapital(WACC).Bynarrowlydefiningcapital,weeliminate
someoftheriskadjustingeffectsofothersourceslikeshort-termdebt,andformacostthat
isdependentonlong-termdebtandcommonequity;itmaybeahigherfigurethanthe
actual,butbettergaugestheriskofthesetwocomponents.
EXPLICITVERSUSIMPLICITCOSTS
Wearealreadyfamiliarwithsomeoftheexplicitcostsofcapitalstructure-those
paidinanactualexchangeofcash.Costsaremadeupoffixedandvariablevarietiesthat
togethermakeupthetotalcostwhenoperatingincomeissubtractedfromsales.Someof
thesecostsinclude:wages,rent,machinerymaintenance,materialsandofficesupplies.
63

Interestexpenseisindeedaprominentexplicitcostthatneedstobepaidregularly.
However,nolessimportantarewhataretermed,“implicitcosts”-coststhathaveaneffect
onthepriceofthestockbutaredifficulttoenumeratebecausetheydonotrepresenta
physicalasset.Ineffect,sincecapitalstructureanalysisinvolvesmakingchoicesbetween
competingactions,manyofitsdecisionsarebasedontheseinherent“implicit“costs.
Oneofthemostfamiliarimplicitcostsisdilution.IftheXYZCompanyhas100
sharesofstock,eachwithearningsofonedollar,increasingthenumberofsharesto110,
willhaveanimplicitcostof(1-(100/110))x(110)=10dollars.Theactionofincreasing
outstandingequitybytenpercenthadtheneteffectofreducingEPS,whichhasaneffect
onthepriceofthestock,butdoesnotreducethefundamentalsonthebalancesheet.
Anotherimplicitcoststemsfromdelayingactions.Forexample,Icanchoosenotto
installpollutioncontrolequipmentandincurasmallfine,orIcanspendtoomuchfora
systemthatwillbebothlessexpensiveandobsoleteinafewyears.The“fine”willbecome
partofthebalancesheet,butthedecisiontodelayandsavemoneyhasnocorresponding
entry.
Sincecapitalstructureanalysisencompassesdecisionsaboutchoicesamong
alternativeactions,theprimaryimplicitcostistermedan“opportunity”cost,againorloss
thatoccurswhenwechooseoneactionoveranother.Thus,anopportunitycostimplies
thatwearecomparingthecostoftwodifferentactions.Forexample,ifbondsarepaying
sixpercentandstocksarepayingninepercent,myopportunitylossisthreepercentifI
choosebondsoverstocks.Acomparativereturnonequity(ROE)ofcompetitorsinan
industryexhibitsmanyofthecharacteristicsthatweterm,“thecostofequity”;thereisno
physical,“upfront”cost,butifmyfirmunderperformsitspeersinROE,thereissome
adjustmentmadetothestockwhichisdifficulttopredictorenumerate.Infact,anytime
thatananalystresearchesindustryaverages,sometypeofcomparativeparadigm,an
opportunitycostsotospeak,isbeingformedinhisorhermind.Thus,weoftenformthese
costsunconsciously.
64

IMPLICITCOSTSOFDEBT
Naturally,interestexpenseistheexplicitcostofdebtandtaxdeductibilityis
acknowledgedwhenweuseittoformthecostofcapital.However,severalotherimplicit
costsexistwhendebtisincurred.
• 1)Theinterestrateneedstobecomparedtonotonlycompetitors’rates,buttothe
risk-freerateofthetenyeartreasuryandtheaveragesintheequitymarketsaswell.If
itistoohigh,debtneedstobecurbedandmoreearningsneedtoberetained.
• 2)The‘real”costofinterestmaynotonlyincludetaxdeductibilitybutinflationas
well.Highinflationhasavaryingeffectonfirmswithgoodcreditbecauseassets
appreciatewhileloansarepaidoffindepreciateddollars.Thecosttosomefirmsis
excruciating.
• 3)Thecostofbankruptcyisalwaysimplicitunlessthefirmisactuallybankrupt.The
firmneedstodeterminewhichassetscanbesecuredascollateralinadditiontothe
immeasurableeffectonthestockofchangesintheprobabilityofdefault.
• 4)Theeffectonthecostofequitymustbedetermined.Ifmoreleverageraisesthe
returnthatinvestorsrequiretoinvestinafirm’sstock,canthefirmbeprofitable
enoughtowarranttheincreaseindebt?Willdemandforthestockactuallydecrease,if
somethresholdamountofreturnisnotsurpassed?
• 5)Theimplicitcostofpossibleassetimpairmentmustbeexamined.Somerestrictive
covenantsinbondindenturesrestricttheuseofassetsandputotherrestrictionsonthe
actionsofmanagement.
• 6.Theimplicitcostofimpairingfuturefinancialflexibilitymustbeexamined.Evenif
interestratesdecline,thereissomecosttorefinancingaloan.Similarly,nofirmwants
tobeladenwithdebtatthetopofamarketbecausethisisthepointofgreatest
earningsopportunitiesformostcompanies.
THEIMPLICITCOSTOFEQUITY
65

Thecostofequityistherateofreturnthatinvestorswillrequiretoinvestinafirm’s
stock.Itisusedsynonymouslywiththeterm“requiredrateofreturn”andisreferredtoas
an“opportunitycost”becauseitcomparestherateofreturnoffirmswithsimilarriskina
leastsquarestypecorrelation.Whenequityisissued,theonlyupfrontcostswillbe
“flotationcosts”whichareapaymentorapercentageoftheproceedstotheunderwriting
firm.Whenequityisbuiltthroughretainedearnings,therequiredrateisappliedtoall
retainedearnings(notjustthecurrentyear’s)aswellasalloutstandingstockthathasbeen
issuedbythecompany.Thus,the“costofequity”isalmostentirelyimplicitandshiftsin
valuefromyeartoyeardependingontherateinvestorswillrequire.Ina“bull”market,
thisratenaturallyrises,whileina“bear”market,itdeclines.
Anotherimplicitcostarisesinthetimingofastockissue.Ifafirmis“maxed”out
onitscreditandisnotearningenoughtoraisecapitalthroughretention,itmustmeetits
fundingneedsthroughissuingstock.However,thepricereceivedwillbediminished
becauseinvestorswillnotfindthestockattractive;ifthefirmhasatargetlevelofcapital
requirements,itwillneedtoissuemanysharestoachieveit.Thus,thereisathreshold
pointwherefundingshouldbedelayedoravoidedbecauseitdiminishesthemarketprice
ofthestocktoodrastically.Alternatively,afirmcanissuestockwhenthepriceishigh,
receivingthemostcapitalpershareissued.Thislattertacticraisesadequatecapital,but
maybeundertakenwhenthecostofequityisveryhigh-suchasattheendofabusiness
cycle.Whenthecostofequity(therequiredrateofreturn)isexceptionallyhigh,thefirm
mayhavetroublecoveringitwithadequateearnings.Theresultisoftenalarge
adjustmentdownwardbecauseperformancedoesnotmeettheover-hypedexpectations.
Thefinalstrategyismostpreferredbyinsidersandlargeinvestors:issuestockwhenthe
priceislowenoughtoappreciatesubstantially.Whenthemarkethasnotfactoredin
expectedearningsfromprojectsthatitknowsnothingabout,theriskandcostofequityis
low.However,thecompany’scapitalstructuremustbeviableenoughnottodependona
stockissueforitstotalfunding;anyCFOknowsthevalueofadiversifiedmixofsourcesof
66

funding.Anytimethatafirmdependstoomuchonasinglesource,thereismoreriskofa
highercostofcapital.
Tosummarizetheimplicitcostsofequity,wecanputthemintooneofthree
categories:
• 1)Theimplicitcostofdilution-ThefirmmustconsidertheeffectonbothEPSand
marketprice,aswellasfuturedividendobligations.
• 2)Theimplicitcostofthe“requiredrateofreturn”-Investorswillnotdemandthe
stockofacompanythatunderperformsitspeers.Afirmthatdoessowillhaveavery
high“opportunitycost”andbeunabletocoveritwithenoughearnings.
• 3)Theimplicitcostoftiming.Raisinglargeamountsofcapitalwithanequityissuehas
manyrepercussions.Theonlytimeitseemsjustifiediswhenamajormergeroccursin
afavorableeconomicenvironment.Thusequityissuesshouldberelegatedto
“executivecurrency”ratherthanexistasamajorsourceoffunding.
THEMOMENTOFTRUTH
Ultimately,mostinvestorswanttotimethemarketsothattheyareintheearly
stagesofalargepayoff.Moreoftenthannot,thatscenariooccurstoanyinvestorwhois
welldiversifiedandstaysinthemarketlongenough,despiteitsvolatilechanges.Itisnota
frequentoccurrence.Ifthestudent/investorobservesthecorporatesideofanyinvestment,
heorshewillunderstanditasashiftincapitalstructurewhereacceleratedearningsbegin
topropelthecombinationsofassets,debtandequityinaparticulardirection.The
uncertaintyisderivedfromthetimingofthatprospectandwhetheritwilloccuratall.
Naturally,itistheprerogativeofmanagementtokeeplagtimebetweeninvestmentand
payofftoaminimum.Someindustries,however(likepharmaceuticals),willhavealong
lagtimebutreturnmoreoncethepayoffoccurs.Infact,morethanoneinvestorhaslefta
firmonlytofindthatmorepatiencewouldhaveledtoprofitability.Inevitably,investment
screensaredesignedtofailbecausethemarketwillchangeandmakesurethattheydo.
67

But-thereareafewsignalsthatarerelatedtobothcapitalstructureandearlyinvestment
success.
• ExecutiveTrades.Whenacompany’sownexecutivesarebuyingstockandaredoing
sofromaleveragedposition,thetidemaystartshiftingtomoreequityfinancing.
• Althoughfinancialstatementsoccur“afterthefact”,lookforquarterlyimprovement
incapitalturnover,%∆ ∆∆ ∆Sales/%∆ ∆∆ ∆Capitalor%∆ ∆∆ ∆Sales/%∆ ∆∆ ∆Long-termdebt
• Investinginacompanywhoisincreasingitsproportionoflong-termdebttocapitalis
riskierthaninvestinginacompanywhoisbuildingequity.However,thereturncanbe
greaterifthefirmknowshowtousedebtstrategically.Theriskshouldbe
accompaniedbysomeconfirmationfromanalyststhatearningsaregoingtoimprove.
• Lookforashifttoasmallerproportionoflong-termdebttocapitalaswellasashiftto
alowerfinancialleverageratio(EBIT/(EBIT-InterestExpense)).Atfirst,thetwo
ratiosmaybe“outofsync”;whenearningsincrease,thefinancialleverageratiowill
begintodropinharmonywiththeotherratio.
• Knowthebusinesscycle.Forexample,expectinglargegainsfromthehousingsectorat
thetopofthemarketmaybewishfulthinking.Earningsacceleratewhenasectoris
receivinghighdemandatthesametimethatitscapitalcostsarelow.

(BacktoTableofContents)
68

APPENDIX:THENETOPERATINGINCOMEAPPROACHTOSTOCKVALUATION
Student/investorsareadvisedtotakethemostconservativeapproachtovaluinga
stock.Whilemoreleveragemayescalatethepriceofafirm’sstockinaworldwithout
bankruptcy,realitydictatesthatreturnsmustbeevaluatedinthedomainofrisk.
Academiciansdevelopedtwomethodstocontrastopposingviews.Thefirstmethodwas
calledthe“netoperatingincome”methodandpostulatedthattheextrareturnfrom
leveragewasbalancedoutbytheextrarisk,contributingnoadditionalvaluetothefirm.
Thesecondapproachwasthe“netincome”method,whichproclaimedthatafirm’svalue
wasanextensionofitsdegreeofleverage,andtherelationshipbetweenitsinterestrateand
thecostofcapital.Bothapproachesweredevelopedinahypotheticalworldof“perfect
competition”-notaxes,bankruptcycosts,ordifferentratesofinterestbetweenfirmsand
individuals.
Whilebothmethodsvalueacompanyasthesumofitsbondsanditsstock,thenet
operatingincomeapproachdeterminesthevalueofthecompanyastheratioofcapitalized
operatingincome:thatis-operatingincomedividedbythecostofcapital.Itthen
subtractsthevalueofthefirm’sbondstodeterminethevalueofitsstock.Inmathematical
notation,thevalueofthestockis:(X/CostofCapital)-Bonds,whereXisequalto
operatingincome.Ontheotherhand,thenetincomeapproachtovaluingafirm’sstock
subtractsinterestexpensefromoperatingincomeandthendividesthisdifferencebythe
costofcapital.Inmathematicalnotationitis:(X-(InterestRate)(Bonds))/Costof
Capital.Itthentakesthisvalueofthestockandaddsthevalueofitsbondstodetermine
thevalueofthecompany.Asanexampleofthetwoapproaches,considerafirmthatis
capitalizedat$10000withD/Eof0%,50%andthen100%.Operatingincomeis$1000
andiscapitalizedat10%.Theinterestrateonbondsis5%.
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Table3-3

NetOperating
IncomeMethod

D/EPercent 0 50 100
NetOperating
income
1000 1000 1000
CapitalizationRate 10% 10% 10%
TotalMarket
Valueofthe
Company
10000 10000 10000
MarketValueof
Bonds
0 5000 10000
MarketValueof
theStock
10000 5000 0

Table3-4

NetIncome
Method

D/EPercent 0 50 100
NetOperating
Income
1000 1000 1000
InterestExpenseat
5%onBonds
0 250 500
NetIncome 1000 750 500
Capitalizationrate 10% 10% 10%
MarketValueof
theStock
10000 7500 5000
MarketValueof
Bonds
0 5000 10000
Totalmarket
Valueofthe
Company
10000 12500 15000

Bycapitalizingoperatingincomeanddeductinginterest,thenetincomeapproach
addsasubstantialamounttoboththemarketvalueofthecompanyanditsstock.
However,thenetincomeapproachassumesthatthereisnorisk;allincreasesinEPSare
immediatelytransferredintothepriceofthestock.Alternatively,thenetoperatingincome
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approachassumesthattheriskofleverageperfectlybalancesthepotentialeffectonEPS
andthatriskandreturncanceleachotherout.Inthenetoperatingincomeapproach,the
valueofthecompanyiscalculatedfirst,andtheamountofbondsissubtractedto
determinethestockprice.Inthenetincomemethod,thevalueofthestockiscalculated
first,andtheamountofbondsisaddedtothisfiguretodeterminethevalueofthe
company.Thestudent/investorwillobservethatiftheinterestrateisthesameasthecost
ofcapital,thereisnodifferencebetweenthetwomethods;indeedthenetincomemethod
rewardsmanagementforkeepingbothratesaslowaspossible.
Miller/Modiglianiarguedthattheonlycorrectapproachwasthenetoperating
incomemethod.TheirPropositionIarguedthatinaworldwithouttaxes,nogainwould
begarneredfromleveragebecausetheinterestratewouldalwaysapproachthe
capitalizationrate.Thusinaperfectlycompetitiveeconomicenvironmentwhere
individualsandfirmscanlendatthesamerate(nobankruptcy),therewouldbenobenefit
fromtheproportionofdebttoequityinthecapitalstructure.Thesameamountof
earningswouldflowtotheshareholdersregardlessofhowthefirmwasfunded
(BacktoTableofContents)

71

4
THECOSTOFDEBT
Whilewedefinecapitalaslong-termdebtandequity,wecannotneglectthe
importanceofshort-termdebtandallcurrentliabilities.Infact,nexttoproportional
capitalallocationitself,thestrategicuseof“workingcapital”formsthebackboneof
sustainableprofitability.Althoughmostindustriesgothroughsomesectorandmarket
volatility,itisworkingcapitalmanagementthatguidesacompanythroughthetroughof
businesscyclesandgrantsittheflexibilitytotakeadvantageofthepeaks.Thereare,
however,severalcharacteristicsthatmakeeachtypeofdebtunique.Despitecreating
productivesynergy,thedifferencebetweenlong-termandshort-termcreditissubstantial
enoughtocausetheeccentricpricingofrisk.Iftheclassicinvertedyieldcurveisasure
signofimminenteconomictrouble,itaccentuatestheproblemofmatchingcostwithrisk.
Whilethetwoareinseparable,theyarenotthesame,andcosthasatendencytoadjustto
riskratherthantheopposite.Hereinliesamajorproblemincapitalstructure.Partofour
solutionistofindaninterfacebetweencostandriskthatreconcilestemporaryinequalities.
Weproposethatinterfaceinthischapter,anddefineitasthecostofbankruptcy.
THEPROBLEMOFSHORT-TERMCREDIT
Thesignificanceofshort-termdebtespeciallybegsthequestion,“Whynotdefine
capitalstructureinthetraditionalmodeoftheproportion,debt/assets?”Whileitistrue
thatsomecompanieswillfundlong-termfixedassetswithrevolvingcreditfromabank,the
pricingandquantificationofriskbecomesobscured.Forexample,onecompanymaytake
outshort-termloanstotakeadvantageoftradecreditdiscountsbecausetheinterestonthe
loanislessthanthediscount.Anothercompanymaybemuchlarger,buysinvolumeand
nevertakesdiscountsatall;infact,itmaytypicallyextendpaymentperiodswellpastdue
andthevendortacitlyacceptsthisbehaviorbecausetheaccountissoprofitable.Which
companyhasthelowerrisk?Theanswerisambiguousbecausewearecomparingan
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opportunitycostofdebttoabusinesscondition.Thefirstcompanyismanagingitscosts,
whilethesecondcompanyistakingadvantageofitsabsolutesizeandpower;thecost
savingsfrom“floating’anon-paymentmaybejustasgreatasthefastidiousmanagement
ofcredit.
Althoughsomeacademicliteraturearguesthatshort-termdebtisonlyafactorin
totalriskanddoesnotcontributesignificantlytomarketrisk,itmustbeobservedasan
adjunct.Asbothalternativefinancing,andasasignalforapotentialincreaseinearnings,
ariseinshort-termcreditcanhelpoptimizelong-termdebtinsomesituations.While
short-termdebtmayhavenoeffectonmarketriskatsomepointsinthebusinesscycle,at
othertimesitmaybeadeterminingfactor-forexample,asasubstituteforlong-termdebt
attheendofacycleRatherthancommittothehigherinterestpaymentsofalargedebt
issue,afirmmaywanttowaitouttheuncertaintyinanticipationoflowerrates.Short-
termcreditencouragesthisfinancialflexibility.
Whilelong-termdebtandequitycanbegaugedintermsofcostandobligation,
short-termcreditislessamenabletoriskanalysis-onashareholderlevel.Thedeceptive
qualityofshort-termdebtencouragestheconfusionofprofitabilitywithinsolvency.For
example,aninventorybuildupcaneitherbeanticipatoryofsalesincreasesorasignalthat
demandistoolow,dependingonthetiming.However,accountspayablewoulddisplaythe
samelargebalanceregardlessoftheboom-bustcondition.Infact,asmorepurchasesare
made,currentliabilitiesoftenrisedramatically,butthesameconditionarisesduringa
shortageofcash.
Inessence,thereisanon-linearrelationshipbetweenthecostofshort-termdebtand
itsrisk.Unlikelong-termdebt,whichalmostperfectlycorrelatesprice(interest),andrisk,
short-termdebtgetspricedintermsoftherisktothecreditorwithlessreferencetothe
long-termviabilityofthecompany.Sinceshort-termdebtisnormallylessexpensivethan
long-termdebt,itistemptingforafirmtocontinuallyfundlong-termprojectswithshort-
termloanstokeepcapitalcostsataminimum.Suchastrategyisfraughtwithtwomajor
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risks:1)Theloansneedtobefrequentlyrenewed,andthecompanymaynothavethecash
flowatthetimeitisneeded.2)Interestratesvary,andashort-termloanexposesthefirm
tobothapotentialriseinrates,andincomevolatility.Tocircumventtheserisks,most
companieswillmatchthecash-flowsfromoperationstothematurityoftheirdebt,andend
upfundinglong-termprojectswithlong-termloans.Ontheotherhand,firmswithmore
seasonaldemandschedules-farmers,skilodgesandgolfcoursesforexample-wouldbe
moreamenabletoshort-termcredit.Thepayoffwouldbemorecertainandbasedon
historicalrepetition.
INTERESTEXPENSEINEQUALITIES
Anotheranomalyoccurswheninterestexpenseattheendoftheyeardoesnot
reflecttheactivityintheshort-termcreditmarketduringtheyear.Interestexpensemay
escalateduringthesecondandthirdquartersbutloansgetpaidoffjustintimeforthe
annualincomestatement.Theresultisaninterestexpensethatdoesnotreflectthegreater
amountofriskduringtheperiod.Infact,a“rogue”financialexecutivecanfinancewith
short-termdebt,exposingthefirmtotheriskofdefault,buttimethecash-flowswith
“luck”andpayofftheloansontime.Verylittleofthisactivitywillbereflectedinannual
reportsanditappearsthattheexecutivesuccessfullyfundedlong-termprojectsand
loweredthecostofcapitalsimultaneously.Moreover,ifafirmchoosestofinanceinventory
withavendor,interestexpensecaneasilybesubsumedinto“costofgoodssold”,andthe
higherriskwillnotbereflectedontheincomestatement.Othertimes,firmswill“netout”
theirinterestexpensewithinterestgainedinsellingsecurities;suchobfuscationis
sometimesaredherring:transparencycanbeconfoundedwithbotheuphemismsand
extensivecircumvention.Thus,investorswhoneedaprecisebreak-downofinterest
expenseattributabletolong-termdebtmustreadthefinancialnotesinafirm’s10Kor
annualstatements.Eachmaturingissuewillbematchedwiththedateofmaturityandan
interestrate.Forexample,inacompanywithaninterestexpenseof9millionand100
millioninlong-termdebt,asamplebreakdownisasfollows:
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Table4-1

DEBTAMOUNT MATURITY INTERESTRATE
33.33(MILLION) 2009 5.5%
33.33 2011 7.5%
33.33 2013 10.5

Theamountofinterestexpenseattributabletolong-termdebtistheamountofeach
maturitymultipliedbyitsrespectiveinterestrateandthensummedtogether:
33.33(0.055)+33.33(0.075)+33.33(0.105)=8.082
8.082millionininterestexpenseisattributabletolong-termdebtandjust$917,933
(0.917933)wasattributabletoshort-termdebt.Toconcludethetreatmentofshort-term
debtwithinthecapitalstructure:
• 1)Capitalstructureasdefinedinthistextisacombinationoflong-termdebtand
stockholders’equity.Asshort-termcredithasamajoreffectonthesecomponents,itis
anadjunctforcetotheriskofcapital.
• 2)Withoutacomponentbreakdownofinterestexpense,theremaybesome
computationalerrorifallinterestisattributedtolong-termdebt.
• 3)Short-termcredithasanon-linearrelationshipwithrisk.Ifitwereincludedinthe
costofcapital,anyattemptsatminimizationofthatcostwouldbeskewed.
RISK,RETURNANDTHESIGNIFICANCEOFSHORT-TERMCREDIT
Thenatureoftherisk-returnconflictforshort-termcreditisthetimingofcash-
flows.Asafirm’scurrentratio(currentassets/currentliabilities)declines,itapproaches
whatisknownas“technicalinsolvency”suchthatitcannotmeetshort-termobligations.
Atthesametime,itmaybegearingupforasuccessfulperiodofrevenuegenerationby
buildinguptradecredit,engagingvendorsthroughpurchasesandcreatinginventory.A
balancesheetwillshowthatcurrentsaleshavenotproducedadequateaccountsreceivable
orcashforthatmatter,whiledebtispilinguponthe“accountspayable”sideoftheledger.
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Thisisoftenthetimewheninsidersbeginaccumulatingstockbecauseitmaybedepressed,
butisreadytosoarwhenrevenuesimprove.Theaverageinvestorperceivesacrisisrather
thananopportunityandfailstoinvest.
Anexaminationoftwoliquidityratiosandtwocash-flowequationswillrevealthe
ambivalentanalyticalnatureofshort-termcredit.Wehavealreadyobservedthe“current
ratio”whichalsohasamodificationcalledthe“acidtest”or“quick”ratio,currentassets-
inventories/currentliabilities.Theseclassicmeasurementsofsolvencydonotalways
indicateprofitability,however.Ahigherratiosimplymeansthatshort-termobligations
canmoreeasilybepaid;itisrarelyindicativeofstockmovement.Thereasonisfoundin
twootherequations,freecash-flowandthecapitalrequirementsequation.Thebasic
unleveredfreecash-flowequationis:
(EBIT)(1-T)+DepreciationandAmortization-CapitalExpenditures-∆NWA
Table4-2

EBIT EarningsBeforeInterestandTaxes
T TaxRate
∆NWA TheChangeinNetWorkingCapital
(definedasthechangeincurrentassets-
currentliabilities)

Thestudent/investorshouldnoticethatasNWAincreases,cash-flowdecreasesandthat
morecurrentliabilitiesincreasecash-flow.Thesecondequationisthecapital
requirementsequation,whichgivesaroughestimateofoutsidecapitalrequirementsinline
withthesalesforecast.Itis:(Assets/Sales)(∆Sales)-(Liabilities/Sales)(∆Sales)-
RetainedEarnings.
Boththeassetsandliabilitiesvariablesarethosethatincreasespontaneouslywithsales
whichincludesmostlythecurrenttype.AsLiabilities/Salesincrease,theneedforoutside
capitaldiminishes.Tradecredit,forexampleisaninternallygeneratedsourceoffunding.
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Thus,whenshort-termcreditincreasesandtheoutlookforearningsispositive,the
potentialreturnisfargreaterthantheriskofinsolvency.
Thestandardmethodforevaluatingshort-termdebtisinthecontextofcash-flow.
Whentheratio,“Assets/Capital”risesatthesametimethatcash-flowincreasesasa
percentage(tenpercentinthelastperiodandtwentypercentinthisperiod,forexample),
thereturnfromrevenueswillmostlikelybegreaterthantheriskofincreasingshort-term
liabilities.Theprimaryconcernisthatoperatingincomeisacceleratingenoughtolower
theriskofdefault.
Dependingontheleveragesituation,theratio,Assets/Capital,followsaloosechain
oflogic.Thedifferencebetweennumeratoranddenominatoriscurrentliabilities.Amore
positiveoutlookfortheissueoflong-termdebtoccurswhenthisratioisincreasingbecause
businessactivityissteppedupandtheturnovertimeforthelargerinvestmentmaybe
shorter.Moreover,anincreaseincurrentliabilitiesmayshowtheuseofalternative
sourcesofcapitaltokeepthecostofcapitalataminimum.Assets/Capitalincreaseswill
alsocontributetoanincreaseinthereturnoncapital(ROC),asitisoneofthethreemajor
componentsofthatratio.First,areturnonassets(ROA)isformedbymultiplyingprofit
margin(NetIncome/Sales)byassetturnover(Sales/Assets).TheresultingROAfigureis
thenmultipliedbyAssets/Capitaltoformareturnoncapital(ROC).Essentially,therise
incurrentliabilitiessupportsinvestmentinlong-termdebtandequity,becausethose
componentsarepurchasedatahighercost.Anytimethatshort-termcreditcanbe
substitutedforcapitalwithoutunduerisk,thefirmmovestowardanoptimalcapital
structure.

THECORPORATECOSTOFDEBT
Banksandratingsagencieswilldetermineacorporation’spotentialdefaultby
analyzingitsvariousleverageratiosanditsfutureprospects.Ariskpremiumwillbe
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attachedtoanappropriaterisk-freerate(atenyeartreasuryyieldforexample)andthis
willbethecompany’sinterestrateinputforitscostofdebt.Thus,anytimeanewloanis
negotiatedatadifferentrate,acompany’scostofdebtchanges.Anewratewillchangethe
marketpriceofafirm’sdebt,dependingontheamountofdecreaseorincreaseintherate,
andalsoonthecompany’spriorinterestexpenseobligations.Wheneconomicconditions
dictateaninterestratechangeforanentireindustry,anewprimerateforexample,those
firmswhodonotincurnewdebtwillstillhaveachangeintheirrespectivecostsofdebt.
Thecostofdebtisanopportunitycostandiscomparedtobothcompetitor’sratesandthe
ratethefirmwouldactuallypayifitchosetoincurnewdebt.
Sinceincurringdebtimpliesataxdeduction,thenewrateofinterestismultiplied
bythereciprocaloftheeffectivetaxrate(1–taxrate)andthisfigureisfurthermultiplied
bythemarketpriceofthefirm’sdebt.Thetheoreticalunderpinningsofthisprocessare
discussedintheappendixentitled,“TheRealCostofCapitalandWhattheInvestorNeeds
toKnow”.
Fortheinvestor,itissimplyoverly“researchintensive”toconfigureafirm’snew
costofdebteachtimeitoccurs.Thecomputationalandinformationalrequirementsare
notjustifiedbytheperformancegainsinaccuratelymeasuringrisk.Aballparkestimate
canbeformedbyequatingeachinterestratethatafirmpaysonitsexistingdebtwiththe
correspondingproportionalmaturityinthefirm’sdebtstructureandthenforminga
weightedaggregate.Suchexpediencywillderiveaninterestexpensethatequatesafirm’s
bookvalueofitsdebtwithitsmarketvalue.This”nominal“costofdebtfailstogauge
immediatechangesinthecostofcapital,butcanbeusedasproxyinotherrelationalvalues
suchasthefinancialleverageratioandtheTIE(timesinterestearned).
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THENOMINALCOSTOFDEBTANDTHECOSTOFBANKRUPTCY
Whencalculatingthecostofcapital,theanalystusestherealcostofdebtwhichis
composedoftheinterestrateonthedebtandataxdeduction;itisthiscostwhich
comprisesthedebtcomponentinvaluationmodelsandcapitalbudgeting.However,in
ordertofunctionallycalculatetheoptimalcapitalstructure,weneedtoincorporateseveral
othercostsandinherentrisksintothemodelandweaccomplishthisbyforminga
comprehensive“costofbankruptcy”.
Themainattractioninusingdebttofinancecapitalneedsisitstaxdeductibility.
Interestexpenseisfullytaxdeductible,whichallowscompaniestogrowatafasterrate
thantheywouldiffinancedsolelybyequity.Thetradeoff,aspointedoutinthechapteron
leverage,isthatearningspersharemayincreaseinvariability.Ineffect,thegovernment
givesanadvantagetofirmswithloweralbeitsteadiercash-flowsbysubsidizinggrowth
throughtaxbreaks.Thosecompanieswithmorevolatileearnings,whowouldbeingreater
dangerofdefault,simplycannotcompeteonthisbasis.Naturally,several“taxstrategies”
emergewhenafirmcanuseleveragetoitsadvantage;themixofcash-flow,deferredtaxes
andtaxgainsorlossesbecomesparamount.
Thecostofdebtissimply,i(1-t),wherei=theinterestrateandT=theeffectivetax
rate.Thus,thenominalcostofdebtisthesummationofeachproportionalmaturity
multipliedbyitscorrespondinginterestrate,andmultipliedagainbythecurrenteffective
taxrate.Theeffectivetaxrateappliesbecauseitistherateatwhichcurrentdeductions
areconsidered.Consequently,eachmaturitylevelofdebthasthepotentialofcostinga
differentamountindifferentyearsbecauseofachangingeffectivetaxrate.Aprecise
enumerationofthecostofdebtmaycontaintenorfifteenseparatematuritiesbutisquite
simpletocalculateinaspreadsheet.Ifonecalculatestheproportionofeachmaturityasa
percentageoftotaldebt,andthenmultipliesbythecorrespondinginterestrate,anaverage
interestratecanbeobtained.Forexample,afirmhas30(million)of7%debt,50of8%
debtand20of6%debtwithaneffectivetaxrateof30%.Totaldebtis100million,andso
79

theproportionsare0.3,0.5,and0.2respectively.Theaverageinterestratecalculationis
0.3(.07)+0.5(.08)+0.2(.06)=7.3%.Inowhavethechoiceofmultiplyingthisrateby(1-
taxrate)toachievearateof.0511or5.11percent.Whenthisfigureismultipliedbythe
100millionintotaldebt,thecostofdebtis5.11million.Alternatively,Icouldalsogo
throughtheentirecalculationof(30)(.7)(.07)+(50)(.7)(.08)+(20)(.7)(.06)=1.47+2.8+
0.84=5.11.Whilethetypicalshareholderdoesnotnormallyneedthetypeofprecisionthat
isusedforcapitalbudgeting,moreinformationhelpsformbetterdecisions.
Whydoesthegovernmentmaketheuseofdebttaxdeductible?Therearemany
sidestothiscontroversialquestion.Perhapsthebiggestreasonistoencouragesmall
businessesandthosewhohavesmallcash-flowstostaysolvent.Asteadyincomethatis
amenabletodebtfinancingencouragessteadyrevenues(forthegovernmenttoo!)and
steadyemployment.Whileitseemstogiveanunfairadvantagetocompanieswhocanmost
afforddebtbothfinanciallyandstructurally,manyotheradvantagesareincurredwhen
equityfinancingisimplementedinstead:considerthelackofinterestrateriskandcredit
crunchesthatall-equityfundedfirmscanembrace.Also,firmsthatfundwithequitymay
reapmorebenefitsingoodeconomictimesbecauseincomeflowsdirectlytothe
shareholders.
Thecostofdebtisbothacomponentofthecostofcapitalandarisk-adjusted
precursortoanoptimalproportionofdebttoequity.Ifthis“symbiotic”relationship
seemsambiguous,itisbecause“risk”and“cost”arenotalwayscompatible.Considerthe
resultoflargecutsinthefederalfundsrate;asinterestratesdecline,theaveragefirmwill
domoredebtfinancingbutnotenoughtoradicallychangecapitalstructure.Theabilityto
usedebtfinancingisderivedfrombusinessriskandimplicitoperatingleverage.;nolevelof
interestratewillaltertheabilitytopayinterestinatimelymanner.Infact,astheriskof
defaultbecomesgreater,banksandunderwriterswillchargegreaterinterestratesto
compensateforgreaterrisk,evenasthis“cost”iscircumventedwithgreatertax
deductibility.Atextremelevelsofdebt,creditorswillsimply“turnoffthespigot”and
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interestrateswillstabilizeatahighlevel.Thereinliestheproblemofusingthecostofdebt
todetermineanoptimalcapitalstructure.Thecostofequityisincreasedbytheuseof
leverage,butthecostofthatleverageneversurpassesit.Evenattheaforementioned
extremelevelsofinterest,taxdeductibilitywillensurethatthecostofequityisgreater;
thereexistsa“riskpremium”thatcompensatesshareholdersforadditionalriskof
uncertainincome.Ineffect,theMillerModiglianipropositionIIbecomesoperative
becausetheoptimalproportionofdebtinataxedeconomywillbeonehundredpercent-if
talliedbycostaloneThisextreme“cornersolution”wasproposedundertheassumptionof
azeroprobabilityofbankruptcy,whichfurtheremphasizesthesignificanceofdefault.An
optimalsolutiontofindingtherightcapitalproportionexistsonlywhenthecostofdebtis
reconciledwiththecostofbankruptcy.
THECOSTOFBANKRUPTCY
Forafirmwhousesleverage,thekeytoanoptimalcapitalstructureistouseas
muchdebtassafelypossible.Theword“safely”isaconnotativeterm,whichneeds
objectification,anditisnoaccidentthatcompaniesspendmillionsinriskmanagementto
gainaprecisedefinition.Inessence,thecorrectproportionofdebtwilldeterminethe
optimalproportionofequity,andsincedebtislessexpensivethanequity,thecostofcapital
willbeminimizedatanygivenlevelofoperatingincome.
Evenwithinanindustry,eachfirmisultimatelystructuredinauniquewaywith
differentpatternsofriskandreturn,dependenton“niche”orspecialty.Toforma
“generic”costofbankruptcyistoassumeadauntingtask,butinroadsintoasolutioncan
bemadewhenwelookforcommonfactorsinthecalculation.Twoofthosefactorsare:1)
Theprobabilityofdefaultand2)Theamountofloss.
THEPROBABILITYOFDEFAULT
Whileteamsofactuariessetlossliabilitiesintheinsuranceindustry,mostinvestors
areatleastfamiliarwiththeFICOscore-thecreditratingwhichneverseemsfactually
accurate,buthauntseveryonewhoevergotturneddownforaloanThereinliesthe
81

problem.Economicconditionschangeandusingthesamemethodologywithdifferent
inputsmayleadtoinaccurateprobabilities.Infact,ascomplicatedasdefaultanalysishas
become,mostanalystssettlefortheproverbial“ballpark”figure.Logit,probitand
multipleregressionanalysisarevaluabletools,butprecisepredictionofnear-term
probabilitiesremainselusive.Althoughspecificconditionslikehousefiresorhomeowner-
liabilitylawsuitscanbedeterminedbyprobabilitydistributions,typesofvariablesrelating
totheeconomyaremorevolatile.Lawsuitsandfireshaveahistoricfrequencythatcanbe
extrapolatedintoalossschedule;thereisnosuchscheduleavailableforperiodsofhyper-
inflationorvariousspeculative“bubbles”.Ineffect,theextremesofsolvencyanddefault
aremuchmorepredictablethanthechanceoftransitioningtoahigherriskcategory
becausethelatterisdependentonshiftingeconomicvariables.
BothMoody’sandStandardandPoor’shavebeenratinglong-termdebtissuesfor
manyyears.Thisratingisofprimaryimportancetoboththeratedcompanyandto
investors.Infact,bondratingssetthestageforcapitalstructurebecausetheyhelp
determinethecostofdebtinbothnominalanddefaultforms.Thenominalcostisaffected
becausebetterbondratingsleadtofavorableinterestrates,whilethedefaultformis
affectedbecausethoseratingsareconfiguredintermsofsolvency-theprobabilityof
default.
Whiletherearemanycommercialalgorithmsavailable,mostratingsystemsare
veryspecificandapplytoaparticularindustryoreconomicoutlook.However,forthe
purposesofcapitalstructure,thegenericratingsystemspromulgatedbyvariousacademics
haveheldupovermanyyears.Infact,theyarerobustfortheveryreasonthatcommercial
bankscannotusethemtosetinterestrates:theyofferageneralpurposeriskanalysis
withoutthespecificityneededtogaugeaparticulareconomicenvironment.Testedagainst
commercialalgorithms,theacademicgenericshaveeclipsedtheminaccuracyovercertain
periods,butlacktheabilitytotransitiontoachangedeconomy.
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EdwardAltman’s“ZScore”isperhapsthebestknownofthese.Theproductof
multiplediscriminantanalysis,itisstill94%accurateinpredictingbankruptciesoneyear
away,andabout72-80%accurateinpredictingbankruptciestwoyearsaway.Forthe
student/investor,itoffersacommongroundwithotheralgorithmsbecauseitbasesits
analysisonanarrayofperformancevariablesasapercentageofassets;asummationis
performedonasset-relatedcomponentsandthenamathematicalprocedureisperformed
onthesum.InthecaseofAltman’sZScore,theprocedureinvolvesdeterminingwhether
thesumislargeenoughorincreasing.Inmostotheralgorithms,logitoperationsare
performedwherethelogarithmof“theodds”areobtained.Usually,theanalystwill
merelyplugindecimalratiosintoaweightedcoefficientequationandtallyascore,whilea
spreadsheetdeterminestheprobability.
Thealgorithmanditscomponentsareasfollows:
1.2(X1)+1.4(X2)+3.3(X3)+0.6(X4)+0.999(X5)
Allentriesaremadeindecimalform,butthelastfigure,X5,maybeaninteger.
Table4-3

ALTMAN'SZSCORE
(X1)=WorkingCapital/TotalAssets
(X2)=RetainedEarnings/TotalAssets
(X3)=EarningsBeforeInterestAndTaxes/TotalAssets
(X4)=MarketValueOfEquity/Liabilities
(X5)=Sales/TotalAssets

Sometimesthemarketwillbeinflated,andoneneedstoformaZscorefrombookvalues.
Inthatcase,themodifiedZScoreis0.71(X1)+0.847(X2)+3.1(X3+0.42(X4)+0.998(X5)
ThisZScorewillproduceafigurefromzerotothreeormore,wherezeroisbankrupt,1.81
isatroubledfirm,andoverthreeisconsidered“safe”.Progressfromquartertoquarter
canbediscernedbyformingarunningtotalonaspreadsheetandanylargeincreasesmay
signalstockpriceappreciation.
83

COMMERCIALRATINGSYSTEMS
TheMoody’sandStandardandPoor’ssystemsareupdatedregularlyanduse
probitanalysisamongothertechniquestocreateratings.Inmosteconomies,theyare
accuratebutrequireasubscriptionfromusers.Investorsarethoroughlyfamiliarwiththe
letteredratingsystemof“AAA”standingforhighinvestmentgradeandasmall
probabilityofdefault,downtoa“D”ratingwhichindicatesdefaultprobabilityofone
hundredpercent.AccordingtoMoody’s,thesixmostsignificantvariablesinprobit
analysisare:
• 1)(EBIT+1/3Rent)/(InterestExpense+1/3Rent+(PreferredDividends/0.65))
• 2)AdjustedDebt/AdjustedBookEquity
• 3)CashandEquivalents/TotalAssets
• 4)FiveYearRevenueVolatility
• 5)RetainedEarnings/AdjustedDebt
• 6)AssetGrowth
Again,weseemanysimilartypevariablesasinAltman’sZscore:operatingincomemust
coverimmediateobligations,salesmustbeadequate,theremustbeliquidity(cash,working
capital)andperformancemustbematchedagainstassets.Formanyyears,Standardand
Poor’susedacombinationofprobabilityalgorithmsandqualitativejudgmenttorate
companies-whichisentirelylegitimatebecausemanyeconomicvariablescanonlybe
measuredaftertheirqualitativeanalogsoccur.Thefollowinglistentailssomeofthe
variablesusedinthisjudgment:
84

Table4-4

VARIABLESUSEDINDETERMININGDEFAULTPROBABILITY
1)Debt/Asset
2)TimesInterestEarned(TIE)
3)TimesFixedChargesCovered
4)CurrentRatio
5)"QuickRatio"
6)MortgageProvisions(Collateral)
7)CallProvisionsOnBonds
8)OtherRestrictiveCovenants
9)SinkingFundProvision(AccountForRetirementOfDebt)
10)RegulatoryClimate
11)Anti-TrustLegislation
12)OverseasOperations,Diversification
13)EnvironmentalFactors
14)ResourceAvailability,VendorStability
15)LaborRelations
16)PercentageBreakdownOfSales/Customer-Diversification

Itisquitedifficulttoendowavariablelike“laborrelations”withanaccurateprobability
thatenhancescreditprediction,whichiswhyanyattemptatprecisionmustbeupdated
frequently.Thestudent/investorshouldrecognizethatsettinganoptimalcapitalstructure
isaprobabilisticventuresubjectto:1)thetechnicalaccuracyofthealgorithm;2)the
effectoftheeconomyontheprobabilityofdefault;3)thecurrencyofdata.Any
determinationofanoptimalcapitalstructurewhileusingdefaultprobabilitiescouldnot
realisticallydelineatebetween30percentdebtand31percentdebtbutshouldbeableto
alerttheinvestortoexcessivelevels-suchasfiveormorepercentaboveorbelowthe
target.
TYPESOFBANKRUPTCY
Oneproblemthatoccurswithgenericapplicationofbankruptcyalgorithmsisthe
lackofuniformityamonglegaldispositions.Largecompaniesaretypicallyencouragedto
filechapterelevenandreorganizeratherthanliquidate;theyhaveassetsandobligations
85

thataregreatenoughtocontinueoperations-underdifferentcircumstances.Government
entities,creditorsandeventhelocalcommunityhaveastakeinseeingtheoperation
continueinadifferentcapacity-eitherdownsized,boughtout,orbrokenup.Thus,while
recoveryofassetsmaybeaslowas20percentinaliquidation,theyare95-100percent
recoverableinareorganization;claimsaresetbythe“doctrineoffairness”andare
recognizedbylegalandcontractualpriority.
Sincethedecisiontoreorganizeorliquidaterestswithtrustees,theyneedtoanalyze
twobasicissues:1)Isthefirmworthmoreasanongoingenterpriseorassoldassets?,and
2)Canearningscoverfixedchargesinthefuture?.Obviously,thetypeofindustryis
significantbecausetheassetstructurewilldeterminewhetheritismarketable.Firmswho
havemoreintellectualpropertyandyethaveagoodhistorictrackrecordofmeeting
obligations,willbemoreofareorganizationtargetthanafirmwhotradesinan
appreciatingcommodity;onefirmrequiresmanagerialforesight,theotherprospersonthe
marketpriceofanasset.Althoughthescienceofprobabilitycanfactorinqualitative
decisions,mostmodelswillnotdifferentiatebetweentypesofbankruptcybecauseofthe
legalambiguitiesinvolved.
THEAMOUNTOFLOSS
Amodelofdefaultwilldeterminetheamountcreditorsreceivebyreconcilingthe
amountofliabilitieswiththeassetstructure.Shareholdersusuallyreceivenothing.
Indeed,partofthetensionbetweenbondholdersandshareholdersstemsfromthe
establishmentofa“riskpremium”whichisderivedfromcontractualpriority;anytimea
firmincurslong-termdebt,thestockholdersforfeitaclaimonthefirm’sassets.Onthe
otherhand,bondholdersareentitledtoaseriesoffixedpaymentandreturnofprinciple
andnothingelse;anyfutureearningsgainedfromtheinvestmentindebtaccruesto
shareholders.Inessence,shareholdersclaimtheintrinsicvalueofthecompany,whichis
thepresentvalueoffutureearnings.Bondholdershaveaclaimonanextrinsicvalue,
86

whichmaybemarketableassetsorprioritizedearningsflow-inotherwords-interest
paymentsandassetsthatcanbeeasilysold.
Therearenosetformulasorseriesofcalculationsthatenabletheanalystto
determineagenericamountoflossinabankruptcy.Eachcaseisuniquebasedonlegal
type,liquidity,structureofdebtandabsolutesize.However,financialtheoristsarewell
awareofthesignificanceofpotentialbankruptcytocapitalstructure,andevenadaptittoa
modifiedversionofMiller/Modigliani’shypothesis:V(l)=V(u)+TB-PV.Thatis,the
valueofaleveredfirmisequaltothesummationofthevalueofanunleveredfirm,the
productofthetaxrateandtheamountofbonds,andthedifferenceofthepresentvalueof
bankruptcycosts.Thecontroversyentailsthedefinitionandenumerationofbankruptcy
costs.
Ifwestatethatastockisworthlessuponbankruptcy,weareimplyingthatthecost
ofbankruptcyistheentirelossofmarketvalue,andyetimplicitinthatvaluearethe
prioritizedclaimsofcreditors.Whenweconsidertheseclaims,thetruemarketvalue
assumessomemonetarymultipleabovethem.Ineffect,weareseparatingtheintrinsic
claimsonearningsflowthattheshareholderspossess,fromtheextrinsicvalueofsalable
assetsthatcreditorspossess.Inbankruptcy,eachisaseparateentity.Duringnormal
operations,the“extrinsic”assetsprovidetheframeworkforearnings;intrinsicvalueis
basedontheprospectoffutureearnings.However,oncebankruptcycommences,the
confluenceisnolongerviable.Unlessthefirmisreorganized,theassetsdonotproduce
presentorfutureincomeandthestockisworthless.Creditorshaveaclaimtopartofthose
extrinsicassetswhileshareholderslayclaimtowhatisleftover.
Thus,itwillbehelpfultoputbankruptcycostsintoperspectivebyrelatingthevalue
ofvariousassetswiththemarketvalueofequity.Boththepriorityofclaimsandthetype
ofassetsdeterminetheamountofloss.Notethatshareholdershaveclaimsduringongoing
operations,butwillforfeitthegreaterpercentageofthemduringbankruptcy.

87

Table4-5

ASSETCLASS PRIORITY TYPES
COLLATERALIZED a.SeniorMortgageDebt a.Marketable
b.AdministrativeFees b.Salvage
c.AccruedLiabilities
dNotespayable
e.Debentures
INTANGIBLE NONE-Byprior
agreement
a.Patents
somecreditorsmayhave
claims
b.Trademarks
onmarketablepatents c.Goodwill
UNCLAIMED CommonStockholders DependentonPrior
Claims

Figure4-1

Theintrinsicvalueofthecompanyisequaltomarketvalueaslongasthecompanyis
solvent.Oncebankruptcyproceedingsbegin,priorityisgiventocreditors,and
shareholdersforfeittheirclamsonassets.
Assetsaremadeupoftangibleassetsandintangibleassets.Tangibleassetsmayor
maynothaveamarketvalue,andshareholdersmaylayclaimtosomeofthem.
Analogously,intellectualpropertylikepatents,classifiedas“intangibleassets”,canhave
Intrinsicvalueofthestock(ongoingoperations)
BookValue Market
Value
TangibleAssets+Intangible
TrueintrinsicValueatBankruptcy
AmountofLoss
ExtrinsicValue
88

marketvalueandbeclaimedbyeithercreditorsorshareholders.However,themajorityof
intangiblesaremadeupbythedesignatedassetclass“goodwill”,whichisprimarilythe
excessmarketvaluepaidforacquisitions.Atbankruptcy,itisvirtuallyworthless,unlessit
isusedasabargainingtoolforadministrators;trusteescanpointtoacompany’shistoric
responsibilitytocreditorsandtheindustry.Priorityofclaimsgoestoseniormortgage
holders,followedbyadministratorswhomayget20-25%ofmonetarygainsfromasset
sales.Subordinateddebtholdersmayreceiveanywherefrom20to70%dependingonthe
claimandmarketabilityofassets.Theleewayforclaimsisquitelarge,andsome
subordinateddebtholdersreceivenothingatall.
Totheshareholder,theamountofassetsacreditorreceivesisimpertinent;heorshe
isleftwithaworthlessinvestment.However,toviewtheamountoflossastheentire
marketvalueofsharesisimproper.Stockholders,ineffect,agreedtopayariskpremium
whentheydecidedtoincurlong-termdebtinanefforttoboostearningsandshareprice.
Thispremiumwasadoubleedgedswordofunrealizedpotential:1)debtmightincrease
thevolatilityofEPSbeforeitboostsshareprice,and,2)notonlyweretangibleassetsgiven
uptocreditors,thepotentialtoraisetheprobabilityofdefaultwasgreater.Aslongas
operationswereongoing,shareholders“rented’acertainportionoftangibleassetsto
producefutureincome.Oncethecontractwasneartermination,thoseassetsrevertedto
thecreditors.Anyunclaimedassetsbelongtothecommonstockholdersandthoseare
designatedbytheratio,“tangiblebookvaluepershare”.Itistheamountashareholder
wouldtheoreticallyreceiveuponliquidation.Therealityofmostbankruptcyproceedings,
however,dictatesthatclaimsbyemployees,pensionfundsandevenauctioneerswill
eliminatethepossibilityofsuchcompensation.
Toconstructaworkingmodelofthisconcept,weneedthecalculationfortangible
bookvaluepershare,whichis(loosely):(TotalAssets-IntangibleAssets(including
goodwill)-UnamortizedDebt)/(NumberofSharesOutstanding).Next,weformaratio
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betweentangiblebookvaluepershareandthemarketpriceofthestockandsubtractthis
fractionfrom“1”.
(1-(TangibleBookValuepershare/Pricepershare)).Lastly,wemultiplythisvalueby
themarketvalueofthecompany,whichisdeterminedbytheproductofoutstanding
sharesandpricepershare.Theentireexpressionisasfollows:
AmountofShareholderLoss=(1-(Tang.book.Val.persh/Mkt.Val.persh))x(#sharesx
MktVal.persh)
Implicitinthislossisallmarketvalueaboveafirm’sextrinsicvaluenetofliabilities,which
rephrasestheterm,“tangiblebookvalue”.
Essentially,theamountoflosswillbesomefunctionofthesethreevariablesanditis
therelationshipamongthethreethatcandeterminetheproperamountofdebttoemploy.
Whenthesevariablesinteractwiththeprobabilityofdefault-whichgaugesthepotentialto
coverinterestexpenses-acostofbankruptcycanbeestimatedBymultiplyingthetwo
constructs:(ProbabilityofDefault)x(AmountofLoss)wecanestablishacomparative
proxy.Althoughthetruecostofbankruptcymustbeconfiguredforeachuniqueentity,
ourstructurallydependentmodelcanbeusedincapitalstructuredevelopment.
Despiteitsutility,thecostofbankruptcymodelhassomeseriousshortcomings.The
amountoflossisprobabilistic,dependingoninteractionwiththeeconomy,competitors
andtheequitymarket.Forexample,aspeculativerunupinthestockwouldaffectthe
amountofloss,perhapsevenseparatingitfromitstrueassetvalue.Secondly,the
probabilityofdefaultneedstoformanexponentialcurve,penalizingfirmsatanincreasing
ratefortakingontoomuchdebt.Alinearformatwouldallowfirmstoreapthetax
benefitsofmoredebtwithoutviolatingtheconstraintsofbankruptcy.Sincemost
algorithmsareformedfromprobabilitydistributionsthatemphasizecentraltendency,
findingadefaultprobabilitycalculationthatisalsopreciseattheextremeswouldbe
difficult.Anyoptimizationmodelmustallowfortheprimacyofall-equityfundingifthe
assetstructureisnotamenabletofinancingwithdebt.Lastly,theamountofshares
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outstandingisavariablethatisdeterminedoutsideofthemodel.However,atheoretically
viablemodelwouldallowthatnumbertobedependentonnecessaryfunding-thelevelsof
equity,debtandcapitalalreadyinthecapitalstructure.Toobservethisdiscrepancy,note
thefollowing“paradox”thatoccurswhenastockhasbeen“beatendown”:
Table4-6

THRIVINGCOMPANY NEARBANKRUPTCOMPANY
#SHARES=100 #SHARES=100
TANGIBLEBOOKVALUE/SH=4 TANGIBLEBOOKVALUE/SH=4
MARKETPRICE/SH=20 MARKETPRICE/SH=7
LOSS=(1-4/20)x(100x20)=1600 LOSS=(1-4/7)x(100x7)=300

Thedifferenceinshareprice($20vs.$7)allowedtheamountoflosstobemuchlessforthe
nearbankruptcompany;thatsmallernumbermayopenthedoorformoredebtfinancing
inanoptimizationmodel-theoneelementthatwouldcertainlypushtheprobabilityof
defaultupward.
THEROLEOFDEBTINCAPITALSTRUCTUREOPTIMIZATION
Debtisthefulcrumbetweenhighertaxbenefitsontheonehandandthechanceof
lossontheother.Theoptimalamountofdebtwilloptimizeequityaswellbutitmustfirst
bereconciledwiththeproductionofincome.Ifmoredebtviolatestheparameterssetforth
inthecostofbankruptcy,futurecash-flowsarejeopardizedandthevalueofthecompany
deteriorates.Toseehowthisworks,wewillrevisittheadaptationoftheMiller/Modigliani
“valueequation”:V(l)=

V(u)

+TB-PVwhichstatesthatthevalueofaleveragedfirmis
equaltothevalueofanunleveredfirmplustheproductofitstaxrateandbondsand
minusthepresentvalueofitscostofbankruptcy.Thusthedistanceinvaluebetweenthe
unleveredfirmandtheleveragedfirmismaximizedwhenthedistancebetweenTBandPV
isalsoatamaximum(V(l)–V(u))=(TB-PV).Themaximumofafunctionsuchas(TB-
PV)occurswhen∆TB=∆PV.Whenthemarginaltaxbenefitsequalthemarginal
bankruptcycost,thefunctionTB-PVwillbeamaximum.Mathematically,whatwehave
91

doneissetthefirstderivativetozero;thatis∆TB-∆PV=0Thefunctionwillincrease
untilthechangeintaxbenefitsequalsthechangeinthecostofbankruptcy,andthenit
shoulddecrease,indicatingthattoomuchdebthasbeenincurred.Therefore,bothTBand
PVmustbeafunctionofdebt;whenwechangethatvariable(debt),bothTBandPVwill
changeaccordingly.Inthatregard,stockholders’equitywillbesetbysubtractingthe
optimumlevelofdebtfromagivenlevelofcapital.Thispresumptionthatcapitalissetat
thecorrectlevelisalimitingconstraintoftheoptimizationmodel;weknowfrom
observationthatfirmsdonotalwaysraisethecorrectamountofcapitalandthatthe
properamountistheoutgrowthofprojectanalysisandcapitalbudgeting-producinga
positivenetpresentvalueoncorporateprojects.
Asafirmincreasesleverage,itstaxbenefitsincrease,butthecostofbankruptcy
alsoincreases.Atsmallerlevelsofdebt,thetaxbenefitswillexceedthecostofbankruptcy.
Asmoredebtisadded,theprobabilityofdefaultincreasesatamuchfasterratethantax
benefits,creatingadisproportionateincreaseinbankruptcycosts.Eventually,ifenough
debtisadded,bankruptcycostswillexceedtaxbenefits,whichisasignalforthefirmto
takeactionandlowerleverage.
Doesthismodelminimizethecostofcapital?Inthelongrun,themarketwill
correctlypriceriskbycharginghigherinterestratesforriskierleverage.However,inthe
shortrun,variousmispricingsoccurthatwilltemporarilyallowtoomuchortoolittledebt.
Byencouragingtheuseoflowerpriceddebttotheextentwhereitdoesnotmaterially
underminethepriceofthestock,norviolatedefaultconstraints,thismodelwillminimize
thecostofcapital.Ifequity,intheformofretainedearnings,wereusedinsteadofdebt,
theleftsideoftheequation(TB)wouldremainstable.Inthemeantime,anyappreciation
ofthestockwouldbecounteredbyalowerdefaultprobability,whichwilllowerthecostof
bankruptcy.Theresultisahighermarginalbenefitsequation,andmovementtowardan
optimalcapitalstructure.Hadthepatternoffundingwithretainedearningscontinued,
theappreciationinthestockwouldbegreatenough,andthedecreaseindefault
92

probabilitysmallenough,toactuallybeginincreasingthecostofbankruptcy.Atthis
point,thecompanyneedsaninfusionoflowercostdebtbecausethecostofretained
earningsistoohigh.
THEOPTIMALAMOUNTOFDEBT
Fromtheperspectiveofatheoreticalidealwheretheintrinsicvalueofthestockis
equaltomarketvalue,wealsoneedanidealdefaultprobability.Besidesdisplayingthe
aforementionedshape,apracticalmodelisconsummatedwhenvariablesinthedefault
algorithmaremadedependentonchangesindebt.Forexample,achangeinlong-term
debtwillaffectinterestexpensewhichwillaffecttheamountoftaxes,andultimately-net
income.Sincethemodelimpliesthatthetaxrateandtheamountoflossareconstants
(determinedasgiven),onlythechangeinlong-termdebtanddefaultprobabilityarethe
dynamicfactors.Infact,theequationcanreduceto:
∆Long-termdebt=(∆ProbabilityofDefault)x(AmountofLoss/TaxRate)
Whenwesolvefor∆Long-termdebt,weadd(orsubtract)thisamountfromtheactual
long-termdebtthatthefirmhadonitsbooks,andthisfigurewillrepresenttheoptimal
amountofdebt.Subtractingtheoptimalamountofdebtfromthetotalamountofcapital
invested,willyieldtheoptimalamountofequity.
Thefirm’scapitalinvestmentisanotherconstraintthatisinputtedasgiven;wemay
secondguesstheamountofcapitalasexcessiveorinadequate,butweneedtouseitasa
realisticconstraint.Asinvestors,wecancontrolourownflowofmoneyintoastockbased
onnumericalaggregatesliketheamountofdebt.However,theamountofcapitalisana
priorifigure.Ifearningsarelarge,whatlookedlike“excessive”capitalturnsinto
“adequate”capital.Thejudgmentofadministration,theanalysisofvariousprojects,and
thetimeframeofmanagementareallvariablesinthedecisiontoraisecapital.Thus,while
theamountofcapitalisimperativetocapitalstructure,itisagivenconstraintin
optimization,outsidethepurviewofthemodel.Whileourmodelcandelivera“realistic”
optimum,itcannotdelivera“true”optimumbecauseitrelinquishescontrolofthecapital
93

functiontooutsidefactors.Whenweoptimizedebt,wedosoinrelationtothevariablesof
defaultprobability-assets,income,andotherliabilities.,butthemostonerousconstraintis
theamountofcapital.
LONG-TERMDEBTANDTHEAMOUNTOFLOSS
Thepeculiaritiesoftheamountoflossmeshwiththeadditionoflong-termdebt:
• 1.Growthstocksoftenhavehigherearningsthanaveragebutmorevolatility.Manyof
themarefundedwithequitybecausetheinstabilityofcash-flowkeepsthemawayfrom
thecreditmarket.Thehighermarketvaluethatisimplicitwithequityfundingwillbe
anoutgrowthofmoresharesissuedwhenearningsareup.Atthisjuncture,thecostof
bankruptcywouldbeprohibitivelyhighforadebtissueevenwithoutahigher
probabilityofdefault.
• 2.Higherstockpricesencouragetheissuanceofequity.Inthismodel,ahigherstock
pricediscouragestheuseofdebt,becausemoredebtwouldraisethechanceofdefault
andbemagnifiedbythehigherprice.ThusthemodelmirrorstheP/Echaracteristics
ofdebt;firmswithalotofleveragetendtohavestockswithalowerpriceearnings
ratio.
• 3Moretangibleassetswoulddecreasethecostofbankruptcyandallowmoredebtto
beused.Fromacreditor’sstandpoint,thisisarealisticassumptionbecausetangible
assetsprovidecollateralforloans.Abusinessthatisfoundedupon“managerial
expertise”isusuallylesscreditworthythanonethathassalableassets.
GRAPHICDEPICTION
Togainabetterunderstandingoftheoptimum,itissignificanttonotethatthe
expressionTBisastraightline.Ontheotherhand,thecostofbankruptcywillbeacurve
thatincreasesatanincreasingratetoreflectmoreriskathigherlevelsofdebt.Sincethe
amountoflossisaconstant,mostofthecurvatureisderivedfromtheprobabilityof
default.WhenthefunctionTBminusthecostofbankruptcyisatamaximum,therateof
94

change(slopes)willbethesameandtheamountofdistancebetweenthelineswillalsobeat
amaximum.
Figure4-2

AtpointO,anoptimumoccurswhichindicatesthatthedistancebetweentaxbenefitsand
bankruptcycostsisamaximum.Themarginaltaxbenefitsequalthemarginalcostof
bankruptcybecausetheslopesarethesame.AtpointD,anoptimalamountofdebtis
incurred.Wherethetwolinescross,debtissoexcessivethatitmustbereducedtosavethe
company.
Itshouldbenosurprisethatthedecisiontousedebtisfoundedonclassiccost/
benefitsanalysis.Whiletheprobabilityofdefaultcurvecanassumemyriadshapesand
includemanycomplexvariables,moststrategieswillbelinearenoughtoallowthe
assumptionofsomeunderstandablerelationshipbetweenbasicfundamentals.Whenthe
modeliscircumvented,itisusuallybecausemanagementisgamblingonsomeunrealized
streamofincomethatisoutsidethenecessaryparametersoftaxincentives,assets,market
valueanddefault.
(BacktoTableofContents)

$Cost
Debt
TB
Costof
Bankruptcy
O
D
95

APPENDIX:MAKINGSURETHATWHATYOUSEEISWHATYOUGET
Mostcompaniesandbusinesspeopleareinherentlyhonest,butthereisagrowing
factionintheinvestmentcommunitythatoperatesontheedgeofthelaw.Armedwith
competentteamsoflawyers,thesecompaniesconcentratemoreonwhattheycanlegally
garnishthanonservicingthecustomerorinvestor.Oftenthecrygoesupthat“Weneedto
doitbecausethecompetitiondoesit.”,whichmaycertainlybetrue.Whilethisisnota
courseonbusinessethicsorforensicaccounting,theobfuscationofdebtispertinentto
capitalstructure;decisionsneedtobebasedontransparentfinancialstatements.The
complexityofthemodernbalancesheetwarrantsanarrayoffootnotestoaccompanyit.
Makesureyoureadthesenotescarefully.Theyshouldnotactastheaccountingversionof
“fineprint”,butasanefforttoeducatetheinvestor,andfullydisclosethecomplicationsin
thebalancesheet.
Enronwerethesuprememastersofobfuscation,butmanyoftheirshenaniganshad
tipoffsthatwouldhavealertedprudentanalysts.Enronwasextensivelyinvolvedin
“entitystructuring”.Whilemanycompanieshaveseveralincorporatedsub-unitswhose
performanceisriskyenoughtoseparatethemfromthelargerentity,Enronattemptedto
usethemtoshieldtheextentofliabilitiesfrominvestors.Forexample,GeneralMotorsis
intheautobusiness,butkeepstheirfinancialunitseparatedfromproducingautos.A
distributioncompanymayhaveitsownincorporated,“inhouse”transportationcompany
thatservesonlythedistributionbusiness.Itiskeptseparatetomaintaincore
competencies,controlexpensesandcreatetaxadvantages.However,Enronpiledsub-unit
uponsub-unitandhadmorethanmostanalystscouldrealisticallytrack.Onelookattheir
last10Kshowedpageafterpageofsub-unitsallovertheglobe.Investorsandanalystsdid
notquestionthepracticebecauseEnronwasa“cashcow”thatapparentlymademoney
andincreaseditsstockprice.
ThisauthorfirstencounteredEnronbecausetheywereusersofacertainbrandof
riskmanagementsoftwarethatdidValue-at-Riskcalculationsonderivativeslikeoil
96

futures.Afteralittleresearch,Ispiedafinancialstatementitemthatwastermed,
“Obligationsincurredinriskmanagementactivities“orsomethingtothateffect,andI
wascurious.Atfirstglance,itappearedthatEnronwasplacingmoneylostinhedging
futuresintoalong-termdebtcategory,whereitcouldconvenientlybepaidbackassoonas
cash-flowimproved.IclosedtheInternetwindowandshuddered.
Whilethefuturesmarketishighlyregulated,anycredit-worthyindividualcan
engageinaforwardcontract,swappingfixedratesforvariablerates,cash-flowsinone
currencyforcash-flowsinanother,adinfinitum.Infact,mostbanksprofitfromthese
swapseverydaybutdonotdetailthemonfinancialstatements.Theincomeislegally
claimed,buttheinvestorknowsnothingabouttheotherpartiesinthecontractor
especiallyabouttheriskinvolved.Asthischapterwasbeingprinted,theentiredomestic
bankingsystemhasbeenunderscrutinyformortgagelendingpracticesandthefurther
securitizationofsuchmortgages,creatingderivativesthatneedtobetracedbacktothe
originator.
Onacorporatelevel,abalancesheetmust“balance”whichallowstheinvestorto
play“detective”iftherearemisappropriationsbetweenshortandlong-termdebt,assets
andequity.Whenmightthelargestshareholdersrefusetomovetowardamoreoptimal
capitalstructure?Whenissuingmoresharestakescontrolawayfromthem.Ifcorporate
controlisanissue,thenafewshareholdersatthetopcanprofitbyissuingdebtinsteadof
equity,evenifitmeansanominaldecreaseinthestockprice.Alargeramountofdebtwill
alsoimmunizeacompanyagainstatakeover,becausemostcompanieshavesecond
thoughtsaboutassumingtheobligationsofanother.Althoughitmayseemthatsenior
managementisdefendingthestockagainstalowershareprice,theunstatedreasonisto
maintainpower.
Sometimestakingondebtisanemotionalissue.Theterm,“agencyfriction”was
developedoutoffrustrationthatmanagementwaslookingoutaftertheirowninterestsand
nottheshareholders’.Acaseinpoint:ACEOemphasizescurrentsalesandoperating
97

expensestotheexclusionoffundingfutureprojectswithlowercostdebt.Althoughinterest
ratesareatanalltimelow,andcompanyincomeisrocksteady,theCEOisleeryabout
“toomuch”debt.Hisreferenceisa“creditcrunch”incidentsixyearsagothatalmost
bankruptedthecompany.However,thisisanewphaseinthebusinesscycle.Theold
paradigmdoesnotwork.Hegoesaheadandfundsprojectswithequity,evenasthestock
pricediminishes.Afewshareholderswillgripe,butmostwillbe“outoftheloop”.The
reason?Thereisnoindicationinfinancialstatementsofwhatthe“proper”capitaltarget
shouldbe.Shareholderswillbeleftwonderingwhythecurrentadequacyofsalesand
incomecouldnotbufferthestockfromdeclining.Ineffect,thecapitalstructuralist
recognizesthatthecostofcapitalroseevenasincomeremainedsteady;thestockhadto
deterioratebecausenotenoughriskwastaken.
Anextremecaseof“balancesheetmagic”iscalled“insubstancedefeasance”.A
companywillattempttoclean-upitsbalancesheetbyconvertingitsdebttohigherinterest
rate,lowerfacevaluebonds.Suchamove,doneinanticipationofhigherearnings,will
wipeoutasubstantialamountofdebt,whileallottingthedifferencebetweenthetwo
amountstonetincome-awin-win,but“borrowingfromPetertopayPaul”,nonetheless.
Inbrokereddefeasance,abrokerbuysafirm’soutstandingbondsandtradesthemtothe
companyfornewlyissuedshares.Thebrokersubsequentlysellstheshares.Ineithercase,
debtisnotbeingremovedthroughincreasedoperatingincome,butismysteriously
disappearingoffthebalancesheet-anotherreasontoreadfootnotes.Whilethese
techniquesarenotimplementedtoobfuscatefinancialviabilityortoconfuseinvestors,they
needtobemanifest,asshouldthepracticeofrefinancingloans.
Sometimesitappearsthatacompanynegotiatedafantasticdealoninterestrates,
wheninfact,itissuedzerocouponbonds-securitieswhichwillbepaidoffinalumpsum
whentheymature.Suchanissueisadvantageoustomostcompanies,becauseoftax
savingsandnoregularinterestpayments.Long-termprojectsthatmightnotpayoffuntil
yearslatercanbeimplementedwithoutexcessiveinterestexpense.Nevertheless,itis
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importantfortheinvestortotreattheamortizationoftheloanasinterestexpenseinan
optimizationmodel.Theriskofnon-paymentwhentheissuecomesdueisviableandneeds
tobedistributedoverthelifeoftheloan.Theseindicationsarealsoavailableinthe
footnotes.
Investorsshouldbeawareofthevariouscategoriesoflong-termdebt,becausesome
companieswillstatethesubunitwithoutreferringtoitas“longtermdebt”.Capitalleases,
anyleasetoowncontractsoranyliabilitylastingoveroneyearshouldbereferredtounder
theheading“long-termdebt”.Iftheinvestorhastomatchthenumberofyearsthata
contractlastswiththeliabilitytype,thatistoomuchworkandaphonecallneedstobe
madetoinvestorrelations.Clarityistothebenefitofbothmanagementandinvestors.
Lastly,thereissometimesanunintentionalmisstatementofdebtobligationsbecause
ofconfusionornaivetéofthepreparer.Tokeepandestablishgoodrelationshipswith
clients,accountingfirmswillbegenerallycompliantandgooutoftheirwaytomakethe
customerlookgood-legally.Theincreasedcomplexityofcorporatefinancehasledtoboth
oversightsandpurposefulmanipulationsCallingabadhedgea“riskmanagementloss”is
notillegalandmaynotevenbepurposefullydeceptive,butwhenitiscouchedinlanguage
thatimpliessuchalossisnormalpartofbusiness,whenitisnot,aredflagshouldbe
waved.Thisauthoroncewentthrougha10Kforawellknownsteelcompanyandcould
notfindanyinterestexpenseintheincomestatement-despiteitshavinglong-termdebton
thebooks.Miraculously,thecompanydecidedtonetitoutwithinterestgainedfrom
investments.Evidently,noonethoughtthatinterestexpensewasmeaningfulenoughto
declare.
(BacktoTableofContents)
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5
THECOSTOFEQUITY
Thereisacostthathoversaboveeverymajorbusinessdeallikeapeskyflyata
summerpicnicthatnoonewantstoacknowledge.ItisrarelymentionedintheWallStreet
Journal.Noaccountingbalancesheetitemizesit,andyetitisomnipresent.Infact,itisa
costsoprominentthatitnotonlyaffectseverymultinationalbusinessfromCiscotoUS
Steel,itisanintegralpartofeverymomandpopstoreaswell.Itisthecostofequity.
Thecostofequityisnotanaccountingcostbutaneconomicone.Itrepresentsthe
“opportunity”oftakingoneactionoversomealternativeaction.Ifweconsiderthatthe
foundationofstockownershipisbasedupontheflowofcorporateearningstoward
shareholders,thisopportunitycostissimpletofathom:acompanycaneitherreinvest
earningsorreturnthemtostockholders.Ifthecompanyreinvestsearnings,itneedsto
makeareturnatleastasgreatasinvestorswouldmakeinalternativeinvestmentsin
companieswithsimilarrisks.Therefore,ifallsteelcompaniesreturn15%andsteel
companyZreturnsonly10%,steelcompanyZhasanopportunitycostof15%butunder
performstheindustryby5%-giventheconstraintthatallsteelcompanieshavethesame
risk.
Whilethisexamplerepresentsanoversimplification,thereadershouldunderstand
thatthecostofequityisacomparativecostthatisimplicitineveryprofit-makingvehicle:
eachdollarofaddedincomecoststheshareholderssomeamountofunrealizedbut
potentialloss.Someofthefactorsthataffectthatpotentialloss(risk)arethefollowing:1.
Dividendyield.2.Thepriceofthestock.3.Alternativeinvestments-intheindustry,in
thebondmarket,orinthestockmarketingeneral.4.Currentincome.5.Future
prospects.Thislistisbynomeansexhaustiveasmyriadotherfactorsaffectthecostof
equity.Infact,acomprehensivelookatthissubjectwouldincludeamodelwithhundreds
100

ofvariables.Forourpurposes,weneedtocreateonlythebestestimatepossible,giventhe
limitedamountofinformationavailabletoinvestors.
MODIFICATIONS
Ultimately,weneedtobringthetheoreticalconcept,“thecostofequity”intothe
practicalrealmofcapitalstructureoptimization,whichrequiressomemodification.
Traditionaluseofthecostofequityforstockvaluationandcapitalbudgetingneedstobe
expanded.Thefollowingissuesneedtobereconciled:
• 1)Thecostofequityisbasedonmarketvaluesandnotbookvalues.Theproper
methodofcalculatingnotjustthecostofequity,butthecostofanysourceofcapitalis
tousemarketvalues.Sincethecostofanycapitalcomponentisgaugedbyitsrequired
return,themarketmethodallowstheanalysttobalancethisequivalencebetweencost
andreturn.Considerafirmwhofloatsabondissueof100millionat8%interest.
Essentially,theybeginbypaying8millionayearininterestexpense.Nowsuppose
inflationtakeshold,andinterestratesareraisedto10%,andthepriceofthis
company’sbondsfallsto80million.Ifweusethe8%rateastherequiredreturnas
wellastheinputintothecostofdebt,thenthecompanycanbuybackitsownlower
pricedbondsinthemarketandearnayieldof10%.Thebookvaluedesignatesdebtof
100millionandinterestpaymentsof8million,butmarketvalueshaveshiftedboththe
requiredreturnondebtanditsconsequentcostupwards.Usingthelowerinterest
valueof8%astherequiredreturnondebtwouldleadtoadebtladencapitalstructure
becauseitwouldunderpriceitscost.
• But-Theobjectiveofcapitalstructureistoseekanequilibriumbetweenmarketrisk
andcompanyriskthatmayrequiretechniquesthatcomparemarkettobookvalues.
Simplystated,bookvaluesaremorecontrollableandactionable.Sincethemarket
valueofastockisbasedonprojectedfuturegrowthinearnings,anycomparison
betweennetincomeandstockpriceisobfuscatedbyextrapolation.Ifearningsareto
bedistributedtoshareholders,andshareholderspayanimplicitpriceforsuch
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earnings,bothvariables,netincomeandequity,needtobecalibratedwithinthesame
timeframe;presentvaluecalculationsonlydiscountfutureearnings.Sincenetincome
isabookvaluecomponent,whichlaterbecomesthebookvalueitem,“retained
earnings”,oncedividends(ifany)arepaid,itisconsistenttousethebookvalueof
equitywhenmakingdirectcomparisons-atleastwhengaugingnear-term
performance.Therefore,capitalstructureanalysismultipliesamarketderived
percentagecostofequitybythebookvalueofequity,andthencomparesittonet
income.Thiscompositevalueisneitherthecostofequity,arequiredreturn,noran
opportunitycost,butreflectsmovementtowardsanoptimalcapitalstructure.Infact,
theconcepthasbeentrademarkedbythefirm.SternStewart,Inc.andiscalledEVA
®

or“economicvalueadded”
2
.Theinvestorfriendlyversionisfurtherdevelopedinthe
chaptercalled,“TheCapitalDynamic”.
• 2.Everyfirmhasanoptimalproportionofdebttoequitythatincreasesreturnsand
minimizesrisk.
• But-Thetargetproportionisalwaysmovinganditisquestionablewhetheran
optimumcanbereached.Anothertenetofcapitalstructureisthatthestockpriceis
maximizedwhenafirm’scapitalstructureisatanoptimum.Thus,thestockpricerises
andfallsbasedontheproportionofdebttoequity,butitneverremainsconstant.
Multiplyingtheestimatedcostofequitypercentagebythemarketvalueofthestock
yieldsarealisticcostofequityforonlyaslongasthestockremainsstable-whichmay
notbeanylongerthanafewminutes!Thisisacircularargumentwhichassumesthat
thepremiseistrue;whenthecostofequityisdependentonashiftingstockprice,a
concreteminimumcostofcapitalcannotbeobtained.Mosttheoreticalmodelsignore
thefactthatsharescannotbeissuedataconstantpriceandthatthetruemathematical
optimumisfleeting.Whileacompanyneedstostruggletominimizeitscostofequity,it

2
EVAistheregisteredtrademarkofSternStewart,Inc.
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mayneverrealizehowcloseitistoitsgoal,becausethedeterminantvariable(stock
price)keepschanging.
• 3)Thecostofcommonstockisvaluedlikethecostofretainedearnings,exceptfor
flotationcostsonnewissues.
• But-theremaybenoactualcashoutlayonanyofthecomponentsWhenan
investmenthouseunderwritesanissueofstock,itchargestheissuingcompanya
substantialfeewhichisdeemeda“flotationcost”;itmaywellbejustapercentageof
thecashreceivedfromtheissue.Therefore,thecostofequityfornewcommonstockis
higherthanforbothretainedearnings,andpastissuesofcommonstockbythisfactor.
However,theamountofpastissuesandretainedearningshasnoimmediatecashoutlay
(disregardingadministrationfees)andmayrepresentinvestmentinsomeassetthatwas
amortizedlongago.Nevertheless,thesecomponentsrepresentasubstantialinvestment
thatmustbeenumerated.Apreciseitemizationwouldrequireseparatevaluationsfor
newcommonissuesandthecategoryofretainedearningsandpastissues,allofwhich
ascendanddescendatdifferentrates.Withoutacashoutlay,andwithinherent
volatilityinthemeasurement,theneedforstalwartprecisionisinsubstantial;itismore
prudenttoseekoutamodelthatyieldsthebestestimategiventhecurrentlevelofrisk.
Fortunately,suchacomprehensivetoolexists:the“capitalassetpricingmodel”
comparesthechangesinequityofanindividualfirmtothegeneralmarket,andeach
componentpartofthefirm’sequityisimplicitinthecomparison.Withan
“opportunitycost”thatshiftsfrequently,thevariablesoftrendandcomparative
magnitudearemostsignificant.Whatweloseinprecision,wegaininexpediencyand
utility.Sincethemarketcanbevolatile,itismorepracticaltousethismeasurementin
near-termcomparisonswhenseekinganoptimalcapitalstructure.Moreover,
observationoflongtermchangesinthecostofequitymayindicatehowthecompanyis
reactingtomacroeconomictrends.
• 4)Thedefinitionofstockholders’equityincludespreferredstock.
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• But-preferredstockisnotvaluedliketheotherequitycomponents.Preferredstockis
ahybridsecurity,combiningaregulardividendwithasetissuedprice,butwithoutthe
projectedgrowthcharacteristicsofcommonequity;themarketforpreferredstockis
limitedandconsistslargelyofcorporateownershipbecauseofthetaxbreaksinvolved.
However,itisvaluedasacomponentofthecostofcapital,anditscostisasfollows:
(PreferredDividend/NetIssuingPrice)x(ProportionofPreferredEquityinthe
CapitalStructure).Manycompaniescarrynopreferredstockatall.Iftheinvestor
ignoresitinhisorhercalculations,thecostofequitywillbehigherthanitactuallyis
becausepreferredstocklowerstheriskofequity.Theregularityofpaymentsgivesit
someoftheriskcharacteristicsofbonds,whileitmaintainstheliquidityofstock.Thus,
makingcomparisonsbetweentwocompaniesthathavepreferredstock,andpricingit
atthecostofcommonequity,willnotbeasaccurateasifpreferredstockwereitemized
asacomponentcost.Inaquickcomparison,itisaconservativeerrorthatwillhave
fewtacitrepercussions.However,inathoroughanalysisorincapitalbudgeting
problems,preferredstockneedstobefullyaccountedfor.Likeshort-termdebt,itacts
asanadjuncttoothersourcesofcapital.Inthiscase,itkeepsthecostofequityless
risky;lesssharesofcommonequityneedtobeissuedwhensomefundingisdone
throughpreferredstock
THEREINVESTMENTRATEANDOPPORTUNITYCOSTS
Someconfusionmayexistbetweenthereinvestmentrateonearningsflowingto
shareholdersandthereturnthatwouldbereceivedoncomparativelyriskyinvestments.
Whenthemarketisinperfectequilibrium(whichisrare),theseratesareequal.If
CompanyAcangetgreaterreturnsthanothercompanieswiththesamerisk,investors
flocktoCompanyAandbidupitsprice.Thisupwardpressureonthestockpricewill
continueuntilthepointwhereCompanyAnolongergarnersanextraordinaryreturn,but
isinlinewithcompaniesofsimilarrisk.Infact,anyinvestorwhopurchasesarisingstock
thatisbeatingthemarketislikelychoosingonethatisnotinequilibriumwithit.This
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“riskarbitrage”isfundamentaltoallspeculation.Similarly,anyreinvestmentratethatis
lowerthancompanieswithsimilarriskwillendupdepreciatingitsstockprice.The
“opportunitycost”istheopportunityofnotinvestinginthepresentcompany,butinvesting
insimilarlyriskycompanies,Thus,ifCompanyAmakes25%onreinvesting
shareholders’earnings,itsreinvestmentrateishigh,butitsopportunitycostmaybelowif
comparativelyriskyfirmsaremakingonly10%.Iftheopportunitycostexceedsthe
reinvestmentrate,itistimetosellthestockand“taketheopportunity”toinvestinother
companies.
Academicsoftencallthereinvestmentrateofreturn,“theexpectedrateofreturn”,
andtherateofreturnoncompaniesofsimilarrisk,“therequiredrateofreturn”.For
purposesofcapitalstructure,wealwaysrefertotheopportunitycost,“therequiredrateof
return”asthetruecostofequity.Weneverassumethatthemarketisinequilibrium,nor
doweassumethatreinvestmentratesaresimilaramongcompaniesofcomparativerisk.
Sincecompanyfundamentalstendtodeterminereinvestmentratesandmarketcompetition
determinesrequiredrates,wesubmittothemarketasthegreaterofthetwoforces.
However,theforcesmayoverlapeachother,workinconcert,oragainsteachotherand
onemaydominatetheother.Indeed,thestudentwhohascomparedthedifferencebetween
“value”investingand“growth’investing,canobservethatbothmethodsarepartofthe
samephenomenon-alackofequilibriumbetweencompanyandmarketratesofreturn
thatworkonthesamecontinuumtocorrectthemselves.
EVALUATINGTHECOSTOFEQUITY:METHODOLOGY
Theattempttoenumerateatheoreticalcostrequiresatoleranceforuncertainty.To
thosewhoworkintheaccountingorengineeringfields,basingdecisionsona
“guesstimate”,maytakealeapoffaith.However,therewillbeenoughcorroboration
fromseveralsourcestocreateourown“inhouse”tolerancelevels.Anymeasurementof
changerequiressomerelationalvaluesarounditinorderforittobemeaningful.In
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capitalstructureanalysis,thoserelationalvaluealwaysprovideasolidfoundationoverthe
long-term,becauseafirmcannotbeinbusinesswithoutadheringtothem.
• 1)TheRiskPremiumMethod:Yearsago,wheninformationwasnotsoreadily
available,analysts(withgreeneyeshadesintact)wouldaddfromtwotofour
percentagepointsontoafirm’sbondyieldandcallit“thecostofequity”.Realizing
thatriskierlowerratedebtwouldcontributetomoreequityrisk,analystssetarisk
premiumthatcombinedthetimingofthebusinesscyclewiththeratingofthefirm’s
bonds.“TripleA”(AAA)ratingswouldjustifyjusttwopercentagepointsadded,while
lowerratedbondsatthetopofthebusinesscyclewouldwarranttackingonfourpoints.
Althoughthismethodissubjective,itdoesgivethemodernanalystsomeguidance:if
heorshecalculatesaneightpointdifferencebetweenequityanddebtcosts,thefigureis
mostlikelytoohighandneedstoberecalculated.
• 2)TheRuleofThumbMethod:Theruleofthumbmethodisamodificationofmarket
valuationmethodsthatusethepresentvalueofdividendsreceivedinthefutureto
obtainthe“fairvalue”ofastock.Inthecasewherethedividendgrowthisconstant,
theGordonModelemerges:P=D1/(K–G).Sincethedividendgrowsataconstant
rate,presentvaluediscountingisimplicitinthecalculation.Theterminologyisas
follows:
Table5-1

SYMBOL EXPLANATION
P Currentpriceofthestock
D1 Dividendreceivedinthenextperiod
K Costofequity
ROE ReturnonEquity(netincome/equity)
RETENTIONRATIO 1-(DividendsPaid/NetIncome)
G Growthratethatdividendsareexpected
tofollow

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Thegrowthrate“G”iscontroversialbecauseitispresumptiveandextrapolatesinto
thefuture.Forthesakeofsimplicity,weequateitwiththeretentionratiomultipliedby
thereturnonequity(RetentionRatioxROE).Inactuality,thegrowthratemaybea
long-termaverageofthisfigure.Forthetimebeing,wewillassumethatG=
(RetentionxROE),andproceedwithderiving“theruleofthumb”method.
Ifwesubstitute“X”fortheretentionratioandusethesymbol,“E”forearnings,the
modelisnowP=(1-X)E/K-(ROE)X.,Furthermore,ifweassumethatROEisequal
tothecostofequity,“K”,thenthefollowingequalityismet:(1-X)E/K-(K)X=(1-X)E
/(1-X)K=E/K.SincewenowhaveanequalitywhereP=E/K,werearrangeand
formK=E/P.Obviously,thisinverseofthe“ageold”financialindicator,“P/E”,is
merelythereturnonthemarketpriceofthestock.ThefactthatP/Escantellusso
muchaboutastock’sbehaviorispartlyattributabletothisrelationship.Used
judiciously,theP/Eisanindicatorofgrowth,andwhen“E/P”approaches“ROE”,the
stockmaybeconsideredabargain.However,liketheP/Eratio,when“E/P”isused
asaproxyforthecostofequity,itmustbegaugedwithareferencetothemarket
averageForexample,growthstocksdonotqualifyforconsiderationusingthismethod.
ManygrowthstockshaveveryhighP/Es;aP/Eof29basedona$20sharepriceand
0.70foranEPSwouldassumearidiculouslylowE/Pof3.5%.Thus,forstockswith
muchanticipatedgrowth,themethodissimplyinadequate.Forstocksthathavean
averageP/Ethatisclosetothemarket,themethodoffersaveryquickestimationofthe
percentagecostofequity.Infact,analystscanscanthisnumberrapidlyandcombineit
withotherinformationtoscreenforprospectiveinvestments.
• 3)ValuationMethods:TheGordonModelisonlyoneofmanydividenddiscount
modelsthatequatethepriceofthestockwiththepresentvalueofcashflowsreceivedin
thefuture.Manyofthesecanbequiteelaborateandrequireforeknowledgeofthepath
ofearningsfarintothenextbusinesscycle.Withastablemultinationalfirm,the
estimationoffutureincomeisnotthatformidableatask,butwithuntestedorvolatile
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companies,themethodcomprisesa“randomwalk”.WhyusetheGordonModelifitis
onlyapplicabletodividendpayingcompanieswherethedividendisgrowingsteadily?
Theassumptionofsteadygrowthwillnotradicallyaltertheviabilityofthecalculation
inthenearterm.Withoutexcessiveextrapolation,weassumethatthenextdividend
willbegrowingatthesamerateasthepresentdividend,aprobabilitythatavoids
judgmentabouttransitions.Consequently,weusethecostofequityfornearterm
comparisonsbetweencompanies,andnottoextrapolatethe“fairvalue”ofastock.We
havealreadybeenintroducedtotheGordonModel,P=D1/(K–G).Thesimple
adjustmentthatwemakeistosolvefor“K”,whichbecomes,(D1/P)+G=K.A
modifieddividendyieldusingthenextexpecteddividendratherthanthecurrent,and
summedwiththegrowthratewillproduceacostofequity.Themajorproblemwith
usingtheGordonModelisthatitissodependentonthefundamentalsofthecompany.
And–obviously–likeanyotherdividenddiscountmodel,itcannotbeusedwithfirms
whopaynodividend.Ultimately,itisabetterstatementofthereinvestmentrate,“the
expectedrateofreturn”thananequitybased,comparative,“requiredrateofreturn”.
However,becauseitmesheswellwiththeearningsandfundingcharacteristicsofa
company,ithasmanymoreusesbesidesdeterminingacostofequity.
• 4)TheCapitalAssetPricingModel(CAPM):Thismodelisthepreferredchoicefor
capitalstructureanalysis.Despiteyearsofacademicandprofessionaldisparagement,
theconceptcontinuestothrivelikeaDarwinian“missinglink”.Withahighvolumeof
literaturetobothsupportandexcoriateit,theCAPMseekstobetheessenceofrisk
comparisonbutfallsfarshortofanyclaimstopreciseaccuracy.Whatitdoesbeyond
disputeistocompareanysecuritytoamarketindexinalinearfashion.Itthen
multipliesaderivedcomparativenumberbythedifferencebetweentheindexandwhat
istermed,the“risk-free”rate,andthenaddsthatfigurebacktotherisk-freerate.In
effect,itcomparestwosetsofnumbers:1.Theindividualsecuritywiththemarket.2.
Themarketwithwhatisthoughttobearisk-freeyield(usuallythetenyeartreasury).
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Itisthis“requiredreturn”thatformsthecostofequity,andtheproverbial“rateof
returnoncompanieswithsimilarrisk”.Noothermethodbetterincorporatestheforce
ofthemarketwithacomparisonbetweenalternatives,i.e.,theindividualsecurityand
therisk-freerateofreturn.
Thekeytothismodelisthecomparisonfactor.TheCAPMusesregression
techniques(seethechapteronstatistics),andderivesacomparisonfactornamed
“Beta”,whichisessentially,∆Y/∆X,thefamiliar“riseoverrun”-onagraph.In
fact,theCAPMisbasicallyastraightlineintheformofY=A+B(x)withsome
modification,andthereinliesitsdownside.Mostfinancialvariableshaveanongoing
multinomialrelationshipthatconstantlychangesandformsacurve.Inoneweek,for
example,therelationshipbetweenassetsandearningsmightbelinear,butinthenext
weektheymightassumeapolynomialrelationshipofthefifthdegree.Whiletrue
linearitybreedscertainty,itisrarelyencounteredinfinanceanditspresumptioncan
leadtopoordecisionmaking-witnesstheimpliedchaosofwageandpricecontrolsin
theearly1970stoobservejustoneexample.
TheCAPMneedstobeperceivedasavaluablebutpotentiallymisleadingtool.
Whenusedcorrectly,eachmethodofdeterminingthecostofequitywilltendto
corroboratetheotherinthedomainofchange-albeitatadifferentabsolutelevel;that
is-ifthechangeinthecostofequitywhileusingthe“riskpremium”methodis20%,
therewillbeacorrespondingincreaseusingtheCAPMmethod,buteachrespective
methodmayyieldadifferentvalue.Thecostofequityisameasureofcomparativerisk
andnotanaccountingstandard.Usedinisolation,however,theCAPMissusceptibleto
periodicinstabilitythatwillleadtoincorrectdecisions.Asmuchinformationabout
leverage,thebusinesscycle(whethertheFedhasraisedorloweredrates)andother
methodsmustsupporttheuseoftheCAPM.Ultimately,performanceinoneyearwill
becomparedtoperformanceinthepreviousyear,andtheemphasismustbeplacedon
consistency.Aslongasthesamemethodologyisusedinthecomparison,theforces
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actingonthestockwillbeverysimilarandwillbemeasuredinsimilarways.Itiswhen
twodifferentmethodologiesareusedthattroublearises,becausethecomponentsofthe
measurementswillbesodifferent.TheE/Pmethod,forexamplewillmeasuremarket
pricemuchmorethanthe“riskpremium”methodwhichwillmeasurethecomparative
riskondebt.Thus,theabsolutevaluesofthesecostsmaybetotallydifferent,butwhen
usedproperlyinthecontextofcapitalstructure,eachpointstooptimality;the
dynamicsofchangedefinetheirutility.
• 5)ConsensusMethods:Thelogicbehindcombiningmethodsintoa“fusion”costof
equitystemsfromtheoppositionoffundamentalforces.Forexample,combiningthe
returnonequity(ROE)withamarketbasedmethodlikethe“E/P”,utilizesthe
differencebetweenbookandmarketvalueswhichisanimplicitfactorinthecostof
equity.Similarly,combiningtheCAPMmethodwiththeGordonmodelgivesweightto
bothmarketcomparisonsandinternallygeneratedcompanyfundamentals.The
judicioususeofthesecombinationsgivestheanalystanadvantagewhengauging
changesinrisk,andinsomespecificsituations,formsamoreaccuratemeasureofthe
costofequity.
Themostfrequentuseofthecostofequityisnotininvestmentanalysis,butin
capitalbudgeting.Whenacorporationoutlinesthecapitalneedsforfutureprojects,
accuracyandprecisionareapremium.Moremistakesaremadefromunderestimating
theneedforcapitalinputsthananyother-partlybecausethepoliticalnecessityof
“tellingthetruth”aboutaprojectcanactuallyundermineit.Whilemanycompanies
usesophisticatedMonteCarloanalysistoforecastapotentialcostofequity,historical
datawithconsensustechniquesmayworkforothers.
Onesuchmethodistoregresseachofthemethodsagainsttheperformanceofthe
stockoverafiveyearperiodinonemultipleregression.Thedependent“Y”variableis
thefiveyearperformanceofthestock,whilethemethodsactasthesequenceofX
variables.Thecoefficientsoftheregressionwillbetheweightsofeachmethodinthe
110

consensus.Whilethismethodislinear,itwillallowtheanalysttocitethemost
historicallyaccuratemethodandtobetterunderstandtheforcesbehindthestock’s
changes.
THECAPMASABUILDINGBLOCKFORCAPITALSTRUCTUREANALYSIS
TheCAPMisintegraltoanareaoffinancethatcommandstheutmostrespect-
modernportfoliotheory,thecombinationofsecuritiesthatwilldiversifyawayriskand
maximizereturns.Itsuseincapitalstructureanalysis,however,isnotsocomprehensive.
Infactonlypartofitspotentialisrealizedinderivingacostofequity.Whileitistypicalof
aneclecticsystemlikecapitalstructuralismtousewhatispractical,thestudent/investoris
encouragedtostudythismodelfromtheperspectiveofcreatingaworkingportfolio-one
thatmaximizesthemeanreturnwhileminimizingthestandarddeviationthereof.
Anydisciplinethatisasprobabilisticasfinancemustadapttoexistingconditions,
sometimestradingutilityforstructuredprecision,butneverthelessencouraging
experimentation.Forexample,manyprofessionallyacceptedstatisticaltechniquesassume
“normality”wherenoneexists.Thatis:theydescribeaprobabilitydistributionwitha
centraltendencyaroundameanandanareathatisdefinedbyasetnumberofstandard
deviations.Therealityoffinancialdataisthatitisactually“heteroskedastic”-definedby
extremeswithheavierweightsattheends.Theareadefinedbyahandfulof“bigwinners”
andalotof“losers”isheavilyskewed.Indeed,iffinanceworkedlikephysicswhichis
mathematicallypreciseandpredictable(onanon-theoreticallevel),thenmuchofthe
returnwouldbeextractedfromit.Thedistributionwouldbelikeasavingsaccountata
bank-highlypredictablebutwithlittlereturn-almostaflatline.Byitsverysimplicity
andflexibility,theCAPMcanbeusedinseveraldifferentways–asaninvestmenttool,for
portfoliomanagement,orforcapitalbudgeting.However,theinvestormustrealizethatit
describesonlya“bestestimate”,givenanarrowrangeofvariables,forabriefmomentin
time.
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Ifoneconceptcancharacterizecapitalstructuretheoryitisthateverydecision
requiresabalancebetweencompetingalternatives-atradeoff.Themarket-enmasse-
willmakethisdecisionwhenitfavorsinvestmentgradebondsovertheequitiesmarket-
theclassicflighttoqualitythatoccursinadownturn.Thefinancialexecutivemakesthis
tradeoffwhenheorshedecidestoraisedividendsandretainfewerearnings.The
individualinvestormakesthisdecisionwheninvestinginadebtladencompanyratherthan
ahigh-flyingcashgeneratorthathasjustpeaked.Essentially,allofthesetradeoffshavea
singleelementincommonwiththeCAPM:whenevermoreriskisengaged,agreater
returnisexpected.
Thecapitalmarketlinedisplaysthistradeoffgraphically,usingthemarketrateof
returnandthestandarddeviationofthemarketasmeasuresofrisk.
Figure5-1

Thegreencurveisacombinationofstocksthatencompassesthemarket.AtpointB,there
isalmostzerorisk(nostandarddeviation),butnoticethatboththereturnandstandard
deviationarelessthantheyareatpointAwherethegreatestreturnwiththesmallest
standarddeviationisachieved.PointBistermed“therisk-freerateofreturn”.Whileno
securityistruly“risk-free”,becauseofinflationandthenominalprobabilityof
Market
Return
Standard
Deviation
B
A
C
112

catastrophe,thispointrepresentsU.S.treasuriesandhasthelowestamountofinvestment
riskassociatedwithit.Ontheotherhand,pointArepresentsthe“efficientfrontier”which
iswherefundmanagersandinvestorswanttobe.Speculators(andunscrupulousfund
mangers)willchoosepointCbecauseithasthehighestreturnassociatedwithit.However,
mostprofessionalswouldeschewthispointbecausethechanceoflossistoohigh.
Pointsabovethelinehaveahigherlevelofreturngivenanylevelofriskassociated
withthem.Thesepointsareonlytemporarilyachievableandtherewillbeforcesthatput
downwardpressureontheirprices.Analogously,pointsbelowthelinewouldhavemore
riskthanwarrantedbytheirreturns,andhaveupwardpricingpressureonthem.Infact,
realitydictatesthatinmanycasesthereturnswillnotsubstantiatetheriskincurred,anda
portfoliocanlanguishformanyyearswithoutmovingtowardtheline.However,the
investorshouldrealizethatsomeoptimalportfolioexistsevenduringrecessions,andthat
therisk/returnlinewouldchangeinproportiontothechangeinthemarket-inclining
duringabullmarketandflatteningduringabearmarket.Ineffect,theslopeoftheline
changeswhentherisk/returncharacteristicsofthemarketchange.Inbullmarkets,itis
typicaltogainlargereturnswithlittlerisk,andsothecapitalmarketslineinclines.Ina
bearmarket,anyamountofriskincurredseemstoyieldnegativeresults,andsotheline
flattens.
ThecapitalmarketslinedisplaysthetheoryofriskbehindtheCAPM,butitshould
notbeconfusedwiththeCAPMitself.Thecapitalassetpricingmodelisactuallya
compendiumofthecapitalmarketsline,andtheregressionlineofanindividualsecurity
againstthemarket.Thatregressionlineiscalledthe“characteristicline”.

113

Figure5-2

CompanyX
%Stock
Increase
Market%Increase

Thislineisusuallydevelopedoverfiveyearsofreturns,usingmonthlychangesinthestock
priceandthemarket,foratotalof60datapoints.Themonthlyreturnandnumberofdata
pointsmakesthecomparativenumericchange,“beta”,lesssusceptibletoerrorthrough
volatility.ThemarketdataisusuallyderivedfromawidelyencompassingindexliketheS
&P500,butmuchdebatehascenteredaroundwhichindexifany,cantrulyinteractwith
thismodelbecauseeachhasdiscrepanciesthatbiasitsdistribution.
The“Y”interceptor“alpha”componenthasalitanyofitsown.Portfoliomanagers
arequicktopointouttherelevancyofalphatotheparticularsituationofthecompany.A
comparativelylargeorsmallalphacanindicateeverythingfromindustrydominanceand
protectionismtoadecayingcompanywithapredilectionforbankruptcy.Whatthe
investorneedstoknowisthatinterpretationofalphaleansheavilyoninvestment
experiencewiththecharacteristicline,andthatextremeYinterceptspointtoless
associationbetweenanindividualcompanyandthemarket.
ThepropermethodtocalculatetheCAPMisasfollows:
• 1.Calculatethecharacteristiclineasstated.The“Y”dataarethepercentagechanges
instockpriceoversixtymonthsfortheindividualcompany.(N+1)entriesofthetype
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((MarchPrice/FebruaryPrice)-1)willproduceadecimalpercentage.Sixty-oneof
theseentrieswillproducesixtyworkingdatapoints.The“X”dataarethemarket
changesoverthesameperiod.Ifneeded,refertothechapteronstatistics.Oncethe
studentgetsusedtodoingtheseregressionsinaspreadsheetlikeExcel,theprocesswill
beswiftandmechanical:datacanbeinputtedandregressionsprocessedinlessthan
thirtyseconds.Oncearegressionlineisformed,thecoefficientofXisthe“beta”
component.WhathappenstotheYintercept,“alpha”?Whilealphaisnotentirelyout
ofthepurviewofcapitalstructure,itisusedtogaugetherelevancyofbeta.A
comparativelyextreme“alpha”,incombinationwithalowcorrelationcoefficient(R)
wouldindicatethattheassociationofthefirmwithothercompaniesofsimilarriskis
weak.
• 2.Therisk-freerateistheaverageyieldforthetenyearTreasurybondovertheperiod
oftheregression-usuallyfiveyears.Insubsequentchapters,weshowhowtocreatea
“FederalReservebias”,byusingashorterspan.However,thepropermethodistouse
theaverageoverfiveyears,becausethebetacomponentshouldcorrespondtothesame
lengthoftimeastheothercomponents.
• 3.Theaveragemarketreturnoverthefiveyearperiodisinputted
• 4.Thethreecomponentsarearrangedasfollows:Riskfreerate+(Beta)(Marketrate-
Riskfreerate).
Thedifference,(Marketrate-Riskfreerate)isespeciallysignificant.Thisdifferenceis
calledthemarketriskpremiumanddelineatestheexcessreturnofthespecificmarketover
theriskfreerate.AlthoughtheCAPMisnotexclusivetothestockmarket,andcanbe
appliedtootherassets,themarketriskpremiumisespeciallysignificantinthatarena.In
essence,thedifferenceservesasagoodindicatorofhowstrongtheequitiesmarketis
comparedtothefixedincomemarket;alargeriskpremiumwillpeakandthenshrink
wheninterestratesareraisedtocombatinflation.Infact,thebusinesscycleisoftenan
expressionofthesizeandaccelerationoftheriskpremium.Atthebeginningofarecovery,
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theriskpremiumbeginstowiden;fundmanagerssellbondsandbuystocks.Although
sellingbondswillraiseyields,thestockmarketacceleratesatamuchfasterpace.Atthe
peakoftheequitiesmarket,demandforequityisatitshighestpointwhichraisestherisk
premium.Eventually,inflationcreepsin,ratesareraisedandbusinesseshaveaharder
timestayingafloat.Theequitiesmarketdeclinesmuchfasterthanratescanbelowered,
andtheriskpremiumisloweraswell.Analogoustothedifferencebetweentheratesof
changeofearningsandthecostofcapital,theaccelerationdifferencebetweentherisk-free
rateandthemarketratedeterminesperformanceinthecapitalmarkets.Whileearnings
andthecostofcapitalworkonamicroeconomiclevel,thecomponentsoftheriskpremium
workonamacrolevel.Thissensitivitytotheinteractionbetweencreditandequity
marketsisonereasonthattheCAPMisagoodtoolforgaugingthecostofequity:capital
structureisdependentonthebusinesscycleandtheinherentchangesofriskinvarious
sourcesofcapital.
PartofthevalueoftheCAPMisthatitissoflexible.Itcanbeusedonanyasset
(commodities,realestate,junkbonds),butitalsodefinesdifferenttypesofrisk.Thebeta
componentiscalledsystematicriskandisnondiversifiable.However,the“Y”interceptin
theregressioniscalledthe“alpha”componentandmaybecombinedwithotherassetsto
diversifyawayrisk.ThemainpurposeoftheCAPMwastoenumeratetheserisksmore
clearlyandcreateaninvestmentpatternthatallowedtheinvestortotakeabroaderlookat
thereasonswhyastockroseordeclined.Thepremiumwasinfindingthecombinationof
securitieswiththegreatestreturnperunitofrisk.
HarryMarkowitzpioneeredmodernportfoliotheorynearlyfiftyyearsago(asof
2008).AlthoughtheCAPMdevelopedintoanecessaryadjunct,theconnectionbetween
portfoliodiversificationandcapitalstructure(aportfolioofcapitalfunding)wasnotso
readilyapparent.TheflexibilitythattheCAPMengenders,however,mayhaveledtosome
ofitslackofacceptanceintheacademiccommunity.Itcombinedflexibilitywithlinear
constraints,whichisanoddmathematicalcombination:itneedstomaintainastraight
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line,butitdoessobyreconcilingvariablesthatwouldnotordinarilyhavealinear
relationship.InfactsomeprofessionalrejectionoccurredafterthefamousBlack,Jensen
and.Scholesstudyofthirty-fiveyearsofstockperformance.Theyfoundthatalthoughthe
actualrelationshipbetweenbetaandaveragemonthlyreturnsmatchedthetheoretical
model,therewereseveralperiodswheretherelationshipwasinverted:thatis-a
downwardslopingcurvewasencounteredthatdescribedlessreturnwithmorerisk.Since
thevalidityoftheCAPMiscontingentonarisk-returntradeoff,WallStreetquickly
rejectedtheconceptandbecamemoreenamoredwithtechnicalanalysis.
Figure5-3
Black,JensenandScholesStudy

Return
Beta(35Years)
Actual
Theoretical

Figure5-4
Return
Beta(1957-1965)
Actual
Theoretical

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Naturally,suchacomprehensiveandimperfectmodelhasstimulatedmany
attemptsatimprovement.Theoriginalmodelcanbeattributedtoaunifiedeffortby
Sharpe,Lintner,TreynorandMossin,allofwhomtriedtoelaborateonitthroughother
techniqueslikethe“singleindexmodel”or“multipleindexmodel”,whicharetermed
“market’modelsmoreconducivetodisplayingtheactualbehaviorofasecurity.The
originalmodelalsohadabevyofrulesthatmadeitdifficulttoapplyinarealisticsituation.
Theseempiricalconstraintswereasfollows:
• 1.Investorsareriskaverse.Theyprefermorereturnandlessriskonaconstantbasis.
• 2.Firmscanlendandborrowatthesamerate.
• 3.Notaxesortransactioncostsexist.
• 4.Themarketportfolio(index)chosenistheappropriateone.
• 5.Investorsaremoreconcernedaboutdomesticcurrencyreturnsthanexchangerates.
• 6.Betasarestable
Everyoneoftheseruleswillbeoverturnedinaninvestmentscenario,anddifferent
combinationswillbeeitherinplaceorsuspendedatanygiventime.Whileadherenceto
theserulesremovessomeoftheconceptualliabilitythemodelwouldhaveifastockdidnot
behaveasexpected,italsoopensupseveralmoreavenuesoftheoreticalapproach.What
aretheeffectsofhightaxesonthemodel?WhatifthedollarisslippingandIwantto
applythemodelinEuros?Doesthemodelworkbetterforastockwitharocksteady
beta?Theseareessentiallyinvestmentquestionsandoutsidethepurviewofcapital
structure.However,liketheMiller/Modiglianimodelwhichalsohasstringentrules,
experimentationisencouragedbecausetherulesareimpossiblenottobreak.Whenever
theorystraitjacketsbehavior,itistemptingtoinventsomewayaroundit.
ANESTIMATEOFRISKANDNOTPREDICTION
PartoftheinconsistencyoftheCAPMhasstemmedfromitsusebyfundmanagers
whoexpectittobeapredictivetool.Inthiscase,variationisconfusedwithperformance:
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variationwiththemarketisexpectedtopresentaforecastofexpectedbehavior,i.e.,ifthe
marketgoesup17%,thenabetaof1willdothesame.However,theequivalenceof
variationmaynotleadtothe“causeandeffect”relationshiprequiredbyprediction,and
eachstockhasaunique“alpha”componentthatisnotsoeasilyquantifiable.Infact,the
myriadcomponentsofalphahaveasmuchtodowithastock’sactualperformanceas
beta;alargealphasignifiesastockthatwillriseevenasthemarketisstagnant.
WhenusingtheCAPMasaproxyforthecostofequity,oneperiodofequityriskis
comparedtoanother,andtherequiredrateisnotusedasagaugeofabsoluteperformance.
Sincewearemeasuringriskandnotcombiningportfolios,askepticmayask,“Whatifthe
risk-returnlinesuddenlybeginsinvertingforonecomparativeyearandnottheother?”.
Inotherwords,theanalystwouldwrongfullyinterpretanincreaseinriskasadecreasein
risk.Obviouslysuchaprospectcanbeembarrassingandfinanciallydisastrous.Forthis
reason,theanalystmuststaywelldiversifiedinhisorhermeasurementactivities-
resortingtoothercostofequitymeasurementsaswellasrelatingittotheproportional
increasesindebt.Forexample,iftheproportionofdebttoequityrises,andyetourCAPM
measurementofthecostofequitydiminishes,weknowthatsomethingmaybeawry,
becausemoreleverageissupposedtoincreasethatcost.Attimes,afirmcansubstantially
increaseearnings,butdecreasethecostofequitysimultaneously.Sinceearningsandthe
costofequityarehighlycorrelated,examinationofthe“alpha”componentintheoriginal
regressionmayholdthekeytothemystery.Analphathatincreasesinarisingmarket,
evenwhilebetashrinks,willimprovestockperformancebutreducemarketrisk.
Therefore,itistotheinvestor’sadvantagetointer-relatethethreecomponentsofthe
CAPM,evenifusingsomeothermethodofanalysis.Thereturnonthemarket,therisk-
freerate,andbetainteractinwaysthatmakethemarketmorecomprehensible.Ifwe
disassociateriskfromabsoluteperformance(marketreturns),wecanextractthe
componentsofthecostofequityandaddthemtocapitalstructureanalysisforamore
comprehensiveperspective.
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Besidesthesometimes-periodicdysfunctionoftheCAPM,theanalystmustcontend
withwhatistermed,“lookaheadbias”-thefactthatdataisonlyavailablesubsequentto
companyperformance.Inotherwords,theearningsdatamaydescribeatotallydifferent
companythantheonethatiscurrentlyfunctioning.Whenaneconomyundergoesa
fundamentalshiftintoadifferentphaseofthebusinesscycle,datalagstheperformanceof
thegivensector.Theinvestor,whoeyes“ahotstock”,makesthemistakeofbuyinga
companywhoseearningswilldomuchworsethancurrentlyexpected.Unfortunately,even
quartertoquarterobservationbyanalystswillfailbecausethereisnoguaranteeof
continuation.Whencapitalstructureanalysisfocusesonproportionalcapitalchanges,itis
becausetheyaremoreindicativeofatrendthanpastearnings;itisalmostprohibitively
expensivetomakemajorchangesincapitalstructureandthentryto“undo”them.For
example,fewcompanieswillmergeinconsecutiveyearsorissuelargeamountsofstockon
topofeachotherbecauseoffearofdilution.Ascoveredinthechapteronthecostofdebt,
mostproportionalrisesindebtwilloccurinsubsequentyearsbecausethereisalagtime
beforetheinvestmentbeginstopayoff.Thus,anyanticipatorychangesinearningsare
derivedfromcapitalshiftsratherthanobservedmomentumfromquartertoquarter.
Momentumisafunctionofbeinginafavorableleveragestatethatistrending.
ANOMALIESPERTAININGTOTHEUSEOFTHECOSTOFEQUITYINCAPITAL
STRUCTUREANALYSIS
Inaprevioussection,itwasstatedthatusingbookvaluestodeterminethetotalcost
ofequity(percentagecostmultipliedbyequity-eithermarketorbookvalues)was
consideredimproper.Marketvaluesreflectthetruetotalcostofequityalthoughsome
textbooksusebookvaluesforthesakeofsimplicity.Oneofthemaintoolsincapital
structureanalysisistheproductionofa“hybridcostofequity”whichusestheCAPM
derivedrequiredrateofreturn,andthenmultipliesitbythebookvalueofstockholders’
equity.Ineffect,wecombinemarketriskwithchangesinequitythatare“organic”-either
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increasesinretainedearningsornewstockissues.Themorerandomandspeculative
marketvaluesarefilteredout.
Anothertacticistomodifytheriskpremium.Incertainmarkets,theriskpremium
willnarrowenoughsothatthereisabsolutelynoreasontobeinthemarketotherthan
speculation:therisk-freereturnisactuallylargerthanthereturnfromthemarketindex.
Underthesecircumstances,thecostofequitymightevenbemeasuredasnegative!To
calculateausableriskpremium,capitalstructuralistswillharboranassumptionthathas
historicalcredibility,butmaynotbecurrentlyoperable:themarketriskpremiumisgiven
a“floor”ofatleastfivepercent.Astockmarketwithverylowriskpremiumsissimplynot
sustainableforalongperiod.Ifaninvestorcangetalargerandmorestablereturnfrom
investinginacertificateofdepositwhichhaszerovolatility,thereisnoreasontoinvestin
stocksexceptforspeculativepurposes.Researchershaveestimatedtheaveragerisk
premiumtobebetweenfourandonehalftosixpercentanditwillbethisnumberthatwill
beinputtedintothemodelwhentheactualpremiumdipsbelowit.Essentially,weare
imposinganartificialequilibriumfactorontothemarkettomakethecostofequitya
workablepercentagefigure.However,whenthemarketriskpremiumgoeswellabovefive
percent,weusethatfiguretoemphasizeincreasingrisk.Thus,whenderivedfromthe
CAPM,thecostofequityhasanupwardbiasbecauseitismeaninglessasagaugeofriskat
extremelylowlevelsoftheriskpremium.
ADAPTIVEEXPECTATIONSVS.RATIONALEXPECTATIONS
Previoussectionsencouragedthestudent/investortodoasixtymonthregressionon
bothanindividualstockandthemarketwhileusingtheaveragemarketreturnsandten
yearyieldsasinputsintotheCAPM.The“rationalexpectationshypothesis”which
professesthatinvestorstakeallinformationintoconsiderationwhenmakingadecision,
wouldencompasssuchalongregression;anyrationaldecisionwouldconsiderthe
possibilityofreversiontothemean.Ontheotherhand,an“adaptiveexpectations
hypothesis”wouldgivemoreweighttorecenteventswhenmakingadecision.For
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example,anyaccelerationofinterestratesinthenear-termwouldmakeusbelievethat
inflationwasbecominganobstacle.
Bothofthesehypotheseshavemerit,dependingonthetimeframeoftheforecast.
Whencapitalbudgetingforalongproject,ananalystwhochoosesfive-yearaveragesmay
beclosertodeterminingtheactualcostofequity,thanonewhoprojectsseveralcurrent
scenarios.However,capitalstructureisconstantlychangingbecausetheoptimumtargetis
inastateofcontinuousflux.Adaptingthecostofequitytoreflectcurrentrisk-freeyields
andmarketreturnswhilemaintainingthelong-termbetaisacombinationthatwillbias
themeasurementinfavorofthecurrentmarket.Iftheinvestorchoosestoinputtheactual
yearlyfiguresformarketreturnandtenyearbondyield,theresultwillbeamuchgreater
orlessrequiredrateorreturn;anymarketsurgeorinterestratehikewillbeadetermining
factorinthis“adaptive”costofequity.Thelong-termregressionwithlong-termaverages
willbelessvolatilebutlessanaccuratereflectionofthecurrentsituation.Again,weare
doingperiodiccomparisonsofthecostofequity:aslongaswedouniformapplicationsfor
eachyear,theresultswillbecomparable.Forexample,allowingthefirstyeartobeafive-
yearaveragewhileusingcurrentmarketreturnsandinterestratesinthesecondyear,will
violatethisuniformity.EvenifwechoosetheE/P“ruleofthumb”method,wecanget
functionalresultsaslongasthemethodisappliedequallytoeachcomparativeyear.That
is:wecannevermixonemethodwithanotherorespeciallyusedifferentaverageswhen
comparingdifferentyears.Whileeachmethodmayyieldadifferentabsolutepercentage,
ourobjectiveistodeterminewhichyearhasthelesserorgreateramountofequityrisk-a
functionofchangeinthederivedcost.
Howaboutbeta?Shouldwemodifyit?Whilebetashaveproventobeunstable,
modifyingbetainaoneyearregression,forexample,wouldbecounterproductive.A
short-termbetawouldsimplyreflecttheexternalriskofreactiontothemarketforthat
yearonly;ifwehavealreadyusedthecurrentmarketrateforthatyear,themodification
ofbetawouldleadtoredundancyandvolatility.EvenintheBlack,JensenandScholes
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studythatobservedtheinstabilityofbetaoveralongperiod,thetheoreticalthirty-five
yearratewascloselycorrelatedwithactualreturns.Infact,reversiontothemeanis
typicalforbetawhichseemstoexoneratetherationalexpectationshypothesis-atleastfor
thismeasurement.Therealdifferenceinthisareaisconfusionbetweentheconceptsof
performanceandrisk.Afundmanagermayusetherequiredrateofreturn,ex-post,asa
measureofperformanceandawhollyshort-termCAPMwillyieldvolatileresultsthat
exhibittheincreaseinstockpriceforthatyear;butanystockchartcantellusthesame
thing.Whenwedoalong-termregressionandmodifytheCAPMwithcurrentmarket
inputs,wecancomparethisfiguretothefigurethatusestheproperfiveyear(long-term)
averagesandobtainameasureofrisk.Ifwearecurrentlybelowthelong-termfigure,we
canlookforariseintherequiredreturnandvice-versa.Thus,adaptiveexpectationscan
notonlygaugetheriskofastock,buttheycandefineourpositioninthebusinesscycleas
well;anydecliningriskpremiumwithalargerrisk-freeratewouldindicateamarkettop.
Whilesuchobservationsmustbetakenincontext,i.e.,sometimesmarketsareincoherent
andlackevenrandomlogic,thereisoftenadiscerniblepattern.
THEDECOMPOSITIONOFBETA
(Thereaderisreferredtothechapteronstatisticsandmathematicsiftheconceptof
covarianceisconfusing)
AnybetacoefficientcanbebrokendownintotheratioCOV(y,x)/Varianceofx.In
astockbeta,“x”isequaltothedistributionofmarketreturnchanges,while“y”isequalto
thedistributionofanindividualsecurity’schanges.Essentially,thexcoefficientina
regressionlinewhichweterm,“beta”ismadeupofthecovarianceofxandydividedby
thevarianceofx.Anycovariancecanbeobtainedfromaregressionbymultiplyingthe
correlationcoefficient,“R”,bytheproductofthestandarddeviationsofxandy.The
expressionissimplifiedasRσ(x)σ(y)
.
Thus,whenweobtainbetafromthecharacteristic
line,anylargeorsmallcorrelationbecomesanimplicitpartofrisk,andthedegreeofrisk
dependsonallthreefactors,R,σ(x)andσ(y).
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Twosimplerulestoapplytocovarianceare:
• 1.ThecovarianceofasumCOV(x+y)withanotherelement,“m”,(COV(x+y,m))isthe
sumofthecovarianceofeachelementoftheoriginalsum(x+y)withtheotherelement.
ThisisequaltoCOV(x,m)+COV(y,m).
• 2.Whenaconstantismultipliedbyoneelementinacovariance,itcanbefactoredout
andmultipliedbytheentirecovariance-example-COV(cx,m)=cCOV(x,m)
Themostsimplewaytoenvisionbetaisthus,COV(Returnonthestockofacompany,
Returnonamarketindex)/Varianceofthereturnonthemarketindex.Thesame
expressionreducesto:(Rσ(x)σ(y)
.
)/σ(x)
2
.
Inthemid1980s,theresearchteamofMandelkerandRheedidmuchtoprovidethe
financiallogicbehindthedecompositionofbeta.Theytheorizedthatsincestockpricesare
thepresentvalueoffutureearnings,thereisanetincomefactorineachstockpricechange.
Moreover,thereissomereturnonequitythatisalsoimplicitinstockpricechangesand
thatthisconstantcouldbefactoredoutandthenmultipliedbytheseriesofearnings
changes.Accordingtorulenumbertwoabove,COV(ROEx%∆NetIncome,Returnon
themarket)/VarianceoftheReturnontheMarket=ROExCOV(%∆NetIncome,R
market)/VarianceofRmarket.“Rmarket”ismerelythereturnonthemarketandisnot
areferencetothecorrelationcoefficientintheregression.
Ifthereaderwillreviewthechapteronleverage,heorshewillrememberthattotal
leveragemultipliedbythepercentagechangeinsalesyieldedthepercentchangeinnet
income.Thechangeinsalesandthechangeinoperatingincome(EBIT)canceloutand
yieldthechangeinnetincome:(%∆Sales)x(%∆NetIncome/%∆EBIT)x(%∆EBIT/
%∆Sales)=(%∆NetIncome)Inastablecompanywithcontrollableleverage,thischange
innetincomewasderivedfromusingtotalleverageasapredictivetool.Ifwesubstitute
DFLandDOLforthedegreesoffinancialandoperatingleveragesrespectively,thechange
innetincome,%∆NetIncome,isequalto(DFL)x(DOL)x(%∆Sales).
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Wecansubstitutethisexpressionforthechangeinnetincomeintheoriginal
covariancetoyield:ROExCOV((DFL)x(DOL)x(%∆Sales),Rmarket)/VarianceofR
market.Wenextdoanexchangeofconstants.BothDOLandDFLareconstantsasis
ROE.Wefactortheleverageconstantsoutoftheequation,whilere-multiplyingROEback
intotheequationandeliminatingdecimalpercentages.Inthisnewmodel,wehavetwo
newsubscripts,p=previousyearandc=currentyear.Thus,ROE=NetIncome(p)/
Equity(p).Theentireexpressionisnow:
(DOL)(DFL)COV[(NetIncome(p))x(Sales(c))/(Equity(p))x(Sales(p)),Rmarket]/
VarianceofRmarket.Toobtainthisexpression,wereasonedthat%∆Salesisequalto
(Sales(c))/(Sales(p))-1,andwhenmultipliedbytheROEconstant,NetIncome(p)/
Equity(p),itisequalto[(NetIncome(p))x(Sales(c))]/[(Equity(p))x(Sales(p))],which
becomesthefirstterminthecovariance.Weeliminateddecimalpercentagesbyusingthe
ratioofcurrentyear/previousyearandthensubtractingone(“1”).
Forthesecondtime,weagainfactoroutROE.Thisfinalexpressionis:
(DFL(c))x(DOL(c))x(ROE(p))xCOV(Sales(c)/Sales(p),Rmarket/VarianceofR
market
Ineffect,itisthecurrenttotalleveragemultipliedbylastperiod’sROE,andagain
multipliedbythecovarianceoftheperiodicratioofsaleswiththemarketindex.This
expressionisthendividedbythevarianceofthemarketindex.Noticethatsalesisno
longerapercentchangebutthereturnonthemarketandvarianceofthemarketremain
decimalpercentchanges.
MandelkerandRheeusedtheoreticalassumptions,thefirstandforemostbeingthat
thereturnonastockcanbedecomposedintoareturnonequityandaseriesofnetincome
changes.Thesecondmajorassumption,whichisbackedupbyleveragetheory,wasthat
thepercentagechangeinnetincomecouldbederivedbymultiplyingtotalleveragebythe
percentchangeinsales.Thatisamathematicalfactattributabletothenatureofthe
componentsintheequation.Thefirstassumption,however,ismorecontroversialbecause
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itassumesthatastockisworthitsintrinsicvalueinnetincomerelativetotheamountof
equity-withoutbeingdiscountedataspecificcost,whichisthecostofequity.Thatisa
disposablecircularargument,becausetheequationdefinesseveralimportantrelationships
amongthecomponents.
Fromacapitalstructureperspective,thedecompositionidentifiesthekeyelements
ofrisk.Althoughtheargumentforaprecisedecompositionremainselusive,Mandelker
andRheegaveusaseriesofsignificantvariablesandconnectedtheminalogicalmanner.
Whileitmayseempretentioustoattributethereturnonastocktowhollyknown
components,bothROEandtheincreaseinnetincomehavegreaterlong-runcorrelation
withstockincreasesthanmostanyotherelementwiththeexceptionofearningspershare.
Producingavalidbetameasurementthen,mightjustrequirealong-termregressionthat
containstherelationshipofROEandnetincomeincreasesasprimecomponents.
Moreover,theuseofbothtotalleverageandthegrowthrateofsales,Sales(c)/Sales(p)
alsocontributetotheoverallinduction.Steadysalescanallowmorefinancialleverageto
beused,thuslimitingtheamountofequityissued.Byusingthedegreeoffinancial
leverage(DFL),MandelkerandRheemadeequityanimplicitvariableinthe
decomposition.NotethattheROEwasthepreviousperiod’sandthattheleverageis
current;theassumptionofimpliedchangesinequityisclear.
Therefore,onapragmaticbasis,wecanusetheseidentifiedvariablestogaugerisk.
Weneednotsubmitthemtoactualbetaequationsbecausetheyexistinthedomainof
probability;someelementwillalwaysbe“outofsync”withtheactualresultsofa
regression.Thevariablesare:
• 1)∆NetIncomeanditsstandarddeviation
• 2)ROE,thereturnonequity
• 3)∆Salesanditsstandarddeviation
• 4)Thedegreeofoperatingleverage
• 5)Thedegreeoffinancialleverage
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• 6)∆Returnonthemarketanditsstandarddeviation
• 7)Thevarianceofthereturnonthemarket
Thereadershouldobservethatthecostofequityisrelatedtothechangesinnetincome
andexistingequity,butisneitherthereturnonequity(ROE)northepercentageamountof
growthinnetincome.Itcombinesmarketforceswithinternalcorporatedynamicsto
produceariskfactorentirelyseparatefromincomefundamentals.
Whilethedecisiontoaddorsubtractequityiscrucialtoformingatotalcostof
equity-thatis:thepercentagecostmultipliedbycommonstockholders’equity-we
developthosecalculationsinotherchapters.Theessentialobservationis:thesubtle
connectionbetweenasustainablereturnandthecostofequity.Thekeywordis
“sustainable”.Withinourdecompositionofbetawereseveraltypesofstandarddeviations
whichstandasthegenericstatisticalmeasurementsofrisk.Thesmallerthestandard
deviation,themoresustainableisaflowofincome.Equityriskisacompositeofthese
otherrisksandwhencomparedtoactualnetincome,addsadifferentdimensiontothat
figure;netincomeisaderiveddeductionofaccountingcostslikeinterestandtaxesfrom
operatingincome.Ontheotherhand,thecostofequityisanopportunitycost,animplicit
economiccostderivedfromseveralriskfactorsthatincorporatemarketvariancewithan
individualcompany’sperformance.Muchofthepracticalapplicationofcapitalstructure
theorycomesfromtheconflictbetweenthesetwoelements-theconcrete,financial
statement-profitabilityofnetincome,withthetheoreticalriskfactorsofthecostofequity.
Together,theirrelationshippointstotheconceptofeconomicprofit,andthedevelopment
ofvariantssuchas“EconomicValueAdded®
3
,and“thecapitaldynamic”.These
relationshipsareex-postindicatorsofperformancebutex-anteestimatesoftheamountof
equityfinancingafirmcanviablydo.Whentheobjectiveistoincreaseperiodiceconomic
profit,balancingthecorrectamountofequitywiththeriskofanychangesinrequired

3
Theacronym“EVA”andtheterm“economicvalueaddedareregisteredtrademarksofSternStewart,Inc.
127

returniscounterpoisedwiththeamountofnetincome.Thesethreeelementsarealwaysin
conflict:tocreatemoreincometendstorequiremoreequitywhichcausesmoreriskwhen
thecostofthatequitygetstoohigh.
BALANCINGLEVERAGE,RISK,ANDTHECAPM
Onemisconceptionthatbothstudentsandfinancialprofessionalsharboristhatthe
optimalcapitalstructureisafunctionofcostratherthanrisk.Ineffect,theybelievein
“shopping”aroundforthelowestpricedcapitalandthencombiningitwiththeright
weightsofequityanddebttoachieveanoptimum.Thus,besidesflotationcosts,thecostof
equitywouldbethecostofdilutingearningspersharebyaspecificamount.Toillustrate
thisconcept,consideracompanywithearningsof$100and100sharesoutstanding.The
priceofthestockis$20pershareandEPSwouldbe$1.Ifthecompanyneededtoexpand
andissued25moresharesforatotalof125sharesoutstanding,atotalof$500incapital
wouldberaised.However,becauseofflotationcostsof-let’ssay2%-andadilution
valueof($1-(100/125))x(125shares)=25,thecostofequityis(2%x500)+25=35.This
myopicapproachtopricingequityturnsitintoanaccountingcost.Retainedearnings
wouldbesimilarlypricedbytheadministrativecostdifferencesbetweenkeepingitinan
interestbearingaccountandmanagingcash.
Costisafunctionofrisk.Whenmeasurableriskisatanoptimum,thecostof
capitalisminimized.But-anoptimallevelofriskmaynotbetheleastriskorthegreatest
riskbutalevelthatisperceivedbytheinvestingpublictobethebestforthefirm.The
subjectiveconnotationof“best”isobjectifiedbymeasurementsfromcreditagencies,and
furthersubstantiatedbythepresentandprojectedcash-flowofthecompany.
Whileequitybearsitsowncostsandrisks,thosefirmswhochoosetofinancewith
debthavetheaddedabilitytoaffectthecostofequitybyincreasingordecreasingitsrisk.
Purelogicwoulddictatethatifacompanychangesitsdefaultprobability,thentheriskof
owningthestockshouldgoupordown.Afirmthatfinanceswith“junk”bondsshould
haveaveryhighcostofequityaswell.Indeed,thereisarelationshipbetweenthecostof
128

bothdebtandequitythatwetreatasdeterministicforpracticalreasons.The
Miller/ModiglianipropositionIIstatedthatmoreleverageincreasestheriskandcostof
equity.Itessentiallystatedthattherequiredrateofreturnonequitywasafunctionofthe
amountofleverage,theinterestrateandthecorporatetaxrate.Whilethe
Miller/Modiglianipropositionswerepostulatedinthedomainofmanyconstraints,the
developmentoftheCAPMallowedthefreedomtomeasureanestimatedamountofchange
intheriskofequityduetochangesinleverage.Theeffectofleverageonthecostofequity
wasnowbeingcomparablyquantified.
BETAANDLEVERAGE
RobertHamadatooktherelationshipbetweenbetaandcapitalstructuretonew
heights.HisseminalarticleintheMay1972editionoftheJournalofFinancewasentitled
“TheEffectoftheFirm’sCapitalStructureontheSystematicRiskofCommonStocks”.
Essentially,Hamadadevelopedthestandardonthetheory:notonlywastheprincipleset
forththatmoredebtraisedequityrisk,Hamadatoldthereaderbyhowmuchandbywhat
mechanism.Infact,theCAPMcouldbeusedtodrawthesameconclusionsas
Miller/Modigliani,whichfurthersubstantiatedtheirresearch:inaworldwithouttaxes,or
bankruptcycosts,capitalstructurewasimmaterial,butwhentaxeswereadded,the
optimumproportionwasonehundredpercentdebt.Theseextremecornersolutions
eliminatedtheconceptthatcapitalcostsweredeterminedoutsideoftheconfinesofthe
corporation;theywerenotdictatedbythemacroeconomy,onlyaffectedbyit.Therefore,
acombinationoftaxpolicy,andmanagingdefaultriskwoulddeterminetheamountof
leverageandhaveaneffectonthecostofequity.
Formanyyears,acommonobservationwasthatmoreleverageinapubliclytraded
companyledtogreatervolatilityinthestock.Worldeventsappearedtoaffectdebtladen
companiesmuchmorethanunleveredones,whichwascorrectlyattributedtothelink
betweenexchangerates,inflationandinterestrates:leveragedcompanieswereatthe
129

mercyofa“creditorchain”-frombankstoforeignsuppliers,andtheincreasednumberof
variablesthataffectedtheflowofearningsmadethestockmoresensitivetochanges.
Hamadagaveanalystsanimprecise“ballpark”figureforchangesinequityrisk
duetoleveragechanges.Again,thefoundationislinearbecausethebestestimateof
extremevariationineitherdirectionisastraightline.Essentially,betahadtwostates:an
unleveredstateinwhichriskwouldflowmostlyfromoperationsbecausethecompanyhad
nodebt,andsecondly,aleveragedstatethatreflectedchangesinthelevelofdebt.
Throughasimpletransformationofbeta,theanalystcouldobservehowmuchriskwas
addedtothestockafteracertainamountofdebtwasincreased,andevenobservetherisk
inastockthatwasattributabletooperations(businessrisk)alone.Giventherestrictions
oftheCAPM,amathematicalproofcouldnowbesetupthatindicatedhowleverage
increasedbeta.Moreover,itbecameapparentthattheoptimalcapitalstructurewas
foundedasmuchupontheeffectofleverageonthecostofequity,asitwasonprevailing
interestrates.Althoughbetaisaffectedbymyriadothervariablesandaprecise
determinantiselusive,thisnewviewofleverageemboldenedthefieldofriskmanagement.
A“ballpark”figurewascertainlybetterthannoneatall,andnowanalystscould
experimentwithcombinationsofdifferentcapitalsourcesandlevelsthatpurportedly
minimizedrisk.
ASIMPLEEQUALIZER
TomakeHamada’sanalysisworkable,onlyfourinputswerenecessary.Theywere:
• 1)Thecurrentbetaofthestockwhichwasavailablethroughregression
• 2)Themarketvalueofdebt
• 3)Themarketvalueofequity
• 4)Thecurrenteffectivecorporatetaxrate
Thesevariableswerecombinedinthefollowingexpression:
(1+[(1-taxrate)xMarketvalueofdebt/Marketvalueofequity])
Thus,theunleveredbetabecameafunctionofthecurrentbetadividedbythisexpression:
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Unleveredbeta=Currentbeta/(1+[(1-taxrate)xMarketvalueofdebt/Marketvalueof
equity])
Theleveredbetabecame:
(Unleveredbeta)x(1+[(1-taxrate)xMarketvalueofdebt/Marketvalueofequity])
Achangeinthebetaduetomoreleveragebecame:
(Originalbeta)/(1+[(1-taxrate)xOldMarketvalueofdebt/Oldmarketvalueofequity])
x
(1+[(1-taxrate)xNewMarketvalueofdebt/Newmarketvalueofequity])
Iftheriskofequityisdependentupontheamountofdebt,doesitfollowthatthe
costofdebtdeterminescapitalstructure?Onlysofarthatinterestratesarea“perfect”
transmissionmechanismforbothgovernmentpolicyandtheprobabilityofdefault.While
thecostofdebtisacontributingfactorthroughtheeffectofinterestratechangesinthe
macroeconomy,the“real”costofdebtisthecostofbankruptcywhichisattributableto
theinterfacebetweenoperatingincomeandtheamountofinterestexpense,aswellashow
assetsarestructuredinthefirm.Bankschargeinterestbasedoncreditworthinesswhich
stemsfromtheabilitytocoveraloan.Thesteadycash-flowthatisimplicitinsuch
coverageisanoutgrowthofoperatingriskandtheamountofdebtalreadyincurred.Since
moredebtincreasestheprobabilityofdefault,itraisesthecostofequity.Whilemoredebt
mayleadtohigherinterestpayments,higherinterestratesalonewillnotleadtomore
equityrisk.
Therelationshipbetweenbetaandtheprobabilityofdefaulthasnotbeenwell
developed.Onewouldexpectinordinatelyhighorlowbetastoforeshadowtheinabilityto
makepaymentsoninterest.However,betaisnotameasureofperformancebutof
volatility.Whilemoredebtmayincreasebothbetaandtheprobabilityofdefault
simultaneously,afirmthatisnearbankruptcywhenthemarketsurgesmayhaveastock
thatlanguishes.Theinabilitytomakepaymentsmaystemmorefromalackofincome
generationthanitdoesfromtoomuchleverage.AsinMandelkerandRhee’s
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decompositionofbeta,salesthatarelanguidcouldcounterbalancetheeffectofhigher
leverage,makingbetanon-reactive.Inthatcase,the“alpha”variableintheregression
wouldtakeoverandbecomeverylow.Evenwhenbetaisup,thestockwouldstillunder
performthemarketandthecorrelation,“R”,wouldbelowaswell.
Theeffectofleverageonbetaismostobservablewhenweunleverafirm’sbeta-
thatis-findingouthowmuchequityriskithaswithoutanydebt.Firmsthathavea
comparativelyhigh-unleveredbeta,likemanytechstocks,canaffordlittledebtbeforethe
stockbecomesprohibitivelyrisky.Analogously,manyhighdebtcompaniesthathave
steadyincomes,likeutilities,willhavelowunleveredbetas;thesecompaniesseelittlerisein
theprobabilityofdefaultevenwhentheyincreasedebt,mostlybecausetheyareheavily
regulated.Thus,manyfirmsthathavemoreleveragethanwarrantedbytheirbetaswill
havenaturallyriskierstocksandbecomethefodderforspeculativebettingonWallStreet.
Ontheotherhand,astockwithtoolowabetawhosefirmisnotoutproducingtheir
respectiveindustrymayunderperformthemarketbecausetoolittleriskisbeingtaken.
Thehappymedium,ofcourse,isthefirmwithalowbetastockwhoisindeedout
producingtheirsector;thesefirmswillhavelargedifferencesbetween“expected”and
“required”ratesofreturns.Theywillalsoofferthemostreturnfortheleastamountof
risk.
ThestrategicimplicationsofHamada’sresearch(andmanyothersinthatsame
period)shouldbeapparent.Anyfirmthatiswealthyenoughtoaffordthelowerinterest
debtfinancingthatisofferedatthebeginningofarecovery,canincreasebetaatthesame
timethatthemarketispickingup.Whentheinvestmentindebtbeginstopayoff,cash-
flowsimprove,attractingmoreequitycapitalintothecompany.Bythetimethenext
downturnoccurs,theproportionofdebttoequitywillhavedecreased,diminishingsomeof
thehighercostofequitythatwouldhaveoccurredbecauseofhigherinterestratesanda
surgingmarket.
CONCLUDINGCOMMENTS
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Anymodelthatpurportstobeascomprehensiveasthecapitalassetpricingmodel
(CAPM)needstobeusedwithjudiciouscaution.Whenitisaccurate,itcanresolveseveral
issues:
• 1)Itcanmeasuretheadditionalriskcausedbyincurringmorefinancialleverage.
• 2)Itcanmeasureoperatingriskandanyadditionalriskderivedfromthecombiningof
assets.
• 3)Itestablishestherequiredrateofreturnonafirm’scommonstock.
• 4)Itcanbecomparedtothe“expected’rateofreturnandusedasa“buy/sell”signal.
• 5)Itestablishestheriskofastockincomparisontotheoverallmarket.
• 6)Itestablishesacostofequityforthecompany.
• 7)Itcanbeusedtogaugethebusinesscycleaswellasthedifferencesbetweenrisksin
theequityandfixedincomemarkets.
• 8)Itcanbeusedasatoolinportfoliomanagementtodiversifyawayrisk.
Thewatchwordsinanyanalysissystemarealwayscorroborationandbalance.Without
understandingandseekingoutalternativeanalyses,theinvestoris“puttingallofhisorher
eggsinonebasket”.Thatisariskyproposition,byanystandard.
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APPENDIX:THEMATHEMATICALRELATIONSHIPBETWEENLEVEREDAND
UNLEVEREDCOMPANIESINTERMSOFTHECAPM
ThecapitalassetpricingmodelcorroboratestheMiller/Modiglianipropositions.In
thecaseofnobankruptcyandnotaxes,capitalstructureisimpertinent;firmsthatfund
withequityhaveanequalamountofriskasfirmswhofundwithdebt.However,when
taxesareapplied,theoptimalstructureisoneofalldebt;taxdeductionsoninterestgivea
distinctadvantagetoleveragedfirmsaslongasthereisnoprobabilityofbankruptcy.In
thissection,weexaminetheMiller/Modiglianiargumentsfromthestandpointofthe
CAPM.First,weestablishthedifferencesbetweenbetainbothleveragedandunlevered
companies,andconcludethattheyarederivedfromtheamountofleverage.Secondly,we
usetheseconstructstoexhibitthedifferenceinthecasesofbothtaxesandnotaxes.
1)EQUATINGTHELEVEREDFIRMWITHTHEUNLEVEREDFIRM
Studentstendtointerpretthisproofasreferringtotwodifferentfirms.Itismore
enlighteningtothinkofthecomparisonasthesamefirmintwodifferentsituations-with
debtorwithoutit.Thus,thenetoperatingincome(NOI)willbethesameforeach
situation,butthereturnonequity(ROE)willbedifferentbecauseintheleveredstate,the
firmhastopayinterest,butintheunleveredstate,itdoesnot.Anotherassumptionisthat
betaisstatedintermsofROEratherthanthestockprice.Sincethestockpricewilltendto
mirrorROEoverthelong-run,makingbetaadeterministicfunctionofnetincomeand
equitywilldisplayacauseandeffectrelationship.Thecertaintythatweimposehelpsto
exhibitpossibletrends,althoughwefullyrealizethatbetaandstockpricehaveamore
volatileandprobabilisticrelationship.

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Table5-2

LEVEREDFIRM(L)
ROE(L)=ReturnonEquityfortheLeveredFirm
NOI=NetOperatingIncome
B(L)=AmountofDebtfortheLeveredfirm
S(L)=ValueofStockoftheLeveredFirm
r=InterestRateonDebt.Therefore,rB(L)isInterestExpense.
ROE(L)=NOI-rB(L)/S(L)
Table5-3

UNLEVEREDFIRM(U)
ROE(U)=ReturnonEquityfortheUnleveredFirm
NOI=NetOperatingIncome
S(U)=TheValueofTheStockoftheUnleveredFirm.S(U)=V(U)=Valueofthe
UnleveredCompany
ROE(U)=NOI/S(U)=NOI/V(U)

STEP1)NotethatNOI=(S(U))(ROE(U)).ThiscanbesubstitutedintotheNOIofthe
leveredversionofthecompanysothatunleveredandleveredcanbeequated.
STEP2)Theleveredfirmisnow[(S(U))(ROE(U))/S(L)]-[r(B(L)/S(L)].Wemerely
broketheexpressionintotwoparts,givingitthecommondenominatorofS(L).
STEP3)Determinethebetaoftheunleveredfirm.Rememberthatbetaisacovariance
dividedbythemarketvariance.WeareusingtheunleveredROEratherthanthestock
priceandso:betaisCOV(NOI/S(U),Rmarket)/VarianceofRmarket.Thisisthesame
asCOV(ROE(U),Rmarket)/VarianceofRmarket.RememberthatRmarketisthe
returnonanappropriatemarketindex.
STEP4)Determinethebetaoftheleveredfirm.Thisismorecomplexbecausewenow
expresstheleveredfirmintermsoftheunleveredfirm(stepsoneandtwoabove).First,we
usetheadditivelawforcovariancetocombinetheentireexpressionintoonecovariance.
Next,weeliminatetheconstantsbecausetheyhaveavalueofzerointhecovariance.
Thirdly,wemultiplythevariableswithinthecovariancebythetermS(U)/S(L)toequate
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theunleveredbetawiththeleveredbeta.Fourthly,wefactoroutthissameterm(S(U)/
S(L))fromthecovariance.
a)Usingtheadditiveproperty:BETA(L)=COV(((NOI-rB(L))/S(L)),Rmarket/
VarianceRmarket=(1/VarianceRmarket)(COV((NOI/S(L),Rmarket)))(COV(rB(L)
/S(L)),Rmarket).Wehavebrokentheexpressionintotwoseparatecovariances.
b)Eliminateoneofthecovariancesbecauseitisaconstant.WeeliminateCOV((rB(L)
S(L),Rmarket).NowBETA(L)=(1/VarianceRmarket)(COV(NOI/S(L),Rmarket)
c)IfwedivideNOIbyS(U)andthenmultiplythetermbyS(U)/S(L),thetermNOI/S(L)
willremainthesame.ThatisBETA(L)=(1/VarianceRmarket)(COV((NOI/S(U)x
(S(U)/SL)),Rmarket)
d)Bythelawofcovariancefactoring,wecanfactoroutS(U)/S(L)sothatnowBETA(L)=
S(U)/S(L)(COV(NOI/S(U),Rmarket))(1/VarianceRmarket)
Noticethatinpartd,theleveragedbetaisthesameastheunleveredbetaifwe
multipletheunleveredbetabyafactorofS(U)/S(L).Theexpression(COV(NOI/S(U),R
market))(1/VarianceRmarket)isthebetaoftheunleveredfirmthatwestatedinstep3.
Thus,merelybymultiplyingtheunleveredbetabyafactoroftheratiosofmarketvalues
(S(U)/S(L)),wecandeterminethebetaoftheleveredcompany.Iftheleveredbetaisa
given,wedivideitbythesametermtoyieldanunleveredbeta.
Bothbetasareequalbyaconstant(S(U)/S(L))thatreflectthedifferencein
financialleverage.Sincetheleveredfirmissuesdebtinsteadofstocktoraisethesame
amountofcapital,thissmalleramountofstockwillbethedeterminingfactor.Thereader
willrememberthatfortheunleveledfirm,S(U)=V(U).Thatis:thevalueoftheunlevered
firmwastotallydependentontheamountofitsstock,andsowearecomparingawhole
value(S(U))toapartialvalue,(S(L)).Thisfigurewilltakeonsomeintegervaluegreater
than1,makingtheleveredfirm’sbetaalwaysgreaterthantheunleveredfirms-bya
factoroftheamountofleverage.
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2.USINGTHECAPMTOCORROBORATETHEMILLER/MODIGLIANI
PROPOSITIONS
Toreviewthelastsection,recallthatwehaveestablishedtwosubstitutions:
• A)BETA(L)=S(U)/S(L)(BETA(U))
• B)SinceNOI=(ROE(U))(S(U)),thenROE(L)=[(ROE(U)(S(U))/S(L)]-[rB(L)/S(L)]
whichessentiallystatesthatthedifferenceinthetwoROEsisbecauseinterestexpense
(rB(L))issubtractedfromoneandnottheother.
Wefurtherestablishtwopremises,equatingthemarketreturnswiththeindividual
companyreturnsthroughthemechanismofbeta.
• Premise1:(E(ROEofafirm)-r)/Betaofafirm=E(ROEmarket)-r.Inthis
expression,“E”istheexpectedreturn,while“r”isequaltotherisk-freerate.Inthis
instance“E”isnotmultipliedbyROEbutistheexpectedreturnthereof.Thisassumes
thattheexpectedreturnofthereturnonequityofanyfirm,dividedbythefirm’sbeta,
isequaltotheexpectedvalueofthereturnonthemarket.
• Premise2:(E(ROE(U))-r)/BETA(U)=(E(ROE(L))-r)/BETA(L).Thisstatesthat
theexpectedvalueofanysecuritydividedbyitsbetaisequaltotheexpectedvalueof
anyothersecuritydividedbyitsbeta.
PROPOSITIONI
InpropositionI,Miller/Modiglianibasicallystatedthatcapitalstructuredidnot
matterinaworldwithouttaxesorbankruptcy.
STEP1:WesubstituteforROE(L)andBETA(L)inpremise2.Again(ROE(U))(S(U))is
substitutedforNOI,while(S(U)/S(L))(BETA(U))issubstitutedforBETA(L).
(E(ROE(U)-r)/BETA(U)=
[(E(ROE(U))(S(U))/S(L)-rB(L)/S(L)-r]/(S(U)/S(L))(BETA(U))
STEP2:Weeliminatetheterm,S(U)/S(L),ontherightsideoftheequationby
algebraicallymultiplyingbyitsinverse,S(L)/S(U).Weobtain:
(E(ROE(U)-r)/RETA(U)=[E(ROE(U)-rB(L)/S(U)-rS(L)/S(U)]/BETA(U)
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STEP3:Weeliminatetermsandmultiplyitthrough:
-r=-rB(L)/S(U)-rS(L)/S(U)
STEP4:Wemultiplyby-1andthenfactor:
r((B(L)/S(U))+(S(L)/S(U))=roralternatively,S(U)=S(L)+B(L).Sincethevalueofthe
unleveredfirmisequaltoitsstock(V(U)=S(U))andthevalueoftheleveredfirmisequal
toitsstockandbonds(S(L)+B(L))=V(L),thenV(U)=V(L).Capitalstructuremakesno
differenceinthevaluation.
PROPOSITIONII
InpropositionII,Miller/Modiglianiarguedthatinaworldoftaxes,theoptimal
capitalstructurewouldbemadeupofonehundredpercentdebt.Inthetaxcase,wego
throughthesamesetofequationsexceptthatNOI(andthesubstitutedvariables)are
multipliedbyafactorof(1-taxrate).
STEP1:ROE(L)=[(ROE(U))(S(U)(1-taxrate))/S(L)]-[(1-taxrate)rB(L)/S(L)]
STEP2:Multiplyingtheequationsthroughyields:
-r=[(-(1-taxrate)rB(L))/S(U)]-[rS(L)/S(U)]
STEP3.Reducingtheexpressionandeliminating“r”:
S(U)=(1-taxrate)B(L)=S(L)oralternatively,
S(U)+(taxrate)B(L)=B(L)+S(L)
STEP4:Applyinglogic:SinceS(U)=V(U)andsinceV(L)=B(L)+S(L)then
V(L)=V(U)+(taxrate)B(L)
Thevalueofaleveragedfirmisequaltothevalueofanunleveredfirmplustheproductof
thetaxrateandtheamountofbonds.Eitherahighertaxrate,ormoredebt,orboth,will
increasethevalueofthefirm,andsothevalueismaximizedatonehundredpercentdebt.
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138

6
THECAPITALDYNAMICANDOTHERTOOLS
Thischapterwillprovidethestudent/investorwithsomepracticaltoolsfordetecting
movementtowardanoptimalcapitalstructure.Whilemathematicaloptimizationremains
controversialandinexact,thesemeasurementsexploitcorrelationandprobability;their
raisondetreَstemsfromcreatingdistancebetweennetincomeandthecostofequity,and
notfromthetime-dependentrequirementsofmaximizingafunction.
Fortunately,thefinancialcommunityprizesthetransitionalprogresstowardagoal
morethanitsactualachievement.Ifthisstatementseemsparadoxical,considertherisk
factorsinvolvedwhenacompanyisalongwayfromreachinganygoal-sales,earnings
stockprice,etc.Atfirst,expectationsareincreasedbyanalystsoratargetwouldnothave
beenoriginallyset.Next,whenacompanyisagreatdistancefromthetarget,therisksof
notachievingitaregreaterthanwhentheachievementis“adonedeal”,andthefirmis
veryclosetoitsobjective;atthispoint,severaldifficult“hurdles”mustbenegotiated.
Finally,WallStreetrewardsthosecompaniesthathavesuccessfullyovercomeobstaclesat
apointwherethegreaterinvestmentcommunityisunawareoftheiroccurrence-before
theknowledgeofprofitabilitybecomescommonplace.Infact,whileitappearsthatthereis
substantialdownsideriskfromnotmeetingobjectives,theupsidereturnoccurs“earlyin
thegame”whentheriskisgreatest.
THEPERCENTAGETRAP
Althoughitismoremathematicallysoundtouselogarithmsratherthanpercentages
asthemeasurementofanincrease,thistextsubmitstothepercentageimperative.
Percentagegainsarethestandardinbusinessprimarilybecausetheyareunderstandable
inacomparativesense;theyaresomewhatakintoanAmericanusingtheEnglishconcept
of“foot”ratherthanthemetricsystem.However,theirowndependenceonreference
allowstheirbasestoshift,creatingshort-termhyperboleratherthanscientificexactitude.
139

Considerasanexample,anickelincreaseonanickelinvestment;suchanincreasecanbe
toutedasa“onehundredpercentgain!”,whiletenmilliondollarsonabilliondollar
investmentis“only”onepercent.Indeed,whenaninvestmentgoesupfrom80to100,itis
a25percentincrease,butifitgoesfrom100to80,itisonlya20percentdecrease,simply
becausethereferencebasehasshifted.Incapitalstructureanalysis,wedonotsell
investmentsortoutearningsincreases.Infact,percentagegainsarerelevantbecause
absolutesizematterslessthanthemovementitself;withoutaneedforreference,
percentagegainsareasimplemethodofenumeratingchange.Dissociatedfromemotional
content,atwentypercentgaininthecostofequity,forexample,willhavemuchless
meaningtotheaveragebusinesspersonthatatwentypercentgaininthecostofgoodssold.
Forthatveryreason,percentagechangesinthese“backgroundfundamentals”–
opportunitycosts-becomethebuildingblocksforchangesinmoreprominent
measurements.
THEWEIGHTEDAVERAGECOSTOFCAPITAL
Introducedbrieflyinthechapteroncapitalstructure,theweightedaveragecostof
capitalorWACC,formsthebackboneofcapitalstructuremeasurement.Althoughitdoes
notalwaysadhereperfectlytoitstheoreticalunderpinnings,WACCchangescantellas
muchaboutthedirectionofthecompanyasearnings.Infact,whenusedintandemwith
earningsmeasurementsandinformationabouttheeconomy,theWACCcanpredict
slowdowns,peaksandplateausaswellasanyeconomicbarometer.
Theproportionalcomponentcostofeachsourceofcapitalinaggregatemakesup
theWACC,anditisessentialthatthiscostbeminimized.Thosecomponentcostsmay
includelong-termloans,bonds,retainedearnings,preferredstock,capitalleases,and
commonstock-bothnewissuesandpaidincapital.Onatechnicallevel,suchaswould
occurincapitalbudgeting,eachcapitalitemneedstobespecifiedasaseparatecost.For
genericestimation,however,wehavegroupedlong-termdebtandstockholders’equity
togethertoformourdefinitionof“capital”:aninvestorwhoneedstocompareseveral
140

companiesinrapidsuccessionneeds“bestestimates”ratherthantechnicalprecision.The
libertiesthataretakenbecomeapracticalextensionofturningatheoretical“opportunity
cost”intoapracticaldecision-makingtool:thecostofequityisremovedfromthe
contingenciesofaccounting,andsotheriskshavetobedefinedbymodelinterpretation.
Someoftheriskwillalwaysremainsubjective,althoughwetrytoeliminateitbydefining
asmanyvariablesaspossible.
Therefore,acorporationwhopreciselyitemizesitscostofcapitalneedstoensure
implementationandreturn,notjustriskandreturn;theimplementationofanyprojecthas
massivelogisticsproblemsonarelativelevel.Abank,forexample,mustdoacomplex
itemizationofcosteffectivenesswhenitinstallsautomatictellers.Theinvestor,however,is
moreconcernedabouttheriskofinstallingthem:thereislessneedfordetailedknowledge,
butmoreofaneedforcomparingalternatives.
Oncethedifferencesinmethodologyarediscarded,thedecisionvehiclewillbe
similar.Corporationswillderiveaninternalrateofreturnandcompareitwiththe
discountedcash-flowofaproject.Investorswillobservethereturnfromacompany,and
compareittowhatcompaniesofsimilarriskwouldyield.Together,eachentityusesthe
weightedaveragecostofcapitaltoformthecomparison.
Onapragmaticlevel,theminimumcostofcapitalisalsotheoretical.Thetaxeffects
ofinterestdeductibilitymandatetheuseofdebtuptothepointwhenacompany’srisk
manifestlybeginstoundermineitsstockprice.Mostcompaniesareriskaverseenoughto
performatalevelsubstantiallybelowthatthreshold.Thus,themajorconcernforthe
investoristoobservethechangesintheWACCandnotworryaboutatheoreticalabsolute.
Forexample,attimeswhentheFederalReserveraisesrates,theWACCmayrisealthough
thefirmhasminimizeditscapitalcosts;sinceacompetitor’sWACCrisesaswell,the
increaseisentirelyrelative.Toresolvesuchproblemsofinterpretation,werelatethe
WACCtoothercapitalstructurevariables,andalmostcompletelydispensewiththe
observationofitsindividualmovement.
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THETHEORETICALSHAPEOFTHEWEIGHTEDAVERAGECOSTOFCAPITAL
CURVE
Combiningthelinearityofthecostofequitywiththeupwardtrendingofthecostof
debtformsaconvexcurve.Atsmalllevelsofdebt,theWACCcurveslopesdownwardto
reflecttheflatterslopeandgreaterproportionoftheequitycurve;moredebtactually
decreasesthecostofcapital.OncetheWACChitsaminimum,debtbecomesmore
expensive,anditbeginstocurveupwardstoreflectthesteeperslope,andgreater
proportionofthedebtcurve.
Figure6-1

Theshapeofthecurveiswhollydependentonthespreadbetweentherespective
costsandrisksofequityanddebtateachlevel.Capitalstructureoptimizesatthe
inflectionpointandthisisalsowherethestockpricetheoreticallymaximizes.Arealistic
renditionwillobservethesometimesabsurddivergencebetweenbondandequitymarkets:
attimes,yieldcurvesbecomeinvertedandshort-terminterestratesarehigherthanlong-
termrates.Theriskpremiumbetweenthemarketsmayevaporateforlongperiodsand
equitieswillhavegreatvolatilitywithonlyaminimumofreturn.Atothertimes,therisk
premiummovesintheoppositedirectionasinvestorssellbondsandbuystocks.Thus,over
Costof
Capital
Debt/Equity
CostofEquity
CostofDebt
WACC
Optimum D/E
142

thelongterm,thecostofcapitalmirrorstheinherentrisksofeachcomponentsourceand
formsahypotheticalcompendium.Whileshort-termvolatilitypreventstheanalystfrom
pinpointinganabsoluteminimumcostofcapital,severalrelationalvariablesallowthe
examinationofadirectionalflow,anditisinthis“vectoring”context,thatinvestment
decisionscanbemade.
Tounderstandtheneedforacombinedcapitalstructuremeasurement,considerthe
theoreticalrelationshipbetweendebtandequity;whenmoredebtisincurred,thecostof
equityrises.However,intherareoccurrenceofFederalReserveratecuts,firmswhocan
stillaffordalotofdebthavetheopportunitytodecreaseboththecostsofdebtandequity
simultaneously.Afirmwithalowprobabilityofdefaultcanmostbenefit.Oncethe
marketisbackinequilibrium,thecostofequityrisesasmoredebtisincurred,andthe
hypotheticalrelationshipisreadilyrestored.Inthemeantime,theWACCmayrisewhenit
issupposedtofallandviceversa.Tocorroborateitsmovement,theanalystusesboth
earningsandchangesintheproportionsofcapitalsources.WhentheWACCismultiplied
bytheamountofcapitalandthensubtractedfromearnings,acomparisoncostifsformed.
Thechangeinthiscomparisoncostwillconfirmordenymovementinthecostofcapital.
ACCELERATIONRATES
ArehigherearningsandadownwardtrendintheWACCasignaltoinvest?While
suchacrosscurrentmayleadtoanoptimizedcapitalstructure,theinformationistoo
spottytomakeadecisivejudgment.Whatisofprimaryimportanceistheaccelerationof
earningsincomparisontotheWACC.Duringarecovery,forexample,bothearningsand
theWACCmayrisetogetherbecausethemarketgetsbetter,andtheFederalReserve
raisesratestocontaininflation;therateofincreaseinearningsfaroutpacestherateofthe
WACCandstocksconsequentlyrise.Whenmarketconditionschange,thecostofcapital
becomeshigherorlowerateachlevelofdebttoequity,changingtheoptimummix.In
effect,theWACCcurveshiftsupordown,butwilllagtherateofearningsineither
direction.Itisthisdisparitythatcreatesopportunityintheequitymarkets;corporations
143

canshifttheirmixesofdebttoequitytotakeadvantageofthedistancebetweenearnings
andtheWACC.
THEWACCANDRISK
Themarketdoesnotalwayspriceriskefficiently.Whilesomeseeopportunityin
thevariouseconomic“bubbles”thatarise,thereisusuallyacompensatorydownsidethat
createsforcesintheoppositedirection.Whendebtisespeciallyinexpensive,thetendency
to“gooverboard”isjustifiedbyalowerWACC.Aslongasthecostofdebtislowerthan
othersourcesofcapital,theWACCtellstheanalysttoloaduponitbecauseitistheleast
expensive.Toproperlygaugerisk,however,acompanymustconsidertheprobabilityof
defaultfirstandforemost.Withoutthecontextofpotentialbankruptcy,theWACCwill
optimizeatacapitalstructureofalldebt,simplybecausetherearenoupwardboundson
it.Sinceinterestrateschangefrequently,andwillrarelybeabovethecostofequityfora
solventcompany,theWACCcannotbeminimizedonthebasisofitsownparameters.For
example,afirmmayloaduponalargeamountofzerocouponbonds,andtheWACC
woulddiminish,notfactoringinthepotentialdistressofpaymentinthefuture.Thus,the
WACCisanindicatorofrisk,butitisnotdefinitive.Itmayshowpositiveornegative
trends,butisnotthefinalarbiterofcorporateaction.Forthatdecision,thefirmneedsto
balancethetaxadvantagesofdebtwiththeprobabilityofdefault.Onlywhenafirm
balancesthestabilityandamountofearnings,thetypeofassets,andtheabilitytomake
promptpayments,willanoptimalcapitalstructurearise.
THEMECHANICSOFTHEWACC:RISKADJUSTMENT
Whenthecomponentproportionsofallsourcesofcapitalaremultipliedbytheir
respectivecosts,aweightedaveragecostofcapitalisformed.Aftercalculatingindividual
costs,thecruxoftheequationrevolvesaroundtheproportionsandthedefinitionof
“capital”.Corporationsandlargeinvestorsneedacompleteitemizationofeachsourceof
funding;theywillincludebothpreferredstockandshort-termnotesinthecapital
denominatoraswellaslong-termdebt,commonequityandretainedearnings.Thesmaller
144

investor,however,maywanttomakequickcomparisonsandusejustthelatterthree
components.Consequently,thedenominatorwillbesmaller,andbothlong-termdebt,and
commonequitywillbealargerproportion.Sincethesmallerinvestorismoreconcerned
withrisk,andlesswithimplementationofaproject(oracontrollingstake)expeditingthe
WACCwillcreateutility;long-termdebtandequityarethemajorriskfactorsandthe
contractionofthedenominatorwillrecognizethis.However,this“riskadjusted”WACC
isnotthetrueWACC,andwillleadtogrosserrorsifusedinthecontextofcapital
budgeting;mostfirmsdiversifyawayriskbyfundingfromasmanydifferentsourcesas
possibletoavoidthisexacttypeof“corner”solution.
Tocontrastthetwomethods,observethefollowingbalancesheetwhereeach
componentisitemizedbyapre-taxcost.Thereaderisreferredtopreviouschaptersfor
themethodologyofdeterminingindividualcost.
Table6-1

TYPEOF
CAPITAL
AMOUNT PERCENTAGE COST
ASSETS 1000000 100
STOCKHOLDERS'
EQUITY
700000 70
PreferredStock 70000 7 8%
RetainedEarnings 140000 14 10%
CommonStock 490000 49 12%
DEBT 300000 30
Long-term 250000 25 7%
CurrentLiabilities
Notes 50000 5 4%
OtherCurrent
Liab.
0 0

CORPORATEMETHOD
Forthesakeofillustration,othercurrentliabilitiesareassumedtobezero.Hadtheybeen
enumerated,itwouldbepropertoexcludethemfromthecapitaldenominatorbecausethey
145

areasourceofinternalandnotexternalfunding.Inthatcase,allothersourcesoffunding
wouldriseinproportion.Forexample,hadothercurrentliabilitiesbeen25000,andnotes
25000,thentheproportionofcommonequitywouldbe(490000/975000)or50.25%and
not49%.Notes,however,wouldgodownto(25000/975000)or2.56%asacomponent
proportion.

Assumingataxrateof30%,debtiscalculatedas(interestrate)(1-taxrate).Theother
costsaremultipliedbytheirproportionsandthensummed(costsareinparentheses)
.07(.08)+0.14(0.1)+0.49(0.12)+0.25(0.7x0.07)+0.05(0.7x0.04)=0.09205or9.2%.
Thefullcapitalbudgetingtypeofanalysisyieldsa9.2%WACC.
RISKADJUSTEDMETHOD
Wechangethecapitalbasetothesumofretainedearnings,commonequityand
long-termdebt.Thecomponentproportionsoftheseelementswillrise:
Table6-2

TYPE AMOUNT PERCENTAGE COST
RetainedEarnings 140000 15.9 10%
CommonEquity 490000 55.68 12%
Long-termDebt 225000 28.4 7%
TotalCapital 880000 100

Thecalculationisasfollows:
0.159(0.1)+0.5568(0.12)+0.284(0.07)=0.1026or10.26percent.Thus,theriskadjusted
WACCissubstantiallyhigher.Suchabiaswillinflatetheimportanceoflong-termdebt
andcommonequityinthecapitalstructurewhichisitsintendedpurpose.
THEMARGINALCOSTOFCAPITAL
Fewmoderncorporationscanattainanoptimalcapitalstructureandremainthere
foranysignificantlengthoftime.Notonlywillchangesintheeconomyalsochangethe
targetmixofdebttoequity,butthefirmcanbepenalizedfortakingtoolittlerisk.In
146

effect,thecompanywillmoveawayfromitsoptimalstructurefromtimetotimebytaking
oninordinateamountsofrisk,andthenideally,movebacktowardthetargetasrapidlyas
possible;suchrapidityimpliesareturnfortheextrariskthatthefirmincurred.
Moreover,itiscosteffectivefromanadministrativeperspectivetoraisecapitalinlarge
incrementsbecausesuchinflowsareoftenpurposefulandacttofocusmanagementonan
objective.However,largecapitalinfusions,whetherindebtornewstock,maytakea
longertimetointegrate,creatingstagnationanduncertainty.Thechallengeatthispointis
perhapsoneofthemostdifficultinbusiness:tobegingeneratingaprofitwhenthe
infrastructureisnewanduntested.
Thesolutiontothisproblemistobeginmovementbacktothetargetcapital
structurewhichcanbetakeninincrements;mostinvestorswilldemandequitywhenthey
seesalesandprofitsgrowing.Theprocesscantakeuptothreeyearsormorebutwillcome
tofruitionwithconsistentperformance.Inthemeantime,managementneedstobeaware
ofitstargetcapitalstructureandthatahigherWACCwillbeimpliedwhenthefirmmoves
awayfromit.Forexample,ifthetargetstructurecallsfor35%debtand65%equity,and
thefirmhas500millionindebt,then500/.35=1429canberaisedintotalcapital.
KnowledgeofthislimitcanhelpaCFOgaugethefeasibilityofcapitalprojects;when
combinedwiththeamountofearnings,someofwhichwillsupplycapitalthroughretained
earnings,theCFOcansetdividendpolicy,andcapitalbudgets,andthenplantofinda
sourceoffundingifneeded.But-itismucheasiertomoveofftargetandthenbackagain
thantobeconstantlyconstrainedbytheamountofearningsandcapital.Movingoffthe
targetwillraisethemarginalcostofcapital-thatis-eachadditionaldollarofcapitalraised
willbemoreexpensive,butwillprovidegreaterpotentialreturniftheriskisnegotiated
well.Ineffect,managementhastoactinatemporarycapacitynottomaximizethepriceof
thestock.Itisatthisjuncturewhenshort-termperformanceissacrificedforlong-term
gainsthatcareersaremadeorbroken.
147

Forinvestors,themostimportantbreakpointcomeswhenretainedearningsare
exhaustedanddebtisalsohigh.Itisatthispointwhennewstockisissued,andthe
investormustdealwithatleastfivediminishingcharacteristics:
• 1)NewissuescandiluteEPS.
• 2)Newissuescandilutemarketprice.
• 3)Newissuescanraisethecostofequitythroughflotationcosts.
• 4)Newissuescandilutecontrolfromexistingshareholders.
• 5)Newissuescanentailanongoingobligationofdividendpayments.
Realizingthatexcesscapitalisbeingraised(orthatretainedearningsareinadequateto
meetthetarget),theinvestorneedstohavefaithinfutureprojectsenoughtowarrant
remainingashareholder.

DECISIONMAKINGANDTHEMARGINALCOSTOFCAPITAL
Considerafirmwiththefollowinglimitations:
Table6-3

FUNDAMENTAL AMOUNT
OptimalTarget 40/60Debt/Equity
NextDividend $1.10
GrowthRate 10%
SharesOutstanding 68.18(Million)
NetIncome 300(Million)
Retention 75%

Thisexamplebringsseveralissuestotheforefront:itshowstherelationship
betweenthevariablesaswellastheadvantageofknowingthetargetcapitalstructure.The
firstquestiontoaskis“Howmuchfundingcanbedoneonthebasisofretainedearnings
alone?”Hadtheretentionratenotbeengiven,itcouldbederivedbymultiplyingthe
sharesoutstandingbythedividend,andthensubtractingthatfigurefromnetincome:(300
148

-(68.18x1.10)=225.Thisamountofretainedearningsisinadditiontotheamount
alreadyretainedinstockholders’equity.Todeterminethetotalamountofadditional
fundingthatcanbedone,wedividethe225bythetargetproportionofequity,0.6.Thus,
thetotalamountofadditionalfundingis225/.06=375.Outofthisamount,(375-225)
or150millionwouldbeinnewdebt.
Ratherthanmeetstringentrequirementsoncapitalfunding,mostfirmscancreate
strategicmovementtowardtheoptimaltargetonaperpetualbasis.Movingpastthetarget
inanygivenyearwillrequireacountermovementintheoppositedirection.Sucha
strategyallowsflexibilityincapitalfundingbecauseopportunitieswillarisethatmay
requireinflowsgreaterthantheamountoffinancingthatiscondonedbytheoptimal
target.Toobservethepotentialdilemmaofbeingconstrainedbythemarginalcostof
capital,considerascenariowhere390andnot375millionwasrequired.Theoptionsare
asfollows:
• 1.Cutcosts,rationcapitalandunderfundsomeprojects.Thisscenariowillleadto
eventualearningsdisastersandshouldbeavoided.
• 2.Fundtheshortfallwithdebt.Thisstrategywillmovethefirmoffitstarget,andmay
reducethesharepriceofthestock,whileraisingWACC.
• 3.Cutdividendgrowthto7or8%.Thisstrategywillalsoleadtoadiminishedstock
price.Bycuttingdividends,notonlyareexpectationslowered,butmoreearningsare
retained,andthefirmstillmovesoffitstargetstructure.
• 4.Issuestock.Only60%x15millionhastoberaisedinnewlyissuedstock.This
relativelysmallamountof9millionwillkeepthecompanynearitstargetlevel.
However,thecostofcapitalgoesupbecauseflotationcostshavebeenincurred,which
willimplyanewlevelofoptimaltarget.Intermsofbankruptcycosts,theamountof
lossrises,andnewtaxadvantageswillbeneededtobalanceit.Atthisjuncture,the
student/investorshouldnoticethathadnetincomebeengreater,theextracapitalcould
havebeenraisedthroughretainedearnings.Infact,moredebtwouldhavebeenraised
149

aswellbecausetheincreaseinnetincomewouldhaveloweredtheprobabilityof
default.
Whyissuestockinsteadofraisingdebt?Obviously,bothstrategieswillmovethecompany
awayfromitstarget,butraisingasmallamountofstockislessdisruptive.Themarketwill
rewardacompanyforissuinglargeamountsofdebtbecausegeneratingprofitswill
consistentlymovethecompanybacktowarditstarget.Suchalargeissuehasstrategic
value-acquisitions,largeprojects,evenleveragedbuyouts.However,alargestockissue
canunderminethemarketpricethroughdilution.Mergersareuncertain,andlesspeople
wanttoownastockunlesstheyaresureofapayoff.Thus,smallissuesofbalancingequity
canbothpreservestockpriceandfundcapitalshortfalls.Similarly,smallissuesofdebt
arelookedonas“movesofdesperation”,tokeepthecompanysolvent;thetaxadvantages
willbelessthantheincreaseinbankruptcycosts.
Inaperfectworld,firmswouldbeattheiroptimaltargetsandcontinuallyfundat
thatlevel.However,thoseconstraintsarehardlyrealistic,andafirmmayneeda
compensatoryamountofcapitalfromonesourcetomovebacktowardthetargetlevel.For
example,iftheoptimaltargetcallsfora50-50mixofdebttoequityandthefirmisat60
percentdebt,itwillneedmuchmoreequitythandebttomakeuptheshortfall.This
balancingactismuchmoredifficultthanitappears:notonlywillthefirmneedtolookat
alternativesources,conditionsintheindustrymaychangethatwillabruptlychangethe
optimalmixaswell.Fortunately,thereisananalysissystemthatcanbothdetectchanges
inthecostofcapitalaswellasmovementtowardtheoptimum-thetheoryofeconomic
profit.
ECONOMICPROFIT,EVA
®
ANDTHECAPITALDYNAMIC:UTILIZINGTHE
OPPORTUNITYCOST
Whileaccountingprofitsaremadebysubtractingcostsfromrevenues,economic
profitsareconfigureddifferently.Anopportunitycost,theamountgivenupbypursuing
onecourseofactionoveranother,issubtractedfromtheearningsderivedfromthe
150

originalcourseofaction.Thus,itisacomparisoncost.IfIamastockbrokerandIgiveup
acareerinmedicine,Ineedtosubtractthecostandincomeofbeingadoctorfrommyown.
Inthecaseofeconomicprofit,ifonefirmoutperformsthoseofsimilarrisk,itseconomic
profitisgrowingbecausetheopportunitycost(whatisgivenup)issosmall.Therefore,
economicprofittheoryoccupiesahypothetical“middleground”betweencost/benefits
analysisandrisk/returnanalysisanduseselementsofeach.
Thefirm,SternStewart,pioneeredtheconceptofeconomicprofitinapractical
“handson”accountingenvironment,callingit“EVA
®
”oreconomicvalueadded
4
.Its
uniqueapproachenabledmanymajorcorporationslikeGE,AT&TandCoca-Cola,to
notonlybuildcapitalbuttocompensateemployeesbasedonimprovementinthe
measurement.However,EVAcalculationscanbeverycomplex,requiringknowledgeof
taxlawandaccountingskills,andthemeasurementnevercompetedwiththemore
simplistic“P/E”asafavoriteofmutualfundsandindividualinvestors.
ELEMENTSINANEVACALCULATION
Usersneedtoderiveafigurecalled“NOPAT”,whichisanacronymfor“net
operatingprofitaftertaxes.Initssimplestform,wetakeEBIT(earningsbeforeinterest
andtaxes)anddeductjusttaxesfromit,leavinginterestuntouched.Inmostcompanies,
severalotherdeductionswillbemadeatthistimeaswell,andderivingacoherentNOPAT
willrequireknowledgeofitemizeddeductions,andcorporatetaxlaw;EVAbecomesa
seriousmanagementtoolwhenusedproperly.
ThesecondvariableinEVAcalculationsistheWACC(corporateversion).Without
interestdeductionsinNOPAT,thetaxadvantagesofdebtbecomeimplicitintheWACC,
andweendupcomparingthosefiguresaftermultiplyingWACCbytheamountofcapital.
ThecomparativeopportunitycostistheproductofWACCandcapital,becausethatisthe
figurethatwouldbemadeonalternativeinvestments.ThusWACCbecomessimilarto

4
EVAistheregisteredtrademarkofSternStewart,Inc.
151

ROC(returnoncapital)exceptthatitisappliedtocompaniesofsimilarrisk-throughthe
costofequitycomponent.
ThisnextexamplegivesastepbysteprenditionofasimpleEVAcalculation:
Table6-4

FUNDAMENTAL AMOUNT
OperatingIncome(EBIT) 145
TaxRate 31.03%
InterestRateonDebt 8%
CostofEquity 10%
Capital 700
Debt 200
Stockholders'Equity 500

STEP1.Thisstepassumesnoothertaxdeductionsexceptinterest.DeriveNOPAT=
(OperatingIncome)-[(TaxRate)(OperatingIncome)]=145-(0.3103)(145)=100
STEP2.DeriveWACC=[(InterestRatex(1-TaxRate)]x(ComponentPercentageof
Debt)+[(CostofEquity)x(ComponentPercentageofEquity)]=[(.08)(0.6897)(0.2857)]+
[(0.1)(0.71249)]=0.87193or8.72%.
STEP3.CalculateEVA.=NOPAT-[(WACC)x(Capital)]=
100-[(0.872)x(700)]=100-61.0355=38.9645

THECAPITALDYNAMIC
Withoutbeingversedinmanageabledeductions,aninvestorcanformthissame
resultusingjustthreevariables:netincome,thecostofequity,andthevalueof
stockholders’equity.Thisadaptationallowstheinvestortoquicklyextractthesefigures
fromfinancialstatementsandthendetermineonlyonecost-thecostofequity.The
conceptofeconomicprofitremainsrelevant,andtheinvestorcanfocusonobtainingan
accuratecostofequity;thesimplerframeworkallowslessroomforerror.Ineffect,the
equationbecomes:NetIncome-[(CostofEquity)x(Stockholder’sEquity)].Thetax
152

advantagesofdeductedinterestexpensebecomeimplicitinnetincome,andtheinvestor
willnothavetoitemizethedifferentinterestrateswithcorrespondingdebtmaturities.
However,managerialcontrolislessapparentinthissimplerstructure,becausedeductions
arenotitemizedasinNOPAT;thecapitaldynamicbecomesaninvestorfriendlyversionof
economicprofit.
Intheaboveexample,netincomeisderivedas((145)-(16)]x(0.6897)=88.97.
Interestexpenseof16iscalculatedas8%of200.The0.6897isafigurefor(1-TaxRate).
Nextwederiveaproductofthecostofequity,10%,andstockholders’equity,500:
(0.1)(500)=50.Finallywesubtract50from88.97andderive38.97,whichisthesame
figureasforEVA.

THERELATIONSHIPBETWEENEVAANDTHECAPITALDYNAMIC
EVAandthecapitaldynamicwillbethesamefigurewhentheinterestrateon
currentdebtmatchestheactualinterestexpensethatispaidout.Theinvestorforcesthe
bookvalueofdebttoequalitsmarketvaluewhichgivesthecapitaldynamiclessresilience
asapredictorthanEVA.However,neitherdoestheinvestorneedtobeprivytothelatest
negotiationoverinterestrates(theriskpremiumthatisattachedtotherisk-freerate),nor
doesheorsheneedtobemiredinintricatecalculations.Thecapitaldynamicoffersthe
investoralegitimatecomparisonbetweentwomainsourcesofrisk:netincomegrowthand
thesizeandvolatilityofequity.WhileEVAmoreaccuratelyreflectsthecurrentcostof
capitalandtheWACC,thecapitaldynamicbetterreflectsthecurrentinvestmentoutlook
becauseincomegrowthisinherentinthecalculation.Analogously,thetypicalinvestoris
muchlessconcernedwithaccuratecapitalbudgetingwhichwouldbeamajorconcernof
thecorporateEVApractitioner.
ECONOMICPROFITANDCORRELATION
153

DespitetheprodigiouseffortsofSternStewarttoeducateinvestors,EVAanalysisis
notaspopularassomeothersystemssuchasthe“PEG”ratio(price-earningsgrowth).
Nevertheless,itishighlycorrelatedwithstockperformance,andnotjustbecausethe
earningscomponentaccountsforsomuchofthevariation.TheWACCcapturesthe
interfacebetweencorporateriskandthestateoftheeconomy,whilethecapitalcomponent
measuresproportionandimplicitlyencompassesmarkettobookvalue
Sincedefaultprobabilityisnotanexplicitvariableinthefunction,anyeconomic
profitformulawillnotoptimizecapitalstructuremathematically-thatis-ina
deterministicfashion.However,thecorrelationvalueissogreatthatimprovementsinthe
measurementcanbereadasmovementtowardthetargetmix.Inthecapitaldynamic,
thereishighcorrelationbetweenallthreevariables;theeffectivenessofthefunctionis
derivedbyobservingoneormorevariablesdecliningwhiletheotherrises,orbyexamining
thegrowthratesofeachcomponent.Ineffect,eachvariableisaffectedbytheother:net
incomeincreasesequitythroughretainedearnings;higherinterestratesthatareimplicitin
thecostofequitymaydiminishnetincome;higherequitydiminishesbeta,whichdecreases
thecostofequity.
TodisplaythecorrelationbetweenEVAandstockprice,SternStewart
trademarkedanotherconceptcalledMVA
®
or“marketvalueadded.”
5
Essentially,MVA
isthedifferencebetweenmarketvaluesofcapitalandtheirbookvalues.Whenallfuture
EVAsarediscountedintothepresentatthecostofcapital,theresultis“MVA”.While
suchextrapolationmaybedebatable(asitisinanyvaluationmodel),thesimilarities
betweenstockpriceandEVAcanbeobserved.AsresearchedbytheteamofFamaand
French,markettobookvalueishighlycorrelatedwithstockprice,thecostofequity,and
especially,equityrisk.ThusitisnottoofarreachingtomakeaconnectionbetweenEVA
andstockprice.

5
MVA
®
istheregisteredtrademarkofSternStewart,Inc.
154

MANAGEMENTOFECONOMICPROFIT
Implicitinthecapitaldynamicisthespecterofdebt;itisneveroutwardly
acknowledged,andyetithasthegreatesteffectonallthreevariables.Thetaxdeductibility
ofdebtbringspotentialincomebutthepossibilityofdefault,andthesefirmsmustmanage
creditadeptly.Ontheotherhand,foracompanywhofundsonlywithequity,the
prioritiesaresimilarbutthefocusisdifferent;thesefirmsmustperformmanyofthesame
actionsasdebtladenfirms,butemphasizesalesandearningsgrowthandstability-two
characteristicsthatareofteninconflict.Thesefirmsdependonequitymanagementand
changesinoperatingrisktokeepahigheconomicprofit.

155

Table6-5

ALLEQUITY
FIRMS

NETINCOME COSTOF
EQUITY
STOCKHOLDERS'
EQUITY
1Match
marketing
strategieswith
demandtrendsin
thebusinesscycle.

. 1.Betais
regulatedby
operatingrisk
Worktokeepsales
asstableas
possiblethrough
diversificationand
focusonfixed
costs.
1.Focuson
retainedearnings
andpayspecial
dividendsifneeded.
2.Taxstrategies 2.Buybackstock
ontheopenmarket.
3.Diversifyamong
products,
customers,
acquisitions
3.Managetheissue
ofoutstanding
sharesthrough
smallincrements.
4.Worktolower
operatingriskby
focusingonfixed
costs.
4.Fundcapital
shortfallsinthe
short-termcredit
market.
5.Bewaryof
expansionatthetop
ofabusinesscycle

156

Table6-6

DEBT
CARRYING
FIRMS

NETINCOME COSTOF
EQUITY
STOCKHOLDERS'
EQUITY
1.Debtladen
firmsmust
concentrateonthe
sameincome
generating
strategiesasall
equityfirms.
1.Betais
decreasedby
increasingthe
proportionof
equityinthe
capitalmix.
1.Likeallequity
companies,
leveragedfirms
mustpaystrict
attentionto
retainedearnings
andnewissues.
2.Anindebted
firmmustbalance
theamountof
interest,andtax
deductionwiththe
increased
variabilityofnet
income.
2.Likeallequity
companies,these
debtladenfirms
mustworkfora
highmeanandlow
standarddeviation
insalesand
income.Suchan
effortwilllower
betarisk.
2.Withless
dependenceon
equityfunding,
thesecompaniescan
payasteadier
dividend.
3.Bothlong-term
andshort-termdebt
willworktolimit
theamountof
sharesoutstanding,
butthefirmmust
monitorthe
probabilityof
default.
4.Sharebuybacks
canbeimplemented
withdebt

Leveragedfirmshavegreaterfinancialflexibilityandtheabilitytomaneuver
throughlessprofitablephasesinthebusinesscycle.Theycangrantasteadydividendand
“brace”thecompanythroughleverage,whenthefirmbecomesatakeovertarget.
However,thepriceextractedisthegreaterriskofdefault,andtheurgencyofmeeting
157

earningstargets.Whileinvestorsdonotexpectall-equitycompaniestobe“bigearners”
duringsomephasesofthebusinesscycle,leveragedcompanieshavebothacommitmentto
shareholders-and-creditors.Theyareputintothepositionof“groworfail”quite
frequentlybecauseoftheaddednecessityofmeetingbothinterestanddividendpayments.
Thisdoublecommitmentcreatesthephenomenonofgrowingbeyondtheconfinesof
“normal”growthoftheindustry;manyofthesecompaniesmustexpandintounrelated
territorieslikefinance(GMCapital)orevenautorepair(Wal-Mart,K-Mart,Sears).
COMPONENTMOVEMENTSOFTHECAPITALDYNAMIC
Thecomponentmovementsofthecapitaldynamicfollowasequentialchainoflogic
onwhichtheinvestorwillfocusi.e.,therateofchangeforearningsmustbegreaterthan
forstockholders’equityorthecapitaldynamicwillfall.Whileeffortsmaybedirectedat
keepingequitygrowthataminimum,theinvestormustrealizethatequitygrowthis
actuallypermissiblewheninterestratesarehigh,andsothecontextofeachchangeismost
significant.Onlywhenthemeasurementistakenasacohesivewhole,willtheperformance
ofthecomponentpartsbecomprehensible.Asanexample,considerthecorrelation
betweennetincomegrowthandthecostofequity:netincomeshouldactuallydecreasethe
costofequitybysteppinguptheproportionofretainedearnings,andloweringbeta.And
yet,bothnetincomeandthecostofequitywilloftenrisetogether.Someofthatpositive
correlationhastodowithincreasingsalesjustasthemarketisrising,butalotofitis
relatedtotheperformanceofthebusinesscycle;theFederalReservewillraiserateswhen
themarketisacceleratingtocombatinflation.Thegreatereffectistoincreaseboththe
levelandthesizeoftheriskpremium(differencebetweenthemarketandrisk-freerates).
Theresultisalargercostofequity.Thus,eachcomponenthasseveralcountervailing
effectsthatmayoccurwhenthemarketisinequilibrium.Theassumptionofcoherency,
howeverisoftenfalseintheshort-term;anyrandomvariablecanputpressureona
component(especiallythecostofequity)thatmakesitbehaveeccentrically.
158

Thefollowingscenarioshavethecapitaldynamiclaidoutascomponentdriven
changes.Thearrowsindicatewhetherthecomponentisrisingorfalling.Inreductionist
terms,thestockmarketissimplyanaggregationofthesethreecomponentchanges.
• 1)Earningsareadequate,andthecompanybeginstopayoffitsdebt.Thescenariofor
thecapitaldynamicwouldbe:(NetIncome↑ ↑↑ ↑)-[(CostofEquity↓ ↓↓ ↓)(Stockholders’
Equity↑ ↑↑ ↑)].Netincomeincreasesretainedearningswhichdecreasestheproportionof
debttoequityandreducesbetainthecostofequity.
• 2)Thefirmfundscapitalrequirementswithmoreleverage.Thescenariowouldbe:
(NetIncome↓ ↓↓ ↓)-[(CostofEquity↑ ↑↑ ↑)(Stockholders’Equity↓ ↓↓ ↓).Inthiscase,net
incomemaybedecreasedbyhigherinterestpayments,whilestockholders’equitymay
havelessretainedearningsandbenefitfromlessofaneedtoissueshares.Thecostof
equitywouldrisebecausethegreaterproportionofdebttoequityincreasesbeta.
• 3)Marketforcesaretakingoverandinflationisbeingcurbedbyinterestratehikes.
Thescenariomightbe:(NetIncome↑ ↑↑ ↑)-[(CostofEquity↑ ↑↑ ↑)(Stockholders’Equity↑ ↑↑ ↑)].
Thefirmmaybeatthetopofthemarket,andperformancewilldependontherateof
accelerationofthethreefactors.
• 4)Amarketdownturnarisesasinvestorsfleetohighqualitybonds.Suchascenario
putsnegativeforceonallthreecomponents:(NetIncome↓ ↓↓ ↓)-[(CostofEquity↓ ↓↓ ↓)
(Stockholders’Equity↓ ↓↓ ↓)]Thereislittledemandforanycompany’sequitywhilesales
andearningsarefalling.Thecostofequityfallsbecausethelevelandsizeoftherisk
premiumdeclines;themarketisdescendingandtheFedhasloweredrates.
• 5)Theinitialphaseofarecovery:(NetIncome↑ ↑↑ ↑)-[(CostofEquity↓ ↓↓ ↓)(Stockholders’
Equity↓ ↓↓ ↓)]Thismaybethebesttimetoinvestbecauseprofitsarerecoveringbut
pricingpressureonthestockissolow.
• 6)Astockbuybackpurchasedwithleverage.Thatfortunatescenariolookslike
this::(NetIncome↑ ↑↑ ↑)-[(CostofEquity↑ ↑↑ ↑)(Stockholders’Equity↓ ↓↓ ↓)].Thecostofequity
risesbecauseleverageforcesbetatoascend.Netincomerisesbecausetheamountof
159

debtisnotsubstantialenoughtoraisethefinancialleverageratio(EBIT/(EBIT-
Interest).Stockholders’equityistargetedfordecline.
Themovementinstockpriceisalmostalwaysconcurrentwiththechangeinthecapital
dynamic,althoughsometimesmarketinefficienciesariseanditfollowsit.Changesinthe
componentsareamatterofdegreeandtheaccelerationofeachisassignificantasits
absolutelevelanditsdirection.
THECOMPARATIVECAPITALDYNAMIC
Althoughsomeperformancecanbegaugedbyincreasesintheactualsizeofthe
capitaldynamicorEVA,itisanabsolutemeasurementthatisafunctionofcorporatesize.
Toplacecompaniesonamorecomparativebasis,itwillbenecessarytocreatearatio
betweennetincomeandthetotalcostofequitythatequalizesqualitativegains.The
comparativecapitaldynamicismerelyNetIncome/[(%CostofEquity)(Stockholders’
Equity)]andisaveryapplicablemeasurementforcompaniesinthesameindustry.Itcan
beusedwithmorecautionforcompaniesindifferentsectorsaslongastheanalyst
recognizesthatstockperformanceisrelatedtoeclipsingthegainswithinanindustry.For
example,ifacomparativecapitaldynamicof2.5ishighforaspecificindustry,that
valuationwillcarrymoreweightthanif2.5weretypical.Someindustrieswillnaturallydo
lessequityfinancing,andtheyneedtobecomparedwithsimilarcompanies.
160

APPENDIX:THEEFFICIENCYOFEVAVERSUSROE
ManyCFOswillconcentrateonthereturnonequity(ROE)measurementasa
gaugeofcorporateperformance.Thebasicmeasurementistheproductofprofitmargin
(Sales/NetIncome),assetturnover(Assets/Sales),andtheequitymultiplier(Assets/
Stockholders’Equity).Ineffect,theseindicatorsdonotmeasureprogresstowardan
optimalcapitalstructureasefficientlyasEVA.WithbothROEanditsdistantcousin
ROC(returnoncapital),debtcanbedirectlysubstitutedforprofitabilityandtheratios
willstillrise.Observethefollowingtable:
Table6-7

ProfitMargin AssetTurn. Equity
Multiplier
ROE
Year1 0.07 1.2 1.8 0.1512or
15.12%
Year2 0.06 1.1 2.4 0.1584or
15.84%

Year2hasahigherROEwithmoredebtbutalowerprofitmarginandassetturnover.
Technically,thefirmcangothroughadownturnbut“redeem”itselfwithmoreleverage.
Bysubstitutingdebtforequityinthecorrectproportion,ROEwasabletorisedespitethe
lowerprofitabilityratios.Ontheotherhand,hadthefirmusedEVAasitsmeasurementof
progress,asmallerincreaseinnetincomemayhavereflectedthelowerprofitabilityratios
andbalancedthedecreaseinequity.Moreleveragewouldhaveincreasedthepercentage
costofequityaswell.
(BacktoTableofContents)
161

APPENDIX:THEREALCOSTOFCAPITALANDWHATTHEINVESTOR
NEEDSTOKNOW

Thecostofcapitalisdefinedasthereturnabusinesscouldmakeifitchosean
alternativeinvestmentwithsimilarrisk.Allofthecomponentcostsofcapital–debt,
commonequityandpreferredstock-areconsideredopportunitycostsandaredetermined
intherealmofmarketvalueswhenconfiguringtheweightedaveragecostofcapital
(WACC).However,theinvestorisleftinthedarkwhendeterminingsomeofthesevalues.
Whilethecostofcapitalmaybethemostimportantfundamentalindetermininga
company’sdirection,theprocessofcalculatingoneofitscomponentcosts,thecostofdebt,
isprivilegedinformation.Justasattorneysandclientshaveaprivaterelationship,sotoo
docreditorsanddebtors.Yournext-doorneighborneednotknowyourmortgagerate,
andneitherdocompetitorsinanybusinessneedtoknowothercompetitors’borrowing
ratesuntilthoseratesbecomepublicknowledge.
Therealcostofdebtisthenextinterestratethatacorporationcanincurafter
analyzingitsriskcriteria(leverageratios)andinterfacingthisanalysiswiththemarket(a
potentialcreditor):adefaultpremiumisderivedandisaddedtotherisk-freerate(an
appropriateTreasuryyield).Whenmultipliedbythetaxratereciprocal(1–TaxRate)
andthenappliedtothemarketvalueofafirm’sdebt,acostofdebtisformed.Ifthe
corporationdecidestoincurdebtatthisrate,interestexpensewillbetalliedand
transcribedtothenextfinancialstatement.However,nomatterhowhighorlowpast
interestrateshavebeen,thecostofdebtisconfiguredatthenewrate.Ifinterestrateshave
been10%andforsomecataclysmicreasonsgodownto5%inonemonth,thenewcostof
debtisconfiguredat5%.Whathappenstopastinterestratesandtheircollectiveeffecton
corporatedebt?Theeffectofongoinginterestpaymentsisreflectedinthemarketvalueof
162

thedebt.Justaswithanybond,themarketpriceofdebttendstorisewheninterestrates
arefallingandvice-versa.
Wheredoesthisleavetheinvestor?Ifthe“nominal”costofdebtisderivedby
averagingeachdebtmaturitywitheachcorrespondinginterestrate,theamountofinterest
paymentswillbetheonethatmakesbookandmarketvaluesequal.Amuchlessaccurate
costofdebtwouldbeformedbyapplyinginterestexpensetothebookvalueofafirm’s
long-termdebt.Theseaccountingversionsofthecostofdebt,despitetheirdefianceofthe
definitionoftrue“opportunitycosts”,maybetterservetheinvestoringaugingrisk.Inthe
followingexample,acompanydecidesnottoincurnewdebtatalowerinterestrate
becauseitconsidersitselfoverleveraged.The“new”percentagecostofdebtismuchlower
thantheinterestrateitactuallypaysbecausetherisk-freeratehasdecreased.
Whiletheaverageinvestorcancopyamodelthatsimulatesthemarketvalueof
debt,heorshehasnoaccesstothenegotiationsthatdeterminetherealinterestrate,nor
wouldsuch“transparency”becosteffective.Asshowninthechapteronleverage,Chapter
Two,thefinancialleverageratiohaspredictivevaluebasedonpastinterestexpensewhich
isanexplicitcomponentofboththecapitaldynamic(EVA)andtherisk-adjustedWACC.
DETERMININGAMARKETBASEDWACC:ANEXAMPLE
TheXYZCompanyisnegotiatingwithitsunderwritertoconfigureanewinterest
rateforaprospectivebondissue.AlthoughalowerFederalFundsratecollectively
decreasedinterestratesbyapproximately2%,XYZisbeyonditsoptimaltarget
proportionandanticipatesadownturn.Thus,theywilleschewlower-ratedebtandare
unabletorefinancebecauseitsbondshaveano“call”provision.Themaincriteriathatthe
underwritersuseisXYZ’sinterestcoverageratiowhichdeterminestheirdefaultspread.
163

XYZhasearningsbeforetaxes(EBT)of500(million)andinterestpaymentsof250,giving
themacoverageratioof2.Onthefollowingchart,thatcoverageratioyieldsadefault
spreadof2%overtheTreasuryyield.
InterestCoverage>than InterestCoverage<than DefaultSpreadPercentage
0.8 1.249999 5%
1.25 1.499999 4.25%
1.5 1.749999 3.25%
1.75 1.999999 2.5%
2 2.499999 2%
2.5 2.999999 1.5%
3 4.249999 1.25%

Toconfigureamarket-derivedWACC,weneedtoapplythemostup-to-dateinterestrate
tothemarketvalueofafirm’sdebt.WewillconsiderXYZ’spositionovertwoyears.The
firstyear(Year1),themarketvalueofthedebtisthesameasthebookvalue.Inthe
secondyear(Year2),weapplyamodeltodeterminethemarketvalueofXYZ’sdebt.
Besidesthismarketderiveddifferenceincapitalproportions,theonlyotherdifferences
betweentheyearsaretherisk-freerateandconsequentnewcostofequity,andthenew
interestrate.
Themodelforestimatingmarketvalueisasfollows:
MarketValueofDebt=InterestExpense[(1–(1/(1+NewRate)
AverageDebtMaturity
))/New
Rate]
+BookValueofDebt/(1+NewRate)
AverageDebtMaturity
.
164

Thefollowingchartsdelineatethechangesinthecostofcapitalovertwosubsequentyears.
ThechangeinthecostofequityisaconsequenceofthelowerTreasuryrate,whilethe
marketvalueofchangesincapitalisderivedfromtheeffectofthenewinterestrateonthe
priceofthefirm’sdebt.

XYZYEAR1 VALUE
Risk-FreeRate 6%
CAPMCostofEquity 10%
InterestRate 8%
MarketValueofEquity(SharesxPrice)
andPercentageinCapitalStructure
7200=0.6973=69.73%
=7200/(7200+3125)=69.73%
MarketValueofDebtandPercentagein
CapitalStructure
3125=0.3027=30.27%
=3125/(7200+3125)=30.27%
BookValueofEquityandPercentagein
CapitalStructure
4000=0.5615=56.15%
=4000/(4000+3125)=56.15%
BookValueofDebtandPercentagein
CapitalStructure
3125=0.4385=43.85%
=3125/(4000+3125)=43.85%
TaxRate 0.3=30%
CostofDebt(Book) (1-0.3)(0.08)=0.056=5.6%
CostofDebt(Market) (1-0.3)(0.08)=0.056=5.6%
AverageMaturityofDebt 10Years
WACC(Book) (0.4385)(0.056)+(0.5615)(0.1)=8.07%
WACC(Market) (0.3027)(0.056)+(0.6973)(0.1)=8.668%
165

Becauseinterestpaymentsareequaltotheproductoftheinterestrateandthebookvalue
ofdebt,themarketvalueofdebtisequaltoitsbookvalue:
250[(1–(1/(1+0.08)
10
)/0.08]+[3125/(1+0.08)
10
]=3125
Forthenextyear(Year2),wemusttakethenewinterestrateandapplyittowardthe
marketvalueofdebt.SincethenewTreasury(risk-free)yieldis4%,thenewinterestrate
(asdeterminedbythedefaultspreadof2%)is6%.Themarketvalueofdebtis:
250[(1–(1/(1+0.06)
10
)/0.06]+[3125/(1+0.06)
10
]=3585.Theincreaseinmarketvalue
occursbecauseXYZ’spriceisbidupbyinvestorswhowantthehighercouponrateonits
debtratherthanthenewlowerrate.Noticealsothatinterestexpenseremainsat250
Millionbecausenonewdebthasbeenincurred–justachangeinmarketinterestrates.
XYZYEAR2 VALUE
Risk-FreeRate 4%
CAPMCostofEquity 8%
InterestRate 6%
MarketValueofEquity(SharesxPrice)
andPercentageinCapitalStructure
7200=0.6676=66.76%
=7200/(7200+3585)=66.76%
MarketValueofDebtandPercentagein
CapitalStructure
3585=0.3324=33.24%
=3585/(7200+3585)=33.24%
BookValueofEquityandPercentagein
CapitalStructure
4000=0.5615=56.15%
=4000/(4000+3125)=56.15%
BookValueofDebtandPercentagein 3125=0.4385=43.85%
166

CapitalStructure =3125/(4000+3125)=43.85%
TaxRate 0.3=30%
CostofDebt(Book) (1-0.3)(0.08)=0.056=5.6%
CostofDebt(Market) (1-0.3)(0.06)=0.042=4.2%
AverageMaturityofDebt 10Years
WACC(Book) (0.4385)(0.056)+(0.5615)(0.08)=6.94%
WACC(Market) (0.3324)(0.042)+(0.6676)(0.08)=6.74%

Theaccountingversionofthecostofdebtdidnotrecognizethenewinterestrate
andmaintaineditsrelationshipbetweeninterestandprinciple(0.08)(3125)=250.Onthe
otherhand,themarketvalueversionofthecostofdebtcreatedamoreexaggeratedchange
intheWACC.Academictraditionacknowledgesthemarketcostofdebtastheonlytrue
opportunitycostandcreatesconsistencywiththecostofequity.However,the
computationalrigorsofthemeasurementbringitawayfromthepurviewoftheindividual
investorandintothecorporateboardroom.Indeed,thereadercanassessthecomplicated
effectofchangingmarketvaluesofequityonthecostofcapitalandcanviewthetemporal
characteroftheWACC.Sincetheinvestorneedstomakerapidcomparisonsbetween
companies,itisrecommendedthatheorsheusetheriskadjustedversionoftheWACC;
therelationshipbetweeninterestandprinciplewhencombinedwithearningsinformation,
isjustasforwardlookingandperhapsmorestablethanthemorevolatilemarketversion
oftheWACC.
DISTORTIONANDACTIONABILITY
167

Forthefinancialprofessional,amarket-basedcostofcapitalcanonlybeminimized
byadheringtotherisk-orientedcriteriathatlowerstheinterestrateprofferedbycreditors,
andbymatchingthelifeofcorporateassetswiththematurityofliabilities.Themarket
valueofequitymayfluctuatespasmodicallywhichdirectsstrategicattentiontotheonly
controllablevariablesinthecostofequity–operatingriskandtheproportionofdebtto
equitywhichbothaffectbeta.
Fortheinvestor,amarket-basedcostofcapitalissimplynotactionableandheor
shemustbecontentwithsubstitutingthejuxtapositionofinterestexpensewiththebook
valueoflong-termdebt.However,interestexpenseandlong-termdebtarebothmajorrisk
factorswhenmakinginvestmentdecisions.Infact,applyingtherealcostofdebttobook
valueswillcreateadistortionbecausethecostofdebtwillnothavepriorinterestpayment
obligationsasanexplicitvariable.Forexample,intheabovescenario,usingbookvalues,
XYZ’scostofdebtwouldhavedecreasedto4.2%from5.6%,understatingtheongoing
couponrateof8%.Whilenotwhollyintegratingopportunitycosts,thecapitaldynamic
betterquantifiesriskfortheinvestorthandoesanEVAthatusesthemarket-basedcostof
debt.Assumingthatpriorinterestexpensequantifiestheinterestratebeingpaidisnot
theoreticallycorrectintermsofaweightedaveragecostofcapital.Suchanassumption,
however,allowstheinvestortogaugeriskfromfinancialstatementswithouttheneedtobe
privytocreditornegotiationsandmayevenbemoreprofitablethandiscerningamarket-
basedWACCthatfluctuateswithvolatilestockprices.
(BacktoTableofContents)

168

7
FUNDAMENTALSANDCAPITALSTRUCTURE
“Fundamental”isawordwithdiversemeanings.Inareligiouscontext,itusually
connotesaliteralinterpretationofasacredtext.Infinance,itreferstoconcrete
performancemeasurements-sales,netincome,andassets.Inthecontextofcapital
structure,weareawareoftheliteral,concreteaspectofbalancesheetitems,andthenwe
turnthemupsidedown:onlyinthedomainofchangedothesefigureshaveanygreat
significancefortheinvestor.
Foroverfortyyears,therehasbeensomeequivocationinacademiaaboutthe
properteachingoffundamentals.Sinceearningsforecastsarebasedonfundamentals,one
wouldcertainlyseetheimportanceofteachingfundamentalsinanybusinesscurriculum.
Indeedmostbusinessstudentsneedtotakeatleastacoupleofaccountingcoursesinorder
tograduate.However,amongacademics,thereisarighteousadherencetowhatistermed
the“semi-strong”formoftheefficientmarketshypothesis.Inbrief,thatdoctrine
proclaimsthatnopubliclydisclosedinformationcancorrectlyforecastthefuturepathofa
stock;themarketisso“efficient”atpricingasecuritythatthepricereactstoinformation
beforeitisannounced.Thisdivergencebetweenthegreatamountoffinancialdata
available,andtheinherentinabilitytoutilizeit,hasfrustratedmanyastudentand
professionalalike.
Tothecapitalstructuralist,theamountandriskofcapitalinflowsdeterminesthe
fundamentalsthemselves,andthereforebecomesthebuildingblockofearningsforecasts.
Whilemostexecutivesandanalystsareoptimisticaboutsalesandearningsincreases,few
willconsidertheirsource.Thenebulousworldofcapitalproportionsandallocationentails
riskandinterpretation,andnotjustthestraightforwardpronouncementofariseinsales.
However,capitalstructureanalysiscanbeclassifiedasamoresophisticatedformof
fundamentalanalysis-albeitonethatanticipatesfundamentalsratherthanreactingto
169

them.Whileatypicalfundamentalanalystmightlookatindustrymarginstoanticipate
revenues,thestructuralistlooksformoreindirectnumbersthatwouldsignalan
environmentconducivetoearningsincreases-asmallerinterestexpense,lowerfederal
fundsratesoranincreaseinlong-termdebt,forexample.Similarly,afundamentalanalyst
wouldbeconcernedwithastock’sintrinsicvalue,thepresentvalueofdiscountedfuture
earningsascomparedtotheactualmarketvalue.Alternatively,acapitalstructuralistwill
beasmuchconcernedwhetherthenumberofsharesoutstandingistheproperamount;the
structuralistseesearningsinthedomainofimmediatechangesinrisk.Toquantifythis
risk,heorshestepsoutoftherealmofrelationalfundamentalsandusesstatistical
techniquestocomparethemean,skew,andstandarddeviationsofadistribution.Only
whenriskandreturnareoptimizedthroughactionablechangesintheproportionofdebt
toequity,willheorshebesatisfied.
Iffundamentalsbythemselveslackpredictivevalue,theymaybethemost
significanttoolintheeducationofafinancialexecutive.Whiletheefficientmarketmay
anticipatefundamentalsanddiscounttheirvalue,itistheexecutiveswhowillimplement
thechangesthataffectthoseratiosforbetterorworse;thesearethechangesthatportenda
riseorfallinstockprice-anewmarketingstrategy,alowercostofdebt,orabroader
customerbase.Thus,inthemostultra-efficientmarket,thestockwillriseconcurrently
withsalesandearnings,andnotafterthefact.Althoughmomentuminthesefigurescan
spurevenmorecapitalinfusioninlaterperiods,thattypeofariseisa“hitormiss”
proposition,basedasmuchoncontinuedsectordominationasonimmediateearnings
history.Whilegreaterearningscanhelpmakethecostofcapitallessexpensive,future
prospectsaregearedtofundingprojectswithahighnetpresentvalue(seethechapter
entitled,“CapitalStructure”)andnotonthegenerationofpastearnings.Inessence,an
idealcombinationoflowcostcapitalsources,someofwhichmayberetainedearnings,
mustbecoordinatedwiththecapitalbudgetingprocess.
170

Notwithstandingtheirvalueasapredictivetool,fundamentalsarelikea“yard
stick”:theyenableexecutivestocompareandcontrastthevariablesthatneedchanging.It
isinthisrevelatoryrolethatastructuralistusesfundamentals-togaugecapitalinflows
anddeterminewhethertheyarebeingchanneledefficiently.
DUPONTANALYSIS

TheDuPontCompanydevelopedanextensive,albeitdeterministicsystemthat
linkedleveragewithsales,profitsandeventheeffectivecorporatetaxrate.Asameasured
result,theDuPontsystemsetthefoundationforfurtheranalysis;itcreatedthe
underpinningsforexaminingtheprobabilitiesandchangesbehindeachinput.For
example,themeasurementEBIT/Assetsmustexceedtheinterestrateifleverageistobe
justified.However,noaccountingsystemcanprojectanoperatingincome,apriori,that
willleadtothisresult.Ultimately,thedifferencebetweenfinanceandaccountingis
establishedbythebalancebetweenchoosingtheactionwiththebestprobabilisticoutcome
andthenmeasuringitsresult.
Thedecompositionofafirm’sreturnonequity(ROE)isamultipurposeexercise
withfourdistinctrewardsforthecapitalstructuralist.
• 1.Whencomparingcompanies,ROEisanaccurate,generalindicatorofcurrent
.performance.
• 2.ThecomponentsofROEwillindicatewhatrisksneedtobeaddressed,andwhich
elementshavepotentialforimprovement.
• 3.ThecomponentpartsofROEpointtowardacompany’scapitalstructure,and
delineateafirmsoperatingandfinancialleverages,howtheyarebalanced,andwhether
theyneedtobechanged.
171

• 4.EachcomponentofROEisaffecteddifferentlybyeachphaseofthebusinesscycle
andanyimbalanceinthecomponentswillaffectperformance.
SomeinstructorswillrefertoROEas:earningsbeforeinterestandtaxes(EBIT)/
Stockholders’Equity,whichthisauthorbelievesnegatestheroleofdebtinreducing
stockholders’equity.Sincecapitalstructureanalysisisfoundeduponthiscrucial
difference,wesubmittotheDuPontAnalysissystemandendupwithROE=NetIncome/
Stockholders’Equity.
Eachfundamentalisextractedfromafinancialstatementandthendividedby
anotherfundamentaltoformacomponentpartofROE.Theresultingfivecomponent
partsarethenmultipliedtogether.
Table7-1

COMPONENT PARTSOFROE
FUNDAMENTAL LOCATION RATIO DESCRIPTION
1)Earnings
BeforeInterestand
Taxes(EBIT)
IncomeStatement 1)EBIT/Sales OperatingMargin
2)Sales IncomeStatement 2)Sales/Assets AssetTurnover
3)Assets BalanceSheet
4)Stockholders'
Equity
BalanceSheet 3)Assets/Equity EquityMultiplier
5)Earningsbefore
Taxes
IncomeStatement 4)EBT/EBIT CostofDebt
(Financial
Leverage)
6)NetIncome IncomeStatement 5)NetIncome/
EBT
TaxRetention

Theshortenedformofthisequationis:(NetIncome/Sales)x(Sales/Assets)x(Assets/
Equity)=ReturnonEquity,butthefullarrayofcomponentsbetterdescribesthedynamics
oftheequation.
Aprimeobservationthatwillbereadilyapparentwhenoneworkswiththeseratios
istheirtendencytobeconsistentwithincertainboundaries-especiallyassetturnover,
172

profitmarginandassetstoequity-thethreecomponentsoftheshortenedformofROE.
Thecharacteristicsofeachindustrydictatelimitationsonthecomponents,andthe
companieswithintheindustrywillsharesimilarlevels.Forexample,Wal-Martmight
struggletoobtaina4%profitmarginandnevermatchMicrosoft’s20%,butneitherwill
MicrosoftmatchWal-Marts’largeassetturnoverorassettoequityratio.Thetwo
companiescanobtainthesameROE,however,byeitheremphasizingwhattheydobest,or
workingontheirrespectiveweaknesses.But-neverwillacompanywithatypicalasset
turnoverof0.8becomeacompanywitharatioof“2”,ifitisinfact,thesamecompany.
Thus,thesizeofthecomponentsofDuPontanalysisconveystherisksofworkingina
particularindustryandcanbeincreasedordecreasedwithinthelimitationsproscribedby
theindustry.Again,aswithleverage,theamountoffixedassetsandtechnologywithinthe
industrywilldeterminetheboundariesofcapitalinflows.Fixedcostsinadepartment
storechain,forexample,aretotallydifferentfromthoserequiredinasemi-conductor
company,andeachwillhaverespectivelydifferentassetturnovers,profitmarginsand
equitymultipliers.
Todisplaythedifferenceinratiosthatanindustrycanimpose,wewillcontrasttwo
companies:Barra,adeveloperofriskmanagementsoftwarewithhighresearchand
developmentcosts,andWal-Mart,theworldrenownedconsumerretailer.
Table7-2

1999
COMPANY NET
INCOME
SALES ASSETS EQUITY
BARRA 23.4 187 169 101.3
WAL-MART 5575 165013 70349 27872

173

Table7-3

1999ROE
COMPANY ProfitMargin Asset
Turnover
Asset/Equity ROE
BARRA 23.4/187=0.1251 187/169=1.1 169/101.3=1.67 23.09%
WAL-MART 5575/165013=
0.0337
165013/
70349=2.35
70349/27872
=2.524
20.00%

Bymerelyobservingthesethreeratios,ananalystcanlearnmuchaboutafirm.Inretail,
theadvantagecomesfromassetturnoverandthesafeuseofcredit-asset/equity.In
specialtysoftwaredevelopment,theadvantageismorequalitativeandstemsfromthe
higherpricessuchproductsmaygarner.Eachcompanyhasdifferentinherentrisks.
WhileBarrahasnocreditrisk,theyareexposedtocompetitionthatcanunder-pricethem.
Ontheotherhand,Wal-Marthasalargecreditriskbutcushionsitwithalargeasset
turnover;morecash-flowdiminishestheprobabilityofdefault.Thereturnonequityis
similarbutthewayeachcompanyarrivedthereistotallydifferent.
Thestudent/investorwillfinddifferentpatternsamongtheindustriesthatbalance
eachotherinthecontextofROE.Forexample-highprofitcompaniesusuallyhave
pricingpowerbutlowerassetturnoveranddiminisheduseofcredit.Thereason?Higher
profitmarginssometimesentailmorevariationinsalesand/ortheuseofretainedearnings
toraisecapital.Withoutthenecessary”trackrecord”ofsteadyearningsandloanhistory,
creditorsarelesslikelytoloanatfavorablerates.Moreover,pricingpowerimpliesthe
creationofunique“niche”productsthatcannotbeeasilyduplicated.Hence,higherprofit
margincompaniestendtobeincapableof“churningout”productatamomentsnotice
becauseoftechnicalormarketinglimitations,andwillconsequentlyhavealowerasset
turnover.Ontheotherhand,highassettoequitytypecompanieswillalmostalwayshave
higherassetturnoversbecausealargeturnoverdiminishesriskandprovidegreater
securityfortheircredit.Theyareoftenfromolder,moreestablishedindustriesthatchurn
174

outsimplebutverynecessaryproducts-whethertheyaretiresorbakerybread.However,
theirownproductivityinterfereswiththepricethattheycancharge,andthesecompanies
mayhaveadifficulttimeincreasingprofitmargin.Infact,inmanyindustries,increasing
theprofitmarginbyeventwopercentagepointsonaconsistentbasiswouldbeconsidered
anamountthatwoulddominatetheindustry,andwarrantasoaringstockprice.Thus,
thesefirmscanconcentratewholeheartedlyonthissinglelack.Infact,ifthemarketwill
pricestocks“efficiently”,itwilldosobycreatingimplicitbenchmarksintheseareas;once
afirmimprovesonadeficiency,itisrewardedbyahigherstockprice.InWal-Mart’s
case,evenaonepercentagepointgaininprofitmarginwouldhaveearnedthecompany
approximately1.6Billion.Analogously,Barraneededtobothlimititsamountofequity
inproportiontoitsassetsandincreasesales.Sincestockpriceishighlycorrelatedwith
improvementsinROE,bothofthesecompaniescouldhaveshiftedcomponentpartstofind
thefactorsthatproducedanoptimum.However,theneedforbalanceisevenmore
imperativebecausedecreasingonevariablehasatendencytoincreasetheother;without
“synergy”,therecklessimprovementinonevariabletothedetrimentofanothercanlead
to“shocks”inthesystemthatneedtobereconciledinfutureyears.
Toestablishabenchmarkcomponentratio,themosthelpfultoolistoresearchthe
industryaveragesoverafiveyearperiod.Thethreelargestcompetitorswillusuallysupply
enoughdatatoestablishavalidaverage,andsomewebsiteswillhavedonethework
already.Indeferencetotheefficientmarketshypothesis,itisdoubtfulwhetherinvesting
onthebasisofimprovedratioscanbeatthemarketforanylengthoftimebecausegainsin
sharepricehappenconcurrentlywiththeratioimprovement.Theonebigadvantagethat
companyinsidersenjoyisthattheyknowwhichratiosareimprovingandbyhowmuch,
becausetheystrategicallysetouttochangethem.Thus,theobservedconfidencethat
managementhasinitsownstockisoneofthefewwaysthattheaverageinvestorcan
indirectlyprofitfromfundamentals.Buyingopportunitiescarrymoreweightthansales
becausemanyinsiderswillsellstockfortaxpurposes.Forthecapitalstructureanalyst,
175

theprimarymissionistocoordinatea“map”oftheterritory-decidingwhetherthe
investmentenvironmentisconducivetoearningsandobservinghowthesectorismeshing
withthebusinesscycle.Inthisregard,theanalystwantstofindasituationwhereearnings
willacceleratemuchfasterthanthecostofcapital;some“insiders”aresimplyfervent
optimistsandweneedtocorroboratetheirenthusiasm.
COMPARINGROECOMPONENTS
ThefollowingchartsdisplaythethreebasicROEcomponentsfortendifferent
companies.Mostofthesefirmsareindifferentindustrieswhicharereflectedinboththe
sizeandstabilityofthecomponents.AnotherpotentialadvantageofROEanalysisisthata
firmcanuseitsmoststableROEcomponentasaplanningtool.Ifafirmhaslargesalesin
termsofassets,butlowprofitmargins,afirmcanplaninventorylevelsandsalesdistricts
aroundassetturnover.Similarly,iftheassettoequityratioisstable,afirmmaywantto
performnearitstargetcapitalstructureatalltimesandnottaketheriskofbrief
directionalmovementsawayfromit.Moreover,keepingonecomponentverystableallows
theothercomponentstovary(inathreecomponentROE).Amongthoseothertwo
components,onewillrepresentthe“weakestlink”toahealthyROE;thechallengetoany
firmistoimprovethisweaklinkwithoutdamagingtheperformanceofothercomponents.
Forexample,ifafirmdisposesofassets(net),itprobablyisnotgrowing.However,sucha
moveintheshort-runmightartificiallypumpupassetturnover.Theobjectiveistoexceed
theindustrystandardforthatcomponent,i.e.,aonepercentriseisprofitmarginmaybe
verysubstantial.Finally,therewillbeonecomponentthatgivesthefirmthemajorityofits
ROEstrength.Thiscomponentwillrepresentitscompetitiveadvantageandmayormay
notbethesameasthe“stability”component.Forexample,acompanylikeCSX(see
charts)hasahugeadvantageinitsassettoequityratio;apparently,cash-flowisstable
enoughtofunditsheavyneedforcapitalwithdebt.ThatisCSX’scompetitiveadvantage.
Theymaylowerthisratioandstillremaincompetitive,buttheyneedtobalanceany
changewithreinforcementfromothercomponents.TheexhibitofROEcomponents
176

displaysthecomponentnumberoverfiveyearsandfollowsbyrankingeachcompanyfor
whichcomponentisstable,weakand/orcompetitive.
Table7-4

DILLARDS
(DDS)

YEAR/
COMPONENT
1997 1998 1999 2000 2001
ProfitMargin 3.9 1.7 1.9 1.1 0.8
Asset
Turnover
1.19 0.95 1.1 1.19 1.15
Asset/Equity 1.99 2.88 2.8 2.74 2.65
Stable
Component
Asset
Turnover

Weak
Component
Profit
Margin

Competitive
Component
Asset/Equity

177

Table7-5

ST.JUDE
MED(STJ)

YEAR/
COMPONENT
1997 1998 1999 2000 2001
ProfitMargin 5.5 12.7 2.2 11 12.8
Asset
Turnover
0.68 0.73 0.72 0.77 0.83
Asset/Equity 1.48 1.72 1.46 1.63 1.38
Stable
Component
Asset
Turnover

Weak
Component
Asset
Turnover

Competitive
Component
Profit
Margin

Table7-6

USTOBACCO
(UST)

YEAR/
COMPONENT
1997 1998 1999 2000 2001
ProfitMargin 31.3 32 31 28.6 29.4
Asset
Turnover
1.7 1.56 1.49 0.94 0.83
Asset/Equity 1.89 1.95 0.37 6.07 3.47
Stable
Component
Profit
Margin

Weak
Component
Asset
Turnover

Competitive
Component
Profit
Margin

178

Table7-7

ECOLAB
(ECL)

YEAR/
COMPONENT
1997 1998 1999 2000 2001
ProfitMargin 8.2 8.2 8.5 9.2 8
Asset
Turnover
1.16 1.25 1.31 1.32 0.93
Asset/Equity 2.57 2.14 1.7 2.26 2.87
Stable
Component
Profit
Margin

Weak
Component
Asset
Turnover

Competitive
Component
Asset/
Equity

Table7-8

INT.
RECTIFIER
(IRF)

YEAR/
COMPONENT
1997 1998 1999 2000 2001
ProfitMargin 0 3 3.7 9.7 9
Asset
Turnover
0.71 0.75 0.77 0.73 0.56
Asset/Equity 1.62 1.93 1.77 2.59 2.07
Stable
Component
Asset
Turnover

Weak
Component
Asset
Turnover

Competitive
Component
Asset/Equity

179

Table7-9

MOLEX
(MOLX)

YEAR/
COMPONENT
1997 1998 1999 2000 2001
ProfitMargin 10.8 11.2 10.4 10 8.6
Asset
Turnover
0.94 0.99 0.9 0.99 1.07
Asset/Equity 1.32 1.3 1.27 1.32 1.25
Stable
Component
Asset/
Equity

Weak
Component
Asset
Turnover

Competitive
Component
Profit
Margin

Table7-10

NATURE'S
SUN.(NATR)

YEAR/
COMPONENT
1997 1998 1999 2000 2001
ProfitMargin 7.2 7.9 6.2 5.4 5.2
Asset
Turnover
2.93 2.85 2.7 2.67 2.44
Asset/Equity 1.43 1.4 1.38 1.35 1.37
Stable
Component
Asset/Equity
Weak
Component
Asset/Equity
Competitive
Component
Asset
Turnover

180

Table7-11

CSX(CSX)
YEAR/
COMPONENT
1997 1998 1999 2000 2001
ProfitMargin 7.5 5.4 0.5 6.9 3.6
Asset
Turnover
0.53 0.48 0.52 0.4 0.39
Asset/Equity 3.46 4.49 3.6 3.41 2.94
Stable
Component
Asset
Turnover

Weak
Component
Asset
Turnover

Competitive
Component
Asset/
Equity

Table7-12

ARCH.DAN.
MID.(ADM)

YEAR/
COMPONENT
1997 1998 1999 2000 2001
ProfitMargin 2.7 2.5 2 2.3 1.9
Asset
Turnover
1.22 1.17 1.02 0.96 1.4
Asset/Equity 1.88 2.13 2.25 2.36 2.26
Stable
Component
Asset/Equity
Weak
Component
Profit
Margin

Competitive
Component
Asset/Equity

181

Table7-13

ARGOSY
GAMING
(AGY)

YEAR/
COMPONENT
1997 1998 1999 2000 2001
ProfitMargin 0 1.3 6.1 6.7 8.4
Asset
Turnover
0.61 0.9 1.05 1.29 0.598
Asset/Equity 17.13 13.81 9.74 5.16 7.37
Stable
Component
NONE
Weak
Component
Asset
Turnover

Competitive
Component
Asset/Equity

*TheAsset/Equityratioisassetsdividedbycommonstockholders’equityandnotthe
fullstockholders’equitythatmayincludepreferredstock.

MODIFYINGANDENHANCINGDUPONTANALYSIS
Thecapitalstructuralistneedsadetailedviewofafirm’sdebtstructure;heorshe
willfurtherdecomposetheassetstoequityratio(commonlycalledtheequitymultiplier)
andalsousethefullarrayofcomponents(five)inthemodel.Theasset/equityratiois
decomposedasfollows:ASSET/EQUITY=(LTD/Equity)x(Asset/Short-termdebt)x
(Short-termdebt/LTD).“LTD”isanacronymforlong-termdebt,while“short-term
debt”issynonymouswithcurrentliabilities(forthesakeofthisanalysis).
Often,fundingwithmoreshort-termdebtandlesslong-termdebtwillaccomplish
oneofthreeobjectives:1)itmayreduceoverallinterestexpenseasshort-termratesare
lowerthanlong-termratesinanormalmarket;2)itmayindicatemoretradecreditwhich
isoftentreatedasaninterestfreeloan,andadditionally,morebusinessactivity;3)ifused
judiciously,itcanreduceexposuretointerestraterisk.Thislastitemneedsqualification:
182

whilefundinglong-termfixedassetswithshort-termdebtcanleadtoinstability,funding
withshort-termcreditwheninterestratesareanticipatedtodropmayreduceexposureto
long-termcommitments-aslongassuchamoveistemporary.
Althoughanincreaseincurrentliabilitiesmayaffectshort-termsolvencyandthe
probabilityofdefault,itisbothasourceofinternalfinancingandfreecash-flow,andisan
importanttoolinmanagingcapitalstructure.Byfollowingthechangesineachcomponent,
thestudent/investorcanobservethebehaviorofthecompleteassettoequityratioina
profitableyear:(LTD↓ ↓↓ ↓/Equity↑ ↑↑ ↑)x(Asset↑ ↑↑ ↑/Short-termdebt↑ ↑↑ ↑)x(Short-termdebt↑ ↑↑ ↑/
LTD↓ ↓↓ ↓)=Asset/Equity.
Table7-14

COMPONENT DIRECTIONOF
CHANGE
REASON
LTD DOWN Lessinterestexpense,risk
ASSETS UP Growthinsalesand
earnings
EQUITY UP Moreretainedearnings
SHORT-TERMDEBT UP Morebusinessactivity

Ifthereaderhasbeenfollowingthetext,heorshewillrealizethatincertainsituationsthe
oppositechangescanaffecttheROEmeasurementinapositivemanner.Thisissimplyan
exampleandnotmeanttoconveyonesetpositivepattern:whentaxbenefitssoarwhilethe
probabilityofdefaultdoesnot,theresultwillbeanincreaseinstockprice.Ourobjective
istocitethemechanismsthatmakethathappen.Sincemanycompanieswillfurtherraise
long-termdebtinveryprofitableyears,itisthesizeofthelong-termdebttoequityratio
thatissignificant,andnotwhetherlong-termdebtisactuallydecreased.
Ofthefourremainingratiosinthefullmodel,twoareimperativetocapital
structureanalysis:theratio,EBT/EBITdistinguishesthecostofdebt,whileNetIncome/
EBTdeterminestheeffectoftaxesonshareholderearnings.Thestudent/investorshould
183

beawarethatearningsbeforeinterestandtaxes(EBIT)minusinterestexpensewillequal
earningsbeforetaxes(EBT),andthatinterestisataxdeductibleexpense.Thus,Net
Income/EBTincreasesasinterestincreases,butthecostofdebtisareciprocalthat
actuallydecreasesasinterestrises.Toputthesefiguresoncommonground,laterinthe
chapterwewillreversethecostofdebtratioandturnitintoEBIT/EBT;thisfigurewill
increaseasinterestexpenseincreases.Thismore“understandable”formistermedthe
“financialleverageratio”oralternately,thedegreeoffinancialleverage”andisthesame
ratiowehaveusedinpreviouschapters.ItisEBIT/EBIT-InterestExpense.
Thetworemainingratios,operatingmargin(EBIT/Sales)andassetturnover
(Sales/Assets),arenolessimportantthantheaforementionedcomponents,buttheyare
lessdirectlymanageable.Theyaremoresensitivetobusinesscyclefluctuations,thelevelof
technology,ageoftheindustry,andcompetitivepressure.Indeed,itwouldnotbe
“steppingoutofbounds”tosaythatthegoalofROEstrategyistooptimizetherisk/return
characteristicsofthesetworatiosbycontrollingtheotherthree.Forexample,financingan
acquisitionwithleveragemayraisetheassettoequityratio,andsincethetargetcompany
hasalargeassetturnover,operatingriskwouldbediminished.Inthatcase,thedeciding
pointwouldbethefearofpotentiallydecreasingtheprofitmargin,andthatissuewould
havetobeaddressed.Thus,eachdecisionmadeaboutanyoneratiowillaffectallofthe
othersandfinancialmanagementmustpursueaproperbalance,understandingthe
repercussionsofeachaction.
Theentirefivecomponentmodelisconfiguredasfollows:
(EBIT/Sales)x(Sales/Assets)x(EBT/EBIT)x(NetIncome/EBT)x(Assets/
Stockholders’Equity)
Thereadercannoticethatthefirstfourcomponentsreducetoareturnonassets(ROA)
becauseallbutthetwofundamentals,netincomeandassets,canceleachotherout.When
wemultiply(NetIncome/Assets)by(Assets/Equity),wegetthefullROEeffect,(Net
Income/Equity).
184

Tocorporatemanagement,athoroughsensitivityanalysisinvolvingallthe
componentsisimperative.Tothecapitalstructuralist,itisthechangesineachratiothat
aresignificant.WhilefinancialexecutivesoftenattempttoextractthelargestROE
possible,theinvestormustgaugetheriskofinteractivechangetowardanoptimalcapital
structure.Inahandfulofcases,morelong-termdebtisneeded,andthetaxbenefitswill
enhancegreatersalesandearnings.However,inthevastmajorityofcapitaltransitions,
profitswillbeextractedfromlessuseoflong-termdebtincomparisonwithequity.While
debtisbeingpaidofffromenhancedprofits,interestexpenseisbettercoveredbyoperating
incomeandtheprobabilityofdefaultdecreases.Moreearningsareretained,andthe
proportionofequityincreases.Whentheeconomy“heats”upandthecostofretaining
earningsbecomesexpensive,thecyclewillbeginagain;thefirmwillloaduponlowinterest
loans,takeonnewprojects,andsometimesmovepastthepointwheretheproportionof
debtisoptimal.
Inreality,theremaybeaninterimwhenoperatingmarginandassetturnoverdo
notincreaseenoughtoparedowndebt,andacorporationwillmakeseveraladjustmentsto
theotherratiostokeepROEfromdiminishing;thisiswheretalentinfinancial
managementisrealized.Althoughnew,profitableprojectsmustflowinto”thepipeline”to
keepthecompanycompetitive,thecapitalstructureorientedratioscantemporarilymake
upthedifference.Eventually,ifsalesarenotgeneratedfromnewprojects,thecompany
facesassetcutbacksand/ordownsizing.However,enhancinganROEwithanincreased
equitymultiplierevenwhileoperatingmarginsandassetturnoveraredepleted,isarisky
strategywithalargepayoffiftheoutlookisfavorable.
Alessriskystrategyistousethethreeleverageratios(EBT/EBIT,NetIncome/
EBT,andAsset/Equitytokeepthetwoprofitratios(EBIT/Sales,Sales/Assets),ashigh
andstableaspossible.Infact,the“ideal”ROEhasbeenobservedmanytimeswhena
dominantcompanyinadominantsectorcomestofruition.
185

Table7-15

THEIDEALROE
COMPONENT RATIO DIRECTIONOF
CHANGE
Operatingmargin EBIT/Sales UP
AssetTurnover Sales/Assets UP
CostofDebt EBT/EBIT UP(Indicatesdecreased
costs)
TaxRetention NetIncome/EBT UP(Indicatesreduced
taxes)
LTD/Equity LTD/Equity DOWN(Moreretained
earnings)
Asset/Short-termdebt Asset/Short-termdebt NEUTRAL(Increase
both)
Short-termdebt/LTD Short-termdebt/LTD UP(Morebusiness
activity)

Athighlevelsofearnings,thereisapenaltyforretainingearningsandnot
distributingthemasdividends,andalsoapenaltyforissuingtoomuchequityintheform
ofnewlyissuedsharesofstock.OurDuPontmodelisnotsophisticatedenoughtodeal
withtheseconcerns-yet.Sofar,wehavenarrowedourperspectivetosevenratios,three
ofwhich(LTD/Equity,Assets/Short-termdebt,Short-termdebt/LTD),area
decomposedversionoftheequitymultiplier,(Assets/Equity).Thetaxretentionratio,Net
Income/EBT,issubjecttoinfluencesfromsalesandoperatingincomeforwhichthereis
littletacticalcontrol.Byconcentratingonthecostofdebtratio,EBT/EBIT,weimplicitly
affecttaxretention;interestexpenseisacommonfactortobothearningsbeforetaxesand
thecostofdebt.
Whiletheabsolutesizeoftheratiosisimportanttotheinvestor,moreconcernis
placedwiththeinteractivedynamicsbetweenthem-whichcomponentsareincreasingor
decreasingandhowwilltheyaffecttheothercomponents.Asanexample,considera
scenarioinwhichafirmunderperformstheindustryinassetturnover.Woulditbe
expedienttolowerassetstoequitytoamorepermanentlytolerablelevel?Thatquestion
186

wouldbeselfevidentiftheequitymultiplierconsistentlyexceedstheindustrystandard,
butwouldbeadifficultchoiceotherwise.Inessence,WallStreethasneverplayedagame
ofabsoluteswhenitcomestoeitherfundamentalsornear-termstockpriceincreases;an
undercovered,smallcapfirmcanoutpacealarge-capDowcomponent.Thechallengeof
goingfrom0.30pershareto0.70pershareinEPSisoftenrewardedmorethanahigh
performingstockthatgoesfromanEPSofthreetofourdollarspershare.Therewards
aremorederivedfrombeatinghigh-riskoddsanddoingtheunexpected,thanfrom
consistentperformance-intheshort-run.Anditisthattimeframe-the“near-term”or
short-run-inwhichreturnonequitychangesoccur.Obviously,themicromanagementof
theseratioscanleadfinancialexecutivesintoatrap,andwithoutastrategicoverlayof
projectanalysisandlowcostfunding,financialengineeringofadesirableoutcomewould
beimpossible.Therefore,ROEcomponentsrepresentanobjective,butnotameanstoan
end.Theyrepresentperformancegoalsbutdonotclarifythedistinctionbetweenriskand
returnenoughtoactastoolswithwhichtomanageafirm.
WhattheROEcomponentslackastoolsofmanagerialfinesse,theymorethanmake
upassignalsforanalystsandinvestors.Wemust,however,modifythemtoencompass
capitalstructurechanges.Inparticular,thecostofdebt(EBT/EBIT)goesupwhenthe
actualcostofdebt,asmeasuredbyinterestexpense,goesdown.Secondly,increasesin
equitydonotautomaticallytranslateintoacompanymovingtowardamoreoptimal
capitalstructure;retainedearningscanbeexcessiveandnewstockcanbeissuedatan
inopportunetime.Thirdly,theassettoshort-termdebtratioisambiguous,andabetter
ratiocanunifythethreeelementsofAsset/Equityintoanunderstandablewhole.
THERETURNONCAPITALRATIO
Throughasimplemodification,thecapitalstructuralistcreatesa“returnon
capital”orROCratio.Capitalisdefinedasthesumoflong-termdebtandstockholders’
equity.Byreplacingthefundamental,“Equity”,with“capital”,thedynamicswillbe
mathematicallychanged.Intheratio,long-termdebttocapital(LTD/Capital),adding
187

long-termdebtincreasesboththenumeratoranddenominator,creatingalessvolatileand
morestatisticallysignificantmeasurement.Ontheotherhand,theratio,AssetstoCapital,
becomesmorevolatileandsensitivetochangebecausewearemakingitsmallerthanAsset
/Equityandnotchangingbothnumeratoranddenominatorintheexpression.Any
increaseinassetstocapitalimpliesarelativeincreaseinshort-termdebtbydefault.Tosee
howthisfitsintothenewexpression,observethefollowing:
ASSETS/CAPITAL=(LTD/Capital)x(Assets/Short-termdebt)x(Short-termdebt/
LTD).AssetstoCapitalbecomesmoreofariskmanagementtoolbecauseitcanbeapplied
toseveralleveragesituationswhereshorttermdebtincreasesinproportiontolong-term
debt.Moreover,long-termdebttocapitalwillshowsignificantchanges,whereasthe
formerlong-termdebttoequityratiomightnot.
Thecostofdebtratio,EBT/EBIT,isinvertedtoEBIT/(EBIT-InterestExpense),
whichwillshowincreasesofinterestexpenseinrelationtooperatingincome.Thisisthe
muchreferenced“financialleverageratio”whichisverymuchliketheinterestcoverage
ratioinbondratings.Increasesinthisratiowillusuallysignifythatthedefaultprobability
forthefirmhasrisen.However,sincedefaultprobabilitieshavecountervailing
components,theremaybesomeotherelementthatbufferstheriskofanincrease.
Withthesethreecomponents,LTD/Capital,EBIT/EBTandAsset/Capital,we
havetheelementsofriskreduction.Reducingallthreecomponentswilllowerrisk,butnot
necessarilyincreasereturn.Itiswhentheseelementsinterfacewiththeprofitcomponents,
operatingmarginandassetturnover,andbecomeintegratedwiththedynamicsofthe
greatereconomy,thatriskisreducedinthedomainoflargerreturns.Infact,theratio
asset/capitalisaveryneutralelementintermsofabsoluteriskbecauseitcanbeusedasa
capitalsubstitutewhenthecostofdebtisveryhigh.Thus,itisdependentonotherfactors
forinterpretation-thebusinesscycle,theotherleveragefactors,theamountofabsolute
debt.However,increasingtheratio,Assets/Capital,willalwayscontributetothereturn
188

oncapitalonasuperficiallevel;aslongasraisingitdoesnottacitlycontributetoa
depletedoperatingmarginorassetturnover,itwillincreasebothriskandreturn.
Infullform,thecompletedreturnoncapitalequationis:
(EBIT/Sales)x((Sales/Assets)x(EBT/EBIT)x(NetIncome/EBT)x(LTD/Capital)x
(Assets/Short-termdebt)x(Short-termdebt/LTD).Fromaninvestor’sperspective,itis
prudenttolookattheshortenedformbecausemanycomparisonsneedtobedonetofind
the“right“company.Webringthisbacktobasicswith:
(NetIncome/Sales)x(Sales/Assets)x(Assets/Capital)=ROC(ReturnonCapital).
Backinthe1990s,adherencetotheprincipleofincreasingallthreecomponents
yieldedasituationweaffectionatelycalled,a“trifecta”.Thenormalsuccessratefora
stockincreasewasabout73%accordingtoourdata,typicalfora“bull”market.When
allthreeofthesecomponentswereraisedsimultaneouslyinanygivenyear,thesuccessrate
hoveredataround90%.Althoughstockswereinflatedandmomentumwasrampantin
thatdecade,an“afterthefact”increaseofthatmagnitudewasphenomenal.
(BacktoTableofContents)
189

8
CAPITALSTRUCTUREANDTHEBUSINESSCYCLE
Thegeniusofmanagementistoplaceitself“intherightplaceattherighttime”.
Whileatalentedmanagercantakethehelminarecessionandslowlyguideacompanyinto
recovery,evenamediocremanagercanprosperifheorsheisprescientenoughto
anticipatethedynamicsofanindustrywhichis“suddenly”favoredbytheeconomy.That
foresight,whencoupledwithevenaslipshodleadershipability,maybeenoughtogarner
hugebonusesattheendoftheyear.Despitetheprotestationsof“moretalented”
underlings,themanagerwhocanoutforeseethecompetition(inthiscase-otherpotential
managers)willbetheonewhoisrewarded.
Apersonalstory-MynephewRandywasawhizatcomputersandhelpeddesign
manyInternetsitesearlyinthegame.Heday-tradedstocksatatimewhensuchapassion
wasunique.However,hefailedto“foresee”shiftsintheeconomywhichsuccessful
managerswillanticipate.Whenstockstumbledattheendof2000,hegothit.Hisfamous
line?“Butthefundamentalsweregreatonthatcompany!”Corporatefundamentalsare
alwayssecondarytotheactionsoftheentireeconomywhichthemarketanticipates.Huge
earningscanbemade,butiftheyaregarneredinaninflationaryperiod,forexample,the
marketwilltotallydiscountthem.Therefore,thebusinesscycleistheultimatesourceofall
stockgainsand“structures”capitalstructure,sotospeak.
COMMONELEMENTSOFBUSINESSCYCLES
Attimes,theeconomyfollowsadiscerniblepattern,andalthougheachmarketis
differentfromthelast,distinctsimilaritiesemerge.Whileeconomistscannotpredictthe
peaksandtroughsofthispatternwithprecision,theyhaveisolatedcommoncharacteristics
ofmostmarkets:
190

• 1)Fourphasesappearvalid(someeconomistswouldargueformoreorless)and
smallersub-cyclesaresometimesprevalent.Theyare:1.Recession/contraction2.
Recovery3.Expansion4.Plateau
• 2)AsimilarpatternofinterestratechangesoccursoverthecycleastheFederal
Reserverespondstoboththeneedforinvestmentandthepotentialblightofinflation.
• 3)Companiesprosperatdifferenttimesovertheentirecycle,separatingthemselves
intoindustrialsectorsthathavesimilarcash-flowpatternsandborrowinghabits.
Thedangerofbusinesscycleanalysiscomesfromexpectations;wenaturallyassume
thatpastpatternswillbeduplicatedandbegintoextrapolateintothefuture.However,
eachmarketisdifferentinsomerisk-takingaspect-legislatively,tax-wise,intheamounts
ofinflationortheratesofforeignexchange.Phasesrarelymakesmoothtransitionsfrom
onetothenext,andleadingindicatorssuchasM2orthestockmarketcanevenbelagging
insomecycles.Sometimesentiresectorswillbeleftoutofarecoveryandexpansion
becauseconditionsinthatindustryhavechangedsincethelastcycle.Afteraboutthreeto
fiveyearsintoarecovery/expansion,prospectsmayagainseemdimandtheFederal
Reservemayengineerwhatistermeda“softlanding”or“growthrecession”-aperiodof
lowGDPgrowthwhichallowsa“bull”markettocontinueforafewmoreyears,contrary
tothebestpundits’predictions.Fortunately,thestudent/investordoesnotneedtomake
accuratepredictionsinordertomakemoney.Heorshecanconcentrateonthecapital
structuredecisionsofthebestsectorsandseekoutpatternsofleveragethatwillreplicate
throughoutthecycle.
THEYIELDCURVEANDINTERESTRATEBEHAVIOR
Studentstendtothinkoftheyieldtomaturitycurveasasupplyanddemandcurve
whichisnotacorrectassumption.Infact,itismuchmoreagaugeofinvestorexpectations
aboutthedirectionoffutureratesthanademandgraphforloanablefunds.Thereasonfor
thisconfusionisthatthedemand(andprice)foradebtissuemovesintheopposite
directionfromchangesintheinterestrate.Alogicalquestionmightbe:“Whywould
191

anyonepaymoreforaninvestmentwithalowerrate?”Theansweris:“Theydon’t.”.As
interestratesareraisedbytheFederalReserve,thepriceofexistingissueswithlowerrates
goesdown.Investorscanmakemoreonanissuewithhigherratesandselloffanybonds
thathavetheolderandlowerrates.Thus,wheninterestratesspikeabovethedebtissue
withlowerrates,thereislessdemandfortheoldissueandthepricegoesdown.Atalower
price,thelowerinterestratenowyieldsmorereturn,givingitparitywithnewissues–
whenheldtomaturity.However,whentheissueissoldbeforematurity,andinterestrates
haverisen,thepricewillbebelowpar.Theprocessisdynamicandnotstatic.
Withtheyieldcurve,theyieldwhichrelatespricetointerestratesisafunctionof
thetimetomaturity.Duringthebusinesscycle,astheFederalReserveraisesorlowers
rates,thecurvechangesshapetoreflectinvestorsentimentandtheprevailingrateforeach
levelofmaturity.Ifinvestorsexpectanormalspateofinflationtooccur,long-termrates
willbeaboveshort-termrates,becauseinvestorsneedtobecompensatedfortheriskof
holdinganinvestmentthatismoreexposedtochangesininterestratesandinflation.
Analogously,financialinstitutionsmakeprofitsbyborrowingatlowershort-termrates
andlendingatlong-termrates,andtheascendingyieldcurveisuniversallyacceptedby
economistsas“normal”.
Asecondincorrectassumptionisthatafirm’schoosingthelowestinterestrate,
basedonthematurityofaloan,willminimizecapitalcosts.Asweshallsee,justthe
oppositeisoftentruebecauseratesreflectinvestorexpectationsasmuchasthepriceof
debt.Financialprofessionalsanalyzeyieldcurvebehaviorthroughwhatistermed“the
segmentedmarketshypothesis”.Thistheoryimpliesthatthesupplyanddemandfor
loanablefundsisderivedfromthecash-flowpatternsofabusiness.Companieswithlarge
amountsoffixedassetsdemandtheuseoflong-termfunds,whilecompanieswithmore
currentassetswillborrowshort-term.Banks,forexample,havemanyshort-term
liabilitiesandtheywillmatchthosematuritiesbyinvestinginshort-termsecurities,mostly
treasurybills.Astheeconomyheatsup,theFederalReservebeginsraisingratesatthe
192

sametimethatloandemandisalsohigh.Tomeetbothrequiredreserveratiosandhigher
loandemand,bankswillselltheseshort-termsecurities,floodingthemarketandpushing
uptheyieldsonthem.
Academics,ontheotherhand,generallyanalyzeyieldcurvebehaviorthroughwhat
istermed,“theexpectationshypothesis”.Long-termratesareviewedasthesumofshort-
termratescombinedintoalongermaturity.Therefore,theshapeofthecurveisa
reflectionoffutureexpectationswhichwilldeterminebasicsupplyanddemand.Iflong-
termratesaretemporarilylowerthanshort-termrates(thedreadedinvertedyieldcurve),
itisbecausetheeconomyisinbadenoughshapefortheFederalReservetobeginlowering
rates.
Inessence,thesetheoriesarenotmutuallyexclusive,andbothappeartoexplain
yieldcurvebehavior.Thesegmentedmarketshypothesisproclaimsthatshortandlong-
termdebtcannotbesubstitutedforeachotherwhichisbackedupbyempiricalevidence.
BraniffAirlinesinthe1980sisacaseinpoint:whenthiscompanybeganusingshort-term
debtasasubstituteforlong-termdebt,itwentbankrupt.Thevolatilityofshort-termrates
began“eating”thecompany’sprofits.Althoughmanycompanieswillconvertshort-term
debtintolong-termonceitreachesaspecifiedlevel,theoppositedoesnotoccurbecause
firmsdonotwanttopayvariableinterestrates;theuncertaintyofthelevelofdefaultrises.
Therefore,demandforloanablefundsisafunctionofboththefinancialstructureofa
companyandexpectationsaboutthedirectionofinterestrates.Whilealargecompany
cannotdelayallofitsfundinguntilinterestratesarelower,itmayrationcapitalby
limitingoutlaystocurrentprojectsandforegoanynewprojectsuntiladownturn
transpiresandtheFedlowersrates.
GRAPHSTHATUNITETHETWOTHEORIES
Tomatchcorporatebehaviorwiththeshapeoftheyieldcurveineachphaseofthe
cycle,thesegraphsservetouniteboththesegmentedmarketsandexpectationshypotheses.
193

Figure8-1

1)Phase:Contraction/Recession
2)ExpectationsTheory:Short-termratesareabovelong-termratesandlong-termrates
areexpectedtodecline.Companiesdonotwanttolockinaloanatahigherrateandwait
forinterestratestodecline.However,thisis“self-fulfillingprophecy”,becauserecessions
beginwheninvestmentandloandemanddeclines,andbecomeworsewhenfirmsdelay
buildingtheirinventories.
3)SegmentedMarketsHypothesis:Bankshaveraisedshort-termratesbyselling
securitiestomeetloandemandinpriorperiods.Consumerspendingisnowdeclining,and
companieswithsteadydemandandshortproductcycleswilldowell.Withhigherdebt
levels,industrialcompaniesmaynotbedemandingloanstomaintainfixedassets,andthe
priceoflongtermdebtisdeclining.Thelackofcapitalexpendituresisaleadingindicator
of“”trouble”downtheroad.
4)CompanyBehavior:Mostcompaniesretrenchandattempttodepleteexisting
inventories.Asstatedabove,firmsdelaymajorpurchasesofplantandequipmentbecause
theyareuncertainaboutthedirectionoftheirrespectivesectors.Anycompanywith
steadydemandwillgenerallyoutperformtheeconomy,evenifprofitmarginsare
squeezed.Thus,“sin”companieslikealcoholandtobacco,healthcaremaintenancefirms,
YIELD
TIME
194

andconsumerstapleslikebathroomtissueetc.willatleastmaintainthevalueofmost
portfolios.
Figure8-2

YIELD
TIME

1.Phase:Recovery
2.ExpectationsTheory:Theyieldcurvetendstobeflat(itmaybeslightlyascendingor
descending),butratesarenowlowerandcompaniesbegintoborrowattheselowerrates
forlargecapitalexpenditures.TheexpectationisthattheFedisthroughwithcuttingrates
andthatnowwouldbeagoodtimeto“lock”themin.Refinancingloansisagaincommon
forfinancialinstitutions.
3.SegmentedMarketsHypothesis:Companieswithmorefixedassetsandsteady
operatingleveragecanbestbenefitfromlowerinterestratesonlong-termdebt.These
firmstendtousealotofdebtandhavelargeperiodicexpenditureswhichwouldlower
capitalcostsifboughtwithlowercostloans.Long-termdebtisnowindemand.Lower
riskcompanieshavethegreatestaccelerationofEPSbeyondthecostofcapital.
4.CompanyBehavior:Firmswillextendinexpensiveloansamongthemselvesandto
consumers.Housing,banksandutilitieswillbenefitfromlowercostborrowing,andthe
slightlyhigherpricetheychargefortheirservices.Thesesectorsaredeemed“interest
sensitive”.
195

Figure8-3

YIELD
TIME

1.Phase:Expansion
2.ExpectationsTheory:Companiesexpectinterestratestoriseastheeconomy“heats”up
TheFeddoesindeedraiserates,perhapsseveraltimesbeforeinflationappears.The
economicimperativeistoborrowandbuy“now”,beforeinterestratesriseandinflation
takeshold.Essentially,thisscenariorepresentsacollectiveraceforimmediate
consumption.
3.SegmentedMarketsHypothesis:Long-termdebtisstillinhighdemand.Companies
withhigheroperatingleveragebegintodowell.Atthispoint,theequitymarketsarein
fullswingwhichrepresentsthemainsourceoffinancingformanyofthesefirms.Higher
GDPgrowthandhigherconsumerspendingoffsetsthehigherrisk.
4.CompanyBehavior:Consumerspendinghasbeenbolsteredbyagreatemployment
marketandloansareextendedfor“consumerdurables”-autos,boats,appliances-so
called“bigticket”items.Intermediateindustrialgoods(usedtoproduceconsumerend
products)andtransportationcompaniesbegintodowell.
196

Figure8-4

YIELD
TIME

1.Phase:Plateau
2.ExpectationsTheory:“Mixedsignals”aregivenoffbyaneconomythatisunsureof
whichdirectionitisgoing.SomethinktheFedwillraiseratestocurbinflation,while
othersseediminishingreturnsandhopeforaratecut.Inessence,theflatyieldcurve
mimicsanearlyrecoveryandyetinterestratesaretoohighforanotherexpansion.The
financialsectorbeginstosuccumbtointerestrateworriesandlobbiesforacut.
3.SegmentedMarketsHypothesis:Atthemarketpeak,companieswithhighoperating
leverageandlittledebtdothebest.Consumersarestillspendingeventhoughthereisless
industrialactivity.Thetechsectorcanbenefitatthistimebecausetheirfinancingis
independent(superficially)ofhighinterestloans.However,theremaybemorevolatilityin
themarket,andsomeofthesestockswill“sky-rocket”,onlytofacetheconsequencesofa
highbetaduringthelatterpartofthephase.
4.CompanyBehavior:Bothpersonalincomeandinterestratesarerelativelyhigh.
Capitalgoodshavebenefitedfromreplacementneeds,butmostcompaniestakea“wait
andsee”approachasmergerandacquisitionactivityslowsdown.Inthismarket,itis
“winnertakeall”andsomesectorsareheavilyfavoredoverothers,causingvolatilityas
investorsareunsureofwheretoputtheirmoney.
197

Thestudent/investorshouldrealizethatthecharacteristicofaphaseisnotderived
fromitspredictedpatterns,butdefinedbyitsanomalies.Canamarketgofromrecovery
toplateauandmissanexpansion?Canbanksdobetterwheninterestratesarehigh?Can
stocksdowellinthefirstpartofarecession?Asimprobableasthescenariosbehindthese
questionssound,theincreasedcomplexityoftheeconomy,especiallythebehaviorof
foreignmarkets,canturnthemplausible.Banks,forexample,increasinglycherish“non-
interestincome”thatdiversifiesthemawayfromdependenceontheFed.Borrowingat
lowratesinJapan,inordertoinvestinChina,makescompanieslesssensitivetotheyield
curve.Inevitably,theremaycomeatimewhenthestockmarketnolongerreflectsriskin
theUnitedStatesalone,andintheperiod2003-2008,wewitnessedanotheranomaly:gold
andstockswereperfectlycorrelated.But-ifwecombinedourownyieldcurvewiththatof
othercountriesandweighteditbyGDP,thatcurvewouldreflecteconomicconditions
throughoutthedevelopedworld.Therealutilitybehindtheshapeoftheyieldcurveisthat
itgraphicallyrepresentsthebusinesscycleateachpointintime.Althoughitfluctuatesand
shiftstoreflectimmediateconditions,noothermeasurementsopreciselycapturesinvestor
behaviorandexpectations.Ifweweretoconcludethatcapitalstructuredecisionsarean
outgrowthoftherelationshipbetweenlongandshort-terminterestrates,wewouldbevery
closetothetruth.Thoseratesaffecttheequitymarketsandthetypeofassetsthatgenerate
income.Thelengthoftimethattheymaintainapattern,theleveltheyareat,thedistance
betweenshortandlong,aswellastheirinherentvolatility,alldeterminetheamountand
timingofcashflows-andalsodeterminehowthosecash-flowsarefunded.
STRATEGICCONSIDERATIONS
• 1)Themarketprecedesactualbusinessactivitybyapproximatelysixmonths.One
reasonthatinsidersprofitistheirabilitytoanticipateincreasedactivityintheir
respectivebusinesses.Thisisalsothereasonwhy“chasingprofits”byinvestinginthe
mostprofitablecompanies,isdoomedtofailure.Bythetimeaninvestmentismade,the
yieldcurveshiftsandbeginstofavoranothersector.Theonehighlyrecommended
198

strategyistoinvestinageneralmarketindexaboutsixmonth’safterarecessionis
officiallyannounced.Historydictatesthatamarketbeginstorecoveratthispoint,and
thatthegreatestgainwillbeatthebeginningofarecovery.Nooneexceptmarket
professionalswillbewatchingtheindex,andthemarketseemstorespondtothislevel
ofanonymity.
• 2)Afavorableleveragestatewillmoveafirmtowardanoptimalcapitalstructureand
ahigherstockprice.Unfortunately,asinterestratesriseandtheyieldcurveshifts,the
confluenceofidealincomeandcapitalcostconditionswillonlybetemporary.Thespan
canbefromsixmonthstotwoyearsbeforeastockbecomes“overbought”.Whenan
investorhasseenacompanydoubleitsstockprice,itusuallysignifiesthatthesectoris
abouttowash,althoughitdoesnotmeanacompanywillmakelessthanoptimalcapital
structuredecisionsorlosevalue.Ifearningsdeceleratecomparedtothecostofcapital,
investorsbeginlookingtoothersectors,butthatdoesnotmeanthatthecompanyisnot
agoodlong-termprospect.
• 3)Twootheraphorismshavehistoricalmerit:1.Thegreatestgainsinthemarket
occurbeforetheFederalReserveraisestheinterestratethreetimesinsuccession.At
thispoint,themarketbecomesmoresectororiented,respondingtoindividualcash-
flow/capitalcostcircumstances.2.Ifafterthreetofouryearsofrecovery,andshort-
termratesexceedlong-term,itmaybetimetoshiftmoneyoutofthemarket.Atthis
point,theFedwilltrytoincreasethemoneysupplywithopenmarketoperationsand
otherlendingfacilities,tryingtoengineerwhatistermed,”asoftlanding”.While
enormousspeculativeopportunitiesexist,prudentinvestorswillcurbtradingbecause
thepotentialriskoutweighsthereturns.Iftheinvertedyieldcurveisatlowenougha
level,itdoeshavethepotentialtoflattenoutandbeginascendingtocontinuethebull
market.However,suchamovewouldsignifythattheFedconsidersinflationtobeat
anacceptablelevelandwouldpenalizecreditorswithdeflateddollars.Sincedebtlevels
199

arehigher,losseswouldbehighunlessinflationwasactuallyheldincheck.The
averageinvestorbestnottemptfate.
• 4)Politicalconsiderationsmaytrumpeconomicdiscretion.Sincethepublicequates
economicbehaviorwiththeprevailingpresidentialadministration,theFederalReserve
triesnottoraiseratesinthelasttwoyearsofanincumbent’sreign.Ifinflationgetsout
ofhand,thepostponementofaratehikemaymakeitworse,forcingtheFedtotake
evenmoredrasticmeasures.Historically,stocksgenerallydotwiceaswellinthelast
twoyearsofaPresident’stermthaninthefirsttwoyears.
• 5)Majortrendsareconfirmedbysequentialmovementinthesamedirectionofall
threeDowcomponentindices,utilities,industrialsandtransports.Atfirst,electric
utilitiesleadtheway,upordown.Secondly,theDowIndustrialsfollowtheutilities.
Lastly,thetransportationindex,followstheDowindustrials.Unlessatrendoccursin
thatspecificorder,itisnotconsidered“confirmed”,andmayleadtoalesspredictable
businesscycleandachaoticmarket.Fromasectorrotationstandpoint,theDow
Theoryiscompletelyrational.Interestratesgettoohighforthe“interestsensitive”
utilities,pushingthemdown.Fewerorderspushdowntheindustrialsbecause
companiesdonotwanttocommittoprojectsathigherrates.Lastly,thetransports
sufferbecausetheyarethemainserviceunitfortheindustrials.
THEBUSINESSCYCLEANDTHECOSTOFEQUITY
Thefirstmisconceptionthatinvestorshaveaboutbetaisthatcompanieswith
greaterfinancialleveragehavehigherbetas.Infact,whileleverageincreasesbeta,the
greaterproportionofbetaisderivedfromtherelationshipbetweensalesandmarket
return.ToreiteratetheMandelkerandRheeequation,Beta=(DOL)(DFL)(ROE)[(COV
%Sales,%Market)/Variance%Market)].Salesisaprominentpartofboththedegreeof
operatingleverageandthecovariancecomponentoftheequation.Moreover,itisan
assumptionofcapitalstructuretheorythatoperatingandfinancialleveragebalanceeach
other;acompanywithmorefinancialleveragewillhavelessoperatingleverageandvice-
200

versa.Althoughsomesectorsemploymoreofbothtypes,withinanysector,themixtureof
leveragewillbesimilarandbalanced.
Theoretically,the“ideal”companywouldhavealowbetabecauseitwouldbewell
diversifiedandbeabletoincreaseitsbetawithmoredebtand/oracquisitions.Playingthe
cycle,itwouldtakeadvantageoflowinterestratesuntilthemarketpickedup,andrates
wereincreased.Atthispoint,itsinvestmentinassetswouldbegintopayoff,andthe
companywouldraiseitsreturnonequity(ROE),whilemaintaininghighdemandforits
products.AstheFederalReserveraisesinterestratestostaveoffinflation,thefirmbegins
topayoffsomeofitsolddebt,attractingequitythroughitshigherEPS.Simultaneously,
thecompanybeginstoretainmoreearningsandlowersitslong-termdebttocapitalratio,
decreasingbetajustasthebusinesscycletransitionstoaplateau.Duringthestagnant
market,thefirmcontinuestodiversifywithacquisitions,loweringoperatingrisk,and
tryingtobroadenitscustomerbaseforthenextprofitcycle.
Thus,the“ideal”companyengineeredastrategythattookadvantageofthree
cyclicalcharacteristics.First,ittookadvantageoflowerinterestratesandbegantakingon
debtandraisingitsbetajustastheeconomywasimproving.Secondly,asinterestrates
werecontinuallyraised,itlowereditsdebtratioandbeganrestructuringitscapital
towardsanequitybase.Concurrently,EPSwasrisingandan“overheated”economy
ensuredthatdemandforitsproductswasstable.Lastly,thecompanypreparedfora
downturnintwodifferentways:1.Itjettisoneditshighinterestdebtandpositioneditself
forgreatersolvency.2.Itbegantobroadenitscustomerbasebyinvestinginrisklowering
acquisitionsthatwoulddiversifyitsoperations.Fromtheperspectiveofcapitalstructure,
afteradownturn,thefirmusesleveragetoacceleratethechangeinEPSwellpasttherate
ofchangeinthecostofequity;thecostofequitywasatacyclicallowbecausethemarket
haddeclinedandtheFederalReservehadloweredinterestrates.Inthesecondphaseofits
strategy,thefirmactuallybeginstolowerbetainresponsetohigherinterestrates.By
paringdownitsproportionofdebttoequity,itnullifiestheriskofleverageathigherrates.
201

Ontheotherhand,itcandonothingaboutthesystemicriskofanoverheatedmarket,and
soitattractsequityfundingwithitshigherEPSandsubstitutesitfordebt.Thethird
phaseofthestrategylowersitsbetainresponsetoastagnatemarketbutalsopreparesfor
thenextbusinesscyclebydiversifyingawaysomeofitsoperatingrisk.Inessence,thefirm
isbothpreparedforadownturnandyet“cautiouslyoptimistic”aboutfutureprospects.
Preposterousyousay?Afantasy?Whileeventhebestruncorporationscannotgo
througheverycyclewithsuchmachinelikeprecision,manyfirmshireeconomiststoguide
themthroughthevariouspitfallsandmissteps.Thebankingindustryinparticularis
exposedtocyclicalrisk,whichcarriesovertoallthosewhoareinfluencedbytheprime
rate-whichencompassesatleastsomeaspectofnearlyeverysectorintheeconomy.
Again,thepremiumisplacedonforesightandnothindsightbecauseifacompanyadopts
thesestrategiesasareactionaryresponse,itwillfinditself“outofsync”withchangesin
thecostofcapital,i.e.,therateofearningsincreaseswillslowandbesuddenlyeclipsedby
thecostofequity,whichwillbegintoaccelerate.Onthedownside,earningswillusually
outpacethedecreaseintherisk-freerate,butevenifearningsarestable,ahigherbetawill
createanoverreactiontoamarketdownturn.Atthispoint,weoftenseefirmswithtwenty
percentearningsincreases-loseandnotgain-twentypercentinstockprice.Themarket
simplyfactorsindiminishedfutureprospects.
Betararelyperformsasexpectedintheshort-run.Infact,rightafterthetheoryof
theCAPMwasproposed,WallStreetimmediatelyjumpedonthebandwagon.Investingin
highbetastocksduringanupswingandtheninlowbetastocksduringadownturn,
institutionalinvestors’attempttotimethemarketwasfutile.Performancewasspottyat
best.However,therealculpritwasmethodology;betawasusedasatoolforpredicting
stockprices,andnottogaugecomparativerisk.Itisalwayspossible(althoughnotlikely)
forahighbetastocktoonlyreactviolentlywhenthemarketisdecliningandtomake
meagergainsduringtheexpansionphaseofatypicalcycle;betaencompassescumulative
volatilityandisnotstableintheshortterm.Suchanomaliescanbefurtherpunctuatedby
202

alowcorrelationcoefficientandahighbutvolatilealpha-thepartofaregressionthat
dependsonfactorsoutsideofmarketinfluence.Forexample,iftariffpolicysuddenly
favorsaparticularindustry,i.e.,steel,thenthatindustrymayprosperwiththeeffectofa
greater“alpha”,andlessbeta;itisnolongerasdependentonthemarket.Theindustry
mayhaveacollectivebetaofperhaps“1”,buthardlyreactsatallduringamarket
downturn.
THECAPITALASSETPRICINGMODELANDSENSITIVITYANALYSIS
ThetrueworthofbetaisgaugedinrelationtotheothercomponentsoftheCAPM.
TheCAPMisadynamicmodelthatchangesdailyasthemarketchanges.Periodically,the
risk-freerateismanipulatedoutsidethesystembytheFederalReserve,butitchanges
yields(notcouponrates)basedondemandfortreasuries.Themorevolatilestockmarket
indexcanvaryfromnegativetwentypercenttopositivetwentypercentoverthecourseofa
year,andthedifferencebetweenthatfigureandtherisk-freerate,knownasthemarket
riskpremium,istheprimaryeconomicfactoraffectingthecostofequity.Ultimately,the
singularrelationshipbetweenbetaandtheriskpremiumwilldeterminethecoherenceof
themodel
Inthefollowingexample,wewillobservetheeffectofaonepercentchangein
interestratesontheCAPM,definingthreelevelsofbeta:lowmedium,andhigh.
Table8-1

EQUILIBRIUM RiskFree
%
Beta Market RiskPrem. CAPM
LOW 0.05 0.75 0.098 0.048 8.6%
MEDIUM 0.05 1 0.098 0.048 9.8%
HIGH 0.05 1.25 0.098 0.048 11%

203

Table8-2

INCREASE
1%
RiskFree
%
Beta Market RiskPrem. CAPM
LOW 0.06 0.75 0.098 0.038 8.85%
MEDIUM 0.06 1 0.098 0.038 9.8%
HIGH 0.06 1.25 0.098 0.038 10.75%

Noticethatwiththehighbetastock(1.25),increasingtherisk-freerateactuallydecreases
thecostofequity(from11%to10.75%).Thisisasystemicadvantagethatencompasses
firmswhomustfinancewithmoreequity.Companiesthathavehighbetasmayhavea
difficulttimeturningtothecreditmarketsfornecessaryfinancing.Wheninterestrates
rise,thecostofcapitalgoesupforthosefirmswhouseleverage.Ontheotherhand,those
whouseequityhaveacompetitiveadvantage,especiallyifthemarketignoresthehigher
ratesandkeepsascending.Thehigherbetaallowsafirmtobothescalateearningswith
lowercapitalcosts,andtemporarilyoutperformthemarket.However,asthemarket
keepsrising,thesecompanieshaveamuchhighercostofcapital,andwheneitherearnings
orthemarketdeclines,highbetastocksfallprecipitously.
Thisnextexamplewillshowsensitivitytomarketchanges.Italsoshowstheimportanceof
alwaysexaminingthecostofequityinthecontextofearnings.IfweexaminetheCAPMin
isolation,amarketdeclineactuallyreducesthecostofequity,butthenwemustremember
thatearningsarehighlycorrelatedwiththemarket;adeclineinmarketvalueimpliesthat
earningsmaybedecreasingbyanevengreateramount.
Table8-3

EQUILIBRIUM RiskFree
%
Beta Market RiskPrem. CAPM
LOW 0.05 0.75 0.098 0.048 8.6%
MEDIUM 0.05 1 0.098 0.048 9.8%
HIGH 0.05 1.25 0.098 0.048 11%

204

Thisscenariocallsforathreepercentdropinmarketreturnto6.8%.
Table8-4

MKT.
DECREASE
RiskFree
%
Beta Market RiskPrem. CAPM
LOW 0.05 0.75 0.068 0.018 6.35%
MEDIUM 0.05 1 0.068 0.018 6.8%
HIGH 0.05 1.25 0.068 0.018 7.25%

Evenwiththeintroductionofextraordinarycashflowduringthisperiod(beatingthe
averagecompanyinearningsgains),itisdoubtfulwhetherahighbetastockcould
maintainitsprice.Certainly,thecostofequitydroppedmorethanthatoflowbetastocks,
butthestudent/investorshouldconsiderthesourceofthehigherbeta-usuallyhigher
operatingriskattributabletovolatilesalesandearnings.Anyfirmthatfinanceswith
equity,andhasahigherbeta,musthavehigheroperatingvolatilitybydefinition.
Oneofthekeystounderstandingthecostofequityistherecognitionofhowmarket
dependentitis.Althoughinterestratechangescanmovethemarket,theywillrepresent
onlyasmallfractionofthecostifthemarketdoesnotrespond.Thenexttableshould
convincereadersthatmarketreactionisparamount:wecuttheinterestrateinhalf,
withoutamarketresponse.
TheequationistheCAPMwithabetaofone:Risk-freerate+(Beta)(Marketrate-Risk-
free).
Table8-5

TheMarketgoesfrom20%to15%Return
.05+(1)(0.2-.05)=0.2or20%
.05+(1)(.15-.05)=0.15or15%

205

Table8-6

InterestRatesareCutinHalf(therisk-freegoesfrom5%to2.5%)
.05+(1)(0.2-.05)=.2or20%
.025+(1)(0.2-.025)=.2or20%
Moreover,thereisnofactorinthemodelthatexpressestherelationshipbetweeninterest
andmarketreturnexceptforthecomparativeriskpremium(marketreturn-risk-free
rate).Thecorrelationbetweenratesandmarketisnotexplicitandcannotbepermanently
quantifiedbecausevolatilityinbothcreditandequitymarketschangestherelationship.
Ultimately,therelationshipisafunctionofyieldcurvebehavior,inflationandaggregate
demandamongmanyfactors.Expressedasalogarithmiccurve,therelationshipisina
stateofperpetualchangewhichdiminishesforecastingability,i.e.,themarketcreates
inflation,whichraisesrateswhichlowersthemarket,whichlowersrates,whichincreases
themarketwhichcausesinflation...
Figure8-5

Themostconstructiveadvicethataninvestororcorporateprofessionalcanreceive
istokeepbetaataminimum;theempiricalevidenceisunchallenged.Lowbetastocksare
rewardedoutofproportiontotheirriskprofiles,whilehighbetastocksarepenalized.In
statisticalterms,adownwardbiasexistsforhighbetastocks.However,thedangerof
InterestRate
MarketReturn
206

makingthisgeneralizationistolosetheupsidepotentialthatsomanyhigherbetastocks
provideduringtheexpansionphaseofthebusinesscycle.Whilesomehighbetastocks
offeranexceptionandachievesomedegreeofstabilitybytheirverysizealone(Intel,for
example),theimperativeistoseekoutfirmswhocanraisebetaandtakeadvantageof
upswings,butnothavethetypeofoperatingriskthatwoulddamagethestockduringa
downturn.
Oneofthebestexamplesofhowbetacanbedeceptive,iswithChapterOne’s
introductoryillustration,FisherScientific(nowThermo-FisherScientific).Withasmall
profitmarginof3to4percent,Fisherwascapableofincreasingsaleseveninadownturn.
Thecompanywaswelldiversifiedwithalowoperatingleverage,buthadadebttocapital
ratiothatsometimesapproachedseventypercentbecauseofnumerousleveragedbuyouts.
Nevertheless,thecompanymaintainedabetaofabout0.6andwasabletoincreasetheir
sharepricesevenfoldinabouteightyears.Howwasthatpossible?Besidesbalancing
operatingandfinancialleverage,thisfirmrarelyreactedasmuchasthemarket.Noone
everbraggedabouthowFisherwasbeatingWallStreetestimatesandthestockwasnot
heavilytraded.Infact,salesandcash-flowwerecomparativelylarge,butthelowprofit
marginsputthecompanyinthe“highturnover”class;assetgrowthwasleveragedthrough
thestabilityofsales.The“mystery”behindFisherwasthatthestocksimplydidnotmove
onthebasisofsalesorprofits,butoncetheword“acquisition”wasmentioned,ittookoff
likeaguidedmissile.Eventually,itwouldagainsettleinforanothersoporificinterim,
waitingforwordofthenextgrowthopportunity.Mathematically,theselargejumpswould
notbeinterpretedasvolatilitybecausetheywereisolatedtospecificshortperiods;thus,
thesmallbeta.Inotherwords,Fisherhadupsidepotentialbutwasprotectedfrom
downsiderisk
OnefamousstudywasconductedbytheformidableresearchteamofBlack,Jensen
andScholes.TheyfoundthattheentireperiodfromApril1957toDecember,1965,was
characterizedbyaskewedrisk-returntradeoff-higherbetastocksproducedlowerreturns
207

thanlowbetastocks.Infact,thesefindingsareoftenpointedoutasacondemnationofthe
entireCAPM.Again,theanomalycanbeexplainedbytheextremityofthemovement;a
stockwithahighbetacantriplethemarketsdownwardpathinonlyafewshortdays,
whileitmaytakeayearormoreforittoachieveanewhighduringanexpansion.That
jackrabbit-volatilityalmostalwaysrepresentsareturntorelativebookvalueandaway
fromspeculativerisk.Anotherexampleofbeing“burnedbybeta”wasduringthetech
stockspeculationofthe1990s.Thisperiodofferedrewardstohighbetainvestorsonlyif
theywereadeptenoughtopartwiththeirinvestmentsbeforethey“fellthrough”.Very
reputablefinancialprofessionalsthoughtthata“newera”haddawned,characterizedby
permanentlyhighpricetoearningsratios,andvolatilestocksthatwould“gobackup”.By
2001,manyhighbetastocksthatcommandedahundreddollarsasharejustafewyears
earlier,couldbeboughtfortendollarsandchange.
Unfortunately,thevolatilityofcertaintechstockshasledtomorespeculationand
lessinvestment.EvenawellruncompanylikeGoogleisnotaninvestmentgradestockas
ofthiswriting(2008),becauseitisoverexposedtoadownturn.Ontheotherhand,
Microsofthasbecomemoreinvestorworthyasitgivesoutspecialdividendsandtrades
betweenamuchnarrowerrangethanitoncedid.Itsbetaisnolongerexceptionallyhigh
andithasdiversifiedintovoicegeneratedprogrammingandvideogames.Therefore,a
highbetashouldnotcondemnastock’sinvestmentpotential;awellmanagedhighbeta
companycanloweritsbetaasittakesadvantageoflowercostequity.However,even
duringanupswing,lowbetastockscanoutperformthehigherbetasbecauseofatendency
toholdtheirgains.
CIRCUMVENTINGTHEOPTIMALCAPITALSTRUCTURE
Therelationshipbetweenshort-terminterestratesandlong-termratesdefinesthe
businesscycle.Ifincomestreamsarecertainoveralongperiod,thecostofborrowing
short-termwouldbesignificantlylessthanborrowinglong-term-givena“normal”yield
curve.Thereasonforthelower“price”ofshort-termdebtisthatthelenderincursless
208

risk.Anypricinganomalyintheborrower’sfavorisshort-livedbecausetheloanwillbe
frequentlyrenewedatthecurrentrate.However,theborrowerincursmuchgreater
defaultrisk-loansmighthavetobepaidwhencash-flowisnegative-and-thereisgreater
riskincurredbecauseofthepotentialforinterestratefluctuation.Mostbusinessesneedto
planfarenoughaheadtobecompetitiveandfrequentratechangesontopoffrequent
paymentswillincreasedefaultprobability.Thisdisparitybetweenthepriceofdebtand
theriskofdebtskewstheabsolutecostofcapitalinthedirectionofgreaterrisk.In
essence,thecompanyisforcedtochoosehighercostdebtbecauseitislessrisky.Sincea
wellrunfirmmatchesitscash-flowwithitsfundingneeds,thereisalwaysthetemptationto
uselessexpensivedebtwhenthefirmisinatemporary“holding”patternatthetopofthe
businesscycle:itmaywishtodelaymajorprojectsbecauseinterestratesareexpectedto
decline.Asbanksselloffshort-termsecuritiestomeetloandemand,thereisatendencyfor
short-termratestorise,indicatingtheprospectofacontraction.Thus,afirmmay
temporarilysubstitutetheincreasinglyexpensiveshort-termloansforlong-termdebt,in
thehopesofavoidingbeing“lockedin”atahigherrate.Thistrade-offofmoreimmediate
riskandexpensefortheprospectoflowerratesinthefutureisaluxurythathighbeta
companiescannotafford.Lowerbetacompanies,whohavelessoperatingriskcanmakea
strategicplaytolowercapitalcostsinthelong-runbyacceptingtheseimmediaterisks:
theydonotfacetheprospectofgreatmarketvolatilitywhichwoulddamageahighbeta
firmthatacceptedthesamerisks.Interestexpensewouldriseintheinterim,aswould
defaultprobability,butthismovementawayfromanoptimalcapitalstructurewould
positionthefirmforgreatergainsoncearecoverycommenced.Essentially,thehigher
pricepaidfortheshort-termloansbuffersthefirmagainstuncertainty,actinglikean
insurancepremium,andcounterbalancingtheriskofdefaultbecausetheactionisonly
implementedtemporarily.
THEGAMEOFCAPITALSTRUCTURE“GOTCHA”
209

Highbetacompanieswhopeaknearthetopofabusinesscycleprimarilyfinance
withequity.Long-termdebtisbothprohibitivelyexpensiveandrisky,becausecash-flowis
notstableenoughtowarrantit.Undernormalcircumstances,retainedearningsprovide
sufficientequitygiventhelowereconomicprospectsthatoccurduringtheplateauphaseof
abusinesscycle.However,thecostofequityisrelativelyhighatthisstage,pushedupbya
marketthathassurgedthroughafewyearsofexpansion.Unlessearningsaremaintained
andevenaccelerated,thecostofequitywillberisingandeclipsingtherateofearnings,
sometimesvectoringoffintoadifferentdirectionaltogether.Withtheprospectofboth
lowercapitalandconsumerspending,theforecastforastablestockpriceisdim.
Whenahighbetastockisatitspeak,companyofficialssometimesfeel
indestructible.Theirunbridledoptimismispunctuatedbyhugebonusesandastockprice
thatissoaring.Opportunitiesforgrowtharesightedandthefirmmaybeginraising
capitaltofundlargeprojects.Atthesametime,anexpandingmarketcreatesmany
unsophisticatedinvestorswhohaveneverseenadownturn.ThemarketseemslikeaLotto
ticketthatalwayspaysoff.Thus,the”perfectstorm”occursincapitalstructure.The
unbridledoptimistsarematchedwiththeunsophisticatedinvestors;oneentitydemands
plentyofequityandtheothersuppliesit.Infact,thehighbetafirmisminimizingcapital
costsbyraisingequitywhenthestockpriceishigh:morefundswillberaisedwithfewer
shares.Whateachplayerinthisscenariodoesnotrealizeisthattheyhaveuppedthe
“ante”atthewrongtime,takingonmoreriskthaniswarrantedbytheeconomicoutlook.
Naturally,theinvestmentbeginstoimplodeassoonasanyofthemajorindustry
participantsmissesearningsexpectations.Therefore,aninvestorneedstoviewequity
issuedlateinthebusinesscyclejustasacompanyviewsshort-termdebt.Thehigherrisk
needstobecounterbalancedwiththepotentialforappreciation-except-inthisgame,the
loandoesnotexpirelikeshort-termdebt.Oncestockisissued,itiskeptuntilsold;the
investormustenterthedeallikeagambler,expectingto“dump”thesharesbeforegetting
210

“burned”.Inessence,evenwiththebestofintentions,bothpartiesenduplikepoker
playersinaLasVegascasino.
IDEALIZEDTRENDS
Businesscyclebehaviordefiesexpectationsmorethanitconfirmsthem.Highbeta
stocksmayrecoverearlierthanlowbetastocks.Temporarily,thecostofequitymay
actuallydecreaseduringanupswing.Themarketmaygointoatailspinjustasthe
expansionphaseisexpected.Exceptionstotheruledonotnegateitslogic,butoffersthe
opportunitytoobservetheworkingsofotherforces.Often,thepoliticalmotivesofalobby
canbeexhibitedinsomepieceoflegislationthatseemsinconsequentialbuthas
repercussionsinthemarket;thelawsofsupplyanddemandarecircumventedbycreating
anartificialscarcityforexample.Speculativeexcess,a“bubble”createdbygovernment
actionorinaction,canoccur.Anexampleofsuchabubblewasthehousingspeculation
thatoccurredintheearlymillenniumwhichwaspurportedtobeanoutgrowthofinterest
ratesbeingtoolowfortoolong.Insuchascenario,theinvestingpublicwillputtoomuch
capitalinoneareatothedetrimentofothers,andtheresultwillbeasector(housingor
Reits)thatremainsprofitablebeyonditscapacitytogenerateincome.Thus,asectorwhose
internaldynamicswouldnormallyletitprosperforonephaseonly,endedupbeing
favoredbytheeconomyforthree.Thisimbalancecanonlyendupaffectingothersectors,
andindeedwesawafalloutwithmortgagecompanies,banksandbrokerscausingasevere
creditdebaclein2007.Byrecognizingtherationalitybehindthe“ideal”businesscycle,the
investorcanthereforebealertedtothedangerofanexception-whetheritbeaspeculative
bubbleoramorecomplicatedsupplyanddemandissuesuchasoccurredwiththepriceof
oil.
211

Figure8-6

VARIABLE PHASEA PHASEB PHASEC
InterestRates LOW MEDIUM HIGH
MarketIndex LOW MEDIUM HIGH
CostofEquity LOW MEDIUM HIGH
RelativeBeta LOW MEDIUM HIGH
RelativeOp.Leverage LOW MEDIUM HIGH
EPSAcceleration INCREASING HIGH DECREASING

PHASEA PHASEB PHASEC
LOWBETASPROFIT BETASNEAR“1”PROFIT BETAS>“1”PROFIT
1.FinancialLeverage 1.FlexibleMixtureof
Debt/Eqty
1.MarketSpendingPeaks
2.StabilityofDemand 2.MoreMarketSpending 2.EquityislessExpensivethan
Debt(relatively)

Themanagerialimperativeistofinditsown“efficientfrontier”withintheparametersof
itsindustry;thatis-itshouldstrivealwaystoachievethegreatestreturnwithagivenlevel
ofrisk.ThereadershouldobservethateconomicriskislessinphasesAandBanditisat
thisjuncturethatcorporateriskcanbeincreased.OnceafirmentersphaseC,corporate
riskisnolongeranoption:itshoulddecreasebeta,reducedebt,andattempttolower
operatingriskthroughdiversification.
Averyobviousexampleofanindustrychangingitsriskprofileislandlinetelecom.
Theseformerlyregulatedcompanieshaveincreasedtheircollectiveriskbybranchingout
intowireless,theInternetandeventelecomequipment.Withoutthelowbetaofa
MarketCap.
Time A B C
212

regulatedutility,thesefirmspeakmuchlaterinthebusinesscycle.Infact,AT&Twitha
betaofaround“1”,onlyhadalongtermdebttocapitalratiorangingfrom15%to33%
throughoutthe1990s.Thetypicalutilityhasmorefinancialleveragebutnotnearlythe
greateroperatingriskthatAT&Thasincurredovertheyears.Extremeamountsofcapital
pouredintothesefirmsrightatthemarketpeakofthelate90s,whichwasthewrongtime
toincursuchrisk.Whenthemarketimploded,telecomsufferedmorethanmost,butcould
haveavoidedsomeofthedamagebyexpandingintheearlierphasesofthecycle.
SECTORROTATION
Toflawlesslypredictwhichsectorwillbethenexttoprofitisapipedream.Most
sectorswillbesegmentedbyperformanceandallfirmswillnotprosperatonce.Norwill
itbepossibletopredicthowlongasectorwillprofitalthoughsixmonthsofaccelerated
earningswillbeanindicatedminimumtobeconsideredas“outperforming”theeconomy.
“Chasing”profitablesectors,however,ismuchlikechasingearnings:theinvestormight
gainfrommomentum,butjustaslikelywilllosemoneybecausethelargeinvestorshave
alreadyspotted“thenextbigthing”andmovedon.Therealvalueinsectorrotationisto
recognizethatadiversifiedportfoliocanbeachievedbyconcentratingonfirmsthatbenefit
fromtherecoveryandexpansionbutshouldalsohavesomedefensivestocksincaseofa
contraction.Inaddition,stocksthatdowellduringaplateaushouldbechosenonthebasis
oflowerrisksimplybecausethehigherriskstocksthatdowellduringthisphasewillbethe
firsttofall.
SECTORLOGIC
Theconceptbehindsectorrotationisthatthecyclefavorsspecificindustrieswithinthe
boundsofinterestratesanddemand.Forexample,wheninterestratesarelow,more
applicantsqualifyforcreditandany“bigticket”itemrequiringaloanwillbefavored.
Consequently,anyindustrythatdependsoninterestrates-autos,housing,banks,etc.-will
befavoredaswell.Duringacontraction,whencreditriskisstillhigh,consumerswillnot
betakingoutloansforpurchases,butwillstillbebuyingbreadandgoingtovisitthe
213

doctorifneeded.Thus,consumerstaplesandthehealthcareindustryarefavored.When
therecoveryandexpansionphaseshit,goodsthatareusedintheproductionofothergoods
-subassemblies,smallmotors,heatexpandersetc.,oftencalledintermediategoods,willbe
indemandandsetthestageforthelateexpansion,earlyplateau.Itisatthisjuncturethat
unusedcapacitydisappearsandmanufacturersbegintoexpandbypurchasing“capital
goods”-thetoolsandmachinerythatconstitutethefinalproductoftheintermediate
goods.Naturally,allofthisfreightmustbetransported,andthevarioustransportation
stocksbegintodowell-railroads,trucking,shipping.Whiletheastutereaderwillnotice
thatsectorrotationismerelyadetailedelaborationofthe“Dowtheory”,thepremiumfor
economistsistoobservehowitisdifferent.Manysectorswill“bleed”overintoaphase
whoseinterest/demandcharacteristicdoesnotfittheindustry.Additionally,most
economistswilldebatewhichphasetheeconomyhasenteredaswellashowmanyphases
orsubphasesactuallyexist.Asageneralguideline,thefollowingtableoffersarough
estimateofatypicalbusinesscycle:
Table8-7

PHASE Contraction RecoveryI RecoveryII Expansion Plateau
GOODS 1.
Healthcare
2.
Consumer
Staples
3.Foodand
Beverage
1.Interest
Sensitive
(banks,
homes,
electric
utilities)
1.Consumer
Durables
(autos,
appliances,
“bigticket”
items)
2.
Intermediate
Goods
1
Intermediate
Goods
2.Consumer
Discretionary
3.Capital
Goods
1.Capital
Goods
2.Consumer
Discretionary
3.
Transportation

Onepatternthatisworthnoting:bothconsumersandbusinessesfollowsimilarborrowing
patterns.Theconsumerswiththebestcreditwillbepurchasingthehomesandautosthat
stimulatetheeconomyinarecovery.Likewise,thelargestmanufacturerswiththeleast
operatingriskwillexpandwiththegreatestfinancialleverage.Paradoxically,asinterest
214

ratesrise,creditisevenmoreobtainableandlesscreditworthycustomerswillbepicking
uploanslaterinthebusinesscycle,albeitathigherrates.Thebasicreasonforthis
anomalyisthatpersonalandbusinessincomesdonotriseuntillaterinthecycle,thus
qualifyingcustomersforloans.However,theaxiomthatthemostcreditworthycustomers
needtheleastamountofcreditistrue;wealthybusinessesandpeopleusedebtasamoney-
makingtoolratherthanasanecessity.Individualsandcompanieswhoaretheleastcredit
worthy“somehow”enduppayingmoreinterestforloansbecausetheydidnotpossessthe
collateralearlyenoughinthe“game”whenrateswerelow.Thisrecipefordefaultcosts
financialinstitutionsbillionsbutnoalternativesystemseemspractical.Thesuccessful
firmswhofinancewithequitydosonotbecausetheycannotqualifyforloans,butbecause
itisthemostcosteffectivemethod,helpingtomaximizestockprice.Ontheotherhand,
firmswhohaveavolatilecashflowwillsometimestakeondebtwhencredittermseaseand
willsuffertheconsequenceslateintheplateauphase.This“survivalofthefittest”scenario
canbecombatedwithknowledgeofthebusinesscycleandappliedjudgment.
Thereadershouldnoticethattheriskpremium,thedifferencebetweenstocksand
therisk-freerate,alsomirrorssectorrotation.Attheprospectofacontraction,thereisa
“flighttoquality”,ageneralmovementintolowrisk,highqualitydebtinstrumentslike
treasuriesandAAAbonds.Thegreatercertaintyinthebondmarketattractscapitalaway
fromstocks.Asthemarketexpands,investorstakeonmorerisk,inflatingtherisk
premium,andstocksareagainfavored.Infact,atthetopofthemarkettherewillbe
investmentinjunkbonds,IPOs(initialpublicoffering)andeveninfirmswithoutany
earnings.Thishigherdemandfordebtinstrumentsintheinitialphasesoftherecovery,
makesdebtlessexpensiveinthecapitalstructure,butasriskpremiumsrise,firmscan
garnermorefundsfromanequityissuedespiteitshighercostbecausestocksarein
demand.Thissituationpresentsanotheranomaly:whendebtisindemandbyinvestors,it
isrelativelyinexpensivefortheissuingcompany,butwhenequityisdemanded,the
companymustpayahigherprice;therisingmarketraisestheriskpremium,andthecost
215

ofequityWhensuchanequityissueissupportedbyhigherearnings,bothbetaandthe
costofbankruptcyproceedtodrop-betabythedecreaseindebttoequityandbankruptcy
costsbyanearningsgenerateddecreaseindefaultprobability.
INDUSTRYRESPONSETOTHEBUSINESSCYCLE
Thefollowingindustriesrespond(notalwayspositively)totherespectivephase:
Table8-8Table8-9

1)CONTRACTION 2)RECOVERY
Utilities ElectricPower
ConsumerStaples PaperProducts,Forestry
Tobacco Chemicals
Food,Beverages Steel
Publishing HouseholdFurnishings,Autos,
Appliances
Drugs CrudeOil
Healthcare Banks
Apparel SmallMachineTools
Intermediateparts
DefenseElectronics
PollutionControl
WasteManagement

Table8-10 Table8-11

3)EXPANSION 4)PLATEAU
CapitalGoods AllTypesofMining
MachineTools OilRefineries
GoldMining TelephoneSystems
Tobacco CommunicationsEquipment
Beverages SpecialtyChemicals
Drugs Transportation
Cosmetics Aviation
OilEquipment Aerospace
ComputerSystems
FinancialServices

216

Table8-12

CROSSOVERSECTORS
INDUSTRY PHASES
Publishing Contraction,Recovery
Beverages Contraction,Recovery
Mining Expansion,Plateau
Oil Recovery,Expansion,Plateau
ElectricUtilities Contraction,Recovery
Tobacco Expansion,Plateau,Contraction
Drugs Contraction,Expansion
DefenseElectronics Recovery,Plateau

ECONOMICSIGNALS
Economicindicatorsaresomixedthatitisverydifficulttoachieveconsensusamong
leadingeconomists.Thedecisionstoinvestinacertainsectormustanticipateitseconomic
milieu,andmuchmoneyismadeinmakingacorrectforecast.However,oncethemajority
ofeconomistsagreeonthestateoftheeconomy,itisalmosttoolatetomoveintoasector
becauseallthemoneyismadethroughearlyanticipation.Theaverageinvestorcanbenefit
fromknowledgeofeconomicsignalsifonlyasaninstructionaltoolfor“whatnottodo”.
Chartsandtablessetuptheillusionthatanticipationofaneconomicphaseiseffortless,but
thesetablesdonotfunctionas“tealeaves”.Forexample,whywouldanyinvestorbuy
stocksonmarginwheninterestratesarehighduringaplateauphase?Iftheinvestorhasa
speculativebent,itismuchbettertotakeadvantageoflowinterestratesandspeculate
duringtherecoveryphase.Nooneneedstobeafortunetellertoalmostguaranteethat
interestrateswilldropduringacontraction.Thefollowingtablesgiveabriefoutlineof
whatsignalstoexpectineachphase:
217

Table8-13

CONTRACTION RECOVERY
1.GDPDeclinesasaNegative
Percentage
1.GDPPercentageChangeturns
Positive.
2..12MonthAveragePercentage
ChangeinFederalFundsRateturns
Negative.
2.12MonthAverageofIndustrial
ProductionChangebecomesPositive
3.ThepercentagechangeinM2turns
fromNegativetoPositive.
3.NonFarmPayrollsIncrease.
4.InterestRatesDecline. 4.InitialUnemploymentClaims
Decrease.

Table8-14

EXPANSION PLATEAU
1.InterestRatesIncrease. 1.TheMovingAveragefortheRateof
ChangeofIndustrialProductionturns
Negative.
2.6MonthMovingAverageintheCPI
(Inflation)turnsPositive
2.GDPDeclinesasaPercentageChange
(2%insteadof4%forexample)
3.NonFarmPayrollsIncrease 3.UnemploymentClaimsIncrease
4.12MonthMovingAverageoftheRate
ofChangeintheFederalFundsRate
turnsPositive.

5.6MonthMovingAverageoftheRate
ofChangefortheRealMonetaryBase
turnsPositive

218

ThearbitrarinessofsomeofthesesignalsisapparentifoneviewsanindicatorliketheCPI
inisolation.Insomeeconomiestherewillbeinflationandrecessionatthesametimeand
sotheaccelerationintherateofchangewillcertainlynotbeanexpansionphaseindicator.
Commonsenseandcoordinationofseveralfactors(somenotenumerated)willbethe
watchwords.Again,thepremiumisplacedonanticipationofthephase,butinvestmenton
thebasisofsuchindicatorsisinitselfariskyproposition.
(BacktoTableofContents)

219

9
OPERATINGRISK
Onemajoradvantageoftheinformationageisthatwecanobservethe
transformationofacademictheoryintopracticalapplication.Beforetheubiquityofthe
PC,datawasobtainedfromoldnewspapersandmicrofiche.Asquaintasthatmayseem,
investorswouldplotchartsoutofstockguides,sometimeslosingtrackofoverallobjectives
inpursuitofesotericdata.AcorrelationbetweenRandD(researchanddevelopment)
expendituresandnear-termsales,forexample,wouldbeconsideredtime-consuming
research,nottypicallyinitiatedbytheaverageinvestor.Ifacademictheorywasreadily
observableinthemarketplaceatall,itwasrestrictedtosuchgeneraltruismsas“higher
earningsleadtohigherstockprices”.Technologyhastransformeddata.Wecannow
obtaindetailedinformationofbothhighquantityand(somewouldargue)quality.
Althoughmorecommunicationhasalsocreatedtheexchangeofinformationwithdubious
qualitythatmostfindobfuscatingandconfusing,thegreaternumberofsourceshas
enabledustocomparedataandgroundourselvesmorefirmlyinthetruth.
Theonearea,inwhichthereislittlemoretransparencythantherewasin1965,isin
theaccountingforfixedandvariablecosts.TheSEC(SecuritiesandExchange
Commission)doesnotrequirecorporationstobreakdowntheircostsintofixedand
variablecategoriesinrequiredfinancialstatements.Althoughitisstandardpracticeto
itemizecostsbetweenfixedandvariable,confusionexistswhenassetcategoriesoverlapand
thetwocostsbecomeindistinguishable.Nevertheless,theFASB(FederalAccounting
StandardsBoard)andtheSEChasnotmadesuchdisclosuremandatoryalthoughitwould
immeasurablyaidtheinvestoringaugingrisk.Thedelineationofsuchcostsiscrucial,
becausethegreatestamountofcorporateactivityrestsentirelyontheconceptofoperating
riskanditsconcurrentmeasurement,operatingleverage.
220

Sincefixedcostsareoftenassociatedwiththetechnologicalinputsofabusiness-
thatismachinery,testequipment,andautomation-manyobserversconsiderthemimplicit
inthetypeofproductoneisselling,andalmostbeyondmanagement’scontrol.For
example,ifmybusinessrequiresaneutronparticleemitter,andallcompetitorshaveone,
thereislittlediscretion;Imustbuytheemitterandpaythefixedcostsformaintenance,
etc.Thus,thetypeofbusinessisthegreatestdeterminantoffixedcosts.Thisoperating
riskissometimesreferredtoas“economicrisk”;itismostaffectedbythebusinesscycle
andthetimingofdemandforthatcompany’sproduct,buttheneedforlong-term
commitmentofcapitalisalsoanimperative.Infact,theleveloftechnologycharacterizes
theamountoffixedcostsinabusiness.Asemiconductorfirm,forexample,willcompete
onthebasisofamuchhigherleveloftechnologythanadepartmentstore.Consequently,it
willbedeemed“capitalintensive”andhaveahigherleveloffixedcosts.Almostwithout
exception,operatingleverageprovidesthefoundationforstructuringabusiness;
marketing,finance,eventheaveragelevelofemployeeeducationisdependentonoperating
leverage,andespeciallytheamountsandconsistencyofitscomponentparts.
FIXEDCOSTSANDECONOMICS
Intheclassicbreakevenpointequation,Profits=Sales-VariableCosts-Fixed
Costs.Salescanbefurtherdifferentiatedinto(QuantityxPrice),andvariablecostscanbe
differentiatedinto(Quantityx(VariableCost/Unit)).Increasingprofitsisasimplematter
ofeitherincreasingsalesordecreasingcosts.Sincefixedcostsreflectthelevelof
automation,wouldreducingthemchangethenatureofthebusiness?Issuchreduction
possible?Theanswertobothquestionsisaffirmative.Theobjectiveofmanymergersisto
“share”fixedcosts,andthusreducetheircostperunitbyincreasingcapacity.However,
thebasicproductionprocessstillrequiresthesameinputsandremainsunchanged.Fixed
costsinsuchamergerwouldalsoremainstable,butthequantityofunitswouldincrease.
Onelookatthebreakevenequationdictatesthatvariablecostswouldincreaseaswell;this
221

proportionalriseinvariablecoststofixedcostslowerstheoverallrisktothemerged
company.
Another,muchmoreinsidiousreductioninfixedcostsoccurswhenproduction
processesquietlybecomeobsolete.Thegreaterthenoveltyandrelativecomplexityof
technology,thesmallerwillbeitssupply.Ifsuchtechnologyoffersacompetitive
advantage,itwillbeindemand,andcommandahigherpricemerelybecauseofitslimited
source.Whenaprocessisgraduallyimprovedovertime,itsrelativecomplexitydecreases,
becauseitcanbemoreeasilyduplicated,i.e.,moreindividualsjumpintoaprofitable
market,andthesourcesofsupplyincrease.Theresultisalowerprice.Eventually,the
supplyofthistechnologywillbegintoeclipsedemandforitbecause“newandimproved”
processesreplaceit,andtheoldtechnologybecomesobsolete.Industriesbecome“capital
intensive”becausethecompetitive“edge”goestothebusinesseswiththelatesttechnology,
whichmustbepurchasedat“anycost”.Suchcompetitionbecomesaratherexpensive
propositionforshareholderswhotendtoinvestinthesecompaniesatspecificpointsinthe
businesscycleandthenselltheirshareswhenthecostofcapitalclimbsandfurther
expansionisunwarranted.Thesecompanieshavealmostinvariablyhighoperating
leverage.
Highfixedcostsareabarriertoenteringamarket.Theyareafundamentalsign
thataprocessrequiressomuchcapital,thatonlyafewenterprisesarewillingtotakethe
riskandparticipate.And-usually-suchparticipationconnotesahigherprofitmargin
andhighunitprices.Ifthereisonemajorflawtothebreakevenpointequation,itisits
failuretocorrelatehigherfixedcostswithhigherprices.Whilepricesaredeterminedby
themarket,higherfixedcostsraisethebreakevenpointforsales.Sincesalesareafunction
ofbothpriceandquantity,atleastoneofthosevariablesneedstochange.However,when
technologyischeapenedtothepointwhereitssupplyisvastandunending,notonlydo
fixedcostsproportionatelydecrease,butthepricechargedfortheproductdecreasesas
well.Thus,profitsaredrivenbychurningoutmoreofaproduct;revenuesincrease
222

becauseunitquantitiesincreaseandnotbecausepricesrise.Asmoreparticipantsentera
market,vendorscutpricestomeetcompetition,whichwillmakeafirm’sinputsless
expensive.Thechainofcostreductioncontinues:cuttingafirm’sfixedassetcostswill
allowmoreparticipantstoenterthatfirm’sproductmarketalbeitatalowerprofitthan
waspreviouslyacceptable.Atthispoint,thefirmcanstampoutaproductthatwas
previouslydeemed,“hightech”,almostatwill.Infact,theveryeaseofproductionhas
allowednumerouscompetitorsintothemarket,forcingcompaniestocompetewithmore
“assetturnover”andlessprofitmargin.Eventually,ifdemandisstableandnotincreasing,
moreofagoodcanbeproducedwithlessinvestment,butbythistime,themarketwillbe
gluttedandpriceswillhavedeflated.
This“negativeeconomicsynergy”isoneofthebailiwicksoftechnologicalchange.
Itistheprimereasonthatcompaniesneedtoremainflexibleandwillingtochange.Ifa
companyisfixatedonaspecificmethodof“doingthings”,orencumberedbyalimited
numberofproductsandprocesses,itwillbedoomedbyalackofdiversification.No
companycanaffordtowaitfor“itstimeinthesun”,i.e.,atimeinthebusinesscyclewhich
favorsitssector.
Thisneedforcompetitivestrategieshasbeenthoroughlyanalyzedanddocumented
byMichaelPorter.Hisoutstandingresearchproducedthreegenericstrategiesthatmost
companiesemphasizeandshare:1)Costleadership2)Productdifferentiationand3)
Focusonnichemarkets.Eachstrategyusesfixedcostmanipulationtogainmarketshare.
Inthefirst,costleadership,acompanycanchargelowerpricesbecauseitcutsvariable
costsandspreadsfixedcostsovergreaterproduction.Anexamplewouldbeadepartment
storethatrentsunusedspacetoanotherbusinesslikeMcDonald’sorStarbucks.A
“partnership”arisesbetweenthetwocorporations,andthedepartmentstoreisspreading
outthesamefixedcostsovermorerevenue.Thesecondstrategywouldbeexemplifiedbya
semiconductorcompanywhocreatesanewchipforamedicalprosthesis,andtestsitwith
thesamedevicesitusesforchipsinPCs.Notonlyisthecompanyspreadingfixedcosts
223

overmoreunits,itisdiversifyingitsproductline,creatingalessriskycashflowand
changingthecharacterofitsoperatingleverage.Nichemarketsaresometimesspecialized
enoughtorequirehigherfixedcostsi.e.,theresearchanddevelopmentinpharmaceutical
companies,andnaturallyrequirehigherpricestocoverthosecosts.Asinthecaseof
“negativesynergy”,thenichestatuscandeteriorateovertimeiftechnologybecomeseasily
duplicable,andmanyparticipantsenterthesamemarket.Flexiblecompaniesmust
ordinarilyadoptallthreestrategies,sometimesemphasizingonetotheexclusionofthe
othersandsometimescreatingahybridofallthree.
THECASEOFCOMPAQCOMPUTER
Duringthe1990sthecomputerbusinessbecamesohotlycompetitivethatmany
companiesfellbythewayside.Becauseoffrequent“pricewars”,computersbecamevery
accessibletotheaverageperson.UserfriendlyoperatingsystemslikeWindows95from
Microsoft,createdacommercialenvironmentfortheInternetthatstimulatedshopping,
gameplaying,andsocialactivitiesaswell.However,suchaccessibilitycamewithapriceof
itsown:manyofthesecompanieswerewellmanagedandyetsawtheirprofitmargins
shrink.Fightingtokeeptheirheadsabovewater,consolidationbecameasurvival
mechanismratherthananopportunity.Compaq,aPCmanufacturerwhoswallowedup
theflounderingenterprisesystemmaker,DigitalEquipmentCorporation,battledto
remainviable,onlylatertoseeitselfswallowedup.Thecomputerindustrywaschanging–
inwhatseemedlikeananosecond.
Whilecomputersarecertainlyhigh-tech,theycanbeeasilyassembledfromaseries
ofmodules.Themodulesthemselvesarerelativelysophisticated,butonedoesnothaveto
bean“electronicswhiz”toconnectseveralofthesemodulestogetherandforma
computer.Increasingdemandforqualitycomputers(onesthatdidnotloseinformation
whenyouturnedonthevacuumcleaner),withgreater“meantimebetweenfailures”,
meantthatmachinerynolongerhadtobereplacedbecauseit“woreout”liketennisshoes.
Infactasstoragespacebecamegreatenoughtoeclipseourabilitytouseit,therewasless
224

ofaneedtoreplacecomputerswithan“upgrade”.Foryears,computerspeedneededto
keeppacewithevermoresophisticatedprogramming,andpartswerenotstandardized
enoughtobeinterchangeable.Inotherwords,puttingonemoduleontopofanotherwas
likeputtingChevypartsintoaFord:Itmightgetyoutothecornerstoreandback,butnot
muchfarther.Whenoperatingsystemsbecoming“userfriendly”andprogramsbecame
compatible,computersmarchedrightoutofthescientificlaboratoryandintotheliving
room.Computerswerenotonlyaccessible,theywerearequirement.
Frequentchangesintheproductionprocess,coupledwithanincreaseinmarket
participantsledtoaninflexibilitywithinthelargestmanufacturers.Custombuilt
computersbythelocalelectronicsstorecouldcompetewithhugePCmakerswhohadthe
addedburdenofhighfixedassetsandcosts.Forecastingdemandbecameahitandmiss
art,andunsoldinventoryforcedCompaqtoadoptanewdistributionmodelcalled,“the
distributionallianceprogram”;computerswouldbemadetoorderandnottoforecast.
Inevitably,computermakerswouldcompeteonthis“customstyle”basis,almostlikea
servicecompany.ManufacturerslikeDellstoppedsellingcomputersinstores,and
computergiant,Gateway,endedupclosingthemajorityofitsdistributioncenters.
THENATUREOFCOSTSANDMARGINS
Thetelltalesignofadeterioratingeconomicpredicamentissimplyfallingoperating
margins,measuredbyOperatingIncome/Sales.Notethatoperatingincomeinthis
instanceisbeforedepreciationandamortizationhasbeendeductedtoderiveEBIT
(earningsbeforeinterestandtaxes).Thebreakevenpointequationbestestablishesthis
relationship:
225

Table9-1

FIXEDCOSTS(FC)=100
SALES(S)=500
QUANTITY(Q)=100
PRICE(P)=5
VARIABLECOSTPERUNIT(VC/UNIT)=3
(PxQ)-Q(VC/U)-FC
(100x5)-(100x3)-100=100
OPERATINGMARGIN=100/500=20%
Aslongasfixedandvariablecostsarestable(thatisfixedcostsremainthesameand
variablecostsareastablepercentageofsales)operatingmarginswillincreaseassales
increase.
Table9-2

FIXEDCOSTS(FC)=100
SALES(S)=1000
QUANTITY(Q)=200
PRICE(P)=5
VARIABLECOSTPERUNIT(VC/UNIT)=3
(PxQ)-Q(VC/U)-FC
(200x5)-(200x3)-100=300
OPERATINGMARGIN=300/1000=30%

Noticethatquantityistheonlyvariablethatchanged.Aslongasmoreunitsarebeing
sold,variablecoststhatriseasapercentageofsales,donotadverselyaffectmargins.In
thenexttable,amere16.66%riseinvariablecoststotallydilutestheeffectofaone
hundredpercentincreaseinsales:Operatingmargindeclinesbackto20%.
226

Table9-3

FC=100
S=1000
Q=200
P=5
VC/U=3.5
(PxQ)-Q(VC/U)-FC
(5x200)-(200x3.5)-100=200
OPERATINGMARGIN=200/1000=20%

Overtime,operatingmarginsrisewhenthepercentchangeinsalesexceedsthe
percentchangeintotalcost,regardlessofthemixturebetweenfixedandvariablecosts.
Thetendencyinmostbusinessesisforfixedcoststobecomeasmallerpercentageoftotal
costsoverthelifespanofaproduct.Such“parity”wouldnotbedestructiveofmarginsif
onlyvariablecostsdidnotrisetocompensateforthereduction.Infact,variablecostsrise
asapercentoftotalcostsandevenaccelerateasfixedcostsdecline:increasedcompetition
“raisesthebar”andeachsaleinvolvesmoredistribution,advertising,packagingand
marketingexpenses.Theconceptisobviouswhenonewalksintoanysupermarketand
pricesgenericcornflakesvs.anamebrand.Thetwocerealsarenearlyidenticalin
productioncosts.Fixedcostsoftheprocessaresimilar,althoughsome“quality”premiums
arebuiltintothenamebrandthatwouldmakeitslightlymoreexpensive.Therealcost
differencesareinsuchthingsasTVadvertising,breadthofdistribution,endorsementsetc.
thatpushupthecosttoselltheproduct.“No-Brand”cornflakesneverhaveaprizeinside
inordertokeepcostslow.
Takentotheextreme,whentheincreaseintotalcostsisgreaterthantheincreasein
sales,operatingmarginssuffer.Insomeindustries,fixedcostsandnotvariablecostsare
theculprit.Theairlineindustry,forexample,hasneverbeenprofitableforanextended
periodoftime.Theircollectiveinvestmentinfixedassetsislarge,buttheirproductive
capacity,(seats)islimited.Whenaplane(afixedasset)carriesitscapacityof300people,it
227

cannotaddcapacityorspreadthefixedcostsofaplaneamongagreaternumberofunits.
Thatisthenatureofthetechnology,andalsothereasonwhyseatsarecreatedtoconform
tothedimensionsofarunwaymodel.Mostairlineshaverespondedbycuttingfrillssuch
aspillows,peanuts,andmeals,inanefforttomakeupinvariablecostswhatitmustspend
infixedcosts.
InCompaq’scase,ithadfinishedadealtobuyDigitalEquipmentandinvested
heavilyintheInternet(CMGIandAltaVista).Ultimately,Compaqwasplaguedbyan
overcapacityandresortedtotheaforementionedchangeinitsdistributionmodel.While
theseinvestmentswereimmediatelyextraneoustotheproductionofPCs,theyshowedthe
capacityofCompaqmanagementtoadapttoasituationthatwasrapidlygettingoutof
hand.The“higherups”couldseethewritingonthewall-theyneededtodiversifyanddo
sorapidly.However,bothfixedandvariablecostswererisingfasterthansalable
production,becausecompetitionhadloweredpricesandfloodedthemarketwithPCs.The
onlywaythatCompaqcouldhavemaintaineditsmarginswouldbetoeitherexpand
productionandsellatdrasticallyreducedprices,orcutitsvariablecostperunitenoughto
bringupoperatingincome.NeitherpathwasfeasibleanditwasnaturalforCompaqto
lookforamergerpartner,whichitfoundlaterinHewlettPackard.
FIXEDCOSTSANDTHEBREAKEVENPOINTFORSALES
Whilehigherfixedcostsactasabarriertoentry,theyalsoentailmoreriskbecause
raisingthemraisesthebreakevenpointforsales.TheidealsituationforCompaqwould
havebeentoeffortlesslyincreaseitscapacityandincurthecostincreasesthatwere
normallycontingentonexpansion-bysellingmoreunits,albeitatalowerprice.However,
Compaqneededtoincreasemarginsandcouldnotrelyonsalesalone.Suchastrategy
wouldhaveraisedvariablecostsinproportiontofixedandmarginswouldhavestabilized
ataverylowlevel.Nocompanycancutitsoperatingmargininhalfandcontinueto
operateunscathed.Thus,themainproblemwithCompaq’scostswerenotariseinfixed
costs,whichactedsolongasabarriertoentryandwerenowdiminished,butadeclinein
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pricingpowerthatwasderivedfromanaccelerationinvariablecoststhatreplacedfixed
costs.
Table9-4

FC=100 FC=200
VC/U=3 VC/U=3
Q=50 Q=100
PROFIT=0 PROFIT=0
PRICE=5 PRICE=5

Notethatwithoutpricingpower,acompanywouldhavetoraiseitsunitquantitywhen
fixedcostsrise.Acompanywhocanraisepriceswithoutcustomercomplaintisinafar
superiorpositionthanthosewhomustdowhatthemarketdictates.Itisfareasiertoraise
apricethantogearupproductionprocessesandchurnoutmoreunits,andyettheresultis
thesamewhenfixedcostsareraised;salesmustrisetomeettheincrease.
Theriskofraisingfixedcosts(orevenbuyingthestockofacompanywithhigh
fixedcosts)stemsfromtherelationshipbetweensalesandoperatingincome.Whenhigher
fixedcostsareincurred,asmallchangeinsaleswillcausealargechangeinoperating
income.Whilethisscenariomaysoundlikeaterrificprofitmakingventure,suchprofits
areonlycontingentuponthestabilityofsales,whichhasanalmostnegativecorrelation
withveryhighoperatingleverage.Forexample,autilitycompanywhohashigherfixed
costs(turbinesetc.)willalsohaveahighdegreeofsalesstabilitybecausetheirproduct
(electricity)hasademandduringdownturns.Ontheotherhand,asemiconductor
companywhomayhavethesameleveloffixedcostsfacesamuchmoredauntingtask
becausethedemandforitsproductismuchmoreelastic:bothbusinessesandconsumers
tendtodolesscapitalspendingtoupgradeequipment(orlifestyle)duringrecessions.In
factthevolatilityofstockpricesissomewhatdependentontherelationshipbetweenthe
amountoffixedassetsandthestabilityofdemand.Thosecompaniesfacedwithboth
higherfixedcostsandunstabledemand,willtendtohavehigherbetas,andanunstable
229

stockpriceaswell.Thus,fixedcostsareadoubleedgedsword;innewerindustries,they
actasabarriertoentryandpumpuppricesbecausethesupplyoftechnologyislow.But-
whenpricesfallduetocompetition,risingvariablecostsdepleteanyprofit.Theywillalso
destabilizeoperatingprofitbecausehighercapitalexpendituresareneededtomaintaina
highleveloffixedassetswhichwillalsorequireahigherlevelofsales.Sinceitisrareto
havesuchidealconditionsoccursimultaneously,thesecompaniestendtodoenormously
wellwhentheirrespectivesectorsarefavoredandthenlagbehindthemarkettherestof
thetime.
COMPAQCOMPUTER:THERESTOFTHESTORY
By1997,Compaqbegantoseemarginsdecline.Thecompanycouldnot
compensateformarketpricedecreaseswithadditionalsalesvolume.Desperatelyseeking
toincreasesalesandprofits,itacquiredUNIXoperatingDigitalEquipmentCorporationto
gainafootholdintheenterprisesystemsmarket.Inwhatwastermedthelargestcomputer
companyacquisitioninhistory,Compaqaddedittoitspreviouspurchase,Tandem
Computer.Enterprisesystemswere“bigticket”itemsincomparisontothecommoditized
PCindustry.Compaqsawthemasasteppingstonetoregainingoperatingmargins.To
understandthegravityofthesituation,twomeasurementsneedtobeintroduced.Thefirst
iscalledthe“capitalintensityratio”,whichmeasurestheimpliedamountofcapitalafirm
needs.Itismerely,TotalAssets/TotalRevenuesanddiscerningstudentswillnoticethatit
istheinverseofthe“assetturnover”ratio.Whenitiscomparedtobothyeartoyear
changeandanindustryaverage,ittendstorevealtheamountoffixedassetsand
consequentfixedcostsinacompany.Thesecondmeasurementisthenoncurrentasset
ratiowhichismerely,(TotalAssets-Currentassets)/TotalAssets,andlikethefirst,
measurestheamountoffixedassets,albeitinamoredirectmanner.Althoughthisratio
canbeobfuscatedbylargeamountsofintangibleassetslike“goodwill”,itcanofferagood
comparativesnapshot;itmustbereiteratedthattheinvestormustdeciphertheamountof
fixedassetsinacompanyassuchinformationisnotdirectlyproffered.
230

Table9-5

COMPAQ YearofDigital
Equip.Purchase
YEAR 1996 1997 1998
CAPITAL
INTENSITY
0.58125 0.5951 0.7395
NONCURRENT
ASSETRATIO
0.12908 0.1787 0.3412

TheDigitalEquipmentpurchasewaspaidforwithoverninebilliondollarsincash
andstockforwhatwas,atthetime,thelargestacquisitionincomputerhistory.The
“higherups”knewtheyweretakingamajorrisk,butrightfullybelievedthatapathto
highermarginsincludedmoreoperatingriskwithhigherfixedcosts;sucha“shotinthe
arm”wouldreformulatethecompanyawayfromhighquantity,lowleveragePCsand
towardanicheproduct-hugeenterprisesystemsthatcouldrunamajorcity.Notall
computersystemsarecreatedequal.Withthepurchaseoflargeamountsoffixedassets,
Compaqhadamonumentaltasktointegratethemefficiently.TheWindowsbasedPCs
wererapidlybeingreplacedbytheproverbial800poundgorilla-systemsthatwereboth
complexandmassive.
Hadtheacquisitionbeenconsummatedfouryearsearlierin1994,Compaqmay
havehadachanceofridingoutwhatwasabouttooccur:oneoftheworstmarket
correctionsinmodernhistory.Techstockswerecompletelyslammed.Whatwas
anticipatedtobea“normal”tentofifteenpercentdecline,increasedtofiftyandeven
seventypercentformanystocksinthetech-heavyNASDAQ.By2001,manystocksthat
hadsoldforeightyorninetydollarsasharecouldbepurchasedforaslittleastendollars.
Compaq’svaliantattempttoreviveitsprofitmarginswasdoomedtofailure.Inessence,
thehigherfixedcostsoftheDigitalEquipmentmergerentailedmorepotentialprofitbut
moreoperatingrisk.Sincethebreakevenpointforsaleswasrisingatthesametimethat
231

theeconomywasindecline,thehigheroperatingleveragejeopardizedCompaq’sposition:
Compaqneededtosellhighprofitenterprisesystemsjustastheeconomywasgongintoa
tailspin.ThelowerleveragefromPCmanufacturingcouldnothelpweatherthestorm
becausePCswereadiscretionaryitem,i.e.,theleveragewasnotlowenoughtomake
consumersbuytheseproductswhen“moneywastight”.Ultimately,amergerwithHewlett
PackardbecameCompaq’ssavinggrace.Theparadoxofseeingmarginsdecreasebecause
oftechnologicalchange,andthenanattemptathigherleveragefailbecauseofchangesin
thebusinesscycle,shouldnotbelost.WhathappenedtoCompaqwas“theperfectstorm”
inoperatingrisk.
OPERATINGLEVERAGEANDPREDICTION
Tounderstandoperatingleverageandtheconceptofasmallchangeinsaleshaving
amagnifiedeffectonoperatingincome,onemustrealizethattheratiohasmultipleuses.It
notonlydisplaystheriskofhigherfixedcosts,butcanpredicttherelationshipbetween
salesandoperatingincome.Thebasicratioisformedbysalesminusvariablecostsinthe
numerator,oftencalled“thecontribution”,andthendividedbyEBIT(earningsbefore
interestandtaxes)inthedenominator.Itshouldalsobeobservedthatthecomponentsof
EBITaresalesminusvariablecostsminusfixedcosts(S-VC-FC).Thetotalratioisthus:
S-VC/S-VC-FCorS-VC/EBIT.Simplystated,fixedcostsdeterminethemagnitude
oftheratio,becausetheothervariablesoccupyboththenumeratorandthedenominator
withthesamerelationship.
Thegreat“mystery”ishowtheseconcretenumbersactuallytransforminto
percentagechangevariableswhenwecompareoneyeartoanother.HowcanS-VC/
EBITturnintothebetaratio,%∆ ∆∆ ∆OperatingIncome/%∆ ∆∆ ∆Sales?Theexplanationis:if
variablecostsremainthesamepercentageofsales,andfixedcostsremaintruly“fixed”
(theydonotchange)thentheratioofS-VC/EBITattheendofthisyear,willmirror%∆ ∆∆ ∆
OperatingIncome/%∆ ∆∆ ∆Salesattheendofthenextyear,andthushaveapredictive
relationshipwiththosevariables.Sincetheratioisacompendiumofperhapsthousandsof
232

internalbreakevenpoints,itisdebatablewhetheroperatingleverageforanentire
companycanbepreciselymeasured.Thediscerningreaderwillnoticethattheconcrete
formoftheratiocanneverdropbelow“1”andyetmanycompanieshaveprocesseswhere
operatingincomepercentchangesarealwayslessthansalespercentchanges.Infact,just
bydiscontinuingonebusinesssegmentandaddinganother,acompanycanradically
changeitspercentages.Therefore,whatweobserveasinvestorswillrarelyconformtothe
academicideal.Sincecostsareneverpublishedintheformatof“fixed”and“variable”,
butmorelike“costofgoodssold”or“administrativeandsellingcosts”,theinvestorneeds
todoaclever“endaround”andinferoperatingriskfromstatisticalrelationships.By
observingthemeanandvarianceofoperatingmargins,sales,operatingincome,andcapital
intensity,overafiveyearperiod,wecanbetterunderstandtherisksofanyfirm’scash
flow.Someresearchreportsmaycontainspecificoperatingleverageinformationforan
industryoracompany.Whenwefindsuchinformation,wecomparethestabilityofactual
percentagestothisidealandtrytocoordinatetheleveragetrendwiththetypesof
productsafirmissellinganditsplaceinthebusinesscycle.Thesevariablesaredifficultto
predict,butahandfulof“astute”investorssawtheCompaqdebaclecomingandacted
withforesight.Itisnotimpossible.
CHARACTERISTICSOFOPERATINGLEVERAGE
WhilehigheroperatingleverageultimatelyincreasesthevariabilityofEPS,justas
financialleveragedoes,mostcompaniestrytominimizethisvariabilitybybalancingthe
twotypesofleverage.Thus,ifacompany’soperatingleverageishighitwillhavea
tendencytolowerfinancialleveragebyfinancingwithequity;moresharesissuedactually
diminishtheriskofunstablecashflow.Conversely,companieswithlowoperatingleverage
haveachanceofraisingEPSsimplybyfinancingwithmoredebt,whichtheycan
presumablydoifoperatingincomeisstable.Creditorsfavorthosecompanieswithstable
revenuesbecausetheriskofdefaultislower.Consequently,banksforexample,willcharge
the“primerate”tothecustomerswhoaremostcapableofpayingoffandrenewingloans-
233

firmswithlargeandstableoperatingcharacteristics.Thecyclecontinuesbecausethese
customerscanusemoredebtintheirrespectivecapitalstructureswheninterestratesare
lower.Thusoperatingleverageisthemajorsourceofmostothertypesofriskincluding:
financialleverage,politicalrisk,foreignrisk,inflationriskandevenrandomeventrisk.
Thetypeofproductoftendeterminesthescopeofrisk.Theelasticityofdemand
determinesthepercentchangeindemandbasedonapercentchangeinprice.Agricultural
products,forexample,usuallyhavelowoperatingleverageandmustbeproducedin
quantitytomakeaprofit.Sincepriceisdeterminedbyacompetitivemarketofmany
buyersandsellers,demandisunresponsivetopriceandtheseproductsarealmostinelastic.
Ontheonehand,mostpeoplewouldbuythesameamountofbreadifpriceswereto
increasebytenpercent.Ontheotherhand,ifpricesquadrupled,astheywouldina
famine,peoplewouldbuylessbread.Elasticityisnotcalculatedfornonnormalperiods,
andthenearinelasticityofbreadholds.Analogously,productswithhighelasticityimplya
higheroperatingleveragealthoughtherelationshipiscertainlynotcauseandeffect.
Vacationresorts,plasmatelevisionsandhigh-techexerciseequipmentallhavehigh
elasticityandwillseelargeshiftsindemandwhenpriceschange.Consequently,ahigher
fixedcostperunitwillbeimplicitintheirdevelopment.Stocksthatpertaintothese
productswilldowellinthebrieftimetheirrespectivesectorsarefavoredandthenlag
behindothersectorsintheinterim.Diversificationcansmoothoutthisrisk,buteachfirm
mustmaintainacorecompetency,i.e.,itwouldnotbodewellforamakerofexpensivegolf
clubstostartsellingbatteries.
Anothercharacteristicofoperatingleverageistheabilitytocombinedifferent
operatingleveragesandchangeariskprofile.Intheaboveallusiontobatteriesandgolf
clubs,thecombinationseemedcontrivedandawkward.However,duringthe1950sand
60s,suchcomboswerefrequentlytriedand“conglomerates”wereformedforthe
expressedpurposeofdiversifyingawayrisk.Unfortunately,asprocessesoverlapped,
inefficienciesoccurredthatdiminishedsalesandprofitforeachproduct.Corporations
234

wereunsureofwhatbusinesstheywerein.A“good”productfromanaveragecompany
wasdiscardedinfavorofa“great”productfromagoodcompany,andmanyfirmsbegan
torefocusduringthe1980sand90s.Such“reengineering”,oftenrequirednumerous
dislocationsanddownsizingsbutincreasedtheoverallflexibilityofthecompany.
“Outsourcing”and“partnerships”becamethebuzzwords,andinsteadofhavingagolf
clubcompanyowningabatterycompany,wewillwalkintoWal-Martandseeakioskset
uptoserveMcDonald’shamburgers.Insteadofplayingtenniswiththesalesmanager,a
salesrepmayplayvideogameswithaprogrammerinIndia.Thediversityincashflows
havebeenoffsetbydiversifyingtheprocesses,althoughfirmsstillattempttodiversifysales
withinanarrowerframework,a“niche”.
Finally,capitalbudgetingtimeframesareanimportantcharacteristicofoperating
leverage.Whenaventurecapitalisttakestheriskofinvestinginahigh-techoperation,the
payoffsneedtobemorerapidthaninalowoperatingleveragescenario.Onereasonthat
Americahasfailedtoinvestin“alternativeenergysources”(asof2008),isbecausethe
payoffisuncertain.Noinvestorwantstotieupcapitalforfiveyearsinthehopesof
doublinghisorhermoney“somewheredowntheroad”.Thereasonthatamajorproject
liketheinterstatehighwaysystemwascompletedissimplybecauseitwasundertakenby
thegovernment,whocanassumetheriskofahugefixedcostoperation.Privateinvestors
expectareturn,andwithhigherfixedcosts,thatreturnneedstobegreaterwithatleast
somemodicumofcertainty.Whiletaxbreaksandincentivescanstimulatesomeaction,
massiveprojectsrequiretheorganizationofmanyinvestors,andtoomanyotherprofitable
investmentopportunitiesaboundforthattooccur.
Moreover,investmentincapitalintensivefixedassetsinvolvestheriskof
obsolescence.Considerthatfixedassetsofteninvolveprocesseswithhightechnologythat
canrapidlybecome“newandimproved”andreplaceexistingtechnology.Withouta
rapidpayoff,theinvestorrisksbeing“eatenalive”bythecompetitionwhomayalready
havethenewtechnologyinplace.Thisbehaviorisreadilyobservableinwhichstocksget
235

“daytraded”andinwhatperiods.Whilethemantraof“buyandhold”servesawell
thoughtoutportfolio,manytraderswantto“getinandgetout”.Thereasonissimple.Ifa
pharmaceuticalfirm,forexample,ownsthepatentonamiraclecure,itwillbeashorttime
beforeitisduplicatedwithadifferent,“designer”formulabysomeothercompany.
Traderswanttogetinandthenleavethestockbeforethetechnologybecomesobsoleteor
duplicated.
OPERATINGTRENDSANDREVERSALS
Thefollowingsectionsaregoingtodiscussevaluatingthesizeandstabilityof
operatingcomponents.Whilestatisticsgiveusinsightintothequalityofsalesand
operatingincomeatanymomentintime,theycannotpredictthefuture.Wecanobserve
increasingrisk,butwecanneversaythatacompanyisaboutto“implode”.Infact,oneof
thehardestdecisionstomakeistofindacompanywithoutstandingsizeandstabilityof
operatingcomponents,andthenviewaperiodofdecliningmarginsasanarbiterof
investment;trendspottingrequirescoordinationbetweencompany,products,industryand
theoveralleconomy.Similarly,ifweseeincreasingmarginsoveralongperiod,weknow
thatsuchtrendsstopwhenmorecompetitionentersthemarket.Sometimes,onehasto
enterthemarketbeforeatrendevenstarts.Inaneedforcertainty,itistemptingto
formulatetrendrulessuchasneverinvestinginacompanythathasathreeyeardeclinein
marginsorlookingforareversalafterthreeyears.Suchrulescanblindaninvestortobig
opportunities.Thetrendinoperatingcomponentsmustbeseeninthecontextofanoverall
movementtowardatargetcapitalstructure;isolatingtrendsinoperatingmarginwillbe
selfdefeatingbecausetheinvestorwillbe“chasingearnings”,andnoanalystcanpredict
whensuchmomentumendsbyobservingoperatingcharacteristicsbythemselves.
THEQUALITYOFANOPERATINGMARGIN
Forlong-terminvestment,thesizeandstabilityofanoperatingmarginisoneofthe
determiningfactors.Weapplyboththemeanvariancemethodandthecoefficientof
variationtofiveyearsofoperatingmargindata.Whentwoinvestmentoptionsdifferin
236

thismeasurement,weusuallychoosetheonewiththelowestcoefficientofvariation.The
reasonthatthisissuchatelltaleratioisthatmostfirmswillgooutoftheircollectiveways
toensurethepreservationofthisfigure.Indeed,wesawhowCompaqevenmadeanine
billiondollaracquisitiontodoso.Thisratiodefinesthecompany-itsmarket,itsfunding,
anditsresponsetochangesinthebusinesscycle.Thefollowingtablespresentthe
operatingmarginsoftwocompaniesalongwithameanvarianceandacoefficientof
variationforeach:
Table9-6

INTUIT
YEAR 1997 1998 1999 2000 2001
Operating
Inc.
107 70.5 254 200 265
Sales 599 593 848 1094 1261
Operating
Mar.
17.86% 11.89% 29.95% 18.28% 21.02%

Table9-7

Statistic Methodology Result
Mean AverageofOperating
Margin
16.26
StandardDeviation Squarerootofvariance 11.09
MeanVariance MeanminusStandard
Dev.
5.17
CoefficientofVariation StandardDev.dividedby
Mean
0.6819

237

Table9-8

H.J.Heinz
YEAR 1997 1998 1999 2000 2001
Operating
Inc.
1096 1834 1412 1575 1282
Sales 9357 9209 9300 9408 9430
Operating
Mar.
11.71% 19.92% 15.18% 16.74% 13.59%

Table9-9

Statistic Methodology Result
Mean AverageofOperating
Margin
15.43
StandardDeviation SquarerootofVariance 3.129
MeanVariance MeanminusStandard
Dev.
12.14
CoefficientofVariation StandardDev.dividedby
Mean
0.2028

Heinz’s’marginsareassteadyandslowasitscatsup,whichiswhythecompanyhas
becomeaninstitution.Foraquickanddecisivesnapshotofoperatinghistory,thereisno
betteranalysisthandoingacoefficientofvariationonoperatingmargindata.Foramuch
moreminuteexamination,anacquisitionspecialistcoulduse60monthsofdata;moredata
pointstranslatesintomoreaccuracy.
ARISKYPROPOSITION:CONFIDENCEINTERVALS
Anydecisionmakingbasedontheextrapolationsofdataisveryrisky.Asinvestors,
ourinformationismuchmorelimitedthanthatofprofessionalanalysts.Ourfiveyear
timeframescontainalimitednumberofdatapoints,andfuturetrendsrarelymirrorpast
performance.Sowhymaketrendpredictions?Whytakethechanceandhaveto“biteour
lips”whenwearewrong?Statisticallyderivingapredictionintervalisnotthesameas
makingaprediction.Wearemerelyimplying,thatfromourverylimiteddata,thereisa
238

certainpercentagechanceofaneventoccurring.Weaddthisinformationtomanyother
indicatorsbeforemakingadecision,andcollectively,weconsidersmallsamplepredictions
tobetheleastreliable.Inourquestfora“ballpark”figure,wearelookingforasmany
diverseindicatorsaspossible.Someofthesewillbecontradictory,andsowewillhaveto
weighteachmeasurementonthebasisofreliability.Suchreliabilityisestablishedbythe
numberofdatapointsandthepropermethodology.Additionally,somedataissoskewed
thatnomeasurementismeaningful;inthatcasewemayuseanunreliableindicatoronlyto
confirmareliableoneRegression,forexample,isproperlyappliedtodatathathasa
“normaldistribution”.Wemayuseittoconfirminferencesaboutdistributionsthatare
anythingbut“normal”,butweshouldnotmakeittheprimarycriteriafordecision
making.
Toformconfidenceintervalsthatexpressvolatility,wetakethefiveyearmeanand
samplestandarddeviationsofoperatingmomentum,whichis%∆ ∆∆ ∆OperatingIncome/%
∆ ∆∆ ∆Sales.Toachievethisamountofdata,weneedsixyearsofconcretefigures,asweare
determiningfiveyearsofpercentagechanges.Wethenformconfidenceintervalsby
multiplyingthesamplestandarddeviationbyaTscore(seeStatisticsPrimer)andthen
dividingbythesquarerootofthesamplesize(5).Thisfigureisthenaddedto(or
subtractedfrom)themean,thusformingtheinterval.Ifourcurrentfigureliesoutsidethe
interval,weknowthereisaspecificpercentagechancethatitwillmovebacktowardthe
mean.Sincedataislimited,wetrytousethe99thpercentileasarulebecauseitwillbeso
extreme,andweneedtotrustasmallsample.Afigurethatwouldviolatethatextremea
constraint,wouldmostlikelyreverttothemean-butevenmoreimportantly,itsuggestsan
upheavalintheproductionprocessandgivesasignalforfurtherinvestigation.The
followingexampleisverytypicalofasmallsamplesize:
239

Table9-10

VARIABLE
YEAR 2000 2001 2002 2003 2004
Operating
Income%
20 29 17 14 19
Sales% 15 18 23 7 24
Operating
Momentum
1.33 1.64 0.739 2 0.79

Thestudent’sTscoreisverymuchliketheZscoreadaptedtoasamplesizeunder30.Like
thesamplestandarddeviation,itautomaticallyadjustsfortheexpectedvolatilityfoundin
smallersamples.Moreover,liketheZscore,itcoversapercentageareaofacurveby
multiplyingaspecificnumberbythestandarddeviation.Therefore,themeanplusor
minusanumberofstandarddeviationscoversapercentageareaofthecurve.EachT
scorealsocorrespondstothesizeofthesample,withasmallersamplesizeindicatinga
higherTscore.Ourownsamplesizeisfive(forthenumberofyears),andthefollowingT
scorescorrespondtothegivenpercentage:

Table9-11

PERCENTAGEN=5,4DEG.
FREEDOM
TSCORE
99% 4.604
95% 2.776
90% 2.132
80% 1.533
50% 0.741

Forthesampledata,weneedtodeterminethemeanandsamplestandarddeviationwhich
is1.294and0.53904respectively.Wedividethesamplestandarddeviationbythesquare
240

rootofthesamplesize,5,or0.53904/√5.Wemultiplythisnumberbythepercentage
confidencelevelandcorrespondingTscore,andthenadditto,orsubtractitfromthe
mean.At99%confidence,thisintervalwouldbe:1.294± ±± ±(4.604)(0.241)=1.294± ±± ±1.11or
0.184≤ ≤≤ ≤X≤ ≤≤ ≤2.404.Wecannotsaywithcertainty,thatifthenextoperatingmomentum
indicatorisnotwithinthesenumbers,itwillrevertbacktothemean,butsinceitwill
violatetheconstraints(0.184and2.404),wemaywanttodosomeextensiveexaminationif
weareseriousaboutinvestinginthiscompany.
Therelationshipbetweentheoperatingcomponents,salesandincome,determines
thecharacterofthecompany.Largepermanentincreasesinthesecomponentsarerare,so
thereisaheavyreversiontothemean.Anothermethodwecanapplyistodeterminethe
individualgrowthratesforsalesandoperatingincome,dividethem,andthencreatean
operatingmomentumoutofthequotient.Thismeanisnotatruemean,buta
characteristicmeanthatcanbeusedtocompareindustriesorindividualfirms.The
methodologyisasfollows:
Table9-12

GlaxoSmithKline
Year 1999 2000 2001 2002 2003
Operating
Income
2702 5190 5508 8498 7365
Sales 8490 18079 20489 21312 21441

Todetermineanestimatedgrowthrate,weformaratiooftheneartermfigureinthe
numeratorandthefartermfigureinthedenominator.Wethen"exponentiate"thisfigure
withtheinverseofthenumberofperiodsbetweenyears(4).Theinverseof4is1/4or0.25.
Thusforsales,thegrowthratewouldbe:(21441/8490)^0.25or1.2606.1.2606isthe
growthrateandifwesubtract“1”,wedeterminethepercentagegrowthrateof26.06%
peryear.Foroperatingincome,thefigureis(7365/2702)^0.25or1.2849fora28.49%
growthrate.Dividingthetwo,wedeterminethecharacteristicoperatingmomentum:
241

(28.49/26.06)=1.0932.Noticethatwedidnotproclaimthepredictedgrowthratesof
eithercomponent,butusedtheresultstoformamoremeaningfulnumber;theprobability
thattheoperatingmomentumwillbearound“1”isfargreaterthantheprobabilityofsales
increasingbyexactly26.06percentinthefollowingyear.
OPERATINGBETA
Thecapitalassetpricingmodel(CAPM)isveryadaptable.Whilenotprecisely
accurate,themodelisflexibleenoughtocompriseawidevarietyoffinancialassetsandwill
relatethemtointeractionsbetweentheriskfreerate(government),themarket(many
buyersandsellers),andtheindividualasset(beta).Althoughsomewouldarguethatthe
modelisinherentlyunstableandrevealsonlyafleetingglimpseoffinancialtruth,others
woulddeclarethatthisvolatilityreflectstherealityofconstantfinancialchange.
Acorporationcanbeviewedasaportfolioofassets,eachwithitsownresponseto
economicandfinancialrisk.Thus,onedivisionofanoilcompany,explorationfor
example,hasadifferent“beta”thananotherdivision.Thecollectivesumofbetasfrom
eachdivision,weightedbyassetvalue,willmakeuptheoverallcorporatebeta.Canwe
filteroutthefinancialriskandfindabetathatpertainstooperationsalone?This
theoretical“unlevering”ofthecompanywaspursuedbyboththeteamof
Miller/ModiglianiandHamadawellbefore1975.Theyfoundthattheycouldextractthe
financialriskfrombetaiftheyfactoredinthedebttoequityratioaswellasthetaxrate.
Themathematicaleaseofdoingsodependedonthelinearityofthefunction,andthe
CAPMisconvenientlyastraightline.Nevertheless,evena“ballpark”riskmeasurement
foroperationsopensupinnumerableotheroptionsbecausesalesandprofitcanbebetter
relatedtothecostofequity.Suchameasurementcanbeusedformergersand
acquisitions,performanceevaluation,andevenfortheevaluationoffirmsthatarenotin
themarketandwhichneedanestimatedbetaforcomparison.
THEUNLEVEREDBETAEQUATION
Theconsensusequationissimpleandisjust:
242

UnleveredBeta=CurrentBeta/(1+[(1-T)(MVDebt/MVEquity)]).MVis“market
value”,whileT=taxrate.Usingbookvaluesinplaceofmarketvaluesistheoretically
improper.Inourexample,wehavemadeupascenariowherebookandmarketvaluesare
thesamefortheeaseofcomputation.Inprofessionalriskmanagement,anydeviationfrom
theidealwouldbeconsideredunsound.
THEARDCOBARBELLCOMPANY:ANEXAMPLEOFUNLEVEREDBETA
TheArdcoBarbellCompanyneedstoexpand.Thereislimiteddemandforold
fashionedweightsalthoughthecompanykeepsitsleveragehighbyofferingnicheproducts.
Thecurrentbetais1.4andthecompanyuseslittledebt,about10/40,or0.25debttoequity.
Themarketvalueisthesameasbookequityinthiscase–40million.Withataxrateof35
%,whatwouldbeitsoperatingbeta?
Table9-13

VARIABLE
BETA 1.4
DEBT/EQUITY 0.25
TAXRATE .35OR35%
UNLEVEREDBETA 1.4/(1+[(1-.35)(0.25)])=1.204
TheArdcoBarbellCompanytakesontwoacquisitions:
• 1)Achainofgymswithabetaof1.6andadebttoequityof40/20or2.Themarket
valueofthisenterpriseis20million.
• 2)Atennisracquetcompanywithabetaof1.1,amarketvalueof10Million,anda
debttoequityof5/10or0.5.Bothtaxratesare35%.
Thelogicbehindbetasisthatiftheyareaddedlinearly,wecandeterminetheoperating
betaofeachunit;allweneedtodoistoweighteachbetabyitsassociatedmarketvalueto
deriveacombinedtotal.
Step1:Findtheoperatingbetasofthenewacquisitions:
GYMCHAIN:1.6/(1+[(1-.35)(2)])=0.696
TENNISRAQUETCOMPANY:1.1/(1+[(1-.35)(0.5)])=0.8301
243

Step2:Multiplyeachoperatingbetabyitsmarketvalueweight.
Thecombinedvalueis40+20+10=70
(40/70)(1.204)+(20/70)(0.696)+(10/70)(0.8301)=1.0037.Thisistheoperatingbetaofthe
newcompany.
Step3:We“lever”thebetabackuptoreflectthenewdebtposition.Noticethatthe
combinedcompanyhas10+40+5=55indebt.Forillustrativepurposes,weassumethese
companieswerepurchasedwithcash,butArdcocouldhaveincurredmoredebttobuy
thesecompaniesandwecouldhaveadjustedthatpropositionintoouranalysis.The
equationis:
(UnleveredBeta)(1+[(1-taxrate)(MVDebt/MVEquity)])=NewCombinedLeveraged
Beta
(1.0037)(1+[(1-.35)(55/70)=1.5163
1.5163isthenewlycombinedbeta.ItishigherbecauseArdcohadtoassumethegym
chain’sdebt.ThebenefitofdiversificationcanbeobservedinArdco’smuchlower
operatingbeta(1.0037vs.1.204),whichtheyhopewillcontributetopayingoffthelarger
debtobligation.
The“topdown“approachtobetawouldmultiplyeachseparateleveragedbetaby
weightedmarketvaluetodetermineafinalbeta.Inthiscase,thatbetawouldbe
(40/70)(1.4)+(20/70)(1.6)+(10/70)(1.1)=1.412.Whichapproachismorevalid?Whilethe
“topdown”approachismoreconventional,itassumesthatseparateentitiesarecorrelated
bymarketvalueandbetaresponse.Weknowfrompreviouschaptersthatthecoefficient
ofdetermination,R
2
,isusuallyavaluebetween0.2and0.4,andthatthe“alpha”
componentsometimessupersedesthebetacomponentinimportance;weoftenassumethat
thecorrelationfactorisstrongerthanitreallyis.Sinceweusetherequiredrateofreturn
todetermineacostofequityandnotforpredictions,theeffectofalowcorrelationgets
bufferedintheanalysis.However,the“topdown”approachassumesthata“singleindex”
marketcorrelationisvalidenoughtocapturethediversificationeffectsofacombined
244

company.Ontheotherhand,theleveredbetatechniqueassumesthatbetaismadeupofa
mathematicalsumofoperatingriskandfinancialriskwithoutadditionaloutliers.Thisis
anoversimplification,butisvalidforthepurposeofanalysis.Infact,betaismadeupof
somerandomfluctuationsintheeconomy,statistical“noise”,andotherundetermined
factors.Sincebetaisunstable,aconsensusaveragebetween“topdown”andlevered
approachesissufficient.
“MOMANDPOP”STOREBETAS:COMPANIESWHOARENOTONTHEMARKET
Mosttransactionsarenotenactedwithinacorporateenvironment.Anexample
wouldbealocalbuildingcontractorwhowantstoaddaroofingcompanytohisportfolio.
Thesebusinessdealsarenotglamorousbutareverytypical,andneedtobeevaluatedfor
risk.Toexaminethem,analystsuseoneoftwoapproaches:1)Anaccountingbetacanbe
determined.SalesorincomedatafromthebusinessisregressedagainsttheS&P500(or
appropriateindex)aspercentagegainsandlosses.Aftertheaccountingbetaisdetermined,
itisunleveredfordebt,andanoperatingbetaisderived;bookvaluesmustbeusedinstead
ofmarketvaluesandweassumetheyarethesame.2)Theanalystusesthe“pureplay”
technique.Theinvestortakesthebetasofthethreelargestmarket-tradedbusinessesinthe
sameindustry,leversthemdownusingtheaveragedebttoequity,andderivesan
unleveredbeta.Anexample:
TheArdcoBarbellCompanynowhasabetaof1.52,amarketvalueof70,andadebtto
equityof55/70.Itwantstobuyachainoftanningsalonswithnoactivelytradedmarket.
Thesalonshaveadebttoequityof15/20andapriceof40Million.Thethreelargest
activelytradedcompetitorsare:
Table9-14

COMPETITOR SMITH BRONZE FRYE
BETA 1.8 1.9 2.1
DEBTTO
EQUITY
2 3 3.5
MARKETVALUE 60 60 40
245

Thecombined“topdown”betais(60/160)(1.8)+(60/160)(1.9)+(40/160)(2.1)=1.913
Theunleveredbetaforthishypotheticalcombinationis1.913/(1+[(1-.35)(2.8333)])=
0.673.
Notethatthe2.8333figurewastheaveragedebttoequityforthethreefirms.Alsonote
thatfinancialleveragecanhaveasignificanteffectonbeta.Withoutdebt,thethreefirms
haveanoperatingbetaofonly0.673whichseemedso“safe”thattheypiledonthefinancial
leveragetoimproveEPS.
Thus,theoperatingbetaofthenewfirmisonly0.673.Thefirmisveryattractiveto
Ardcobecausetheyhavesolittledebtinanindustrythatseemstothriveonit
(hypothetically).Toformacompletelyleveredbeta,wemultiplytheunleveredbetabythe
firm’sdebttoequitymultiple:Thatis(UnleveredBeta)(1+(1-.taxrate)(D/E))
Thecompletedbetais0.673x(1+(.65)(.75))=1.00111.Theacquisitionisprobablya
“young”firmintheindustry,andhasnotestablisheditselfenoughtoincurthemassive
amountofdebtofitspeers.ThisisanopportunityforArdco,andtheyimmediatelysnatch
itup.
OPERATIONSRESEARCHFORTHEINVESTOR
Mostinvestorsdonothaveaccesstodetailedcorporatedatathatitemizesthetypes
ofassets(prepaidinsuranceforexample)orthetypesofprojectsthatneedcapital
budgetingattention.Thereisabondofmutualtrustbetweentopmanagementand
shareholderswhenacquisitionsaremade;synergyhasbeenevaluatedandtherisksofa
purchasehavebeenevoked.However,goodmanagementisfearless.Theywelcome
questionsfromtheleastofemployeesandthesmallestofinvestorsbecausethereisan
objectiveprinciplethatsubstantiatestheirposition.
Partofriskmanagementistofindbalanceandcommongroundbetweentwosetsof
data.Whenacquisitionsaremade,theremaybeahistoryofoperatingincomeandsales
forbothcompanies,andtheinvestorcanusethisquarterlydatatomeasurethecovariance
246

betweenpercentchanges.Iftheacquiringcompanyishighrisk(operatingandfinancial
leveragesarehigh),alowcovariancewillindicateastrategyofriskreduction.
Analogously,alowriskcompanymayattempttostepupitsprofitmarginbytargetinga
companywithahighcovariance.Otherstrategiesinclude:sectortiming.Ahighrisk
companymaywanttotargetanotherhighriskcompanyifthatsectorisanticipatedto
growassoonasassetsareefficientlyintegrated.Sincefewcombinationscanbethis
strategicallyfacile,theinvestorneedsto“looktwice”,whenthisscenariooccurs.Similarly,
whenalowriskcompanybuysacompanywithlowcovariance,itmaynotneedtheimplied
diversificationasmuchasitneedstoseekouthighprofit,“riskier”,projects.Thenatural
inclinationistotrustoperationstothosewhoknowitbest;theyoftenhavelargestakesin
thesuccessofamerger.Nevertheless,askingquestionsistheprerogativeofthe
shareholder,anddoingsowillhelpmanagementaswell.
Thefollowingexamplecontinueswithatableofcashflowdata,comparingArdco
Barbellwiththeproposedacquisitionofyetanothertennisracquetcompany,andalsoa
vitamincompany.Themeans,standarddeviationsandcovariancesareatthebottomof
thechart.
Table9-15

QUARTER(Period) ARDCOBARBELL TENNISRAQUET VITAMINS
1 22 14 20
2 17 10 16
3 19 9 18
4 31 11 25
5 14 21 12
6 15 24 13
7 22 20 14
8 26 30 19
9 15 31 17
10 11 32 4
Mean 19.2 20.2 15.8
StandardDeviation 6.106 8.94 5.61
R(withArdco) -0.5882 0.77294
COV -32.108 26.477

247

*ALLDATAAREPERCENTCHANGES
Inthisshortenedexample(atleast20quartersshouldbeused),itisobviousthatthe
vitamincompanyismoreriskyfromadiversificationstandpoint.Ontheotherhand,the
tennisracquetcompanysellstennisracquetsinthespringandsummer,whileArdcosells
fitnessequipmentinthewintermonthsaspeople“getinshape”forsummer.Also,the
chainofdistributorswouldbesimilarforArdcoandthetennisracquetcompany,butthere
wouldbeaneedfornegotiationswithahealthfoodchainifthevitamincompanywere
purchased.Additionally,anyfixedassetsfromthevitamincompanywouldbeuniqueto
thatmanufacturingprocessandwouldneedtobeseparatedfromArdco.Similarly,trucks
andwarehousesthatcarryfitnessequipmenthavedifferentprioritiesthatmaynotinclude
themoredelicatestorageofvitamins.Therefore,Ardcomakesthedecisiontopurchasethe
tennisracquetcompany-and-triestoputitslabelongenericvitaminswithanother
companyinchargeofdistribution.
TWOMASTERS:FISHERANDBUFFETT
Twoofthegreatestanalystsofoperatingriskdisplayedanalmostintuitive
quantitativesense.Theywerewellknownforstrategicinvesting,butshareda
mathematician’sperceptionforminutedetail.TheyarePhilipFisherandWarrenBuffett.
PhilipFisherwasafinancialanalystduringthedepthsofthedepression-almosta
prerequisitefortenacity-andascendedfromthatmorasswithdedicationandvision.His
book,CommonStocksandUncommonProfits,becamea“mustread”inthefinancial
community.Hisbestknowntenetwastoevaluateacompany’slong-termprospectsby
studyinggrowthandsalespotential,andthenfavoringthosecorporationswhowere
dedicatedtoproducingatthelowestcost.Thisqualitativeapproachhadasitsfoundation,
athoroughknowledgeofmanagementskillsandmanufacturingprocesseswhichFisher
wouldexhaustivelyresearch.Fisherrejectedwhathetermed,“marginalcompanies”-
thosethatshowedhighprofitsduringeconomicupswings,onlytolagbehindintherestof
thebusinesscycle.
248

Fisheralsoexcelledindetectingoperatingsynergy-areasofgrowthinwhich
productsorprocessescomplementedeachother.Forexample,whiletheaverageinvestor
mightnoticeanagingpopulationandinvestinnursinghomes,Fisherwouldhaveinvested
intheproductsandservicesneededtooperatethosehomesandthatwereusedin
collaboration-perhapsdisposableneedlesand“sharps”containers.Twoofthebest
examplesofthisacumenwereinvestmentsinDuPontandAlcoa.DuPontwasa
gunpowdermanufacturerwhostandardizedprocessesandwentontoproduceunique
syntheticmaterialslikecellophaneandLucite.Inaddition,theirmanagementteamwas
responsiblefordevelopingthepreliminaryanalysisusedtoevaluatecapitalstructure,the
aforementioned“DuPontequation”.Alcoawasanaluminumcompanywhocapitalizedon
theairplanemanufacturingthatwasattheforefrontoftechnologyinthe1930sand40s.
Bothcompaniesremainedflexibleandadaptedtheiroperationstonewproductdemand
andtechnologies.
WarrenBuffettisinaclassbyhimself.Fewinvestorshavematchedhisdedication
togaugingriskandpositioningforlong-termgains.Curiously,hedoesnotfretatallabout
economicfluctuationsorFederalReserveactions,andappearstohaveunbridledfaithin
thenotionofa“goodidea”.However,hedoespossessaneconomist’sinsightaboutmost
macrotopics,includinginflation.Hisnaturalinclinationistoavoidcompanieswithlarge
amountsoffixedassets,becauseinitialrisesinassetturnoveraredepletedwhencapital
expendituresfinallyneedtobemade.Inflationactslikeasmokescreenblindingthose
firmswithahighpercentageoffixedassets,becausesaleswillinitiallyoutpacetheneedfor
investment.
AsecondmajorprincipleofBuffett’sistoinvestinfirmswithconsistentoperating
history.Hereasonsthatthosecompanieswhoareintheprocessofamajorchangein
operationsarenotgoodinvestmentprospectsbecauseofhigherrisksassociatedwithcost
andrevenueinconsistencies.
249

Thirdly,andmostimportantly,Buffettseeksoutcompanieswithwhatheterms,
“economicgoodwill”.Thesearecompaniesthatproduceaboveaveragelong-termprofits
becausetheypossess“franchisevalue”-theabilitytoraisepriceswhenneeded.Theytend
toproduceunregulatedproductsforwhichthereisnoclosesubstitute,andofteninducea
“brandloyalty”amongtheircustomers.Appropriately,Buffettshunswhathecalls
“commoditytype”businesses-lowprofitbusinessesthatchurnoutundifferentiated
products.Hereasonsthatthesebusinessescanonlycompeteonthebasisofpriceandcan
onlyprosperduringtherareeventofashortsupply.
Whilemostanalyststreatthefutureasanextensionofthepast,bothBuffettand
Fishercreatedadifferenttypeofmentalcalculus.Theyappearedtocomparetheratesof
changeamongseveralvariableswhichcoalescedintoaninvestmentstrategythatproduced
long-termgainsamongmanycommonlyknownbrands-Coke,TheWashingtonPost,
ABC,Etc.Buffetsdesireforboth“pricingpower”andoperatingconsistency,seemsto
seekacompanywithahighbutconsistentoperatingleveragethatwillnotdeflateatthe
prospectofadownturn.Hightechnologyfirmswouldbeeliminatedbythatconstraint,but
“niche”companieswhohavecreatedabrandconsciousnessamongconsumerswouldnot.
Ahigh“mean”andalow“standarddeviation”amongbothoperatingmomentumand
operatingmarginswouldmeetthatobjective.However,asmallcapitalintensityratio(one
withoutalotoffixedassets)wouldalsofitBuffett’sobjective,exceptthattheseoften
designatethevery“commoditytype”industriesthatheavoids.Naturally,aproductive
balanceisimplementedwhentheseseveralconstraintsaresatisfied,butsuchastrategic
combinationisdifficulttofind.
ABRIEFOPERATINGANALYSISOFFED-EXANDSTAPLESFORTHEYEAR2000
Mostanalystsexaminecompaniesinthesameindustries,becauselargedisparities
maybemoreindicativeoftheindustryratherthanthecompany;thereissamplebiaswhen
differentcompaniesindifferentindustriesarecompared.Theneedforprecisionrequires
focus,butwhenonecompanyissubjecttoforces(demand,legislation,tradebarriers)that
250

theotherisnot,theanalystcannotformvalid,actionableconclusions.Weclosethis
chapterbysummarizingourindicatorsthroughanalysisoftwoseparatecompaniesintwo
separateindustries.Whilesuchcomparisonisstatisticallyunconventional,itisrealistic
fromaninvestor’sperspective.
WeofferafiveyearoperatinghistoryofbothFed-Ex,thenextdaytransitspecialist,
andStaples,theofficesupplyfixture.Salesandoperatinggrowthisdetermined,andthen
changesinfixedassetsandcapitalintensityarederived.Finally,wedomean-variance
statisticsontheoperatingmarginsofeachcompany.Thethemethatrunsthroughthe
analysisisthechoicebetweengrowthandstability.Aretherisksofslowinggrowthgreater
thantheeffectofstagnation,forexample?Doesaperiodoflonggrowthpreclude
investment,i.e.,notgettinginsoonenough?Whenthestatisticsbecomecontradictory,we
addsome“qualitative”analysisandtrytoperceivethesituationasFisherorBuffettwould.
STAPLESANDFED-EXOPERATINGHISTORIES1994-1999
Table9-16

FED-EX
Year 1994 1995 1996 1997 1998 1999
Sales 9392 10274 11520 15873 16773 18257
Op.
Income
1244 1344 1477 2047 2198 2376
Current
Assets
1728 2133 2880 3141 3285
Total
Assets
6699 7625 9686 10648 11527
Table9-17
Fed-ExBeta

BETA(2000) 0.98
EQUITY(2000) 8191
DEBT(2000) 1899

251

Table9-18

STAPLES
Year 1994 1995 1996 1997 1998 1999
Sales 2000 3098 3968 5181 7123 8937
Op.
Income
110 191 260 355 514 708
Current
Assets
926 1151 1666 2064 2192
Total
Assets
1403 1788 2455 3179 3814
Table9-19
StaplesBeta

BETA(2000) 1.03
EQIUITY(2000) 1837
DEBT(2000) 2152
ANALYSISANDSTATISTICS
Allbetasarenotcreatedequal.Withoutunleveringthebetas,wecanreadilyobservethat
Staples’operatingbetaislowerbecausetheyhavemuchmoredebtintheircapital
structure,andyetbothcompanies’betasarenearlythesame.SinceFed-Ex’soperations
areorientedaroundtransportation,whichrequiresaheavyinvestmentinfixedassets,
Fed-Exhasmoreeconomicrisk.Additionally,theyareexposedtotheriskofhigherprices
intheoilmarketwhicharetotallyoutofthefirm’scontrol.Theseareinherentrisksthat
comewiththenatureofthebusinessandcanonlybeminimallydiminishedby
diversification.However,aswewillobserve,Fed-Excompensatesforthisdetrimentwitha
highlevelofefficiencyandstability.
252

Table9-20

FED-EX
Percent
Change

YEAR 1995 1996 1997 1998 1999
Operating
Income%
8.04 9.9 38.59 7.38 8.1
Sales% 9.39 12.13 37.79 5.67 8.85

Table9-21

Staples
Percent
Change

YEAR 1995 1996 1997 1998 1999
Operating
Income%
73.64 36.13 36.54 44.79 37.74
Sales% 53.4 29.34 30.57 37.48 25.47

ThefollowingtabletabulatestheextraordinarygrowthofStaples’salesandoperating
incomeandcomparesitwithFed-Ex’sratherordinarygrowth.However,whatthe
investorshouldobserveissustainability.Nocompanygrowsattwentypercentforever.
Althoughthegrowthoccurredinthecontextofalongbullmarket,fivetosixyearscanbe
thelengthofanentirebusinesscycle.Staples’growthwasderivedfromastructural
changeinthewayAmericadidbusiness:theInternetspawnednumeroushomebusinesses
thatneededsmallamountsofofficesupplies.Suchatransitionwouldnottakenearlyas
longasIBM’s,forexample,whichcomputerizedentireindustries.Competitionwould
cropupeasilyinofficesupplies,butnotinindustrieswhichrequiredhugeinvestmentsin
fixedassets.Thus,whileStaples’growthratelookedlikeatemptinginvestment,itwould
havebeenfarriskiertoputcapitalintoitin2000thanin1996or1997.
253

Table9-22

FED-EX MEAN-
VARIANCE
STAPLES MEAN-
VARIANCE
SALES 1.697 SALES 24.22
OP.INCOME 0.898 OP.INCOME 29.797

*Wemeasuremean-varianceas(mean-standarddeviation)whichisatypicaladaptation.
Table9-23

AverageOperating
Momentum
Lastyear(1999)operating
Momentum
FED-EX 0.99 0.915
STAPLES 1.265 1.4817

Staples’growthisbothhighandsteady,anditwouldbeeasyforaninvestortobedeceived
bytheseoperatingstatistics.Incapitalstructuralism,ourdesireisalwaystoanticipate
growthandneverto“chase”it.Capitalizingonanoverlylonggrowthcycleisreservedfor
the“lucky”few;ahandfulofinvestorscanmakemoney“withoutknowinganybetter”,
becausetheyhappentobeintherightplaceattherighttime.Whilethereismoneyinhigh
riskmomentumtrading,itisnotrecommendedforeventhemostskilledinvestors,because
itissuchagamble:theoddsarebetterplayingblackjackinLasVegas.However,there
maycomeatimewhentheinvestorobservesthreetofouryearsofgrowth,andmayhave
informationaboutmovementtowardanoptimalcapitalstructure.Atthispoint,both
equityandthecostofequitymaybelowenoughtojustifyinvestment.Theinvestor
appearstobecapitalizingonmomentum,butisnotinvestingonthecriteriaofprior
growth:heorshehascorrectlyanticipatedaprofitablechangeincapitalstructurewhich
shouldbeactualizedbyajumpineconomicprofit.
THECONFIDENCEINTERVALTOOL
254

Whenwesightaneartermnumberthatisuncharacteristicofothersinthe
sequence,itiscauseforconcern.Newdevelopments(changesincostsordemandfor
example),mayaffectourinvestment.Therefore,werecommendusingthe99%confidence
intervaltogaugeanyodditieswemayencounter.Withsmallsamplesizes,itissuspectasa
measurement,butwemerelyuseitasachecktoseewhetherfurtherinvestigationneedsto
bedone.Thefollowingcapitalintensityandnoncurrentassetratiosapplytothe
companies:
Table9-24

FED-EX
YEAR 1995 1996 1997 1998 1999
Capital
Intensity
0.652 0.662 0.61 0.6348 0.6314
Non
Current
AssetRatio
0.7421 0.7201 0.7027 0.705 0.715

Table9-25

STAPLES
YEAR 1995 1996 1997 1998 1999
Capital
Intensity
0.457 0.4506 0.4796 0.4463 0.4267
Non
Current
AssetRatio
0.3399 0.3562 0.3214 0.3492 0.4252

Alloftheseratioslookliketheyareinanorderlysequence,exceptforthe1999valueof
noncurrentassetsforStaples.At0.4252,itislargerthantheothers,andwouldbethe
mostlikelytoaffectourpotentialyear2000investment.Wedecidetosubmitittothe
student’sTtestandderiveconfidencelimitsat99%.
Table9-26
255

STAPLES
NONCURRENTASSETRATIO
Mean 0.358396
SampleStandardDeviation 0.03956
SampleSize 5
DegreesofFreedom 4
SquareRootofSampleSize 2.23606
Student'sT 4.604
ConfidenceInterval 0.358+/-(4.604)(0.03956)/2.236

Thelimitsoftheintervalare0.2765onthelowsideand0.4394onthehighside.Since
0.4252isbetweenthatinterval,wewillnotinvestigatethemeasurementanyfurther.
However,theeccentricityisevenmoreevidentbecausethislastnumberispartofthe
sampleitself.Also,thelargechangeinnon-currentassetsisnotconfirmedbyajumpin
capitalintensity.Ifbothmeasurementsrose,wewouldinvestigatetheiracquisitions,
distributionchanges,etc.Infact,thesimpleexpenditureofalargeamountofcashforan
acquisitioncandepletecurrentassetsandinflatethenon-currentassetratio,whichisthe
reasonforobtainingcorroboratingevidence;oneratiocanacttoconfirmtheother.
OPERATINGMARGIN
Thesizeandstabilityofoperatingmarginsisparamount.Sofarouranalysishas
encompassedtheamountandstabilityofgrowth.Asgrowthisoftenstimulatedbya
sector’spositioninthebusinesscycle,ittendstowaverandattractinvestorsintheshort-
term.However,intheabsenceofotherinformationaboutfinancialleverageandcapital
structure,decisionsmadeonthebasisofoperatingcharacteristicsshouldbelong-term.
Rememberthatfinancialleveragewillrespondtothesizeandstabilityofsalesandincome
andnotnecessarilyitsgrowth;theprobabilityofdefaultisloweredwheninterestcoverage
ratiosrise.Thefollowingtablesexhibittheoperatingmarginhistoriesforbothcompanies:
256

Table9-27

OPERATING
MARGINS
(Decimal)

YEAR 1995 1996 1997 1998 1999
FED-EX 0.1308 0.1282 0.129 0.131 0.1301
STAPLES 0.0623 0.0655 0.0685 0.0722 0.0792

Alargeandstableoperatingmargincanleadtothreepositivescenarios:1)Alargercash
flow.2)Moredividendsflowingtoinvestorsand3)Retainedearnings,insteadofcredit,
thatcanbeusedforpurchases.Thus,whilegrowingsalesleadstoalargeroperating
income,thecoststructureofabusinesscanbeoptimizedbutnotchanged.Stapleshad
growingoperatingmarginsthatwouldpotentially“topout”,whenallefficiencieswere
realized.Ontheotherhand,Fed-Exhadanoperatingmarginthatwasnearlytwicethe
sizeofStaples’.Theyweremakingastableprofitinabusinessthathadmuchmore
inherenteconomicrisk.Amean-varianceanalysisrevealsthedifference:
Table9-28

OPERATINGMARGIN
%
FED-EX STAPLES
Mean 12.982% 6.954%
SampleStandard
Deviation
0.1197 0.6523
Mean-Standard
Deviation
12.8623% 6.3017%

ThehigheroperatingmargingivesFed-Exmuchmorefinancialflexibility.They
arealowdebt,highequitycompany,andyettheirearningsarelargeandstableenoughto
financewithmuchmoredebtiftheyneededto.Choosingtofinancewithretainedearnings
lowerstheriskofinterestratechangesandbufferstheeffectofhavingahighleveloffixed
assets.Inthisrespect,theirinherentbusinessriskmightbetoohighforaninvestorof
257

Buffett’scaliber,buttheydohave“pricingpower”asoneofthefewplayersinalimited
field;overnightshipmentstoGreenlandorAfricaensurethatFed-Exwillbeknownasa
“brand”.Such“franchisevalue”and“economicgoodwill”wouldberightupFisher’sand
Buffett’salley
Ratherthantheproverbial“cointoss”,ahigheroperatingmarginisanarbiterof
investment.However,whatifFed-Ex’smarginsdeclineasStaples’rise?Forthatvery
reason,wetrytocoalesceasmuchinformationaspossible,neitherdependingonearning
forecasts,companyhype,orevenlongandshort-termmovingaverages.Enoughdatamust
becoordinatedtoformacohesivepicture,andoperatingcharacteristicswillnottellthe
entirestory.Andyet-ifweaddfinancialleverageandmarketinformationtothemix,
muchofwhatweneedtoknowwillbeinthemargins.
(BacktoTableofContents)
258

10
OPERATINGMOMENTUM
Operatingmomentumhasneverbeenastandardmeasurementofrisk.Whileit
mirrorsoperatingleveragewhencostsarestable,itsownvarianceissovolatilethatit
defiesrationaluse.Inanygivenyear,itcanbealternately,small,large,orevencomposed
ofnegativenumbers,leadingtotheconclusionthatanapplicationofthisratioisan
exerciseinfutility-andnotutility!
Moststatisticianswouldarguethatitisanirrelevantlyimprecisemeasurement.As
anexample,considerthepremisethatwedefineoperatingmomentumasthepercentage
changeinoperatingincomedividedbythepercentagechangeinsales.Thus,50/50,15/15,
and-11/-11areallthesamenumber.Sinceitisameasureofvelocityratherthan
magnitude,weneedtoobtainlong-termaverages(atleastfiveyears)tousethe
measurementinameaningfulway.Anincreaseofthisratiorequiresthreeyearsofdata.
Infact,itsveryimprecisionandrelativityforcesustoobtainasmuchinformationas
possible.Theneedfordatacreatesalinkbetweenyearsthatallowsthisratiotobemore
comprehensiveandforward-lookingthanitwouldfirstappear.
Whileoperatingleverageusuallychangesinresponsetonewtechnologythat
changestheproportionalrequirementoffixedcosts,anychangeincost,priceorquantity
willaffectoperatingmomentum.Thisinherentvolatilitycausesittoriseandfalltenfold
insomeperiods,especiallywhensalesandearningsareoutof“sync”.Atcertaintimes,a
onepercentincreaseinsalescanleadtoafifteenpercentincreaseinoperatingincome,
creatinganuncharacteristicratiooffifteen.Sincetherealoperatingleveragemaybeonly
1.5,andthelong-termaverageofmomentummaybeonly1.2,theseoutlyingmeasurements
createvolatilityandtendtomakewildswingsincompaniesthatareundergoingmajor
changes.Wesmooththisvolatilitybytakingseparategrowthmeasurementsforboth
operatingincomeandsales,insteadofaveragingindividualratiosforeachyear.
259

REASONSFORSTUDY
• Operatingmomentumisrelativelyunexploredterritoryamongacademics.Statistical
methodswilloftenneglectitsimportancebecauseitdoesnotfittheparametersof
“normality”.Althoughboththenumeratoranddenominatorcontain“essential”
measurements(salesandoperatingincomerespectively),thebehaviorofthecombined
ratiohasnotbeenexaminedthoroughly.
• Analystsoftenmisunderstandoperatingmomentum,confusingitwith“operating
leverage”,whichitmirrorsintheory.Whileoperatingleveragereflectsthestabilityof
acoststructureinaproductionprocess,operatingmomentumreflectstherealcost
over-runsandvolatilityofthatprocess.Litigation,restructuringcharges,and
abandonedbusinesseswillallextractcashfromoperationseveniftheyareaccounted
forseparately.
• Operatingmomentumhascashvaluefortheinvestor.Oncewecanrelateoperating
momentumtootherratiosandtheearningspotentialofacompanyinthenear-term,it
isplacedinamoremeaningfulcontext.
Considerasmallmanufacturingcompanywiththefollowingoperatingincomeandsales
distributions:
Table10-1

Variables YearOne YearTwo-
Probability=1/2
YearTwo-
Probability=1/2
Sales 100 50 150
OperatingIncome 10 5 15
TotalCost 90 45 135

Inthehypotheticalabsenceoffixedcosts,operatingmomentumandoperatingleveragefor
bothscenarioswouldbeequalto“1”-althoughonescenarioinvolvesanincreaseoffifty
percentincostsandsales,whiletheotherinvolvesadecreaseofthesamemagnitude.
Neithermeasurementwouldfullyreflectrisk.Iffixedcostsbecametenpercentoftotal
260

costs,thetrueoperatingleveragewouldincreaseto1.9,butoperatingmomentumwould
remainat1.Fromtheperspectiveofcommonsense,itwouldseemthatthedecreasing
capacityscenariowouldbemoreriskymerelybecauseunusedcapacityismoredifficultto
managethantheprospectoffullcapacity;fixedcostsstillneedtobepaidalthough
revenueshavedeclined.Whilethosefixedcostsareanexplicitpartofoperatingleverage,
theyremainimplicitinoperatingmomentum:wemeasuresensitivitytototalcostwiththe
latterratioandinferthatfixedcostsareincreasingwhenoperatingincomeincreasesata
fasterratethansales.Operatingleverage,ontheotherhand,isdependentontheindustry
andchangesgraduallyovertimeasnewtechnologyisadded,whichultimatelyspreads
fixedcostsoveragreaterquantity.Whenastateofover-productionisreached,priceswill
decrease,causingfirmstoeitherattempttoreducefixedcostswithevennewertechnology,
ortoleavethebusinessentirely.Ultimately,operatingmomentumrespondstothevagaries
ofthemarket,reactingtoextraneousfactorslikelawsuits,discontinuedbusiness,and
foreigncurrencytranslation.Whilesuchvariableswouldnotbereflectedinbasic
operatingleverage,theyareaninherentpartofoperatingmomentum;eachofthese
outlyingfactorsdrainscashfromcollectiveproductionprocesses,evenwhentheyare
countedasonetimeseparatecharges.Amulti-billiondollarsettlementagainstatobacco
company,foranexample,maynotbereportedaspartofnormaloperations,butwillaffect
productionforyearstocome.Thus,thecloseroperatingmomentumistooperating
leverage,themorestabletheproductionenvironment.
Comparingindustry-averageoperatingleveragetocompany-specificoperating
momentumwillrevealproductionrisksnotapparentineventhestandarddeviationsof
salesandincome.Reasonsfordivergenceinclude:changingthebasicnatureofthefirm
throughacquisitions,andanover-dependenceonasmallbaseofeithervendorsor
customers.Whilediversificationcanlowerrisk,anoperatingmomentumthatisactually
lowerthanindustryoperatingleveragecansignifythatthecompanywillunderperform
theindustrywhenthatsectorisfavored.Sincetheobjectiveofdiversificationistolower
261

overallriskinthelongrun,companieswithloweroperatingriskareatatemporary
disadvantagewhentherelativesectorsurgesaheadintheeconomy,becauseearningswill
tendtoincreaseataslowandsteadypace.Those“sacrificial”profitsaregainedbackin
long-termviability.Forexample,compareGallowinestoasmallwineryinFrance.The
smallwinerymustdependonafavorablegrowingseason,isnotdiversified,andmakes
largeprofitswhenconditionsare“right”.Galloisadiversifiedwinerymuchless
dependentonafavorablemarket,andcansellwinefarintothefuture.Itsoperating
momentummaybemeasuredtobelessthantheindustryaverageof“operatingleverage”,
butittradesimmediatehighprofitsforlong-termviability.Therefore,itisimportantto
combineinformationaboutthisdivergencewiththestandarddeviationofbothincomeand
sales.Ifallthreemeasurementsarehigherthanaverage,theinvestmentrequiresextensive
analysis,ormightwarrantshelvingaltogether.
Inafewindustriesthereisthepowertochangepriceswithoutaffectingdemand.
Theseelitecompaniesareusuallygoodinvestments,possessingwhatWarrenBuffettwould
call“franchisevalue”.Toillustratetheeffectofchangesinpriceonbothoperating
leverageandoperatingmomentum,considerthefollowingscenarios:
Table10-2

HIGHOPERATINGLEVERAGE
VariableCosts=700 OperatingLeverage=
OperatingIncome=300 (1200-700)/300=1.66
Sales=1200
Price=4 OperatingMomentum=
Quantity=300 1(GivenasaHypothetical)
FixedCost=200

262

Table10-3

LOWOPERATINGLEVERAGE
VariableCosts=800 OperatingLeverage=
OperatingIncome=300 (1200-800)/300=1.33
Sales=1200
Price=4 OperatingMomentum=
Quantity=300 1GivenasaHypothetical)
FixedCosts=100

THEEFFECTSOFA12.5%PRICECUTFROM4TO3.5
Salesbecome1050from1200,whileoperatingincomedeclinesto150from300.Other
variablesremainunchanged.
Table10-4

HIGHOPERATINGLEVERAGESCENARIO
(1050-700)/150=2.33
LOWOPERATINGLEVERAGESCENARIO
(1050-800)/150=1.66
OPERATINGMOMENTUM
-50/-12.5=4

Noticethatbothratiosdisplayedthegreaterriskofapricecutbyincreasing,butthat
operatingmomentumreactedmoreviolently,increasingfourfold.
THEEFFECTSOFA12.5%PRICEINCREASEFROM4TO4.5.
Salesbecome1350from1200,operatingincomeincreasesto450from300.Othervariables
remainunchanged.

263

Table10-5

HIGHOPERATINGLEVERAGESCENARIO
(1350-700)/450=1.44
LOWOPERATINGLEVERAGESCENARIO
(1350-800)/450=1.22
OPERATINGMOMENTUM
50/12.5=4

Theessenceofpricingpoweristhatitsignificantlyreducesrisk(operatingleverage)while
raisingoperatingincome.Sincevariablecostsincreasewhenquantityincreases,thehigher
coststhataccompanyquantitydrivenchangesinsalesareavoided.Whenpricecan
increaseatafasterratethanquantity,thefirmmayhavecreatedanichethatcompeteson
thebasisofquality-drivenproductdifferentiation.
However,itshouldbenotedthatoperatingmomentumincreaseswhetherpricesare
increasedordecreased.Thismovementhaspredictivevalue.Wheneveritmoves
substantiallyawayfromthemean,whichinthiscaseweassumedtobe“1”,wecanexpect
ittocompensatebyrevertingtowardtheaverageinthefollowingyear.Whilethe
reversionisbynomeansa“hardandfast”rule,investorswillactuallydemanditbecauseit
meansproductionisstabilizing.Thus,afteraquickriseto“4”,analystswouldbelooking
fortheconditionsthatwouldloweroperatingmomentum-greaterquantitiesandmore
variablecosts-hopefullywithincreasedearnings.Althoughoperatingmomentumdoes
notdifferentiatebetweenspecificrisksaswellasoperatingleverage,anylargeshiftswillso
upsetcorporateequilibrium,thatthefirmwillbeforcedtocontrolcost,quantity,orprice
toredirectmomentumbacktoitsmean.Evenapriceshiftthathaspositiveacceptance
fromthecustomermustbemetwithacountervailingforcebecausemoreriskhasbeen
incurred;suchriskscouldentailincreasedsalarydemands,discontinuanceofsome
operationsorevenrestructuringcharges.
264

Agoodexampleofoperatingmomentum-shiftsoccursinindustriesthatsell
commodities.Whensupplyofacommodityisparticularlylow,theentireindustrycan
raiseprices,whichwillincreaseoperatingmomentum,becausedemandisessentially
inelastic-itwillnotdecreaseaspricesincrease.Theconsequentriseinoperatingincome
relativetosalesoccursbecausesalesrisewithoutaquantity-drivenchangeincostsi.e.,
variablecostsdonotincrease.Thestockpricewillriseforabriefperiod,onlytobe
followedbyaselloffbecausethesituationistemporaryandtheinherentrisksreturnto
normal.Ifthecompanyfailstocounterthe“positive”riskofincreasedprices,itmust
suffertheconsequencesofanothershiftinoperatingmomentum.
Anotherexampleofcounteractingtheriskofhighergrowthoccurswithaprice
announcement.Marketingstrategiesaregearedtowardtheriskofoperatingmomentum:
Canthecompanycutquantityandstillmakeaprofitifcustomersfindalessexpensive
substitute?Canthecompanycounterthismoveinthefollowingperiodwithaquantity
drivenproductlinethatappealstoamorecost-consciouscustomer?Thesearethetypesof
questionsthatfueldiversificationandarethereasonthatmorediversifiedcompanieshave
aloweroperatingmomentumandinherentlylessriskthan“oneproduct”companies.
Anothertopicthataffectsbothleverageandmomentumistheimpactofinflation.
Thestudentwillobservethatintimesofinflation,companieswithmorefixedassetsmay
actuallybenefit.Thedistinctlagtimebetweeninitialsalesandtheneedtoupgrade
equipmentwilltemporarilyboostincomeabovethosecompaniesthatmustdealwithmore
immediaterisesinvariablecosts.Ontheotherhand,risktothesecompaniesactually
increasesbecausenotonlydotheyhavetomakethenecessarycapitalexpenditures,they
mayhavetodosoallatonetimetokeepoperationsrunningsmoothly;sacrificinglong-
termviabilityforshort-termgainsisthusariskystrategy.
OPERATINGMOMENTUMSENSITIVITY
Acomparisonbetweenoperatingmomentumandleveragerevealstheimplicit
volatilityofoperatingmomentum.Thevariablesinthebreakevenequationare:price,
265

quantity,variablecostperunitandfixedcosts.Ifwechangeeachbreakevenvariablebya
factorof5%andthen25%,andkeeptheotherbreakevenvariablesconstant,wecan
observetheeffectsonbothleverageratios.Thechangesinvariableandfixedcostsassumes
aonepercentchangeinsalesWeestablishahypotheticalbaseandthendisplaytheeffects
ofbothfiveandtwenty-fivepercentincreasesanddecreases:.
Table10-6

BREAKEVENPOINTVARIABLES-BASE
Quantity=100
Price=4
Sales=400
VariableCosts=2perunit
FixedCosts=100
OperatingIncome=100

266

Table10-7

OPERATING
MOMENTUM

VariableChange=5% Increase Decrease
Price 4 4
Quantity 2 2
VariableCosts -6 14
FixedCosts -1 9

Table10-8

OPERATING
MOMENTUM

VariableChange=25% Increase Decrease
Price 4 4
Quantity 2 2
VariableCosts -48.5 52.5
FixedCosts -23 29

Table10-9

OPERATING
LEVERAGE
BaseOp.Lev.=2
VariableChange=5% Increase Decrease
Price 1.83 2.25
Quantity 1.91 2.11
VariableCosts 2.11 1.91
FixedCosts 2.105 1.9

267

Table10-10

OPERATING
LEVERAGE
BaseOp.Lev.=2
VariableChange=25% Increase Decrease
Price 1.5 NA
Quantity 1.67 3
VariableCosts 3 1.66
FixedCosts 2.66 1.6

Operatingmomentumisinsensitivetopriceandquantitychanges,buthyper-sensitiveto
changesinvariablecosts.Naturally,isolatedchangesoccuronlyinthelaboratory.Reality
dictatesthatthebreakevenvariablesinteract,andasvariablecostsrise,thecompanymay
cutproduction,raiseprices,orboth.Whenacompanycanonlycompetebychurningout
moreofanundifferentiatedproduct,thatproductbecomesacommodity.Asquantities
increase,variablecostsbecomemoreprevalent,eventuallyeclipsinganyoperatingprofit.
Themuchnarrowerrangeofvaluesmakesoperatingleverageabettergaugeofrisk
thanmomentum.However,operatingmomentummaybethebetterforecastingtool,
becauseofitsveryinstability.Whiletrueoperatingleveragemaychangeoverthelongrun
throughchangesintheproductionprocess,momentumcapturesthevolatilityofyearto
yearchanges;periodsofstabilitycanbereadilycontrastedwithdisturbances.Besides
reversiontothemean,whichassumesstatistical“normality”,thereareothertechniques
from“extremevaluestatistics”thatmaybettercharacterizethisfleetingmeasurement.
Ifweassume“stable”productionprocesses(aconceptthatmanyoperations
managerswouldscoffat),thenextexamplewillshowthemirrorrelationshipbetweenthe
twomeasurements.
Infouryears,TheBeeGoodHoneyCorporationhasthreesalesincreasesandsalesfor
eachyearof1000,1500,1700and1800respectively.Eachyear,fixedcostsare300and
variablecostsare60%ofsales,exceptinthelastyearwhenfixedcostsincreaseto400.
268

Table10-11

YEAR OP.LEV.=(S-VC)/(S-
VC-FX)
OPMOM.=
%OP/%SALES
Year1 (1000-600)/100=4 NA
Year2 (1500-900)/300=2 200%/50%=4
Year3 (1700-1020)/380=1.78 26.666%/18.33%=2
Year4 (1800-1080)/320=2.25 -15.79%/5.9%=-2.6

Observehowoperatingmomentumwillperfectlymirroroperatingleveragewhencostsare
stable.OncefixedcostschangeastheydoinYear4,thatmirrordiminishesandthe
predictivepowerofoperatingleverageislost.Sincethereisequivocationaboutthe
definitionof“fixed”and“variable”inrealaccountingcosts,operatingleverageisrelegated
toahypothetical.Ontheotherhand,a“real”measurementlikeoperatingmomentumis
lessreflectiveofriskandhardertointerpret.
Thepredictiveabilityofoperatingmomentumispredicatedontheprobabilityof
increasingoperatingmargin.Operatingmarginisaffectedby:
• 1.Thetypeofbusinessandindustry
• 2.Thelevelofcompetition,especiallythebarrierstoenteringthefield
• 3.Theeconomicoutlookandbusinesscycle
Withinthatframework,managementcanmaximizepotentialmargins,butmustcounterits
limitationswithadditionalstrategies;highermarginswillnotcontinueindefinitely,andit
isanastutemanagementthatwilllowermomentumwithalargesalesincrease,i.e.,the
introductionofaquantity-drivenproductthatlowersoperatingrisk.Thefollowingtable
illustratestheprobabilitiesofoperatingmarginandmomentumincreasesinadatasetof
about180differentsamplepoints.

269

Table10-12

INCREASING
OPERATINGMARGIN

STATE NUMBER PERCENTAGE
TotalOperatingMargin
Increases
104/182 57.14
WithIncreasing
OperatingMomentum
64/91 70.33
WithDecreasing
OperatingMomentum
40/91 43.96

Therefore,theprobabilityofanoperatingmarginincreaseisgreaterwhenoperating
momentumincreases.Bydefault,anyoperatingincomedecreasewillleadtoanegative
momentumnumberifsalesincreaseatthesametime.Analogously,simultaneous
decreasesofboththecomponentswillleadtoapositivenumberandapotentialincrease.
Inessence,wearemeasuringhowcorrelatedincomeiswithsales,anddesignatingthe
amountofriskbythecovariance,butwithoutrecoursetothechangesinfixedandvariable
costs.Thereadershouldnoticethatthesampleof182datapointsdisplayedadistribution
ofexactlyonehalf(91)momentumincreasesanddecreases–anindicationofrandom
variation.
REGRESSION
Whenlinearregressionisappliedtooperatingmomentum,comparativeriskis
vague.Withoutreferencetobothsizeandvariabilitytogether,novaliddecisionruleexists.
Thepercentageincreasesofperiodicoperatingincomearethe“Y”variable,while
percentagesalesincreasesaretheindependent“X”variable.Thefollowingtablesare
comparisonsbetweenthreecompaniesthathavelittledebt,andwhosemajorriskis
economici.e.,operatingrisk.

270

Table10-13

1996 1997 1998 1999 2000
MOLEX
OP
INCOME
7.69 16.37 5.63 -4.36 29.62
SALES 15.44 11.35 5.39 5.48 29.50

BIOMET
OP
INCOME
12.66 14.61 25.49 23.05 14.29
SALES 8.41 12.24 16.28 21.66 11.94

FAIR,
ISAAC

OP
INCOME
37.69 38.27 11.92 15.16 8.15
SALES 30.70 33.56 23.62 12.60 7.58

Table10-14

COMPANY YINTERCEPT
(ALPHA)
R COEFFICIENT
MOLEX -4.223 0.881 1.133
BIOMET 4.359 0.842 0.9684
FAIR,ISAAC -2.177 0.871 1.129

Theproblemwithregressionisininterpretation.Allnumbersinthedatatableare
percentageincreases.Asthestudentwillobserve,thereislittlethatregressioncantellus,
evenwhenoperatingriskisconsideredsogreatthatnolong-termdebtisincurredatall.
Thebestindicatorsofriskremainthestandarddeviationsofsalesandincomerespectively,
andtheirvariousadaptationslikethecoefficientofvariation,andthemean-variancerule.
271

Table10-15

COMPANY MEAN STANDARD
DEVIATION
MOLEX
SALES 13.43% 9.92
OPERATINGINCOME 10.78% 12.66%

FAIR,ISAAC
SALES 21.68% 11.26
OPERATINGINCOME 22.23% 14.59

NoticethatMolexandFairIsaachavealmostidenticalregressionprofiles,butonelookat
theirrespectivedistributionsmakesuschoosethelatter.MostoftheriskforFair,Isaacis
ontheupside.Withouttheabilitytointer-relatesalesandincomethroughspecificcosts,
ouronlyrecoursewouldbetoevaluateoperatingmomentumbycreatingaratioof
coefficientsofvariationforbothoperatingincomeandsales.Theratioofstandard
deviationsalonewouldmisstatetheriskforpercentagevaluesthatwereparticularlylarge;
smallvalueswouldhaveasmallerstandarddeviationandappearlessrisky.ForMolex,
thecoefficientofvariationforoperatingincomeis1.1619,whilethatforsalesis0.7385.
Dividingthetwoyields1.5731.ForFair,Isaac,thecoefficientofvariationforoperating
incomeis0.656,whilethatforsalesis0.5211.Dividingthetwoyields1.259.Thus,Molex
hasariskierstreamofincomeandwewouldusethesefigurestoevaluateoperating
momentum.
THEGENERALELECTRICSOLUTION
Eventothisauthor,thecoefficientofvariationseemslikeanincompletesolution.
Whileitenumeratestheseparaterisksofbothsalesandincome,itseemstocreate
independencebetweenthetwofundamentalsthatdoesnotexistinreality;weknowthat
salesandincomeareinterdependentandtheriskthatweneedtomeasuremustflowfrom
theirworkingtogether.GeneralElectric,acompanywithenoughpersonneltopopulatea
272

majorcity,hastheirowndefinitionofoperatingleverage.Intheir2006prospectus,they
defineitasthepercentchangeinrevenueminusthepercentchangeintotalcost,or%∆ ∆∆ ∆
Revenue-%∆ ∆∆ ∆TotalCost,whichisautilitarianconcept.;operatingmargin,definedas
operatingincomedividedbysales,mustriseanytimethepercentchangeinrevenueis
greaterthanthepercentchangeintotalcost,andbothofthosevariablesarepositive.
Consequently,whenthatconditionarises,operatingmomentummustbegreaterthanone.
Whileoperatingmarginscanincreaseovertime,theyusuallymovecyclically,pushedby
thechangesinmomentum.Thefinelinebetweencost,risk,andhighermarginstranslates
toabetterreturnonequityandhigherstockprices.
The%Revenue-%TotalCostsolutionhasgreatpracticalvalue.Itwillyielda
numberthatishighlycorrelatedwithoperatingmargin,ROC/ROE,andstockprice.Like
thepreviouscoefficientofvariation,anytypeofperformanceevaluationcanrevealthe
returnandstabilityofbothmarginandmomentum-butwillnotexplicitlydivulgetherisk
offixedassets.Again,thespecificityoftrueoperatingleveragecannotbesupersededby
anyothermeasurement.Thefollowingtwotablesshowtherelationshipbetweenoperating
marginandmomentum,andthe“GEversion”ofoperatingleverage.Performanceis
measuredthroughthemean-variancemethod,andthe%Revenue-%TotalCostformula
istermed“Distance”.
Table10-16
“COMPANYA”

Sales Total
Cost
OpInc. Op.
Marg.
Op.
Mom.
%Rev. %TC Distance
100 90 10 0.1 NA NA NA NA
120 102 18 0.15 4 20 13.33 6.67
132 110 22 0.167 2.22 10 7.84 2.16
140 120 20 0.143 -1.5 6.06 9.09 -3.03
165 130 35 0.212 4.199 17.86 8.83 9.53
150 110 40 0.266 -1.57 -9.09 -15.38 24.47

273

µ µµ µDistance=7.96,σ σσ σDistance=10.38,µ µµ µ-σ σσ σ=-2.42,Thus,themean-variancefor
CompanyAis-2.42%.Thestudentshouldobservethatinthelastdatapoint,the
operatingmomentumwaslessthan“1”andoperatingmarginstillincreased.Thesecond
conditionoftherelationshipwasnotmet;theDistanceparameterrequiresthatthepercent
changeinrevenueispositive.
Table10-17
“CONPANYB”

Sales Total
Cost
Op.Inc. Op.
Mar.
Op
Mom
%Rev. %TC Distance
80 70 10 0.125 NA NA NA NA
84 75 9 0.107 -2 5 7.14 -2.14
99 90 9 0.0909 0 17.86 20 -2.14
121 100 21 0.1725 5.99 22.22 11.11 11.11
140 130 10 0.0714 -3.34 15.7 30 -14.3
160 135 25 0.15625 10.5 14.28 3.85 10.43

µ µµ µDistance=0.592,σ σσ σDistance=10.54,µ µµ µ-σ σσ σ=-9.948.Thus,themean-variancefor
CompanyBis-9.948%.TheoperatingmarginisgrowingmorevigorouslyforCompany
A.Bycoordinatingoperatingmomentumand“Distance”,anycompanycanviewthe
necessaryrequirements,i.e.,salesandincomechanges,forincreasingoperatingmargin.
Althoughmarginsincreasewhenweimplementourmethod,thereisstillthechance
ofmorevariabilitybecauseriskisnotexplicit;therearenoindicationsofchangesinfixed
costswhichcanhavelong-termeffectsonproduction.Whenoperatingmomentumis
growingovertime,ahigherlevelofcapitalexpendituresandfixedassetsmaybeneeded,
butonlyoperatingleveragecanspecifytheamount.Thefollowingchartisafouryear
comparisonofchangesinfixedcostsandvariousoperatingriskmeasurements:
274

Table10-18

Year Fixed/Total Fixed/Variable Op.
Leverage
Op.Mom. %Rev.-
%TC
Year1 0.33 0.5 4 NA NA
Year2 0.25 0.33 2 4 16.67
Year3 0.2272 0.2941 1.78 2 3.33
Year4 0.2702 0.3703 2.25 -2.6 -6.24

Ofthethreeoperatingriskmeasurements,onlyoperatingleveragefullyreflectsthe
increasesinfixedcosts.Thetwoothermeasurementsreacttotheincreasesthroughthe
interfaceoftotalcosts,buttheirmeasuredresponseismorevolatile,atfirstdecliningand
thengoingnegative.
Ifcompaniesspecifiedfixedandvariablecostsonfinancialstatements,theinvestor
wouldnotworryaboutmomentumbecausealloftheinformationtoincreasemarginsin
thedomainofriskiscontainedintheoperatingleveragemeasurement.Sincesomeassets
havedualuseandhavebothfixedandvariablecosts,derivingagenericmeasurementisa
monumentaltask.Otherdilemmasoccurbetweeninvestinginthesizeandstabilityof
income,andinvestingingrowthpotential.Liketheequivocationbetweenlargecapstocks
andsmallcaps,theanswerismoredependentonthesituation,thanaformula.Picking
growthoverstabilityisfineaslongasthegrowthisXeroxinthe1970sorGoogleinthe
newmillennium.Sincesuchchoicesarerare,theinvestorwhostickswithstabilitycando
well-aslongasthat“RockofGibraltar”typecompany“upstheante”bybalancingstable
incomewithgreaterleverage.Themarketwillrewardrisk-seekingbehaviorwhen
financialleveragehasa“counterweight”,i.e.,steadyinterestcoverageandalowdefault
probability.
Whileitisfutiletotimemarkets,itisnevertoodifficulttogaugetheinteraction
betweeninterestrates,inflationandmarketactivity,anddecidewhetheroneisintheearly
orlatestagesofarecovery;everyoneiswellawareofwhenthelast“downturn”occurred.
275

Itiswhentheanalystattemptstotimethepeaksandshiftsbetweencyclicalstagesthat
predictionsgoawry.Mostinvestorsfindthatgrowthestimatesareasmuch“art”as
“science”,andthatconcentratingongrowthfactorslikethe“PEG”ratioisarisky
propositionatbest.Professionalanalystsgetdirect“guidance”fromcompaniesbecause
accurateforecastsofrisingearningswillattractcapital.Formanyyears,estimatesmade
fromfundamentalswereoffbyasmuchastwenty-fourpercent-andnotthroughthefault
ofanalysts.Thereweresimplytoomanyuncontrollablevariablestomakeanaccurate
forecastwiththeconsistencyneededforinvesting.Thedebatebetween“value”and
“growth”investingthathasbeenongoingsincethedaysofPhilipFisherandBenjamin
Grahamisstillragingtoday;exceptthatitisdirectedtowardtheflowofincome.While
thegrowthofoperatingmarginsisconstrainedbytheproductioncharacteristicsofmost
industries,themethodsbywhichreturnismaximizedarenot.Therearenumerousother
variablesthatcanbeenhanced,evenasmarginstemporarilydecline.Suchclassic
argumentslike“leasingversusowning”ormodernmethodslike“outsourcing”,are
essentiallywaysofreducingfixedcostsandminimizingriskThus,whentheargumentis
phrasedas“riskversusreturn”ratherthan“valueversusgrowth”,newavenuesof
approachareencounteredbecauseinterdependenceisrecognized.
CLASSICALMICROECONOMICSANDOPERATINGMOMENTUM
Studentsoftentakeintroductorymicroeconomicsasaprerequisitetoupper-level
courses.Frequently,onewillhearcomplaintsthatprofitmaximizationtheoryisnot
“realistic”,that“marginalrevenueneverequalsmarginalcost”.Infact,suchascenariois
valid,particularlyincommodityindustries.Asanexampleofthismarginalanalysis,
consideranagri-businesswhoserevenueinoneyearis200with40inoperatingprofit,and
160intotalcosts.Thenextyearisveryfertileandrevenuesgoupbyfiftypercent.The
companydecidesto“rampup”production,andseesariseintotalcostsoffiftypercent.
Whathappenstooperatingincome,momentum,andtheGEinvention,“Distance”?The
answercaneasilybedecipheredfromthenumbers:
276

Table10-19

VARIABLE YEARONE YEARTWO
Sales 200 300
OperatingIncome 40 60
TotalCost 160 240
OperatingMomentum NA 1
Distance(%Revenue-
%TC)
NA 0
Inanalternativescenario,whencostsarerisingfasterthanrevenues,operatingmomentum
willdecreaseand“distance”willdeclinepastzero.
Table10-20

VARIABLE YEARONE YEARTWO
Sales 200 300
OperatingIncome 40 40
TotalCost 160 260
OperatingMomentum NA 0
Distance(%Revenue-
%TC)
NA -12.5

Whiletheprovisionthatoperatingmomentumequalsoneand“distance“equalszero,does
notimplythatprofitsarebeingmaximized,anegativechangeindistancecombinedwitha
movementofoperatingmomentumtowardzeroindicatesthatquantityisbecoming
counterproductive.
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Figure10-1

Figure10-2

$

TOTALREVENUE
(TR)
TOTALCOST
(TC)
$
Quantity
OperatingProfit
Quantity
278

Thetopgraphshowstotalrevenueandtotalcost,whilethebottomgraphshowsoperating
profit.Whenmarginalrevenueequalsmarginalcost,theslopesarethesame,andthe
distancebetweentheconcretevaluesismaximized,asisoperatingprofit.When∆ ∆∆ ∆Total
Revenue>∆ ∆∆ ∆TotalCost,thereispressuretoincreasethequantityproduced.When∆ ∆∆ ∆Total
Revenue<∆ ∆∆ ∆TotalCost,thereispressuretoproduceless.Althoughtheequalityis
consummatedwithabsolutesandnotpercentagechanges,thereissomeoptimumof
percentagechangesinsalesandoperatingincomethatallowsthis“hypotheticalideal”to
occur.Infact,thepercentagechangeinoperatingincomewillapproachzero,becausethe
increaseintotalcostsexactlyoffsetstheincreaseinrevenue.Thus,whenoperating
momentumapproacheszero,producingmoreofanitembecomescounterproductive–a
nightmarishscenarioforanyfirm.

(BacktoTableofContents)

279

11
STRATEGICCAPITALREQUIREMENTS
Takenoutofcontext,anafter-thefact,“ex-post”analysiscanbebothhumblingand
beguiling.Wepresentseveralsimplifiedmethodsofcomparinganidealizedcalculationof
acompany’scapitalrequirementstoitsactualadditions.Attheoutset,theinvestorneeds
torealizeseveralconceptsbeforeweproceed.Short-termmanipulationofcorporate
fundamentalscandamagethelong-termviabilityofacompany.Whilethematerial
presentedinthischapterentailsmethodsofraisingcapitaltomeettheobjectivesofthe
investor,itdoesnotadvocatethem.
Moreover,thecalculationsaremodelsthatareimperfectintheirsimplicity:they
leaveoutmanyvariablesandcontainmanyassumptions.Theyfunctionmerelyas
guidelinestoeducateinvestorsastowhyafirmbehavedinacertainmanner,andarenot
meanttobefinalarbitersfordecision-making-fromeitherinvestors’ormanagements’
perspectives.Nevertheless,wecanextractacomparativelogicbehindsettingshort-term
benchmarksforcapitalrequirements,ifweobservesomeoftherealitiesbehind“funding”.
THEREALITIESOFFUNDING
• 1)Thebestcompaniesoftenmoveawayfromtheirtargetcapitalstructuresforayear
ortwo.Certainlargerisksmustbeincurredtoensurelargereturns,andthatentails
“takingonestepbacktomovetwostepsforward”,i.e.,acumulativethreeyeargainof
fiftypercentisbetterthanatwentypercentgainovertwoyears.
• 2.Determiningcapitalrequirementscanbeacomplicatedmathematicalexercisegiven
thecomplexityofmostlargefirms.Often,individualassetsareitemizedandthe
requirementsofsmallerunitsareaggregated.
• 3.Theidealmodelassumeslinearitywhilerealityimposesajaggedcurve.Economies
ofscaleanddifferentutilizationratesoffixedassetscreateanexponentialrelationship
betweensales,assets,andprofits.
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• 4.Acquisitionsrequiremuchmorecapitalthanwouldbewarrantedbynormal
increasesinsales.Sincemostpubliclytradedcompaniesgrowasmuchthrough
acquisitionsasthroughinternal“organic”growth,theneedforfundsescalates.
• 5.Onthesamenote,overcapitalizedcompaniesoftendobetterthanundercapitalized
firms,becauseinvestorsexpectlargereturnsfromthesecapitalinfusions.
• 6.UsingtheEVA/CapitalDynamictodeterminecapitalrequirementsispremisedon
theaccuracyoftheCAPM-whichhasbeenshowntoberandomlyunstableandnot
alwayscorrelated.Itisalsopossibletohaveanoverabundanceofeitherequityor
debt,andstillimproveafirm’sEVA.
• 7.Capitalstructureoptimizationintheshort-termmaynottakeintoaccountthe
exigenciesofthecompetitiveenvironment,ortheoutlookfortheeconomy.For
example,ifinterestratesarehistoricallylow,itmaymakesensetotakeonmoredebt
thanisdeemedoptimal,andbuybacksharesofstock.Evenifnetincomeislowerin
theimmediateyear,thecapitaldynamicmayrisetogreaterheightsinfutureyearswith
fewersharesonthemarket.
THEPROPERAMOUNTOFCAPITAL
Thegreatestimpedimenttocapitalstructureoptimizationistheadditionoftoo
muchcapital.AlthoughmostexecutiveswillconcentrateonminimizingtheWACC,once
fundingoccurstherearepracticalconstraintsthatprohibitefficientcombinationsofdebt
andequity.Forexample,arestrictivecovenantinanexistingbondcontractmaypreclude
theaccumulationofdebtaboveaspecificlevel.Tomaintaincontrol,shareholdersmay
wanttorestrictstockissueseveniftheyarewarranted.Short-terminterestratesmaybe
sohighthatnormaloneyearloansarediscardedinfavoroflessexpensivelong-termdebt
Thus,optimalcombinationsoffundingarenotalwayspossibleunless“ideal”internal
conditionsexistforthefirm.
Thenwhyistheamountofcapitalsoimportant?TheEVA/capitaldynamicisa
universalfilterwithafewlimitedvariables.Itisamathematicalexercisethatcarrieslittle
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restraint:thehigherthenetincome,andthelowertheamountandcostofequity,the
higherthefunction.Whencomparedtopreviousyears’performances,itmustworkwithin
specificlimitationsinordertoimprove.Anexcessofadditionalcapitalwillbetoocostlyin
relationtotheincomeitisrequiredtoproduce,andwillbemirroredbyadecreased
EVA/capitaldynamic.Ifprospectsaretrulyfavorable,thepotentialforefficientcapital
utilizationincreases,andEVAwillincreaseaccordingly.
IfthestudentexaminestheSpearmanrankcorrelationsinthesectionabout
probability,heorshewillfindthatmorecapitaliscorrelatedwithstockpriceincreases,
whichoccursbecausebothcapitalandnetincomeareheavilycorrelated.Evenlarge
equityincreaseswhencoupledwithlargeearningsgainsusuallyleadtohigherstockprices.
Ontheotherhand,largedebtincreasesarerarelyconsistentwithhighnetincome
increasesbecausegreaterinterestpaymentscutintooperatingincome,inadditiontothe
inclinationfor“troubled”companiestotakeonmoredebt.Thus,greaterequityincreases
willaccompanyhighernetincomebecausethereisatendencytobothpayoffloans,and
retainearnings;ahigherincomeattractscapitalintothestock.Conversely,mostofthe
marketgainswillbespeculativewhenacompanyincursmoredebt:taxbenefitsare
immediate,butthe“value”oftheinvestmentmaynotpayoffuntilearningsareactualized.
AlsointhechaptersconcerningtheSpearmanrankcorrelations,weobservedthe
effectsofcapitalrationing-adiminutionofmarketvaluebecausecorporations“over
spent”intheprioryear.Whilethesituationwashypothetical,impliedbytransitivity,it
representsthetruedangerofovercapitalizing,becauseacompanymaybeperceivedas
moreriskyifincomehasyettocometofruition;otherprofitableprojectsmaybediscarded
inordertoconcentrateonthecapitalinfusion.ThisisanotherdangerofusingEVA
expectationstomakecapitalrequirementsdecisions:itmayimposeartificialrestraintson
capitalthatnormallywouldberaisedtomeetcompetitiveneeds.Inessence,itcreatesa
chasmbetweeninvestorswhowantimmediateresultsandfinancialexecutiveswhoare
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concernedaboutlong-termviability.Ultimately,itmayleadtoa“worstcasescenario”:
themanipulationofbalancesheetfundamentalstoappeasethelargestshareholders.
THEDEBT/EQUITYTRADEOFFANDEVA
Intheveryspeculativeyearof1998,companieslikePMCSierra,SunMicrosystems
andLucentTechnologieswerethedarlingsoftheinvestmentset.Thesewerethe
companiesthatweregoingtochangeAmericaandbringusboldlyintothetwenty-first
century.Fromacapitalstructureperspective,theirunbridledearningspotentialseemedto
warrantamassiveinfluxofequitycapital-eventhoughhistoricalearningsfluctuations
andalackofoutstandingcreditmighthavedeemedotherwise.Technologyprovided
investorswithanelixir-thevisionofatransformedeconomythatwouldalwaysout
perform“thepast”.Therestofthestoryiswellknown.Whenthemarketfortechstocks
finallycollapsed,millionsofinvestorswereleftwithalargeamountofsharesworthonlya
fewdollarseach.Howcouldthishavebeenprevented?
Whilenetincomewasclimbingrapidly,thelackoflong-termdebtwouldhavebeen
avaguesignalthattheincomestreamwasrisky.Moreover,thelargebetasforthesestocks
wouldhavebeenatip-off,becausetheyindicatedalevelofriskthatonlyafewinvestors
couldhavesafelytaken.“Buyandhold”strategiesdidnotworkinaneraofmergerand
acquisition.The“safe,littlecompany”thatGrandpaputintohisretirementaccountfive
yearsago,wasnowahightechbehemoththatwasaboutto“bettheranch”.Evenasa
higherEVAmayhaveindicatedmovementtowardtheoptimal(throughabnormallyhigh
earnings),athoroughanalysisoftrendsinboththecostofequityandtherateofchangein
equity,wouldhaverevealedotherwise.Hadmostofthetechstockscarriedbetasof0.5
insteadof1.5,theimminentdisastermayhavebeenprevented.Althoughthemarket
wouldnothave“skyrocketed”,itmighthavestabilizedataslightlyaboveaveragelevel
whichwouldhaveattractedcapitalfarintothenewmillennium.Thusthecapitaldynamic
/EVAdoesnothavegreatpredictivepowerbecauseitfocusesonimmediateearnings
283

ratherthanpotentialcapitalutilization;itisaconcurrentindicator,andnotaleadingone,
andwillnotforecasttrendsoverthecourseofthebusinesscycle.
Sinceequityisproportionatelymoreexpensivethandebt,thefirmispresenteda
tradeoffbetweentwoformsofrisktoshareholdervalue:theriskofdilutingmarketvalue
withmoreshares,andtheriskofcompromisingdividendincomewithmoreinterest
expense.Lessdebtwillreduceinterestpaymentscreatingaconsequentriseinnetincome.
Iftheearningsthatareretainedfromthisincomerisefasterthanthecostofequity,EVA
willincrease:theneteffectofincreasesinincomemorethanoffsetthecorresponding
increasesinstockholders’equity.Thisistheleveragemechanismthatissocorrelatedwith
movementtowardanoptimalcapitalstructure.Bydefinition,itoccurswhenthedifference
betweennetincomeandtheabsolutecostofequityislarge.
Onrareoccasions,acompanywillincreasedebtbutdecreaseequitybyaneven
greateramount,causingashiftupwardsintheEVA/capitaldynamic.Sinceitisimperative
toprotectEPSanddividends,theseareusuallyisolatedoccurrences,indicativeofa
recapitalizationsuchasaleveragedbuyout.Manipulationscananddooccursoitis
importanttoknowthecontextoftheseshifts.Infact,EVA/capitaldynamicanalysiswillbe
impervioustotechniqueslikeshiftingexpensesfromincomestatementstocapitalaccounts
simplyto“pumpup”immediateearnings.However,theinvestorshouldcertainly
differentiatebetweenequityissuesandretainedearnings,becausetheformerisoftenused
as“currency”foracquisitions,whilethelatterhasonlyacomparative,“opportunitycost”
whichrarelydilutesmarketvalue.
GivenaprojectedEPS,wecansetlimitsontheamountofequitycapitalthatcanbe
raisedwithoutdiminishingmovementtowardtheoptimalstructure.Withincapital
constraints,aknowledgeoflimitsonequitywillproduceacorrespondingcalculationof
allowabledebt-giventhedefaultratingsofagencieslikeMoody’s.Together,wecanuse
thisdatatosetarough“guesstimate”forcapitalrequirementsthatwouldbeidealfroman
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investor’simmediateperspective-andmayormaynotbeconducivetoafirm’slong-term
growth.
Sincetheinvestors’immediategoalistoatleastpreservethedifferencebetweenthe
costofequityandnetincome,itisasimplemattertotake:1)Ananalyst’sprojectednet
income;2)AnestimatedrequiredrateofreturnfromtheCAPM;and3)Lastyear’s
dataonnetincomeandstockholders’equity-tocalculateanabsolutelimitonthisyear’s
equity.Thefollowingexamplewillsuffice:
COMPANYXYZ
Table11-1

YEAR ONE YEAR TWO
NetIncome 100 NetIncome
(estimate)
115
Equity 500 Equity ?
CAPMPercentage 7% CAPMPercentage 8.5%
CostofEquity 35 CostofEquity ?
EVA/Capital
dynamic
65 EVA/Capital
dynamic
Goal=65ormore

Thecostofequityisderivedbysubtraction.115-X=65,X=50.Thatcostof50isthen
dividedbytheestimatedCAPMpercentagetoobtainavalueforequity.50/.085=588.235.
Thusgiventhecorrectestimates,themaximumthatstockholdersequitycouldincreaseand
stillmaintainthesizeofEVAwouldbe88.235.
TheestimationoftheCAPMpercentagecanbedifficultbecauseoneiscorrelating
therelationshipbetweeninterestrates,themarket,andafirm’sbeta,butprofessional
opinionisusuallyavailableforthecomponentpartsofthisrate.Inthescenarioabove,if
XYZcomesinat600foranequityfigure,itdoesnotnecessarilymeanthatitistimetosell
thestock,butitwillsignaltheneedtoexaminethecontextofthedeclineinEVA-sales,
sectorandmarket-moreclosely.Relianceonestimates,whethertheybefromanalysts,or
evenone’sownresearchistreadingonshakyground,andsothevalueofthisanalysis
285

comesafterthefact-expost.IftheEVA/capitaldynamicindicatorisprimarilya
concurrentgaugeofstockperformance,whyisitimportanttoknowwhatitisafterthe
fact?
InordertoanalyzethepotentialforanincreaseintheEVAandbyassociation,the
marketvalueofthestock,itisimportanttoknowhowmuchleewayisavailableforan
equityincrease.TheXYZexampleabovesuggestedthata17.6%increaseinequitywas
enoughtoabsorbthe15%increaseinnetincome.Butwhatifequitywerealreadyhigh?
Whatifitcouldonlymoveupfiveorsixpercenttoabsorbtheincreaseinnetincome?In
thatsituation,capitalfundingwouldhavetobeprovidedthroughlong-termdebtwhich
increasesthevariabilityofEPS.Thus,highequity,whichusuallyactsasabufferagainst
risk,canhavetheoppositeeffectifthelevelishighenoughtowarrantmoredebtfinancing.
Whenthatscenariooccursatinopportunetimes,suchasinahighinterestrate
environment,theentirecompanysuffersthroughhighercapitalcostsandadepressed
stockprice.Thelowerthelevelofequityincomparisontonetincome,thegreaterthe
potentialformovementtowardanoptimalcapitalstructure.
EVA/CAPITALDYNAMICBASEDIMPROVEMENT
Inpreviouschapters,wesuggestedthattheEVA/capitaldynamicimprovementis
basedupontherelationshipbetweeninterestratesondebt,andtheriskpremiumofthe
capitalassetpricingmodel.Moreover,wesuggestedinthischapterthatanoptimization
basedonEVAincreasesmightsetthecompanyupforalaterfallbecausecapitalfunding
wasnotcontingentonthenetpresentvalueofprojects.Adisconnectoccursanytimethat
capitalbudgetingbecomesbasedontheshort-termgoalsoftheinvestor,ratherthanon
soundfinancialprinciples-suchasacceptingthoseprojectswithapositivenetpresent
value.
Tousethismaterialproperly,wewouldneedtoknowthedefaultlimitssetondebt
byratingsagencieslikeStandardandPoor’s-andestablishthethresholdlimitsofthe
company’sratingclass(AAA,AA,BBB,etc.).Sinceweknowthelimitsonequity,itis
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imperativetohavealegitimatestandardfordebt/equity-whichcanbeindustryaverages,
companyfiveyearaverages,orevenastudyofcyclicalpeaksofthestockprice.Asinthe
previoussection,themaximumamountofequityisderived,givenaspecificlevelofincome.
Additionally,wedeterminewhatlevelofretainedearningsmustbeachievedtoimprove
EVA.Wesetupasimplealgebraicequationandsolveforretainedearningsunderthe
constraintthatnoadditionalsharesareissued;retainedearningsareaddedto
stockholders’equityoncedividendsaresubtractedfromnetincome.Fromthegivenlevel
oftotalcapital,wedeterminethechangeindebtbysubtractingthenewlevelofequity
(previousequity+newretainedearnings).Whenwemultiplythisfigurebythecurrent
interestrate,wewillobtainaninterestexpensethatcanbeusedtocalculatethenew
financialleverageratio.Inessence,weareworkingbackwardstofindthelevelofdebtand
equitythatwouldincreaseEVA,aswellasdetermininganylevelofadditionalequity
(issues)thatwouldbewarrantedbythedifferencebetweentheoptimalandproposed
amounts.Suchanequationisa“win-win”forinvestorsbecauseitessentiallydisplays
whereabreakinthemarginalcostofcapitalwilloccur.Theamountofdividendsactsasa
stresstestfornetincomeandadditionalsharescanbecomparedwiththenecessary
dividendsthatwouldjustifythem.
Threeotherassumptionsarerelevanttothisanalysis:1)inagivenyear,theinterest
ratedoesnotriseincorrespondencetotheamountofdebt;2)betadoesnotrisewhenmore
debtisincurred;and3)operatingincomeshiftstoaccommodateeithermoreorless
interestexpense.Thoseareunrealisticassumptions,whichmaketheminvalidinputsfora
workingcorporatemodel.The“ballpark”figureisahypotheticalidealmeanttogauge
thepotentialforshiftingcapitalproportions.Indeed,anyuseofanEVAdetermined
capitalmodelmustharborsomeassumptionsbasedonforecastsandwouldbeproneto
error.Whilecorporatecapitalrequirementsarecontingentonsalesexpectations,EVA
definedrequirementscoalesceseveralotherforecastsinvolvingvariablessuchastaxes,
dividendsandnetincome–eachofwhichcanbefundamentallywrong.
287

INCREMENTALEQUITYIMPROVEMENT
Thedefinitionoftheincrementalequityimprovementistheamountofequityto
raise,anditsrelationtonetincome,thatwouldmaintainorimproveafirm’sEVA.Inthe
example,Year1referstothecurrentyearwhileYear2isconsideredthenextyear.
Table11-2

VARIABLES
Year1NetIncome
Year1PercentageCostofEquityasdeterminedbytheCAPM
Year1Stockholders'Equity
Year2NetIncome(projectedorestimated)
Year2PercentageCostofEquity(estimatedfromchangesincomponentsofthe
CAPM)
Year2Stockholders'Equity?Determinedbyanalgebraicsolution
Year1=(yr1),Year2=(yr2)

Year2Stockholders’Equity=((Equity(yr1)x%CostofEquity(yr1))-(NetIncome
(yr1))+(NetIncome(yr2)))/%CostofEquity(yr2)
ThisfigureisthemaximumamountofequitythatcanberaisedinYear2foran
improvementinEVA.AneasiermethodistosetupanEVAequationandsolveforequity:
NetIncome-((newcost%)(X)=EVA.TheEVAshouldbeasleastasgreatastheprevious
period’s.ThisistermedthethresholdEVA.
THEIRRATIONALITYOFRATIONINGCAPITAL
Withoutreferencetotheinternaldynamicsofcapitalbudgeting,allocatingcapitalonthe
basisofimmediateeconomicprofit,i.e.,EVA,isdoomedtofail.TheEVA/capitaldynamic
makesimprovementsbasedonchangesintheshort-termcostofcapital,butacompany’s
long-termviabilityiscenteredondevelopingproductsthatmeetmarketdemandoverthe
entirebusinesscycle.Thatprocessentailsfundingprojectsbasedonpositivenetpresent
valuesandhavinganinternalrateofreturn(IRR)thatisgreaterthanthecostofcapital.
Ifindeednetincomerisesandthecalculatedamountofcapitalprovesinadequate,thereis
288

adangerofprojectionsnotbeingmet.Ontheotherhand,thereturnonbothequityand
capitalmaybegreaterintheshortrunsinceonlyprojectswiththehighestnetpresent
valuewillbeaccepted.Thisrationingofcapitalmayfavorprojectsthatonlyreturnan
amountabovethecurrentcostofcapital-whichmaybeacostthatisactuallybelowthe
costthatwascalculatedwhensomeoftheseprojectsweredeveloped.
INCREMENTALDEBT
Themaximumamountofequitytoraisepresentsanextremecornersolutionto
capitalfundingifnodebtwereraised.Raisingdebtwoulddilutenetincomewithinterest
paymentsbutalsodecreasetherequiredamountofequityandthusitscost.Bysettingthe
equationtothepreviousperiod’sEVA,thechangeinequityimpliesachangeindebt.
Subtractinganidealizedequityfromagivenamountofcapitalwillyieldaresidualdebt
figurethatwemultiplybytheinterestratetodetermineinterestexpense.Thereisno
implicationthatthisfigurerepresentstheideallevelofdebt,becausetheamountofraised
capitalmaybeincorrect.However,withinthelimitationssetbythemodel,itistheonly
realisticchoiceifEVAisgoingtoimprove.
DIVIDENDSANDRETAINEDEARNINGS
Whenwesolvefornetincome,givenalevelofEVA,wealsoaddretainedearnings
tothepreviousyear’sequity.Thedividendamountthatwesubtractfromnetincomemust
projectthenextdividendbutusethelastperiod’ssharesoutstanding;wewanttodevelopa
netincomewithoutreferencetoanequityissue.Forinvestors,thisassumptionis
significantbecauseitcreatesaleveloffundingwherethemarginalcostofcapitalwillnot
beraised.Forsensitivityanalysisincorporations,thatstandardcanberelaxed,anda
companycanfindalevelofadditionalsharesthatwouldleastdilutestockvalue.
CAPITALFUNDINGFROMEVA:TWOMETHODS
METHOD1:SOLVINGFORTHEOPTIMALEQUITY
Usingtheactualnetincomefromacompany,wehavealreadyidentifiedthe
maximumamountofequity.Thisoptimumcanbesubtractedfromactualcapitalto
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determinetheresidualamountofdebt.Ifweuseanalysts’forecastsforearnings,ouronly
alternativefordeterminingcapitalistoassumethatthereturnoncapital(ROC)willbeat
leastthesameaslastperiod’s.Whilethisassumptionispurespeculation,ithassome
validitybecauseweareimprovingEVAaswell.Thederivedoptimalequityvalueisthen
subtractedfromthisquotientofproposednetincomeandpreviousROC.Thereisnoneed
tocalculatedividendsinthismethodbecauseretainedearningsareimplicitintheequation.
Oncedebtisdetermined,itismultipliedbyanestimatedorcurrentinterestratetoderive
interestexpense.Actualorproposednetincomeisthendividedby(1-taxrate)toproduce
anewEBT.OnceinterestexpenseisaddedtoEBT,a“target”operatingincomeis
determined.
METHOD2:SOLVINGFORTHEOPTIMALNETINCOME
WelookforaminimumleveloffundingthatwouldimproveEVA,andsowesetthe
newequationtothepreviousEVAandsimultaneouslysolvefornetincome,andretained
earnings.Dividendsaredeterminedbymultiplyinglastperiod’snumberofshares
outstandingbythenextproposeddividend.Thestudent/investorshouldnotethatany
amountofhypotheticalEVAcanbeset,aslongasactualshares,proposeddividends,and
realisticequityamountsareused.
290

Table11-3

VARIABLES EXPLANATION
NETINCOME The"X"Factor
PROPOSEDNEXTDIVIDEND ProjectedorKnown
OUTSTANDINGSHARES(Year1) LastPeriod'sNumberofShares
Outstanding
STOCKHOLDERS'EQUITY(Year1) LastPeriod'sStockholders'Equity
CAPM%(RequiredRateofReturn) Eitherbasedonpastregressionsor
estimated
RETAINEDEARNINGS EqualsNetIncome-Dividends
NEWEQUITY EqualsRetainedEarnings+Stk.Hlds'
Eqty.Yr.1

ThefullequationisNetIncome-((Yr2%CostofEquity)x(NetIncome-(Yr2
Dividends))+(Yr1Equity))=Yr1EVAAlgebraically,wesolvefor“netincome”asall
othervariablesareknown.TheYear2Dividendsvariableistheproductofthelast
period’soutstandingshares,multipliedbytheprojecteddividend.Again,thereisroomfor
adjustmentandsensitivityanalysisonafullspreadsheet.
Table11-4
DETERMININGCAPITALPROPORTIONSANDREQUIREMENTS

VARIABLES EXPLANATION
NETINCOME DerivedfromPreviousCalculation
TAXRATE CurrentEffectiveRate
YEAR2EBIT Derivedfrom(EBT+InterestExpense)
EBT EqualsNetIncome/(1-taxrate)
IMPLIEDINTERESTEXPENSE (InterestRate)x(long-termDebt)
CURRENTINTERESTRATE TheEffectiveRateEqualsActual
InterestExpense/Actuallong-termDebt
LONG-TERMDEBT EqualsCapital-Equity

Oncenetincomeisderived,wesimultaneouslycalculatethenewamountofequity,because
wehaveobtainedtheamountofretainedearningsthatsolvestheequation.Inorderto
solveforthenewlevelofoperatingincome,,weneedthecurrenteffectivetaxrate.We
291

subtractthisratefrom“1”anddividethisdifferenceintoourderivednetincometoyielda
newEBT(earningsbeforetaxes).Themethodis:NetIncome/(1-taxrate)=EBT.We
thenaddtheimpliedinterestexpensetoEBTtodeterminetheamountofoperatingincome
neededtoachievethisEVAimprovement
PROJECTEDANALYSIS
Whilethedeterminationofoptimalnetincomeisusedtoevaluatetheperformance
ofcompaniesinanex-postmanner,itisasmallsteptoactuallyprojectEVAscenarios.
Thethreemainvariablesneededwouldbe:1)aprojectionofthenextdividendpershare;
2)anaccurateforecastofthenextEBIT;3)somedeterminationofcapitalrequirements;as
withtheoptimalequitymethod,wewouldmostlikelyformulateaminimallyacceptable
levelofcapitalfundingbydeterminingthequotientoflastperiod’sROCandanalysts’
projectedearnings.Onewouldhavetoextrapolateboththecostofequityandinterest
rates,whichisonlyachievableinastableeconomy.
FINANCIALENGINEERING:SETTINGCAPITALREQUIREMENTSFROMEVA
Ifweassumethatoperatingincomeisconstant,thenouroptimalnetincomewill
implyaspecificlevelofinterestexpense,andbydefault,anamountoflong-termdebtthat
correspondstoit.Inessence,weworkdeductivelybackwards.Westartwithanoptimal
netincome,determineacorrespondingequity,andcalculatetheimpliedlong-termdebt.
Whenweaddtheequityamounttothedebtamount,wedetermineaderivedamountof
capital.Thismethodisparticularlyinsidiousbecausenoanalysisofcapitalbudgetingor
economicviabilityneedstobedone.Wedeterminecapitaloutlaysfrompotentialprofits
regardlessoftheirproductivesource.
CONOCOPHILLIPS:2005-2006AREALWORLDEXAMPLE
Afterfouryearsofrecordprofits,theoilcompanyConocoPhillipsbought
BurlingtonResourceswithalargeamountofstock,andassumedthatcompany’s
outstandingdebt.ConocoPhillipshadtoraiseenoughcapitaltopayforthepurchase,
whichmoveditawayfromitsoptimaltargetstructure.Asapercentageofsales,average
292

earningbeforetaxesis6.4%(EBT,notEBIT),andthecompanywouldnotnormally
descendbelowthislevelwithmoreinterestexpense.Thefollowingdataappliesto2005-
2006.
Table11-5

CONOCOPHILLIPS
Variables 2005 2006
NetIncome 13529 15550
CAPM% 6.82% 8.25%
Stockholders'Equity 52731 82646
Long-termDebt 10758 23091
InterestRate(effective) 4.62% 4.71%
TaxRate(effective) 42.1% 45.1%
EVA/CapitalDynamic 9933 8732
InterestExpense 497 1087
Sales(fromoperations
only)
179442 183650
OutstandingShares 1388.98(millions) 1581.25(millions)
DividendperShare 1.18 1.44
DividendsPaid 1639 2277
FinancialLeverageRatio 1.0212 1.038

WeobservethatConocoPhillipsincreaseditsfinancialleverageratioonly1.6%to1.038
andthatalargerincreasewouldhavepossiblydeleteriouseffects,giventheprevailing
higherinterestratesintheeconomyandshrinkingmarginsonoil.Thegoalistocreatea
leveloffundingthatwouldpreservetheprevious9933inEVA.Atenpercentincreasein
thefinancialleverageratioiswithinhistoricalbounds,whichwouldmakeitequalto
approximately-1.14.
METHOD1:CAPITALPROPORTIONSFROMOPTIMALEQUITY
STEP1:Determinetheoptimalequity
((Yr1EquityxYr1%Cost)-(Yr1NetIncome)+(Yr2NetIncome))/(Yr2%Cost)=
((52731x.0682)-13529+15550)/.0825=68088.Asecondwayofachievingnearlythe
sameresults:15550-(.0825)(X)=9933.(0.0825)(X)=5617,X=68084.85
293

STEP2:SubtractFromcapitaltodeterminedebt
105737-68088=37649
STEP3:DetermineInterestExpense
37649(.0471)=1773.27
STEP4:DetermineOperatingIncomeTarget
EBT=15550/(1-taxrate)=15550/0.549=28324.23.Addinterestexpense28324.23+
1773.27=30097.5ConocoPhillipswouldneed677.5(million)moreinoperatingincometo
achievethisEVAideal.
METHOD2:CAPITALPROPORTIONSFROMOPTIMALNETINCOME
STEP1:Determinethethresholdlevelofnetincome.
TheequationisX-((Yr2%CostofEquity)x(X-(Yr2
**
Dividends))+(Yr1Equity))=Yr
1EVA.InthisexampleitisX-((.0825)x((X-2000.13)+(52731)))=9933whichreducesto
.X-(0.0825X+4185.3)=9933or0.9175X=14118.3.,X=15387.79.Yr2
**
dividendsare
determinedbymultiplyingthelastperiod’ssharesoutstandingbythelatestdividendor
1388.98(1.44)=2000.13
STEP2ComputetheamountofEquity.(Xstkequalsnewequity)
NetIncome-(CostofEquity%)(Xstk)=PreviousEVA=15387.79-(.0825)(Xstk)=9933,
.0825(Xstk)=5454.79,Xstk=66118.67
STEP3:Determinetheamountofdebt.
105737-66118.67=39618.33
STEP4:DeterminetheamountofinterestExpense
(39618.33)(0.0471)=1866.02
STEP5:Determinethetargetoperatingincome
15387.79/.549=EBT=28028.76,EBT+InterestExpense=OperatingIncome,28028.76+
1866.02=29894.78
FINANCIALENGINEERINGMETHOD
294

DerivedOptimalNetIncome=15387.79.DerivedEquity=66118.67,ActualOperating
Income=29420,ActualEffectiveTaxRate=45.1%,(1-taxrate)=0.549
EBT=15387.79/0.549=28028.76.OperatingIncome-EBT=InterestExpense
InterestExpense=29420-28028.76=1391.24
ImpliedDebt=InterestExpense/InterestRate,1391.24/0.0471=29538
ImpliedCapital=DerivedEquity+ImpliedDebt,66118.67+29538=95656.67
ActualROE=18.82%,ProposedROE=23.27%,OldLTD/CAP=21.83%,New
LTD/CAP=30.88%.
ACOMPARISON
Whilebothmethodsaddeddebt,theoptimalnetincomescenarioproducedalowercostof
capitalandimpliedanoperatingincomethatwasonlyslightlymorethantheoriginal
(29894.78Vs.29420).Thelowercostofcapitalwasproducedbyusingslightlylowercost
debt.
ThecapitalthatConocoPhillipsactuallyraisedwas42248whichisthedifferencebetween
thetwoyears’sumsoflong-termdebtandequity.Thisanalysisraisesthesameamountof
capitalwithfargreaterdebt.Onadefaultprobabilitybasis,theadditionaldebtmaybe
excessive.Bankruptcyriskcancrippleastockandsomostincreasesinleveragearewithin
theboundariesoftheindustry,andcorrespondtothehighestobtainablecreditrating.
Withinthoseratings,operatingincomedeterminesinterestcoverage,whichfurther
determinestheamountofallowabledebt.Thetwoboundariesforoperatingincomeare
operatingmarginononesideandthefinancialleverageratioontheother.Toobtainthe
optimallevelofdebt,operatingincomemustbehighenoughtoabsorbinterestpayments
withoutexceedingindustryaveragesforfinancialleverage,andyetlowenoughsothatthe
taxadvantagesofthosepaymentsexceedtheadvantagesofextraincome.Thisbalancing
actcontinueswithoperatingmargin:Whilegreatermarginsleadtomoreretained
earnings,lowermarginsimplythatlessequityfinancingwillbedone;thesemarginshave
tobewithinindustryboundariesorinvestorswillpresumethatthefirmismorerisky.
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Whenanalystsforecastyearlyearnings,theyextrapolatefromprojectedsales,takinginto
consideration,margins,debtandinterestpayments.Therefore,debtbecomesimplicitin
mostnetincomeprojections.Effectivetaxratesremainfairlystableformostcompanies,
andsoafifteenpercentincreaseinoperatingincomewillimplyfifteenpercentincreasesin
bothinterestexpenseandnetincomerespectively.
Table11-6

COMPARISON 2005 2006 Financial
Eng.
Optimal
NetInc.
Optimal
Equity
Long-termDebt 10758 23091 29538 39018.33 37649
Equity 52731 82646 66118.67 66118.67 68088
Capital 63489 105737 95656.67 105737 105737
Interest
Expense
497 1087 1391.24 1866.02 1773.27
NetIncome 13529 15550 15387.79 15387.79 15550
Financial
LeverageRatio
1.0212 1.038 1.0496 1.0666 1.0626
LTD/CAP 16.95% 21.84% 30.88% 36.9% 35.6%
Operating
Income
24044 29420 29420 29894.78 30097.5
ROE 25.66% 18.82% 23.27% 23.27% 22.84%
ROC 21.31% 14.71% 16.086% 14.55% 14.71%
EVA/Capital
Dynamic
9933 8732 9933 9933 9933

Therefore,withamajorincreaseindebt,EVAwouldhavebeenmaintained,andequity
wouldnothavebeenissued.Capitalrequirementswouldhavemetthe105737standard,
andthisconformancemayhavebeencrucialtofutureEVAs.Whilewedonotknow
whetherConocoPhillips’projectswereproperlyfunded,wedoknowthatcapitalrationing
canmakethings“lookgoodonpaper”,underminingtheexigenciesofcapitalbudgeting.
WithoutathoroughexaminationofConocoPhillipsleverage,wecannotsecondguesstheir
management.Theirproposedcapitalrequirementsweremostlikelyproper,considering
296

thatlargeacquisitionswerebeingmade,andthatfundingwentwellbeyondexisting
operations.
THEADDITIONALFUNDSNEEDEDEQUATION
Thestandardmethodologyforassessingcapitalrequirementsisthepercentageof
salesmethodanditscloserelative,theadditionalfundsneededequation,orAFN.These
techniqueshavebeenmainstaysoffinancialtextbooksforoverfiftyyears,andseemalmost
passégivenWallStreet’smoderndaypenchantformergersandacquisitions:theequation
rarelymatchescapitaloutlaysbecauseassetaccretionthrough“organic”salesgrowthhas
beensupersededbytheoutrightpurchaseofothercompanies.
Withinthecomponentpartsoftheequationliesawonderfulfinanciallogicthatis
elegantinitssimplicity.Itsbasicpremiseisthat“nothinghappenswithoutasale”-a
principleoftenforgottenbycontemporaryhedgefundswhoaremoreenamoredbyrisk
managementthanthemundane“upsanddowns”ofthebusinessworld.Infact,theAFNis
almostacomprehensive,shorthandversionofthepercentageofsalesmethod,which
itemizeseachbalancesheetitemasapercentageofexistingsales,andthenusesthesales
forecasttoprojecttheestimatedsizeofeachitem.Onlythoseitemsthatincrease
spontaneouslywithsalesareincluded;theseassetsarecomparedwiththeinternally
generatedfundingavailablefromshort-termcreditandretainedearnings,andthedeficitis
madeupfromthe“additionalfundsneeded”-externallygeneratedcapitallikebond
issues.
CorporateanalystsusetheAFNequationtoprojectneededfunding,butinvestors
canuseitasascreentoidentifythosecompaniesandindustriesthathaveanabsolute
advantageovertheirpeers.Thosecompanieswiththehighestaveragesalesincrease,
coupledwiththeleastneedforadditionalfundsaremoredestinedtomovetowardan
optimalcapitalstructure;theircapitalcostsarelow.Toillustrate:

297

THEVARIABLES
Table11-7

VARIABLE EXPLANATION
A/S(assets/sales) AssetsthatIncreasewith
Sales
∆ ∆∆ ∆S ChangeinSalesfrom
Year1toYear2
(AbsoluteandConcrete-
notaPercentage)
L/S Liabilitiesthat
SpontaneouslyIncrease
withSales(notNotes
Payable,forexample)
S1 AbsoluteandConcrete
FigureforProjectedSales
M ProfitMargin(net
income/sales)Thisisa
Projection
(1-D) TheRetentionRatioonce
DividendsarePaid
D DividendPayoutRatio
(Dividends/NetIncome

Sincepreciseaccuracywiththisequationrequiresanaccountant’sknowledgeofthe
company,familiaritywillbreedflexibility,i.e.,onecanderiveaballparkfigureby
assumingthatL/Simpliescurrentliabilitiesandthatprofitmarginisafiveyearaverage.
298

Ifdividendsareconsistent,theycaneasilybeprojectedthroughthegeometricgrowth
method(seestatisticschapter).
THEADDITIONALFUNDSNEEDEDEQUATION
(A/S(∆ ∆∆ ∆S))–(L/S(∆ ∆∆ ∆S))-(M(S1)(1-D))
Essentially,theequationiscomposedofassetsthatincreasedwithsalesminusthe
internallygeneratedfundingavailablefromtradecredit,wagespayable,andother
businessactivity,minustheinternallygeneratedfundingavailablefromincreasedprofits.
Anegativeorlowfigureisusuallycorrelatedwithlowersalesasmeasuredonayearto
yearbasis.But-onoccasiontherearecompanieswhoconsistentlygenerateinternalfunds
abovetheirimmediateneeds,andrequirelittleoutsidefunding.Thesesamecompanies
willovercapitalizeforthesakeofacquiringothercompanies-thetypeoffundingacquired
byConocoPhillipsinourpreviousexample-andoffertheinvestoragreatopportunity.
Overcapitalizationusuallyrequiresamovementawayfromtheoptimalcapitalstructure,
andaconsequentloweringofthereturnoncapital,simplybecausethefundsarenotused
fortheimmediategenerationofsales.Evaluationisbasedonthecompany’shistorical
capitalturnoverrate,sales/capital;ifitishigh,thenovercapitalizationislessrisky.In
essence,sincethefirmhasmorecapitalthanneeded,itscapitalcostswillbetoohigh,even
iftheindividualcostofthecomponentsislow,andthatscenariocancauseadropinboth
EVA/capitaldynamic,andthereturnoncapital.
JustlikeEVAandthecapitalrequirementsmodel,theAFNlendsitselfto
spreadsheetoptimizationthroughalinearprogrammingmoduleusinganequationsolver.
Sensitivityanalysisisalsoeasilyperformedwithadatatableoraonevariablesolverlike
“GoalSeek”.LikeEVAhowever,theAFNismechanisticandoblivioustocontext.Asan
example,consideracompanywhoseemingly“overfunds”,alowprofitprojectmuchtothe
consternationofvariouscorporate“quants”.Ifthatfundingoccursattheendofa
businesscycle,itmaybejustthe“strokeofgenius”thatthefirmneedstobufferthemfrom
adownturn;thedemandforthatproductmaybeconstant,andlowerfixedcosts.Thus,
299

therearemanyextraneousvariablesthatdeterminethelevelofcapitalfunding.TheAFN
givesusacomparative“ballpark”figuretoaddtoourdecisionmakingandcanbea“red
flag“tocheckmoreclosely.
Mostindustriespossesseconomiesofscaleinwhichmoresalesareincreasingly
generatedwithlessassets.Anylargedistributionchainknowsthebenefitsofconsolidating
inventoryintoafewkeylocations,andnotduplicatingprocesses.Thesynergiesofmost
mergersinvolvethecostsavingsofreducedinputs,asmoreunitsaredistributedoverthe
sameamountoffixedcosts.Whilesalesdonotincreaseexponentially,theydoincreaseby
amuchgreaterlinearfactor.Secondly,changesinthebusinesscyclecanoffsetadditional
fundsbecauseexcessinventoriesbuildupduringunforeseendownturns.Notonlywill
theseexcessesbeunaccountedforintheAFNequation,butsotoowilltheunusedcapacity
offixedassets;machinerywillbeidlethatwilllowerexpectedsales.
Thirdly,thecostandnatureoffixedassetsrequirethattheybeboughtand
implementedinlarge“blocks”.Atfirst,theywillbeunderutilized,generatinglesssales
andthengraduallyproducingatcapacity.Thisinconsistencycausesalargedropinthe
assetstosalescurve,followedbyasteadyincrease.
THEMODIFIEDADDITIONALFUNDSNEEDEDFUNCTION
ThedeficienciesoftheAFNequationarereadilyapparent.Whileitisausefultool
todeterminesomelevelsoffunding,holdingamoderncorporationtotheAFNstandardis
myopicatbest.TherealvalueoftheAFNistouseitasanalgorithmtogaugecapital
efficiency.Bydividingthelastfigure,retainedearnings,bysalesandthendividing,not
subtracting,onefigureintoanother,wecanobtainameasureofcapitalselfsufficiency.
Whenwecomparefirmswithinindustries,wefindittobeapreferredmeasureofrisk.
Theequationreducesto:(A/S)÷ ÷÷ ÷(L/S)÷ ÷÷ ÷(RetainedEarnings/Sales).
Thesignificanceofthesethreecomponentsisasfollows:TheA/Sfigureisacapital
intensityratiothatgaugestheamountoffixedassetsinabusiness.Italsogivesa“rough
estimate”totheamountofoperatingleverage.ThelargertheA/S,thelargertheamount
300

offixedcosts,withtheimplicationthatabusinessismore“capitalintensive”.Whenthis
ratioisespeciallyhigh,earningsmaybemorevariable,andwewouldlookforlessfinancial
leveragetobeemployed.
TheL/Sratioisvital.Thegreatertheliabilitiesthatrisespontaneouslywithsales,
themorefundsthatwillbeinternallygeneratedbybusinessactivity.Thereasonthatsome
companiesquicklyturnlong-termdebtintoprofitisthattheycreateliabilitiesthat
significantlylowertheircostofborrowing.Vendorrelationshipsthatdevelopsignificant
tradecredit,alongwithvolumediscountsandtheabilitytoextendloans,createa“capital
substructure”thatisneveradequatelymeasuredbyanalysts.Short-termcreditis
normallylessexpensivethanlong-termdebt,andfinancialexecutiveshavelearnedto
exploitdisparitiesintheyieldcurvethatofferarbitrageadvantagesincapitalfunding.
Theretainedearningstosalesratiowillencompassthosefundsthataregenerated
bymoreprofit.Theretentionratioisasignificantcomponentofgrowth;intheGordon
model,wemultiplieditbyROEtoobtainagrowthfactorforthecostofequity.Wehave
alsoobservedthattoogreatanamountofretainedearningscanraisethecostofcapital,
especiallyattheendofabusinesscyclewhenthecostofequityishigh.Fewcompanies
havetoworryabout“toomuch”retainedearnings;eveninthecaseofexcess,retained
earningscanreduceshareissueswithoutincurringaccountingcosts.Whenthecompany’s
returnoninvestmentislowerthanthecostofequity,theyshouldbedistributedas
dividends,butforacompanywithbothahighcapitalintensityandvariableincome,they
offertheleastexpensive,mostdependablesourceoffunding.
ThegistofthemodifiedAFNfunctionistohavethelowestratiowithinaspecific
industry.Onecanobservethemechanismifoneconsidersthecapitalintensityratio,A/S,
asahypotheticalmeasureofoperatingrisk.Companieswithhighoperatingriskcan
affordlessdebtandmustgeneratemoreinternalfunds.Ifwedividetheretainedearnings
ratiointoahighA/S,andobtainalargenumber,itmaymeanthatretainedearningswere
toosmalltoprovideadequatefinancing,especiallywhencomparedtosimilarcompanies.
301

ThemodifiedAFNfunctionissimilartoEVA/capitaldynamic,exceptonadifferentscale.
Improvementisachievedwhentheratiodecreases,anditsabsolutesizedependsonthe
typeofindustry;commodityindustrieshavelargemodifiedAFNs,whilehigherprofit
businessesfallonthelowerendofthescale.Sinceeachentityiscapableofimprovement,a
decreaseisrelativetotheprioryearandtheindustrythatcontainsit.LikeEVA,itruns
concurrentwithstockprices,exceptthatitisnegatively,notpositivelycorrelated.
Theelegantsimplicityofthemeasurementisthatitcanbecalculatedinthirty
secondswithoutreferencetothecostofcapital,andassociatedregression,muchliketheDu
PontequationforROE.Initssimplestform,theDuPontequationmultipliesprofit
marginbyassetturnoverandtheequitymultiplier,or:(NetIncome/Sales)x(Sales/
Assets)x(Assets/Equity).Thisequationcontainsthesametypesofcomponentsbutgives
themthecommonreferencepointofsalesandthendividesthem.Whilethemeasurement,
ROE,doesnotdistinguishbetweenthetypesofindustry,themodifiedAFNseparatesthem
bytheamountofoutsidefundingrequired,andshouldbeusedforintraindustry
comparisons.Thefollowingexamplewillillustratethescopeofthenumbers.The
student/investorisencouragedtolookfortrends.
Table11-8

XEROX
YEARS 1969 1974 1978
Assets 1516 4207 5578
SALES 1357 3505 5902
CurrentLiabilities 419 1050 1339
RetainedEarnings 113.07 249.53 315.85
A/S/L/S/R/S 42.98 56.25 76.39

302

Table11-9

MANPOWER
YEARS 1994 1997 2000
Assets 1204 2047 3042
SALES 4296 7259 10843
CurrentLiabilities 668 1005 1522
RetainedEarnings 75.51 149.24 155.61
A/S/L/S/R/S 103.23 98.49 138.89
Table11-10

BARRA
YEARS 1993 1996 2000
Assets 38.4 84.2 226
SALES 45.6 105 224
CurrentLiabilities 12.3 32.6 68
RetainedEarnings 3.6 13.5 45.3
A/S/L/S/R/S 39.67 20.06 16.47

Table11-11

WALMART
YEARS 1992 1996 2001
Assets 20565 39604 83451
SALES 55484 104859 217799
CurrentLiabilities 6754 10957 27282
RetainedEarnings 1775.55 2567.04 5603.04
A/S/L/S/R/S 95.97 149.14 120.82

Table11-12

MICROSOFT
YEARS 1993 1997 2001
Assets 3805 14387 52150
SALES 3753 11358 19747
CurrentLiabilities 563 3610 9755
RetainedEarnings 953 3439 7785
A/S/L/S/R/S 26.51 13.11 18.47
303

Noticethatcompanieswhoeschewoutsidefunding,likeBarraandMicrosoft,fall
intoamuchnarrowerrangethanhighturnovercompanieslikeManpowerandWal-Mart.
Higherassetturnover(smallercapitalintensity)allowsacompanytotakeonmoredebt
withlessrisk,butcutsintoanalreadynarrowprofitmargin.Themarketwillseta
premiumontheonequalitythataspecificcompanydoesnotpossess.ForWal-Mart,the
premiumisonprofitmarginandmoreretainedearnings.ForMicrosoft,thechallengeis
tolowercapitalintensity.Eachcompanyiscapableofimprovementwithintheirrespective
degreesofAFN.Moreover,ahigherdegreeofAFNwillgiveacompanymoreflexibilityas
tostrategiccapitalallocation;amorediversemixofcapitalfundingisavailablewhena
companyusesexternalfinancing.Withnolong-termdebt,acompanylikeBarramustsell
stockifretainedearningsareinsufficienttomeetanticipatedneeds.Theyaredependent
onthevicissitudesofoperatingincometomeetcapitalgoals.Ontheotherhand,if
Manpowerhasapooryear,butanticipatesbetterfutureprospects,theyhavetheoptionof
turningtothecreditmarkets,fundingwithdebt,andthenpayingofftheloanwiththe
proceedsofanequityissuewhenearningsincrease.Thus,thereisnoabsoluteadvantagein
havingalowDegreeofAFN.Theadvantagecomeswhenoneeitherdecreasesthevalue,or
possessesthelowestDegreeofAFNwithinasector.Intheformercase,adecreasewould
mostlikelysignifythatacompanywasprofitableenoughtopayoffdebt-aslongas
existingcapitalneedsweremet.Inthelattercase,thefirmmayhaveaprofitmargin
slightlyaboveothersinthesamesector,whichwouldbelikelyifthefirmwereanindustry
leader.
DEGREEOFAFNLOGIC
ThelogicbehindthedegreeofAFNisstraightforward.Mathematically,ifwe
multiplybytheinversesoftheequation,wederiveaquotientbetweencostcomponentsand
fundingcomponents:(Assets/Sales)x(Sales/CurrentLiabilities)x(Sales/Retained
Earnings).Simplified,theexpressionis(AssetsxSales:/(CurrentLiabilitiesxRetained
304

Earnings).Sincetherespectivelevelsofretainedearningsandcurrentliabilitiesare
dependentonsalesandassets,anabsoluteincreaseintheratioindicatesmorefinancingis
derivedfromexternalsources-whichhasagoodprobabilityofraisingthecostofcapital.
WhilewecanneverbecertainthatloweringtheAFNwillalsolowerthecostofcapital,a
higherprofitmargin,moreretention,andincreasedbusinessactivityareallcorrelated
withminimizingcapitalcosts.
HowwellthedegreeofAFNstandsuptoconventionalindicatorslikeROEisthe
subjectofcontinuedresearch.Onapurelyutilitarianlevel,bothofthesemeasurements
areimperfect;theROEcanimprovedespitemassiveloadsofdebtbecauseleverage(Assets
/Equity)isimplicitinthemagnitudeofthecalculation.Ifafirmbecomesobligatedto
payinghighinterestratesfarintothefuture,suchanindicatorcanbemisleading.Onthe
otherhand,thedegreeofAFNisdependentontherelationshipofsalestotheother
variables;thisisabetterconcurrentindicatorofperformance.Whileitdoesnotmeasure
majorchangesincapitalstructurelikeROE,itmaybeamoreaccurateindicatorofboth
riskandreturn.Withouttheoptimizationofproportionaldebttoequity,ahigherROE
canraisethecostofcapital.Toillustratehowclosethesemeasurementscanbe,consider
thefollowinganalysisofManpowerin1999-2000.Thecostofequityisskewedupwards
becauseitwascalculatedfromaoneyearrenditionoftheGordonModel;amoreaccurate
fiveyearCAPMregressionwouldhavechangedthesizeofEVA,butnottheoverall
relationshipbetweennetincomeandequity.
305

Table11-13
MANPOWER-1999–2000

VARIABLE 1999 2000
ROE 22.94% 23.12%
ProfitMargin 1.53% 1.58%
AssetTurnover 3.59 3.56
EquityMultiplier 4.18 4.11
Assets 2719 3042
Sales 9770 10843
Currentliabilities 1418 1522
RetainedEarnings 135 155.61
DegreeofAFN 138.98 138.74
Netincome 150 171
Equity 651 740
Costofequity 20.65% 21.04%
EVA 15.56 15.3

NoticethatthedegreeofAFNmirroredtheROEasaperformanceindicator.
However,EVAdecreasedeversoslightly;useoftheGordonmodelmakesEVA
calculationsmoreexactingbutlessaccurate,becausetheydependoninternal,ratherthan
marketdynamics.Mostinvestorswouldhaveavoidedthisstockbecausetherearenoclear
indicationsofthedirectionofthecompany,andindeedStandardandPoor’sgavethis
stockan“avoid”ratingin2001,becauseofconcernsabouttheemploymentmarketduring
aconcurrentrecession.
Amorethoroughanalysisindicatesthatthecompanyincreasedbothoperating
momentumandfinancialleverage,aswellaslong-termdebttocapital.However,theasset
/capitalratiodroppedto2.47in2000from2.7in1999.Whilesomecompaniesavoid
short-termdebtwhentheyieldcurveisinvertedasitisbeforearecession,Manpower’s’
ratiowasprobablymoreindicativeoflowerbusinessactivity.Theslightdeclineinasset
turnoverto3.56from3.59wouldnothavebeenasforwardlookingasadropincurrent
306

liabilitiesasanindicationofbusinessactivity.Additionally,thecompanywastakingon
debtasinterestrateswerepeakingwhichmayhaveraisedthecostofcapital.
THENEEDFORQUALITATIVEASSESMENT
Althoughnumericalanalysiswasquiteneutral,itprovidedthelogicforqualitative
assessment:aseriesoftradeoffsandstalematesleadingtouncertainty.Evenwithalow
betaof0.8,Manpowerwas“inthewrongplaceatthewrongtime”.Theywereinthe
employmentbusinessinthemiddleofarecession.Althoughtheywouldreceivesomeofthe
overflowfrombusinessesthatdidnotwanttofullycommittheirresourcestohiring
employees,theycouldnotcompensateforcutbacksintemporarylabor.Thus,capital
structureanalysispossessessomepowerfulcomputationaltools,butitisnotasubstitutefor
analyticalcommonsense.SellingChristmastreesinJulymaynotbesuchagoodidea,
evenifthefundamentalstellyouthatitis.
THEPROBLEMWITHOPTIMALITY
Inanygiventimeperiod,analystscanconstructacollectiveprobabilitydistribution
forsimilarcompaniesconsistingofinterestcoverageratiosandthefrequencyofdefault.
Thisdataisthenturnedintoalogittypeprobabilityfunctionthatchoosesbetweendefault
andsolvency.Theoretically,distressedeconomictimeswouldcreateahigherstandardand
“tightencredit”,while“booms”wouldloosencreditandallowlowerTIE(timesinterest
earned)ratios.However,unlessthesecreditstandardsareflexible,theywillbeunableto
mirrorthechangesindemographicsandassetstructurethatcomprisethelargereconomy.
Whendisparityoccurs,numerousfinancialinstitutionsundergoamassdislocation,with
consequentfallouttosmallerbusinessesandtherequisiteFederalReserveinvolvement.
Atthehighestlevels,mostmajorcompanieshavesomeoptimizingsoftwarethat
attemptstoputconstraintsontheamountofcapitalspendingwithinthedomainofbetter
performance.Bychangingthelevelsofconstraintstomeetneweconomicstandards,the
companycreatesitsowndefaultprobabilitymodel.Forexample,ifIknowthatthe
industrystandardis30%long-termdebttocapital,therewillbesomepenaltyinviolating
307

thatconstraintandthatsomecompensatingfactor-increasedmarketshare,more
diversifiedoperations,etc.,-mustcounteractit.Eventually,thecompanyfacesasimilar
dilemmaasmostfinancialinstitutions:thegreaterthecomplexityoftheeconomy,the
morerandomvariationaffectsdecisionmaking.Probabilitymodelswillsometimesfailto
worksimplybecausetheyareunabletoencompassnewinformation.Evenwhenvariables
arecomputergenerated,thereisbothalagtimeandinadequacyintheirbreadthof
coverage.Thus,wegetneuralnetworksthatprimarilygettheirinputfrompast
performanceandareunableto“foresee”newdevelopments.
Thecruxofproblemswithdefaultprobabilitymodelsliesnotwiththehuman
frailtiesofanalystsorinmathematics,butinhowtheyareused.Basingconsumercredit
onaprobabilitymodelthatisderivedfromonecompany,inonetimeperiod,hasthesame
risksthatanynondiversifiedbusinessplanhas:itmayworkwellforaperiodoftime,
whichencouragesoverdependence,andthencollapsescompletely,becauseitfailstoadapt
tochangingcircumstances.Whenwebasecapitalstructureoptimizationonashifting
parameterofminimizingcapitalcosts,giventheconstraintsofdefault,weequivocate
betweenaddingdebtwhenitislessexpensive(usuallywheninterestratesarelow),and
addingequitywhenitisattractive,andearningsarehigh.However,withouttheseself
imposedconstraints,capitalspendingoptimizesatastructureofalldebt,simplybecause
interestistaxdeductible.Thesolutionofcourse,istonotsomuchconcentrateonthecost
ofcapitalasthecostofbankruptcy,whichisevenmoreundefined,unique,andarbitrary
thantheformer.Sincebankruptcycostsimplytheuseofdefaultprobabilities,weagain
entertheterritoryof“overdependence”-analgorithmthatcansendusinthewrong
direction.Tocircumventthisdependence,wemustusetheprobabilityofdefaultina
uniqueway:weneedtosolveforthevariablethatwouldmostimprovethealgorithm-
earnings-andrelateittheamountofdebt.Secondlyweneedtojuxtaposeimmediatetax
benefitstolong-termbenefits,realizingthehighernetpresentvalueoftheimmediate
benefit.Lastly,weusethestockpriceasabarometerofvalue:anymarketvaluethatwas
308

createdwithoutlowerdefaultprobabilities,oratleastwithoutmoretaxbenefitsfromdebt,
isviewedasatransitorynegative.Thus,theprobabilityofdefaultisasmuchapartofthe
solution,asitisaconstraint.Anygenericprobabilityofdefaultcanofferinputonwhatthe
bestlevelofearningswouldbe,althoughmathematicalprecisionwouldbelacking.
Nevertheless,wecanatleastobtainaballparkfigurethatwouldenableustocomparean
idealizedcapitalstructurewithourown.Suchanidealwilllackthemarketadaptability
mentionedpreviously,butwillbelessdependentoncreatinganabsoluteconstrainton
default;thelevelofdebtwilldependontheinteractionofprofitabilityandtaxadvantages,
andonlythenonthelevelofdefault.Inessence,weuseourbiggestliabilities,taxesand
debt,toouradvantage-asameasuringstickthatbalancesseveralothervariables-
income,assets,stockpriceandtangibleassetsthatcanbeusedascollateral.
MERGERMANIA
Iftangiblebookvaluepershareisoneofthelinchpinsofouroptimization
algorithm,itisbecauseithasbecomeprominentfortworeasons:1)hedgefundsand
privateequityfirmshaveusedmergersandacquisitionstocreatetheillusionofgrowth;2)
accountingpolicieshavechangedoverfromthe“pooling”methodtothe“purchase”
methodofaccounting.Thedifferenceiscrucial:whencompaniespayapremiumoverfair
assetvalue,theexcessistermed“goodwill”,andbecomesanintangibleasset.However,it
isstillcountedinthe“bookvalue”ofassetsoverliabilities,whichmakesanymultipleof
marketpricetobookpriceseemlessspeculative.Infact,theindicatorbecomesmore
speculative,becauseitisbaseduponmanagement’sjudgmentofthemerger’spotential,
ratherthaninvestors’choicestofundastock.
Thelegitimatepurposeofmergersistoincreaseeconomiesofscaleandachieve
synergisticearningsthatwouldnototherwisebepossibleinasmallerenterprise.
Diversificationreducesriskandanyfirmthatdecreasesoperatingleveragecanultimately
increasethevalueofthefirmbyaddingfinancialleverage.However,thescopeoftoday’s
mergers,withthehooplaofCNBCcrowingabout“MergerMondays!”,isthatboth
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investorsandmanagementgetconnedbytheasymmetryofinformation:manyofthese
dealsaresimplymethodsofmakingalarge“commission”forafewparticipants.The
investorsbelievethatmoreassetswillequalahigherstockprice,whilemanagementhasan
unshakablefaithintheefficiencythatcomesfrompoolingresources.Infact,both
investorsandmanagementcansuffertheconsequencesofamergerthatlookedgoodon
paper,onlytorealizelaterthatgreatermarketsharedidnottranslateintogreaterprofit
persharebecausethemarketwasdeclining.
Defendersofmergershavethreevalidarguments.Iffixedassetscanbesharedby
thetwocompanies,therewillbeeconomiesofscaleandsomesynergythathelpreduce
costsandincreaseprofit.Secondly,evenifnosynergyoreconomiesexist,acashflowthat
istimeddifferentlyfromtheacquiringcompany’swillhelpreducerisk.Thirdly,greater
sizewillallowquantitypurchasesthatwillreducevariablecosts.Whatthesearguments
haveincommonisthateachdependsonquantitativegrowth,notnecessarilytothe
exclusionofthequalitative-butatleastemphasizingit.Whatinvestorslookforina
companyisoftenan“emotionalideal”thatisdifferentiatedfromthecompetitioninsome
discernibleway.ConsideralegalmergerbetweenFed-ExandUPS,orCokeandPepsi.
Whatwouldbetheproducts?Howcouldinvestorschoosesides?Inessencegreater
growthisnotalwaysacashcowforinvestors,especiallyifgreaterdemandisnot
stimulated.However,itisalmostalwayslucrativeforthosewhobrokerthedeals.Infact,
manymergersarebasedonwhatEugeneBrighamtermed,“theillusionofgrowth”.Here
ishowitworks:
CompanyXisnotgrowinginternallyanymore.Saleshavestagnatedandtheyneed
toincreaseearningspershareorriskanalysts’downgradingthestock.TheirP/Eis20and
theirEPSis$1/share.Foryearstheyhavebeengrowingat20%andinvestorsexpect
thatratetocontinueinthefuture.Whattheydon’tknowisthataworldwideshortageof
thecompany’smaininputwilleventuallyescalatecosts,cripplinganychanceof“organic”
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growth.Ontheotherhand,companyYisdistressed,andataP/Eof10,lookslikea
bargain.CompanyXmakesaplayforcompanyY.
IfcompanyXhas20millionsharesoutstanding,eachearning$1pershare,their
earnings,ofcourse,are20milliondollars.CompanyYhas10millionsharesoutstanding,
eachalsoearning$1pershare,foratotalof10milliondollarsinearnings.After
discussingwaystoconsummatethemerger,thecompaniesdecidethatthemostequitable
methodwouldbetosetupanexchangeratioof10/20or0.5sharesofcompanyXstockfor
eachshareofY.Themergerseemstogounquestioned;P/Eratiosareinlinewith
earnings,price,andthenumberofshares.Thenewearningspershareofthecombined
companyare:$20Million+$10Million/20millionshares+5millionshares=30/25=
$1.20/share.Suddenly,companyXhasgrown20%inEPSsimplybycombiningtwo
piecesofpaper!
NowwhatifcompanyYisahighlyprofitablebioresearchfirmandcompanyXisa
toolanddiemaker.CompanyYhaspatentsabouttoexpireandsothevalueofitsassetsis
muchlessthanthe$100Million(5millionsharesx$20/share)instockthatcompanyX
paidforit.Infact,supposecompanyYisonlyworth$50Million.CompanyXwould
adjustforthedeficitlikethis:
Table11-14

NETINCREASEINPLANTANDEQUIPMENT$50MILLION
NETINCREASEINGOODWILL$50MILLION
NETINCREASEINEQUITY$100MILLION

IfcompanyXoriginallyhada4/3(1.33)markettobookvalue,itwoulddeclineto5/4
(1.25),andtangiblebookvaluewouldincreasebyonlyonehalftheassetvalue(50vs.100
Million).Ifwereversetheratioandgobybooktomarketvalue,bookvalueincreases
relativetomarket,risingfrom3/4(0.75)to4/5(0.8).Butifwegobytangiblebookvalue
pershare,theratiois3.5/5(0.7),whichislessthantheoriginalvalue.
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Twosignificantpoints:1)BypurchasingacompanywithalowerPE,andpaying
foritsmarketvalueinstock,wehaveincreasedEPSby20%withoutanycorresponding
increaseinproductivity.2)Bypurchasingacompanyinexcessofitstruemarketvalue,
andattributingthedeficittoanotherassetclass,“goodwill”,wehavetaken$50Millionin
assets,andcreated$100MillioninmarketvalueInoursimplifiedmodelofbankruptcy
costs,adecreasedtangiblebookvaluepersharewascoupledwithgreatermarketvalue,
andwouldhaveincreasedthesedistresscostswithoutanyadditionalinterestpaymentsor
ratechanges.Sincethedealwaspaidforinstockandnotdebt,therewerenoconcurrent
taxadvantagesthatwouldhaveabsorbedthehigherdefaultcosts.Nevertheless,earnings
wouldhaveincreasedby20%inthenear-term,leavingahandfulofshort-terminvestors
happier,andthebrokersofthedealalotwealthier
MERGERGROWTHILLUSIONANDEVA
LikeearningsthereisnotelltaleoutlierthattellsusEVAisbeingmanipulated.
Assumingthatthe“ruleofthumb”inverseofthePEgivesusanaccuratecostofequity,we
canapplyEVAtobothcompanies.CompanyXhasa1/20or5%costofequity,while
companyYhasa1/10or10%costofequity.CompanyXhada(20-(.05)(300))or$5
Millioneconomicprofit.CompanyYhada(10-(.1)(100))orzeroeconomicprofit.
Togetherthecombinationproduced(30-(((.75)(.05)+(.25)(.!))(400))or30-25=$5
MillionEVAUltimately,thefinalmergerengenderedahighercostofequityforcompany
Xwithnorealgainineconomicprofit.Tocontinuegrowingwithoutproductivesynergy,
companyXwouldhavetotakeonincreasinglylargermergersorsuffertheconsequences
oflessgrowthandalargercostofequity.
Themainconcernofanoptimaltargetstrategyistoensurethatthetaxbenefitsof
anyleverageusedtobuyanothercompanyareequaltotheadditionaldistresscosts.Ifthe
gapbetweenmarketvalueandtangiblebookvalueincreases,thosemarginalbankruptcy
costscanoffsetanygainintaxbenefits.Theaverageshareholdercannotbeawareofall
thepurchasesmadebyafirm,butlargeinstitutionalinvestorshavetobe.Ifthereisno
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realgainineconomicprofit,butearningsaretoutedas“growing”,itmaybetimetolook
foranotherinvestment.
(BacktoTableofContents)
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314

315

SECTIONII:BUILDINGCAPITALSTRUCTUREMODELS
12
THEECONOMICPROFITLABORATORY:COMPUTER
APPLICATIONS
Thischapterwillrequiretheusertocreateaneconomicprofitmodelina
spreadsheetprogramlikeMicrosoft’sExcel.Withoutsuchaccess,thestudent/investorcan
stillfollowtheconclusionsoftheexperiments,andmaywanttoreviewtheentirechapter
beforeproceeding.Thereisnospecialskillrequired,eitherincomputerscienceor
mathematics-exceptforremedialknowledge.However,theuserwillfindthataworking
modelisinstructivewhenheorshetriestofollowthelogicofthematerial.
SETUP
Theprogramissetupforbothsensitivityanalysisandoptimization.Itwillrequire
twosectionswhicharenearmirrorduplicatesofeachother.Thefirstsectionisforinput
ofactualvaluesfromfinancialstatementsforsensitivityanalysis.Thesecondsectionwill
beasetupforoptimizationoftheactualfigures,andwillallowentryofonlyonevariable.
SECTIONONE
Sectiononehas14columnsand4rows.Thecolumnsarelabeled“A”to“N”,but
columnAisjustatitlecolumn.Theusershouldinputtheword“ACTUAL”inboldprint
inA1.Theothercolumnsandrowsaresetupasapatternofonerowoftitlesandanother
rowofcalculationsbelowit.Row1isalltitles,androw2isallcalculations.Row3isall
titlesagain,androw4iscalculations.

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SECTIONONE
Table12-1

Column/Row Title Calculation Column/Row Title Calculation
B1-B2 EBIT ENTER B3-B4 Interest
Expense
D4xE4
C1-C2 NetIncome (B2-B4)-(C4
x(B2-B4))
C3-C4 TaxRate ENTER
D1-D2 Numberof
Shares
ENTER D3-D4 Interest
Rate
ENTER
E1-E2 EPS C2/D2 E3-E4 Long-term
debt
H4-J2
F1-F2 Book/sh. J2/D2 F3-F4 Costofdebt D4(1-C4)
G1-G2 Risk-free
rate
ENTER G3-G4 Debt/Equity E4/J2
H1-H2 BETA ENTER H3-H4 Total
Capital
ENTER
I1-I2 Market
Rate
ENTER I3-I4 WACC ((F4x
E4)/H4)+((
K2x
J2)/H4)
J1-J2 Equity ENTER J3-J4 Costof
Capital
I4xH4
K1-K2 Costof
Equity
G2+(H2x
(I2-G2))
K3-K4 TotalCost
ofEquity
J2xK2
L1-L2 EVA C2-(k2x
J2)
L3-L4 Stock E2/K2
M1-M2 LTD/CAP E4/H4 M3-M4 ROE C2/J2
N1-N2 ROC C2/H4 N3-N4 EVAStock
Value
L2/I4

SECTIONTWO
Sectiontwoisforoptimization.Itstitlesformaperfectmirrorimageofthosein
sectionone-exceptfortwocells:inN6thetitleis“EVADifference”andnot“ROC”,with
acalculationof(=L7-L2)placedbelowitinN7.Thecalculationsintheoptimization
sectionaredeterminedbytheinputsinsectionone,exceptfortheentryof“Equity”inJ7.
Technically,sectiontwochangesBETAeachtimeanewproportionofdebttoequityis
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inputted.Bychangingjustonecell(“Equity”inJ7),anewnetincomeandcostofequityis
calculatedwhichchangesEVA.
ThebetacalculationsaremerelyrestatementsoftheHamadaresearchthatwas
coveredinthechapteronthecostofequity.Byholdingoperatingincome,capital,andthe
interestrateconstant,allchangesinEVAaredrivenbychangesinequity.Properly
speaking,themodelisbasedonthecapitaldynamicandnotEVA,butweusethese
conceptsinterchangeablywheninterestpaidondebtmirrorstheinterestrate.
Table12-2

Column/Row Title Calculation
B6-B7 EBIT B2
C6-C7 NetIncome (B7-B9)-(C9x(B7-B9)
D6-D7 NumberofShares D2
E6-E7 EPS C7/D7
F6-F7 Book/sh. J7/D7
G6-G7 Risk-freeRate G2
H6-H7 BETA H2/[(1+(1-C4)xG4)x
(1+(1-C9)xG9)]
I6-I7 MarketRate I2
J6-J7 Equity ENTER
K6-K7 CostofEquity G7+(H7x(I7-G7))
L6-L7 EVA C7-(K7xJ7)
M6-M7 LTD/CAP E9/H9
N6-N7 EVADifference L7–L2

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Table12-3

Column/Row Title Calculation
B8-B9 InterestExpense D9-E9
C8-C9 TaxRate C4
D8-D9 InterestRate D4
E8-E9 Long-termDebt H9-J7
F8-F9 CostofDebt B9x(1-C9)
G8-G9 Debt/Equity E9/J7
H8-H9 TotalCapital H4
I8-I9 WACC (F9x(E9/H9))+(K7x
(J7/H9))
J8-J9 CostofCapital I9xH9
K9-K0 TotalCostofEquity K7xJ7
L8-L9 Stock E7/K7
M8-M9 ROE C7/J7
N8-N9 EVAStockValue L7/I9

IncellA6,inputtheword“OPTIMIZATION”inboldletters.CellsA7,A8andA9willbe
leftblank.Anotheroptionthattheusermayfindhelpfulistocopytheentire“ACTUAL”
section,sectionone,andpasteitafewrowsbelowtheoptimizationsection.Inthismanner,
thestudent/investorcanmakecomparisonsbetweenthesamefirmordifferentfirmssince
themoduleis“standalone”andnotdependentonanoutsidesourceforcalculations.
SAMPLEDATA
Toemploybothoptimizationandsensitivityanalysis,wewillusesomesampledata
toenterintothe“ACTUAL”section.Afterinputtingthevariables,anumberof“derived”
variableswillbecalculated.Theyarelistedheretomakesurethatyouare“ontrack”.
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Table12-4

INPUTED
VARIABLES
AMOUNT DERIVED
VARIABLES
AMOUNT
Equity 500 Long-termdebt 500
TaxRate 30% EPS 4.375
InterestRate 5% NetIncome 87.5
TotalCapital 1000 BookValue/sh. 25
Shares 20 EVA 37.5
OperatingIncome 150 InterestExpense 25
Risk-freeRate 4% ROE 17.5%
BETA 1 ROC 8.75%
MarketRate 10% StockValue 43.75
EVAStockValue 35.13
Long-termDebt/
Cap.
50%
WACC 6.75%

Usethederivedfigurestocheckyourcalculations.Itisquiteeasytoplacean
inappropriatesign.Theusercanconfiguretheprogramasdecimalsorpercentsbut
shouldprobablysticktodecimalsinthebeginningtomakesureitworkscorrectly.
SENSITIVITYVERSUSOPTIMIZATION
Sensitivityanalysisismorerealisticthanoptimizationbecauseeachvariablecanbe
changedtomeettheactualdemandsoffinancialstatements.Thus,arealisticrenditionof-
say,GE’sEVAispossibleaswellasanindicationofthenecessaryinputstoimproveit.On
theotherhand,optimizationismoretheoreticalbecauseweneedtokeepbothinterestrates
andthenumberofsharesconstant;thesevariablesarederivedfromsourcesoutsidethe
model.Thenumberofsharestoissueissometimesapoliticaljudgmentwithalittle
mathematicsthrownin,whileinterestrateschangeonaperiodicbasis.Thereisno
predictivemodelthatcanencompasseitherofthesevariableswhenmassivechangesin
capitalstructurearemade.Therefore,optimizationassumesthatafirmcanraiseasmuch
debtasrequiredatthegiveninterestrateandthattheamountofshareswillnotchange.
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However,giventhoseassumptions,itcanpointthefirmintheproperdirection;without
makingchangesinthenumberofsharesissuedorthecurrentinterestratethatispaid,the
firmhastheoptionofmovingslightlyinthesuggesteddirection,andsomeimprovementin
actualEVAisviable.Athirdnominalconstraintistheamountofcapital;thismodel
assumesthattheproperamountofcapitalisbeingraisedandworkswithinthose
limitations.Sincecapitalallocationisthemostimportantdecisionthatmanagementcan
make,underoroverfundingprospectiveprojectscreatesnumerous“shocks”tothe
system.Whiletheseprogramscanexhibithowthoseproblemscanbecircumvented,they
cannotcalculatetheproperamountofcapital.“Fixing”theoverageorunderagewitha
shiftincapitalproportionwillonlydelaythepainofinefficiencyuntilacompensating
capitalinflowactuallyneutralizesit.
PROVINGTHECAPITALDYNAMIC/EVAHYPOTHESIS
Economicprofitisalinearconstruct.Byminimizingtheamountofdebt,wecan
emphasizethe“netincome”sideofthefunctionbecauseinterestwillnotbededucted,and
theearningsfigurewillgrowtoitsmaximum.However,ifthecostofdebtisinexpensive
enough,thentheinterestdeductionsmaybebothsmallandtaxdeductiblesuchthatequity
shouldbeminimized.Minimizingequitywoulddetractfromthe“Stockholders’Equity”
sideofthefunctionandcreatealargerEVAbydefault.IfEVAdoesindeedmaximizeat
extremesofthecapitalcomponents,thentheremustbesomecombinationofcostelements
thatcreatesanindifferencebetweendebtandequity.
SETTINGTHECONSTRAINTS
Toexaminethishypothesis,wewillusethesampledatafromabove.Atthistime,it
isnecessaryforthestudent/investortobefamiliarwithalinearprogrammingmodulelike
“Solver”,whichislocatedinExcel’stoolsection.Solverisan“AddIn”forsolvinglinear
problemswithconstraints.SinceEVAisalinearfunction,itisamenabletochangingits
parametersandmaximization.Ifunfamiliarwiththeprocedure,gototheinformation
sectionandreadtheinstructionsonSolver;otherspreadsheetprogramshaveverysimilar
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modules,anditbehoovesthestudent/investortoatleasthaveaworkingfamiliaritywith
these.Inessence,wewillbeabletochangeanyblankinputcell(withoutacalculationinit)
thatispartoftheeconomicprofitfunctioninordertooptimizeit.Theprocedureisas
follows:
STEP1.Gototheoptimizationsection(section2)andinputincellJ7,anynumber
between1andtheamountoftotalcapital.Say,500inthisexample.
Step2.EngageSolverinthetoolssection.ClickonthecellwiththeEVAcalculationinit,
L7.Thatisthefunctiontobeoptimized.
STEP3.Wheretheoptionsgive“minimize”,“maximize”,or“setequalto”,click
“maximize”.
STEP4.Intheboxthatstates“bychanging”,wetypeinJ7
STEP5Wesettwoconstraints.WeaddthatcellJ7isgreaterthanorequalto(>=)the
number,“1”.Wedothisbecausethenatureofbetaistodividedebtbyequityandweneed
tohaveanonzerofunction.Inthesecondconstraint,wesetlong-termdebt,cellE9toany
numbergreatertoorequaltozero(>=)becausewedonotwanttooptimizewithnegative
numberswhichwouldbeimpossibletoobtain.
STEP6.Click“Solve”
Unlessthecombinationofcapitalcostcomponentsisveryunique,thefunctionwill
maximizewhenequityiseither“1”oratthecapitallimit(inthiscase1000).Thisextreme
cornersolutionmaynotbepracticalorobtainablebutitshowsinwhichdirectioncapital
componentsmustmoveinordertoimproveeconomicprofit-withexistingparameters.
TRIGGERPOINTS
Inalinearfunctionlikethecapitaldynamic,theremaybesomecombinationofcost
componentsthattotallyneutralizestheeffectofchangingcapitalproportions.For
example,iftheinterestrateishighenough,EVAwilloptimizeatanallequityvalue,butat
somelowerrate,optimizationwillbeintheotherdirection-acapitalstructurecomposed
ofalldebt.Itishelpfulforafirmtoknowwhatthese“triggerpoints”aresothattheycan
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setpriorities;attemptingtochangeEVAbychangingcapitalproportionsmaybe
productiveatsometimesandnotatothers.Wheninterestratesareespeciallylow,for
example,wealthiercompaniescanincurdebtandimproveEVAthroughleveragealone.It
ishelpfultoknowwhatthisrateis.Ineffect,thestudent/investorwillfindthatthe
relationshipbetweenthe“riskpremium”inthecapitalassetpricingmodel,andtheinterest
ratethatafirmpaysonitslong-termdebt,isperhapsthemostimportantdeterminantof
EVA.Moreover,thetaxratebecomessignificantnotjustforthedeductibilityofinterest
expense,butbecauseitaffectsbetacalculationsandthecostofequity.Withoutariskof
default,EVAmaximizationbecomesanexerciseincombiningcostcomponents,anherein
liesitsgreatestliability;amarketthatlacksequilibriumcantemporarilyskewthesecost
variablesandmisleadafirmintomakingbadjudgments.
SETTINGTHETRIGGERPOINTMODULE
Intheoptimizationsection,weinputeithera“1”orthecapitallimit(inthiscase
1000)inthe“Equity”cell,J7.WethenengageSolvertosettheoptimizeddifferenceto
zerobychangingoneofthecostofcapitalcomponents.Thefollowingbriefprocedure
takesusthroughadetermination:
STEP1Asstated,entera“1”orthecapitallimitofH4incellJ7
STEP2.EngageSolverinthetoolssectionofExcel.
STEP3.ClickoncellN7,“EVADifference”.ThiscellsubtractstheactualEVAfromthe
optimizedversion.
STEP4.Clickthe“setequalto”button,andenterazero.
STEP5.Inthe“bychangingcells”part,pickanycellforwhichyouwishtofindatrigger
point.Thecellneedstobeablankentry(nocalculations)andshouldbeacostofcapital
variable.Inorder,thoseelementsare:TaxRate,Risk-freeRate,MarketRateBETAor
InterestRate
STEP6.Iftheconstraintsarenotsetastheywereintheoptimizationmodule,change
themtothatconfigurationnow.Otherwiseleavethemastheyare:J7>=1,andE9>=0.
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STEP7.Click“SOLVE”
Asanexample,usecellD4,“InterestRate”asyourtriggerpoint.Enterthatcellinthe“By
changing”section.Withthesuggesteddatastillinplace,thatcellwillchangeto7.23%.
Keepingallothercostofcapitalcomponentsconstant,ifwechangetheinterestrateto
7.23%,EVAwilloptimizeatonehundredpercentequity.Ifwechangetheinterestrateto
7.22%,EVAwilloptimizeatonehundredpercentdebt.Thus,ifafirmisnearthis
combinationofcostelements,theemphasisshouldbeonincomemanagementandnot
capitalproportions-atleastinthedomainofEVAimprovement.Atthisjuncture,an
indifferencecurveformsandthecostofmakingchangesbasedoncapitalproportionwould
belessthanthebenefits.
THEEARNINGSSOLUTION
WhilemanagingcapitalproportionscanhaveaprofoundeffectonEVA,itisnot
nearlyascorrelatedtostockmarketincreasesasearnings.Infact,throughthe
managementofretainedearningsalone,afirmcangainacompetitiveadvantage;
operatingincomefuelstheprofitabilityofequityfinancing.Althoughthecostofretained
earningscanescalateanddiminishEVA,fewfirmswillbemateriallyhurtbyfundingin
thatmanner.Theculpritinascenarioofcostlyretainedearningsisalwaysthepercentage
increaseinnetincomewhichneedstobehighenoughtojustifyretention.Thus,what
mightseemtobeahealthyincreaseinearningsmaynotbeadequatetoeclipsethepotential
increaseinequity,andeconomicprofitdeclines.However,afirmwhoisworryingabout
“toomuchretainedearnings”,isusuallywealthyenoughtohaveacompensatingdividend
policyorasharebuybackprogram.
Morenetincomecanalsogiveimpetustoawell-managedshareissuewhichwill
usuallymoveacompanyawayfromitstargetstructure.Wheneverafirmexpands
throughshareissuesratherthanretainedearnings,flotationcostsareincurredandtherisk
ofowningthestockgoesup;theweightedaveragecostofcapitalrises.Moreearningscan
bufferthedilutioneffects(bothinEPSandshareprice)ofastockissuewhileattracting
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buyersandcreatingdemandatahighmarketprice.Anytimeretainedearningsare
inadequatetocovercapitalrequirements,afirmhasachoicebetweenvarietiesofother
sources:thechoicetofinancewithnewstockseemscosteffectiveifthepriceishigh
enoughbecausemorecapitalisraisedwithlessshares.Duringtheissue,EVAcanstill
increasedespitethenon-optimalityofcapitalproportions.Inthiscase,morecapitalwould
beraisedthanwarrantedwhichwouldincreaseitscost.Thattypeofdecision-toraisea
largeamountofcapital-representsatemporaryriskthatshiftsafirmawayfromitstarget
capitalstructureinordertogainmorepotentialreturninlaterperiods.
OPTIMIZATIONANDCORRELATION
Inouroptimizationmodel,therewasaperfectsubstitutionofdebtforequity;aswe
loweredonecomponent,weraisedtheother.Ineffect,wecouldincreaseEVAduringa
debtissuebecausethereductioninstockholders’equitywasgreaterthanthereductionin
netincome.Thisscenariooccurredatlowerinterestrates,andoncea“triggerpoint’was
engaged,netincomewasreducedfasterthanequitywoulddecrease.
Whileitiscertainlymathematicallypossibletoincreaseboththeproportionofdebt
andEVAsimultaneously,itisimprobablethatsuchanincreasewouldberelativelylarge.
Fromthenetincomeside,interestpaymentsmaybegreaterandmostcompanieswanta
nettaxadvantageovertaxespaid,issuingdebtwhenearningsarediminished.;
additionally,thereislessdemandforanequityissuewhenearningsaredepleted.
However,thechoiceisrarelyonesourceofcapitaloveranother,butthequestionof,“How
muchofboth?”.Firmsfundinadiversifiedmannertolowertheriskofdependence,just
astheymayengageseveralvendorsforthesamepart.Equitywillbeincreasedduring
mostdebtissues,andsincemoredebtraisesthecostofequity,itwillbemoreexpensiveas
well.Thus,thestockholders’equitysideofEVAmayriseevenasnetincomeincreasesare
minimalduringadebtissue.TheneteffectwillbeasmallerEVAandnota“managed
substitute”ofdebtforequity.
RAISINGCAPITALEFFECTIVELY
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Insensitivityanalysis,wecanlowertheinterestrateenoughtoraisebothEVAand
increasedebttoequityproportionally.Thisisthescenarioinwhichmanyfirmsfind
themselvesearlyoninarecovery:“theFed”lowersratestothepointwherefirmscannot
affordtoeschewdebt.Morecapitalcanberaisedatalowercostwhichincreasesthe
optimalityforthosewhofundwithdebt.Thepreviousexampleoftoomuchcapital
causingashiftawayfromtheoptimaltarget,becomesmuchlessofaproblem;thereare
simplygreatertaxadvantagesatalowerprobabilityofdefault.Infact,theentirecostof
bankruptcydiminishesbecauseassetpricesgetdepletedduringadownturn:whenthe
prospectsofcoveringinterestpaymentsimprove,theadditionofdebtmaymovea
companytowardamoreoptimalstructuresimplybyrestoringgrowthtoassets.Duringa
markettop,raisingtoomuchcapitalimpliedtheuseofanon-optimalsourcelike
convertiblebondsorastockissue.Inanenvironmentoflowcapitalcosts,however,raising
morecapitalisencouragedbecauseitcanbedoneinexpensivelyandwillsetthefirmupfor
acompetitiveexpansionwithotherfirms.Thus,itbehoovesanyfirmtokeeptheWACCto
aminimumbecausemorecapitalcanberaisedwithsuchacombination;thehallmarkwill
behighmarketvaluesaccompaniedbyalowprobabilityofdefault.
Forthosewhocanrememberthe“TechBubble”ofthelate1990s,muchofthe
damageoccurredbyraisingtoomuchcapitalatthewrongtime-attheendofabusiness
cycle.Thepromiseofa“NewAmerica”throughtechnologyalmostmimickedthe“Better
LivingthroughChemistry”axiomofthe1960swhenplasticswererevolutionizingthe
productindustry.Theoutlookforstartupsandventurecapitalseemedpositivewithno
endinsight.However,notonlywerethecostsofbothdebtandequityaccelerating
upwardsbylate1998,butfirmswhohadlittlestableearningshistorywereissuingmany
sharesofequitytofundwhateverInternet-relatedprojecttheyhaddreamedup.Over
productioninfiberopticsrequiredhugeamountsoffixedassets,andyettheworldwas
subtlyshiftingtowirelessaccess.Somethinghadtogive.
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Whenthemarketcollapsedintheearlyyearsofthenewmillennium,thereasonwas
notalackofinnovationorvision.Itwasnotbecauseafewspeculatorswerepumpingup
themarketwithexcessiveoptimismandaquick”pull-out”.Itwasnotbecausewewere
underproducingcomparedtotherestoftheworld.Thereasonwasasimpleneglectofthe
principlesofthecostofcapital.Investorswerepumpingmoneyintocompanieswitha
diminishedEVA,expectingexcessiverisktoproduceanexcessivereturnwherenonewas
warranted.
THECONNECTIONBEWTEEN,CAPITAL,STOCKPRICE,ANDEVA
Inthecomputerprogram,thereisbothacellfor“StockPrice”and“EVAStock
Price”,whichareartificialconstructsthatdivideanearningscomponentbysomeelement
ofthecostofcapital.Inthecaseof“StockPrice”itisearningspershare(EPS)dividedby
thecostofequity,while“EVAStockPrice”isEVAdividedbytheweightedaveragecostof
capital(WACC).Thesevalueshavesometheoreticalvalidityina“no-growth”situation
whereallearningsarepaidoutasdividends.However,hypotheticalunderpinnings
notwithstanding,theyeachshowearningsaccelerationcomparedtoaccelerationinthecost
ofcapital;inamicrocosm,thesearethemaindeterminantsofascendingstockprices.
Ifthestudent/investorcanobservethehighcorrelationbetweenEVAandstock
price,thenthepercentageformulaforEVAevincestheconnectionbetweenearningsand
capital:
(NOPAT/Capital-WACC)xCapital=EVA.Whenearnings(NOPAT)declinesand
capitalstaysthesame,thenEVAwilldecrease.WhileNOPAT/Capitalisnotquitethe
sameas“returnoncapital”or“ROC”whichisNetIncome/Capital,thesimilaritiesare
greatenoughtoequatetheentities.Therefore,ifcapitalremainsthesame,andthecostof
capitaldeclines,anyincreaseinearningswillhaveapositiveeffectonbothEVAandstock
price.Inessence,bothEPS/CostofEquityandEVA/WACCwillalsobegreater.
327

SENSITIVITYANALYSIS:THEEFFECTOFCHANGESINOPERATINGINCOME
ANDCAPITAL
Increasedoperatingincomeisnotmathematicallylinkedtoequityissuesor
increasesinequity.Netincomehasaspecificrelationshiptoequitybecauseinterestis
deductedwhendebtisincurred,butthereisnodirectlinkbetweenoperatingincome
increasesandariseinequity.However,astrongcorrelationexistsbetweenthetwo
becausetheconditionsthatareconducivetotheirgrowthinteractconcurrently:when
operatingincomeisup,debttendstogetpaidoff,andearningsgetretained.Usingthe
sampledata,wecanreadilyobservetheeffectofonemoredollarofoperatingincomeon
EPS,EVA,ROEandhypotheticalstockprice.Achangeinoperatingincomechangesthose
variablesmorethananyothers.
Table12-5

INPUTED
VARIABLES
AMOUNT DERIVED
VARIABLES
AMOUNT
Equity 500 Long-termdebt 500
TaxRate 30% EPS 4.375
InterestRate 5% NetIncome 87.5
TotalCapital 1000 BookValue/sh. 25
shares 20 EVA 37.5
OperatingIncome 150 InterestExpense 25
Risk-freeRate 4% ROE 17.5%
BETA 1 ROC 8.75%
MarketRate 10% StockValue 43.75
EVAStockValue 35.13
Long-termDebt/
Cap.
50%
WACC 6.75%

Forthisexperiment,operatingincomeisat150,andwearegoingtobothaddandthen
subtractoneunittoobservehowtheothervariablesreact.
328

Table12-6

CHANGEOPINC.TO
151

Variable DirectionofChange Amount
EPS UP 4.4083
EVA UP 38.065
ROE UP 17.63%
HypotheticalStockPrice UP 44.083

Table12-7

CHANGEOPINC.TO
149

Variable DirectionofChange Amount
EPS DOWN 4.34
EVA DOWN 36.8
ROE DOWN 17.36%
HypotheticalStockPrice DOWN 43.4

Whiletheamountofchangeincapitalisalsopositivelycorrelatedwithstockpricechanges
intherealworld,intheeconomicprofitlaboratoryitisnot.Thereason?Thereareno
forward-lookingmeasuresofprospectivesuccessandonlycurrentperformanceisgauged.
Ifacapitalinflowdoesnotimmediatelytranslatetomoreprofit,theeconomicprofit
laboratoryseesitas“deadweight”,neitherproducingmoreincomenorminimizingthe
costofcapital.Inthefollowingtables,theproportionofdebttoequityispreservedby
addingandthensubtractingtwounitsofcapital.Thusintheadditionalcapitalexample,
bothdebtandequityare501,andinthedecrease,bothare499.
329

Table12-8

INCREASECAPITAL
BY2

Variable DirectionofChange Amount
EPS DOWN 4.3733
EVA DOWN 37.365
ROE DOWN 17.46%
HypotheticalStockprice DOWN 43.733

Table12-9

DECREASECAPITAL
BY2

Variable DirectionofChange Amount
EPS UP 4.3768
EVA UP 37.635
ROE UP 17.54%
HypotheticalStockPrice UP 43.768

Duringtheincreaseincapital,amovementtowardnon-optimalitywasenacted.Although
betaremainsthesame,earningspershare(EPS)decreasedwithoutanychangeineither
thenumberofsharesoroperatingincome.Theadditionalunitofdebtcreatedmore
interestexpenseandlessnetincome.Moreover,theadditionalunitofequityeclipsedthe
taxbenefitsofdeductibleinterestforcingEVAdownward.
Creatinggreaterreturnsthroughtheefficientuseofcapitalisnotoptimizingcapital
structure.Whilesuchefficiencyevokestheprocessofoptimization,andiscorrelatedwith
ahigherstockprice,theparametersthatgovernEVAareverywide;earningsanomalies,
lackofadefaultprobability,andanabsenceofforesightcanskewresults.However,itis
nottooradicaltostatethateconomicprofitandstockpricegohandandhand,andthat
gainsinEVAareheavilycorrelatedwithmovementtowardanoptimaltarget;false
readingsofEVAaretheexceptionratherthantherule.
330

Forthosewhocravecertainty,usingadefaultprobabilitylikeAltman’sZScorein
combinationwithEVAanalysiswouldhelpcorroborateit.But-theinvestorneedsto
alwaysbewarybecausebothofthesemeasurementsarecoincidentindicators;wecannot
makepredictionsfornextyearoffofthisyear’sEVA.However,wecantellwhentheEVA
componentsareatapointwhereimprovementwouldbequiteeasytoachieve,given
earningsoutlooksandnormalincreasesinboththeriskpremiumandcorporateequity.
Alessdefinitivecombinationwouldbetousethecapitaldynamicformofeconomic
profitwiththeWACC.SincetheWACCisimplicitinthecapitaldynamic,anerrorinone
willcauseanerrorintheother,andsocorroborationinthisregardismoredangerous.
Whentheeconomyisnotinequilibrium(thereareinefficiencies)riskmaynotbepriced
correctly,andtheWACCwillrisewhenallfinanciallogiccallsforittofall.Additionally,
theprecisionofthemeasurementdependsonhowwelltheusercalculatesthecostofequity
whichispartiallysubjective.Thus,smallchangesintheWACCcanlargelybeignored.
Thecorrelationvalueofeconomicprofitwithanoptimalcapitalstructureis
primarilyderivedfromitsabilitytocounterpoiseearningswithcapital.Byforminga
constraintbetweenvariablesthatwouldnormallybecorrelated(netincomeand
stockholders’equity),economicprofithasalltheingredientsofanoptimizingfunction.
Forexample,thebetacomponentinthecostofequitywilldeclinewithanincreasing
proportionofequitytodebt,buttheriskpremiumwillrisetocounterthataction:when
themarketasawholeimproves,morefirmsuseequityfinancingdespiteitshighercost.
Analogously,bothnetincomeandthecostofequityriseconcurrentlybecausemore
earningsleadtoabettermarketrateandapossibleincreaseininterestrates.Whenwe
mathematicallyopposehighlycorrelatedvariablesweresolvetheconflictbygivingmore
weighttoonethantheother.Ineffect,riskmanagementwilladjusttheratesofchangein
eachvariablebydampeningitscorrelationvaluetomakenetincomerisefasterthaneither
stockholders’equityorthecostofequity.
331

ESTABLISHINGGUIDELINES
Unlessoneisinthethroesofabullmarket,investinginex-postEVAincreasesisa
strategythatisdoomedtofail.Whilesomesuccessmaybegeneratedfrommomentum,
ultimatelytherewillbeasmanytransitionsdownwardasupward,andtheinvestorwillnot
beatthemarketandmayevenunderperformit.
Abullmarketwillproduceaboutatwentypercentthresholdoffirmsthatwillout
performtheirpeersoveraonetothreeyeartimeframe;atanygiventime,onlyasmall
percentageofcompanieswillproducelargereturnsThe“miracle”forwhichinvestorsare
lookingisthefirmwithsustainableearningsthatacceleratefasterthanthecostofcapital.
Ifthecharacteristicsofthesectorandfirmarefavorable,firmsthattravelthelongest
distancetoreachanoptimaltargetandyetaremovingrapidlyinthatdirection,tendto
havethehighestrisksandreturns.Firmsthatareclosertothetargetbutmakefavorable
useofcapitalaregenerallymorestableoverthelongrun.Thereforethefirstguidelineis
tohavesomeestimateofwhattheoptimaltargetstructureshouldbe.
• 1)Attempttodetermineatleasta“ballpark”figureofwhattheoptimalcapital
structuretargetshouldbe.Thismayseemeasierthanpresumediftheanalystiswilling
todosomeresearch.Byobservingtheaveragesoverfiveyearsforthethreeleading
companiesinasector,orbycoordinatingstock-pricepeakswithcapitalstructurefor
anindividualfirm,theinvestorcanachieveaworkable“guesstimate”.The
mathematicalmodelinthistextmayconfirmrealworlddata,butthestudent/investor
shouldrealizethatitoptimizesdebtandequityinthedomainofnetincome;itisnot
forwardlookinganddoesnotconsidernewopportunities.
• 2)Knowtheleverageposition.Theeconomicprofitmodelworksbestifequityislow
andnetincomeisabouttoincreasesubstantially.Inthatframework,EVAcanincrease
fortwotothreeyearswithoutthe“hazard”ofabuildupinstockholders’equity.When
afirmisincreasingitsproportionofequity,betawilldecreaseputtingdownward
pressureonthecostofequity.However,theinvestorneedstoanticipatethisfavorable
332

positionbyobservingtheleverageratiosandinvestingaccordingly.Seethe
“Fundamentals”chapterformoreinformation.
• 3)Beawareofthebusinesscycle.Anentirechapterisdevotedtothissubject.Simply
observingthepatternofinterestratehikesordecreasesandthemarket’sreactionto
themwillgivesomeindicationofwheretheeconomyisheaded.Firmswithlower
operatingrisktendtodowellinadownturnandearlyrecovery,whileriskierfirmsdo
wellatamarkettop
• 4)Useanalyst’sforecaststoyouradvantage.Ifthereisaconsensusaboutthefuture
prospectsforasector,byallmeansdosomeresearchonafewofthefirms’leverage
positions.Oftentimes,afirmwhohasbuiltupdebtisreadytostartpayingoffits
investmentandattractequityinterest.Moreover,earningsestimatesareprobably
availableonaprospectiveinvestmenttarget.Comparingthoseestimateswithboth
existingequity,andhistoricequitygrowth,willgivetheinvestoraperspectiveaboutthe
capacityforEVAimprovement.Ontheotherhand,avoidjudgmentsaboutindividual
firms.Theremaybesomanydowngradesandupgradesonafirmthattheevaluations
becomemeaningless.
• 5)Useexecutivetradesasasignal.Oncethestudent/investorcanspotaleverage
positionthatmightyieldafavorableEVA,checktoseeifcompanyinsidersare
investinginit.Maketheefforttoresearchtheleveragefirst,andusethelistedinsiders’
tradesasconfirmation.Donot,however,mistakeblindoptimismforaninvestment
opportunity.Manyinsidersarerequiredtotakeastakeinthecompany.

(BacktoTableofContents)
333

APPENDIX
EVAOPTIMIZATIONWITHSAMPLEDATA
A B C D E F
1ACTUAL EBIT
NetIncome
#Shares EPS Book/Share
2 150 87.5 20 4.375 25
3 InterestExpense TaxRate InterestRate LTD CostofDebt
4 25 30.00% 5.00% 500 3.50%
5
6OPTIMIZE EBIT NetIncome #Shares EPS Book/Share
7 150 70.035 20 3.501 25
8 InterestExpense TaxRate InterestRate LTD CostofDebt
9 49.95 30.00% 5.00% 999 3.50%
10
11COMPARE EBIT NetIncome #Shares EPS Book/Share
12 0 0 Div0! 25
13 InterestExpense TaxRate InterestRate LTD CostofDebt
14 0 0 0.00%

G H I J K L M
RF Beta K(m) Equity CostofEquity(Rate) EVA LtD/Cap
4.00% 1 10.00% 500 0.1 37.5 0.5
D/E TotalCap WACC CostofCap TotalCostofEquity Stock ROE
1 1000 0.0675 67.5 50 43.75 0.175

RF Beta K(m) Equity CostofEquity(Rate) EVA LtD/Cap
4.00% 411.94118 10.00% 1 24.75647059 45.279 0.999
D/E TotalCap WACC CostofCap TotalCostofEquity Stock ROE
999 1000 0.0597 59.7214706 24.75647059 70.724 70.035

RF Beta K(m) Equity CostofEquity(Rate) EVA LtD/Cap
0 0 #DIV/0!
D/E TotalCap WACC CostofCap TotalCostofEquity Stock ROE
#DIV/0
! #DIV/0! #DIV/0! 0
#DIV/0
! #DIV/0!

N
ROC
0.0875
EVAStock
35.12880562

EVADifference
7.778529412
EVAStock
42.72682084

ROC
#DIV/0!
EVAStock
#DIV/0!
334

FINDINGATRIGGERPOINTFORTHEINTERESTRATEONDEBT

A B C D E F
1ACTUAL EBIT
NetIncome
#Shares EPS Book/Share
2 150 79.706 20 3.9853 25
3 InterestExpense TaxRate InterestRate LTD CostofDebt
4 36.134 30.00% 7.23% 500 5.06%
5
6OPTIMIZE EBIT NetIncome #Shares EPS Book/Share
7 150 105 20 5.25 25
8 InterestExpense TaxRate InterestRate LTD CostofDebt
9 0 30.00% 7.23% 0 5.06%
10
11COMPARE EBIT NetIncome #Shares EPS Book/Share
12 0 0
#DIV/0
! 25
13 InterestExpense TaxRate InterestRate LTD CostofDebt
14 0 0 0.00%

G H I J K L M
RF Beta K(m) Equity CostofEquity(Rate) EVA LtD/Cap
4.00% 1 10.00% 500 0.1 29.706 0.5
D/E TotalCap WACC CostofCap EquityCost Stock ROE
1 1000 0.0753 75.294 50 39.853 0.1594

RF Beta K(m) Equity CostofEquity(Rate) EVA LtD/Cap
4.00% 0.5882 10.00% 1000 0.075294 29.706 0
D/E TotalCap WACC CostofCap EquityCost Stock ROE
0 1000 0.0753 75.294 75.294 34.863 0.105

RF Beta K(m) Equity CostofEquity(Rate) EVA LtD/Cap
0 0 #DIV/0!
D/E TotalCap WACC CostofCap EquityCost Stock ROE
#DIV/0! #DIV/0! #DIV/0! 0 #DIV/0! #DIV/0!
N
ROC
0.079
EVAStock
27.626

EVADifference
0
EVAStock
27.626

ROC
#DIV/0!
EVAStock
#DIV/0!
335

13
THEMARGINALBENEFITSEQUATION:ANEXPERIMENTAL
MODEL
Oneofthegreatestconflictsinourtimecomesfromthetensionbetweenobfuscation
andtransparency.Manywhoholdpowerdesiretocreateasystemofasymmetrical
informationwhereinspecializedknowledgebecomesabridgetoaccomplishingatask.
Whentheinformationishoardedandisolated,itisusedforpoliticalpurposes,creatinga
certainpositionorstatuswithinagroup.Thus,patents,copyrights,“secretformulas”,
esotericclubmemberships,andcompromisingphotosallharborthecorrelationbetween
specializedinformationandpoliticalpower.However,inanagethatdisseminates
informationveryquickly,powertendstoriseandwanejustasfast,becauseofthe
transformationalqualityoftheinformationitself
Defaultalgorithmsarepowerfultools.Whenthestatisticiansuddenlybecame
infusedwiththepowertodecidewhogetscreditandwhoisrefused,thestakesinthat
occupationroseexponentially.Themassivepopularizationof“creditscores”andthe
influencetheyentail,isjustoneexampleofan“invisiblehand”regulatingmostofour
publicaffairs.Intheframeworkofcapitalstructure,theprobabilityofdefaultisthe
“missinglink”betweentheresearchoftheMiller/Modiglianiteamandthepractical
applicationofmovementtowardatargetoptimalstructure.Infact,alloftheconclusions
fromtheirresearchwerearrivedatgiventheabsenceofbankruptcy,anditwasasimple
“tweak”oftheirfamousequation,V(L)=V(U)+TBthatprovidedtheimpetusfor
optimization:wesubtractthecostofbankruptcy.
Thereinlaystheproblemofoptimization.Thecostofbankruptcyisnotageneric
cost,norisitalegallyuniformterm;theremaybemanyunique“costsofbankruptcy”that
applytoeachfirm’sspecificsituation.Onecompanymaysellallitsassetsandanother
may“reorganize”;athirdmaymergewithacompetitorandbecomeacompletelydifferent
336

company.Incapitalstructureanalysis,wearetaskedwithcreatingacommoncostof
bankruptcythatattemptstoreconciletwoentities:thebookvalueoftheproportionof
debttoequity,andthemarketvalueofafirm’sstock.Consequently,wediscoveran
interfacethatunitesthosevaluesintheprobabilityofdefault-theriskthatthefirmcannot
maketimelyinterestpayments.Implicitinthatinterfaceistheutilizationofassets:the
rateandamountofgeneratedincome.
THEMODELEDCONCEPT
Underthepremisethatthereexistssomeoptimalproportionofdebttoequitythat
maximizesthevalueofthefirm,wecreateafunctionalmodelbasedonthe
Miller/Modiglianiconcept.Taxadvantagesofdebtarebalancedwiththeproductofthe
amountoflossandtheprobabilityofdefault,whichwehavetermed,“thecostof
bankruptcy”.Therefore,anyadditionalvaluecreatedbydebtwillbeapparentwhentax
advantagesexceedbankruptcycosts.Whenthechangeinbankruptcycostsbeginsto
exceedthechangeintaxadvantages,anoptimumisfound,andthisisthelimitingfactoron
additionaldebt.Ineffect,thechangeintaxadvantageswillequalthemonetarychangein
thecostofbankruptcy,andthefirstderivativeoftheentirefunctionwillequalzero,
becauseamaximumhasbeenobtained
Ideally,theequationwewanttomaximizeis:[(TaxRate)(Long-termdebt)]-[(%
ProbabilityofDefault)(AmountofLoss)].Furthermore,theamountoflossisconstructed
ofthereciprocaloftheratiobetweentangiblebookvalueandmarketvaluemultipliedby
marketvalue.Thatis-theamountoflossisequalto:[(1-(TangibleBookValue/Market
Value))(NumberofSharesOutstandingxPriceperShare)].Fortheratiooftangiblebook
valuetomarketvalue,wecaninterchangeablyusepersharevalues,andmarketvaluewill
bedeterminedbytheproductinthelastparentheses.Ineffect,thisequationistellingus
thattheoptimalamountofdebtisbasedonabalancebetweentaxadvantages,default
performance,assets,andstockprice.
THEMARGINALBENEFITSEQUATION
337

Onceweacceptthepropositionthattheincrementalvalueofafirmisequaltothe
differencebetweenbankruptcycostsandtheproductoftheamountofbondsandthetax
rate,weneedtoaccountforthosefirmswhocreatevaluewithoutdebt.Manycompanies
lacktheassetstructuretosupportdebttothepointwhereityieldsataxadvantage;sales
maynotbestableorassetsmaynotoffergoodcollateralvalue.Thus,weassumethatthe
unleveredfirmhasthesameincomegeneratingcapacityastheleveredfirm,andthatthe
onlydifferencebetweenthemishowtheyarefunded;aplantassethasthesameearnings
potentialwhetherfinancedbydebtorequity.Withtheadditionofbankruptcycosts,
however,thepropositionchangesbecausebankruptcyisnotalinearfunction;ithassome
thresholdamountandrisesatanon-constantrate.Inessence,thetypeofassetsdetermines
boththebankruptcyfunctionandtheamountoffinancialleverageavailable.Thosefirms
whoproduceahighoutputatalowerfixedcostwillhavealowercostofbankruptcyand
havethecapabilityofincurringmoredebt.
Hypothetically,firmsthathavenodebtwillhavealargeramountofpotentiallossto
shareholdersthatwillprohibitthemfromtakingonleverage.Byminimizingthenumber
ofcommonsharesoutstandingandyetgeneratingahighlevelofsales,thesefirmscankeep
bankruptcycoststoaminimum.Toanunleveredfirm,bankruptcycostsrepresenta
thresholdamountthatmustbeexceededbypossessingahigherearningscapabilitythana
leveredfirm:whattheyloseintaxadvantages,theymustmakeupinthepotentialfor
generatingincome.Withoutsuchcapacity,therewouldbenoreasontobeinanybusiness
thatdidnotrequireleverage,becauseallunleveredfirmswouldbevaluedlessthantheir
leveragedcounterparts.
Theincrementalvalueofafirmwhohasnodebtislessthanzero,becausetherewill
alwaysbeaminimumlevelofbankruptcycoststhatwouldbederivedfromoperational
incapacity.Thus,theunleveredfirmmustgeneratealevelofincomethatovercomesthis
functionaldisadvantage.Whenwesubtractbankruptcycosts,weassumethattheyrise
withthelevelofdebt,andareuniquetothatfirm.Thecostofbankruptcy,however,is
338

moremultidimensional;notonlywillbankruptcycostsrisewiththelevelofdebt,theywill
adjustforthetypeofasset,andtheincomegeneratingpotentialthereof.Inthismuchmore
realistic,non-linearcapacity,twicethedebtwillnothavetwicetherisk,butwilltakeon
anynumberthatthebankruptcyalgorithmgivesit.Inthiscontext,“operatingrisk”isa
confluencebetweentangibleassetsandtheprobabilityofdefaultandoperatingleverageis
implicitlydefined.
Althoughamodelcangiveanestimateofanoptimaltarget,itworks
probabilistically,definedbythecomponentsofthealgorithm.Therelevancyofanycredit
algorithmchangesperiodicallyastherelationshipbetweenincomeanddebtshiftsinthe
greatereconomy.Therefore,anyworkingcapitalstructuremodelwillalwaysremain
transientandexperimental.Notallcompanieswillmeetitsconstraints.Somemayevenbe
inoperable.Banksandinsurancecompanies,forexample,haveassetstructuresthatare
muchdifferentfromamanufacturingcompany.Likewise,autilitycompanymaytakeon
moredebtatahigherdefaultratesimplybecausethelocalgovernmentinfusesitwithcash.
Theseareanomaliesthatareoutsidethepurviewofthemodelandnegatethepossibilityof
inventinga“onesizefitsall”algorithm.However,therearecommonaltiesamongall
bankruptciesthatcanbeaddressed,especiallyconcerningthefateofthecommon
shareholder,andthesearetheinputsintothemodel
DEFAULTPROBABILITYANDBANKRUPTCY
Amongthegreatnumberofbothgenericandcommercialdefaultalgorithms
available,ahandfulwouldfittheneedsofcapitalstructuretheory.Thealgorithmneedsto
bebothprohibitiveofexcessivedebt,butflexibleenoughtoinputandsolveforvariables.
Italsoneedstobecheckedagainstsomeotherstandard,likesalesornetincome,for
viability.AnadaptationoftheZmijewskialgorithm,hasthatcapacity.
339

TheZmijewskialgorithm
*
willallowforthesolutionofvariablesthathelpminimize
it.Withtheadditionofthetaxbenefitsofimmediateinterestpayments,itoptimizesinthe
domainofnetincome,allowingfortheoptimizationofbothnetincomeanddebtwhenthe
nettaxbenefitsofinterestaredividedbythenettaxbenefitsofdebt.Byitself,withoutthe
additionofinterestbenefits,thealgorithmisnotrobustenoughthroughoutitsentirerange
tooptimizedebt.Likemostdefaultalgorithms,itisconstructedfromaveragesthatwill
allowacompanytobecapitalizedentirelybydebtbeforeitregistersa“onehundred
percent”chanceofdefault.Thus,itwouldnothelpmeetthetestofastandalonemodel
thatmaximizeswhenthefirstderivativeisequaltozero.Nevertheless,whenadaptedfor
interestbenefits,andusedintwocounterpoisedequations,itwillyieldanamountofdebt
thatcreatesparitybetweentaxadvantagesandthecostofbankruptcy.Givenaspecific
levelofcapital,theequationthenfindsthelevelofdebtthatkeepsdefaultvalueslowand
incomelevelshigh.Theoptimizationisnthedomainofnetincome,avariableinthe
defaultalgorithm,allowingittomeetacomparativestandardotherthanitsownincreasing
value.
THEINTERESTBENEFITSMECHANISM
TousetheZmijewskialgorithmincapitalstructureoptimization,wemustmodify
themarginalbenefitsequation.Ineffect,weformaratiobetweenthemarginalbenefitsof
interestexpenseandthemarginalbenefitsoflong-termdebt.Inthenumerator,weinput
thefullmarginalbenefitsequation,exceptthatwereplacelong-termdebtwithinterest
expenseinthefirstpartoftheexpression.Wethendividebytheentiremarginalbenefits
equation,andattempttomaximizethefunction.Thefinalfunctionlookslikethis:[(Tax
Rate)(InterestExpense)]-[(%ProbabilityofDefault)(AmountofLoss)]/[(Tax
Rate)(Long-termdebt)]-[(%ProbabilityofDefault)(AmountofLoss)].Anyincreasein
theratioisinterpretedasmovementtowardtheoptimal.Alternatively,whentheratio

*
Zmijewski’soriginalanalysisof840bankruptandsolventcompaniesusedprobitanalysistoformanalgorithm.
Thisisalogiisticversionofthatresearch.
340

decreaseswhilemarginalbenefitsareincreasing,theoptimumhasbeenpassed:thenature
ofthealgorithmallowsmarginalbenefitstoincreasepasttheoptimumwhichisthereason
itneedstobemodified.Inayeartoyearcomparison,themarginalbenefitsequationwill
beliketheweightedaveragecostofcapital(WACC):movementisatentativeindicator
becauseothervariablesmayinteractwithitandskewtheresults.However,whenusedin
combinationwithinterestbenefits,theprobabilityofdefaultwillbeloweredinthedomain
oftaxadvantages,anda“guesstimated”targetcanbeobtained
CHECKINGRESULTSAGAINSTAVIABLESTANDARD
Thegistofoptimizationoccursintherealmofbalancingthereturnonequity(ROE)
withthereturnoncapital(ROC).Whendebtreplacesequity,greaterinterestpayments
depletenetincome.However,equitydecreasesatamorerapidrateandthereturnon
equityrises.Inthemeantime,ROCisdecreasedbecausetheeffectofmoredebtisto
decreasenetincome.Althoughthecapitalbaseremainsstable,ROCdeclineswhenROEis
atamaximum.Ontheotherhand,whenequityreplacesdebt,theoppositephenomenon
occurs:ROCismaximized.Withlessinterestpaymentsfordebt,netincomeincreases
untilitismaximizedinacapitalstructureofallequity.Toachieveanoptimumfordebt,
theprogramwilltradebasispointsbetweenthetwomeasurementsbecauseitattemptsto
createthegreatesttaxadvantagesinthedomainofalowerdefaultprobability.Thetax
advantagesaregreaterwhenROEismaximized,andthedefaultrateislesswhenROCis
maximized.Together,thetwomeasurementsareoptimizedbyinputtingthecorrect
amountoflong-termdebt.
DEFAULTMECHANICS
TheZmijewskimodelhasaminimumnumberofvariables(four),buttheinherent
flexibilityofthemodelmakesiteffective.Theproductofparametersandfundamental
ratiosformsthelogarithmofaprobabilityofdefault.Wealgebraicallyeliminatethe
logarithmandsolvefortheprobability.Thus,Ln[P1/(1-P1)]=X1BwhereP1isthe
probabilityofdefault,X1arethefundamentalratios,andBarethecoefficientsofthe
341

algorithm.Toobtainaprobability,weturntheequationaroundandinputP1=1/1+
EXP[-XB],wherethefundamentalratiosaregivennegativesigns.Theinterceptisalso
givenanegativesignbecauseitwasoriginallymultipliedby“1”,andnowitisbeing
multipliedbynegativeone(-1)toformapositivenumber.Thefollowingtablecontainsa
definitionofthefundamentalratiosandthecoefficientsofthealgorithm.
Table13-1

ZmijewskiDefault
NAME FUNCTION COEFFICIENT
TL/TA TotalLiabilities/Total
Assets
6.384
CA/CL CurrentAssets/Current
Liabilities
0.069
NI/TA NetIncome/TotalAssets -1.06
Intercept NONE -9.479

Asanexample,wecaninputtypicalratiostoshowhowthebasicfunctionworks:TL/TA
=0.5,CA/CL=1.5,NI/TA=0.07.
P1=1/1+[EXP((6.384)(-0.5))+((0.069)(-1.5))+((-1.06)(-0.07))+((-9.479)(-1))]=
1/1+EXP(6.2577)=.00191or0.19%
Whilewecanquestiontheaccuracyofthisdetermination,astudent/investorwho
researchesgenericalgorithmswillfindthattheZmijewskiprobabilitysharessome
commonaltieswithothers.Ohlson,ShumwayandMertoneachexplicitlyinputtedan
assetsvariable,anincomevariableandanexistingdebtvariableintotheirdistributions.
Infact,eachoftheseisdesignedtodetectmajorfinancialcatastrophes,butfallshortof
predictingbankruptcyforafirmthroughoutitsentirerangeofdebt/assetcombinations.
However,theyareexplicitriskindicatorsandespeciallyworkwellintermsofmeasuring
themagnitudeofchangesinoverallfinancialposition.
STRATEGICIMPLICATIONS:FINANCIALLEVERAGE
342

Whendebtisaddedtothecapitalstructure,achainofeventsensuesthataffects
eachcomponentofthemarginalbenefitsequation.First,thetaxbenefitsrise,increasing
thetotalincrementalvalueofleverage.Secondly,thequalityofpurchasedassetsbecomes
paramountbecausetheinfusionwillinitiallycauseanincreaseintheprobabilityofdefault;
incomemaynotbeimmediatelygeneratedfromapurchaseandthelagcausesthe
probabilityofdefaulttorise.Thirdly,ifmorecommonsharesarenotissued,thebalance
betweenmarketvalueandtangibleassetsmaychange,affectingtheamountofloss.
Therefore,anycompanythattakesondebtmustmonitorthedefaultratetoseehow
thesubtractionofinterestpaymentsaffectsnetincome,andhowtheotherratioscanbe
bufferedtomaintainthecurrentlevelofsolvency.Ultimately,themorerapidlyafirmcan
turnapurchaseintoanincomegeneratingasset,thelesseffectondefault,andthebetter
wasthedecisiontousedebt.Intangibleassetsarenotnecessarilylessworthythantangible
assetsbutwillbemoredifficulttocollateralizeandamortize.Moreover,anincreasein
tangibleassetswillallowmarketvaluetogrowandstillmaintainmoremarginalbenefits.
Inthismodel,ifmarketvaluegrowswithouta“legitimatereason”-thatis-withoutgreater
taxbenefitsorlowerdefaultprobability,itisobservedtobeaspeculativerun-upandis
expectedtofallprecipitously.
Fromtheequityside,thereislessconcernaboutgeneratingincomefromassets
becausenetincomeisimplicitinequitygrowthfromretainedearnings.Naturally,any
stockissuewouldberegisteredasmoresharesoutstandingwhichinisolation,wouldraise
theamountofloss.However,equityderivedfromretainedearningsshoulddecreasethe
probabilityofdefault,andthatistheprimarysignaltoobservewhentheproportionof
equityisincreased.Asecondsignalwouldbedebtneutralityorevenslightincreasesin
long-termdebtthatwouldincreasetaxadvantages.Ineffect,payingoffdebtandreplacing
itwithequityisnotconducivetoassetgrowth,andmayevenincreasethecostofcapital-
but-increasingtheamountofbothwilloftenunitethetwinobjectivesofgrowthand
optimalproportion.
343

STRATEGICIMPLICATIONS:OPERATINGRISK
Weassumethattheparametersofthismodelarecorrect,buttheyareexperimental.
Theremaybebetter,“standalone”defaultalgorithmsthatneednomodification.Amore
precisebankruptcycostcanbedeveloped.Andespecially-amodulethatallowsforthe
interactionofoperatingleveragecanbeinputted.Infact,withouttheinclusionof
operatingleverage,acapitalstructuremodelisincomplete.Onlybyobservingtheeffectof
increasedfixedcostsonafirm’sbreakevenpoint,cantheproperamountofleveragebe
determined.Whatwehavedoneissubstitutedassetclass,anddefaultprobability,forthe
effectofoperatingleverage,makingitanimplicitfactor.However,theeffectofoperating
leverageisparamounttoincomegenerationbecauseitwilldeterminethe“base”from
whichfinancialleveragecanoperate.Forexample,alargeoperatingleveragewillproduce
alargerincreaseinoperatingincome,whichnaturallydiminishestherateofdefault.A
lowerdefaultratewillimplytheuseoflessdebtandmoreretainedearnings.
Consequently,afirmwhoachievesthisfinancialstatewithfewersharesoutstandingwill
seetheirstockpricegrow.
Whenoperatingleverageisbothlargeandunstable,therecanbenotaxadvantages
fromdebt,andmarketvaluewillbeafunctionofmoreshareissuesandlessprice
appreciation-thesamedebaclethathitmanyNASDAQstocksinthelate1990s.The
problemwithhighoperatingleverageisthatitwaversandmaycreateanunstabledefault
probability:nocreditorswanttotakeachanceonacompanywhosedefaultrateisless
thanonepercentinoneyearandtenpercentinanother.Thelarge“intercept”inthe
defaultalgorithmaccountsforthevarianceofinput,butalsoaccountsforalarge
percentageofdefaultprobability.
Stableoperatingmarginsleadtotheproperuseofleverage.Althoughfirmswith
high,unstableoperatingleveragecanprosperatcertainpointsinthebusinesscycle,their
stockwillbespeculativeatbest.Someofthebiggertechnames,Cisco,Google,Inteland
Microsofthave“softened“theirapproachbydiversifyingintorelatedfields,attemptingto
344

maintainahighearningscapacitythatismorestable.Thosefirmswhocannottake
advantageoftaxbreaksmustearnenoughtocoverathresholdamountofbankruptcy
costsorbeatadisadvantagetofinanciallyleveragedcompanies.Whilethismodeldoesnot
accountforthe“benefitsoffundingwithretainedearnings”inlieuoftaxadvantages,one
oftheprovisionswouldbethegenerationofincomeaboveandbeyondthetaxbenefitsthat
arelost-includingthesubtractionofinterestpaymentsandtheadvantagesofalower
defaultrate.
Figure13-1

OperatingLeverage
Equity
Debt
DefaultProbability
Amount
of
Loss
Tax
Benefit

Thestudent/investormustkeepinmindthatthemodelisarenditionoftheincremental
valueofdebt-andnotthevalueofthefirmitself.Ifafirmchoosesnottofundwithdebt,
wecancheckthroughthemodelwhetherthedecisionisvalid,butwecannotgaugethe
periodtoperiodperformanceofmarginalbenefitsbecausetheywillbelessthanzero.We
can,however,usethecostofbankruptcysidetomeasureperformancebybalancingthe
rateofdefaultwiththeamountofloss.Ifweseetherateofdefaultgodown,weshould
lookforabalancingincreaseintheamountoflosssinceitrepresentsmostlymarketvalue.
SPREADSHEETCONSTANTS
345

Themarginalbenefitsmodelispartlystaticandpartlydynamic.Whileallinputs
canbechanged,somevariableswillremainconstantsimplybecausethereisnorealistic
methodofmakingthemreact.Forexample,thevariable,“NumberofShares
Outstanding”canbechangedbutwillnotreactastheothervariableschangebecauseitis
deemedtobeoutsidetheconfinesofthemodel.Similarly,the“MarketPrice”ofthestock
willnotreacttochangesinthemodelbecausenoknownformulacandeterminetheprice
changeofacommonstock.Analogously,operatingincomerespondstosales,whichimplies
interactionwiththegreatereconomy.Sincetherearenoproductionvariablesinthe
model,EBITisagiven.Thus,variablesthataredeterminedtoberealistically
uncontrollablearemadeintoconstants.
Secondly,theamountofcapitalisandassumedtobethecorrectamounttoraise.
Therelationshipbetweenassetsandcapitalisfixed,carryingovertotangibleassetsand
marketcapitalaswell.Noadditionalamountofdebtorequityshouldaffectthequality
andtypesofassetstopurchase.However,iftheamountthatafirmraisesiswellbeyondits
requirements,thenweareoptimizingdebtattoolargealevelofcapitalanditwillbe
incorrect.Byusinglong-termaverages,wediminishyeartoyearanomalies,i.e.,making
calculationsdependonanunusualamountofcapitalraisedinanyoneyear.Alternatively,
theamountsthatweinputascapitalarealsoactualamountsandsoitis“realistic”to
attempttooptimizeatthatlevel;theterm,“optimal”isonlyoperativeinrelationtothe
constraintsofthesituation.
Thirdly,itisassumedthattheinterestratewillnotchangeasnewlevelsofdebtare
engaged.Thatisarealisticassumptionifafirmisalreadyneartheoptimaltarget,butnot
realisticifafirmmustgofromaleveloftentothirtypercentdebttoequity.Mostfirms
woulddesiretogetmoredebtatthesamerate,buttheWACCispredicatedonincreasing
ratesforincreasingrisk.Additionally,theinputtedinterestrateisthe“effectiverate”as
appliedtolong-termdebt.Thisratio,(InterestExpense/Long-termdebt)iseffectivefor
theperiodanddeniesinconsistenciesbetweeninterestexpenseandtheactualrate.
346

Fourthly,thetaxrateisaconstant.Whiletheaverageeffectiverateisused,itdoes
notchangeinresponsetochangesinfundamentalsthatverywellmightdictateanewrate.
Theeffectiverateforabanneryear(whenthemodelincreasestheamountofnetincome)is
thesameforadismalyearofnearnegativeincome.
Finally,wemakecurrentliabilitiesandcurrentassetsconstantsbecausetheyreact
tomyriadvariables,muchlikethestockprice.Therecanbenodeterministicfunctionfor
eithervariablebecausetheydependonsuchoutliersasinterestraterelationships,vendor
credit,typeofindustry,etc.Theinteractionsaretoovariedtoinputamodelfunctionthat
wouldberealistic.Thelistofconstantsis:
• 1.Capital-Capitalisinputtedasagivenamount.Theamountofcapitalactsasa
baseforthetradeoffbetweendebtandequity.Italsoimpliesthattheamountofassets
andtherelationshipbetweentangibleandintangibleassetsisconstant.
• 2.InterestRate-Theinterestratebecomesafunctionoftherelationshipbetween
interestexpenseandlong-termdebtbutremainsunchangedintermsofthemovement
ofothervariables
• 3.TheNumberofSharesOutstanding-Inputtedastheactualamountattheendofthe
measuredperiod.
• 4.TheMarketPriceoftheStock-Themid-rangepriceduringtheperiodisinputted.
Themid-rangeismerelythehighpriceofthestockduringtheperiod,plusthelow
price,dividedbytwo.
• 5.CurrentLiabilitiesandCurrentAssets-Thesevariablesdependoncomplex
interactionsoutsideofthemodel.
• 6.TaxRate-Thetaxrateremainsconstantdespitevicissitudesinnetincome.
• 7.OperatingIncome(EBIT)Thisvalueformsthebasefornetincomebefore
deductionsofinterestandtaxes.
SPREADSHEETLOGIC
347

Whenlong-termdebtisincreased,interestisdeductedfromoperatingincomeatan
appropriaterate.Thechangeindebtcausesacorrespondingchangeintotalliabilitiesand
netincomewhichaffectstheprobabilityofdefault.Whilemoredebtwillcreatemoretax
advantages,thebenefitsmustbeweighedagainstthepotentialforincreasingbankruptcy
costs.Theappropriateamountofdebtwillbetheamountthatmaximizestheratioof
interestbenefitstomarginalbenefitswhenbothofthosefiguresaregreaterthanzero.
Forthosefirmswithlargeintrinsicvalueswellpastthevalueoftangibleassets,the
programshouldregisterzeroornegativeinterestbenefitsandindicatethatacapital
structureofallequityismosteffective.Infact,oneofthesavinggracesoftheZmijewski
algorithmisthatitseemstobe“forgiving”enoughtoallowinterestbenefitsinthefirst
place;thedefaultrateisnotsostringentthatinterestbenefitsaredenied.Moreover,we
haveaddedmanyofthefunctionsfromEVAoptimizationthatallowsustoviewthe
programinanothercontext.Forexample,weseeoptimizeddebtinthecontextofmore
EVAand/orbalancingROEandROC;inotherwords,wecanviewtherecommendations
inthedomainofrepercussions.Iftheprogramrecommendsanallequitystructure,wecan
observehowfollowingthatrecommendationaffectsEVAandROC.
DYNAMICVARIABLES
Onceweinputagreaterorlesseramountoflong-termdebt,achainofeventsensues
thataffectstheothervariablesassociatedwithmarginalbenefits.Thevariablesthat
changewhenlong-termdebtischangedarecalled“dynamic”variables,andcanbe
realisticallydeterminedfromeitheraccountingfunctionsorspreadsheetlogic.Mostof
thesevariablesareexplicitlysetforthinthespreadsheet.Inthecaseoftheonethatisnot
(taxespaid),theusercancalculatethefigureorcreateanothercellthatdoesthatjob.The
followingare“dynamic”variables:
• 1)Equity-Itispossibletoincludepreferredstockinthisfigure,becausetheprogram
simplysubtractslong-termdebtfromcapital.However,weincludeWACCandbeta
348

calculationstosupplementthemarginalbenefitsinformation;preferredstockwillbe
anoutlieranditisbetternottoincludeit.
• 2)InterestExpense-Theprogrammultipliestheinterestratebylong-termdebtand
thensubtractsthisamountfromoperatingincome.
• 3)TotalLiabilities-Theoptimizationsubstitutesdebtforequityandaddsto(subtracts
from)totalliabilities.Thebasefigureiscurrentliabilitieswhichremainsconstant.
• 4)NetIncome-Wheninterestissubtractedfromoperatingincome,taxesarededucted
andtheexpressionbecomes“netincome”.
• 5)TaxesPaid-Asmentionedabove,theprovisionforincometaxesisimplicitbecause
theaccountingtotalisnotneededformarginalbenefits.Anextracellcanbecreated
forthecalculation.
• 6)TaxBenefitsonDebt-Thisexpressionformsamajorpartofthemarginalbenefits
equationandistaxratemultipliedbylong-termdebt.
• 7)TaxBenefitsonInterest-Thisexpressionisinterestexpensemultipliedbythetax
rate,andformspartoftheinterestbenefitsmechanism.
• 8)TheProbabilityofDefault-Thisisaninteractionbetweensomeoftheother
dynamicvariables,whichareconfiguredbytheZmijewskialgorithm.
MODELSETUP
Themodelissetupasa“standalone”optimizerforthepurposesofillustration.However,
theEVAsensitivitymoduleinchaptertwelvecangivecorroborationofthe
recommendationsfrommarginalbenefits.Together,thetwomodelscanbeintegratedif
onemakestheEVAvariablesdependentontheZmijewskivariables,allowingthestudent/
investortoobservetheeffectonthecostofcapital.Theonlyadditionalentrieswouldbe
thethreevariablesthatcomprisetheCAPM,whichare:therisk-freerate,themarketrate
andthebetaofthecompany.Suchinterdependenceallowstheusertotesttheoptimum
againstEVA,EPS,ROEetc.Theprogramisalsosetupforcomparisonssothatthe
modulecanbecopiedandconfiguredfortheinputofacomparisonfirm.Thelistof
349

formulasintheprogram,andtheentireset-upofthespreadsheetareavailableinthe
appendix.
THEPROCESS:ENTRYVARIABLES
Thereareelevenentryvariablesthatareenteredintothegraycellsofthe
spreadsheetOncetheentryvariablesarecompleted,thereisone(redhighlighted)
decisionvariableforlong-termdebtthatisenteredintheoptimizationsection.Itisthis
cellwhichwillyieldtheoptimizedvaluefordebtandchangetheenteredvalues.Thus,
elevenvariablesareenteredinsequenceinthe“ZmijewskiVariables”section;these
variableswillcarryovertothe“OPTIMIZATION”moduleandbetransformedas
differentnumbersareenteredinthered“LTD”cell.
Itisbesttouseahistoricalfiveyearaverageinalloftheentryvariables.However,
theprogramcanstillgiveafair“guesstimate”ifoperatingincomewastypicalfora
particularyear,thusallowingperiodtoperiodinput.Theentryvariablesanddecision
variablearelistedasfollows:
• A)Elevenvariableslocatedinverticalsequenceinthe“ZmijewskiVariable”section.1.
Assets2.CurrentAssets3.CurrentLiabilities4.LTD(actual)5.EffectiveInterest
Rate(InterestExpense/LTD)6.EBIT(earningsbeforeinterestandtaxes)7.Market
Priceforthestock,whichisanaverageoftherange.8.TheTangibleBookvalueper
share9.Theeffectivetaxrate.10.Theamountofcapital(withpreferredstock
deductedforbetteraccuracy).11.Thenumberofsharesoutstanding
• B)Thedecisionvariable.Highlightedinred,thereisonedecisionvariablelocatedin
theblueoptimizationsection,belowthetopsection.
350

THEPROCESS:OPTIMIZINGWITHSOLVER
Optimizationoccurswithaminimumofconstraints.Thekeycellsare:B28which
containsthedecisionvariable“LTD”inred;L16whichcontainstheoptimizedamountof
marginalinterestbenefits:J16whichcontainstheoptimizedamountofmarginaldebt
benefits;andB35,“Equity”,whichmustbesettoavaluegreaterthanorequalto“1”,so
thatthechangeinbetacanregisterproperly(whenusedinconjunctionwithanEVA
module).Thefullratiotobemaximized,marginalinterestbenefits/marginaldebt
benefits,islocatedinO16.Wesettheparametersasfollows:1.MaximizecellO16;2.By
changingcellB28;3.Subjectto:L16>=0,B28>=0,B35>=1.IfSolverhasnofeasible
solution,itisbecausethereisnopositivemarginalinterestbenefitthroughouttheentire
range.Therefore,theoptimalamountofdebtforthatcompanyiszero.Manyhighbeta
stocksfallintothatcategory.
THERESULTS:THREEEXAMPLES
Whileitmaybenexttoimpossibletoproveandverifytherecommendationsas
“optimal”,thestudent/investorcandetectchangesinEPSorbetathatreflectefficiency.In
fact,theprogramdoesnotuniformlytrytolowertheproportionofdebttoequityinorder
toraisenetincome.Itproceedsbyevaluatingtheprobabilityofdefaultwiththeexisting
amountofincomeandthenmakesadeterminationabouttaxbenefits.Therefore,three
separatecasesarise:caseoneiswherethereisarecommendationforlessdebt,which
naturallyraisesthereturnoncapitalandEPSwhileloweringbeta;casetwoiswherethere
isarecommendationformoredebtwhichlowersEPSandROCbutraisesbetaandROE;
casethreeistherecommendationtousenodebtinthecapitalstructurebecauseno
marginalinterestbenefitsareobtained.Inthislastcase,“nofeasiblesolution”isregistered
inSolver,andeithertheprobabilityofdefaultistoogreat,ortheamountoflossisgreat,
orboth.
351

CASEONE:LESSDEBTRECOMMENDED
*Note*ineachcase,theamountofcapitaliscomposedoflong-termdebtandcommon
equity.
Table13-2

LOWE'S2000
(LOW)

ENTRY
VARIABLE
AMOUNT
(Mil)
Key
Measurements
Actual Optimized
Assets 11376 Long-term
Debt
2698 1774
CurrentAssets 4175 LTD/CAP 32.93% 21.65%
Current
Liabilities
2929 Financial
Leverage
1.1136 1.071
LTD 2698 EVA 153.87 117.73
Effective
InterestRate
0.0541 ROC 9.88% 10.27%
EBIT 1431 ROE 14.74% 13.1%
MarketPrice 25.37 EPS $1.06 $1.10
TangibleBook
Val./sh.
7.18 ROC-WACC
%
0.75% 0.69%
EffectiveTax
Rate
0.37 ROE-Equity
%
2.8% 1.83%
Capital 8192 BETA 0.99 0.89
Numberof
Shares
764.15
a.Risk-free
Rate
5.5%
b.Beta 0.99
c.Market
Rate
12%

Inamodelofthistype,decreasingdebtwillautomaticallyincreaseEPSandthereturnon
capital(ROC),whiledecreasingthereturnonequity(ROE).However,the“distance
ratios”thatmeasurethedifferencebetweenROCandthecostofcapitalforexample,did
notimprove.Ontheotherhand,thelimitedreturnoncapitalof10.27percent(optimized)
ismuchmoresustainableatthislevelofdebt.Theprogramregisteredafairlyhigh
352

probabilityofdefaultatthethirty-twopercentdebtlevelandpareditdownbylimitingthe
amountofdebttoapproximatelytwenty-onepercent.Ahigheroperatingincomewould
allowahigherdebtlevelbecausetheprobabilityofdefaultwouldbelower.
CASETWO:MOREDEBTRECOMMENDED
Table13-3

MERCK2001
(MRK)

ENTRY
VARIABLE
AMOUNT
(Mil)
Key
Measurements
Actual Optimized
Assets 44007 Long-term
Debt
4799 6823
CurrentAssets 12962 LTD/CAP 23.02% 32.72%
Current
Liabilities
11544 Financial
Leverage
1.04 1.0656
LTD 4799 EVA 6217.24 6174.95
Effective
InterestRate
0.0968 ROC 34.93% 34.26%
EBIT 10721.33 ROE 45.37% 50.93%
MarketPrice 76.025 EPS $3.14 $3.08
TangibleBook
Val./sh.
3.77 ROC-WACC
%
28.23% 27.37%
EffectiveTax
Rate
0.29 ROE-Equity
%
38.73% 44.02%
Capital 20849 BETA 0.42 0.47
Numberof
Shares
2319.1
a.Risk-free
Rate
4.2%
b.Beta 0.42
c.Market
Rate
10%

Incasetwo,theprogramsawthatMerckhadphenomenalearningpowerandalow
probabilityofdefault.ItraisedbetaandROEattheexpenseofthereturnoncapital
(ROC)andearningspershare(EPS).Theemphasiswasobviouslyonincreasingtax
353

benefits.However,analystsknowthatdrugcompaniescanfallprecipitouslybecauseof
lawsuitsandexpiredpatents.Weassumethatthistypeofvolatilityisimplicitinthe
relationshipbetweenearnings,assetsandshareprice,butotherintangiblemeasurements
maycapturethisriskbetter.
CASETHREE:THERECOMMENDATIONFORNODEBT
Table13-4

CITRIX1999
(CTXS)

ENTRY
VARIABLE
AMOUNT
(Mil)
Key
Measurements
Actual Optimized
Assets 1038 Long-term
Debt
314 0
CurrentAssets 570 LTD/CAP 37.1% 0%
Current
Liabilities
137 Financial
Leverage
1.0699 1
LTD 314 EVA -2.42 -24.8
Effective
InterestRate
0.0407 ROC 13.38% 14.32%
EBIT 196.6 ROE 21.27% 14.32%
MarketPrice 59.125 EPS $0.58 $0.62
TangibleBook
Val./sh.
2.92 ROC-WACC
%
-1.22% -2.9%
EffectiveTax
Rate
0.38 ROE-Equity
%
-0.4% -2.9%
Capital 847 BETA 1.52 1.11
Numberof
Shares
195
a.Risk-free
Rate
5%
b.Beta 1.52
c.Market
Rate
16%

CitrixSystemsisaveryrepresentativecase.Throughoutthenineties,thiscompany
escheweddebtbutdecidedtotakeonthreehundredandfourteenmillioninlong-termdebt
354

in1999.Likemany“tech”stocksitsoperatingleverageisfundamentallyhigh,whichis
reflectedbyahighbeta.Theadditionofdebtintoitscapitalstructureaddedtomore
equityriskwhichmadeitexcessivelydifficulttoachieveapositiveEVAeveninabanner
yearlike1999.Bythistime,anoverheatedmarkethadpusheduptheriskofallequity.
ThisprogramdoesnotfindafeasiblesolutionwithSolverbecausebankruptcycostsare
greaterthanthemarginaltaxbenefitsofinterest,makingthemnegative.The
recommendationofzerodebtbringsbetadowntoafarmorereasonable1.11.
EVADISCREPANCIES
Thestudent/investorwillnoticethatEVAplungedineachcaseof“optimization”.
WeknowfrompreviouschaptersthatEVAoptimizesatextremesofequityordebt
dependingontherelationshipbetweentheirrespectivecosts.Reconcilingalong-term
optimizationwithvolatilechangesinthecostofcapitalistenuous;weassumethatthe
weightedaveragecostofcapitalwillreflectriskoverthelong-run.Inoptimization,
however,long-termchangesarecombinedwithcurrentEVAinformationthatwillbe“out
ofsync”withtheperiodicimprovementsthatarenecessary.Forexample,ifoptimization
tellstheusertoretainmoreearningsandshifttoalowerdebttoequityratio(Lowe’s)then
itmustbeassumedthatsuchchangescannotoccur“overnight”,andthatacertain
consistencyinoperatingincomemustbearrivedat.Analogously,norecommendationfor
moredebtinthecapitalstructurecanbeundertakenduringa“creditcrunch”when
interestratesareespeciallyhigh.
Itisfallacioustoarguethatthismodelwillsetstandardsofoptimizationforevery
company.However,ifthereaderwillobservetheaverageproportionsofdebttoequityin
anindustry,orthosesameproportionsduringthetimingofastockpeakduringabusiness
cycle,themodeloftenyieldsarealisticrendition.Ultimately,eveninthecasesthatitdoes
notoptimize,itbalanceskeyvariablesandoffersmanagementseveralancillarytargets.
(BacktoTableofContents)

355

APPENDIX:SPREADSHEETFORMULASANDZMIJEWSKIOPTIMIZATION

A B D E G H

1Zmijewskivar. variable negative variable amount
2assets coefficient
3currentassets intercept 9.479 LTD 0
4currentliab. TL/TA -6.384 taxbenefit 0
5LTD CA/CL -0.069
6interestrate NI/TA 1.06
7interestexpense 0
8EBIT Actual
9EBT 0 ROE LTD/CAP LEV. ROC
10netincome 0 #DIV/0! #DIV/0! #DIV/0! #DIV/0!
11totalliabilities 0
12equity 0
13mktprice
14bookvalue #DIV/0! OPTO.
15marketvalue 0 ROE LTD/CAP LEV ROC
16tangibleprice #DIV/0! #DIV/0! #DIV/0! #DIV/0!
17taxrate
18capital
19#shares

J L M O
1amountof
loss default
cost
bank
2
3DIV/0! intermediary #DIV/0! #DIV/0!
4 exp #DIV/0!
5 final #DIV/0!
6
7
8
9Marginal
Benefits
Interest
Benefit
INT/
Marg.
10#DIV/0! #DIV/0! #DIV/0!




15Marginal
Benefits
Interest
Benefit MAX
16#DIV/0! #DIV/0! #DIV/0!

356

A B D E F G H

23OPTIMIZE
24Zmijewski
var. variable negative variable amount
25assets 0 coefficient
26current
assets 0 intercept 9.479 LTD 0
27currentliab. 0 TL/TA -6.384 taxbenefit 0
28LTD CA/CL -0.069
29interestrate 0 NI/TA 1.06
30interest
expense 0
31EBIT 0
32EBT 0
33netincome 0
34total
liabilities 0
35equity 0
36mktprice 0
37bookvalue #DIV/0!
38market
value 0
39tangible
price 0
40taxrate 0
41capital 0 Marginal
Tax
Benefit
Bank
Cost EQUALIZE
42#shares 0 0 #DIV/0! #DIV/0!

J L M O

24amountof
loss default
cost
bank
25
26#DIV/0! intermediary #DIV/0! #DIV/0!
27 exp #DIV/0!
28 final #DIV/0!
29

357

FORMULASFROMRANGEA1:O42
H3.=B5
J3.=(1-(B16/B13))*B15
M3.
=E3+(E4*(B11/B2))+(E5*(B3/B4))+(E6*(B10/B2))
O3.=M5*J3
H4.=B17*B5
M4.=EXP(M3)
M5.=1/(1+M4)
B7.=B5*B6
B9.=B8-B7
B10.=B9-(B17*B9)
D10.=B10/B12
E10.=B5/B18
F10.=B8/(B8-B7)
G10.=B10/B18
J10.=H4-O3
L10.=(B7*B17)-O3
O10.=L10/J10
B11.=B4+B5
B12.=B18-B5
B14.=B12/B19
B15.=B13*B19
D16.=B33/B35
E16.=B28/B41
F16.=B31/(B31-B30)
G16.=B33/B41
J16.=H27-O26
L16.=(B30*B40)-O26
O16.=L16/J16
B25.=B2
B26.=B3
H26.=B28
J26.=(1-(B39/B36))*B38
M26.
=E26+(E27*(B34/B25))+(E28*(B26/B27))+(E29*(B33/B25))
O26.=M28*J26
B27.=B4
H27.=B40*B28
M27.=EXP(M26)
M28.=1/(1+M27)
B29.=B6
B30.=B28*B29
B31.=B8
358

B32.=B31-B30
B33.=B32-(B40*B32)
B34.=B27+B28
B35.=B41-B28
B36.=B13
B37.=B35/B42
B38.=B13*B42
B39.=B16
B40.=B17
B41.=B18
B42.=B19
E42.=H27-H4
F42.=O26-O3
G42.=E42-F42
(BacktoTableof
Contents)

359

14

ANINTRODUCTIONTORESIDUALECONOMICPROFIT
THEORY:USINGA
CONSTANTDIVIDENDDISCOUNTMODEL

ANINTRODUCTIONTORESIDUALECONOMICPROFITTHEORY
Theopportunitycostofanactionisthebenefitlostbynotchoosingthebest
alternative.Thatstandardconceptfromeconomicsbecamethefoundationforcapital
evaluationtechniqueslikeEVAandthecapitaldynamic.Onemerelycomparedthe
incomethatafirmwasactuallygeneratingtowhatsimilarlyriskyfirmsweregenerating;
theopportunitycostwasthelinkbetweenthecomparisons.However,neithertechniqueis
sufficientfor“handson”determinationofdividendpolicy,newshareissuesortheamount
ofearningstoretain.Outsideoftheamountofleverage,fewofthevariableswere
controllablebythefirm,andindeed,the“costofequity”wasverymarketdependent.
Themorepragmatic“residual”economicprofit,hasthesamefoundationand
frameworkasEVA,butusesthe“expectedrateofreturn”fromavaluationmodelasits
costofequity.Itallowstheusertocontrolalevelofcurrentdividend,nextdividend,new
stockissues,andtheamountofretainedearningsintherealmofnetincomeincreases.
Thus,givenalevelofnetincome,thefirmcanoptimizeitsdividendpolicyandattemptto
improveitsresidualeconomicprofitfortheyear.Oneofitsstrategicadvantagesistofind
alevelofnetincomewhereastockissuewouldnotunderminecapitalstructure.Secondly,
itcandecidewhetherthegrowthratefordividendsisoptimalorneedstobechanged.
Thirdly,itcancreateanoptimalamountofretentionthatwillmaximizeeconomicprofit.
Yearsago,analystswouldequatethecostofequitywiththereturnonequity(ROE)
andusetheminterchangeably.But-itwasdecidedthatROEwasnotatrueopportunity
360

costbecause,NetIncome-[(ROE)x(Stockholders’Equity)]=0.Tobeatrueopportunity
cost,thecostofequityhadtobesomelevelbelowthereturnonequity.Whenafirm
maximizedthisdistance,itwasfunctioningabovethelevelofitspeers.Valuationmodels,
especiallytheGordonmodel,yieldedanexpectedrateofreturnthatcouldbecompared
withROEtogaugeafirm’sperformance.Sincethis“expectedrateofreturn’wasdriven
byinternalfundamentalsanddidnothaveasmanymarketvariablesastheCAPM-
oriented“requiredrateofreturn”had,itwasmoreamenabletocorporatecontrol;the
onlymarketdrivenvariablewasthepriceofthestock.Althoughitwouldlackthe
performanceaccuracyofEVAorthecapitaldynamic,itcouldbeusedtofinetunecapital
structure.Theamountofretainedearnings,dividends,debt,andevendividendgrowth
wouldbederivedfromthemodel.
Theassumptionsinthemodelarenumerous;
• 1.TheusermustacceptthatamodelliketheGordonmodel,whichisonlytheoretically
applicabletofirmswhopayaconstantlygrowingdividend,canbeusedasanear-term
proxyforthecostofequity.
• 2.TheusermustacceptthatthegrowthfactorintheGordonmodeliscomposedofthe
productofROEandtheretentionratio.
• 3.Theusermustacceptthatthestockpriceisdeterminedoutsideofthemodel,bythe
market,andthatitwillnotchangeinresponsetoanychangesmadetothe
fundamentals.Itisaconstantinthemodel,althoughinreality,itmaychangedaily.
• 4.Nondividendpayingstockscannotbeinputted.Firm’swhoretainonehundred
percentoftheirearningswouldhavebothagrowthrateandacostofequityequaltoits
ROE.Aswehaveseen,theeconomicprofitinthatsituationwouldbezero.
Thethreepillarsofresidualeconomicprofittheoryare;opportunitycost,dividend
discountvaluation,anddividendtheory
OPPORTUNITYCOST
361

Theopportunitycostthatisconveyedbytheresidualeconomicprofitmodelismuch
differentthantherequiredrateofreturn.Whiletherequiredrateofreturnused
companiesofsimilarrisktocomparegeneratedincome,theresidualeconomicprofitcites
the“opportunity”ofeitherreinvestingnetincome,orpayingitoutintheformof
dividends.Ineffect,itisasmuchareinvestmentrateasitisanopportunitycost.Ithasa
smallmarketinterfacewhenitusestheexpecteddividendyieldbecausethecurrentstock
priceisthedenominatorofthatcomponent.However,itlacksthefar-reachingmarket
orientationthattheCAPMgeneratedratepossesses.Theexpectedrateofreturnwill
approachthetruecostofequityonlywhenthemarketisinequilibrium;companiesof
similarriskwouldhavesimilarreturns.Atthatpoint,therewouldbenodifference
between“required”and“expected“ratesofreturn.
Fundamentally,residualeconomicprofittheorydictatesthatthechoicesmadein
reinvestmentordistributionarederivedfrombalancingtheneedsofthecompanywiththe
exigenciesofthemarket.Forexample,iftheeconomyisnearrecession,afirmmight
decidetodistributeearningsasdividendsratherthantoretainthem,simplybecausethe
outlookfornewprojectsissopoor.Thus,theoptimalamountoffundingisimplicitinthe
model.
VALUATIONMODELS
Valuationmodelsofferanopportunitytogaugemarketresponsetoearnings
fundamentalsbybalancingfuturegrowthwiththecostofcapital.Theyaddatime
elementthatplacesacurrent-dollarfigureonanticipatedearnings.Theresultisafigure
thatisreferredtoas“fair”valueor“intrinsic”value.Whencomparedtothemarketvalue
ofasecurity,thisvaluewillhelptheanalystdeterminewhetherthestockisunderorover
priced.
Likemostanalyticaltools,valuationmodelscanbeveryaccurate,butontheother
hand,theirprojectionsmaybesooffbasethatthemethodlosescredibility.Whilesome
firmshaveverypredictabledividends,theanalystmustmatchthesewithasuitablecostof
362

capitaloveralonginterim.Sincepredictingsuchratesforevenoneyearisagargantuan
task,forecastinginthismannerisopentonumerouserrors,andsomeanalystssimply
reverttocapitalizingoperatingincometodetermineafairvalue.Thevalidityofvaluation
models,however,isfoundedontheoreticalabsoluteswithoutrecoursetoperiodic
disparities;itmeasuresgrowthoverlongtimespans.
Thetheorybehindvaluationissound.Earningsbelongtotheshareholders.Unless
theyarereinvestedandanticipatedtoreturnahigherratethanshareholderscanreceive
oninvestmentsofsimilarrisk,theyshouldbepaidoutasdividends.Thus,itistheamount
andgrowthofthesedividendsthatdetermineshowmuchaninvestoriswillingtopayfora
shareofstock.Iftheinvestorpaysmorethantheanticipatedflowofdividends,thestockis
overvalued.Ifheorshe(hopefully)paysless,thestockisundervalued,anditcanbesold
ataprofitatafuturedate.Moreover,twoadditionalfactorsneedtobeconsidered:since
astockisownedinperpetuityuntilitissold,itsonlysourceofreturnduringthatinterimis
thedividend.Secondly,theword“anticipate”connotesthediscountingprocessof
evaluatingfutureincomeintermsofpresentdollarswhichinvolves“exponentiating”the
quotientofcash-flow(dividends)tothecostofcapital-foreachyearthestockremains
active.Thus,almostlikeeconomicprofit,astockisrightfullyvaluedbytheproductionof
incomecomparedtothecosttoproduceit.
DIVIDENDTHEORY
Dividendsaresacrosanct.Notonlyarestocksevaluatedbytheirpotentialstreams
ofdividends,butthegrowthrateofdividendswilloftenmirrorthegrowthrateofthe
company.Forthisreason,theaccelerationindividendgrowthwillbelessthanthe
accelerationinearnings;mostcompanieswanttoensurepayment,andanydecreasesends
anextremelynegativesignaltoinvestors.Infact,cuttingthedividendisperhapsthesingle
mostextremesymbolofmanagerialdefeatoutsideofdeclaringchapter11.Evenwhen
warrantedtosaveacompany,shareholderswillseetheactionasasellsignal.Ontheother
363

hand,dividendgrowthiscitedasasymbolofmanagerialconfidence,andthebest
companieshaveasolidtrackrecordofsteadilyincreasingdividends
Mostcompaniespegdividendgrowthatarateveryclosetoearningsbecausethe
commonstockholderneedstobecompensatedfromtheprofitsofthefirm.However,
alternativetheorieshaveoftencreptintotheacademicliterature,advocatingdifferent
paymentrates,fixedpercentagesoftheprofits,andevenaconcepttailoredtostockprice
optimization-theresidualtheoryofdividends.
Theresidualtheoryofdividendsstatesfourprinciplesbehindcreatingacoherent
dividendpolicy:
• 1)Determinetheoptimalcapitalbudget
• 2)Determinetheamountofequityneededtofinancethisbudget.
• 3)Financethisamountofequitywithretainedearningstothegreatestextentpossible.
• 4)Paydividendsonlywhenretainedearningsarenotfullyexhausted
Forexample,ifCompanyXneeds100millioninfunding(thecapitalbudgetis100
million)andtheirtargetcapitalstructurecallsfor65percentequityand35percentdebt,
then65millionofthe100millionwillbeinequity.If80millioninearningsisavailable
(netincomeis80million)tomeetthatbudget,then(65/80)or81.25%willberetained
earnings,whichleaves15millionfordividenddistribution.Fromamathematical
perspective,suchapolicydoesindeedminimizethecostofcapital.Aslongastheamount
ofequityisoptimal,fundingwithretainedearningswillnotincurflotationcostsnorwillit
potentiallydilutethemarketvaluewithnewissues;anynewstockissuerepresentsa
futureobligationtopaydividendsaswell.However,ifthecapitalbudgetweretogrow
suddenly(perhapsbecauseofgreateropportunities),thefirmcouldrenegeondividend
growth,whichmightbedevastating-dependingoncontractualdemandsandthehistoric
patternofpayments.Ineffect,afirmpaysoutdividendsevenwhenthereinvestmentrate
maybehigherontheissueofnewstock.Whilethatconceptopposestherationalityofan
opportunitycost,itisarealisticaffirmationofthepsychologicalmilieu;thefirmcannot
364

assumethatshareholdersdesiretoincurtheriskofpostponingimmediateconsumptionfor
futurepotentialreturns.
Inreality,netincomewillnotalwaysbesufficienttoprovideretainedearnings,or
willinterestratesandcreditavailabilitybefavorableenoughtoincurdebt.Shareholders
willcontinuetodemandhigherdividendsdespiteanuncharacteristicallybadyear.Infact,
dividendpolicyisanunsolvedconundruminthebusinessworld;no“onesizefitsall”
policyexistssinceeachentityisstructureddifferently.Older,establishedcompaniescater
topensionfundsandretireesandrarelycuttheirdividends,whilenewer,“startups”may
establishapolicythatistailoredtotheirearningsflowthatmightincludeonly“special
dividends”whentheyareperiodicallydeclared.
Theresidualeconomicprofitmodelallowsflexibilityinthisarea;theusercan
declareanydividendforthisyearornextyear,butconsistencyisimplicitinthemodel.
ThevalueofusingtheGordonmodel,evenwhenitisnotapplicabletotheactualdividend
distribution,isthatitprovidesashort-termanswer;thedividenddistributionimplication
mayevenberealisticgiventhevolatilityinsomemarkets.Sincetheeconomicprofitinthe
currenttermisbeingcomparedwithadjacentyears,thelossinaccuracywillnotbeas
profoundastheutilityindeterminingproperproportions.
RESIDUALECONOMICPROFIT
Theresidualeconomicprofitmodelappliestheexpectedrateofreturnto
stockholders’equityandthensubtractsitfromnetincome.Inthismanner,ithasthesame
frameworkastheothereconomicprofitmodels.However,itisfarmorevolatilethanthe
“requiredrateofreturn”;adirectrenditionofcurrentgrowth(ROEmultipliedby
retention),withoutanysmoothingfromafiveyearmovingaverage,willgivetheexpected
rateofreturnacurrentbias.Withfiveyearsmoothing,amorereliablefigureemerges,
albeitonethatismuchmoredependentonthefundamentalsofthecompanythanmarket
averages.Theanalystcanusethisdependenceoninternalfundamentalstogaugethe
365

effectsofdividendpolicyandsharebuybacks.Indeed,theonlydifferencebetweenROE
andtheexpectedratewillbehowacompanyretainsearningsanddistributesdividends.
THEDIVIDENDTRAP
Toensureastable,growingdividend,afirmwillattempttoaccelerateearningsata
fasterpacethandividends;suchapolicyalsoraisescapitalintheformofretained
earnings.Afterseveralsuccessfulyearsofthispolicy,afirmwillfindthatstockholders’
equityhasbuiltuptoanuntenablelevel:retainedearningskeepgrowinginperpetuity,
whilenetincomeistabulatedonayearlyschedule.Almost“outofnowhere”,itappears
thatanylevelofnetincomewillcauseenoughearningstoberetainedsuchthateconomic
profitdeclines.Thecompanyhasfallenintothe“dividendtrap”.
Fromamodelperspective,thereareonlytwowaysoutof“thetrap”.Eitherthe
companycanpayaspecialdividendthatdepletesequitybyanadequateamount,oritcan
buybacksharesofstock.Mostcompanieschoosetodothelatter,andbuybackshave
becomestandardpractice.WhenMicrosoftpaidaspecialdividend,analystshadnoidea
thatthedecisiontopayanydividendatall,originallyimplementedataboutthesametime
thetaxlawchanged,putthefirmintoanentirelydifferentcategory.Withoutahugely
activemarketfornewissues,circa1997,Microsoftwasretainingearningsandbuildingup
equityattoorapidapace.Thechoicebetweenspecialdividendandbuybackissignificant.
Asmostfinancialobserverswillnote,themarketvalueofthecompanyisimmediately
depletedbytheamountofthedividendpayout.Ontheotherhand,abuybackwillraise
marketvaluebytakingsharesoffthemarketbutcreatesaglutoftreasurystockand
makesitdifficulttoissuenewshareswhenthetimeisadvantageous.Bothtechniqueswill
requiremassiveamountsofcash.
Mostcompaniesendup“takingitonthechin”andhaveamediocreyear,great
earningsnotwithstanding.Ineffect,thetotalcostofequitybecomestooexpensive-not
onlybecauseearningshaveacceleratedthepercentagecostofequity,butbecause
stockholders’equityistoohigh.Somecompanies,liketheoneinthefollowingexamples,
366

willusethisopportunitytoloadupondebtandmoveawayfromtheoptimalcapital
structure:alargeacquisitionthatpaysoffrapidlywillmovethecompanybacktothe
target,usuallywithahigherstockpriceintow.Lesswealthyfirmswillundergoa
downturnthatexpandsliabilitiesbutcontractsassets,ascenariothatwilldiminishequity
andlaterallowittorespondtoimprovedearnings.Thus,the“dividendtrap”isa
fundamentalparadox.Afirmisinbusinesstogenerateincome,butiftoomuchisretained
andreinvested,theabsolutefactorsofgrowth,thefirmwillsuffertheconsequencesofa
lowereconomicprofit.
MODELOPTIMIZATION
Mathematically,thismodelwilloptimizewhenthepayouttotheshareholderisone
hundredpercentandnoearningsareretained.Forthatreasonitismorerealisticfor
sensitivityanalysisthanoptimization.Nevertheless,itispredicatedongeneratingincome
withoutregardstogrowth;ittreatsgrowthasacostandnotasourceoffutureincome.
Thestringentparametersstrictlyconstraincorporateperformancetoasetofactions,
whichifviolated,willdiminisheconomicprofit.Therefore,aseriesofimprovements,with
thisdefinitionof“residualeconomicprofit”,willleadtostockpriceappreciation.
Besidestheinadequaciesofusingadividendgrowthmodelfordeterminingthecost
ofequity,thedefinitionofgrowthfactors,ROEandretention,aresubjecttodebate.While
themarketpriceofthestockisaverysmallpartofthemodel,ittooisaconstant,and
subjecttodebate.Notwithstandingthosediscrepancies,itishardtoimaginean
improvementinthisversionofeconomicprofitandnotobserveparallelimprovementsin
othermethodslikeEVAandthecapitaldynamic.Theparametersaresostrict,thata
smalldeclineinresidualeconomicprofitmayevenleadtoanincreasewhencalculatedas
EVA.Forthatreason,EVAisamuchbetterinvestmenttooleventhoughitlacksthe
operationalcapacityofresidualeconomicprofit;EVAisintunewithwhatthemarket
demands,whileresidualeconomicprofitdisplaystheinternaldynamicsofthecompany.
MODELBACKGROUND
367

Exceptforallowingchangesinthenumberofsharesandamountofdividends,the
standardGordonmodelisthebasisforthe“opportunitycost”.Wederivean“expected
rateofreturn”byshiftingthevariablesintheequation,P=D1/(K-G).Theexpected
rate,“K”becomes:K=(D1/P)+G,wherePisthecurrentpriceofthestock,D1isthe
nextexpecteddividend,andGisthegrowthrate.Wefurtherdecomposethegrowthrate,
“G”intoaproductofreturnonequityandretention.Mathematically,theretentionratio
isdeterminedbysubtractingthecalculation,[[(numberofsharesoutstanding)x(Dividend
pershare)]/Netincome]fromthenumber,“1”.Ifwemultiplythisnumberbynet
income,weobtaintheamountofretainedearnings.Thedividendpershareisthecurrent
dividendandnotD1,whichrepresentsthenextexpecteddividend.
Thestandardmethodologyofeconomicprofitapplies:wemerelymultiplyour
derivedexpectedrateofreturnbystockholder’sequity,andsubtractthisproductfromnet
income.Theideaistoimprovethisfigureyearoveryearanddeterminethereasonsit
mightnot.ItispossibletousethemoreexactingcalculationsusedinEVAmodels,i.e.,
operatingincome,interestdeductionsetc.,buttheconceptisbestexemplifiedinthe
investor-friendlyformatof:thecapitaldynamic,NetIncome-[(opportunitycost)
(stockholders’equity)]
Theconceptofthemodelistomakechangesinequitybychangingexistingshares,
newshares,dividendsandnetincome.Theseshiftswillcauseconcurrentchangesin
residualeconomicprofitandallowustoobservepotentialyearoveryearimprovement.
Anychangeindividendscausesashiftinretainedearningsasdoeschangesinnetincome.
AsROEandretentionchange,theresidualeconomicprofitascendsordescends.
368

MODELSETUP
Table14-1

ROW COLUMNA COLUMNB
1 INPUTS
2
3 NetIncome (ENTER)
4 CurrentDividend (ENTER)
5 OldSharesOutstanding (ENTER)
6 NewSharesOutstanding (ENTER)
7 OldBookValue/Sh. (ENTER)
8 MarketPrice/Sh. (ENTER)
9 GrowthRate (ENTER)
10 NewIssuePrice/Sh. (ENTER)
11
12 DERIVED
13
14 Old(Last)Equity EqualsB5*B7
15 NewIssuedEquityBook
Val.
EqualsB6*B10
16 TotalShares EqualsB5+B6
17 TotalCurrentDividends EqualsB4*B16
18 RetainedEarnings EqualsB3-B17
19 PayoutRatio EqualsB17/B3
20 RetentionRatio EqualsB18/B3
21 ROE EqualsB3/B24
22 BookValue/Sh. EqualsB24/B16
23 ExpectedDividend EqualsB9*B4
24 TotalStockholders'
Equity
EqualsB14+B15+B18
25
26 ECONOMICPROFIT
27
28 Growth EqualsB20*B21
29 ExpectedDividendYield EqualsB23/B8
30 ExpectedRateofReturn EqualsB28+B29
31 TotalCostofEquity EqualsB24*B30
32
33 ResidualEconomicProfit EqualsB3-B31
COLUMND LABEL COLUMNE
D1 Capital E1(ENTER)
D2 Long-termDebt E2EqualsE1-B24
D3 LTD/CAPITAL E3EqualsE2/E1
369

MODELADAPTATIONS
Thismodelcanbeusedasa“standalone”forsensitivityanalysisoradaptedfor
comparisonsbetweenyears.Whenadapted,threeseparatecalculationsaremadeoutside
ofthemodelforentryintotheinputsection:
• 1)Determinethegrowthrateofdividends.Thisisafactorsetupas(1+Decimal
percentage).Thefactorcanbeanestimateforthenextyear,oritcanbecalculatedasa
trend.Forexample,inthenextsection,wecalculateageometricmeanoverfiveyears:
Dividendfiveyearsago=0.74.Currentdividend=1.44.Numberofyearsbetween
interim=4.Inverseofthisnumber=1/4or0.25.Thecalculationisasfollows:(1.44
/0.74)
0.25
=1.1811.Theproperfiguretoinputis1.1811
• 2)Inputabookvaluepershareforlastyear’s(period’s)equity.Simplydividelast
year’sstockholders’equitybythenumberofsharesoutstandingduringthatperiod.
Example:Lastperiod’sequity=52731.Lastperiod’sshares=1377.8.Calculation:
52731/1377.8=$38.27/sh.
• 3)Inputanissuepricefornewsharesifany.Takethisyear’sendingequityand
subtractbothretainedearningsforthisyearandthetotalvalueoflastyear’sequity.
Dividethatfigurebythenumberofnewsharesoutstanding,whichisthedifference
betweenthisyearstotalsharesandlastyearstotalshares.Example:Lastperiod’s
equity=52731,lastperiodsshares=1377.8.Thisperiod’sequity=82646,thisperiod’s
shares=1646.1,thisperiod’snewretainedearnings=13179.62.Differenceinthe
numberofshares=(1646.1-1377.8)=268.3Calculation:82646-52731-13179.62
=16735.38Dividebythechangeinshares:16735.38/268.3=$62.376/share
Thesethreecalculationsstandasinputsintothenextsection.
THECASEOF:CANYOUTOPTHIS?
370

ConocoPhillipswaspartoftherunawayoilindustryinthenewmillennium.By
2005,thestockpricehadtopped$110pershareandwasstillgrowing.Withrecordprofits
andnoendinsight,ConocoPhillipsdecidedtosplitthestock.By2006,however,theyhad
hitabitofawall:inthepastfouryears,earningshadgrownatabouta40%pacewhile
dividendshadgrownatabout20%.Thedisparitycausedabuildupofretainedearnings
sothatitwasnexttoimpossibletoimproveontheeconomicprofitfigurefor2005.No
amountofincomecouldhavebeatenthediscrepancyunlessretainedearningswere
severelyrestricted.Ontheotherhand,ConocoPhillipsusedthis“wall’asanopportunity
toexpand.Ratherthanattemptingtobeatthephenomenal2005figure,theydecidedto
raiseevenmoreequityandbuyBurlingtonResources.Atthisjuncture,thedecisioncould
havebeentobuyupalotofstockorgiveaspecialdividend,butConocoPhillipsoptedto
moveawayfromtheiroptimalcapitalstructureandraisebillionsindebt.Infacttheyalso
issuednewsharesofstockwhichtheyautomaticallybeganbuyingbackin2007.The
decisionwassound.Ifmoreincomewasnotthesolutiontoimprovingeconomicprofit,it
wastimetomoveawayfromitsoptimalcapitalstructureandformanewoptimum.
ConocoPhillipswasafavoredcompanyinamostfavoredindustry,andthisriskwasnot
insurmountable.
COMPARINGSPREADSHEETS
ThefollowingfigureswereapplicabletoConocoPhillipsresidualeconomicprofitin
2005:
Table14-2

2005 QUANTITY
NetIncome 13529
Stockholders'Equity 52731
TotalDividends 1639
MarketPrice(Endofyear) 116.36
2006ExpectedDividend 1.44

371

Table14-3

2005 QUANTITY
RetentionRatio (13529-1639)/13529=0.8789
ROE 13529/52731=0.2566
ExpectedDividendYield 1.44/116.36=0.0124
ExpectedRateofReturn (0.2566)(0.8788)+0.0124=0.2379
ResidualEconomicProfit 13529-[(0.2379)(52731)=984.29

Thus,theapproximateresidualeconomicprofitof984.29canbeinputtedasacomparison
figure.Spreadsheet#1showstheinputforConocoPhillipsin2006withoutanychanges;
The416.82inresidualeconomicprofitisnotnearlyaslargeasthe2005figure.However,
thecompanyraisedasubstantialamountofadditionalcapitalandonlyraisedlong-term
debttocapitalbyasmallamount.Raisingalotofcapitalwithoutgreatriskwillbodewell
forthefuture
Inthisspreadsheet,wecanchangethethreemainparameters,dividends,net
incomeortheamountofshares.WemerelygotothetoolssectioninExcelandclickon
GoalSeek.Wethensetcell#33to984.29bychangingoneofthethreecellsthathavethe
keyvariables.Spreadsheet#2showsthesolutiontoConocoPhillipsPhillipsproblem;we
changedthenumberincellB4,thecurrentdividend.Accordingtothecalculation,if
ConocoPhillipshadpaidaspecialdividendof$2.97pershareforatotaldifferenceof
4896.141-2370.384or2,525.757(Million),economicprofitwouldhaverisensubstantially.
Thatdecisionwouldhavetakenconsiderablecashthatwastiedupinthepurchaseof
BurlingtonResources.Alternativedecisionssuchasraisingnetincomeorbuyingback
shareswouldnothaveworkedasexemplifiedinSpreadsheet#3.Inthatcase,weraised
theissuepricetothemarketpriceofapproximately$71.95,(sharesarebeingtakenoffthe
market)andwehadGoalSeekchangecell#B6,newlyissuedshares.Wewouldexpect
thatwewouldobtainanegativenumberinthatcellthatwoulddiminishstockholders’
372

equity.Sinceweobtainedanonsensicalnumber,thedecisionwasnotvalid.Hadwetried
tochangenetincome,thesameimpossibleresultwouldhavebeenobtained.
Toconcludethissection,wedonotrecommendthatacompanyadheretothe
residualeconomicprofittheoryunlessitisinthefirm’sbestinterestsandcoalesceswithset
goals.The“bar”maybesetsohigh,thatitmaybenexttoimpossibleforafirmtobeata
priorfigure.ConocoPhillipsdisplayedamasterfulendaroundbychangingtheir
capitalizationentirely.Nevertheless,economicprofittheoryexhibitsanarrayofoptions,
andmaysolveproblemsonceitisdevelopedintoacohesivestrategy.
(BacktoTableofContents)

373

SPREADSHEET#1
A B D E
1)INPUTS Capital 105737
2)
Long-term
debt 23093.4972
3)NetIncome 15550 LTD/CAP 0.218405073
4)CurrentDividend 1.44
5)OldShares 1377.8
6)NewShares 268.3
7)OldBookValue/sh 38.27
8)Price/sh 71.95
9)GrowthRate 1.1811
10)NewIssuePrice/sh 62.376
11)
12)DERIVED
13)
14)Old(Last)Equity 52728.41
15)NewlyIssued
Equity 16735.48
16)TotalShares 1646.1
17)TotalCurrent
Dividends 2370.384
18)RetainedEarnings 13179.62
19)PayoutRatio 0.152436
20)RetentionRatio 0.847564
21)ROE 0.188158
22)BookValue/sh 50.20564
23)ExpectedDividend 1.700784
24)TotalStockholders'
Equity 82643.5
25)
26)RESIDUAL
ECONOMIC
PROFIT
27)
28)Growth 0.159476
29)ExpectedDividend
Yield 0.023638
30)ExpectedRateof
Return 0.183114
31)TotalCostof
Equity 15133.18
32)
33)ResidualEconomic
Profit 416.8225
374

SPREADSHEET#2

INPUTS Capital 105737

NetIncome 15550
Long-term
debt 25619.25382
CurrentDividend 2.974388 LTD/CAP 0.242292233
OldShares 1377.8
NewShares 268.3
OldBookValue/sh 38.27
Price/sh 71.95
GrowthRate 1.1811
NewIssuePrice/sh 62.376

DERIVED

Old(Last)Equity 52728.41
NewlyIssuedEquity 16735.48
TotalShares 1646.1
TotalCurrent
Dividends 4896.141
RetainedEarnings 10653.86
PayoutRatio 0.314864
RetentionRatio 0.685136
ROE 0.194089
BookValue/sh 48.67125
ExpectedDividend 3.51305
TotalStockholders'
Equity 80117.75

RESIDUAL
ECONOMIC
PROFIT
Growth 0.132978
ExpectedDividend
Yield 0.048826
ExpectedRateof
Return 0.181804
TotalCostofEquity 14565.71

ResidualEconomic
Profit 984.29

375

SPREADSHEET#3

INPUTS Capital 105737

NetIncome 15550
Long-term
debt 215870.0799
CurrentDividend 1.44 LTD/CAP 2.041575607
OldShares 1377.8
NewShares -2502.16
OldBookValue/sh 38.27
Price/sh 71.95
GrowthRate 1.1811
NewIssuePrice/sh 71.95

DERIVED

Old(Last)Equity 52728.41
NewlyIssuedEquity -180031
TotalShares -1124.36
TotalCurrent
Dividends -1619.08
RetainedEarnings 17169.08
PayoutRatio -0.10412
RetentionRatio 1.104121
ROE -0.14119
BookValue/sh 97.95161
ExpectedDividend 1.700784
TotalStockholders'
Equity -110133

RESIDUAL
ECONOMIC
PROFIT
Growth -0.15589
ExpectedDividend
Yield 0.023638
ExpectedRateof
Return -0.13226
TotalCostofEquity 14565.71

ResidualEconomic
Profit 984.29

376

SECTIONIII:REALWORLDCASES
15
ANALYTICALTOOLS:PRACTICALAPPLICATION
Capitalstructureisdependentonthecostofequity.Forthosewhoareeducatedin
thesciences,itmightbehardtoconceiveofatheoreticalnumberthatcanshiftfromdayto
dayandthenuseitasadecision-makingtool.Ofcourse,wecanusemanyconcrete
measurementstoconfirmourdecision,butthecruxofanalysisrevolvesaround
determiningthechangeinariskbasedopportunitycost-thecostofequity.Inessence,we
arepricingtheriskofonefirm’sequityandthencomparingittoanother,usingreturnasa
criterion.Ifthatconceptseemsabstract,thencompareittoahumidityindexinweather
forecasting;theindexrangesbetweentwonumbersdependingonlocation,butonceit
reachestheupperlimitsofitsrangeforaconsiderableamountoftime,raincanbe
expected.However,thelimitsforSeattlewillbemuchdifferentfromthoseinPhoenix.
Thatdifferenceinboundariesisanalogoustohowthecostofequityworksincorporations;
onefirmdoesverywellwithinarangeofeleventothirteenpercent,butforanother
companysuchnumberswillspelldisaster.
THETOLERATIONOFIMPRECISION
Sincethecostofequitychangesfromdaytoday,theanalystmustbeabletotolerate
imprecision;heorshewillmostprobablynotdetermineanexactfigureforthecostof
equity.Thepremiumisplacedondeterminingacostthatwillreflectthereactionofthe
firmtotheearningsofothercompanieswithsimilarrisk.Thus,itmaybebettertobe
imprecisewithaconcretevalue,but“deadly”accuratewhenitcomestodetermining
whetherthefigureisgrowingordeclining.Forexample,anaccuratemeasurementof10
%withamisjudgmentofa1%decrease,mightbelesshelpfulthananimprecise
guesstimateof13%butwithaveryprecisegrowthestimateof2%.Thecapitalstructure
analystislessconcernedwithstaticvaluesthanwithmeasurementsofdynamicchange.
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Forthisreason,periodtoperiodchangesinEVAaremorevaluablethantheabsolutesize
ofEVA,whichwouldbenefitfromaprecisemeasurementofthecostofequity.Theanalyst
candetectmovementtowardtheoptimalcapitalstructureaslongasthemethodologyof
determiningthecostofequityreflectsanaccurategaugeofchangesinthecostofcapital.
Weillustratethisconceptbyusingradicallydifferentmethodologiestoarriveatthesame
decision.
Inthechapteronthecostofequity,wementionedthatthedifferenceinthevarious
methodsofdeterminingthatcostistheresultofthemarketandthecompanynotbeingin
equilibrium-thestockmaybeoverpricedorthecompanymaybeoutperformingthe
marketintermsofearnings.Forexample,ifacompanyhasareturnonequity(ROE)that
ismuchgreaterthanthemarketforanumberofyears,anditscostofequityisdetermined
throughadividenddiscountmodel,thefigurewillbesignificantlyhigherthanone
determinedthroughthecapitalassetpricingmodel(CAPM).Infact,savvyanalystscan
exploitthisdifferencebyobservingthatthe“expected”return,determinedfromthe
discountmodel,isgreaterthanthe‘required”returnasdeterminedthroughtheCAPM.
Theirconclusionwouldbetobuythestockbecauseitisoutperformingcompaniesof
similarrisk-orinotherwords-itsrisk/returnprofileismuchbetterthancomparable
firms.
Forcapitalbudgeting,mostexpertssuggestusingaconsensusmethodthatwill
balanceanearnings-derivedcost(dividenddiscountmodel)withamarketderivedone
(CAPM).Sincethesameforcesaffecteachmethodsimilarly,usingadividenddiscount
modelshouldnotchangeadecisionevenifitdeterminesacostwellaboveorbelowthe
marketdetermination.Interestratechangesandtheproportionofdebttoequitywillbe
theprimefactorsthatchangeeachrespectivecost.Foranon-growthstock,evenusingthe
simplisticproxy,earningspershare/pricepershare,theinverseofaP/Eratio,canleadto
acorrectinvestmentdecision-iftheforcesthatmoveafirmtowardtheoptimalcapital
structurearestrongenough.
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ERRINGONTHESIDEOFCONSERVATISM
Whenusingdifferentmethodstodeterminethecostofequity,webuilda
conservativeapproach:
• 1.Wecanusethehighestdeterminationofthecostofequityoverlowercost
calculations.Aslongastheperiodtoperiodchangeissimilar,wecancompareany
absolutefiguresforEVAwiththehighestcostpossible.Theworstcasescenariois
usingalowcostofequityforonecompanyandcomparingittoanotherusingahigher
estimate.
• 2.IntheCAPM,theriskpremiumisdeterminedbytherisk-freerate(tenyearbond)
subtractedfromthemarketrate.Whatifthatmarketratehasbeenabnormallylow
foranumberofyears?Thatwouldgiveabiastothedownside,evenifthemarketwas
surging.Tocombatsuchaskew,researchershavedeterminedthatinvestorsnormally
needafivepercentagepointgainofequitiesovertherisk-freerateinordertoinvest.
Thus,fivepercentshouldbetheminimumriskpremium,althoughlargernumberscan
beusedasappropriateandwillrealisticallyescalatethiscost.
• 3.Inashort-termdividenddiscountmodel,weneedtodetermineagrowthratebefore
determiningthecostofequity.Justasweusefiveyearsofdatatodeterminethe
CAPM,weuseamovingaverageoffiveyearsofreturnonequityandretentionratio
data.Suchanaveragewillsmooththedataandpreventaparticularlyinordinateyear
fromdeterminingthecostofequity.
• 4.ThepropermethodologytodeterminetheCAPMinvolvesobtainingthefive-year
averagesforboththemarketandtherisk-freerates.However,wemaysometimesuse
thecurrentrisk-freerateinourcalculations,inordertogiveita“FederalReserve
bias”.Thisistechnicallyimproper;riskistobeassessedovertheentireperiodofthe
regression.However,thetenyeartreasuryrateisnowherenearlyasvolatileasthe
marketrate,andusingacurrentrateallowsustospotpotentialtrends,especiallyshifts
inFederalReservepolicy.
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BRIEFMETHOLOLOGIESFORDETERMININGTHECOSTOFEQUITY
1.THECAPM:Thepreferredmethodisthecapitalassetpricingmodelbecauseitbrings
somuchmarketinformationtothetable.
• a)Wedeterminetheaveragerisk-freeratebydownloadingrelevanttenyeartreasury
datafromawebsitelikewww.federalreserve.gov.Expertsadviseusingtheaverage
rateduringtheperiodofregression.
• b)WedeterminethemarketratefortheperiodbydownloadingmonthlydatafortheS
&Poverthelastfiveyears.[(lastfigure-firstfigure)-1)]willyieldarate.Wedivide
thisoverallpercentagechange,bythenumberofyearsintheregression(five)toobtain
anaverage.
• c)Wedoaregressionbetweenafirm’sfive-yearmonthlystockpriceandtheS&P
(percentageincreases,notabsolutefigures).
• d)Weassembleourcostofequity:Risk-freerate(stepa)+[(betafromstepc)(Market
ratefromstepb-Risk-freerate)]
Oncethestudent/investorgoesthroughtheprocedureafewtimes,itwillbeautomaticand
effortlessandoneneednotbeatrainedstatistician.TheregressionwillproduceaY
interceptandabeta,andeachofthesewillbeexaminedforchangesbecausetheyare
separatetypesofriskindicators
2.THEGORDONMODEL:WhiletheGordonmodelwasdevelopedspecificallyforuse
withconstantdividendstocks,itseaseofimplementationmakesitidealfortheinvestor.It
maybeconceptuallyincorrecttousethismodelwithalltypesofdividendpayingstocks,
butthenwehavetoviewanyestimationofnextyear’sdividendwithsuspicion;toassume
constantgrowthintheshort-termwillnotproducealargedisparityandmayevenbe
actualized.
• a)Weestimatenextyear’sdividendfromafive-yeargrowthtrend:(LastDividend/
DividendFivePeriodsago)^0.25-1.Thisequationwillyieldapercentagevaluefor
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yearlygrowth.The0.25exponentistheinverse(1/4)ofthenumberofperiodsbetween
years(4).
• b)Wedeterminetheaveragemidrangepriceforthestockovertheappropriateperiod
byaddingthehighandthelowanddividingbytwo.
• c)Wetakeafiveyearhistoryofthereturnonequityandtheretentionratio,[1-
(dividendspaid/netincome)],andmultiplythetwoforeachyear.Thisproductisour
growthrateforeachyear.Wethentakethefiveyearaveragetodeterminethegrowth
rate.Forthenextdata,wedetermineanotheryearlygrowthrateanddropthefirst
datapointtomakeitafiveyearmovingaverage.
• d)Weassembleourcostofequity:(NextDividendEstimate/CurrentMidrangePrice)
+Growthrate.Thegrowthrateisafiveyearmovingaverage.
Normally,thisfigurewillbewellbeloworabovethefigureobtainedthroughtheCAPM
becausethetwowillnotbeinequilibrium.However,thesameforcesworkoneach
method:ifretainedearningsareinsufficient,afirmmustgotothecreditandequity
marketstoraiseadequatecapital.ThegrowthratethatisexplicitintheGordonmodel,
becomesimplicitinthebehaviorofbetaintheCAPM.AlthoughtheCAPMisthe
preferredmethod,dataisnotalwaysavailableandtheGordonmodelisagoodsubstitute;
itmirrorsmanyoftheinteractionsfoundintherelationshipsbetweenCAPMvariables.
3.THEE/PEARNINGS/PRICEMETHOD:Inapinch,theanalystcanresorttousing
theP/Einverse,earnings/priceasasubstitutemeasurement,butshouldnotexpect
premiumresults.WeaddthismethodbecauseitrationalizestheuseofP/Eanalysisandit
workswellifacompanyisnotagrowthstockandexhibitsstrongmovementtowardan
optimalcapitalstructure.Forexample,ifearningsrisetwentypercent,butE/Prisesforty
percent,wecaninterpretthecostofcapitaltobewellbehindtheaccelerationinearnings
andthefirmwouldbeagoodinvestment-atleastuntilthemarketfactoredintheincrease.
UsingthisratiousuallyunderestimatesthecostofequityandthusoverestimatesEVA,but
aperiodicdifferencewillreflectsomebasicchangeinthecostofcapital.Sinceitisso
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quicklycalculated,itcanbeusedtoidentifyfavorableinvestmentsituationsthatwarrant
furtherexamination,butitshouldneverbeusedinisolation.
WhilemanyanalystsstillusetheP/Eapproach,measuringtheperformanceofthe
inversionshouldnotseemunusualandmayclearupsomeoftheidiosyncrasiesobserved
overtheyears.IndividualP/Esareoftencomparedtothemarkettocheckifafirmisover
soldoroverbought.Inmanymarkets,theP/Eisaproxyforthegrowthratethatisneeded
tomaintainprice.Forexample,the“Peg”ratioofP/Einthenumeratortoactualearnings
growthinthedenominatorwouldbea“buy”indicatorifitwaswellunderoneanda“sell”
ifitwasoverone.However,growthstocksinparticularseemimmunetosuchanalysis
becausecapitalflowsintothemsoerratically,pumpinguppriceswhenasectorisfavored,
andallowingthemtofallprecipitouslywheninvestorsmoveon.Often,arisingP/Ewill
indicateapotentialinvestmentifearningsaregrowingevenfaster,andsotheinvestor
mustweightheaccelerationfactorsofthetwojustaswiththecostofequityandnet
income.Infact,EVAisamirrormeasurementofaproper“Peg”applicationwhenone
considersthatitisoptimizedwhilenetincomeisrisingandthecostofequity(readE/P)is
declining.Again,itisnotpropertoconsidereitherE/PorP/Easastaticmeasurement;
onlywhenoneexaminesthedynamicrelationshipbetweenearningsandP/Ewillsuchan
indicatorbeuseful.
PuttingP/Einthedomainofthecostofequity,wecanclearupsomeoftheeccentric
behaviorthatP/Eshaveexhibitedovertheyears:RaisingdebtlowersaP/Ebecauseit
raisesthecostofequity(E/P).HigherinflationandinterestrateswillleadtoalowerP/E
andahighercostofequity-E/P.Agreatervariabilityofearningsistheproductofmore
financialleverageandindicatedbyalowP/Eorahighercostofequity.Unfortunately,a
blindfaithinP/Eanalysiscancreatehavocbecauseinsomemarkets,P/Escanbedistorted
andbecomemeaningless.Withinaspecificrange,theymaypredictcompanybehavior,but
assoonasthatboundaryisviolated,theindicatorbecomessuperfluousandinvestor
emotionstartscontrollingthemarket.Thisdiscrepancycanbestbeobservedby
382

comparingtheGordonmodeltoE/Pforagrowthstock.Asthereaderwillnoticethe
judgmenttousetheCAPMcostofequityasmuchaspossibleisderivedfromabasicneed
foruniformity.Inthisexample,weuseXerox,adarlingofthe1960sandnowastruggling
company.Atthetime,theywerethepremiergrowthstock,growingatarateofoverfifty
percent.In1969,earningswere$2.08pershareandthecurrentpricewas$58.00.The
expecteddividendwas0.58andsotheGordonmodellookedsomethinglikethis:
(0.58/$58.00)+.53(growth)=54%.TheE/Pruleofthumbwouldcalculatethesamecost
as:
$2.08/58=3.59%.Thus,whengrowthisabovefifteenpercentitisalmostderigortouse
theCAPM,fornotonlydoesitcreatemoreuniformity,butitisapplicabletonon-dividend
payingfirmsaswell.
THEHURDLERATE
Thedangerofstaticinvestingistoblindlyinfusecapitalwhenafirmisataspecific,
measuredlevel-whetheritissales,EPSorassetvalue.Thedangerisevenmoreemphatic
tothosewho“value”investinlowP/Es.Withoutknowingthecontextofthepriceand
earningsbehavior,investorsmayinvestinastocksimplybecauseithasthelowestP/Ein
theindustry.Amorethoroughcheckmayrevealpricingproblems,toomuchdebtoreven
acorruptbutthoroughlyentrenchedmanagement.Thereis,however,oneconcretefigure
thatcanbeusedasabenchmarkwhenevaluatingthecostofequity.Justasafirm’sIRR
establishesthe“hurdle”rateforcapitalbudgeting,thereturnonequity(ROE)establishes
ahurdlerateforthecostofequity.TheratioNetIncome/Stockholders’Equityisthe
maximumrateatwhichEVAwillbezero.Anycostofequitypercentagebelowthisrate
willproduceapositiveEVA.Consequently,movementtowardamoreoptimalcapital
structureismeasuredbythechange(again,notthestaticversion)inthedifferencebetween
ROEandthecostofequitypercentage,(ROE-costofequity%),overatleasttwoperiods.
Industrieswithcharacteristicallyhigherdifferenceswillnotbefavoredoverthosewith
smallerdifferencesunlesstheirdynamicsarebetter;therateofchangeinthedifference
383

betweenROEandthecostofequitymustbeincreasing.JustaswithEPS,ifWallStreet
expectsacompanytohavetenpercentagepointsdifference,itwillnotrewardafirmthat
meetsthecriteria.However,afirmwhousuallyhasasevenpointdifferencewillbehighly
rewardedifitshiftstoanelevenpointdifference.Capitalflowsintounexpectedgrowth.
Thusthepremiumisforanalystswhocanforeseechangesinearnings,stockholders’
equity,orthecostofequity.Whilemostanalysisconcentratesonearnings,correctly
forecastingastockissuecanbejustasprofitable.Infact,salesandsectorvolatilitymake
earningssodifficulttoforecastthatanalystsoftenresortto“guidance”-gleaning
informationfromcompanyofficialsabouttaxes,plansforlong-termdebt,andoperating
efficiencies.Ontheotherhand,equitychangesareimplementedmoregraduallybecause
companyofficialsexerciseatleastsomecontrol-overbothnewissuesandtherateof
earningsretention.And-althoughthecostofequitycanbevolatile,ittoohassome
predictabilitysinceitlagsbehindearningsandfollowsbothinterestratebehaviorandthe
proportionofdebttoequity.
THEEVA/CAPITALDYNAMIC
Werefertoourinvestor’sversionofeconomicprofitasthecapitaldynamicbutwemay
useitinterchangeablywithEVAbecauseityieldsthesameresult.Inourapproach,wedo
notfiguretheweightedaveragecostofcapital(WACC)nordowefigurewhatistermed
“NOPAT”ornetoperatingprofitaftertaxes,althoughitmaybeessentialtohavethese
numbersonhandforcomparativepurposes.Wemerelysubtracttheproductofthe
percentagecostofequityandstockholders’equityfromnetincome.Wethencomparethis
derivedfigurewiththenextperiodanddeterminethepercentageincreaseordeficiency.
Thefinalequationis:NetIncome-[(PercentageCostofEquity)(Stockholders’Equity)].
THEWEIGHTEDAVERAGECOSTOFCAPITAL(WACC)
Itisextremelydifficultfortheaverageinvestortodetermineanaverageweighted
costofcapitalbecauseaprecisefigurerequirestheenumerationofeachpercentageof
capitalateachspecificrate-includingpreferredstockandshort-termdebt.However,the
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professionalanalystshouldordinarilyhaveknowledgeofthisbreakdownfroma10Kor
prospectusandcaneasilydetermineanychangesonaspreadsheet.Weknowfrom
previouschaptersthattheWACCisthesummationoftheproductsofthevariouscostsof
capitalcomponentsandeachpercentageofthecomponenttypeinthecapitalstructure.
Forourpurposes:
• RetainedearningsandcommonstockarepricedatthederivedCAPM“required”rate.
• Preferredstockisaperpetuity-figuredbydividingthepreferreddividendbythe
issuingprice-thatisnetofanyflotationcost.TheequationisCostofPreferred=
PreferredDividend/NetIssuingPrice
• Thecostofbothshorttermdebtandlongtermdebtis(interestrate)(1-T)withT
representingtheeffectivetaxrate.Theanalystiscautionedtousethecurrentinterest
ratesthatarepaidonlong-termandshort-termdebtrespectively.Dividinginterest
expenseintodebtisnotanaccuratesubstitute.
Abriefexample:
Table15-1

TYPEOFCAPITAL AMOUNT PERCENTAGE
SHORT-TERMDEBT 5 5
LONG-TERMDEBT 35 35
PREFERREDSTOCK 10 10
COMMONSTOCK 50 50
TOTAL 100 100

385

Table15-2

MARKETCOMPONENT RATE
PREFERREDDIVIDEND $8.00
PREFERREDISSUINGPRICE $100.00
MARKETRATE 0.11
BETA 0.95
10YEARTREASURY(RISK-FREE
RATE)
0.0425
ONEYEARBANKNOTE(SHORT-
TERMDEBT)
0.06
15YEARAARATEDBONDS(LTD) 0.09
EFFECTIVETAXRATE 0.4

Table15-3

TYPEOFCAPITAL FORMULA COST
SHORT-TERMDEBT .06(1-.4)= 0.036
LONG-TERMDEBT .09(1-.4)= 0.054
PREFERREDSTOCK $8.00/$100.00 0.08
COMMONSTOCK .0425+[(.95)(.11-.0425)]= 0.1066

Summingtheproductsoftherelativepercentagesandthecosts:[(.05)(.036)]+[(.35)(.054)]
+[(.1)(.08)]+[(.5)(.1066)]=.082or8.2%.
OneusestheWACCwarily.Evenwiththemostprecisecalculation,interpretation
ofitsmovementisambiguous.Inamarketwithrisinginterestrates(anormalyield
curve),amovementdownwardoftheWACCcoupledwithanupwardmovementinnet
incomewillmostlikelyindicateamovetowardamoreoptimalcapitalstructureanda
higherstockprice.However,anyupwardmovementdoesnotcertainlymeanthata
companyismovingawayfromthatstructure.Minimizationofthecostofcapitalcanoccur
bothdownwardandupward,dependingonthecorrectproportionofdebttoequityin
coordinationwithinterestratechanges.Onereasonthatweconcentratemoreonthecost
ofequityisthatitgivesusmorefocusedinformation,butliketheWACC,upward
386

movementcannotbeinterpretedasessentiallynegativebecauseitmustbeexaminedinthe
contextofearningsacceleration;atthetopofthemarket,thecostofequitywillhaverisen
significantly,buttherateofchangeinearningsshouldbeevengreater.
COMPARINGRISK:JUSTIFICATIONFORTWOCOSTSOFEQUITY
Ratherthanbreedingconfusion,theusualdiscrepancyinvaluesbetweenthe
GordonModel(oranydividenddiscountmodel)andtheCAPMoffersanopportunity.
Sincetheserespectivecostsofequitywillbesimilaronlyduringbriefperiodsof
equilibrium,thedisparityreflectstheinternaldynamicsofacompanyeitherout
performingorunderperformingthecollectivemarket.Forexample,consideracompany
whoisclosetoequilibrium.IftheGordonModeldictatesatwelvepercentexpectedreturn
versusanelevenpercentCAPM-derived“required”return,andthecompanyfollowsup
withjusttwopercentgrowth(ROEtimesretentionrate),thesavvyinvestorrushestosell
thestockbecausethemarketwillcertainlyrepriceitsrisk.Likewise,ifthedividend
discountmodeliswellabovetherequiredreturninthemarket,theremaybeupward
pressuretobuythestocksuchthatbothmarketanddividenddiscountmodelarein
equilibrium.Thisisnottosaythatastockcannotlanguishdespitealargedisparity,butif
thecorrelationintheoriginalregressionislarge(marketindexandstockprice),therewill
bestrongpressuretounitethetwocosts.
CHANGESINTHECAPM
WhentheFederalReservecutsinterestrates,stocksimmediatelypickupvalueand
certainspecialistswillprofitfromthismove.However,thereisfargreaterprofitincapital
structureforesight:theabilitytocoordinateseveralvariablesthatindicatecapitalflows
andthegaugingoftheriskthatweencounter.TheCAPMoffersareal-timeindicatorthat
isfarmorecomprehensivethanmosttechnicalanalysisbecauseitbringsinexogenous
variableslikeinterestrateandmarketrisk,andisnotjustdependentonpriceandvolume.
Moreover,theCAPMgivesusfreedomfromtheevaluationoffinancialstatementswhich
arenotpublisheduntiltwomonthsafterthefact,Suchalagcreatesa“lookaheadbias”;
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anyearningsinformationwegleanfromastatementisnotuptodateenoughtoactupon.
Themarketwillfactorinearningsinformationalmostinstantly-and-sometimesbefore
accountantsevenfinishthetallyifrumormillsarestrong.Thefollowingadaptationsmay
workfortheanalyst:
• Thepropermethodologyistousesixtydatapointsfrommonthlyindexdataandthen
regressafirm’sstockpricechangeagainstthemarket’schangeoverafive-yearspan.
Everyquartertheanalystcanupdatetheregressionwiththreenewmonthlypoints,
droppingthethreeoldestonestocreateamovingaverage.Thisupdateallowsthe
investortoexaminechangesinalpha,betaandthemarket.However,makingthe
marketindexandrisk-freeratesyearlyaveragesratherthanfive-yearaverages,while
conventionallyimproper,willgivethecostofequitya“currentbias”.Ifwewereto
averagethemovertheperiodoftheregression,moreweightwouldbegiventoperiods
ofsustainedvolatility.Forexample,ifthemarketisexceptionallyhighduringsix
monthsofoneyear,theCAPMwouldbeskewedinthatdirection.
• Asacomparisonfigure,thestudent/investorisencouragedtodoanotherregression
withdailydataoveraoneyearperiodandtousecurrentrisk-freeandmarketrates.
Theoutcomewillbeamuchmorevolatilefigurethatismostlydeterminedby
conditionsinthecurrentstockmarket.Whilethismethodisinsufficienttopricerisk,it
willallowtheindividualtoobservepressureonthecostofequity.Anyradicalchange
inmarket,interestrateorbetawillcreatemorevariationinthecostofequity,butmay
alsoindicatethedirectionittakes.
• Changestowatchinclude:1.Achangeinalpha.2.Achangeinbeta.3.Achangein
Rsquaredand(1-Rsquared).4.Achangeintheinterestrate.5.Achangeinthe
market.Toelaborateon“alpha”:althoughalphaisnotpartoftheCAPM,observing
changesallowstheinvestortogaugenon-systematicrisk.Ifanalphaisquitelargeand
growing,acompanyisnotonlylessdependentonthemarket,itsstockmayimprove
evenwhenthemarketisdown.Suchfavorablestatusisusuallytemporarybutmay
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happeninscenarioswherethefirmreceivesspecialtreatment(tariffs),orhasspecial
pricingpower(goldminingwhenfinancialconfidenceisshaken).Ontheotherhand,if
(1-Rsquared)isgrowingandalphaisnot,thestockmaybeunstable,reactingviolently
inacalmmarketornotatallduringperiodsofmarketappreciation.
THECOMPARATIVECAPITALDYNAMIC
Thestudent/investormayfaceadilemmabetweeninvestingintwogoodprospectsin
separateindustries,oneasmallmanufacturerandtheotheralargemultinational.The
investorhasdeterminedthateachisabouttoincreasetheirrespectiveEVAs,butisunsure
aboutthesignificanceofactualsize.Inthiscase,onecouldusethequotientformofthe
capitaldynamic,whichthisauthorterms,“thecomparativecapitaldynamic”.Remember
thatthecapitaldynamicisaninvestorfriendlyversionofEVA,whichisadifference
operation.Inthecomparativecapitaldynamic,wedividethetotalcostofequity,thatisthe
productofstockholders’equityandthepercentagecost,intonetincomeandderivearatio.
TheratioNetIncome/TotalCostofEquitycanbeusedasacomparativeindicator.The
highertheratio,thegreateristheeconomicprofitgiventheinternaldynamicsofcapital
structure.Whenonecompanygoesfromasmallernumberlike1.5,toamuchlarger
numberlike3.5,upwardpressureonthestockmaybefollowedbysubsequentdownward
pressure;thefirmfindsitdifficulttofollowsuchastellarperformance.Infact,ifthe
student/investorobservesthisnumberovertime,heorshewillfindthatmanyappreciating
stockswillhaveasimilarcomparativecapitaldynamic,andsoeachmarketseemstoputa
premiumonreachingaspecificnumber-asitrewardsthecompanywithahigherstock
price.
THEMARGINALBENEFITSEQUATION
Manyfinancialinstitutionswillguardtheirprobabilitymodelslikestatesecrets
whichhaveledsomeacademicstoexaminethemin“deconstructionistmode”,attempting
todebunktheirefficacy.Continuingwiththethemeofadaptation,thegeneric,publicly
availablealgorithmscansuitourneedforestimation;theymaynotperfectlyinformusifa
389

firmisabouttobecomeinsolvent,butourmethodologyisfardifferentfromthedecisionto
grantcredit.Inessence,weuseadefaultprobabilitymodelastheprimevariableinthe
determinationofthecostofbankruptcy.Whenthetaxbenefitsofdebtexceedthiscost,
marketvalueiscreatedandthestockappreciates.
Withanalgorithmthatmatchesthespecificprobabilityofdefaultforthecompany
andindustry,optimizationofdebttoequityoccurswhenthefunctionismaximizedandthe
firstderivativeisequaltozero.Bothstockholders’equityandlong-termdebttocapital
shouldbecomponentsofthatalgorithm.However,fortheevaluationofmovementtoward
theoptimal,weonlyneedtoexaminethebehaviorofthecomponentsandtoobservethat
thefunctionisincreasing.Ofparticularsignificanceisthebehaviorofthedefault
probability.Ifitincreasesatall,itmustbeaccompaniedbyalargedebtissueandonlya
smallstockincreasebecausetherewillbecountervailingforcesinthenextyeartobalance
theequation.Inmostcases,ifdebtincreases,andthedefaultprobabilitydeclines,itis
becauseearningspressureispositiveandthecompanyhasaddedequitytobufferthedebt
toequityratio.Inarisingmarket,thisscenarioisidealbecauseitrepresentsbothasset
growthandearningsgrowth,withadeclineinthelong-termdebttocapitalratio-more
returninthedomainoflessrisk.Thekeytotherelationshipistheinteractionbetween
defaultprobabilityanddebt.Ifmoredebtleadstoarapidincreaseincash-flow,the
defaultprobabilitydecreases,andthestockwillappreciate.However,ifadebtissue
languishesandrequiresmoreinvestmentwithlittlereturn,theprobabilityofdefaultwill
rise,andthestockwillunderperform.Tocreateaworkingmarginalbenefitsequation:
• 1.LiketheEVA/CapitalDynamic,weseektoincreasethefigureyearoveryear.This
authoranalyzesperformancebasedonthefiscalyearofthecompanysimplybecause
managementstrategyisexhibitedinthebehaviorofdefaultprobabilitycomponents
overthatperiod.
• 2.Theleftsideoftheequationismerelytheoutstandinglong-termdebtmultipliedby
theaverageeffectivetaxratefortheindustry.(Long-termdebt)x(EffectiveTaxRate)
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• 3.Todeterminetherightsideoftheequation,theinvestormustcalculatethe“tangible
bookvaluepershare”.Inordertodecipherhowmuchofmarketvalueisintrinsic
valueandhowmuchismadeupofassetsthatareunclaimedbycreditors,wesubtract
intangibleassetsandunamortizeddebtfromtotalassets.Wedividethisfigurebythe
totalnumberofsharesoutstandinganddeterminethe“tangiblebookvaluepershare”.
Thefullfunctionis:(Totalassets-Intangibleassets-Unamortizeddebt)/Numberof
sharesoutstanding.
• 4.Wedeterminethedifferencebetweencurrentmarketvalueandtangiblevalueto
determinetheamountofpotentiallossincaseofbankruptcy.[1-(Tangiblebookvalue
pershare/Marketvaluepershare)]x[(Numberofsharesoutstanding)x(Marketvalue
pershare)]
• 5.Weuseaprobabilitydefaultmodeltodeterminea“ballpark”figurefordefault.
Sincewearenotdoingcreditanalysis,agenericalgorithmcandisplaytheincreasein
riskfromyeartoyear.Altman,Shumway,Merton,OhlsonandZmijewskihaveall
publishedusablealgorithms,butthisauthorprefersZmijewski’sbecauseitiseconomic
andcapturesdefaultriskinafewexpressions.Inthefollowingmethodology,wewill
showthestudent/investorhowtotransformtheparametersintoalogitexpressionand
thenaprobability.
Table15-4

COMPONENT(ZMIJEWSKI'S) VALUECOEFFICIENT
Intercept -9.479
TotalLiabilities/TotalAssets 6.384
CurrentAssets/CurrentLiabilities 0.069
NetIncome/TotalAssets -1.06

Logitprobabilitiesareexpressedinlogarithms.Wecanalgebraicallyeliminatethe
logarithmandreplaceitwiththeEXPfunctionwhichisacommandtomultiplyEuler’s
number(2.7182818...)byanexponent.WhenwesubstituteEuler’snumber,wealsomust
391

makeallthecomponentsinZmijewski’salgorithmnegative.Thus,ifcurrentassets/
currentliabilitiesis“2”,itbecomes-2.
Themechanicsofthisoperationareasfollows:Ln[P
1
/(1-P)]=X
i
ß
P
1
=1/[1+EXP(-X
i
ß)]
Theinterceptisalsonegativebecauseitisinferredthatithasacoefficientof“1”.Withso
muchoftheexpressiondependentontherelativelylargeinterceptof-9.479,itshouldbe
quiteobvioustothemathematicianthatthepredictionofbankruptcyisnotanexact
science!.However,“throwingthebabyoutwiththebathwater”getsusnowhere,and
usingthealgorithmtoobservechangesinriskrelativetodebtandstockpricemakesita
valuabletool.
• 6.Wedeterminethecostofbankruptcybymultiplyingthedefaultprobabilitybythe
potentiallossor:(ProbabilityofDefault)x[1-(Tangiblebookvaluepershare/Market
valuepershare)]x(NumberofsharesoutstandingxMarketvaluepershare)
• 7.Thefinalexpressionisthedifferencebetweenleftandrightsideswhichweexpectto
seeincrease.(Long-termdebtxEffectivetaxrate)-[(ProbabilityofDefault)x(1-
(Tangiblebookvaluepershare/Marketvaluepershare))x(Numberofshares
outstandingxMarketvaluepershare)]
Ifthestockpricefalls(perhapsasareactiontotheeconomy)onecanreada“false
increase”intothisequationsoitisimportanttounderstandtheinteractionbetweenthe
componentparts.Thebasicpremiseisthatthevalueofaleveredcompanyisgreaterthan
anunleveredonebecauseinterestistaxdeductible.Ifafirmisstilladdingdebtevenasit
increasesearningsandequity,theprobabilityofdefaultwilldecreasewhichwillput
upwardpressureonthestock.Thissamefunctioncanbeusedtofindatargetproportion
ofdebttoequityaslongastheproperdefaultalgorithmisused;thefunctionmaximizes
whenthefirstderivativeequalszero.Inmanyfinancialtextbooks,theauthorwillreferto
thissituationas“marginaltaxbenefitsequalmarginalbankruptcycosts”.
LEVERAGESTATEANALYSIS
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Withoutquestion,theanticipationofaprofitableleveragestatewillbethemost
formidableweaponinyourarsenal.Whileotheranalyticaltoolsareprimarilyconcurrent
indicatorsofstockprice,aleveragestatethattransitionsfromrequiringmorecapitalto
payingoffinvestorswithhigherprofitsispredictive.Thepremiumistosearchforastate
thatwillnotonlygeneratemoreearnings,butdoessowithaminimumofriskthatwill
sustaintheaccelerationofearningsforaslongaspossible.Minimizingthecostofcapital,
however,oftenrequiresadifferentleveragestateforeachphaseofthebusinesscycle;the
costofcapitalcanactuallyrisewhileafirmisminimizingit.Thisvolatiledichotomy
betweenthecostofcapital,theamountofcapital,andhowtheyinteractwitheachotherin
thebusinesscyclecanbeperplexing.
Thelogicchainbehindleveragestatesisbasic.Astheeconomyimproves,the
FederalReserveraisesinterestratesmakinglong-termdebtmoreexpensive.Therefore,a
premiumiscreatedforequityfunding.Equityisbuiltbyeitherattractinginvestorstothe
stockthroughhigherearnings,orretainingthosesameearningsanddecreasingthe
proportionofdebttoequity.Whentheeconomicoutlookdeclines,theFederalReserve
lowersrates,rewardingthewealthiestcompanieswhocanaffordthemostdebtwitha
lowercostofcapital.Companiesthatproducethemostoutputduringarecovery,
compensateshareholderswithnetincomethatisgeneratedfromlowerinterestratesand
increaseddemandforitsproducts.Theirgreaterfinancialleverageallowsthemtofinance
withlessequity,andthesharepriceescalates.
Betweenthesetwoextremesareintermediatepositionsthatarebasedonphase,
sectorandtransition.Operatingleverage,forexample,isextremelyimportanttofirms
whodonotfundwithdebt.Ahigherrelativeoperatingleverageforthesefirms,whentheir
respectivesectorsarefavored,willguaranteehigherprofitsbecausedemandisbothstable
andhighduringthatperiod.However,thesamefirmmaywantaloweroperatingleverage
duringasectordownturn.
Thetwomostbasicindicatorsare:
393

• 1.Thefinancialleverageratio.Thisratioisformedbysubtractinginterestexpense
fromearningsbeforeinterestandtaxes(EBIT)anddividingitbackintoEBIT.The
fullfunctionis:EBIT/EBIT-I.Analystsmightrecognizethisexpressionasthe
inverseoftheDuPontequationsimileEBT/EBITwhichisacomponentpartofthe
returnonequity(ROE).Theimportantpointtorealizeisthatasearningsincrease,this
ratiobeginstoshrink-evenifbyaminusculeamount.Theprobabilityofdefault
decreasesasmoreoperatingearningscoverinterestexpense.Ashifttoasmallerratio
oftensignalsamovementtowardanoptimalcapitalstructurewithlessinherentrisk.
• 2.Thelong-termdebttocapitalratio.Thisratiowillmeasuretheproportionofdebtto
equityinameaningfulway.Ifearningsarehigh,theywillberetainedoncedividends
arepaidandtheLTD/CAPratiowilldecrease.Ifinterestratesarelowenough,an
increaseinthisratiowillactuallyentaillowercapitalcostswithatypicalearnings
increaseinsubsequentyears.Thus,likethefinancialleverageratio,theeconomic
contextofachangeintheratioisparamount.Forexample,asimultaneousshift
upwardinbothratios(moreinterestandmoredebt)alongwithafavorableearnings
forecastwillbeaprecursorforatransitiontoproportionallylessdebtandmore
earnings.
Twosecondaryindicatorsalsoexist.Theyare:
• 3.OperatingMomentum.%∆ ∆∆ ∆EBIT/%∆ ∆∆ ∆Sales-Whilethisratioisoftenused
interchangeablywithoperatingleverage,itisonlythesamefunctionwhenafirmisin
equilibrium-arareoccurrenceconsideringmoderncorporatevolatility.Nevertheless,
itofferstheinvestorameasurablefunctionthatindicatesashort-termtrendin
earnings.Itissignificantbecauseitaffectsfinancialrisk;whenacompanytakeson
greaterdebt,anoperatingmomentumthatsuddenlydecreaseswillincreasethe
company’sdefaultrisk-itsabilitytopayoffinterestexpenses.Likewise,ifmoredebtis
incurred,arisingoperatingmomentumwillbufferthatsameexpense.Althoughthe
absolutevalueintotalleveragemaybesimilarforeachsituation,thechangeinratiosis
394

indicativeofoperatingmargins.Nofirmwantstoincurdebtfromapositionof
decreasingmargins.Firmswhousedebtstrategicallywanttoincurdebtfroma
positionofstrength.
• 4.Theassettocapitalratio.Whilemuchismadeoftheassettoequityratio,thisratio
maybeindicativeofa“pick-up”inbusiness.Itistruethatmorecurrentliabilitieswill
decreaseworkingcapitalandleadtoahigherprobabilityofdefault,butitisequally
validthatmorelabor,morevendorcontractsandmoreshort-termcreditsignalsa
potentialincreaseinbusiness.Short-termdebtisalegitimatesourceoffinancingthat
maylowerthecostofcapital.Short-termdebtisalsoaprecursortomoresales.When
suchsalesareactuated,theybecome“accountsreceivable”,andcurrentassetsagain
balancecurrentliabilities.However,whenthisoccurs,itwillbetoolateforthe
shareholdertoinvestbecauseearningswouldhavebeenincreasedandshareprice
wouldhavemovedconcurrently.
Sincetheinvestorcannotdependonaleveragestatetoprovidemomentum
(investinginastatewhereearningsarehigh)heorshemustanticipatethetransitionfrom
a“debt”statetoamoreprofitablestate.Gaugingriskbyobservingthebehaviorofthe
financialleverageratioandlong-termdebttocapitalratiooveranumberofquartersis
standard,butthereisnoformula;theproportionoflong-termdebttocapitalismoretrend
worthybecausefirmsmustaddorsubtractcapitalinlargeincrementstobecosteffective.
ThatisnotaninvitationtoinvestassoonastheanalystobservesalowerLTD/CAPforone
quarter.Infact,ifcreditstandardsarelowerintheoveralleconomy,thecompanymay
actuallybemovingtowardahighercostofcapitalinthatscenario.However,thisisa
situationinwhichtheinvestorcandependonanalyst’sforecasts.Ifthecompanyhastaken
onleverageandanalystspredictcomparativelyhigherearnings,thepayoffisexpectedto
berapid,andtheinvestorcanlookforwardtoahighershareprice.
Secondly,aninvestorcanobservethecurrentmostprofitablesectorintheeconomy.
Whatwastheleveragestatebeforeitbecameprofitable?Whatisitsleveragestatenow?
395

Notallcompaniesinasectorwillfallintothesamepattern,butifthestudent/investoris
tenaciousenough,heorshewillderiveasolidindicationofhowtheseleveragestate
componentsshouldbecoordinated.Therationaleforacoherentstrategyisthateach
economypricesriskandreturninaspecificway;thepropercombinationofleverage
factorswillleadtothehighestpointonthe“efficientfrontier”-thehighestreturnperunit
ofrisk.Inessence,thereisonestatethatwillencouragetheminimizationofthecostof
capitalperunitofincomeaboveallothers.Therewillalsobeastatethatactuatesthe
movementtowardanoptimalcapitalstructure.Theinvestor’simperativeistobeinthe
gameearlyenoughtocapturetheaccelerationofearnings.
Lastly,observing“inside”activityisamust.Whenaleveragestateissolid,
companyexecutiveswillbegintoaccumulateshares.Althoughmassivesellingactivityis
oftenfortaxpurposesandisnota“sell”indicator,thepurchaseofmoresharesisa“buy”
indicator-iftheanalystexaminestheleveragestatefirst.Theseinvestmentsarefarmore
lucrativeatthebeginningandmidstagesofarecovery/expansionthaninthelaterstages,
atthetopofthemarket.Theinvestorshouldavoidbuyingsharesifearningacceleration
hasalreadyoccurred,butmightconsiderinvestingwhenthecompanyhasbothinsiderand
debtactivityoccurringsimultaneously.Investingafterearningshavealreadybeen
actuatedcanoccurwhenexecutivesmake“goodfaith”investments,butunbridled
optimismisnotthepurviewofanobjectiveanalyst.
THELOOKAHEADBIAS
Thedifferencebetweeninvestinginleveragestatesandotherfundamentalslike
earningsorsalesisthattheleveragestatelackswhatistermed,a‘lookaheadbias”.
Frequently,investorsmakedecisionsafterreceivingreportsonearningsoranother
fundamentalandfailtorealizethatthefirmisinaconstantstateofflux;thereportrefers
toinformationthatwasreceivedlongagoandmaynolongerbeactionable.Moreover,any
screenorstrategythatisconstructedonthatbasismaybeobsoletebecausethemarketwill
nolongerreacttosuchinformationinthesameway.Fundamentalsareconcurrent
396

indicators;theyperformconcurrentlywiththestockprice.Ontheotherhand,leverage
statesarepredictiveindicatorsbecausetheyaredevelopedwellbeforeapriceisexpectedto
rise.Infact,thereisatenmonth“windowofopportunity”ineachfiscalyearbecausea10
Kwillcomeoutabouttwomonthsaftertheyearisover.Socalled‘smartmoney”investors
maybeaddingsharesatthistime,buttheinvestingpublicwillbeunawareuntilearnings
begintoescalate.Thepredictivenatureofleveragestatesversusconcurrentindicatorslike
EVAisthataleveragestatewillforeshadowthedirectionofthecostofequityinrelationto
earnings.Whileitisdifficulttopredictpreciselywhenprofitswillriseorevenifasector
willbestrongatallduringabusinesscycle,weknowthatbetawillreacttoachangeinthe
proportionofdebttoequity.WealsoknowwhentheFederalReserveisloweringratesor
raisingthemandthattheymoveinadiscernibletrend.Whenthecostofequitybecomes
lowenoughcomparedtothechangeinearnings,theequitymarketbeginstorise.
Therefore,aleveragestateissimplyanextensionofthesamecapitalstructurethemeof
earningschangesinrelationtothecostofequity;thatstatewhichencouragesearningsto
risefastestinternsofthecostofequity,willbethestatethatoffersthemostreturnforthe
leastamountofrisk.Atthesametime,itwillbethestatethatmovesthefirmtowardan
optimalcapitalstructurewhichmaximizesthepriceofthestock.
MICROANALYSIS:QUARTERLYOBSERVATION
Fewtechniquesarefraughtwithmoreriskthanquarterlyextrapolationof
performance.Althoughwecandetectchangesinearningsandsalesfromperiodtoperiod,
short-termpredictionsareverysusceptibletorandomvolatility,simplybecausefactors
outsideofthemodelmayhaveasmuchaffectonthestockpriceastheinternaldynamicsof
thecompanyitself.Considerthe2007-2008creditcrunch;firmsthathadexcellent
earningsandcreditweredamagedbyspeculationinthehousingmarket.Adecreaseinthe
costofequityovertwoquartersmayhavebeenacomparativeadvantage,butitcouldnot
preventastockfromfalling.Moreover,thereisnofundamentalthatissostablethatit
offersareliablepredictionvariable.Evenchangesinthefinancialleverageratio,which
397

canbeminute,mustbeaccumulatedoveraseriesofquarterstobeconfirming.Thus,
tryingtobe“inthegame”early,byanticipatingafavorableleveragestate,canbecostly.
Forexample,consideracompanywhogoesthroughthreequarterswithlowerLTD/CAP
andlowerfinancialleverage.Theinvestormakesamoveandaccumulatesstock,onlyto
findoutthatintheforthquarterthecompanytakesonanunsoundacquisitionandpays
foritwithanequityissue.
ThehallmarkofquarterlyanalysisistoanticipatealargejumpinEVAbeforeit
occurs.Professionalanalystsconstantlyforecastearningsandsoanear-termoutlookis
almostalwaysavailable.However,predictingchangesinthecostofcapitaland
stockholdersequitymaybevexing.Whilemanagementhasincrementalcontrolover
equityanddesiressmoothchanges,thereisnoguaranteethatthegrowthratewillnot
suddenlybecomeeccentric.Financialprofessionalsknowthatthestockpriceisamultiple
ofbookvalueandmaywantittoconformtoindustryaverages,ortheymaywantto
exerciseoptionsinanticipationoffurthergrowth.Ontheotherhand,thecostofequity
willmirrorthechangeininterestratesandstockprices,aswellastheproportionofdebtto
equitywithinthefirm.However,itlagstheperformanceofearningsandisdifficultto
measureonashort-termbasis.Thecostisnotalwaysreflectiveofimmediateequityrisk
becauseitiscalculatedoverasixtymonthperiod,butobservationoftheriskpremium,the
differencebetweenthemarketindexandthetenyearbond,canindicatethedirectionof
change.Again,thepremiumisplacedonearningsacceleratingfasterthanthetotalcostof
equity,andthenextsectionswillfocusontheattempttopredictsuchaphenomenon.
NAIVEEXTRAPOLATION
Innaiveextrapolation,wecomparethetotalcostofequityfivequartersagotowhat
itisnow,andderiveagrowthrate.Wethencompareanalyst’sestimatesofearningsasa
growthratetothegrowthrateintotalcostofequity.Weplacethechangeinearningsin
thenumeratorandthechangeinthetotalcostofequityinthedenominatorandcreatea
percentagechangeversionofthecomparativedynamic.Ifitisover“1”,weanticipatethe
398

EVA/capitaldynamictoriseandthestockpricetodolikewise.Infact,wecanevenmake
concretepredictionsofEVAifwemultiplethegrowthratesbylastperiod’sbaseofnet
incomeandtotalcostofequity.Howeversuchpredictionsdonotanticipatetransitional
changesinequityandearningsthatmaybetotallyskewed.Analystscanoftenchange
forecastsonce“guidance”isreceivedfromthecompany,buttheaverageinvestordoesnot
havesuchrecourse.Anaiveextrapolationisverymuchlikeproclaimingthattheweather
tomorrowwillbejustlikeitistoday.Fouroutoffivetimes,thatpredictionwillbecorrect
buttwentypercentofthetimeitwillfailbecauseitdoesnotanticipatethetransitionsfrom
sunnytostormyorviceversa.
Weapplytheexponentialgrowthratetechnique(AKAgeometricmean)overaspan
offivequartersalthoughfourperiodsisacceptableifdataisunavailable;inthiscase,we
arelookingforaconfirmation,notadecisionindicator.Growthrateextrapolationis
accurateforastabledividend,butisnotappropriateforvolatilemeasurementsunlessitis
usedasacomparisontoadifferentbutrelatedratio.Forexample,extrapolatingaten
percentgrowthrateforsalesandassumingthatsalesareexpectedtorisebytenpercentis
amisuseandwillbeinaccurate.However,ifweextrapolatethetenpercentsalesrate,and
thenextrapolateathirteenpercentincreaseforvariablecosts,therelationbetweenthetwo
issignificant.
Tousethegrowthratetechnique,weneedboththepercentagecostofequityfrom
fivequartersagoandthebalancesheetitem,stockholders’equity.Wealsoneedthe
currentdataforthoseitems.Wethenmultiplyeachpercentagecostofequitybyeach
entryforstockholders’equity.Wethenmakearatiobetweenthelatestdatainthe
numeratorandthehistoricaldatainthedenominator,andmultiplybyanexponentthatis
theinverseofthenumberofperiodsbetweenthedataentries.Inthecaseoffiveperiods,
thenumberbetweenperiodsisfourandtheexponentis“1/4”or0.25.Iftheperiodlength
weretwelveyears,thenumberbetweenperiodswouldbeelevenandtheexponentwouldbe
“1/11”or0.0909.Toillustratethetechnique,examinethefollowingdata:
399

Table15-5

VARIABLE CURRENT 5QUARTERSAGO
%COSTOFEQUITY 10.6% 9.4%
STOCKHOLDERS'
EQUITY
100 84

Wedeterminetherespectiveproductsandusetheresultsasthecomponentsoftheratio.
(.106)(100)=10.6and(.094)(84)=7.896.(10.6/7.896)
0.25
=1.0764.Asthisisthegrowth
factor,wesubtract“1”toobtainadecimalpercentage=7.64%perquarter.Whenwe
examineanalysts’earningsestimates,theywillusuallybeanEPSfigureforayear,andso
weneedtodeterminethatgrowthrateanddividebyfourtoputitonaquarterlybasis.
Forexample,lastyearsEPSwas$1.00pershareandtheforecastisfor$1.19.(1.19/1.00)
equalsanineteenpercentyeartoyeargain.Whenwedividebyfour,weobtaina4.75
percentquarterlygain.Thefinalratioisthen4.75%/7.64%.Theconclusionisthatthe
totalcostofequityisgrowingfasterthanearningsandsothiswouldconfirmanegative
evaluationonthestock.However,ifotherindicatorspointtoabanneryear,thegrowth
ratestudyshouldbedisregarded.Thepremiumisonjudgment.Thepercentagecostof
equitynaturallyrisesuntilthenextdownturn,butthecompanycanloweritsbetainthe
interimandbuffersomeofthatincrease.Ifthefirmisnowintheprocessofbuyingback
stock,theprospectswouldbebetterthanourgrowthstudyconcluded.
EARNINGSPRESSURE
Theartandscienceofforecastingearningsisdifficult.Perhapsthebest
methodologybeginswithademandforecastfortheindustrythatconsidersthedirectionof
theeconomy.Nextthemarketshareoftheindividualfirmmustbeexamined.Finally,the
internaldynamicsofthefirmitselfareconsidered.Thecomplexityofthisfeatcreates
variabilityinforecastsbecauseitisessentiallyamathematicalversionofMurphy’sLaw:
morevariablesinthemodelcanleadtomoreinaccuracyespeciallyifthosevariablesare
400

independentofeachother.However,analystsdoformconsensusopinionsanditismuch
bettertousetheircollectivejudgmentthandependonnaiveextrapolation.Ifearningsare
a“hitormiss”proposition,anyattempttoachieveprecisionwithoutathoroughlyvetted
modelwillsurelybea“miss”.Whenweusenaiveextrapolationofearnings,itbecomesa
benchmark;itissimplyanaveragegrowthrateoverasetperiod.Wecanaddthis
extrapolationtoourownfundamentallyderivedestimate,andthencomparebothofthese
estimatestoanalysts’expectations.Again,wealwaysuseourestimatesasaconfirming
indicator.Anyforwardlookinginputsforearningsshouldbefromtheanalystsandnot
fromextrapolation
Thefirstprocedureistoconstructanestimatefromfundamentals.Thiswillyielda
percentageincreasethatwouldoccuriftherelationshipbetweentheinputsremained
unchanged.Oneadaptation-weusethebookvaluesofdebtandequityratherthanthe
marketvalueasaninput.Wearelookingfora“ballpark”benchmarkandnotaforecast.
Toconstructthisestimate,weneedonlytoplugalistoffundamentalsintoastraight
expression:
Table15-6

VARIABLE FORMULA
A)PAYOUTRATIO Dividends/NetIncome
B)RETURNONASSETS(ROA) NetIncome+((Interestexpense)(1-tax
rate))/TotalAssets
C)TOTALDEBT/STOCKHOLDERS'
EQUITY
Bookvalueofdebt/Bookvalueofequity
D)INTERESTRATEONTOTAL
DEBT
InterestExpense/InterestBearingDebt
E)TAXRATE Decimaleffectivetaxrate

Intheexpression,itismucheasiertoworkfromrighttoleft:
(1-A)x(B+(Cx(B-(Dx(1-E)))))
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Whenweparsethisfunction,thefactorsthatimproveanearningsoutlookarequite
obvious:lessinterestandmoredebt,butagreaterreturnonassetsaswell.Thenatureof
thefunctionistocreatetensionbetweenitscomponents,becauseelementswithnegative
correlationareaddedtoormultipliedagainsteachother.Likethecostofequityas
determinedbytheGordonmodel,muchofthegrowthcomesfromimprovingtheretention
ratio-(1-A).
Oncewehaveafigurefromthefundamentals,wecandoafive-yearexponential
growthrateonearningsanddeterminehowearningswouldgrowiftheyfollowedatrend
line.Again,thisisthesamefunctionthatweusedinquarterlyextrapolation,exceptthat
weuseyearsinsteadofquartersasaperiod.Wenowhavetwoofourown“earnings
estimates”tocomparewithprofessionalanalysts’estimates.
OnWallStreet,whenacompanyperformsaboveanalysts’expectations,theyare
rewardedwithanincreasedshareprice.Theobjectiveinthisexerciseistocompare
analysts’forecastswithourmathematicaldeterminations.Whenanalysts’estimatesare
abovebothourfigures,weinterpretthatdifferenceasapotentialbuyindicatorbecause
theremaybeupwardspressureonearnings.Whenanalysts’estimatesarebelowbothour
figures,itisapotentialsellindicator,becausetheremaybedownwardpressuretounder
performearningstrends.Ifanalysts’estimatesareinthemiddle,weinterpretthesituation
asneutralandgleanmoreinformation.Ourestimatesarederivedfromtrendsand
fundamentalsandlacktheextensiveinformationanalysts’areprivyto.However,our
calculationsalsostandasabenchmarkbecausetheyareobjectiveandmechanical,and
formthefoundationforcomparison.
(BacktoTableofContents)
402

APPENDIX:DIVIDENDDISCOUNTMODELS
Sincemanyanalysts“gobythebook”andusethevariousdividenddiscountmodels
todetermineastock’s“fairvalue”,weincludeanexplanationofabasicmodel.However,
themodelsrequireextrapolationongrowthrates,sometimesyearsintothefuture.The
readerisreferredtoBurtonMalkiel’sARandomWalkDownWallStreettoobservesome
oftheodditiesofthisprocess.Infact,mostinvestmentbanksstillusesomeformof
discountmodeltoevaluatestocksbecausethemodelsdoindeedhavelegitimacywhenthe
marketisfairlyvalued(aboutthemiddleofabusinesscycle).Thetheoreticalbackground
ofthemodelsissound.Astockisvaluedatthepresentvalueofdividendsthatare
anticipatedtobepaidinthefuture;thatvalueisbasedonthegrowthrateofthecompany
andthecosttoborrowmoney-theweightedaveragecostofcapital(WACC).The“chink”
inthearmorcomesfromanticipatinggrowthratesandthecostofcapitalwhichareso
volatilethattheyoftendefyprediction.Moreover,theeconomymaybeinaphasewhen
stocksareoverorundervalued,makingempiricalapplicationlessthanviable.
Thereaderisreferredtoafundamentalfinancetexttounderstandtheconceptof
presentvalue:thebasicconceptrevolvesaroundtheknowledgethatadollarreceivedin
thepresentisworthmorethanadollarreceivedinthefuture,becausethepresentdollar
canearninterest.Anyamountinthefutureisdiscountedbyafactorof(1/(1+borrowing
rate)^numberofperiodsinthefuture).Inthiscase,the“borrowingcost”isequatedwith
thecostofequity.Thus,ourgrowingdividendsarediscountedbyoneplustheborrowing
ratemultipliedtothepowerofthenumberoffutureperiods.Wesumallofthepresent
valuesovertheperiodofonegrowthrateandthenaddthisfiguretothepresentvalue
derivedfromthenextgrowthrate.
PRICE=[ΣD(1+G1)
T-1
/(1+K)
T
]+[(D(1+G1)
N-1
/(1+K)
N
)x((1+G2)/(K-G2))]
Thefollowingtablewillitemizethevariables.Ofparticularinterestmaybethefunctionof
“T”.Tisacommandtodothecalculationinnumericalsequenceuntilthenumber
specifiedby“N”isreached.Forexample,ifN=3,thentherespectivedenominatorsinthat
403

calculationwillbeinsequence:(1+K)
1
,(1+K)
2
,(1+K)
3
.Thereadershouldalsonoticethat
(N–1)representstheyearsofgrowthandshouldnotconfusethatfigurewith“N”,whichis
oneperiodafterthenumberofyearsofgrowthisoveror(YearsofGrowth+1).
Table15-7

SYMBOL EXPLANATION
Σ Acommandtosumthesequenceof
calculations
D Thepresentdividend
K Thecostofequity
N-1 Thenumberofyearsthatgrowthwill
occurataspecificrate(G1)
T StartingatT=1,acommandtodothe
calculationinintegersequenceuntil"N"
isreached
G1 Thegrowthratethatoccursduring"N-
1"years
N NumberofYearsofGrowth+“1”
G2 Thegrowthratethatoccursafter"N-
1"years

Dividenddiscountmodelscanbequiteinvolvedandcomplex,enumeratingthreeorfour
differentgrowthratesatatime.Approachthesewithcaution.
(BacktoTableofContents)
404

16
KIMBERLYCLARK-“TOOMUCHOFAGOODTHING”
EconomicProfitandMarginalBenefitsAnalysis
Therecessionof91-92wasfollowedbyoneofthelongestbullmarketsinhistory.
Thespeculativeexcessesthathelpedfueltheeconomyencouragedtheissueofmassive
amountsofequity.Althoughprofitswererising,optimismwasrisingfaster,andthelarge
issuesdidnothingtodiluteanalreadyoverheatedmarket.Oncethebottomfelloutin
2001,shareholders(especiallythosewhohadinvestedheavilyinNASDAQstocks)wereleft
holdingthebag.Techstocksthathadbeentradingforoveronehundreddollarsashare
couldoftenbeboughtforlessthantendollars.Infact,asofthiswriting(2008),NASDAQ
tradesataboutone-halfitsvaluein1999.
UNDERPINNING1:POSITIONINTHEBUSINESSCYCLE
Tothosewhosawthisdebaclecoming,goodinvestingsenseledthemintodefensive
sectorstocks,mostlyconsumerstaples,healthcareandhouseholdproducts,whosedemand
wouldoutpacealaggingeconomy.Kimberly-Clark(KMB)wasalarge,well-knownpaper
productscompanywithmorethanthirteenbilliondollarsinrevenue.Itsbetaof0.44made
itaperfectcandidateforportfoliorebalancinginplaceofhigherbetatechandtelecom
equipmentstocks.Asalowbetahouseholdproductscompany,itwaspositionedwellinthe
businesscycle-whichisthefirstoffourbasicunderpinningsthatdeterminesour
investmentanalysis.Itsprofitswerestableenoughtotakeadvantageoffinancialleverage,
butitsequityriskwaslowenoughsothatdebtwasnotexcessive;Kimberly-Clarkcould
takeonmoreleverage,especiallyinalowinterestrateenvironment.
Thefirm’spositiongaveitafavorablecombinationofcostanddemandfactorsthat
wouldyieldastrategicadvantage;positioninthebusinesscycleissoimportantbecauseof
itsintegrativeeffectonallotherfactors.Whenafirmhastherightcombinationof
405

operatingandfinancialleveragetheinterfacebetweensalesandcapitalisstrengthened.
Hence,inadownturn,thosefirmswithsmallbutsteadygrowtharelessrisky.

UNDERPINNINGS2,3,AND4:OPPORTUNITIESFORANALYSIS
Mostfirmsareintegratedwiththegreatereconomythroughoperatingandfinancial
risk.Duringeachphaseofthecycle,somefirmwillpossessacombinationofextraordinary
factorsthathelpsitdominateothers,andwhentheeconomychanges,thosefactorsrecede.
However,outsideofsectorrotation,thereislittletheanalystcandotopredictafirm’s
reactiontoachangingmarketWithoutknowledgeoftheforcesthatmoveanindividual
company,ourdecisionswillbelimitedtopriceandvolumemovements.Although
macroeconomicconditionshavethegreatestimpactoncorporateactivities,weneedatleast
threeothertenetstogovernouranalysis-amethodologythatcorroboratesafirm’s
possessionof“favorablefactors”ifyouwill.Theotherthreeunderpinningsare:shiftsto
anoptimalcapitalstructure;potentialincreasesincomparativeeconomicprofit;and
increasesinsalesandearningspotential.
Researchingcorporatehistoryforaveragesincapitalproportionscanbe
painstaking.Thereisnomandatethatacompanywillperformatthataverageorthatthe
averageisevenrelevantgiventhecontingenciesinthecurrenteconomiccycle;interestrate
changescanshifttheoptimalproportion.However,certainpatternsofleveragechanges
arecorrelatedwithperformance,andanychangeintheprobabilityofdefaultisusually
accompaniedbyaconsequentchangeinstockprice.Sincedefaultisafunctionof
probability,itisquitedifficulttoconfiguretheproperlevelofdebttoequity
deterministically;notwodefaultfunctionsarealike.Forthatreason,werelyonseveral
measurements,realizingthattheemphasisshouldbeondetectingmovementtowardan
optimalproportionratherthanoncalculatingadecisiveratio.
Oneofthecorroboratingtechniquesistoanalyzeeconomicprofitforthepotential
toincrease-whichmaynotbeso“esoteric”asitseems.Whenweinvestonthebasisof
406

earnings,webaseourjudgmentononevariable-income-whichistheprojectedoutcome
ofcoordinatingcosts,salesandtypeofindustry.Witheconomicprofitanalysis,wehavean
interactionofatleastthreevariableswhichalsorepresentsthecollectiveanalysisof
numerouscomponents-beta,retainedearnings,newissuesandtaxes.Ourjudgmental
riskbecomesdiversified.Wecanbewrongaboutnetincome,forexample,butprecisely
accurateaboutariseinthecostofequityandstillmaintainsomepredictivecapability.
Statistically,weknowthatalargemoveawayfromthemean,willrevertintheopposite
directionbecauseeachindustrysetsapatternfordividends,retentionandtheamountof
equityafirmcansafelyissue.Balancesheetsneedto“balance”,andweusethat
conformancetoexaminechangesineconomicprofitthatshowshiftsinafirm’slevelof
risk.
Becauseoftheirinherentvolatility,changesinsalesandearningsarethemostrisky
predictionsthatanalystswillmake;mostprofessionalanalystswillreceive“guidance”
fromboththeirindustryandtargetcorporation.Incapitalstructureanalysis,wetrynot
tomakeearningsforecastsourselves,butwillrelyonconsensusopiniontoprovideinputs
forsensitivityanalysisineconomicprofitmodels.Wearemuchmoreconcernedwiththe
changingpatternofoperatingriskthatoccurswhensalesandearningschange.Andwe
attempttointegratesalesandearningschangesintomarginalbenefitsanalysisbytreating
themasriskfactors.Inanydefaultmodel,earningsbecomesthelinchpinindetermining
howmuchdebtispermissible;werecognizethatmaximizingearningsmayincreaseriskto
intolerablelevels,creatingareboundeffectthatunderminesgrowthinfutureperiods.
Thus,weattempttoobservesustainablelevels,amountsthatcanoptimizecapital
structureandyetcreateshareholderwealth.
THELEVERAGESTATE
Thestudent/investormayestimateKimberly-Clark’soptimaltargetstructurefrom
thechapteronmarginalbenefitsmodeling.Fromthatmodel,we“guesstimate”Kimberly-
Clark’stargettobeapproximately26%long-termdebttocapital,butrecognizethatthe
407

constraintsareartificial,especiallyintherealmofinterestratesandcapital.Nevertheless,
weattempttoestablishthatKimberly-Clark’slowriskstemsfromitsproximitytothe
optimalcapitalstructureandthatonlyahigh-riskmoveawayfromthattargetandthen
backagain,wouldgreatlyappreciatethestock.Sincethisinvestmentisanon-speculative
portfoliorebalancingduringadownturn,theparametersfitourneedsperfectly.
Inanormalmarket,wemightlookforafirmwhoisabouttoenteraproportionate
equitybuildingcycle,acompanythatisgoingtoloweritsdebtratiowhileprofitsare
increasing.In2000,however,manyfirmswerecomingoffoflongstretcheswherefunding
wasdoneprimarilythroughretainedearningsandequityissuesthatfloodedthemarket
withnewstock.IftheFederalReservebeginstolowerrates,thosefirmswhocanmost
affordnewdebtwillhaveabigadvantage;thecostofcapitalwillbelessexpensive.Thus,
Kimberly-Clark,whoseprofitshavebeenexceptionalandwhohoversnearanoptimal
capitalproportion,wouldbeaperfectchoiceforaninvestment.However,theimportance
ofobjectiveanalysiscannotbeunderestimated;weneedabreakdownoftheircurrent
leveragestate,andlater,wemustmakeananalysisofbothEVAandmarginalbenefits.
1.OperatingRisk
Toestablishameasureofoperatingrisk,weusethefirm’soperatingmomentum:
(%∆ ∆∆ ∆OperatingIncome/%∆ ∆∆ ∆Sales)whichgivesanapproximationofoperatingleverage.
Wealsoestablishthefiveyeargeometricaveragegrowthwhichis5.2percentforoperating
income,and6.33percentforsales.Thisratioof5.2/6.33equals0.82whichis
comparativelylow.Wethencomparethisfiguretothemostrecentmomentumfiguresfor
1999and2000.
408

Table16-1

Kimberly-Clark
Year 1998 1999 2000
OperatingIncome 2320 2815 3203
Sales 12298 13007 13982
Operating
momentum
21.34/5.77=3.7 13.78/7.5=1.84
Change1999/2000 -50.34%
GeometricAverage 5.2/6.33=0.82

Kimberly-Clark’soperatingmomentumhasbeenbuttressedbyahighoperatingincome
whichisintheprocessofrevertingtoitsmean.Theexpectationofaneconomicdownturn
wouldfurtherdimprospectsforahigherincome,andsowewouldexpectalower
operatingmomentumandasmallerincreaseinEBIT.Thetaxeffectsoftakingondebt,
wouldbejustifiedbythelowertaxespaidonincomeandthepotentiallylowerinterestrate
thatwoulddecreasecapitalcosts.However,itisalwaysa“crapshoot”anytimedebtis
raisedproportionately;incomemustbeincreasedenoughtolowertheprobabilityof
defaultorthefirmcanmeander-withmoredebtmakinguptheshortfall.

Table16-2
2.FinancialLeverageRatio

KMBFinancialLeverage
YEAR 1999 2000
InterestExpense 213 222
EBIT 2654 2844
FinancialLeverageRatio 1.087 1.085
Change1999/2000 -0.18%

Althoughthechangeinthefinancialleverageratiowasslight,itstillreflectsa
smallerprobabilityofdefaultwhenallotherfactorsareheldconstant.Despitethehigh-
409

interestrateenvironmentof2000,Kimberly-Clarkmovedtoreducethisratio;thehigher
EBITallowedthefirmtobothincreaseitstotalamountoflong-termdebt(andtax
advantages)andreduceitsfinancialleverageratiosimultaneously.Itis,however,
necessarytoobservethefinancialleverageratiointhecontextofproportionalchangesin
long-termdebt.Whenthetwomoveinoppositedirections,moreanalysisisrequired
becausethereisequivocationinboththemovementofthecostofcapitalandinearnings;
suchanomaliesrepresentashiftinbalanceandaredifficulttointerpret.Forexample,
whenafirmtakesonzerocouponbonds,financialleverageratiosmaydecreaseatthesame
timethatdebtbecomesahigherproportionofcapital;interestexpensemaybekept
artificiallylowuntila“dayofreckoning”.Inthatcase,theleveragestatedoeslittleto
reflecttheinherentrisk,andtheanalystwouldproperlydependmoreoneconomicprofit
analysistomakeadetermination.

3.ProportionofDebttoEquity
Table16-3

KMBDebt/
Equity

YEAR %LTD/CAP Long-term
Debt
Stockholders'
Equity
Capital
1999 27.44 1926.6 5093.1 7019.7
2000 25.75 2000.6 5767.3 7767.9
1999/2000
Change
-6.15%

AnineyearaverageshowedthatKimberly-Clark’saveragelong-termdebtto
capitalwas23.35%.Theapproximately26%optimumthatwedeterminedfrom
marginalbenefitsanalysisisa“ballpark”figurebasedonaveragesfromthepastfive
years.Thus,themovementto25.75%appearstobeinthe“right”direction,butthe
marginoftoleranceissosmallthatweneedtodependonothermeasurementstoconfirm
410

it.Fromabusinesscycleperspective,takingonlessdebtwheninterestratesarehigh
encouragesoptimalitybecausemoreincomeisfreedforshareholdersintheformof
dividendsorstockbuybacks,andlessispaidoutinmoreexpensiveinterest.Thehigher
amountofretainedearningsbecomesthesourceforfunding,butmustbeaccompaniedby
alowcostofequitytobeeffective.WithoutknowledgeofEVAandthecostofequity,any
analysiswouldbeincomplete.Nevertheless,wecanbegintoclassifytheinvestmentitself-
verylowriskwithahighprobabilityofexceedingthereturnonatenyeartreasurynote.
4.TheAssets/CapitalRatio
Theimportanceofthisindicatorcannotbedismissed.Raisingshort-termdebtcan
beatemporarysubstituteforlong-termfundinginperiodsofuncertainty;firmswho
wouldotherwiseraiselong-termdebtdelaypurchasesandnewprojectsuntiltrendsbegin
tounfold.Theassettocapitalratiohelpsinatleastfourotherways:
• a)Itsignalsapotentiallygreaterreturnoncapital
• b)Itmaysignalanincreaseinfree-cashflow
• c)Itmayhelplimittheamountofexternalfinancingbycovering“shortfalls’inthe
capitalbudget.
• d)Itmaysignalgreatervendoractivityandpotentialsalesincreases.
SinceKimberly-Clarkraisedthisratiofromapositionofstrength(closetoanoptimal
capitalstructure),itcanonlybeviewedasa“plus”andnottheinsolvencymeasurement
thatmightoccurinleanertimes.Kimberly-Clarkraiseditsassetsby12.98percentand
capitalby10.66percent;theincreaseinassetstocapitalwasminimalandprobablywasnot
greatenoughtocoveranycapitalshortfall.Withsuchproximitytoitsoptimalcapital
target,therewassimplynoneedtousethisratioasanadjunct.
411

Table16-4

Assets/Capital
YEAR Assets Capital Assets/Capital
1999 12816 7019.7 1.83
2000 14480 7767.9 1.86

CHANGESINECONOMICPROFIT
Despiteamovetolowerriskwithgreaterequity,therequirementstoimproveEVA
arestringent;afirmneedsthecorrectamountofequityinthedomainoftwoother
variables-thecostofequity,andnetincome.Observethefollowingcomparisonfor
percentageincreasestobettergaugethesituation:
Table16-5

Percentage
Changes

YEAR NetIncome Percentage
Change
Stockholders'
Equity
Percentage
Change
1999 1668 5093.1
2000 1801 7.97% 5767.3 13.23%

Inthelastsection,wedescribedcapitalasa10.66percentchange,andnowwecancontrast
itwiththechangeinequitywhichwas13.23percent.Already,wecanseethatpotentialfor
anEVAincreaseisgreatlydiminished,becausewewouldmostlikelyneedadecreaseinthe
costofequitytoaccomplishit.However,thecostofequitywillalwaysberaisedtowardthe
endofabusinesscycle,notonlybecausethemarketis“overheated”,butbecausethe
FederalReserveraisesratestocombatinflation;evenanearrisk-lessstockwillundergoa
percentagecostofequityincreaseThus,wehaveaset-upforthe“perfectstorm”:the
companydoeseverythingright,butthesituationisuntenablebecauseretainedearnings
havebuiltuptoahighlevelrightatapointwheretheyaremostexpensive(comparatively).
THEEXTREMECONSENSUSMETHOD
412

Toobtainacostofequityfigure,weutilizewhatthisauthorterms“theextreme
consensusmethod”.Thechainoflogicforthiscombinationisasfollows:boththe“ruleof
thumb”,E/PmethodandtheGordonmodelcanbederivedfromthesameequationofP=
D1/(K–G).Whenusedalone,thecostofequityfortheGordonmodelwouldreduceto
(D1/P)+G.Ifwemaketheassumptionsthat“G”,orgrowth,istheproductofreturnon
equity(ROE)andretention,andweequatethecostofequitywithROE,thenROEwould
reducetoE/Pwhenboththebookpriceandmarketpriceareequal.However,inthe
Gordonmodel,pricemakesasmalldifferenceinthecostofequity,whileintheE/P
methoditisadeterminingfactor.Inreality,thetwomethodsproduceextreme
comparativecostswhicharehypotheticallylinkedbythedifferencebetweenmarketand
bookvalues.Ifweaveragethetwopercentages,wecangetafairlycomprehensiveideaof
whatthecostofequityactuallyis,andmoreimportantly,agaugeofrisk.Therelationship
betweenthecomponentpartsofeachmethodisstableandwilldisplaychangesinequity
riskwhenthemeasureascends.TheGordonmodelismorefundamentallydrivenbecause
ofitsdependenceonthebookvalues,netincomeandstockholders’equity.Ontheother
hand,E/Pisquitelikeitsinverse,“P/E”:itisvolatileanddifficulttointerpretandyet
dependsonthemarket.Together,thetwomethodsformauniqueconsensus:bothmarket
drivenanddependentoninternaldynamics,butoriginallyformedfromthesamefunction
(withassumptions).
1.GordonModelDeterminations
TomakedeterminationswiththeGordonmodel,weneedthreemeasurements:1.
AnaverageofgrowthoverthepastfiveyearstobedeterminedbytheproductofROEand
retention.2.Prospectivedividendgrowthfor2000(alreadyknown)and2001.3.An
averagepricetocomparewiththatdividendfortheyears,1999and2000.

413

Table16-6

1999Growth
Year RetentionRatio ROE Growth
1995 1 0.001 0.001
1996 0.63 0.345 0.2174
1997 0.39 0.205 0.0799
1998 0.54 0.244 0.132
1999 0.67 0.371 0.249
Average 0.1349

Table16-7

2000Growth
Year RetentionRatio ROE Growth
1996 0.63 0.345 0.2174
1997 0.39 0.205 0.0799
1998 0.54 0.244 0.132
1999 0.67 0.371 0.248
2000 0.68 0.322 0.2257
Average 0.1806

Next,anaveragerangepriceisdeterminedforthepurposeofderivinganE/Pfigureand
forinputintotheexpecteddividendyield,“D1/P”.Theaveragepriceintermsofrange
maybebetterthanthemeanasanindicatorofthepotentialdistributionofastockbecause
volatilityisexpressedthroughouttherange.Fewpeoplebuylowandsellhighand
investorstendtobuyspasmodically,increasingvolumeasastockclimbshigher.However,
earningsareaccumulatedthroughoutaperiod,anditmaybemorepropertomatchthe
endofperiodpricewiththeendofperiodearningsfigure.Astrictfundamentalistwould
certainlychoosethelattermethod,whileananalystwhowasfixatedontheprocessof
changewouldpicktheaveragerangemethod.
414

Table16-8

AverageRange
Price

YEAR LOW HIGH AVERAGE
1999 44.81 69.56 57.185
2000 42 73.25 57.625

Sinceourhypotheticalanalysisbeginsin2000,wehavealreadyobtaineda
prospectivedividendfigurefor1999-theactualdividendof$1.08,paidin2000.Toobtain
anexpecteddividendfor2001thatwillbeappliedtotheyear2000(thenextexpected
dividend),weneedtoextrapolateagrowthrateandmultiplyitbytheactualcurrent
dividend.Weneedthreepiecesofdatatoobtainthisrate:thecurrentdividend,the
dividendfiveyearsagoandthenumberofyearsbetweenfiveyears.Inrespectiveorder,
theyare:$1.08,0.92,and4.Wethenmakearatiooutofthedividendsandusetheinverse
offour(1/4)asanexponent:(1.08/0.92)
1/4
=1.0408whichbecomesthegrowthrate
multiplier.Growthextrapolationtendstoworkwellwithdividendsbecausefirmspride
themselvesonsteadiness.Theexpecteddividendfor2001is$1.08(1.0408)=$1.12.We
nowhavetwonextexpecteddividends:$1.08whichisthenextexpecteddividendfor1999,
and$1.12whichisthenextexpecteddividendfor2000.TheD1/Pfigurefor1999isthus,
1.08/57.185=1.89%andfor2000,itis1.12/57.625=1.94%.Thesefiguresarethen
addedtotherespectiveROEfigurestocompletetheGordonmodel:
415

Table16-9

Gordon
Model

Year NextYield(D1/
P)
Growth(ROEx
Ret.)
EQUATION Expected
Rate
1999 0.0189 0.1359 0.0189+
0.1359
15.49%
2000 0.0194 0.1806 0.0194+
0.1806
19.96%

2.“RuleofThumb”,EarningstoPriceorE/PDeterminations
OncetheGordonmodelcalculationsarecompleted,therestofthemethodis
remedial.Wemerelymatchearningspersharefortheyearwiththemid-rangeprice.
Table16-10

E/PAnalysis
Year EPS Mid-rangePrice E/P
1999 3.09 57.185 3.09/57.185=5.4
%
2000 3.34 57.625 3.34/57.625=5.8
%

Inanormalanalysis,theCAPMwouldbeusedtoderiveacostofequity.However,with
non-growthstocksthatarerelativelystable(mostDOWcomponents)thestudent/investor
shouldobservethatextremeconsensusisaviableoption.Theobjectivemethodologyis
thatwhichbestcapturesboththechangesinthemarket,andtheinternaldynamicsofthe
firmsimultaneously.ThecombinationofthemarketderivedE/Pandthebookvalue-
drivenGordonmodelcancreateaworkingcostofequitybecausetheyarefunctionally
related.

416

3.CreateaCostofEquity
Wenowaveragethetwofiguresforeachyearandcompare:
Table16-11

CostofEquity
Year E/P GordonModel EQUATION CostofEquity
1999 0.054 0.1549 (0.054+0.1549)/2 10.45%
2000 0.058 0.1996 (0.058+0.1996)/2 12.88%

Higherinterestrates,greatervolatility,andanover-heatedmarketpushedthecostof
equityupin2000.Comparatively,Kimberly-Clark’slowbeta,lowprobabilityofdefault
andadherencetoatargetcapitalstructurewereasavinggrace.However,asweshall
observeinthenextsection,eventhebestcompaniesmayhavelimitedoptionswhen
constrainedbythesequentialeconomicdeclineofcompaniesaroundthem.Atthesetimes,
itmaybebettertomove“sideways”thaneitherupordown.
ECONOMICPROFIT
Atthisjuncture,thecalculationofthecapitaldynamicisremedial;wemerelyplug
inthenumbers:NetIncome-[(%CostofEquity)(Stockholders’Equity)].
Table16-12

Economic
Profit
Kimberly-
Clark

Year NetIncome CostofEquity Stockholders'
Equity
Capital
Dynamic
1999 1668 0.1045 5093.1 1135.77
2000 1801 0.1288 5767.3 1058.17
Change
1999/2000
-6.8%

417

Inthechapteroneconomicprofitoptimization,westipulatedthatearningsarethe
liberatingforceforequity.Hindsightcangiveusanideaofwhatthemaximumequity
couldhavebeengiventhesameincreaseinnetincome.OLDEVA=NewNetIncome-
[(New%CostofEquity)(X)].Wesolvefor“X.”1135.77=1801-[(0.1288)(X)].Then“X”
=5164.82
Thus,Kimberly-Clarkwouldhaveincreasedeconomicprofitwithamaximumequity
increaseofonly71.72versusthe674.2thatactuallyoccurred:(5164.82-5093.1=71.72),
(5767.3-5093.1=674.2)
Wasthe71.72feasible?Absolutelynot.Tofundexistingsales,Kimberly-Clark
mustraiseaminimumamountofnewcapital.Iftheadditional748.2thatwasraisedis
goingtowardprojectswithapositivenetpresentvalue,therewasnowaythatthefirm
shouldrationcapitaltomakea“paperprofit”.Fromthenetincomeside,wecan
determinetheshortfallbyusingthesamesensitivityanalysisandmakingnetincomethe
“X”variable:1135.77=X-[(0.1288)(5767.3)],X=1878.59.Thus,a78milliondollar
increaseinnetincomewouldhaveprovidedtheimpetusforagreaterincreaseineconomic
profit.
Giventhehighercostofretainedearningsandthepossibilityofaneconomic
downturnloomingonthehorizon,itisprobablethatKimberly-Clarkmayhaveraised
muchmorecapitalthanrequired.Asuperficialexaminationindicatesthatnearlyallofits
expandedsalescouldhavebeenfundedwithlessretainedearnings.However,raisingthe
payoutratiowouldhavecommittedthecompanytofuturedividendpaymentsthatmay
havebeenunwieldy,andwouldhaveimpededfinancialflexibility.Declaringaspecial
dividendwouldhavediminishedretention,butthebestdefensewastheroutethat
Kimberly-Clarkactuallytook:theybeganaseriesofsharebuybacksthatnotonly
diminishedthebookvalueofequity,buttooksharesoffthemarketaswell
TOOMUCHOFAGOODTHING
418

Andhereinliestheproblemofboomandbustcycles.Withrecordsalesandprofits,
Kimberly-Clarkwas“victimized”bytheeconomicrealityofanover-heatedmarket.The
costofequityskyrocketedbecauseinvestorswereattractedtohigherprofits,buyingup
sharesandincreasingthedemandforequity.The“internal”financingthatKimberly-
Clarkwasimplementingthroughretainingearningswassubjecttothesamemarket
turmoilasothersourcesoffunding;itwasonlyascosteffectiveascomparisonswould
allow.SinceKimberly-Clarkwasgrowingearningsata7.97percentpaceandnotthe
12.64percentthatwasneeded,themarketdidnotrewardthefirmwithastockprice
increase.However,thefirmhadsuchasolidfoundation,thatitsstockdidnotdecrease
either-andrepresentedalowriskcomponentinanyportfolio.
Thecapitaldynamicprovedtobeavalidmeasurementofcorporaterisk.Whileit
didlittletoindicatemovementtowardanoptimalcapitalstructure(thefirmwasalmost
there)itreflectedthehighpriceofequityandtheinterfacewiththegreatermarket.Italso
reflectedtheneedtocompensateshareholderswithsomecompendiumofbenefitsrather
thanretainearningsatahighprice.SinceEVAwassohighin1999,therewaslittlethat
Kimberly-Clarkcoulddoin2000toincreaseit.Thereturnonequitywasover37percent
in1999versusthestillveryhigh33percentin2000.Whilesomecompaniesdocommit
financialmanagementtorisk-less,stable,increasesinEVA,manyfactors(interestrates,
typeofindustry,market)aresouncontrollablethatanyimprovementinthemeasurement
becomesthegoal,ratherthansomespecificamount.Kimberly-Clarkmanagedthe
situationasitarose,avoidingsomeofthespeculativeexcessesofitspeers.Companiescan
anddoget“painted”intocorners.Historicallocationsofcapital,timelinessinthebusiness
cycle,andhonoringcontractualdemandscanallstymiethebestintentionsofmanagement.
MARGINALBENEFITSANALYSIS
Nodefaultmodelisperfect.Whilemostmodelscovermajorvariableslikeassets
andincome,eachisdevelopedinadifferentperiodwhichdeterminestheoveralleffectof
eachvariable.Thus,amodeldevelopedinthe1970’smightemphasizeassetvaluesand
419

inflation,whileamodelcreatedin2008wouldemphasizesubprimeexposure.Thebetter
genericmodels(Ohlson,Shumway,Altman,MertonKMV)willagreewithinafew
percentagepointsastotheprobabilityofdefaultbutwillnotevincethesameamountof
accuracythroughouttheentirerange.Theyareaccurateenoughtodetectlargemovesin
theprobabilityofdefaultwhichistheirprimarypurpose.Aswiththecostofequity,the
usermusthave:1)sometoleranceforimprecisionasthederivedfigureisanestimateand
notadecisiontool.2)corroboratingmethodsandanalysisthatconfirmafindingand3)
theabilitytoobservechangeinthemeasurement.
Asintheeconomicprofitanalysis,theyears1999and2000werecomparedby
enteringthenecessaryfundamentalsintoafunction.Wemeasuredthecostofbankruptcy
andtheinherenttaxadvantagesinthedecisiontousedebtbyformingamarginalbenefits
equation.Wethenobservedanyimprovementwhenthesubsequentperiodmeasurement
waslargerthantheinitial.
Theslightchangesinmarginalbenefits,economicprofit,andthemarketpriceof
thestockconfirmthecorrelationvalueofthemeasurements.Ineffect,thedifference
betweenthemeasurementswasslightenoughtobeinconclusivebutmatchedthe
performanceofthecompany-tentativebutstable.Thestateofthecompanyseemedtobe
ina“holdingpattern”thatwouldneitherconfirmnordenyitasaninvestmentvehicle.
However,atthejunctureof2000-2001,thesoundestjudgmentwastoseekastockthat
wouldminimizerisk,andKimberly-Clarkfitthatbill
BASICMETHODOLOGY
Fordetailedinformation,seethechapteronmarginalbenefitsanalysis.The
student/investorsetsupafunctionthatequatestheproductoflong-termdebtandthetax
rate,withtheproductofaprojectedamountoflossandtheprobabilityofdefault.The
functionmaximizeswhentheincrementalchangeonbothsidesisequaltozero.Thisisthe
pointwherethefirstderivativeofthefunctionisequaltozeroandistheprime
determinantofanoptimalcapitalstructure.However,wecangaugeyeartoyear
420

improvementsimplybyobservingwhethernextperiod’smarginalbenefitsarelargerthan
theinitialperiod’s.Moreover,wecanalsotestthemarginalbenefitsofinterestinthesame
functionandusetheresultasthenumeratorinanimmediatebenefitsratio.Whenwe
dividethisnumberbytheoriginalmarginalbenefitsfigure,wecanlookforimprovement;
anestimatedoptimumoccurswhentheratioismaximized.
Inessence,wehavetwofunctionstolookat:
1.[(Long-termdebt)(TaxRate)]-[(ProbabilityofDefault%)(AmountofLoss)]=X1
2.[(InterestExpense)(TaxRate)]-[(ProbabilityofDefault%)(AmountofLoss)]=X2
WelookforimprovementsinX1,butmoresignificantly,welookforanimprovementinX2
/X1.Incertaincases,thetaxadvantagesofinterestexpensewillbelessthanzerowhich
willsignifythatthecompanyshouldnothavedebt.
TAXBENEFITSFORKIMBERLY-CLARK
ThetaxbenefitcalculationsforKimberly-Clarkarethemostremedial,requiring
multiplicationofthetaxrateandtheamountoflong-termdebt.Thecalculationis
replicatedwithinterestexpense.
Table16-13

Tax
Benefits

Year TaxRate Interest
Expense
Long-term
debt
(Tax)(Interest) (Tax)(Debt)
1999 0.3 213 1927 63.9 578.1
2000 0.29 222 2000.6 64.38 580.174

AMOUNTOFLOSSFORKIMBERLY-CLARK
Creatingagenericamountoflossforinputintoabankruptcycostisapurely
experimentalendeavor.Sincetheword“loss”issubjective,thereisroomfor
interpretation,buteachdefaultisalegalconstructwithuniquerequirements.Our
421

constructionofa“loss”isbasedonthelosstoshareholdersaboveatangibleassetvalue
whichisassumedtobethepropertyofcreditors.
Theconstructionofthisfunctionis(1-(TangibleBookValue/MarketValue))
(NumberofSharesOutstandingxMarketPricepershare).Tangiblebookvalueis
constructedbysubtractingallintangibleassets,goodwillandunamortizeddebtfrom
assets,andthendividingbythenumberofsharesoutstanding.Themarketvaluepershare
isdeterminedbythesamemethodasinprevioussections;itisanaveragebetweenthelow
stockpriceandhighstockpricefortheyear.
Table16-14

Amountof
Loss

Year Tangible
Book/sh.
Market
Price/sh.
Numberof
Shares
Amountof
Loss
1999 7.12 57.185 539.8 27025.09
2000 7.04 57.625 539.22 27276.443

THEPROBABILITYOFDEFAULT
Mostdefaultprobabilitiesareverygoodindicatorsofrisk,butfewwillbeboth
accurateandflexibleenoughforcapitalstructuremodeling.Theuniquerequirementsof
capitalstructurearevariablesthatemphasizetheconsequencesofincreasingdebtby
allowingsolutionforlong-termdebtorequity.Ineffect,weneedanalgorithmwhichwill
curveupwards,displayingincreasingriskatanincreasingrate,andyetoptimizeinthe
domainofearnings.
TheZmijewskimodelissimpletoapply,andalthoughtherearemoreaccurate
defaultalgorithms,fewpossesstheinherentflexibilityofthismodel.Inanexperimental
mode,itworkswell.Thebasiclogicbehindthefunctionisthattheproductofparameters
andfundamentalratiosformsthelogarithmofaprobabilityofdefault.Wealgebraically
eliminatethelogarithmandsolvefortheprobability.Thus,Ln[P1/(1-P1)]=X1Bwhere
422

P1istheprobabilityofdefault,X1arethefundamentalratios,andBarethecoefficientsof
thealgorithm.Toobtainaprobability,weturntheequationaroundandinputP1=1/1+
EXP[-XB],wherewegivenegativevaluestothefundamentalratios.Thefollowingtable
containsadefinitionofthefundamentalratiosandthecoefficientsofthealgorithm.
Table16-15

ZmijewskiDefault
NAME FUNCTION COEFFICIENT
TL/TA TotalLiabilities/Total
Assets
6.384
CA/CL CurrentAssets/Current
Liabilities
0.069
NI/TA NetIncome/TotalAssets -1.06
Intercept NONE -9.479

Table16-16

Kimberly-
Clark

Year TL/TA CA/CL NI/TA Default
Probability
1999 0.45045 0.92616 0.13015 0.00126=
0.126%
2000 0.45405 0.8286 0.12438 0.00129=
0.129%

THECOSTOFBANKRUPTCY
Tocalculateourexperimentalcostofbankruptcy,wemultiplytheamountoflossby
theprobabilityofdefault.Theresultwouldbeafigurethattheshareholderswouldlosein
theeventofliquidationofassets.
423

Table16-17

Kimberly-Clark
Year Probabilityof
Default
AmountofLoss Costof
Bankruptcy
1999 0.00126 27025.09 34.052
2000 0.00129 27276.443 35.187

MARGINALBENEFITS
Theprimaryobjectiveincomparativeanalysisistotestwhetherthetaxadvantages
havegrownrelativetobankruptcycosts;eachbankruptcycostissubtractedfromeachtax
advantageandtheperiodicfiguresarecompared.WiththeZmijewskialgorithm,wecan
alsoobservewhethertheimmediatetaxeffectsofinterestaregrowingincomparisontothe
overalltaxadvantagesofdebt.Somealgorithmswillnotpermitthiscalculation,butthe
Zmijewskifundamentalsoptimizeinthatdomain-wherethisratioismaximized.
Table16-18

Kimberly-
Clark

Year Tax
Benefitsof
Debt
Bankruptcy
Costs
Marginal
Benefits
Interest
Benefits
Interest/
Debt
Benefits
1999 578.1 34.052 544.048 29.848 0.05486
2000 580.174 35.187 544.987 29.193 0.05357

Theinterestbenefitswerederivedbysubtractingbankruptcycostsfromthetax
advantagesofinterest(63.9and64.38for1999and2000respectively),whilearatiowas
formedbydividingthisfigureintothemarginalbenefitsofdebt.
Aswouldtypifyacompanythatishoveringaroundanoptimaltarget,thereislittle
changeindefault,taxbenefitsortheamountofloss.Allindicationsfrombotheconomic
424

profitandmarginalbenefitsanalysiswouldpointtothenecessityofmovingawayfroman
optimaltargettoseekmorerisk-ifindeedKimberly-Clarkwantedtoappreciateitsstock.
However,stayingatthetargetwouldprovideminimalriskwiththepossibilityofspecial
dividendsandbuybacksaswellasthenaturalappreciationoftheregulardividend.Such
strategicdecisionscannotbetakenlightlybecausefutureprospectsneedtobeweighed
againstthepotentialtemporarydiminishmentofshareholdervalue.

CONFIRMATION
Ascorroborationofourfindings,perhapsnodefaultmeasurementhasstoodup
betterthanAltman’sZscore.Itslinearitymakesituntenableforuseincapitalstructure
models,butasasimplemeasureofchangingrisk,itisunsurpassed.A“Z”Scoreisthe
summedproductsofratiosandcoefficientswherealargerscoreisbetterbecauseit
indicatesalowerprobabilityofdefault.AnyincreaseinAltman’sZScorecanbematched
withcorrespondingdefaultprobabilitiesfromothermethodstoseeiftheyconfirmone
another.
ALTMAN’SZSCORE:BOOKVALUEVERSION
ThestandardZscoreissetformarketvaluesandiswidelyavailable.However,
marketvaluesgetinflated,andsothebookvalueversionismoreconducivetoobserving
theeffectofcapitalstructurevariables.Wemerelypluginfundamentalratiosandthen
addupthescore.Thebasicfunctionis:0.71(X1)+0.847(X2)+3.10(X3)+0.420(X4)+
0.998(X5).Thefollowingtabledescribesthecomponentratios:
425

Table16-19

ALTMAN'SZSCORECOMPONENTS(BOOKVALUEVERSION)
X1=WorkingCapital/Assets***Workingcapitaliscurrentassetsminuscurrent
liabilities.

X2=RetainedEarnings/Assets
X3=EBIT/Assets
X4=BookValueofEquity/BookValueofLiabilities
X5=Sales/Assets

Evenifeachelementinthenumeratorstaysstrongandstable,increasingdebtwill
increaseeachdenominatorleadingtoalowerZscore.Intheyearofadebtissue,tax
benefitswillbalancetheincreaseindefaultprobability,butgreaterriskoccursinthenext
period;ifearningsdonotimproveenoughtoincreasetheirrespectivenumerators,alarge
amountofassetswillremainunderperformingWithoutanewinfusionofdebt,therewill
benotaxbenefitstocounteractthechangeindefaultprobabilityandtheresultwillbea
stockthatfalters.Althoughafirmcanissuemoredebtinsubsequentperiods,thefirm
mustbeginpayingbackandloweringtheproportionofdebttoequity.Atthispoint,the
risk/returnratiofortheinvestorrisesbecausethefirmcaneitherwallowinlow
profitability-ifthewrongprojectshavebeenimplemented-orbeginpayingoffrapidly
andincreaseitsstockprice.Thus,theZscoreisbothmathematicallysoundandintegrated
withcapitalstructuretheory.
426

KIMBERLY-CLARK’SZSCORE
Table16-20

1999FUNDAMENTALS AMOUNT
WorkingCapital -284
Retainedearnings 6764.6
EBIT 2654
BookValueofEquity 5093.1
BookValueofLiabilities 5772.6
Sales 13007
Assets 12816

Table16-21

2000FUNDAMETALS AMOUNT
WorkingCapital -784
RetainedEarnings 7982
EBIT 2844
BookValueofEquity 5767.3
BookValueofLiabilities 6574.6
Sales 13982
Assets 14480

427

Table16-22

Kimberly-
ClarkZScore
YEAR(X1) (X2) (X3) (X4) (X5) ZScore
1999 -0.022 0.528 0.207 0.882 1.015 2.4567
2000 -0.054 0.551 0.196 0.877 0.996 2.364

Fortheyear1999,thenumber2.4567canbecomparedwith2000’snumber,which
declinedto2.364,indicatingahigherprobabilityofdefault.Thestudent/investorwill
noticethatAltman’sfigureagreeswithZmijewski’s,evidencingslightlymorerisk.
INVESTMENTCONCLUSION
Kimberly-Clarksfinancialacumenisadmirable.Theyknowhowtogaugerisk.
However,inorderforthestocktoappreciate,theyneedtomakeamoveawayfromthe
optimaltargetandthenbackagain.Ifitseemsunusualnottotaketheriskneededto
appreciatethestock,considerthetimingofsuchamove-atthebeginningofadownturn.
Thefirmiscorrecttoplayitconservativelywhichmakesitanattractiveadditiontoany
portfolio.The“planoftheday”inearly2001wastodiminishrisk,andfewcompanies
wouldaccomplishthatbetter.
(BacktoTableofContents)

428

APPENDIX:EXTRAPOLATEDRISK-When“Normal”istoorisky
Investingonthebasisofforecastsistenuous.However,iftheinvestorcanadapta
contingencyplantoeachforecast,andrecognizeitsinherentfragility,heorshewillhave
moreoptionsandgreatersuccess.Businessesthatadoptacontingencyplanareflexible
enoughto“shiftgears”whenconditionschangeandthereinliesthesecretofcorporate
longevity;contingencyplanningwillhelpdiversifyafirm’sactionsandlowersitsoverall
risk
Whenweusethegeometricmeantoextrapolatethethreecomponentsofthecapital
dynamic,wearenotforecastingperse.Wearefollowingthetrendlineformedovera
numberofperiodsanddeterminingtherisktoeconomicprofit.Whenwecomparethat
risktoothercompanies,wearemerelystating,“Thisistherisktoeconomicprofitifthings
keepgoingastheyare.”Thus,itispurelyamathematicalexercisedevoidofnumerous
outlierssuchassectorrotation,theeconomy,orthecostofcapital.However,somefirms
createanenvironmentwhereeconomicprofitcannotgrow,anditisinthesecasesthat
extrapolatedriskisvaluable;toomuchequityissuedattoohighapricewillshowupasa
trendthatcancripplethecapitaldynamic.Atthispoint,thefirmmustoverhaulitscapital
structurethroughacquisitions,stockbuybacksorevendivestiture
Justasweextrapolatednextyear’sdividendintheGordonmodel,wecanfinda
trendlinefornetincome,capital,andstockholders’equity.Sincethecostofequityisless
affectedbycompanytrends,weleaveitasis.However,thecorrelationbetweencapital,net
incomeandequityisveryhigh;theinteractionbetweenretainedearnings,additional
equity,andcapitalformationisquitestrong.Welookateachelementoverafiveyear
interim.Ifwespotabadearningsyearaseitherthefirstorlastyearintheperiod,wedrop
thatfigureanduseamoretypicalyear;again,theemphasisisnotonprecisionbutto
produceagrowthfigurethatencompassesthetrendinthatelement.
Theconstructionofthegeometricmeanissimple.Wemakearatiooutofthelast
yearinthetrend(current)anddivideitbythefirstyear(fiveyearsago).Wethenusethe
429

inverseofthenumberbetweenperiodsasanexponent.Thisfigureisagrowthfactor.If
wesubtract“1”weobtainanaverageyearlypercentagegrowth.Inthecaseofafiveyear
period,thenumberbetweenperiodsisfourandtheinversewouldbe1/4or0.25.Ifthe
periodweretenyears,thenumberbetweenwouldbeninewithaninverseof1/9or0.1111.
Thestudent/investorneedsacalculatortousethefractionalexponent.Thegrowth
functionis:(CurrentNumber/NumberXperiodsago)
1/(X-1)
.
Atthisjuncture,wepluginacompany’sfiguresintothegeometricmeanfunctionandthen
doacapitaldynamiccalculationontheextrapolatedfigures,leavingthecostofequityasis.
Toobtainariskcalculationforcomparison,wedividetheextrapolatedcostofequityinto
extrapolatednetincome;thisfigureisthecomparativecapitaldynamicforthatcompany.
Table16-23

Kimberly-
Clark

Year NetIncome Stockholders'
Equity
Capital CostofEquity
1996 1404 4483 6222 N/A
2000 1801 5767 7767.6 0.1288

Table16-24

FUNDAMENTAL FUNCTION GROWTHFACTOR
NetIncome (1801/1404)^0.25 1.0642
Stockholders'Equity (5767/4483)^0.25 1.0649
Capital (7767.6/6222)^0.25 1.057

Theextrapolationofthecapitaldynamic:1801(1.0642)-[(0.1288)(5767)(1.0649)]=
1916.62-790.99=1125.63.Theriskmeasurementis1916.62/790.99=2.423
430

Thecurrentcapitaldynamicis1801-[(0.1288)(5767)]=1058.21,withariskfactor
of1801/742.79=2.424;avirtualtiethatisdescribedbytherateofgrowthofnetincome
andequity.Ifthecostofequitygoesdownin2001,theeconomicprofitmayrise.
Asecondimplicationoftheanalysisistheriseinlong-termdebt.Wemultiplythe
growthfactorsbythefundamentalsforcapitalandequityandthensubtracttoobtainan
extrapolatedfigurefordebt.Ifcapitalisgrowingfasterthanequity,thefirmistakingon
debt,andanextrapolatedfigureprovidesinformationonwhata“normal”increasewould
be.
Table16-25

EXTRAPOLATEDLONG-TERMDEBT
ExtrapolatedEquity=5767(1.0649)=6141.28
ExtrapolatedCapital=7767.6(1.057)=8210.35
Capital-Equity=Long-termdebt=2069.07

Withoutreferencetomanyotherfigures,debtisnotanabsolutemeasureofrisk,butwe
canatleastobservewhata“normal”increasewouldbe.Andthatisthecruxof
extrapolation-toobservewhatisnormal,anddecidewhether“normal”maybetoorisky.
Thetechniqueismoreapplicabletolowrisk,lowbetafirmswhohavesteadyincomes(like
Kimberly-Clark).However,mostfirmsdesireastableequitybecausethemarketpriceof
thestockwillbesomemultipleofthebookvalueandstabilityhelpsmaintainthe
difference.
(BacktoTableofContents)

431

17
FULLSTEAMAHEAD:ANANALYSISOFCONOCOPHILLIPS,
2002-2006
Whenafirmhasearningsthatareacceleratingmuchfasterthanthemarketrate,
themeasurementsareforthright;performanceiscapturedinbothfinancialstatementsand
stockcharts.However,signsofincipientandsustainablegrowtharemoreelusive.The
risksofgrowthafterPhillipsPetroleummergedwithConocoin2002wereapparent.
Investmentsuccesswasnotguaranteedinaneconomicenvironmentplaguedbyboth
recessionandthepreparationforwarintheMiddleEast.Whilethepricefluctuationsof
anynaturalresourcecancripplecommodityrelatedbusinesses,volatilityintheoilmarket
causescomparativelymorerisk.Notonlydoshortageshavefarreachingmacroeconomic
consequences,butanoilglutcreateslesscompetitionwithintheindustryitself-and
ultimately,lessprofit.Consequently,hedgingoilrelatedcommoditypricesisanimportant
partofthebusiness.Asoilpricesrise,industryplayerswantto“lockin”alowerpriceand
mayprofitfromthesedecisions.Anythreattosupply,whetheritisitfromOPEC,orthe
warinIraq,willpropelfuturespricesupward.However,nothingpreparedinvestorsfor
thesteepriseinoilpricesthatwereacombinationofbothpoliticalriskandglobaldemand
afterthewarstarted.ThatConocoPhillipswouldestablishitselfasapremierplayerinan
industrythatwoulddominateanentirebusinesscyclewassimplyunforeseeable.
THECONTEXT
Rarelydowehaveachancetoassociateaspecificcompanywiththeperformanceof
anentirebusinesscycle.Byobservingcapitalstructuredecisionsfromtroughtopeak,the
student/investorcancorrelateindividualcorporatebehaviorwiththeforcesthatworkon
thegreatereconomy.Mostcyclesaredistinguishedbytheinterspersingofseveralsectors,
eachofwhichdominatesoneortwophases.Inevitably,thefallfromgraceoccurswhen
capitalcostsbegintoeclipseearnings,andthenextsectortohaveearningsaccelerationwill
432

bethe“risingstar”.InthecaseofthemergerbetweenPhillipsPetroleumandConocoin
2002,themeteoricriseinearningswaspunctuatedbyfiveyearsofsolidriskmanagement
thatexploitedagrowingeconomy.Severalriskrelated“hurdles”weredeftlyhandledby
ConocoPhillips:
• 1.ConocoPhillipswasformedintheaftermathofthe911attacksandincreased
tensionsintheMiddleEast.Forlackofabetterword,thestockmarket“crashed”in
2001and2002,leavingarecessiontrailingbehind.Equitybasedcompanieswere
especiallyhardhit.
• 2.TheFederalReservebegantolowerthefederalfundsratetolevelsnotseeninfifty
years.Ontheotherhand,PhillipsPetroleumdidnothaveexcessivedebtonitsbalance
sheet,norhadtheyissuedalotofequityassomecompaniesdidinthelate90s.
• 3.OilpricesbegantorisewellbeyondthepointwarrantedbytheriskintheMiddle
East.Infact,IndiaandChinaweretobecomemajoreconomicplayersontheworld
stageandemergingmarketsbegantogrowatafuriouspace.Thedemandforoilwas
nolongeranisolateddomesticconcern.
• 4.Oilbecameapoliticalissue.Tosaythattheoilcompanieshad“friends”in
Washingtonmaybeanunfaircriticismoranunderstatementdependingontowhom
onespeaks.However,publicoutcryabout“BigOil”becamelargeenoughtowarrant
post-KatrinahearingsinCongress.Infact,theformerassistantSecretaryofStatesat
ontheBoardofDirectorsatConocoPhillips.
Oilcompaniesmanageriskaswellasthebestfinancialinstitutionssimplybecausethe
natureofthebusinessissospeculative.Exploringforoilisperhapsthearchetypalrisky
businessandcallstomindsuchimagesasTexaswildcattersand“instant”wealth.For
ConocoPhillips,theriskswerefarmorecomplicatedthanmerespeculation:theyhadto
foreseetheeconomicrecoverythatwasforeshadowedbyasurgingstockmarketinMarch
of2003.Secondly,theyneededseveralplanstonegotiatethroughtheriskofMiddleEast
turmoil:aplan,forexampleifoilweretobeshutoff-theworstcasescenario.Any
433

extremesinpricewouldentailmoreriskbecausechangesindemandwouldhavean
exaggeratedeffectonvariablecostsontheupsideoralternatively,onunusedcapacityifthe
recoverywereshort-lived.
Theeconomicrecoverythatbeganin2003wasclassicinmanyways;theFederal
Reserveloweredinterestrates,andthefirmsthatcouldmostafforddebttookadvantageof
lowercapitalcosts.Inthe“normal”sequence,lowbetastocksbegantorecoverfollowed
byriskierconsumerdiscretionarystocks.However,thisrecoverywasmoreunusualthan
othersinseveralrespects:
• 1.Employerswereslowertohire,andtherewaslittlewage/pricepressureatthe
anticipatorylevel.Workersdidnotcausehigherinflationaryexpectationsand
employersdidnot“bidup”thepriceofwages.Thecruxofthisanomalyliesinthe
alternativesprofferedbyaglobaleconomy.Notonlywereillegalimmigrants
competingforlowwagejobs,butinformationservicejobsmovedoutofthecountry;a
computerglitchcanbefixedfromIndiaaswellasfromSanFrancisco.Moreover,
manufacturingjobsmovedtoChinawhereinexpensivelaborcouldmakeawidget,and
thensenditbacktotheUnitedStates.
• 2.TheFederalReserveloweredinterestratestohistoriclowsandthenkeptthem
there.Thiswasarealestatespeculator’sdream.Interestsensitivestockstookoffwith
housingleadingtheway.Anybodywithamortgagewasrefinancingatalowerrate.
Whenhousingpricessoared,thebubblebegantoburstbecausecorporateearnings
couldnotprovidetheequilibriumthatwouldmatchhigherhomepriceswithworker
income.Achainreactionoccurredthatbecame“thecreditcrunch”of2007-2008with
acombinationofhighratesofforeclosures,defaultsonloans,andhousingderivatives
(collateralizeddebtobligationsorCDOs)thatwereworthless.
• 3.Thegovernmentwentonaspendingspree.InordertopayforthewarinIraq,the
UnitedStatesgovernmentfloatedlargebondissuestoChinaandranuphugedeficits
simultaneously.Inthemeantime,thedollarsanktocomparativelows.When
434

multinational“profits”weretranslatedfromanascendingcurrencytoonethatwas
depreciating,earningswereinflatedabovetheirtrueproductivevalue.Additionally,
theU.S.exportmarketpickedup,notonthequalitativebasisofbetterproductsand
services,butbecausethedollarwasatanalltimelow,andAmericangoodswerea
relativebargain.
Thestagewassetforarecoveryandexpansionthatwerehighlyskewed.Allsectorsinthe
economydidnotparticipatenordidtheentireworkingpopulation.Someareas,like
Michigan,remaineddepressedthroughoutthe“recovery”.Ontheotherhand,areasof
heavyconstructionlikeLasVegasprofitedenormouslyfromthehousingboom.Infact,the
economyfavoredtwosectorsthroughoutthebusinesscycle-oilandhousing-whileothers,
likenewspaperpublishing.,begantofallbythewayside.Whilesuchcyclicaldominance
doesnotbodewellfortherespectivefuturesoftheseindustriesinthenextcycle,their
collectiveresponsetoachangingeconomywasintegratedintospecificcapitalstructure
decisionsthatpositionedthemsowell.ConocoPhillipsmayhavebeeninthe“rightplaceat
therighttime”,butitwastheforesighttomanageriskthatallowedthemtocontinueto
profit.
THEDECISION
ThedecisiontomergePhillipsPetroleumwithConocowasamasterpieceofboth
timingandoperatingsynergy.Thegreaterriskintheoilindustrywasthwartedby
counterbalancingitwithlessriskasamergedcompany.Ifthestudent/investorwill
observejustthreefundamentalsfromthisperiod(2001-2006),thecasecanbemade:
Table17-1

YEAR 2001 2002 2003 2004 2005 2006
OP.
Income
4937 4953 12638 18713 28297 36704
Sales 25030 57201 105097 136916 183364 183650
Assets 35217 76836 82455 92861 106999 164781

435

The2001figuresareforPhillipsPetroleumalone.Besidesthetremendoussurgeingrowth
aftermergingwithConoco,noticethatPhillips’operatingmarginin2001was19.72%(Op
income/Sales).Ontheotherhand,in2005,atthepeakofgrowth,itwasonly15.43%.
Assetturnover(sales/assets),however,wasjust0.7107in2001,whileitwas1.714in2005,
almosttwoandonehalftimesaslarge.Whathappened?Thecharacterofthemerged
companywasradicallydifferentthantheoldPhilipsPetroleum.Withasmallsacrificein
marginalprofit,themergerdecreasedthecapitalintensityratio(Assets/Sales)requiring
lessfixedassetsperdollarofincomegenerated.Thisincreasedproductivitycreateda
moreevencash-flow,allowinggreaterflexibilityinfundingbutwithoutchangingthe
leveragecharacteristicstowardgreateruseofdebt.Ineffect,theConocoPhillipsmerger
increasedreturn,butreducedriskwhichisarareandformidablecombination.
Onebenchmarkofanyinvestmentisthetimeittakestoreturnit.Whenany
companypurchasesalargeamountofassets,thereisusuallyalagbetweentheintegration
ofthoseassetsandprofitability.Itisatthisstage,thatstockpricesdeclineorbecome
stagnatebecausecapitalistiedupinaprojectwithlittlecurrentyield.Inthecaseofthe
ConocoPhillipsmerger,thereturnswerealmostimmediate.Bythefourthquarterof2002,
operatingincomewassurging,settingthenewlyformedcompanyupformoreprofitability
tofollow.Infact,ConocoPhillips“recovery”almostperfectlycoincidedwiththatofthe
greatereconomy.Hadthelagbetweenassetpurchaseandprofitabilitybeenayearortwo,
thecompanywouldhavealmost“missedtheboat”,failingtoparticipatesuccessfullyinthe
firstphaseoftheexpansioncycle.Thatscenarioalonecouldhavedevastatedshareholders
becausetheremainderoftheeconomywasbeginningto“heatup”.Fromatechnical
standpoint,anyrisingdefaultprobabilityquicklybegantodissipatebythefourthquarter
of2002assalesandprofitspickedup.Theslightlyincreasedleveragefromthe
combinationofbalancesheetsreducedthepotentialforshareissuesaswellasincreasing
taxbenefits.
PRICEPERFORMANCE
436

Inthemajorityofbusinesscyclesahigherstockpricereflectssectordominance
whichmayspananintervalfromsixmonthstotwoyears.However,assumptionsabout
stockpricescanblindustotherealityofdefiedprobabilities.Weassumethatafirmlike
ConocoPhillipscanmovetowardanoptimalcapitalstructureforonlyashorttime,butin
thiscase,thetraderswhospeculatedonthebasisofmomentumwonthe“jackpot”:the
naiveinvestorwhokeeps“playingthesamenumber”wasrewardedbyanoilmarketthat
soared.
Table17-2

YEAR START END LOW HIGH %
CHANGE
2002 60.12 48.39 44.66 63.73 -19.51
2003 49.33 65.57 45.31 65.57 32.92
2004 65.48 86.83 64.78 90.99 32.61
2005
(SPLIT)
84.11 116.36 84.11 116.36 38.34
2006 60.61 71.95 56.03 73.07 19.71

ANTICIPATINGPERFORMANCE:LEVERAGESTATES
ConocoPhillipsdisplaystheclassicprogressionfromadebtorientedstatein2002to
asequenceofprofitgeneratedequitystatesin2003to2005backtoadebtorientedstatein
2006.Whileinterestrateswereincreasing,debtwasneverprohibitivelyexpensive;equity
statesweregeneratedbymoreretainedearningsandanattempttomaximizethe
efficienciesofthemerger,whicheffectivelyreducedrisk.Thetaskfortheinvestoristo
forgethetransitionbetween“debtstate”and“profitorequitystate”byrecognizingthe
shiftincapitalstructure.
437

Table17-3

YEAR 2001 2002 2003 2004 2005 2006
Financial
Lev.
1.0734 1.129 1.0766 1.03 1.0179 1.0305
LTD/CAP
%
37.52 39.05 32.22 25.17 16.94 21.84
OpMom. -0.5973 0.00519 1.853 1.59 1.51 190.48
Assets/Cap 1.5345 1.5864 1.6261 1.6265 1.6853 1.5504

Themostprofitableyears(2003-2005),werecharacterizedbysteadyoperatingmomentum
withinanarrowrange.However,whenacquisitionsweremade,firstwithConocoin2002,
andlaterwithBurlingtonResourcesin2006,thestablerelationshipbetweensalesand
operatingprofitwasupsetbecausethesenewassetsmustbeintegratedintotheexisting
structure,requiringrestructuringcharges,layoffsetc.ToConocoPhillips’credit,the
“debt”yearswerecharacterizedbyincreasingoperatingmomentumwhichsignifiesthat
additionalinterestexpensecanbepaid,andwillnot“ratchetup”theprobabilityofdefault.
Additionally,operatingmomentumwasraisedduringtheinitialyearoftheexpansion
(2003)evenasfinancialleveragewaslowered.Inessence,ConocoPhillipswasabletoraise
betaduringaperiodofmarketexpansion,butreducetheotherrisksassociatedwith
financialleverage.This“miracle”ofmarkettimingproducedanetgaininbetaattheonly
timeinthecyclewhensuchagainwouldbeadvantageous-whentheentiremarketis
risingandsectorperformanceisnotyetcritical
AlsonoteworthyishowthemergerleftPhillipsPetroleum’s’debtstructure
relativelyuntouched.Themergerwasconsummatedwithmoredebt,butitwassoon
bufferedbyprofitgeneratedequitysothatlong-termdebttocapitaldecreased.This
decreaseallowedgreaterflexibilityintheuseofdebtwhenConocoPhillipsneededtomake
anacquisitionastheydidin2006withBurlingtonResources.Thatdealrequiredmore
equitythandebt,althoughConocoPhillipsmorethandoubledexistinglong-termdebtto
438

23091.TheconsequentLTD/CAPratiowentuptoonly21.84%fromadiminutive16.94
%.
Incaseswherebothdebtandoperatingmomentumareincreased,greaterassetsto
capitalactsasanadditionalplusfortheinvestorratherthananegativeindicator.Such
increaseswillescalatethereturnoncapital(ROC)andcanofferalessriskysourceof
financing.However,whenitisdecreased,asitwasin2006,ConocoPhillipsnolonger
neededtohedgetheriskinlong-termdebtastheydidin2002;profitshadbeensurging
andthelong-termdebttocapitalratiowasrelativelylow.Thediminishedratiowouldhave
beenmoreofa“judgmentalnegative”hadthecompanyorsectorbeensufferingandthe
stocklanguishing.
QUARTERLYLEVERAGERESULTS
Therationalconnectionbetweenspeculativegamblingandprobabilisticinvestingis
greatertodaythanatanytimeinfinancialhistory.Optionstrading,currencyswapsand
exoticderivativeshavegainedlegitimacybecausetheirproperuseoffersriskreductionand
protectionthataninvestormightnothaveotherwise.Itdoesthestudentadisserviceto
denythatspeculationissometimeslucrativeandthat“highrollers”existonWallStreet
whomakeitaprofessionalcareer.However,themathematicsofshort-termdecision
makingfavorsthevariationcausedbyuncontrollablerandomfactors.Ifoneinvestsina
stockthatistrendingforthreeweeks,itisacrapshoottoassumethatitwillbehave
similarlyinweeksfourandfive.
Whileleveragestateinvestingoffersbetterchoices,anticipatingastate(andthe
transitionbetweendebtandprofit)isfraughtwiththesamepitfallsasanyshort-term
investment:thecompanywillhavehigherprofitsfortwoquarters,onlytomakeabad
debtladenacquisitioninthethirdquarter.Notallcompaniesworktooptimizetheir
capitalstructures.Withthatcaveat,thefollowingquarterlydataindicatesthatspeculation
onConocoPhillips’leveragestatewouldprovetobethecorrectandobviouschoice.:
439

Table17-4

QUARTER 3rdQTR2002 4thQTR2002 1stQTR2003 2ndQTR2003
Operating
Income
1058 2065 3651 2756
Sales 15678 20688 27077 25595
Financial
Leverage
1.145 1.1186 1.0607 1.0715
LTD/CAP% 37.31 39.057 32.757 31.32
Operating
Mom.
N/A 2.978 2.55 4.48
Assets/
Capital
1.6196 1.5864 1.742 1.7308

Anyfundamentalsthatmimicthistypeofrelationshiparenottobeinterpretedasworthy
ofspeculation.However,weobserveearningspressurecoincidentwithadeclineinlong-
termdebttocapitalandthefinancialleverageratioovermorethantwoquarters.The
firmisreducingitsprobabilityofdefaultaswellasloweringthefinancialleverage
componentofbeta.Aftertakingondebtin2002toconsummatethemerger,itwouldbe
improbablethatConocoPhillipswouldbeginincurringgreaterlong-termdebttocapital
afterreducingitinquartersoneandtwo.Suchanassumptionisproblematic;ifprofits
begantofalterinthethirdandfourthquartersof2003,theinvestorwouldbeleft“holding
thebag’withlesslong-termdebtbutagreaterfinancialleverageratiobecausetheability
topayinterestexpensewouldbeundermined.Suchatransitionstateof“halfandhalf”is
muchmoredifficulttoreadandisonereasonwhyspeculationshouldbeavoided.
INTERPRETINGREGRESSION
Withoutafullestablishmentofthesecuritiesmarketline(CAPM),wecanalso
interpretthequarterlyregressionin2003.Theseregressionsaretheprecursorstothe
determinationofacostofequity.Theyaresimplyfiveyearregressionsbetweenthe
percentagechangeinthestockandthemarketpercentage,withthreedatapointsdropped
andreplacedasanewquarterisadded.WearesearchingforchangesinRsquaredor
440

alphathatwouldindicatelessormoredependenceonthemarket,andchangesinbeta
whichwouldbeattributabletogreaterleverage.
Table17-5

PERIOD LINE CORRELATION ACTUALMKT%
2002 Y=0.3057+0.3814(X) 0.288006 -9.995%
1stQTR2003 Y=0.3331+0.3408(X) 0.237738 4.2%
2ndQTR2003 Y=0.4405+0.3554(X) 0.246158 5.11%
3rdQTR2003 Y=0.5256+0.5226(X) 0.35043 9.03%
4thQTR2003 Y=0.9668+0.6477(X) 0.408869 7.65%

Inthisdisplay,thenumberthatprecedes“X”isbeta,whiletheothernumberisalpha.The
correlationis“R”andnotRsquared.Theregressionlineitselfusesfiveyearsofmarket
datatoestablishabeta,buttheactualmarketchangesforthatperiodareposted.Ineffect,
ConocoPhillipsincreasedalpha,beta,andthecorrelationcoefficientsimultaneously,while
themarketwasincreasing.Sincethefirmwasreducingitsdebttoequityratioatthistime,
theincreaseinbetaisderivedfromincreasingoperatingincomerelativetothemarket.As
thisinitialrecovery“surge”inthemarketbegantosputter,ConocoPhillipswouldcontinue
toreducefinancialleverageaswellasitsdependenceonthemarket-thecorrelation
coefficient,“R”.However,non-systematicrisk-asmeasuredbyalpha-wasincreased.A
“cartel-like”auraformedaroundoilwhichseemedtoimmunizeitfromcyclical
downturns:Thestockswouldriseevenifthemarketdidnot.Thatanomalywasthe
outgrowthofpriceanddemandeffectsthatwereintheoilcompanies’favoratthetime,
althoughpublicfearsofcollusionwereforeverimminent.Thehigheralphaindicatesthat
thecompanyisgoingtoproduceareturnevenifthemarketreturnsnothingandisa
functionoftheintegrationofcompanywithindustry.Anyindustrythatproducesan
especiallyvaluablecommoditythatisinconstantdemand,andcommandsahighprice,will
haveahigheralpha.ConocoPhillipsbeganreducingrisktothepointwhereprofitswere
nolongersystemic,butdependedontheirpositionintheoilindustry“peckingorder”.
441

ESTABLISHINGACOMPARATIVECOSTOFEQUITY
Ratherthandependingononemethodofdeterminingthecostofequity,the
interactionbetweenearnings,priceandmarketcanbestbeshownwiththree.Weshow
thatasurgingcompanylikeConocoPhillipsisresilientenoughtoharborradicallydifferent
costsofequityandstillestablishanincreaseinEVA.However,forinvestmentpurposes,
webelievethattheCAPMoffersthemostequitablemethodformostfirmsbecauseofthe
tendencytodependonthemarket:Nineoutoftenstockswillgodownduringabear
market,andthreeoutoffourstockswillgoupduringabullmarket.Whenusingthe
GordonmodelortheE/Pmethod,idiosyncrasiescreepinthatareidentifiedwithmarket
skeworthespecificsituationofthecompany.Theinvestorwantsacomparativerisk
figure,anopportunitycostthatisbestderivedfromasamplepoolthatcomprisesallstocks
-theCAPM.
• THECAPM.Belowarethetalliedcostsofequityfortheyears2002-2006.Amonthly
fiveyearregressionwasperformed,startingin1998forthe2002figureandcomprising
2002to2006forthelatterfigure.Inthisperiod,themarketriskpremiumnever
exceededfivepercent,andsothatfigurewasestablishedasafloor.Theaveragerisk-
freeratesaretabulatedaswell.

Table17-6

YEAR BETA RISK
PREMIUM
RISK-FREE
%
CostofEquity
2002 0.331477 0.05 0.0461 0.0652
2003 0.647655 0.05 0.0401 0.0725
2004 0.823431 0.05 0.0427 0.0839
2005 0.505491 0.05 0.0429 0.0682
2006 0.690769 0.05 0.048 0.08254

442

• THEGORDONMODEL:TheGordonmodelseemstopricethecostofequitytoo
high,butestablishesameasureofperformanceabovethemarketifthefirmisdoing
comparativelywell.Thereasonthatthemeasurementisplacedwellabovethatderived
bytheCAPMisthatitestablishesaninternalbenchmarkforthecostofequity-
dependenceonboththereturnonequityandtheretentionratioforearnings-which
maynotreflectmarketaverages.LiketheCAPM,moreearningswillincreasethecost
ofequity,butunliketheCAPM,underperformancewilldecreaseit.Forthatreason
alone,itcanbeusedasacomparativefigurewiththeCAPM,butisnotareliable
measureofcomparativeriskwiththemarket.ThefollowingtablesgiveROEsand
retentionratiosfortheappropriateyears.Thestudent/investorshouldbeawarethat
theproductofthesetwofiguresisaddedtothe“expected”dividendyield-thatis-the
dividendexpectedinthenextfiscalperiod.
Table17-7

YEAR 1997 1998 1999 2000 2001
NetIncome 959 237 609 1862 1661
Equity 4814 4219 4599 6093 14340
ROE 19.92% 5.617 13.24 30.56 11.58
Retention
Ratio
68.19% 0 43.51 81.41 75.74
Growth 12.59% 0 5.76 24.88 8.77

Table17-8

YEAR 2002 2003 2004 2005 2006
NetIncome 698 4735 8129 13529 15550
Equity 29517 34366 42723 52731 82646
ROE 2.364% 13.66 19.03 25.66 18.82
Retention
Ratio
0% 76.62 84.84 87.89 85.36
Growth 0% 10.47 16.15 22.55 16.06

443

Table17-9

YEAR 2002 2003 2004 2005 2006
Average
Price
$54.20 $55.44 $77.89 112.965* $64.55
Next
Dividend
$0.82 $0.90 $1.18 $1.44 1.70*
*Price:IndicatesSplit
*NextDividend-IndicatesAuthor’sProjection

Wethenassemblethegrowthinformationinafiveyearmovingaverageandaddeach
figuretothemodifieddividendyieldforeachyear.

Table17-10

YEAR 2002 2003 2004 2005 2006
Gordon
Model
9.39% 11.6 13.59 12.85 15.64

• EARNINGS/PRICEOR“E/P”:Inanyirregularmarketwherestocksareeither
undervaluedorovervalued(justaboutallmarkets),theE/P“ruleofthumb”failsto
work.However,itisthecapitalstructureequivalentofaP/Eratio,andtherelationship
betweenearningsandpricecarriesalotofinformationaboutthecostofequity.When
investorsvalueonestock’searningsaboveanother,theyarewillingtobiduptheprice
ofthestockandthefirmcaneasilyattractequity.Equityissuesbecomeprofitable
becausethegreatestamountofcapitalisraisedfortheleastamountofsharesissued.
Theuncertaintyofthismeasurementisderivedfromthevolatilityofthemarketwhich
444

makesthepricingofequityunreliableasanopportunitycost.Althoughtheprice
changesonadailybasis,theriskofequityismorestable.Nevertheless,inasurging
company,eventhisunreliablemeasurementwillcreateaballparkfigurefor
percentageincreasesinEVAbecauseittendstoriseandfallsimilarlytotheCAPMand
theGordonmodel.Thebasiclogicbehindthiscorrelationisthatbothpriceand
earningsriseintandemthroughoutatypicalbusinesscycle,reachapeak,andthenfall
whentheriskoflowerearningseclipsesprice.Thatsub-cycleisanalogoustohowa
firmattractsmorecapitalwithbetterearnings.Unfortunately,therelationshipisnot
mathematicallyprecise,andusingthismodelwithcertaingrowthstocksorintimesof
excessivespeculation,willbadlyskewanycomparisontocompaniesofsimilarrisk.
Table17-11

YEAR 2002 2003 2004 2005 2006
EPS 0.72 3.45 5.8 9.55 9.66
PRICE 54.2 55.44 77.89 112.905 64.55
E/P 1.32% 6.22 7.45 8.45 7.49

DIFFERENCINGROEANDTHECOSTOFEQUITY
Table17-12

YEAR 2002 2003 2004 2005 2006
ROE 0.02364 0.1366 0.1903 0.2566 0.1882
Costof
Equity
0.0652 0.0725 0.0839 0.0682 0.0825
ROE-Cost
ofEquity
-4.16% 6.41% 10.64% 18.84% 10.57%

Theperformanceofthismeasurementmirrorsstockperformanceasmuchasthe
percentagegaininEVA.Theyareverysimilarmeasurements;adecreaseinthisindicator
(orEVA)doesnotnecessarilysignifyadecreasingstockprice,althoughthecorrelationis
445

strong.Ifthemarketissatisfiedthatevenadecrease(asin2006)willoutperformthe
market,equitycapitalmaystillflowintothecompanyprovidingthatthenear-term
outlookisoptimisticenough.
CONTRASTINGTHEREQUIREDRETURNWITHTHEEXPECTEDRETURN
TotakeadvantageofthedifferencebetweentheCAPMandtheGordonmodel,we
recognizethattheCAPMexpressesamarketcomparative“requiredreturn”,anddividend
discountmodelsliketheGordonmodelwillexpressan“expectedreturn”thatismore
dependentontheinternaldynamicsofthecompany.Wheninternaldynamicsoutpacethe
market,thereisoftenupwardpressureonthestock.Whenastockunderperformsthe
market,theGordonmodelcalculationwilloftenbebelowtheCAPMderivedcostofequity.
Thislackofequilibriumcanbeaninvestor’sbestfriend;ifwesubtracttheCAPMcostof
equityfromthedividenddiscountmodel(inthiscase,theGordonmodel)wecanusethe
differencetocomparethetworisks-marketandinternal.

Table17-13

YEAR 2002 2003 2004 2005 2006
GORDON 9.39% 11.6 13.59 12.85 15.64
CAPM 6.52% 7.25 8.39 6.82 8.254
DIFFERENCE 2.87% 4.35 5.2 6.03 7.386

Whilethedifferencedoesnotrepresentaperfectrenditionofpressureonthestock,this
indicatorissimilartoEVAandtheROEdifferencingthatwedisplayedpreviously.The
growthfactorintheGordonmodelisderivedfromearningsandretention,whilethe
CAPMismoredependentonforcesinthemarket.Effectively,wearemeasuringthe
accelerationofearningsincomparisontothecostofequity.Noticethough,thatthefigure
in2006wasabovethatin2004and2005.Sinceitisaconcurrentindicatorofstock
performance,similartoEVA,theinvestordoesnotknowifthefigurehaspeakedandifthe
446

stockwillsubsequentlydecline.Inthisregard,theinvestorneedstofollowthemarket
imperativeandrecognizethesignsofamarket“top”(seethechapteronthebusinesscycle)
aswellasexaminingleveragepositions.
THEEVA/CAPITALDYNAMIC
Institutionalinvestorssuchaspensionfundsmustdiversifyriskandsearchfor
companieswhohavestablecash-flows.Ex-postevaluationofseveralyearsofEVA
increasesisaprovenindicatorofviability.Notonlydoincreasescorrelatewithpositive
changesinstockprice,butthesizeandstabilityofEVAcanbeaforcethatguaranteesa
growingdividend.However,incapitalstructure,wearemoreconcernedwiththe
movementofEVAthatitsabsolutesize.ApositiveincreaseinEVAdoesnotalways
translatetomovementtowardanoptimalstructure,becauseitisdependentonthecostof
capitalratherthanthecostofbankruptcy.Whilebankruptcycostsarealmostalways
minimizedwhenthecostofcapitalisminimized,theremaybetimeswhenthecapital
structurecannotconformtothemarket.Forexample,ifinterestratesareespeciallylow,a
companymayneedtoshedsomedebtinsteadoftakingonnewdebtatalowerrate.Inthis
case,theprobabilityofdefaultwouldbetoohighandwouldeclipsetheneedformoretax
benefits.Moreover,EVA/capitaldynamicwouldpenalizethecompanyfornottakingon
thedebt,becausethetaxadvantagewouldoutweighthedeclineinnetincome.ThusEVA
woulddeclineevenasthefirmattemptstominimizethecostofbankruptcy.
ForasurgingcompanylikeConocoPhillips,thethreemethodsofcalculatingthe
costofequityrevealthesameearnings/riskpressure;iftherequireddecisionisinvestment
grade,ratherthananacademicillustration,theCAPMshouldbechosentocalculatethe
costofequity.But-ajudicioususeofE/PinfirmswithaP/Erightaroundthemarket
averagecanidentifycompaniesthatmightwarrantfurtherexamination.Inessence,both
E/PandtheGordonmodelarevaluablecomparativetoolstoquicklylocateaprospective
investment.Atthattime,afullregressionisdoneandapreciseassessmentismade.
447

InthecaseoftheGordonmodel,thestandardEVAcalculationwillrevealthatthe
companymustretainthecorrectamountofearningsandpayoutalargeenoughdividend,
incomparisontonetincomeandstockholders’equity.Thishighbenchmarkwillplacethe
calculationveryclosetoROEandproduceasmallEVA.However,periodiccomparisons
ofthismethodindicatethecompetencyoffinancialmanagementbecausethereisalow
thresholdforerror.Forexample,ifdividendsgrowatanexorbitantpaceincomparisonto
priceandearnings,thedeficiencywillberevealedinasmallerEVAcalculation.Similarly,
ifstockholders’equityballoonstonewheights,thismethodwillexaggeratetheincrease.
ThefollowingtablesitemizenetincomeandequityforConocoPhillipsandthenapplythe
threedifferentmethodstodeterminetheEVA/capitaldynamic.Thereaderwillremember
thatthecalculationis:Netincome-[(%costofequity)(stockholders’equity)]

Table17-14

YEAR 2002 2003 2004 2005 2006
NetIncome 698 4735 8129 13529 15550
Stockholders'
Equity
29517 34366 42723 52731 82646

Table17-15
1.CAPM

YEAR 2002 2003 2004 2005 2006
CAPM 0.0652 0.0725 0.0839 0.0682 0.0825
EVA -1227 2243 4545 9933 8732

448

Table17-16
2.GORDONMODEL

YEAR 2002 2003 2004 2005 2006
GORDON 0.0939 0.116 0.1359 0.1285 0.1564
EVA -2074 749 2323 6753 2624

Table17-17
3.EARNINGS/PRICE(E/P)

YEAR 2002 2003 2004 2005 2006
E/P 0.0132 0.0622 0.0745 0.0845 0.0749
EVA 308 2597 4946 9073 9360

Thestudent/investorshouldnoticehowtheCAPMandGordonmodelsboth“punished”
ConocoPhillipsforissuingtoomuchequityin2006.Themarginalbenefitsfunctionwill
laterrevealthatindeedthetaxbenefitsoftheacquisitionofBurlingtonResourcesfarout
weighedanyincreaseinbankruptcycosts;theprobabilityofdefaultwasvirtually
unaffected.Therefore,beforetotallydismissingtheE/Pindicationsofmovementtoward
anoptimalcapitalstructure(anincreaseinEVA),moreindepthanalysisneedstobedone.
NAIVEEXTRAPOLATION
Ifthecapitalstructuralistwereastute,heorshewouldhavepickedupon
ConocoPhillipsinearly2003.Themarketsoaredandthefirmwaspositionedtotake
advantageofthesurge.Theleveragepositionwassolidinanexpandingeconomy-the
proportionofequitywasbuildingupthroughretainedearnings.However,bytheendof
2004,thecompanywouldhavehadtwoyearsofoverthirtypercentgains.Atthispoint,
“smartmoney”investorswouldsurelytakeprofits.Hadinvestorshesitated,theywould
havemissedoutonanotherthirtypercentgain:theyear2005turnedouttobe
ConocoPhillips’biggestyetwithastocksplit,andrecordsalesandprofits.Howwouldan
449

investorplaythisdilemma?Fromaleverageperspective,theprobabilitywasagainst
anotherbanneryear.
Asinlate2002,therewasaconfluenceofriskfactorsinthefirm’sfavor.Thewar
intheMiddleEastdidnotproduceuncontrollablesupplyanddemandissues-justasteady
riseinoilprices.TheFederalReservewasstillraisingratestohedgeinflation;the
economywasheatingup.IndiaandChinawereinthethroesofcompetitionformoreoil;
theirrespectiveeconomieswerebooming.Althoughonecannotanticipateapositive
corporatemovementafteryearsofstockgainswithleveragetheoryalone,thecollective
judgmentofprofessionalanalystsofferssomesolace.Theincreaseinearningswasa66.42
%gainin2005-whichcouldnotgounnoticedevenifthepredictionwereoffbyhalf.
Thus,analystswouldhaveperceivedtheinordinatedemandforoilandextrapolateditinto
ausableforecast.Ifweaddedthatinformationtoourownnaiveforecast,investorswho
watchedConocoPhillipswouldhavebeeninfor“theride”in2005.Investorswhojudge
primarilyonthebasisofprobability(thisauthor)wouldhavetakenprofits.
Thenaiveextrapolationprocedurerequiresustofindthegeometricmeanofgrowth
forbothearningsandthetotalcostofequityinthenearterm.Anytimethatwecompare
quarterlyperformanceoneyearapart,theeffectisthesameasseparatingthe
fundamentalsbyfiveperiodswithfourintervalsbetweenperiods.Therefore,the
calculationisthesamethatweuseforyearlyperiods:[(ThisPeriod’sX/5Period’sAgo
X)^0.25]-1=PercentageGrowthperPeriod.Inthiscase,wearetestingtoobserve
whetherornotearningsaregrowingfasterthanthetotalcostofequity.Whilenoindicator
canguaranteethatthefirmwillnotbeginacceleratingequitythroughstockissuesassoon
asaninvestmentismade,theprobabilityofanEVAincreaseisgreaterwhenearningsare
leadingequity.

450

Table17-18

QUARTER 4thQUARTER2003 4thQUARTER2004
NETINCOME
(Cumulative)
4735 8129
EQUITY(Cumulative) 34366 42723
CAPM% 0.0725 0.0839
TOTALCOSTOF
EQUITY
2492 3584

Thethreecalculationsareasfollows:
1.NetIncome:[(8129/4735)^0.25]-1=14.47%
2.CostofEquity:[(3584/2492)^0.25]-1=9.51%
3.ComparativeRatio:14.47/9.51=1.52

Thereaderwillnotethatnetincomeaccumulatesthroughouttheyeartodeterminean
annualfigure,butstockholders’equityisacumulativetotal.Sinceaquarterlynetincome
figuremightnotbepartofanactivetrend,weusethecumulativeyearlytotalsandtreat
themasagrowthprogressionmadeoverfourperiods.Forexample,ifthefourthquarter
in2003hadarestructuringcharge,earningsmightbenegativeforthatquarteronly.
Ratherthanresorttousingthethirdquarterfigure,simplyusingtheyearlyfiguresfor
2003and2004willsmoothoutanyerrantnoise.Unfortunately,naiveextrapolation
mirrorsthesizeoftheincreaseinEVAandassumesthatnextyear’sEVAwillbelikethis
year’s.Themajoradvantageofnaiveextrapolationisthatwecangaugetherelativesizeof
componentchangesandthencomparethemtoanalyst’searningsforecasts.Exceptfor
duringaneconomicdownturn,weneverassumethatthecostofequitywilldecelerate,and
soanalysts’consensusexpectationsbecomeabenchmarkforfutureEVAforecasts.While
earningscanbevolatile,thecostofequityismorestableinthenearterm;financial
managementdoesnotwantequitytoradicallyshiftandpotentiallydilutethepriceper
451

marketshare.However,periodicchangesaremadewhenitiscosteffectivetoissuenew
stock,andthosechangesareunpredictable.In2006,forexample,ConocoPhillipsissued
stockasamethodforpurchasingBurlingtonResources.WithConocoPhillipslowlong-
termdebttocapitalratioofapproximatelytwenty-onepercent,onlythosewhospoketo
companyofficialswouldhavepredictedthelargeequityissue.Theinstitutionalimperative
wouldhavebeentoissuemoredebt.
THEMARGINALBENEFITSFUNCTION
Themarketcantemporarilymispriceriskcausingadivergencebetweenthecostof
capitalandtheprobabilityofdefault.Inessence,ifloweringthecostofcapitalincreases
thecostofbankruptcy,itshouldbeavoided.Overthelongterm,suchdisparitieswillwork
themselvesout;moredebtwillincurahighercostandincreasebankruptcycosts
simultaneously.However,arisingmarginalbenefitsfunctioninthedomainofadeclining
EVAmayhaveupsidepotential.EVAalwaysoptimizesonthebasisofthelowestcostof
capital,butremainsaconcurrentindicator;anddoesnotportendachangeinthe
income/capitalrelationship.Ontheotherhand,themarginalbenefitsfunctionanticipates
newdynamicsbecauseitmaximizeswhenthechangeoneachsideofitisequal.Theneed
forbalancedistinguishesthefunction.Iflong-termdebtdeclines,wewouldlookfora
reductionineitherstockpriceordefaultprobabilityontheotherside.
ThisanalyticaldichotomybetweenEVAincreasesandthemarginalbenefits
functionwasillustratedinfiscalyear2006.ConocoPhillipsboughtBurlingtonResources,
increasingbothlong-termdebtandequity.FromanEVAstandpoint,ConocoPhillips
issuedtoomuchequityandhadthecapacitytoincreasedebt.Althoughthepotentialto
increasetheEVA/capitaldynamicwasapparent,thatfiguredeclined.However,fromthe
perspectiveofmarginalbenefits,ConocoPhillipsissuedthepreciseamountofdebtto
forestallanincreaseintheprobabilityofdefaultandincreasetaxbenefitsatthesametime.
Infact,moredebtwouldhavewouldhaveunderminedtheincreasesinassetsandnet
income,andConocoPhillipseffectivelyoptimizedlong-termdebtinthedomainsoftax
452

benefitsanddefaultprobability.Toexhibittheseconcepts,wewillgothroughthestepby
stepcalculationsfor2005and2006.ThereaderisreferredtothechaptersonAnalytical
ToolsandCapitalStructure,respectively,forhelpwiththemechanics.Toreiteratethe
equation:MarginalBenefits=(TaxBenefits)–[(DefaultProbability)X(AmountofLoss)].

Table17-19
2005-2006DATA

ZMIJEWSKIFUNCTIONS ZMIJEWSKIPARAMETERS
Intercept -9.479
TotalLiabilities/TotalAssets 6.384
CurrentAssets/CurrentLiabilities 0.069
NetIncome/TotalAssets -1.06

Table17-20

YEAR 2005 2006
TotalLiabilities/Total
Assets
0.4962 0.4912
CurrentAssets/Current
Liab.
0.9182 0.9484
NetIncome/TotalAssets 0.1264 0.0944
MidrangeStockPrice 98.215 129.1(withoutsplit)
NumberofShares
(millions)
1455 1706
Long-termDebt 10758 23091
TaxRate(decimal) 0.421 0.451
UnamortizedDebt 53093 80940
IntangibleAssets 16439 32439

1.ESTABLISHTHETAXBENEFITS
2005:(10758)x(0.421)=4529
2006:(23091)x(0.451)=10414
453

2.ESTABLISHTHETANGIBLEBOOKVALUEPERSHARE
2005:(106999-16439-53093)/1455=25.75
2006:(164781-32439–80940)/1706=30.13

3.ESTABLISHTHEAMOUNTOFPOTENTIALLOSS
2005:MarketValue=(1455)x(98.215)=142,903
2005PotentialLoss:[1-(25.75/98.215)]x(142903)=105437
2006MarketValue=(1706)x(129.1)=220,244.6
2006:PotentialLoss[1-(30.13/129.1)]x(220244.6)=168842.82

4.ESTABLISHTHEPROBABILITYOFDEFAULT
2005:1/[1+(EXP(9.479)-((0.4962)x(6.384))-((0.9182)x(0.069))+((0.1264)x(1.060)))]=
1/[1+(EXP6.3818874)]=1/592.042=0.001689069=0.169%
2006:1/[1+(EXP(9.479)-((0.4912)x(6.384))-(0.9484)x(0.069))+(0.0944)x(1.060)))]=
1/[1+(EXP6.3778)]=1/588.6334=0.00169885=0.169%

5.COMBINETHEEXPRESSION
2005:4529-((105437)x(0.001689069))=4350.91
2006:10414-((168843)x(0.00169885))=10127.16

Bymaintainingadequateearningsandissuingtherightamountofdebt,
ConocoPhillipscreatedamergerthatdidnotincreasetheriskofdefault.Iflessdebtis
incurredinthenextyear,thepremiumwillbeonincreasingstockpricewhiledecreasing
theprobabilityofdefault.Suchataskisdifficulttoaccomplishsosoonafteramajor
acquisitionbecauseitentailstherapidassimilationoftheotherfirm’sassetswhile
increasingprofitability.Often,costoverrunscoupledwithslowintegrationwillrequire
454

morecapitalandretainedearningswillnotbeadequatetocoverthedeficit.Theresult?-
Ahigherproportionoflong-termdebttocapital.Thisisonemorereasonthatdebtladen
leveragestatestendtobesequential.Thereadershouldalsonotethatthecomparison
between2005and2006entailedanadjustmentforthe2005stocksplitbyputtingthe2006
priceonthesamelevel.
WecanconcludethatnoneoftheaddedassetvaluewasreflectedinEVA.
ConocoPhillips’improvedpotentialwasmoreapparentinthemarginalbenefitsfunction,
butthatcalculationcannotpredictfutureprofitabilityeither.Toreconciletherisksofthe
mergerwouldentailexaminingBurlingtonResourcespastprofitswhileitemizingfixedand
variablecostsandlookingforsynergy.Anevenmoredetailedexaminationwouldentail
producingatimelineforimplementation.Inmostcases,theonlyrecoursefortheanalyst
istodoacomparativehistoryofthecapitalturnoverratio%∆SALES/%∆CAPITAL
andensurethatthecompanyiscompetitive.Justaseffective,butpronetoexaggeration,is
toweightheestimatesfromseveralcompanysources-aninformaltypeof“guidance”.
THECOMPARATIVECAPITALDYNAMIC:GAUGINGUPSIDEPOTENTIAL
Therelationshipbetweenearningsandthecostofequitycannotimprove
indefinitely.AlthoughEVAincreasesareconcurrentwithstockpriceappreciation,thereis
littleabilitytodetectadownsideshiftinearningsandalmostnoabilitytopredictanequity
issue.Whileweattempttocompensatefortheinformationdeficitwithgrowthrate
comparisonsandleveragestateanalysis,abettermethodmightbederivedfromusingthe
comparativecapitaldynamic.
Throughoutthistextwehaveemphasizedthepointthatstockpricemaximization
occurswhenthetargetcapitalstructureisreached.Theactualizationoftheoptimum
remainsafunctionofearningsacceleratingfasterthanthetotalcostofequity,or%∆Net
Income/%∆TotalCostofEquity>1.Theratiooftheabsolutes,NetIncome/TotalCost
ofEquityisanadaptationofEVAthatoffersachancetocomparemagnitude.Whena
firmtakesondebt,itscomparativecapitaldynamic(CCD)tendstobesmallerthanwhenit
455

isgrowingthroughretainedearnings;bydefault,earningsmustbegrowingtoproduce
moreretainedearnings.Laterinthebusinesscycle,moreearningswillenlargetheCCD
untilitcomestoapeak,wheremorefinancingiscosteffectivefromanequityissue.Inthe
caseofConocoPhillips,theCCDpeakwasreachedin2005whenthestocksplit,twofor
one.In2006,thefirmacquiredBurlingtonResourceswithstockanddebtthatdiminished
theCCD.Althoughthestockstillappreciated,muchofthegainwasfromtheparticular
circumstancesintheoilmarketwithrisingpricesandpentupglobaldemand.
Ineffect,eachindustryhasadifferentstandardofCCDbasedontherelationships
betweenthreespecifictypesofreturns:returnonassets(ROA),returnonequity(ROE),
andreturnoncapital(ROC).Whilesomeintersectorcomparisonscanbemade,the
analystmustbecarefulaboutcomparingdifferentfinancialstructureslikeinsuranceor
investmentbanks,bothofwhichhaveveryhighCCDs,withahighturnoverCCDsuchasa
restaurantchain.Nevertheless,theprimefunctionoftheCCDistodointraindustry
comparisons,andcomparisonsbetweenintervalsforaspecificcompany.Asthereader
willobservefromthedata,theCCDhitsapeakwhereearningsbecomemorerisky.Also
significantwouldbetheprevailinglevelofinterestratesintheeconomy.Iftheyare
generallylow,thentheCCDwilltendtobelarger.
Table17-21

YEAR 2002 2003 2004 2005 2006
NetIncome 698 4735 8129 13529 15550
TotalCost
ofEquity
1925 2492 3584 3596 6822
CCD 0.363 1.9 2.27 3.76 2.28
%Stock
Price
-19.51% 32.92 32.61 39.34 18.71

456

Sincetherearenoindustrystandards,theresearcherislefttointerpretwhat“toohigh”a
numberwouldbe.LikeP/Es,thesefiguresriseandfallbuthavemorestabilityand
rationalitybehindthem.Forexample,ifConocoPhillipsrosebacktoabovea“4”,the
investormightquestionwhetherthenextyearwouldbe“bearish”.
EARNINGSPRESSURE
Ifwecomparenaivelyextrapolatedearningsgrowthrateswithanalysts’forecasts,
weobtaininformationthatcontrastsatimeprogression(naiveextrapolation)withan
integrateddemandforecast(theanalysts’).Wedonothavetosellastockifanalysts’
forecastsarelessthanthetimeprogression,butweneedtorecognizethatchangesoccur
afterearningsaccelerationpeaksandweneedtoassessrisksmoreclosely.Moreover,we
alwaysassessearningspressureinthedomainofanalyst’sforecastsbecauseconsensus
opinionismoreinformedthananytimeseriescanbe.However,anothertechniquecan
produceafundamentallyderivedforecastthatcomparesfavorablywithnaive
extrapolation,and-iftheanalysthasanideaaboutthedirectionofearningscomponents-
withforecasts.Thefollowingequationisa“pluginthenumbers”functionthatworks
easiestifdonefromrighttoleft:

(1-A)x(B+(Cx(B-(Dx(1-E)))))

Table17-22

FUNCTION EXPANATION
A)PayoutRatio DividendsPaid/NetIncome
B)ROA NetIncome+((int.expense)x(1-tax
rate))/Assets
CInterestBearingDebt/Equity
D)InterestrateonTotalDebt InterestExpense/InterestBearingDebt
E)TaxRate EffectiveTaxrateexpressedasa
decimal

457

Theequationwillproduceagrowthrate,whichwillbecurrentwhenguidanceaboutthe
directionofthecomponentsisgiven.Forexample,ifaccountantstelltheanalystthatthe
effectivetaxrateisestimatedtobe39%thisyear,thatisonepieceofinformation.If
interestratesaregoingupbytwenty-fivebasispointsaquarter,thatisanotherpieceof
information.Inessence,theequationcanbeputintoaspreadsheetandatrailingtwelve
monthfigurecanbeproducedfornetincomeandtheretentionratiosothateachquarter
theequationisupdatedwithnewinformation.However,asaninvestor,weproducea
concurrentgrowthrateandcompareitwithanalysts’estimates.Whenestimates
underminethisgrowthrate,weassumedownsideriskandearningspressure.Ifanalysts’
expectationsexceedthisgrowthrate,welooktoitasapossibleinvestmentvehicle.The
followingwasanassessmentmadeattheendof2006:

Table17-23

PRELIMINARYCOMPONENT YEAR2006
NetIncome 15550
InterestBearingDebt 27134
Stockholders'Equity 82646
TaxRate 45.1%
InterestExpense 1087

Table17-24

FUNCTION CALCULATION RESULT
A)Payout 2277/15550 0.1464
B)ROA 15550+((1087)(1-
.451))/164781
0.09799
C)Debt/Equity 27134/82646 0.3283
D)InterestRate 1087/27134 0.04
E)TaxRate 0.451 0.451

458

Pluggingthesenumbersintotheequationyieldsagrowthrateof0.10495or10.495%.
EarningspershareforConocoPhillipswere$9.80persharein2006.Analysts’estimates
are$8.89persharein2007foradecreaseof(8.89/9.80)-1=-9.29%.Thus,anyinvestor
shoulddoathoroughlongtermassessmentbecauseanalysts’estimatesundercutourown
growthfigure.Thereisdownwardpressureonearnings.
(BacktoTableofContents)
459

APPENDIX:SELECTEDFINANCIALDATA-CONCOCOPHILLIPS2001-2006
Table17-25

YEAR 2001 2002 2003 2004 2005 2006
EBITDA 4937 4953 12638 18713 28297 36704
SALES 25030 57201 105097 136916 183364 183650
ASSETS 35217 76836 82455 92861 106999 164781
INTEREST 338 566 844 546 497 1087
LTD 8610 18917 16340 14370 10758 23091
EQUITY 14340 29517 34366 42723 52731 82646
CAPITAL 22950 48434 50706 57093 63489 105737
NETINCOME 1661 698 4735 8129 13529 15550
ROE% 11.58 2.364 13.66 19.03 25.66 18.82
RETENTION% 75.74 0 76.62 84.84 87.89 85.36
LTD/CAP 37.52% 39.05 32.22 25.17 16.94 21.84
FIN.LEV* 1.0735 1.129 1.0766 1.03 1.0179 1.0305

*ThefinancialleverageratiowasdeterminedfromEBITDA(earningsbeforeinterest,
taxes,depreciationandamortization).ThestandardmethodologyistouseEBITonly.
(BacktoTableofContents)

460

18
MICROSOFTVERSUSCONOCOPHILLIPS:COMPARING
COMPANIESINDIFFERENTINDUSTRIES
Earningspershare,forbetterorworsehasbecometheuniversalcomparative
measurementincorporatefinance.Itsoffshoot,theP/Eratio,isoftenusedtocompare
companieswithinindustries,indicatinga“valuebuy”whenthefigureiscomparatively
low.Bothofthesemeasurementssufferfromwhatbehavioralfinancecalls,“reference
dependence”:onedollarandninety-ninecentsisonlymeaningful,whenwedefineone
dollarasa“small”amount,andaninety-ninepercentincreaseas“large”.Inanother
allusiontopsychology,wealsoneedtodefinewhatistermed,“normal”,andwedosoby
makingconstantcomparisons.Ifninety-ninepercentincreasespassfor“normal”,thena
ninety-eightpercentincreaseisconsidered“small”andsub-standard.Thus,ourtwo
dependablemeasurements,EPSandP/E,giveuslittleinformationtodistinguishthe
qualityofwhatismeasured.
Thecapitaldynamic/EVAisbynomeanstheperfectmeasurementeither.In
theory,itcancomparetwocompanieswithdifferentoperatingandfinancialleveragesand
putthemonanevenkeel.Forexample,acompanywithlowoperatingleverageshould
haveasteadyenoughincometoaffordmoredebt,andbuildupEPSthroughamore
limiteduseofequity.Thatrelationshipshouldincreasethecapitaldynamiceventhough
netincomemightbecomparativelysmall.Analogously,acompanywithmoreoperating
leveragebutlessfinancialleveragewouldbeabletoincreaseitscapitaldynamicbymaking
largeincreasesinnetincome.Sincethesecompanieswouldpresumablybeindifferent
sectors,thephaseofthebusinesscyclewoulddetermineafirm’srespectivecostofcapital.
Latestagesinthecyclewouldfavortheequityfinancingcompany,whichwouldhavea
comparativelysmallreactiontointerestratehikes.Earlystageswouldfavorwealthier
companieswhofundwithdebtandcouldtakeadvantageoflowerrates.
461

Severalquestionsneedtobeaddressed:accountingforthesizeofthecompany,
woulddividingEVAbytotalassetsbeabettercomparativefigurethanEPS?Whatwould
theresultsbeifweputEVAonapersharebasis?Infact,therecanbenouniversal,
comparativeindicatorbecausethecomplexityofstockmarketpriceincreasesdoesnot
warrantit;atdifferentintervals,pricesmaytracksales,dividends,earnings,capital
expenditures,andeventheholidayseason.Ourcontentioninthischapteristhatthe
adaptationsofEVAoffermoreinformationthaneitherearningsgrowthorP/E
calculations,andthattheycanbeusedtocomparecompaniesinentirelydifferent
industries.
APPLESANDORANGES:MICROSFTVERSUSCONOCOPHILLIPS
FewcompaniesareasdifferentasMicrosoftandConocoPhillips.Onecompanyspends
billionsofdollarscombingtheearthforaresourcethatliterallyfuelstheworld’s
productionlines-physically.Theotherspendsbillionstofuelthosesamelines
intellectually-producinga“virtual”symbolicvariantofthe“real”.Naturally,thetwo
companieshaveentirelydifferentcapitalstructuresinplace.ConocoPhillipsis
comparativelywellbalanced,generatingincomewithequalpartsofprofitmargin,asset
turnoverandequitymultiplier.Ontheotherhand,Microsoftdependsalmostentirelyon
profitmarginforitsnetincome.Itsshunningofdebtfinancinghasbeenlegendary.Both
ofthesestructuresarerepresentativeoftheirrespectiveindustries,characterizedby
differentamountsandvolatilityofcash-flow.Thefollowingtablesdisplaythecomparative
fundamentalsfortheyears2005and2006:
462

Table18-1

MICROSOFT
YEAR 2005 2006
Sales 39788 44252
OperatingIncome 15416 17375
Assets 70815 69597
NetIncome 12254 12599
Stockholders'Equity 48115 40104
CAPM%CostofEquity 11.15 10.11
Growth* 25.47%x0.7345=18.7 31.42%x.0.7345=23.07
SharesOutstanding 10710 10062
DividendsPaid* 36112 3345
*Microsoftpaidaspecialdividendin2005.Thegrowthrateofretentionmultipliedby
ROEisadjustedforthispayment.
Table18-2

CONOCOPHILLIPS
YEAR 2005 2006
Sales 183364 183650
OperatingIncome 28297 36704
Assets 106999 164781
NetIncome 13529 15550
Stockholders'Equity 52731 82646
CAPM%CostofEquity 6.82 8.25
Growth 22.55 16.06
SharesOutstanding 1416.65 1609.73
DividendsPaid 1639 2277

AsdetailedinthechaptersonCapitalDynamicsandAnalyticalTools,theEVAforboth
companiesisdeterminedasfollows:NetIncome-[(CAPM%CostofEquity)x(Equity)]=
EVA.
ConocoPhillips
2005:13529-3596=9933
2006:15550-6818=8732
463

Microsoft
2005:12254-5365=6889
2006:12599-4055=8544
COMMONGROUND
Whilewebelievethatthepercentagegaininthecapitaldynamic/EVAwillmirror
ashifttowardanoptimalcapitalstructure,weareunsureofthemagnitude.Forexample,
weneedtoaskourselvesthequestion,isatwentypercentgaininasmallEVAbetterthana
tenpercentgaininanEVAthatistwiceaslarge?ToputtheEVAsonacommonbasis,we
candividebybothassetvalueandthenumberofsharesoutstanding.
Table18-3

ASSETS CONOCOPHILLIPS MICROSOFT
2005 9933/106999=9.28% 6889/70815=9.73%
2006 8732/164781=5.30% 8544/69597=12.28%
Table18-4

PERSHARE CONOCOPHILLIPS MICROSOFT
2005 9933/1416.6=7.01 6889/10710=0.64
2006 8732/1609.7=5.42 8544/10062=0.85

Ultimately,wefaceasimilardilemmathatwehadwithearnings;weareunsure
howthemarketwillvaluethemeasurements.Microsoftisthesuperiorcompanybasedon
valueperdollarofassets,butConocoPhillipsisbyfarthebettercompanybasedonEVA
pershare.Thefundamentaldifferenceisderivedfromthequalityoftheirrespectiveassets
andthemethodbywhichtheyarefunded.Microsofthascomparativelylittletangibleasset
valuepersharebecauseitproducesitsincomefromintellectualpropertyandplacesa
premiumonmanagerialandprogrammingtalent.Ontheotherhand,ConocoPhillipshas
manytangibleassetsbecauseoilexplorationproducesaphysicalcommodityrequiringa
heavyinvestmentinmachinery.Theexaggeratedgrowthcycleintechnologyduringthe
464

1990srequiredMicrosofttoissuealargeamountofequityforwhichithasbeenpenalized;
theybuybackshareswithretainedearnings.Alternatively,ConocoPhillipshasabalanced
approachtowardfinancing,keepingsharestoaminimumandexpandingwithretained
earningsandsomelong-termdebt.Atonetime,theinvestorwouldchoosebetweenthe
moreriskygrowthofMicrosoftandthesteadydividendofPhillipsPetroleum.Afterthe
Conocomergerin2002,theriseofoilcompanieshaveprovidedbothrapidgrowthand
dependabledividendincome,whiletechnologystockshavemirroredthepeaksandtroughs
intheeconomy.
Thetwocompaniesfacepolarizedrisksaswell.ForConocoPhillips,therisksof
legislation,politicalturmoilandscarcityaffectthepotentialsupplyoftheirproduct.For
Microsoft,amarketgluttedwithinnovativesoftwarecanreduceeffectivedemand.To
illustratethisdichotomy,considerthefollowing:mostindividualswillneverseeanoilwell
intheirhometowns,butthelocaluniversityprobablyhasquiteafewindividualswhoare
capableofproducingacommercialsoftwareproduct.This“democratization”of
technologyhasafflictedboththepersonalcomputingandsoftwareindustrieswithover
production.Althoughthedemandforaqualityproductremainsstrong,competitionhas
producedenoughsubstitutes(Linux,OpenSourceCode)tounderminethepricingpower
ofmajorsoftwaredevelopers.
Additionally,thecapitalintensityratioismuchgreaterforMicrosoft,requiringa
higherpercentageoffixedassets.Althoughoilproductionisassociatedwithdrillingand
machinery,softwareproductionrequiresalevelofexpertiseandtechnologythatproduces
morefixedcosts.SinceMicrosoftcarriesnofinancialleverage,thebetaforitsstockis
affectedalmostentirelybyoperatingrisk.And-althoughitislowandstablein
comparisontomosthightechfirms,Microsoft’sbetaisabouttwiceaslargeas
ConocoPhillips’,andmoremarketdependentaswell.Infact,theuniquepositionofoilas
ascarceandvaluedcommodityhaschangedthedynamicsofthecostofequityformostoil
companies.Thecorrelationwiththemarket,the“Rsquared”componentoftheregression,
465

hassteadilydeclined,whilethenon-systematicriskelement,the“alpha”componenthas
risen.Ineffect,ConocoPhillips’stockhastakenona“lifeofitsown”.Itriseswithout
beingdependentonstockmarketvolatility,evenasitbecomesmoredependentonthe
commoditiesmarket.Moreover,anexaminationofeachfirm’sregressionlinesfor2005
and2006revealssomeofthetruthbehindtheircapitalstructures;whileahigherbetais
notsynonymouswithequityfinancing,moredebtraisesrisk,andwillpropelahighbeta
stockfurtherupward:
Table18-5

CONOCOPHILLIPS
YEAR ALPHA BETA RSQUARED REGRESSION
2005 0.657499 0.505491 0.1030512 Y=0.657+0.505
x
2006 0.343046 0.690769 0.0766277 Y=0.343+0.691
x

Table18-6

MICROSOFT
YEAR ALPHA BETA RSQUARED REGRESSION
2005 0.633924 1.373933 0.32198 Y=0.634+1.374
x
2006 -0.28049 1.112178 0.380048 Y=-0.28+1.112
x

WhilestockpricesmirrorEPSincreasesintheshort-run,itisthesizeandstability
ofearningsthatwillhelpmaintainthosegains.Theconsiderableadjustmentforthe
amountpershareandthenumberofsharesoutstandingmakesacomparisonbetweenthe
twofirmsanexerciseinprobability;givenasetofvariables(marketcap,beta,economic
outlooketc.)howwillanincreaseinEPStranslateintoanincreaseinmarketprice?The
greateramountofinformationusedinEVAcalculationseliminatessomerandom
466

variation,butthevalidityofpredictionisstillbasedonthedynamicsofthemarketplace.
Themarketdecideshowitwillvalueeachsecurity,pricingintheriskfromanarrayof
economicfactors.Ineffect,itplacesavalueonprospectivegrowth.Duringtherecovery
andexpansionphasesofabusinesscycle,somearbitrarystandardwillbeset:themarket
willdecidethatgrowthinsomeindustriesismoredesirableandsustainablethaninothers
basedonpatternsofdemandandthecostofcapital.
AlthoughthesurgeinConocoPhillips’stockmirrorstheperformanceofMicrosoft’s
adecadeago,theinvestorneedstolookpasttheimmediatedemandforoilaswellasthe
overproductioninsoftwareproducts.Microsoftisinfinitelymoreflexiblethan
ConocoPhillips.Liketheauto-makersinDetroit,oilcompaniesaretiedtotheproduction
process.Achange-overtoalternativefuelswouldrequireextensiverisk-takingand
investmentthatwouldnotimmediatelytranslateintoprofits.Ontheotherhand,Microsoft
caninvestinbothnewsoftwareandthephysicalworlditrepresents-innovative
applicationsmultiplythedemandforevenmoresoftware.Consider,forexample,theneed
fordiagnosticsoftwarethatiscontingentonthedemandforanewoperatingsystemor-
chartmakingsoftwarethatcantieintoanExcelspreadsheetThus,thefutureprospects
forthesefirmsmaynotbeanextensionoftheirpresenteconomicrealities.
Giventheexigenciesoftheirrespectiveindustries,eachfirmiswellmanagedand
mademovestooptimizetheircapitalstructures.Inthisregard,theanalystneedstousethe
EVA/capitaldynamicasasinglearbiter;withoutanyfinancialleverage,Microsoft’s
optimalstructurewilldependonthequalityofitsoperatingleverageandthemanagement
ofitsequity.Moreover,useofacomparativemarginalbenefitsfunctioniseliminatedfrom
theanalysisbecauseMicrosofttakesnotaxbenefits.Formyriadreasons,theirtarget
structurecontainszerodebt,butrequiresthemtorestricttheapplicationofretained
earningstoperiodswhenthecostofequityisrelativelylow.Sincethatconstraintis
tantamounttocapitalrationing,Microsoftmayfacemorevolatilityandadilemmanot
encounteredbycompanieswithfinancialleverage:itcandoallprojectswithapositivenet
467

presentvalue-evenduringperiodswhenthecostofequityishigh-andfacediminished
returns,oritcanrestrictprojectstoperiodswhenthecostofequityislow,andeffectively
“ration”capital.Ineitherscenario,Microsoftwillmoveawayfromitsoptimalcapital
structureandEVAwillbediminished.

AMARKETDISCONNECTANDEVENTUALRECONCILIATION
Table18-7

CONOCOPHILLIPS
YEAR 2005 2006 PERCENTAGE
GAIN
PRICE 116.36(split) 71.95 18.71
EVA 9933 8732 -12.09

Table18-8

MICROSOFT
YEAR 2005 2006 PERCENTAGE
GAIN
PRICE 24.18 22.98 -4.96
EVA 6889 8544 24.02

Adirectcomparisonbetweenbothcompanies’EVAsandstockpricesdisplaysa
marketreactionthatisdiametricallyopposedtocapitalstructuretheory.While
ConocoPhillips’EVAwentdownto8732from9933,a12.9percentdecrease,theirstock
wentupanothernineteenpercent.Inthemeantime,Microsoft’sEVAwentupabout
twenty-fourpercentto8544,buttheirfiscalyearstockpricedecreasedfrom$24.18to
$22.98,adeclineof4.96percent.Normally,EVAisaconcurrentindicatorofstockprice,
butinthesecases,twounusualscenarioswereencounteredthatcreatedadelay.Inthe
firstscenario,ConocoPhillipsboughtBurlingtonResources,increasingthesizeofthe
companybyalmosttwothirds;speculationabouttheacquisitioninaneconomic
468

environmentofrisingoilpriceswouldmomentarilytrumpEVA.Inthesecondscenario,
Microsoftgaveinvestorsaspecialdividendof$3.40ashare.Whennetincomeroseonly
2.8percentin2006,investorswereblindedtothefactthatMicrosoftwasdecreasingequity
andbuyingbackshares.The36billiondollarpay-outcompensatedforaslightlyreduced
sharepricein2005.However,in2006,thereaderwillnoticethatMicrosofteffectively
reduceditsbetato1.1from1.3.Thecombinedforceofalowercostofequitypercentage,
coupledwiththealreadyreducedstockholdersequityproducedahigherEVA.
Additionally,the”expected”rateofreturnfromretentionandROEroseto23.07percent
froma2005figureof18.7percent(modifiedforaspecialdividend).Whencomparedto
thelower“required”rateofreturnderivedfromtheCAPM,Microsoftseemedlikeagreat
bargain;anytimegrowthrisesatthesametimethattheCAPMpercentagedeclines,
upwardpressureisplacedonthestock.Andyet-fiscalyear2006closedwithaslight
decrease.Theanswertothisconundrumisthatanalystswhoonlyfollowedearningswere
unimpressedbythepaltryincreaseinnetincome.Nevertheless,thestockbeganclimbing
inadelayedreactionthatisaprimeillustrationofastockthatisoutofequilibriumwith
themarket.Themovementtoamoreoptimalcapitalstructurewascoupledwithbetter
earningsprospectswiththereleaseofthenew“Vista”operatingsystem;thestocksoared,
andgainednearlyfiftypercentbeforethemarketpeakedin2007.
AsevidencedinthepreviouschapteronConocoPhillips,thelargeequityissuethat
helpedpayforBurlingtonResourcesdiminishedEVA.Fromacapitaldynamic
perspective,toomuchequityattoohighapriceproducedmovementawayfromanoptimal
capitalstructure.However,by2007,ConocoPhillipswasalreadybuyingbackshares.The
nineteenpercentstocksurgethatoccurredinspiteofthedeclineinEVAwasatriple-play
combinationofmomentum,speculation,andlow-riskleverage;therewassimplynobetter
placeforinvestorstobethan“BigOil”mid-waythroughthedecade.
Thecomparisonbetweenthetwofirmsillustratesthreeimportantprinciples:
469

• 1.AlthoughEVAismostlyanindicatorthatisconcurrentwithstockprices,anEVA
thatrisesonthebasisofalowercostofequitymaybeapreludetoariseinthestock
sincepricesmoreimmediatelyrespondtoearnings.
• 2.Wellmanaged,“trusted”companieslikeConocoPhillipscantemporarilymoveaway
fromtheiroptimaltargetstructuresandmakeupthedeficitwiththe”“promise”of
prospectiveearnings.Thenineteenpercentpricegainmadein2006wasnotnearlyas
largeasthethirty-ninepercentgainin2005,butstillbeatthemarketbyawidemargin.
• 3.LikeEPS,theEVA/capitaldynamicmustbeassignedariskpremiumbythemarket;
anygainsmustbecomparedtotheindustryoutlookandtheperformanceofafirm’s
peers.
INDUSTRYCOMPETITION:CHEVRONANDTHECOMPARATIVECAPITAL
DYNAMIC(CCD)
Excludingfirmsinthefinancialsector(insurance,banks,brokeragesetc.)thatare
capitalizeddifferentlyfrommanufacturingandservicecompanies,wecanexamine
differentfirmsindifferentindustriesusingthecomparativecapitaldynamic(CCD).
UnlikeEVA,theCCDisameasureofmagnitude;itisaratiothatmeasuresrelativesize,
ratherthanabsolutesize.Wemerelydividenetincomebythetotalcostofequity(Net
Income/TotalCostofEquity);implicitintheterm“total”istheproductoftheCAPM
percentageandstockholders’equity.
Asariskbasedindicator,theCCDispotentiallymoreusefulthanP/Ebecauseit
encompassesmoreinformation.Bybringingintheconceptofan“opportunitycost”inthe
formofthepercentagecostofequity,itcomparesamarketbenchmarktothefundamental
earningpowerofthecompany.UnlikeP/Ewhichisvulnerabletospeculativeexcess,the
CCDisgroundedinthemechanicsofcapitalstructure.SimilartotheP/E,however,the
CCDcanbeusedtocomparecompaniesbetweenindustriesandwithinsectors.For
example,ifourcurrentresearchshowsonlyahandfulofcompanyhaveaCCDover3.5,
thenwewouldperceivethatafirm’sriskincreasesatthatpoint.Ineffect,thefirmwould
470

“retrench”beforebuildingahigherEVAagain.AnotheranalogytoP/Emechanics,are
thedynamicsofanincrease.AhigherEVAcoupledwithalowerCCDsignifiesadifferent
relationshipthanifbothincreasetogether.Justaslowerearningsorahigherprice
increasesP/E,theCCDcanbeincreasedwithalowercostofequity,ahighernetincome,
orsomecombinationofboth.ThefollowingdataforChevronwillhelpillustratethemany
usesoftheCCD.
Table18-9

CHEVRON
YEAR 2005 2006
Sales 198200 210118
OperatingIncome 25679 32427
Assets 125833 132628
NetIncome 14099 17138
Stockholders'Equity 62676 68935
CAPM% 7.11 8.41
Growth% 16.31 18.4
SharesOutstanding 2155.81 2197.17
DividendsPaid 3876 4456

Table18-10

CHEVRON
YEAR 2005 2006 PERCENTAGE
CHANGE
STOCKPRICE 56.77 73.53 29.52
EVA 9643 11341 17.6

471

Table18-11

CHEVRON
YEAR ALPHA BETA RSQUARED REGRESSION
2005 0.980456 0.563904 0.17575 Y=0.98+0.564
x
2006 1.050042 0.721824 0.213414 Y=1.05+0.722
x

Chevronisawellknown,equallysizedcompetitortoConocoPhillips.Itfollowed
the“sectorimperative”,paringdownlong-termdebttocapitalandexpandingwith
retainedearningsbeforeithadatwenty-ninepercentgaininthestockin2006.Like
ConocoPhillips,therunupinstockpricehadbeensorapid,thatitsplititsstock-in2004.
IncontrasttoConocoPhillips,itexpandeditsEVAin2006to11341.The“expected”rate
ofreturn,surpassedthe“required”rateofreturn,derivedfromtheCAPM,by
approximatelyninepercent,whichimpliedthatthestockhadupwardpressureonit.
AlthoughChevronhadahigher“alpha”intheirregressionthandidConocoPhillips,they
werealsomoremarketdependentwithahigherRsquared.Howeverbothoilcompanies
hadacomparablebetawhichwouldbeexpectedforfirmswithsimilarcapitalstructuresin
thesameindustry.TheEVAdelineated“riskpremium”,thenaturalcorrelationofstock
pricetofundamental,wasnothigh.WhileChevronpushedtheirEVAupapproximately
seventeenpercent,theirstockroseonlyslightlyaboveConocoPhillips’,whohadactually
decreasedEVA.Again,theimperativewastobegrowingwithinthesector;ConocoPhillips
wasperceivedbyinvestorsasacompanywhowasrapidlyimprovingmarketshare-inthe
“right”market.
Thecomparativecapitaldynamicswereverysimilarforbothoilcompanies.Each
rosefromaround“2”toover“3”andthenbackagain.LikeP/E,theCCDseemstostay
withinparticularboundariesforeachmarket.Ifthemarketisrapidlydeteriorating,the
CCDshoulddeclineaswell:.Netincomewoulddecrease,andthetotalcostofequitywould
472

beoverlyhigh-notonlybecausetheCAPMpercentageincreased,butbecausethe
formerlyhighnetincomeattractedmoreinterestinequityissues.Inthefollowingdata,a
sidebysidecomparisonismadewithMicrosoftincluded.Noticehowthemarketseemedto
rewardeachcompanyforreachinga“3”inCCD.
Table18-12

CHEVRON
YEAR NetIncome TotalCST.
Eqty
EVA %Change
EVA
CCD
2005 14099 4456 9643 3.16
2006 17138 5797 11341 17.6 2.956

Table18-13

MICROSOFT
YEAR NetIncome TotalCST.
Eqty.
EVA %Change
EVA
CCD
2005 12254 5365 6889 2.28
2006 12599 4055 8544 24.02 3.107

Table18-14

CONOCO-
PHILLIPS NetIncome TotalCST.
Eqty.
EVA %Change
EVA
CCD
2005 13529 3596 9933 3.76
2006 15550 6818 8732 -12.09 2.28

BymaintainingarelativelyhighCCDofnearlythree,ChevronincreasedEVAandstock
pricesimultaneously.Aspreviouslymentioned,Microsoftencounteredadelayedreaction
whentheysurpassed“3”,notseeingasubsequentriseinthestockuntilthefiscalyearwas
overandthefinaltotalsweretallied.AndwhenConocoPhillipshadaCCDof3.76in2005,
theyhadtheirbestyeareverwithathirty-ninepercentgaininpriceaswellasastocksplit.
473

Inthesomewhatobscureterritoryoccupiedbyfinancialindicators,theCCDstakes
outapositionbetweenP/EandROE.Itisrelativetobothfundamentalsandthemarket,
butitneedstobegaugedbybothitsownperformanceandcommonstandardsforthe
industry.Arestaurantchain,forexample,willhaveadifferentoptimalCCDthanasteel
company.AnindustrywithahistoricallysmallROEwillhaveamuchlowerCCDthan
high-ROEindustrieslikesoftware.Theemphasiswouldagainbeontherisk/return
differenceofmean-variance,maintainingthehighestpossibleCCDwiththelowest
standarddeviation.Anycomparisonbetweenfirmsinanindustryshouldrevealthatthe
competitorwiththehighestCCDisoptimizingcapitalstructurebetterthanothers,and
maximizingthepriceofthestock.
PERCENTAGEOFNEWRETAINEDEARNINGS
IfthecomparativecapitaldynamicisdecliningandEVAisincreasing,therateof
growthofthecostofequitysurpassesthatofearnings.Thatscenarioisanalogoustoafirm
thatmaintainsitsstockpricedespitelowerearnings;theeffectiveresultisahigherP/Eand
morerisk.Whenwedecomposestockholders’equityintoitsconstituentparts,wewillfind
oldretainedearnings,recentretainedearnings,oldpaidincapital,recentstockissuesand
preferredstock.Eitherweeliminatepreferredstockaltogetherandusetheaggregate
figureforcommonequity,orweintegratepreferredstockintoourcalculationbyweighting
itwithitspercentageandcost.Thelatterapproachismoreconservativeandexacting,and
emphasizestheweightedcostapproachtothecostofequity.Infact,itwetreatequitylike
theweightedaveragecostofcapital(WACC),wecanusethepercentchangeinnew
retainedearningsasanindicatorofpotentialperformance.Notonlywillmoreretained
earningsimplythatnetincomehasincreased,buttheycanpotentiallypropelthefirminto
aleveragestateinwhichriskisrapidlyreducedbyloweringbeta.Thus,itwouldbe
helpfultocalculatenewretainedearningsasapercentageofthetotalcostofcapital.In
thisillustration,weassumethatpreferredstockiszero.
474

Thecalculationis((1-(Dividendspaid/NetIncome))x(NetIncome))x(Percentage
CostofEquity)/TotalCostofEquitywhichwillsimplifyintoNewRetainedEarnings/
Stockholder’Equity.Therationalebehindviewingnewretainedearningsinapositive
lightisthattheyareimplicitinnetincomeandwillnotdecreasethatsideofthefunction.
Thus,forexample,ifnewretainedearningsweresubstitutedforastockissue,therewould
beanetgaininEVA,becausenetincomewouldincrease,andthenonlyapercentageof
retainedearningswouldbesubtracted.Paidincapital(astockissue)wouldnotincrease
netincomeandwouldfullydetractfromEVA.
ThefollowingexamplewillemphasizethecorrelationwithEVA.Inthechapteron
Kimberly-Clark,wesawthatmoreretainedearningscandetractfromEVAwhenthecost
ofequitypercentageishigh(suchasattheendofabusinesscycle).However,eveninthat
extremecase,thedecreaseinEVAcanbeconsideredthe“leastharmfulpossible”because
capitalisineffectbeingraisedwithoutanyaccountingcosts.Alternativesourceslike
equityissuesordebtwouldbeevenmorecostly-ineitherinterestpaymentsorflotation
costsanddilution.
Table18-15

CONOCOPHILLIPS
YEAR 2005 2006
DividendsPaid 1639 2277
NetIncome 13529 15550
RetainedEarnings 11890 13273
Stockholders'Equity 52731 82646
RetainedEarnings/
Equity
22.55% 16.06%
CCD 3.76 2.28
EVA 9933 8732

(BacktoTableofContents)
475

SECTIONIV:CORRELATIONANDPROBABILITYSTUDIES
19
OPERATINGINCOMECORRELATIONSTUDIES
Operatingincomeisthelinchpinofcapitalstructure.Aswesawinourobservations
ofFed-ExandStaples,ithasbothriskandreturncomponentsthatsometimesoffseteach
other.Ouranalysiswasfullofcountervailingbalances,andwecametotheconclusionthat
theincomestreamfromFed-ExwasmoredesirablethanthatfromStaples-althoughit
entailedmorerisk.Thevalidityoftheargumentwasbasedonthesizeofthereturn,but
alsoonanimportantqualitativefactor-Fed-ExhadpricingpowerthatStapleslacked.
Rarelyshouldriskanalysisbepursuedinisolation.Operatingincomeinterfaces
withsales,thedemandvariable,butitalsoaffectscapitalstructurebydeterminingthe
source,thecostandthetypeoffunding.Infact,operatingincomeissocrucialtocapital
budgeting,thatratingsagencieslikeStandardandPoor’sandMoody’suseitasaprime
componenttodeterminecreditratings:
(NEXTPAGETABLE)

476

Table19-1

RATIO(Percentages
whereAppropriate)
AAA BB
PretaxInterestCoverage 16.66 1.59
PretaxFixedCharge
Coverage
6.39 1.33
FundsFlowInterest
Coverage
22.98 2.75
Fundsfrom
Operations/TotalDebt
134.7 17.9
FreeOperatingCash
Flow/TotalDebt
49.2 0.9
PretaxReturnonTotal
Capital
24.2 9.1
OperatingIncometoSales 22.5 10.6
long-termDebt/Capital 11.7 51.1
TotalDebt/Capital 23.2 56.3
Therefore,ifCompanyXwantstofloatabondissueandreceivean“investment
quality”ratingofAAAinthegivenyear,theywouldneedtocoverinterestbyanaverage
of16.66timesintheprecedingthreeyears.Notethatsixofthesetopninekeyratios
containsomeadaptationofoperatingincomeasamaincomponent.
Thefollowingstudyisapragmaticexplorationoftherelationshipbetween
operatingincomeincreasesandlong-termdebt.Originallyculledtogetherasone
investor’sattempttocapitalizeonabullmarket,whatitlacksinscientificlegitimacy,it
makesupintimelyeffectiveness.However,thestudentshouldbeawareofmethodologies
bywhichthestudycouldhavebeenimproved.Attheendofthechaptersomekey
statisticalconceptswillbediscussedtobothcriticizethisstudyandproposealternative
hypotheses.
NAME:ComparisonEffectsofChangesinOperatingIncomeandLong-termDebton
NextYear’sMid-rangeStockPrices
PREMISES:1:Inaneconomicenvironmentofbothrisingmarketsandrisinginterest
rates,equitybecomesproportionallylessexpensivethandebt.2:Asoperatingincome
477

rises,companiescanuselessdebtandmoreretainedearningstolowerthecostofcapital.
3:Acombinationofhigheroperatingincomeandlessuseofdebtencouragesafirmto
maximizeitsstockprice.
DATAPOINTSANDSTRUCTURE
TwentyfourcompanieswerepickedfromtheS&P500atrandom,butany
duplicateindustriesweredeleted.Bothfinancialinstitutionsandutilitieswereleftoutof
thestudy,becausetheirrespectivecapitalstructuresareuniqueandnotrepresentative,i.e.,
themeasuredoperatingandfinancialriskswouldskewanymeaningfulresult.Sevento
eightyearsoffundamentalincreasesweretabulatedforeachcompany,creatingone
hundredandeighty-twoseparatedatapoints.Whilethestudywasconductedduringa
periodofrelativeeconomicprosperity(1990-1999),nomacro-variablessuchasinterest
ratechangesorriskpremiumspreadswereincluded
Uniquetothestudywasthemeasurementofchangesinstockprice.Thesubsequent
year’smid-rangepricewascomparedtoseveralfundamentalvariablesthathadbeen
segmentedaccordingtowhetheryeartoyearoperatingincomewasincreasingor
decreasing.Mid-rangepriceismerelytheaveragebetweenthehighandlowpriceforthat
yearwithoutregardfortiming.Consequently,itmeasuresvolatilityasmuchasit
measuresperformance,butalsocapturesanyinherenttrendwhenusedcollectively.
Companiesthathadnochangeinthelong-termdebttocapitalratioorhadnolong-
termdebtatallwerecountedasdatapointsthatdecreasedlong-termdebttocapital.
Althoughthese“all-equity”datapointsmightskewresults,itwaslaterdeterminedthat
theywereactuallyantagonistictotheresearcher’spremise,loweringtheoverallprice
effectsintheirrespectivecategories.Inasimilarmanner,ifoperatingincomedidnot
changeatall,itwascountedasadecrease.
CATEGORIES
Datapointswereseparatedintosixdistinctpopulations,basedonincreasesand
decreasesinbothoperatingincomeandlong-termdebttocapital,hereuntoreferredtoas
478

“LTD/CAP”.Thepopulationswereidentifiedas:1)Operatingincomeincreases2)
Operatingincomeincreases,LTD/CAPincreases3)Operatingincomeincreases,
LTD/CAPdecreases4)Operatingincomedecreases5)Operatingincomedecreases,
LTD/CAPdecreases6)Operatingincomedecreases,LTD/CAPincreases.
Eachpopulationwasanalyzedintermsofdescriptivestatisticstoenable
comparisonsbetweenpopulationgroupsandSpearmanrankcorrelationsthatextracted
relationshipswithineachgroup.Sincethesamplesizewaslimited,mediansratherthan
meanswereusedtoidentifyaverageswithinthepopulation,andstandarddeviationsof
eachfundamentalwerecalculatedtoprovideascopeoftheskewofthedistribution.The
Spearmanrankcorrelationsareassociationsmadebyregressingtherankedorderofthe
dataagainsteachother.Dataissimplyrankedfromlowesttohighestandastandard
linearregressionisperformedontheranks;thisordinalmethodwillproduceassociations
thatarecurvilinearandrevealrelationshipsthatmightnotbeapparentinnormalleast
squares-typeregressions.However,theprobabilityassociatedwitheachcorrelationmust
bereadas“proofofthenullhypothesis”thatnoassociationexists;thatis-thelowerthe
probability,themorevalidtheassociation.Allvalueswithaninety-fivepercent
significancearereported,butthereadermustrecognizethatthestudyisinvalidatedby
smallsamplesizeandismeanttoidentifytrends,notabsolutes.Analogoustolinear
regression,thecorrelationvalueisscaledfrom-1to1withgreaterassociationrepresented
attheextremes.

479

COMPANIESINTHESAMPLE
Table19-2

EnescoGroup(ENC) CeridianCorp.(CEN) BCE,Inc.(BCE)
ClaytonHomes(CMH) TenetHealthcare(THC) McKessonHBOC(MBK)
CompaqComputer(CPQ) McGraw-Hill(MHP) Halliburton(HAL)
Diebold,Inc.(DBD) PhelpsDodgeCorp.(PD) HomeDepot(HD)
EmersonElectricEMR) AdvancedMicroDev.
(AMD)
BlackandDecker(BDK)
H&RBlock(HRB) CVSCorp.(CVS) HiltonHotels(HLT)
PharmaciaCorp(PHA) NucorCorp.(NUE) GeneralElectric(GE)
ElectronicDataSys.
(EDS)
CendantCorp.(CD) CharlesSchwab(SCH)

FUNDAMENTALVARIABLES
VariablesderivedfromfinancialstatementsincludefivevariablesthatencompassDuPont
-typeanalysisthatwouldgivesomeindicationofeffectsofthereturnonequityorROE.
Theseareyearlyincreases/decreasesinoperatingincome,sales,profitmargin,thecapital
multiplier(assets/capital),andassetturnover.Sevenvariablesthataffectthecostofcapital
arealsoincluded.Theseare:yearlychangesinassets,capital(thesumofequityandlong-
termdebt),totaldebt,long-termdebttocapital(LTD/CAP),long-termdebt(LTD),the
financialleverageratio(EBIT/EBIT-Interest)andtheinterestrateontotaldebt(interest
expense/totaldebt).Eachvariableisanincreaseoradecrease,andwasregressedagainst
themid-rangestockpricechangeofthenextyeartoobserveanydiscernibleeffects.Other
variablesincludedinthestudyareyearlychangesin:cash,capitalexpenditures,operating
momentum,EPS,andthenumberofsharesoutstanding.Descriptivestatisticsareincluded
fortheDuPont-typeROEvariablesaswellasforthecostofcapitalvariableswiththe
exceptionoftheinterestrateontotaldebtwhichisdeemedbeyondafirm’sdirectcontrol.
Eachvariablewasregressedagainstthechangeinnextyear’smid-rangestockpriceand
reportedifaprobabilityunder.05(95%confidence)wasencountered.Allyearlychanges
arereportedonapercentagebasis.Ifapercentagechangewasjudgedtobeoverlyskewed
480

(suchasachangeinvolvinga10,000percentdecrease),itwaseliminatedatthediscretion
oftheresearcher.
ALLVARIABLES
Table19-3

NextMid-rangeStock
Price
InterestRate(onTotal
debt)
CapitalMultiplier
(Assets/Capital)
OperatingIncome TotalDebt TotalCost(Sales-OpInc.)
Sales AssetTurnover OperatingMomentum
OutstandingShares ProfitMargin Long-termDebt
InterestExpense CapitalExpenditures Long-termDebt/Total
Debt
Assets Cash TotalLeverage
Capital LTD/CAP TotalLeverage-absolute
EPS FinancialLeverageRatio OperatingMomentum-
Abs

Thelastratiosareconcrete,absolutemeasurementsthatindicateascalarnumberrather
thanachange.Thesewereincludedtoobservewhetherthesizeoftheseratiosaffected
stockprice.Theterm“leverage”in“totalleverage”isderivedfrommultiplyingthe
financialleverageratiobyoperatingmomentumandnotindicativeof“true”operating
leverage,whichisnotmeasured.

481

STATISTICALRESULTS(PercentageIncreases)
INCREASINGOPERATINGINCOME
Table19-4

Variable Median StandardDeviation
Sales 15.58 25.84
OperatingIncome 21.15 67.6
ProfitMargin 3.67 254.05
CapitalMultiplier -0.0268 20.98
AssetTurnover 1.7 20.11
Mid-rangePrice 16.6277 30.66
Assets 14.25 46.85
Capital 13.64 70.58
LTD/CAP -7.09 740.05
LTD -0.0359 2268.56
TotalDebt 16.5 40.11
FinancialLeverageRatio 0.8413 8.34

INCREASINGOPERATINGINCOME,INCREASINGLTD/CAP
Table19-5

Variable Median StandardDeviation
Sales 14.39 25.59
OperatingIncome 17.83 51.38
ProfitMargin -2.83 215.48
CapitalMultiplier -1.73 29.7
AssetTurnover -0.57 24.32
Mid-rangePrice 8.56 22.28
Assets 16.22 75.41
Capital 20.06 110.26
LTD/CAP 39.2 1296.78
LTD 69.39 4034.9
TotalDebt 17.033 47.6
FinancialLeverageRatio -0.1613 7.09

482

INCREASINGOPERATINGINCOME,DECREASINGLTD/CAP
Table19-6

Variable Median StandardDeviation
Sales 16.1 25.99
OperatingIncome 22.49 73.93
ProfitMargin 4.46 267.57
CapitalMultiplier 1.16 15.82
AssetTurnover 2.83 17.44
Mid-rangePrice 21.28 32.62
Assets 13.63 24.92
Capital 12.06 42.46
LTD/CAP -17.17 26.66
LTD -4.14 34.1
TotalDebt 16.5 36.52
FinancialLeverageRatio -1.38 8.72

DECREASINGOPERATINGINCOME
Table19-7

Variable Median StandardDeviation
Sales -2.58 17.51
OperatingIncome -11.6 20.8
ProfitMargin -22.45 173.25
CapitalMultiplier -1.44 32.5
AssetTurnover -7.68 15.8
Mid-rangePrice 5.47 29.21
Assets 1.34 20.97
Capital 2.96 25.34
LTD/CAP 0 47.99
LTD -1.43 66.29
TotalDebt 1.71 30.87
FinancialLeverageRatio 0.0992 13.8

483

DECREASINGOPERATINGINCOME,INCREASINGLTD/CAP
Table19-8

Variable Median StandardDeviation
Sales -5.23 19.32
OperatingIncome -14.67 22.53
ProfitMargin -14.37 239.12
CapitalMultiplier -1.097 47.51
AssetTurnover -8.5 17.85
Mid-rangePrice 7.82 35.53
Assets 3.09 26.8
Capital 6.35 34.69
LTD/CAP 55.17 131.68
LTD 29.18 80.43
TotalDebt 5.07 32.32
FinancialLeverageRatio 1.75 16.3

DECREASINGOPERATINGINCOME,DECREASINGLTD/CAP
Table19-9

Variable Median StandardDeviation
Sales 0.0192 16.27
OperatingIncome -11 19.87
ProfitMargin -29.78 113.53
CapitalMultiplier -1.52 14.24
AssetTurnover -2.35 14.48
Mid-rangePrice 2.78 24.41
Assets 1.31 16.38
Capital 2.55 16.76
LTD/CAP -8.02 25.78
LTD -7.37 27.82
TotalDebt 1.61 30.12
FinancialLeverageRatio 0 11.05

484

SPEARMANRANKCORRELATIONS:NEXTYEAR’SMID-RANGEPRICE

INCREASINGOPERATINGINCOME(N=130)
Table19-10

Variable Correlation Probability
Assets 0.172891 0.049177
LTD/CAP -0.238255 0.006339
FinancialLeverageRatio -0.211257 0.015833
LTD/TotalDebt -0.187093 0.033053

INCREASINGOPERATINGINCOME,INCREASINGLTD/CAP(N=40)
NOSIGNIFICANTCORRELATIONS

INCREASINGOPERATINGINCOME,DECREASINGLTD/CAP(N=90)
Table19-11

Variable Correlation Probability
Assets 0.282562 0.006968
Capital 0.261687 0.012722
FinancialLeverageRatio -0.242514 0.021278

DECREASINGOPERATINGINCOME(N=52)
Table19-12

Variable Correlation Probability
InterestRateonTotal
Debt
-0.351063 0.010717
OperatingMomentum
(Abs.)
0.340562 0.013494
TotalLeverage(Abs.) 0.338513 0.014102
485

DECREASINGOPERATINGINCOME,INCREASINGLTD/CAP(N=21)
Table19-13

Variable Correlation Probability
InterestRateonTotal
debt
-0.484416 0.026056
OperatingMomentum
(Abs)
0.57013 0.006966
TotalLeverage(Abs) 0.554545 0.009083
OperatingMomentum% 0.616883 0.002895
TotalLeverage% 0.631169 0.002153

DECREASINGOPERATINGINCOME,DECREASINGLTD/CAP(N=31)
NOSIGNIFICANTCORRELATIONS

INTERPRETATION
Thereareseveralcaveatstoobserveinthisstudy.Itisnottheintentionofthe
researcherto“implicate”long-termdebtasthemainculpritinprofitabilityloss.Debt
issuesarenotdestructiveinandofthemselvesunlesstheyarebeingsubstitutedforless
costlysourcesofcapital.Sincecorrelationshowsassociationandnotcausation,itis
importanttolookforundocumentedvariables(likerisinginterestrates)thatoccuroutside
thedomainofthestudy.Probabilityandeconomicsmakestrangebedfellowsifonly
becauseoftheexistenceofsomanyothervariablesthatcanrefuteahypothesis.For
example,manydebtissuesgotofundlargeacquisitionsthatmustbeintegratedintothe
corporatestructureinsubsequentyears.Ifsuchintegrationprovesrisky,slow,and
ultimatelyunprofitable,thetypeoffundingcannotbeheldliable;foresightwaslackingon
thepartofmanagement.Ifthissituationoccursregularly,isitthefaultoflong-termdebt,
ordoesitstemfromthesizeofthecapitaloutlayprecludingtheuseofequity?Attimes,a
largeissueofstockcandodamagetosharepricemerelyonthebasisofsupplyand
demand,andretainedearningswouldnotusuallybelargeenoughtocoverthedeficit.
486

Moreover,ourstatisticscanbemisleadingbecausetheyoccurredduringaperiodofrising
interestratesandrelativeprosperitywhichwouldhavecreatedapropensityforequity-
typefinancing.Inthehighlyinflatedmarketofthe1990s,companieswouldhavedesired
toexercisestockoptionsandissuenewequitybecausetheycouldhavedonesowithout
payingthepenaltyfordilutingtheshares;manysuchissuesrose“automatically”.Thus,
ourpremisesarelargelyunprovedandourresultsareinconclusive,althoughthestudy
raisedmanyquestionsandpointedusinthe“rightdirection”.
Thedataitselfdisplaysaclassicargumentforminimizingthecostofcapital.The
increasingoperatingincome,decreasingLTD/CAPcategoryinparticularexhibitedamid-
rangestockpricedifferenceofasmuchaseighteenpercent.Additionally,theDuPont-type
fundamentalsthatcompriseROEaremuchhigherforthatcategory.Whileweareunable
todrawfirmconclusionsfromthedata,wecanuseseveralknownpropositionstosupport
it:
• Long-termdebtobligatesacompanytopayinginterestexpense.
• PayinglowerinterestexpenseautomaticallyraisesEPS,allothervariables
beingequal
• Raisingtheproportionoflong-termdebttoequitywillincreasethecostofthat
sameequity
• Inanormalmarket,long-termdebtwillbemoreexpensivethanshort-term
debtbecauseinvestorsneedtobecompensatedfortheinflationriskofalonger
maturity.
• Moreoperatingincomeandlessinterestexpensecanleadacompanytodo
moreequityfinancingthroughretainedearnings.
• Greateroperatingincomehasthepotentialtobedistributedasahigher
dividend,compensatingshareholdersandraisingthestockprice.
• Operatingincomeincreasescanleadto“momentum”,whichisanacceleration
ofearningsafteraninitialincrease.
487

Statedasfact,thelastpropositionisquestionable.TheresearcherJosephMurphy,
whostudiedthreehundredandforty-fourcompaniesintwelvedifferentindustriesfound
nodiscerniblecorrelationbetweenyeartoyearearningsdata.Ontheotherhand,Manown
KisorandVanMessnerfoundapatternthattheytermed“increasedmomentuminrelative
earnings”whichiscomposedofanacceleratedrateofchangeofearningsincomparisonto
theperformanceoftheentiremarket.FurthersubstantiatedbybothRobertLevyand
RobertHagin,thisphenomenonisespeciallyapparentduringrisingmarkets.Itmerely
encompassesasixmonthincreaseinearningsonceearningsacceleratesfasterthanthe
marketintheprevioussixmonths-anditisessentiallyprobabilistic,notdeterministicIn
thisstudy,anautocorrelationofoneyear’searningsregressedagainstanotheryear’s
provednocorrelationbetweenthetwosetsofdata.
Besidesrejectingthenullhypothesisfortheincreasingoperatingincome,decreasing
LTD/CAPdata,afewothercomparisonswerepotentiallysignificant.Ifonecomparesthe
datasetsofpureoperatingincomeincreasestopureoperatingincomedecreases,onewill
findalargedifferenceinthereturnonequityfactorslikesalesandprofitmarginaswellas
substantiallydifferentcapitaloutlays;13.64%vs.2.96%.Observingthelong-termdebt
increaseinbothdatasetsrevealsthatthereislittlesignificantdifference;bothdecreased
long-termdebtbyaboutonepercent.Evidently,morelong-termdebtdoesnotdrivethe
decreaseinoperatingincomeortheconsequentROEfactors,butmayriseproportionally
becausetherearelessretainedearningstobufferitinthecapitalstructure.Anydecrease
inearningsisderivedfromaninefficientuseofcapital,andactualizedbyacombinationof
lesssalesandhigherproductioncosts.Itseemsthatwhileloweringcapitalcostswill
furtherenhanceanalreadyprofitablecompany,itwillnotpropeladistressedcompany
into“theblack”.
Withfurtherdataseparation,wefindthatcompanieswhoincreasedbothoperating
incomeandLTD/CAPhadadequatesales,earnings,andcapital,butperformedlesswell
thancompanieswhoincreasedoperatingincomeanddecreasedLTD/CAP.Onefinds
488

similarincreasesinassets,andyettheROEfactorsfortheincreasedLTD/CAPset
significantlyunderperform.Ifmorelong-termdebtdoesnot“drain”acompanyofprofit,
thensomeotherfactormustbeworkingtolimitperformance.Thedatadoesnotrevealthe
peculiaritiesofacquisitions.SinceS&P500companiesneedsubstantialcapitaltogrow,
retainedearningsandcashproveaninadequatesourceoffundswhenpurchasesare
literallyinthebillionsofdollars.Suchlargepurchasesarenormallymadewith
combinationsofequityexchangesandbondissues,alongwithcash.Acquisitionsoftarget
companiesneedtimetobeintegratedintotheacquiringfirm’sassetstructurewhichputsa
strainonexistingresourcesandmayleadtosomeunderperformance.The“synergistic”
effectsofanacquisitionarenotautomatic.Infact,itistypicalthatspeculativecashgoes
intoanacquiringfirm’sstockifthepurchaseisconsidereda“smart”move,onlytobe
removedinthenextyearbecausethecapitalturnoverwasnotrapidenough.Therefore,
thequalityofassetsmustbeexamined.Alargeamountofcashonthebalancesheetisfar
differentfromtheintegrationofacompetitorintoone’sassetstructure.Sincethisstudy
waslimitedtonumericaldifferencesandnotqualitativeones,wecanonlyspeculateonthe
natureofthereasonbehindthem.
METHODOLOGICALCRITICISM
Althoughastudyofthismagnitudecanposevaluablequestionsandgive
researchersleadsthatmayyieldsomeanswers,itlacksstatisticalvaliditybecauseitfailsto
proveordisproveapremise.Unfortunately,financialdataisheavilyskewedasevidenced
bythelargestandarddeviationsinthedescriptivestatisticssection.Suchdistributions
requireamuchlargersamplesizeandamuchnarrowerfocus-suchasonlyonesegment
ofoneindustry-tobevalid.Whileseparatingthepopulationintouniquecategorieshelpsto
accentuatethedifferences,thesamplecomprisedonlylargewell-knowncompaniesleaving
outsmallcapsandprivatebusinesses.Howdoweknowwhetherdifferenceswereobtained
onthebasisofsizeorcapitalization?Researcherscompensateforthisbiasbysettingupa
“control”groupandcomparingthepopulations-andyetthattoomayleadtodifficulties
489

becausecompaniesmayprovetobedissimilar.Unlike“twin”studiesinthebiological
sciences,fewfactorsarecontrollableintheeconomicenvironment.
Characteristicsofmeasurementwerealsoproblematic.Sinceseventoeightyearsof
dataareextractedfromeachcompany,thedatamaybeseriallycorrelated:Acompany
mayhaveastrategyoveraperiodoftimethatskewsthedatainonedirection.For
example,ifonesellshomesatthebeginningofanexpansion,thatsectormaybeprofitable
forseveralyearsinarow,biasingsalesandincomeinanupwardsdirection.Tomakesure
themeasurementsarenotbiased,itwouldbebettertohaveasmanycompaniesaswehave
datapointsinthesample.Analogously,theperiodinwhichthesampleislocatedmaybias
thestudy.Anyrecommendationsshouldbederivedfromafewbusinesscycleswhichmay
haveaprofoundeffectontheresults-especiallywhentheycompriseincomeanddebt.
Lastly,percentagechangesareinferiortologarithmicchangesbecausethebaseofthe
percentagewillchangeandskewtheresults.Forexample,anickelchangeonanEPSof
tencentsisafiftypercentimprovement,whichisthesamemeasurementasanEPSthat
goesfromfourdollarstosixdollars.TheSpearmanrankcorrelationswouldhavefurther
emphasizedthisanomalybecausetheyareordinalbasedmeasuresofmagnitudewithno
referencetoastablebase.
Inthepursuitofmoreinformation,bothstudentsandinvestorsshouldbe
encouragedtoexperiment.Whilestatisticallyvalidstudiessometimeshavetoonarrowa
focustobeofinteresttothelayperson,farreaching,buttechnicallyincorrectstudiescan
proposehypothesesthatmayhavelaterlegitimacy.Althoughitisnotourobjectiveto
defend“badstatistics”,ideasthat“breaktherules”mayoffersolutionswhenoldmethods
becomestagnant.Sincemosteconomichypothesesmustadapttoachangingmarket,they
oftenloselegitimacywhenrepeatedlytestedagainstreality.Thehypothesiswasnotwrong
atthetimeofformation,butwasreplacedbyanewdevelopment.Forexample,our
hypothesisaboutdebtandtaxdeductionswouldbeobsoleteifthenationwenttoanational
salestaxandawayfromanincometax.Companieswithsteadyincomes,whocanmakethe
490

bestuseofdebtfunding,wouldbepenalized.Gradually,somenewsocialoreconomic
constructwoulddeveloptoreplaceit.Inessence,scholarshipthatproducespractical,
usefulideasshouldbeencouraged,andinfinance,thatentailsobservingallpossibilities.
Fourtenableexplanationsforourdatacanbeproduced:
1.Thestudywasflawedandnoideaswerelegitimate.
2.Companiesthatproportionedtheircapitalstructurescountercyclically
tothechangesininterestratesprofitedmorethanthosewhodidnot.
3.Arisingmarketmadeequityfundingmorefeasibleandprofitable
becausemostcompanies’stockwasinhighdemand.
4.Largedebtissueswillraisethecostofcapitalandbeunprofitable
inthenear-term.
Thefirstandlasthypothesescanberejectedonahistoricalbasis.Many
researchershavefoundthatcapitalstructureisfirmlyintegratedwithtaxandinterest
rates,stockpricesandprofitabilityofthecompany.Whenmoredebtisincurredatalower
rate,capitalcostsareoftenminimizedbecausethereislessofarisktoequityandthe
inherentcostofequityremainsstable.Consequently,thereisnorealcorrelationbetween
typeofcapitalstructureandstockpricebecausethemarketdetermineswhichstructure
willbefavored.Whentheriskpremiumbetweendebtandequitybecomesverylow,
investorssellstockandbuybonds.Whentheriskpremiumishigh,investorsaremore
rewardedbyequities.Sincetheinterfacebetweenthemarketandthecompanyisthe
interestrate,capitalcostsaredeterminedbytheeffectsofinterestratechangesontheasset
structureofthecompany.Companieswithlowoperatingriskwillbeinabetterpositionto
takeadvantageoflowratesandincurmoredebt,whilethosewithmoreoperatingrisk
mustfinancethroughretainedearningsorequityissues.Whenratesrise,astheydoin
prosperoustimestocombatinflation,thosecompanieswhoneedlessdebt,orwholower
theirlong-termdebttocapitalratios,willberewarded.
(BacktoTableofContents)
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20
CHANGESINCAPITALSTRUCTUREANDTHEIREFFECTON
STOCKPRICES
Thischapterexaminesthesamedatathatfueledtheoperatingincomestudyinthe
lastchapter.Itattemptstoestablishahypotheticalrelationshipbetweenchangesinstock
pricesandchangesincapital.Whileittendstoconfirmconventionalwisdomonthe
subject,italsoopensupavenuesofdiscussionintwootherareas:1)whetheralarge
capitaloutlayinoneyearcreatesdiminishedcapitalfundinginthenext(capitalrationing),
and2)whetherfinancialleverageratioshaveanypredictivevalueconsideringthatmore
riskmayimplyahighercostofcapitalinthenearfuture.Asstatedpreviously,the
statisticalviabilityofsuchastudycanbequestionedbecauseofsmallsamplesizeandserial
correlation,butthepracticalvalueistoobservethebehaviorofcapitalstructurevariables
overanentirebusinesscycle.
THEVALIDITYOFLEVERAGEFACTORS
Ifindeedfinancialleverageratioshavenopredictivevalue,itisbecausethemarket
issupposedtofactorinsuchinformationinan“efficient”manner.Likeearnings
momentum,theremaybebriefperiodswherethereare“arbitrage”opportunitieswhen
inefficienciesoccur;atthesebriefjunctures,theinvestorcanuse“stockscreens”,
momentum,orfinancialleverageinformationtomakeextraordinaryprofits.However,the
marketchangesandthefactorsthatcreatedsuchopportunitieswillnolongerbeoperable.
But-leveragefactorsareaninherentpartoftheeconomicsystemanddefychange;return
riseswithrisk,butifriskbecomestooexpensive,asitmayduringaninterestratehike,
thenreturnisdiminished.Thus,therearesystemicfactorsthatvalidatethepossibility.
Moreover,onecanarguethateconomicfactorslikeinflationbehaveinapredictive,albeit
unstablefashion..Inflationmaydisappearforyearsonlytocomebackrampantly,andit
isalaggingindicator,notaforwardlookingone.Thecasewemakeforleveragefactorsis
thattheyarespecificallyactionable,andaffectprofitsandassets.Thereisalwayssome
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combinationofleveragefactorsthatwillyieldthehighestamountofreturnwiththeleast
amountofriskinanymarket.Ontheotherhand,theresponsetoeconomicfactorslike
inflationisreactive,anddifficulttodevelopintoacoherentstrategy;wemaychoosean
assetclasslikegoldorrealestatetohedgeagainstinflation,butwillneedtomoveaway
fromitoncetheprospectofhigherpricesdiminishes.
Onereasonthatthebullmarketofthe1990swasagoodlaboratoryforstudying
capitalstructurewasthestabilityofearnings;atwotermpresident,apeacedividend,the
endoftheColdWar,andlowinflationallcontributedtostockmarketincreases.Excess
speculationinthelatterthirdofthedecadehadaskewingeffectontheresultsofthisstudy,
butthesamplepopulationismadeupoffirmswithprimarilylargecapitalizations;
absolutesizetendstobuffersomevolatility.Whilethereisalwaysthetendencytointerpret
correlationas“causeandeffect”insteadofmereassociation,ourobjectiveinthischapter
isnottoproveatheory,buttogetthereadertothinkintermsofpossibilities-and-even
ifheorshesochooses,waystorefutethisresearch.
CONNECTINGTHEDOTS:EARNINGSANDDIVIDENDGROWTHANDTHECOST
OFEQUITY
Throughoutthistext,wehaveemphasizedourbeliefthatstockappreciationisa
functionofearningsacceleration.Whenonefirm’searningsrisesfasterthanotherfirms’
inthemarket,thatfirm’sstockwilloutperformthoseofsimilarrisk.Secondly,wecan
inferthatearningsarerisingfasterthanthecostofcapital(specificallythecostofequity)
whenthissituationoccurs.Thirdly,wehavestatedthattheenvironmentforsuchearnings
increasesiscreatedbyanoptimalcapitalstructure.Thetheoreticalunderpinningsforthis
scenariowouldbethechangeineachcomponentpartofthecomparativedynamic,%∆ ∆∆ ∆
NetIncome/%∆ ∆∆ ∆CostofEquity.Infactahypotheticalcomparativedynamiccanbe
constructedfortheentireeconomywith%∆ ∆∆ ∆GDP/%∆ ∆∆ ∆RiskFreeRate(10YearBond)
Inessence,thegainfrominvestmentmustoutpaceitscost.Wheninterestratesriseand
stocksascendtoorapidlyincomparisontorisk,thecostofequityoutpacesearningsand
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thestockmarketwithers.Therelationshipbetweencomponentsofthecapitalassetpricing
model(CAPM)isestablishedbythisbalancebetweenearningsandthecostofcapital.
Analternativetothis“topdown”theoryistomicro-managecapitalstructure
throughthedividend.Thosewhoespousedividendtheorybelievethatallstockvaluationis
inherentindividendpaymentsandthattheproportionofequityincapitalstructure
dependsonthemanagementofretainedearnings.Theresidualtheoryofdividends
proclaimsthatunlessprojectedearningsmeetaspecificlevelofreturn,theyshouldbepaid
outtoshareholders.Inthiscase,theopportunitycostofretainingearningsisgreaterthan
payingthemout,asmeasuredbythecostofequity.Thattenethasmademany
corporationsreluctanttocutdividendsintheworstoftimes,becauseofthenegative
informationthatsuchamovesignals.Notonlywillsuchacompanyfailtocompensate
shareholders,butitwillneedtofinanceinthecreditmarketsforlackofsufficientretained
earnings.Thistypeoffundingraisesthecostofcapitalevenasearningsaredepleted,and
theresultisadiminishedstockprice.Thus,thedynamicsareamicrocosmofthe“top
downapproach”;thechangeinearningsisdecreasedwhilethechangeincapitalcostsis
increased.
TheGordonmodeloffersanestimateofthecostofequity,butissubjectto
distortionindetermininganadequategrowthrate.Nevertheless,thedynamicsbehindthe
modelareinformative,becausetheydirectlyrelatethecostofequitytothepriceofthe
stock,albeitataconstantgrowthrateofdividends.Whilewebelievethatamoreaccurate
costofequityisobtainablefromtheCAPM,itisentirelypossibletomanagecapital
structurefromtheperspectiveofdividendgrowthandretention.Infact,without
knowledgeofbeta,aneffectiveuseofdividenddiscountmodelsshouldprovidethesame
outcomeastheCAPM,becausebothmethodsconcentrateontherelationshipbetween
earningsandthecostofequity.
EARNINGSACCELERATION
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ToreiteratetheGordonmodel:Thecurrentpriceofthestock=NextDividend/
(Ks–G).KsisequaltothecostofequityandGisthegrowthrateforwhichwehave
formedthegenericequivalent,((ROE)(Retentionratio)).WhiletheGordonmodelisonly
applicabletostockswhosedividendsgrowataconstantrate,wedonotuseitforvaluation.
Weobtaina“ballpark”figureforthecostofequity,whichiscomparabletoanIRRfor
thatstock.IfitishigherthanthatobtainedthroughtheCAPM,thenweobservewhether
thatstockisagoodcandidateforinvestment.Inthatcase,theinternalreturnforthe
companyisoutpacingstocksofsimilarriskonthemarket.
Toobtainthis“internal”costofequity,wealgebraicallyturnthemodelaroundand
seethatKs=(NextDividend/StockPrice)+Growth.Sincewehavemadegrowth
contingentuponearnings,boththeamountretainedandthereturn(ROExRetention),we
caneasilyobservehowthecostofequityhasadirect,positiverelationshipwithearnings.
Infact,throughoutthebusinesscycle,thecostofequityrisesasearningsriseexceptthatit
lagsbehindtherateofearningsgrowth.Thislagisadoubleedgedsword:asearnings
outpacethecostofequity,stocksrise,butwhenadownturnerupts,earningsdeteriorate
farmorerapidlythanthecostofequity.WhiletheFederalReservedesperatelycutsrates,
stockscannotrecoveruntilearningsagainoutpacethecostofequityintheopposite
direction-usuallyasixmonthprocessinrecentdecades,buttotallydependentonthe
severityofthedecline.
ThedynamicsofthislagareimplicitintheGordonmodel.Ifacompanydelaysin
cuttingitsdividend,orcommunicatesexpectationsthereof,theproposeddividendyield
component,(NextDividend/Price)willgrowbecausestockprices(thedenominator)
decrease.Atthesametime,thegrowthcomponentisshiftingdownwardbecauseretention
andearningsarebothlower.Thus,earningsoutpacethecostofequity.Thesame
phenomenonoccursduringanexpansion:companiesarenotsurewhethergrowthisstable
enoughtowarrantadividendincreaseandtheproposeddividendyieldshrinkstocausean
upwardlagbehindearnings.
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IntheCAPM,thelagappearstobecreatedbydelaysincuttingorraisinginterest
rates.Aparadoxicalrelationshipbetweeninterestratesandstockpricesoccurs;stockswill
bepositivelycorrelatedwithinterestratesuntilratesarehighenoughtodiscourage
investment.Atthatpoint,stocksbegintobenegativelycorrelatedwithinterestrates,and
theFedbeginsacampaignofratecutting.Sinceinflationisalaggingindicatorinitself,the
Fedmustbewaryofstymieingbusinessgrowth.Itletsearningsgrowthoutpacerate
raisinginitiativesandthestockmarketrises.Duringadownturn,theFedcannotlower
ratesfastenoughwithoutcausingdislocationsinthecapitalmarkets.Inessence,the
connectionbetweenthetwomodelsliesinexpectations:boththeriskfreerateandthe
proposeddividendsoffirmsarefunctionsofthecollectiveexpectedeconomicoutlook-but
-theyarereactionaryandnotforwardlookingsimplybecausechangingthementailsso
muchrisk.
STATISTICALVALIDITY
Thepropositionthatchangesinleveragefactorssuchasthelong-termdebtto
capitalratio(LTD/CAP),orAssets/Capitalshouldbecorrelatedwithstockpricesisevident
fromtheimplicationsofthesemodels.IntheGordonmodel,theamountofdebtisimplicit
intheretentionratio,whichregulatesgrowth.Ahigherpercentofretainedearningswill
raiseafirm’sequityposition,butmayunderminedividendgrowthifitisexcessive.
Analogously,intheCAPM,ahigherbetaiscreatedfromtakingonmoredebtwhichwill
potentiallyraisethestockpriceinarisingmarket.Together,thetwomodelscreatethe
foundationforcorrelation,andyetthereareseveralequivocalvariables.Bothinflation
andrisinginterestratescanskewtheresults.Forexample,duringtheearlypartofan
expansionwheninterestratesarelow,morelong-termdebtmaybecorrelatedwithhigher
stockprices.Ontheotherhand,atamarkettop,thehighercostofdebtmaycausethose
variablestobenegativelycorrelated.Similarly,ifinflationishigh,earningswillnotputas
muchpressureonstockprices;themarketfactorsintherealrateofinflation.Inthatcase,
moredebtmightbecorrelatedwithhigherpricesbecausethemarketfactorsinthe
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repaymentofloansindepreciateddollars.Thus,thefutilityofacontrolledexperimenton
leveragefactorsshouldbeevident.Inordertoachievestatisticalvalidity,theresearcher
needsalarge,unbiasedsample.Butwhenitislargeenough,factorsoutsideofthe
experimentwillchangetherelationshipbetweenvariables.Thisparadoxhascanblind
researcherstotheinherentvalueofsomefundamentals.If,forexample,depreciationis
highlypositivelycorrelatedfortwoyears,andthennegativelycorrelatedforone,the
resultswouldbetermedstatisticallyinconclusive.Infact,onehastogaugethevalueof
thatfundamental(depreciation)intermsoftheeffectofsomeoutsidefactor-achangein
thetaxlaw,forexample.Fromamathematicalperspective,thereisnolongterm
correlation,butfromaninvestor’sperspective,itmayendupbeingvaluablebecauseitis
viewedwithinaspecificcontext.Incapitalstructuralism,weneedtoviewtheleverage
factorsfromthecontextofchangesinthecostofcapitalwhicharespecificforeach
company.Ifthecostofdebtisridiculouslylowforonecompany,thatfirmwillprobably
incurmorelong-termdebtsimplybecauseitminimizesthecostofcapitalevenasinterest
ratesareclimbing.However,whentheyieldcurveisascending,inflationisincheck,and
earningsarerising,aneconomicenvironmentwillbeconducivetoformingtrendsamong
someleveragefactors;whatisconsidereda“normal”businesscyclecreatesan
equilibriuminwhichriskispricedcorrectly.Mostcompaniesreacttothesamemarket
conditionsandactsimilarlywhenitcomestochangingcapitalstructure.Therefore,
researchersinthissubjectmusttreadafinelinebetweentheneedformathematicalproof,
andthepracticalobservationof“real”economicbehavior.Inthiscase,anystudythatisso
narrowlyfocusedastobestatisticallyvalid,mayalsobeirrelevant.
ABRIEFSTUDY
Usingthesamedataasintheoperatingincomestudyofthepreviouschapter,
changesinmid-rangestockpriceswereregresseddirectlyagainstchangesinleverage
factorsonapercentagebasis-exceptwithoutfurthercategorization;eachvariablewas
freelyregressedagainstmid-rangepriceswithoutreferencetoanysubcategory.Boththe
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changeinthecurrentmid-rangeprice(theyearoftheleveragechanges)andthechangein
thenextmid-rangepricearedescribed.Thisdivergenceallowedtheresearchertoobserve
theimmediateeffectsonpricesandalsotheforwardlookingeffects(ifany).Thefollowing
tabledelineatesthevariablesusedinthestudy:
Table20-1

NextMid-rangeStock
Price
InterestRate(Totaldebt) CapitalMultiplier
(Assets/Cap)
OperatingIncome TotalDebt TotalCost(Sales-OpInc)
Sales AssetTurnover OperatingMomentum
OutstandingShares ProfitMargin Long-termdebt
InterestExpense CapitalExpenditures Long-termdebt/Total
Debt
Assets Cash TotalLeverage
Capital LTD/CAP TotalLeverage-absolute
EPS FinancialLeverageRatio OperatingMomentum-
Abs.
CurrentMid-rangeStock
Price

Thosevariablesthataresignificantatthe95%level(a95%chanceofassociationwiththe
stockprice)aredisplayed.Additionally,anyvariablethathasexplanatoryvalueinterms
ofcapitalstructuremaybeexhibited;someofthevariableswereregressedagainsteach
otheriftheyverifiedsometenetofcapitalstructuretheory.Thesampleincludesthesame
onehundredandeighty-twodatapoints,representingthesamenumberoffundamental
changesasinthepreviousstudy.Thesamecaveatsalsoapplybecauseseveraldatapoints
willrepresentonecompany(twenty-fourcompaniesinall)andtheremaybeserial
correlationinwhichonedatapointwillinfluenceasubsequentdatapoint.Thusthestudy
mayevidencestrategiestakenbyafirmoveraspecificperiod.Thisqualitativeaspecthas
pragmaticvalue,butinvalidatessomestatisticalconclusions.Ineffect,wecanobservehow
capitalstructurechangesaffectedstockpricesoveraneconomiccycle,butwecannot
attributecauseandeffect;therearesimplytoomanyuncontrolledvariables.
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THREEASSUMPTIONS
Weinterprettheresultsgiventhreeassumptions:
• 1)Weassumethatthereisnotransitivityofcorrelation-thatis:-ifonevariableis
correlatedtoanothervariable,andthatvariableiscorrelatedtoathirdvariable,wedo
notassumethatthefirstvariableisalsocorrelatedtothethird.
• 2)Secondly,weassumethatthereisconsistencyincorrelation.Ifassetsarecorrelated
tosalesinyearone,forexample,,weassumethatthecorrelationisvalidinyeartwo,
unlessprovenotherwise.Thatassumptionisonlyrealisticifthetwovariablesare
deterministicfunctionsofeachother;thatis-onevariablesuchassaleswill
mathematicallydetermineanothervariablesuchasoperatingincome.Inthatcase,the
variableswillalwaysbeconsistentlycorrelatedbecausetotalcostissubtractedfromone
toobtaintheother.However,inprobabilisticassociations,suchaswithstockprices
andleverage,thatconsistencydoesnotalwayshold.
• 3)Weassumethatconventionalfinancialwisdomisvalid.Stockpricesrisewhen
earningsrise.Variablesthatincreasethecostofcapitalwilldecreasethepriceofthe
stock.Weusethestudytodefendthesearguments,butalternatively,theremaybe
connectionsthatinvalidatesuchfinancialtruisms.Eacheconomiccyclehasperiodsof
completeincoherencywhen“normal”correlativevaluesaresuspended.
AllregressionsinthestudyusetheSpearmanrankcorrelation.Dataisranked
fromhighesttolowestbeforelinearregressionisapplied.Thismethodcapturesthe
associativevaluebetterthanstraightlinearregression,butdoesnotcapturethestrengthof
theassociationaswell.Nevertheless,itisthepreferredmethodbecauseittendsto
emphasizecurvilinearrelationshipsthatmightnototherwisebeapparent.Correlations
arescaledfrom-1to+1justasinlinearregression,buttheexhibitedprobabilitiesarethe
probabilitiesofnoassociation.Thehighertheprobability,thelessthetwovariablesare
associated.Thus,the95%probabilitylevelisstatedas0.05orless.Thisprocessconfuses
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studentsandinvestorswhohavebeentaughtthat“more”connotesalargernumber.In
thiscase,weareactuallyfindingtheprobabilitythatthe”nullset”(noassociation)istrue.
EXPECTATIONS
Itisexpectedthatcurrentyearfundamentalswillbemorestronglycorrelatedwith
stockpricechangesofthesameperiodthanwithstockpricechangesofasubsequent
period.Moreover,itisexpectedthatnocurrentperiodvariablewillbehighlycorrelated
withearningsinthenextperiod.Theargumentforan“efficient”marketstemsfromfutile
attemptstopredictmarketbehavior;capitalstructuralismacknowledgesthetransientand
unstablerelationshipbetweenfundamentalsandstockprices.Whenthecostofcapitalis
minimizedatvaryinglevels,thecombinationoffundamentalsthatachievesthisoptimum
keepschanging.Therefore,no“exact”amountofsales,incomeorcapitalwillyieldalarge
changeinpriceunlessitcontributestoloweringthecostofcapitalfirst.Atthatpoint,any
magnitudeofchangewouldrestupontheamountofdiminishedrisk,usuallyimplyinga
movementtowardacostreducingcapitalstructurecoupledwithanappreciablechangein
income.
Athirdexpectationisasimpleextrapolationofdeductivelogicwhichmostfinancial
professionalswouldrecognize:pricesareaffectedbyearningswhichcontributetoretained
earningswhichwouldraisetheproportionofequitytodebtwhenearningsarehigh.In
EVAanalysis,wheretheflowofincomeisbalancedwiththechangeinequity,thereislittle
explicitawarenessofthequalityofequitychanges.Weoftenassumethatthecostofequity
willriseifafirmissuesstock,butthatsucharisemightnotbemalignantiftheequity
buildupwasderivedfromretainedearnings.Wealsoassumethatthecompanywillpaya
penaltyifitretainsearningsinsteadofdistributingthemasdividendswhenthecostof
equityisparticularlyhigh.However,inthemajorityofobservedcases,whennetincomeis
greatenoughtowarrantlargeincreasesinretainedearnings,thestockrespondspositively:
netincomeismorethanenoughtoabsorbtheincreaseinequityandthecostofequityis
keptlowbecausemoreretainedearningsdiminishbeta.Thus,weshouldexpectatleasta
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concurrentlystrongcorrelationbetweenearningsandstockpriceandanegative
correlationbetweenlong-termdebttocapitalandearnings;anincreaseinLTD/CAPmight
implythatretainedearningshavedecreased,althoughbothcanriseatthesametimeunder
theproperconditions.
DATA(SeeTables)
INTERPRETATIONANDRESULTS
Thebehaviorofthelong-termdebttocapitalindicator(LTD/CAP)defied
expectations.Whileithada76.76%probabilityofnoassociationwiththecurrentmid-
rangeprice,whenregressedagainstnextyear’sstockprice,ithadaprobabilityofno
associationof0.2%.Infact,threeothercostofcapitalfactors-long-termdebttototal
debt,thefinancialleverageratioandtheinterestrateontotaldebt-displayedthesame
“leadingindicator”characteristic.Theyeachshowedsignificantcorrelationwhen
regressedagainstnextyear’sprice,butlittleassociationwhencomparedtocurrentprices.
Thereadershouldnoticethatwhentotaldebtalonewasregressedagainstmid-range
prices,itdisplayedastrongercorrelationwiththecurrentmid-rangepricethanthenext;
thisindicatorexhibitsthesamebehaviorasmanyoftheearningsassociatedfundamentals
likesales,assetsandoperatingincome.However,withtheadditionoflong-termdebtinthe
numerator,itdisplaystheleadingcharacteristicoftheothercapitalcostcomponents.
Whilelong-termdebtandcapitalinisolationbothexhibitstrongercurrentprice
correlations,oncetheyarepairedinaratio,thecorrelationbecomesstrongerwithnext
year’smid-rangeprice.Thestudent/investorshouldbecognizantofthetaxbenefitsof
morelong-termdebtbecausethecorrelationbetweenlong-termdebtandstockpriceturns
frompositivetonegative.Oncethedebtiscarriedovertothesubsequentyear,thetax
benefitsmayremainthesamebutnowtheprobabilityofdefaultrises-unlessthedebt
beginstoenhancereturns.Infactthelagissopronouncedforanyvariablethatdirectly
affectsthecostofcapital,thatwecanseparatevariablesinto“capitalcost”components
and“profit“componentswhicharemorecorrelatedwiththecurrentprice.
501

Table20-2

COSTOFCAPITALCOMPONENTS:MORECORRELATEDWITHNEXT
YEAR’SPERFORMANCE
Long-termdebt/TotalDebt
InterestRateonTotalDebt
FinancialLeverageRatio:OperatingIncome/OperatingIncome-Interest
Long-termdebt/Capital

Table20-3

PROFITCOMPONENTS(MAIN):MORECORRELATEDWITHCURRENT
YEAR’SPERFORMANCE
OperatingIncome
Sales
Assets
Capital
ProfitMargin
Long-termdebt
NumberofSharesOutstanding

Fromacapitalstructureperspective,wecaninterpretthelagasanincreaseinriskthatis
notfactoredintothestockuntilitfullyaffectsthecostofcapital.Moreover,sincethedata
describesa“normal”marketwithrisinginterestrates(the1990s),wecannotpinpoint
whethertheproportionoflong-termdebttocapitalraisedthecostofcapital.Again,there
isacombinationofmarketfactors(interestrateandequitymarketincreases)that
contributedtothelag.However,suchamarket“inefficiency”wasthemechanismthat
poweredthisresearch;inanalreadyinflatedstockmarket,gainsofoneandahalftimes
theaveragecouldbeexpectedsimplybychoosingcompaniesthatwereloweringtheLTD/
CAPratiothroughmoreretainedearnings.Withasmallerriskpremium(thedistance
betweentheriskfreeinterestrateandequities),theeffectonLTD/CAPmighthavebeen
lesspronouncedandlong-termdebtwouldhavebeenlessexpensive.Alternatively,
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increasesinlong-termdebttocapitalratioscouldevenindicateanexpansivemarketif
interestratesarelowenoughandearningsprospectsarehigh.

HYPOTHETICALCAUSATION
Whilecorrelationisnottobeconfusedwithcausation,evenstatisticalinference
amongallthevariableswillnotgiveasatisfactoryexplanation.Onlythefinanciallogic
inherentincapitalstructure,alongwithobservationoftheinvestmentprocess,canyieldan
answer.Thereason?Thereisnoconcretemeasurementthatcananticipatearapid
turnoverofcapitalandassets:thesoonerafirmcanturnthepurchaseofanassetintoa
profitableventure,themoreinvestorswilldemandequityinthatcompany.Sincemost
largedebtissuesareforthestrategicpurchaseofprofit-makingassets,thereissomelag
betweenpurchaseandthegenerationofincome.Inthisinterim,firmswilloftentake
restructuringcharges,giveoutexecutivecompensation(goldenparachutes)and
consolidateoperations.Attimes,theconfluenceofoperationsbringsunanticipated
problemsandtheneedforanother(albeitsmaller)loan.Forthesereasons,itistypicalto
seetheproportionoflong-termdebttocapitalriseformorethanoneyear,andtoobserve
atleastsomestagnationinthestock.
Sometimes,theincurringofdebtisnotastrategicplay.Companieswhoareina
sectorthathasnotbeenfavoredbythemarketmayuselong-termdebttofundfixedassets
thatmaintainexistingoperations.Inthesecases,thestockisnotindemandandlong-term
debttocapitalrises.Again,theincreasemaybepartofapatternthatlastsatleasttwo
yearsifnotmore.Noretainedearningsareavailable,butthecompanymusthaveasource
offundingorfacetheprospectofdownsizingandsellingassets.Long-termdebtbecomesa
tooltoforestallinsolvencyuntilthecompanycanincreaseincome.
Ifwecoordinatethebehavioroflong-termdebttocapitalwithourknowledgeof
EVA,thereadercanobserveanotheravenueofapproach.Whenweacceptthepremise
thatbothearningsandEVAarehighlycorrelatedwithstockprice,weneedtoexaminethe
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capitalcomponentsoftheEVAequation.Accordingtoourcorrelations,thereisno
variablethatisstronglycorrelatedwithanincreaseinnextyear’searnings.Bytheprocess
ofelimination,ifcurrentLTD/CAPisnothighlynegativelycorrelatedwithnextyear’s
earnings,thenetincomepartoftheEVAequationisunaffected.Thatleavesariseinthe
costofequityasthereasonforadiminishedEVAandstockprice.Suchariseinthecostof
equitywouldbeafunctionofahigherbetacausedbymoreleverage-theincreasein
LTD/CAP.
THEHAZARDSOFPLAYINGDETECTIVE
Theconnectionbetweenthecostofcapital,stockprices,andtheproportionofdebt
toequityisallencompassing.Unfortunatelywemaytendto“read”athreadintoa
scenariowherenoneexists.Theinsistenceoninterpretationthroughcapitalstructure
changescanblindustootherexplanationsthatmaybejustaslegitimateifnotmoreso.
Forexample,thecostofcapitaldoesnotalwaysrespondtoincreasedrisk.Considershort-
termdebtasanillustration.Short-termdebtmayexposeafirmtotheriskofdefaultmore
easilythanlong-termdebt(morefrequentpaymentsatvaryingrates),andyetitisless
expensive;thecorrelationbetweencapitalcostsandriskisnotalwayspositive.Inessence,
itisdifficulttoobtainmathematicalproofofcausationbecausethesamplecontinually
changesaseconomicconditionsarise:inonemarket,astockwillrisewithmorelong-term
debttocapital,andayearlater,thesameindicatorwillbenegativelycorrelatedtoit.Such
amarketefficiencyhascreatedthe“randomwalk”theorybecausefewcansuccessfully
coordinateavailableinformationtomakeaccuratepredictions.
Intheexhibitofearningscorrelations,thestudent/investorshouldnoticethe
strengthofcorrelationforconcurrentfundamentalslikesalesandassets,andthencontrast
thesewhentheyareregressedagainstnextyear’searnings:fundamentalshaveno
predictivevaluewhatsoever.Thereisnofactorthatsomemanagercan“grabaholdof”
andimprovenextyear’searnings.Infact,thefollowingtablerepresentsastraight
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autoregressionofoneyear’searningsincreasesonthenext,andthereadercanobserve
thatnomomentumwasexhibited.
Table20-4

AUTOCORRELATIONWITHNEXTYEAR'SEPSPERCENTAGE
YIntercept=22.9816
Coefficient=-0.04087
RSquared=0.001671
Y=22.9816-0.04087(X)
Theminusculecoefficientofdeterminationrevealsthatthereisnopredictivelinear
connectionbetweenyeartoyearearnings.However,severalresearchershavefoundthatif
earningsaregreaterthanthemarketoverasixmonthperiod,theywilltendtoriseinthe
nextsixmonthsaswell.Inthelate1960s,ManownKisorandVanMessnerworkedwith
earningsacceleration,andRobertLevyofAmericanUniversityparalleledthisapproach
withstocks.Bothfoundsixmonthmomentumtrendsfollowingaccelerationincreases.
Eveninthedepthsofthedepression,nolessaresearcherthanAlfredCavellostatedthatif
stockswentupforayear,theywerelikelytofollowwithanothergain.
Muchoftheupwardtrendinstocksthatoccurredafterloweringlong-termdebtto
capital,maybeattributedtoearningsmomentum.Whenearningsarehigh,moreretained
earningsarecreatedthatlowersthelong-termdebttocapitalratio.Theproportionof
equitynaturallyrisesbecausemoreearningsattractdemandforthestockaswell.Thus,it
wouldappearthatthisleverageratioisinverselycorrelatedwithearnings-whichthedata
substantiates:LTD/CAPhasanegativecorrelationwithearningsof-0.195179anda
probabilityofnoassociationofonly0.008280or99.2%chanceofbeingassociated.
However,thecorrelationofcurrentLTD/CAPincreasestonextyear’searningsincreasesis
almostinsignificantat-0.039136witha0.625401probabilityofnoassociation.Obviously,
morelong-termdebttocapitalisnotdepressingnextyear’searnings,althoughitmaystop
earningsmomentum.Whilelong-termdebttocapitalisheavilynegativelycorrelatedwith
currentearnings,therewillbesomeresponsefromtheinvestmentthatwillpropelearnings
505

slightlyhigherinthenextyear.Theintensityofthat“response”seemstodetermine
whetherthestockwillbecomeattractiveandthefirmcanbeginraisingequity.
Perhapsthebestexplanationofthedynamicsofproportionalityisfoundinthe
marginalbenefitsequation.Weknowthatontheleftsideoftheequation,moredebtwill
increasetaxbenefits.IfoneexaminesatypicaldefaultprobabilityalgorithmlikeAltman’s,
thestudent/investorwillfindthatmanycomponentshave“assets”inthedenominator-
retainedearnings/assets,operatingincome/assets,sales/assets,etc.-whichmakesupthe
majorfactorontherightsideoftheequation.Asweraisedebt,wealsoraisetheasset
portionofthedefaultprobability.Inthenextyear,withoutaninfusionofmoredebt,we
needtoincreasetheperformancevaluesthatarecontainedinthenumeratorpartofthe
defaultprobability-thesales,workingcapital-thebasicreturnonassets.Whenthese
variablesdonotincrease,theprobabilityofdefaultrises,andthemarginalbenefits
equationwilldecrease.Thus,thesoonerafirmcanintegrateassetsintoaprofitable
scenario,themoremarginalbenefitswillrise.However,anylargeacquisitionormergeror
evenachangeinfixedassettechnology,requiresa“periodofadjustment”beforethese
assetscangenerateaprofit,nottomentionthepossibilitythattheacquisitionmaynot
matchthefirm’soperatingcharacteristics.Alloftheseriskswouldbereflectedbysome
stagnationifnotdepreciationofthefirm’sstockprice.
THEARGUMENTFORCAPITALRATIONING
Byfarthemostcuriousrelationshipwasfoundbetweencapitalandtheinterestrate
ontotaldebt.Regressionswereperformedbetweencurrentcapitalandnextyear’sinterest
rate,aswellasthecurrentinterestrateandnextyear’scapital.Althoughweassumefrom
capitalstructuretheorythatmorecapitalwillincreaseriskandleadtohigherrates,we
werenotpreparedtoobserveadecreaseincapitalforthesubsequentyearwheninterest
rateswereraisedduringthecurrentyear.Thisnegativecorrelationoccursinacontext
wherecurrentlong-termdebtincreasesarehighlycorrelatedwithcurrentincreasesinthe
interestrateontotaldebt.Paradoxically,currentincreasesincapitalhavenosignificant
506

associationwithcurrentyearinterestratesatall.Accordingly,wecanhypothesizeatleast
threereasonsforthisoccurrence.
• 1)Overtheeightyearstudyperiod,anomaliesoccurredinthedatathatcreateda
negativerelationshipbetweennextyear’scapitalandthecurrentinterestrateontotal
debt.
• 2)Thegreaterriskthatisimplicitinhigherinterestratesencouragesfirmstofund
projectsinlargeblocksofdebt,especiallywheninterestratesareanticipatedtorise.
• 3)Firmsrationcapitalandcutbackonprojectswhenalargeacquisitionismadein
ordertoconcentrateonmakingitaprofitableventure.
Innormalcapitalbudgeting,afirmacceptsallprojectsthathaveapositivenet
presentvalue.Inlayperson’sterms,thatpropositionobligatesafirmtotakeonall
profitableprojects,givenaspecificcostofcapitalandrecognizingfuturecashflowin
currentdollars.Fromeconomics,weknowthatafirmshouldproducetoapointwhere
marginalrevenueisequaltomarginalcost,whichisgenerallyanalogoustoaccepting
projectswithapositivenetpresentvalue.Ifafirmdoesnotfundallprojectsthatwould
exceeditscostofcapital,itdoesnotmaximizeitsvalueandpartakesinwhatistermed
“capitalrationing”.Whilefinancialprofessionalsrecognizecapitalrationing,thescenario
islessfamiliartotheaverageinvestor.Inshort,itistradingtheviabilityoffutureprojects
inordertomeetsomeshorttermobjective-whichareoftennumerouswhenlargemergers
areimplemented.Theshiftinprioritiesisoftentermedagencyfactorsor“agency
friction”,becausemanagementactsasan“agent”fortheshareholder.Thesefactorsmay
includethefollowing:1)thebeliefthatraisingmorecapitalwillimmediatelyraiseits
inherentcost;2)therecognitionofgreaterdefaultriskoncealargeblockofdebtis
incurred;3)thefearoflosingvotingcontrolbyissuingmoreequity;4)thebeliefthat
currentprojectsareeitherveryriskyand/orunderstaffedandrequiremoremanagerial
attention.Bynomeansanexhaustivelist,anyofthesebeliefswillundermineafirm’svalue
whencarriedtofruitionbecausetheywillfrustratemovementtowardanoptimalcapital
507

structure.Under-fundingprospectiveprojectswillleadtodiminishedearningsandthe
potentialtomisallocatetheproportionofdebttoequity.
Companiesthatincurlong-termdebtareessentiallygivingupfinancialcontrolto
creditors.Therightsofabondholderarealmostalwaysprioritizedoverthoseof
shareholderswhichsetsupanenvironmentconducivetocapitalrationing.Indentures
oftenrestricttheraisingofnewdebttoaspecifictimesinterestearnedratio(TIE)andif
retainedearningsarenon-existent,thefirmwillhaveproblemsfinancingnewprojects;
equityisnotattractiveunlessthefirmisgeneratingsufficientoperatingincomewhichis
difficulttoachievesosoonafteranacquisition.Thealternativeistorationcapitaland
maximizeprofitgiventhoseconstraints.
Withouttransitivityofcorrelation,wecanalsoobservethatlikethecurrentinterest
rate,currentlong-termdebttocapitalincreasesarenegativelycorrelatedwithnextyears
capitalincreases.Evidently,moredebtraisesinterestrateswhichraiserisk.Sincemany
longtermprojectsarefundedwithlong-termdebt(cashflowmatching),thesecapital
intensiveprojectsmustbefollowedbysmaller,moremanageableprojectsinsubsequent
years,andthuschangesincapitalbecomenegativelycorrelatedwithcurrentrisk
However,thehypothesisofcapitalrationingcannotbeproved.Whileitisalwaysa
possibility,thepremiseisbasedonknowledgeofafirm'sspecificIRRand“project
pipeline”towhichfewindividualshaveaccess.Thisalternativeconcept(adequatefunding
forsmallerprojects)isareliableassumptiongiventhestrongcorrelationbetweenincreases
incurrentstockpriceandincreasesincurrentcapital(acorrelationof0.418036witha
probabilityofnoassociationof0%).Ifindeednewprojectsrequirelesscapital,whileat
thesametimeoperatingincome(ROA)istemporarilydepressedbytheneedtointegrate
newassetsandpayadditionalinterestexpense,themid-rangestockpricemightdecline.
Thequotientofeconomicprofitisthecomparativedynamic,NetIncome/Costof
Equity.Inthisratio,thecostofequityisthefullcostoftheCAPMpercentagemultiplied
bystockholder’sequity.Inthecapitalrationingscenario,withincreasingleverage,net
508

incomeisslightlydiminishedwhiletheCAPMpercentagerisesbecauseofanincreased
beta.Sinceallprofitableprojectsarenotbeingfunded,netincomemaynotincrease
enoughtoraiseeconomicprofit.TheresultwillbeadiminishedEVA,andadeclining
comparativedynamic,eventhoughequityfundingwasnotextensivelyused.Thefirmfails
tomovetowardanoptimalcapitalstructuresimplybecauseresourceswerechanneled
towardlastperiod’scapitalallocationandawayfromcurrentprofitableprojects.In
industriesthatrequirebothahighleveloftechnologyandahighlevelofdebt,project
defermentcanleadtoobsolescencebecauseafirmcanonlycompetewiththenewest
innovationswhichtendtohaveashort“shelflife”.Suchcompaniesarehitwitha“double
whammy”;theyneedtodecreasethecostofcapital,butbythetimetheydo,theprojects
theywouldhavefundedarenolongerlegitimate.This“hidden”costofdebtisseldom
discussedwhenfirmsintegratetheiroperatingandfinancialrisks,becauseoperating
leverageonlymeasurestheamountoffixedcostsandnottheirquality.Forexample,the
PCindustrywaschangingsorapidlyinthelate90sthatevenwithaloweroperating
leverage,theriskofcreatingunsoldinventorybecamefartoogreat.
Thelackofasignificantcorrelationbetweenanycurrentfactorandincreasesin
nextyear’searningsleadstotheconclusionthatraisingthecostofcapitalistheprime
reasonforalowerstockpriceinthesubsequentyear.Bydefault,whenweexaminethe
nextEVA,wefindthat:1)netincomeisbasicallyunaffectedbylastyear’scapital
allocation;2)capitaloutlaysmaybedepressediflong-termdebttocapitalwasincreased
inthelastperiod,and3)theincurringofdebtraisesbeta,whichincreasesthecostof
equity.TheonlyfactorthatcouldpossiblyoffsetthisdecreaseinEVAwouldbean
immediatedecreaseinLTD/CAPthatwouldbederivedfromretainedearningsorequity
issues;suchanoccurrencewoulddiminishbeta,butwouldonlybeachievableifoperating
incomewerebolstered,orifthestockwasespeciallyattractiveatalowprice.
Withoutspecificreferencetoanumericcostofcapital,ourconclusionsaremerely
speculative.Toobtainstatisticallyviabledata,thisstudywouldhaveneededtonotonly
509

measurethedifferentcostsofcapitalforeachperiod,buttodeterminetheamount
attributabletomyriadfactors-theFederalReserve,thestockmarket,theinternal
dynamicsofthecompany.Therefore,thereadermustbewarnedwiththecaveatthatthis
studycannotbeoverlaidonotherperiodsandbeexpectedtoberelevant.Itwasthe
workablepatternofthe1990s,butmaynotrelateto2015.Levelsandchangesoftherisk
premium,technologyshifts,andotherviablealternativeinvestmentsmaychangethewaya
firmmovestowardanoptimalcapitalstructure.Othershiftsincludechangesin
bankruptcylawsandtaxlegislation.Forexample,taxingdividendsatthesamerateas
capitalgainsmakesthosestocksmoreattractive.Greaterdemandforequityinthese
companiesmayshiftthecostofcapital,andraisinglong-termdebtmayactuallybenefitthe
stockinsubsequentyears.Similarly,theshifttoalowerlevelofinterestratesinthenew
millenniumalsoshiftedtheoptimalcapitalstructure.Theprobabilityofdefaultwas
differentforthesameamountofdebtheldindifferentyears.Thus,thestudent/investoris
encouragedtodoresearchonwhichleveragepatternisworkingforthetopsectors,andto
understandwhyitisprofitablebyobservingthecomponentsofthecapitaldynamic:(Net
Income-CostofEquity).

510

SPEARMANRANKCORRELATIONWITHPERCENTAGEINCREASESIN
CURRENTANDNEXTYEARMID-RANGESTOCKPRICES

Table20-5

VARIABLE CURRENT
MID-RANGE
NEXTYEAR
MID-RANGE
Most
Significant
Correlation Probability Correlation Probability
Operating
Income
0.414726 0 0.230556 0.001741
Numberof
Shares
0.190681 0.009926 0.102052 0.17042
Assets 0.415331 0 0.159849 0.031123
Capital 0.418036 0 0.140295 0.058892
InterestRate -0.06787 0.36263 -0.153022 0.039177
Sales 0.443389 0 0.150517 0.042544
TotalDebt 0.222137 0.002579 0.155414 0.036176
EPS 0.209008 0.004632 0.197081 0.007661
Capital
Expend.
0.275874 0.000164 0.072362 0.331668
ProfitMargin 0.166469 0.024704 0.149717 0.043669
LTD/Total
Debt
0.038071 0.609878 -0.172137 0.020146
LTD/CAP -0.022051 0.767631 -0.220211 0.002816
Financial
Leverage
-0.171175 0.020864 -0.251781 0.000606
Capital
Multiplier
-0.135234 0.068727 -0.041765 0.57561
Long-term
debt
0.149316 0.044241 -0.106845 0.151118

Eachiteminthevariablecolumnrepresentsapercentchangeinthatfundamental.
Allitemswithaprobabilityofassociationof95%arelisted,butifanitemhascomparable
valuee.g.,capitalmultiplier,thatfundamentalislistedaswell.Additionally,ifanitemis
significantlycorrelatedinoneyearbutnotinthenextorpreviousperiods,itisalsolisted.
Severalitemswerenotlistedsimplybecausetheywerenothighlycorrelated-suchas-
511

assetturnoverandendofyearbalancesheetcash.Theirexclusiondoesnotmeanthatthey
areanylessimportantthanthelistedvariables,justthattheylackedcorrelationwithstock
priceincreasesforthespecificyearswiththesetwenty-fourS&P500companies.
SPEARMANRANKCORRELATIONONCHANGESINTHEINTERESTRATEON
TOTALDEBT
Theeffectofchangesincurrentfundamentalsoncurrentinterestrates:
Table20-6

CURRENTYEAR
VARIABLE
CURRENTYEAR
INTERESTRATE
Variable Correlation Probability
LTD/CAP 0.297846 0.000044
Capital(Equity+LTD) 0.037876 0.611708

Theeffectofchangesinthecurrentyearinterestrateonchangesinnextyear’s
fundamentals:
Table20-7

NEXTYEAR CURRENTYEAR
INTERESTRATE
Variable Correlation Probability
OperatingIncome -0.045664 0.56886
Sales -0.067203 0.401484
Capital -0.167101 0.035859
Assets -0.09137 0.253549
TotalDebt 0.045173 0.573031
CapitalExpenditures -0.10865 0.17418
NumberofShares -0.082255 0.304204

Outofseveralvariables,onlychangesincapitalhaveasignificant(95%)chanceofbeing
associatedwithincreasesinthecurrentinterestrate.Correlationisnotcausation,butit
appearslogicalthatlesscapitalwouldbedemandedifthepriceofithasrisen.Thispointis
512

evenmoreemphaticinlightoftheprevioustable’sindicationofnosignificantcurrent
associationbetweenthetwo.
Theeffectofchangesincurrentfundamentalsonchangesinnextyear’sinterestrateon
totaldebt:

Table20-8

CURRENTYEAR
VARIABLE
NEXTYEAR'S
INTERESTRATE
Variable Correlation Probability
LTD/CAP 0.290095 0.000278
Capital 0.165464 0.037738
FinancialLeverageRatio 0.065025 0.416949
CapitalMultiplier 0.068533 0.392213

Noticethattherelationshipbetweencurrentinterestexpenseandincome(financial
leverage)isnotsignificantlyassociatedwithnextyear’sinterestrate,butassoonaslong-
termdebtisincurred,thereisaneffectonnextyear’sinterest.Evidently,theincurringof
long-termdebtobligatesthecompanytoaseriesofinterestpaymentsthatraisestherisk
associatedwiththecostofcapital.Moreover,greatercapitaloutlaysinthecurrentyear,
tendtoforcetheinterestrateupwardinthenextyear,butthishypothesisisstatistically
inconclusive:theeffectmaybeduetoFederalReservehikesandnottheimplicitincrease
incorporaterisk.
SPEARMANRANKCORRELATIONBETWEENCHANGESINTWOCURRENT
FINANCIALLEVERAGEMEASUREMENTSANDCHANGESINNEXTYEAR’S
FUNDAMENTALS

513

Theassociationbetweenthechangeinthecurrentfinancialleverageratioandthechange
inthecurrentLTD/CAPmeasurement:
Table20-9

CURRENT LONG-TERMDEBTTO
CAPITAL
Variable Correlation Probability
FinancialLeverageRatio 0.29166 0.000065

Theassociationbetweenchangesinthecurrentfinancialleverageratioandchangesinnext
year’sfundamentals:
Table20-10

NEXTYEAR’S CURRENTFINANCIAL
LEVERAGERATIO
Variable Correlation Probability
OperatingIncome 0.05538 0.489493
Sales 0.034869 0.6636
Capital -0.185999 0.019291
Assets -0.103109 0.197328
NumberofShares -0.104523 0.191216
TotalDebt -0.00365 0.963699
CapitalExpenditures -0.119273 0.135525

Onlycapitalhasastronginter-periodrelationshipwiththechangeinthefinancialleverage
ratioanditisnegative.Wecanonlyassumethatfirmsaredecreasingthecostofcapitalby
minimizingnextyear’scapitalallocation.Itisnotproved.

Theassociationbetweenchangesinthecurrentlong-termdebttocapitalratioandnext
year’sratio:
514

Table20-11

NEXTYEAR’S CURRENTLONG-TERM
DEBTTOCAPITAL
Variable Correlation Probability
LTD/CAP 0.034729 0.664871

Whilethisauthorbelievesthatincurringdebttendstoencouragemoresubsequentdebt,
thisstudydisputesthatassumption.Thereislittleassociationbetweenchangesinthe
amountofdebtinjuxtaposedyears,althoughwedonottestforthestatisticalviabilityofa
debtincreasebyitself.Long-termdebttocapitalmaystillriseinthenextyearwhendebt
isincurredinthecurrentyear,buttheamountofchangeisnotrelatedtopreviouschanges.
Theeffectofchangesincurrentlong-termdebttocapitalonchangesinnextyear’s
fundamentals:
Table20-12

NEXTYEAR’S CURRENTLONG-TERM
DEBTTOCAPITAL
Variable Correlation Probability
OperatingIncome -0.003137 0.968793
Sales -0.104414 0.191686
Capital -0.221585 0.005142
Assets -0.224585 0.004555
NumberofShares -0.138209 0.083311
TotalDebt -0.17629 0.026711
CapitalExpenditures -0.173104 0.029626

Thistableshouldconvincethereaderthatgrowthinthesubsequentyearwasstymiedby
anincreaseoflong-termdebttocapitalinthepreviousyear.SinceWallStreettendsto
prizegrowthaboveallelse,thestockpricewouldnaturallydecline.Noticethatbothassets
andcapitalinthenextperiodaresignificantlyassociatedandthateverycorrelationis
negative.Noticealso,thatoperatingincomeisbarelyaffectedwhichwouldprovidethe
515

foundationfornoassociationwithnextyear’sEPS.Wecannotprovethatassetsand
capitalareintentionallykeptlowtoimprovethereturnoninvestment.Sincelargeblocks
ofcapitalaremorecostefficientthanthesameamountspreadoverseveralyears,we
assumethatcapitalrationingisnotbeingimplemented.

SPEARMANRANKCORRELATIONBETWEENCHANGESINEARNINGSPER
SHAREANDCHANGESINFUNDAMENTALS
WedisplayonlythecapitalcomponentsinthecorrelationwithcurrentEPSchanges
becausemostfundamentalshaveastronglypositivecorrelationwithcurrentearningsand
toexhibitthemwouldberedundant.Itisrighttoassumethatassets,sales,capitaland
operatingincomewillriseconcurrentlywithEPS,butthechallengefortheinvestoristo
determinethetimeandquantityofthatrise.Whenafirmincreasesitslong-termdebtto
capital,thevalueofthecompanyimmediatelyincreasesbecauseoftaxbenefits,andyetthis
riseinstockpriceisdisconnectedfromearnings.Itimmediatelyappearsthatinvestorsare
speculatingaboutnewassets,butweknowfromourstudyofcapitalstructurethat
marginalbenefitsareincreasing.Thisdisconnectcanbeobservedinthetriadrelationship
betweenlong-termdebttocapital,earningsandstockprice.Currentlong-termdebt
increaseshavelittleassociationwithcurrentstockprice,butcurrentEPSincreasesare
heavilyassociatedwithit.Ontheotherhand,currentlong-termdebttocapitalchanges
haveastrongnegativeassociationwithcurrentEPSchanges.Weconcludethattheremust
besometimeswhenthecurrentstockpricerisesstronglyinthelightofalong-termdebtto
capitalincrease;theseriseswouldencompassalargegainintaxbenefitsasopposedtoa
smallerincreaseindefaultprobability,theexactrecipeforanimprovementinthe
marginalbenefitsequationand(mostlikely)inEVA.

516

TheeffectofchangesincurrentfundamentalsonchangesincurrentEPS:
Table20-13

CURRENTVARIABLE CURRENTYEAR’S
EPS
Variable Correlation Probability
LTD/CAP -0.195179 0.004616
Capital 0.202482 0.00612
FinancialLeverageRatio -0.14146 0.0568
CapitalMultiplier -0.069514 0.351096
InterestRateonTotal
Debt
-0.017927 0.810172
CurrentMid-rangeStock
Price
0.209008 0.004632

Theinformationthatwouldbemosthelpfultocorporateexecutiveswouldbeforward
lookingindicatorsofearningsgrowth.Whatstrategicactionscanwetakethisyearthat
willleadtoincreasedearningsgrowthinthenext?Asrevealedinthisstudy,thereis
certainlyno“magicwand”.Allfundamentalsmustbesmoothlycoordinatedforsuch
growthtooccur.Therecanbenoleadingstatisticalmeasurementthatwilldetermine
whetheracompany'ssaleswillsuddenlyescalate,andsuchresearchisnotintherealmof
investorfinance,butisinthedomainofcorporatemarketing.Infact,partoftheproblem
withforecastingearningsandtheneedforcompanyguidanceisattributabletothislackof
correlationasevidencedinthefollowingtable.

Theeffectofchangesincurrentfundamentalsonchangesinnextyear’sEPS:

517

Table20-14

CURRENTVARIABLE NEXTYEAR'S
EPS
Variable Correlation Probability
LTD/CAP -0.039136 0.625401
Capital -0.013119 0.870044
FinancialLeverageRatio -0.086882 0.277712
CapitalMultiplier 0.134557 0.091873

Ifthereweresomeassociationbetweenanycurrentfinancialstatementitemandchangesin
nextyear’sEPS(outsideofordinarymaintenancelikecapitalexpenditures),itwouldhave
beenexploitedlongago.However,this“analyticalconfusion”hassetupthecapital
structuralistwiththeopportunitytocoordinateseveralvariablesandattemptto
distinguishthepathofcapitalcosts.Whileitmaynotbeassimpleasincreasingor
decreasingoneortwovariables,itfollowsachainoflogicthatmostinvestorsarecapable
ofimplementing.Firmsmustminimizecapitalcoststoreachanoptimalproportionofdebt
toequity.Inthisstate,profitswillbenearlymaximizedwhilethepriceofthestockwillbe
maximized
(BacktoTableofContents)
518

21
PROBABILITYANDCAPITALSTRUCTURE
Inthemid1960s,astatisticianbythenameofEdwardThorpwroteabookthat
completelyrevolutionizedthegameofblackjack.Thebookwascalled“BeattheDealer”
andtoutedthepremisethatiftheplayercountedtheamountoftencountcards,heorshe
wouldhaveadistinctadvantageoverthehouse.Formerly,goodblackjackskillsmeant
“hitting”or“standing”onthebasisofthedealer’supcard,astrategythatgavemost
casinosathreetofourpercentadvantage.Assoonasprofessionalgamblersbegan
applyingThorp’sprinciples,thecasinosbeganlosingalotofmoneyandeitherbeganusing
multipledecks,ormorelikely,threwthecardcountersout.
AlthoughmanyinvestorswilltreatFederalReserveratehikeslikeadealer’sup
card,thesimilaritieswithblackjackarenotextensive.Theprobabilitiesincardgamesare
alwaysconcrete,stableandcalculable,whilethoseinthefinancialmarketsarenot.The
market,unlikethehouse,willgivetheinvestorafavorableupwardbiasovertime-the
yearlyaveragegainapproachestenpercent-butvariablerelationshipsandtheir
consequentprobabilitieschangedramatically.Relationshipsbetweenvariableslike
inflation,GDP,foreignexchange,andtheleveloftechnologyareconstantlyevolving,
leadingtoaninherentunpredictability.
Anexampleofavariablethattypifiesthischaoticfluxisthecaseofearningsin1999
to2001.Bylate1999manyinvestorswereputtingmoneyintoInternetstockswhichwere
mostlystart-upswithlittleornoearnings,oratbest,increasingearningsthatwerestill
negative.Someofthesestocksshotuptofiftyoronehundreddollarsashare.“TheNew
Economy”wastoutedbythefinancialpress,andinvestorsanticipatedbigpaydaysjust
aroundthecorner.Bylate2000,evencompanieswithgoodearningsbegantoseetheir
stockpricesplummet.Thetechnicalanalysisthatallowedinvestorstoanticipateandprofit
519

offtrendsbegantofail,andinvestorsbegancuttingtheirlosses.Thecorrelationbetween
thelastperiod’searningsandthenextstockpricewasnolongervalid.Whathappened?
Thestoryofthetechbubbleishistoricallycomplex,butitissafetosaythatthe
marketbegancorrectingitselfbeforearecessionwasimminent.Thebloatedmarketcould
notwithstandinvestorperceptionchanges,higherpricesandlowerexpectationsforGDP.
Inessence,the“NewEconomy”wasoverbecausethemarketrevertedtoitsmean;
projectedfutureearningscannotbethefoundationforaninvestmentiftheylackthe
productioncapabilitiestobackthemup.Withoutanassetbasethatrepresentedlower
operatingrisk,the“pieinthesky”InternetcompanieswentthewayofFloridalanddeals
andTexasoilwells.
THEEFFICIENTMARKETSHYPOTHESIS
Analystshaveattemptedtopredictcyclicalshiftsformanyyearswithoutmuch
luck.Infact,anentirebodyofliteratureexiststhatcategorizesourabilitytopredictprices
basedonpriorinformation,anditisfoundthatthemarketalmostinstantaneouslyprices
securitiesbeforethosewithpubliclydisseminatedinformationhaveachancetoreact.
Whileillegal“insider”tradingisalmostalwaysprofitable,tradingonthebasisof
fundamentalsgleanedfromaprospectusisnot.Toexplainthisseeminginjustice,financial
academicsproposedtheefficientmarketshypothesiswhichcategorizesreactionto
informationinthreebasic“forms”:weak,semi-strongandstrong.Intheweakform,the
hypothesisstatesthatallpastpricingdataisfullyreflectedinastock’spriceandcannotbe
usedtopredictfutureprices.Thesemi-strongformstatesthatallpubliclyavailable
information,frompastpricingdatatonewlypublishedsalesfigures,cannotbeusedto
predictfutureprices.Finally,the“strong”formstatesunequivocallythatnopublicor
evenprivateinformationisusefulforcreatingavalidforecast.Sinceinsidersdomake
moneyoffofillegaltrading,mostfinancialprofessionalsadoptthesemistrongformasthe
mostrationaltenet.
SCREENS
520

Stockscreenshaveanunreliablehistoryfortheveryreasonsdiscussedabove:The
marketwillchangeenoughtomakethemobsoleteaftertheyappeartobeworkingfora
while.Theillusionofbeatingthemarketstemsfromtheupwardspressureofearnings
thattendstocreatemomentumwhentheeconomyisinhighgear.Threeoutoffourstocks
willriseinabullmarketandnineoutoftenwillfallduringabearmarket.Thecorrelation
betweenearningsandpriceishighandvolatileinthebullmarket,lowandvolatileinthe
bearmarket,andstrongandstableinthelongrun.Whenthemarketistrending,screens
likethePEGratiocanworkverywell,butwillstoptheir“magic”assoonascapitalcosts
outpacetheaccelerationofearnings.Cyclicalstocks,asanexample,willtypicallydowell
rightafterarecession,butthenstagnatefortherestofthebusinesscycle.Theseinterest
rate-sensitivestockswillhavehighpriceearningsratioswhentheyshouldbebought,and
lowratioswhentheyshouldbesold,whichistheexactoppositeofconventionalwisdom!
Thereasonforthisanomalyisthatearningsincreasethroughoutthebusinesscycle,but
investorsmoveontomoreprofitablesectorsasinterestratesrise,depressingtheprices.
Anotherexampleofafailedearningsscreenoccurredduringthe1970s.Withdoubledigit
inflationandunemployment,“reading”theeconomywasdifficultatbest,becausehigher
earningsdidnottranslateintohigherstockprices;onehadtogaugetheindustrytoseeifit
weretobecomesuddenlyobsolete,oroversensitivetotheriseincommoditypricesthat
occurredsimultaneouslywithanoilshortage.
THERETURNONCAPITAL
OuradaptationoftheDuPontequationyieldedareturnoncapital,ratherthana
returnonequity.Thefullreturnofcapitalequationwascomposedof(EBIT/Sales)x
(Sales/Assets)x(NetIncome/EBT)x(EBT/EBIT)x(Assets/Capital).Wefurther
decomposedAssets/Capitalinto(LTD/Capital)x(Assets/Short-termDebt)x(Short-term
Debt/LTD).WeknowfromoptimizationmodelsthatROEwillbemaximizedatacapital
structureofalldebt,whileROCwillmaximizeatastructureofallequity:givena
constantoperatingincome,ROEdirectlytradesequityfordebtwhileROCmaximization
521

hasnointerestexpense.Ifweexaminetheequationbyitsfiveparts,weintuitivelydiscover
thatthelastthreepartsconcerncapitalinvestmentthatbecomesthefoundationfor
increasingthefirsttwoparts,operatingmarginandassetturnover.Whenwelookfor
changesintheleverageratios(EBT/EBITismerelytheinverseofourfinancialleverage
ratio,EBIT/EBIT-Interest)wewillfindthattheysometimesoffsetthe“profit”ratiosof
operatingmarginandassetturnover.Infact,thereisultimatelyatendencytoincreasethe
profitvariablesbyagreaterdegreewhentheleverageratiosaredecreased.Ofcourse,
therearemanyinstanceswhenbothleverageratiosriseandprofitratiosrise,but
identifiablepatternsemergeinwhichassociationstendtobenegativelycorrelated.There
isalwaysalagtimebetweencapitalinvestmentandprofitability,andthestockreflectsthis
risk.Differentcombinationsofchangesintheratiosseemtohaveafavorableor
unfavorableeffectonrisk/returnfactorsandultimatelyonthecompany’sstock.Whilethe
patternsseemliketheoldscreens“dressed”inprobabilisticgarb,theymerelyofferamore
elaboratemethodofobservingrisk.Theyarebothactionableonacorporatelevel,and
viewableonaninvestorlevel,andofferaninterfacebetweentrendsinthecapitalmarkets
i.e.,lowerinterestrates,andintracompanyfundamentals.Theyarenotmeanttoforecast
stockprices,becausethemarketreactstotheproportionofdebttoequitybasedonthe
priceofriskofeachrespectivecomponent.Forexample,atthebeginningofanexpansion,
debtmayberelativelyinexpensiveandleverageratiosthatentailincreasingdebtmight
flourish.Ontheotherhand,afterinterestratesrise,leverageratiosthatimplyequity
financingmightbemoreprofitable.Inessenceeachcombinationformsa“leveragestate”
thathasacharacteristicprofitabilityandforeshadowsnear-termcapitalchanges.
LEVERAGESTATES
Considerthenatureofcapitalinvestment.Companiesdonotwanttoissuestockeachyear
becausesuchactionsdilutethepriceofoutstandingsharesandhaveprohibitivelyhigh
floatationcosts.Yet-companiesdowanttomakepublicissueswhenthepriceofthestock
ishighenoughsuchthattheissuednumberofsharesiskepttoaminimum.Secondly,
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onceacompanyeitherstartstopayoffitsdebtorreplacesitproportionatelywithequity,it
tendstodosoforaslongasitssectorisfavoredbythemarket,Inessence,ahighermarket
willmeanbothmorestockissuesandmoreretainedearningswhichwillboostthe
proportionofequitytodebt,aswellasthestockprice.Rarelywillapatternofalternating
yearlydebtincreaseswithequityincreasesbeprofitable,becausethereisalwayssomelag
time,andmomentumthatwillmakechangesineachcapitalcomponentfallintoatrend.
Whenmanyincreasesinleverageoccuroveranumberofyears,itisindicativeofan
insolventcompanyandthestockfalls.Iftoomanyequityincreasesoccur,thenthe
companyisviewedasnottakingonenoughrisktobecompetitive,andagainthestockfalls.
Thekeytostockappreciationistomoveawayfromtheoptimalcapitalstructureand
followitupbyanumberofsmalljumpsbacktowardsit.Companiescanmoveawayfrom
thetargetwitheitherdebtorequity,butmostmovementswillentailtheacquisitionof
productivecapacitypurchasedwithadebtissue.Inthiscase,themovementbacktowards
theoptimaltargetstructureencompassespayingoffdebtwithhigherearningsand
retainingthosesameearningstoimprovethecompany’sequityposition.Successful
companieswilltrytominimizetheyearsthatleverageincreases,andmaximizethenumber
ofyearsaninvestmentpaysoff.Usually,themomentumofthecompany’srespectivesector
willdetermine,howlonghigh-demandforitsproductswilllast.Atthe“omega”point,a
companywillretrench,andhopefully“recharge”thecyclewithresearchanddevelopment,
small,riskreducingacquisitions,andevenmoredebtissues.Inessence,aleveragestate
willreacttothemarketintermsofpriceandrisk,andchangesintheROCfactorswillbe
derivedfromtheintegrationoftheproductioncyclewiththecapitalmarkets.Ontheother
hand,thelevel(proportion)ofdebtinthecapitalstructurewillbederivedfromthe
steadinessoftheproductioncycleandthetypeofassetsitneeds.ROCfactorscantellusif
weneedtoincreasedebtorequity,buttheycannotsettheoptimaltargetproportionby
themselves.
INDUSTRYAVERAGES:LEMMINGSVSLEADERS
523

Thetypeofindustryrespondstomarketdemandbyestablishingaveragevaluesfor
eachROCfactor.Theamountoffixedassetsandtheinherentriskstheyentail,establishes
apatternofprofit,costs,andcapitalneeds.Whilenoindustryaverageis“setinstone”,
ROCfactorsgenerallyreverttotheirmean,allowinganalyststomakepredictions,and
establishingdefinitivecorporatebehaviorforeachleveragestate.Infact,manycompanies
withinasectorwillsharethesameleveragestate,simplybecausetheirresponsetoproduct
demandissosimilar.Depreciationratesaresimilar,andeachcompanymustmakea
requiredamountofcapitalexpendituresatthesametime.Thus,entireindustrieswillbe
takingondebtorbuildingequity,dependingonexistingmarketfactors,andthecostof
capital.Whencapitalstructureisinvolved,acompanymustexamineitsexisting
prerogatives–especiallyifitfindsitself“outofsync”withthefundingactionsofthe
competition.Althoughitispossibletotakeriskswhenotherfirmsare“restingontheir
laurels”,themarketwilldeterminewhichcapitalincreasesaremostefficient.Infactifa
majormacro-factorlikeinterestratesisanticipatedtobeatacertainlevelforalongtime,
theoptimaltargetstructuremaychangetoconformtoit.
THELEVERAGESTATERATIOS
WemodifytheROCfactorstomakethemmoreuseable.Thecostofdebt,
EBT/EBIT,becomesthefinancialleverageratio,EBIT/EBIT-Interest.Wechange
operatingmarginintoadynamicratio,operatingmomentum,whichis%∆ ∆∆ ∆EBIT/%
∆ ∆∆ ∆Sales.Wemeasurethechangeinlong-termdebttocapital,LTD/CAP.Lastlywe
measurethechangeinassetstocapital,Assets/Capital.Alloftheseratios,including
operatingmomentum,aretreatedasanincreaseoradecrease;inthecaseofoperating
momentum,weareactuallymeasuring“achangeofachange”.Althoughthetaxretention
ratio,NetIncome/EBT,iscrucialtothemarginalbenefitsequation,itisnotincludedinthe
leveragestatebecauseitistheleastsubjecttostrategicchange;firmsmustmanagetheir
taxstructureswithintheparameterssetbythegovernment.Operatingmomentumandthe
financialleverageratioestablishaninterfacebetweenproductionandthecostofdebt.
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Long-termdebttocapital(LTD/CAP)establishesnotonlytheproportionofdebttoequity,
butimpliesthecostofequity,whichriseswiththeproportion.Lastly,theratio
Assets/Capitalestablishesthedegreeofcurrentliabilitiesemployedbythecompany;an
increaseinthisratiocanimplythatthecostofcapitalisdecreasingbecauseofalternative
short-termfinancingorontheotherhand,thatdebtissopervasivethatsolvencyis
endangered.Itthereforerequiresmoreextensiveanalysistointerpretcorrectly,andmay
revealdynamicsnotencompassedbyothermeasurements.
COMBINATIONS
Thestudent/analyst/investorisencouragedtosearchformeaningfulcombinations
ofchangesintheseratiosthatprecedefuturegrowth.Thisauthor’scombinationsareonly
suggestedbecausetheyworkedovertheentiredecadeofthe1990s.Whilesentimentswere
“bullish”duringthoseyears,someoftheseleveragestatesproducedpaltrygainsifany.
Othersbeatthemarketbyasubstantialmargin.Moreover,someofthesecombinations
occupiedahighpositiononthe“efficientfrontier”,suchthattheleastamountofriskwas
combinedwiththegreatestamountofreturn.Sincethemarketchanges,eachofthese
stateswillbevaluedsomewhatdifferentlyineachbusinesscycle.Asanexample,consider
whatmighthappenifoneincreasesAssets/Capitalwhentheyieldcurvebecomesinverted
andshort-termborrowingratesareabovelong-termrates.Anyalternativefinancingdone
withshort-termdebtactuallybecomesmoreexpensiveandraisesthecostofcapital.The
marketthenendsuprevaluinganyleveragestatebasedonthisratio.Inessence,investing
onthebasisofaleveragestatewithoutdoingpriorresearch,andevaluatingthecontextof
themarket,willcreateanuncoordinatedresponsetocurrentconditions.
525

Table21-1

LTD/CAP FINANCIAL
LEVERAGE
RATIO
OPERATING
MOMENTUM
ASSET/CAPITAL
1.INCREASE + +
2.INCREASE + -
3.INCREASE - +
4.INCREASE - -
5.DECREASE + -
6.DECREASE + +
7.DECREASE - + +
8.DECREASE - - +
9.DECREASE - + -
10.DECREASE - - -

Assets/Capitalbecamealegitimatecategoricalvariablewhenfirmsdecreasedtheir
proportionoflong-termdebtandfinancialleverageratiobecauseitindicatedasubstitute
methodoffinancing.Infact,withthe1990sdata,itsuccessfullypredictedyearlycapital
outlayswhenitwasincreasedwhileoperatingmomentumandtheleverageratioswere
decreasing.However,extrapolationintootherperiodsrepresentsaspecificdanger;assets
tocapitalwillactdifferentlywhentheyieldcurvechanges.
THEMECHANISMOFLEVERAGESTATES
Whenwecangrowacompanybyincreasingbothdebtandequityand
simultaneouslydiminishtheprobabilityofdefault,wewillmaximizethetaxbenefitsof
debt,withoutincreasingthecostofbankruptcy.Suchascenarioischaracterizedbyan
increasingEVA,andisperpetuatedbylowerinterestrates,alowercostofequity,orboth.
Thefoundationsforthismechanismarethefollowing:
• CHANGESINBETA:BothHamadaandtheMiller/Modiglianiteamhadestablished
thatbetachangedbecauseofincreasesintheproportionofdebttoequity.
Additionally,MandelkerandRheedecomposedbetaonthebasisofoperatingrisk.
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Thusfinancialriskandoperatingriskwillchangetherisk/returncharacteristicsofa
stock.
• EARNINGSPRESSURE:Anytimeearningsacceleratesfasterthanthatofotherfirms
inthemarket,thestockrises,usuallybecauseoneofthetwocomponentsofoperating
momentum,EBITorsales,isacceleratingaswell.
• CHANGESINTHECOSTOFCAPITAL:Diminishingbetawilldecreasethecostof
equity.MoreearningsretainedatthesametimethatLTD/CAPisdecreasingwillgive
thefirmamorefavorableinterestrateinadditiontoprovidinginternallygenerated
fundsthatwillbelessexpensivefromanaccountingperspective.Fromaneconomic
standpoint,thesefundsmustbegaugedbythecomparativerisk/returnprofileofthe
market,aseventhis“free”sourceofcapitalcanbecostlywhenthemarketisespecially
overheated.
• TRENDSANDTHEOPTIMALCAPITALSTRUCTURE:Whenafirmisclosetoits
targetcapitalstructure,itsprofitsarenearlymaximizedagainstthecostofcapital,
whichismeasuredbychangesinEVA.Reversionoftheleveragestatecomponentsto
theirmeansisless,becauseafirmneedstotakelessactiontoachieveanoptimum.
Consequently,astrategythatbringsacompanynearitstargetwillbealmostself
perpetuating;thegenerationoflargeprofitswillhavediminishedtheneedformore
debt,andthefirmwilltrytotakeadvantageofitsequitypositionaslongasdemandfor
thestockisbeingupliftedbymoreearnings.
Marketinefficienciesseldomoccurforanylengthoftimeandwhentheydo,
popularityquicklyeliminatesthem.Forexample,ifItradeonlineandfindthata“double
stochasticcrossover”isespeciallyprofitable,itismostprobablethatothershave
discoveredit,willbeginusingit,andthatitwillbegintoworklessandlessprofitably;the
marketfactorsintheinefficiency.WhenMichaelMilkienstudiedthejunkbondmarketin
the1980s,herealizedthatdefaultprobabilitiesdidnotcorrespondtoprices.Hetookthat
knowledge“allthewaytothebank”untilpriceanddefaultwere“insync”-which
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occurredassoonastheinvestmentbecamepopular.Similarly,HarryMarkowitzdid
convertiblebondarbitragebeforeinvestorsrealizedthatsuchanopportunityexisted.
Again,popularityledtoitsdemise.
Sincetheseleveragestatesinvolvechangingdynamicsbetweenleverageandthe
market,theyarenotexploitinganinefficiencyperse,onlythedefinitionofthefactors
leadingtothehighestcombinationofreturnandrisk.Theyneedtoberedefinedwhenever
themarketreachesaturningpoint,usuallybecauseofanimminentdownturn,but
sometimesbecauseoftechnicalinnovation(popularizationoftheInternet)andeven
becauseofcatastrophicevents.Eightsuchmarket-changingfactorsareasfollows:
• 1.InterestRateLevelsandChanges
• 2.YieldCurveChanges
• 3.LiquidityPreference
• 4.Legislation-Newtaxlaws,SarbanesOxley,etc.
• 5.ForeignMarketRisk
• 6,ExchangeRateRisk
• 7.InflationRisks:BothcurrentandExpected
• 8.ConfidenceinEquities
Asanexample,afteradownturn,moredebtforacompanywithastrongbalance
sheetmightlowercapitalcostsbecauseinterestrateswouldhavebeenloweredbythe
FederalReserve.Inthatscenario,aleveragestatethatincreasestheproportionofdebt
andyetincreasesoperatingmomentumaswell,mightbebetterthanonethatincreasesthe
proportionofequity.Stockwouldnotbeinhighdemandatthispoint,norwouldretained
earningsbehigheither.Infactthemarketmightevendowngradeafirm’sprospectsfor
nottakingonenoughrisk.Wheredoesthatleavecompaniesthatmustfinancewithall
equity?Becauseoftheirhigherbetas,suchfirmsmustdependmoreonearningswhich
wouldberelativelylowimmediatelyafteradownturn.Thesefirmsmustdoalltheycanto
eliminatehigheroperatingriskbyexpandingcustomerbasessothatthereislesssingular
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dependenceonasmallgroupofcustomersorvendors.Suchactionswilllowerriskwithout
changingthefundamentalnatureoftheirbusinesses-usuallyahighprofitalbeithighrisk
andlowdebtscenario.
MATCHINGTHELEVERAGESTATETOTHEBUSINESSCYCLE
Thefollowingtableindicatestendenciesandnotabsolutes.Therearefirmswho
takecontraryactionstothebusinesscycleandalsodowell.
Table21-2

ECONOMICSTATE
RECOVERY EXPANSION MARKETPEAK

CAPMVariables CAPMVariables CAPMVariables
Market-Low Market-Medium,
Increasing
Market-High
RiskFreeRate-Low RiskFreeRate-Medium,
Increasing
RiskFreeRate-High
Beta-Low Beta-Increasing Beta-Highand
Decreasing

Debt-Medium Debt-Highand
Increasing
Debt-Highand
Decreasing

FavoredIndustries FavoredIndustries FavoredIndustries
InterestSensitive SecondaryGoods CapitalGoods
ConsumerDurables Transportation

OperatingRisk-Low OperatingRisk-Medium,
Increasing
OperatingRisk-High,
Decreasing

FinancialLeverage FinancialLeverage FinancialLeverage
High MediumtoHighand MediumtoLowand
Increasing Stabilizing Decreasing

Thecapitalassetpricingmodel(CAPM)offersasimplisticbutsometimesvalid
explanationfortheconformityofsomefirms’capitalstructurestothebusinesscycle.Ifwe
529

canacceptthatbetaincreaseswiththeproportionofdebtinafirm’sstructure,andthat
theFederalReserveraisesinterestratesastheeconomyimproves,wecansurmisethatthe
greatestamountofdebtshouldbeincurredwhenbothinterestratesandbetaareatlow
points.Whenthefirmdoesthegreatestamountofdebtfinancingatthebeginningofan
expansion,itisincurringtheleastamountofriskforthegreatestamountofpotential
return.Asbetariseswithmoredebt,thefirmcantakeadvantageofrisingstockprices.At
thispoint,earningswillbeacceleratingfasterthanthecostofequityandcapitalwillbe
flowingintothecompany.AstheFedraisesrates,debtfinancingbecomeslessandless
attractiveandthefirmbuildsequitythroughhigherretainedearnings,andsometimesnew
stockissues,whichhavebecomemoreattractivewithincreasedearningspershare.
Decreasingtheproportionofdebtinthecapitalstructurewilllowerbeta,whichisexactly
whatthecompanyneedstodo:bythistime,theeconomyhaspeakedandbeginsto
plateau,andearningshavebeguntodecelerate.Althoughthestrategicallyastutefirm’s
betahasdecreased,boththerisk-freerateandthemarketratehaverisen,creatingmore
risk.Eventually,thecostofcapitalrisesfasterthanthevelocityofcollectiveearningsand
theeconomygoesintoadownturn.FromaCAPMperspective,themarketriskpremium
willbegintofall,asmoremoneyflowsintobonds;stockswillbegintoofferbothmorerisk
andlessreturn,althoughdividendyieldswillrise.Themarketactslikeabarometerfor
earningsexpectationsastherateofchangeofearningsbecomeslessthantherateofchange
forthecostofequity,andstocksbecomeoverpriced.
Itisasdifficultforanycompanytofallintothisstrategicimperative,asitisfor
investorstoprofitfromit.Theideaofmoving“fund“moneyintoutilitiesandconsumer
staplesduringadownturn,isdirectlyreflectiveofthosesector'scharacteristicallylow
betas.Thesefirmshavelowoperatingleverageandsteadydemandeveninabadeconomy,
andofferareturnthatexceedsthatoftreasuries.Acting,likeamicrocosmofthelarger
company,theinvestorprofitsbyshiftingassetsintoareasoflowerrisk.Whilethat
530

techniqueoffersbothentities(thecompanyandtheinvestor)animmediatereward,itisnot
asconducivetoloweringriskasisdiversification.
PROBABILITYANDDIVERSIFICATION
Mostacademicshaveahealthyskepticismaboutbeta.Infact,thisbookoffers
severalalternativecalculationsforthecostofequitysimplyforthepurposeofanalytical
diversification;ifallmethodspointusintherightdirection,theprobabilityofbeingwrong
ismuchless.OnecanneverforgettheBlack,JensenandScholesstudyofthelatefifties,
earlysixtiesthatfoundhighbetastockstobenegativelycorrelatedwithreturn,whilelower
betastockscompensatedinvestorsmuchmorethantheirinherentriskswarranted.Since
thetheoreticalidealencompassesa“riskreturntradeoff”,betawasdroppedbymanywho
wereontheCAPMbandwagon.Mathematically,eachcompanyhasadifferentcorrelation
coefficienttothemarketindex,whichmakesbetaanissueofindividualresponseandnot
collectivedynamics-althoughtheCAPMsometimesmakesperfectpredictionsaboutthe
market.Whenthecorrelationcoefficientissmaller,betawilltakelesspreeminencethan
“Alpha”,whichwillexplainsucheventsaslawsuits,favorablelegislation,andeven
industrycollusion.
Thedownwardbiasofhighbetastocksshouldbeviewedasbothawarningandan
opportunityforinvestorsandcorporationsalike.Mostofthestocksinthetechbubble
werehighbetastocksandyetthelowbetasstocksroseaswellduringthatperiod.Whena
largecompanyisgrowingbyacquisitions,itcanminimizeitsmarketvolatility,but
increasethe“Alpha”componentandrespondwithlargepricejumpsatthetimeofthe
purchases.Suchactionswillkeepbetatoaminimumandyetpotentiallyincreasethestock
priceatarategreaterthanthemarket.Secondly,whenacompanydiversifiesits
operationsintootherrelatedareas,itcanexpanditssalesandlowerits“unlevered”beta,
creatingalowprobabilityofdefault.Infact,acquisitionsareoftenimplementedforthis
veryreason:Thereductioninriskisderivedfromalowercovariancebetweensalesand
themarket-whichisatheoreticaldeterminantofbeta.
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SALESANDBETA
Ahighermeanincreasecoupledwithalowerstandarddeviationshouldbethesales
goalofanycorporation.Steadiersaleswillincreaseprofitsallowingmoredebttobe
incurredwheninterestcoverageincreases.Forallequitycompanies,moreretained
earningswillbeproduced,andfundsflowingintothestockwillfollowasteadierpattern.
Ineffect,acompanycansacrificesomeprofitmarginforassetturnoverandproducethe
samereturnonassetswhileloweringrisk.Ofcourse,mostcompaniesdonotwanttogive
uptheinherentpricingpowerthatcomesfromhigherprofitmarginsandsotheysettle
themselvesintoa“niche”wherethereislittlecompetition.Sincetechnologyisagreat
“equalizer”andoftenremovesniches,theimportanceofsalesdiversificationisself-evident.
ThecornerstoneofMandelkerandRhees’sdecompositionofbetawasthestrong
relationshipofacompany’ssalestothestockmarket.Toreviewthatconnection,recall
thatthreemainfactorswereinvolved:
• 1.Thehistoricalreturnonequity,ROE.
• 2.ThecurrentperiodTotalLeverage,determinedbymultiplyingthepureform
operatingleverage(operatingmomentum)bythepureformfinancialleverage:(%
∆ ∆∆ ∆OperatingIncome/% ∆ ∆∆ ∆Sales)x(%∆Ν ∆Ν ∆Ν ∆ΝetIncome/ % ∆ % ∆ % ∆ % ∆OperatingIncome)
• 3.Themostrecentcovarianceofthereturnonthemarketwithcompanysales,divided
bythevarianceofthemarket:COV(Sales,Market)/Marketσ σσ σ
2

ThefinalequationismerelyROExTotalLeveragexCOV(Sales,Market)/Market
Variance.
Thelastfactor(3)istheprinciplecomponentofbothsectorrotationinthegreatermarket
anddiversificationwithinthecompanyitself.Forexample,inthelate1990s,techsales
wereprizedmorethannaturalresourcesalesandproducedbothagreatercovariancewith
themarket,andlargeamountsofcollectiveoperatingleverage.DuringtheY2Kfallout,
theeconomysoaredbecauseoftech“upgrades”,butbecamemoreriskybecausethemore
volatiletechsectorbecamealargerproportionoftotalGDP.Onelookatthebasic
532

structureofcovariancecantellusasmuchasmostjournalistichistories:Allthree
componentsofcovarianceroseatthesametime.
• 1.“R”:Pearson’sCorrelationCoefficient::Themarketcorrelationwithcompanysales
soaredastechbecamemoreprominentandtheInternetbecamepopular.
• 2.Thestandarddeviationofthemarketreturn:Asinterestratesrose,thefargreater
returnonthemarketproducedahighriskpremium.Moneyflowedintoequities,but
wasofteninvestedina“promise”ratherthanrealassets.IPOs,startups,andbiotechs
thathadnoearningshistoryreceivedlargeamountsofcapital.
• 3.Thestandarddeviationofthechangeincompanysales.Mostfirmsenjoyedsteady
salesthroughoutthe1990s;theirriskremainedlow.Unfortunately,theprominenceof
techsalesinducedmoreoperatingriskintotheeconomyandacollectivelyhigher
standarddeviationforsales.
Thecovarianceisthuscomposedof“R”multipliedbythestandarddeviationofthechange
incompanysales,multipliedbythestandarddeviationofthemarketreturn.Thestrategic
implicationsofthisequationarevast.Althoughfewcompaniescantimethemarket,
financialmanagementdoestrytotakeadvantageoflowinterestratesoranaboveaverage
demandforcompanystock.Duringanexpansion,thereislessriskfromraisingboth
leveragecomponents,andbetawillrisewiththemarket.Asthemarket“overheats”,
companiescanexpandcustomerbases,andsimultaneouslylowerbothoperatingleverage
andthestandarddeviationforsales.Atthesametime,theycanlowertheirproportionof
debtinthecapitalstructure.Betawillnaturallydropwithlessrisk,butweneedto
rememberthatitwillalwaysbewithintheboundsoftheindustry.Ahighbetabiotechwill
neverdropdownto0.5,iftheinherentbetais1.5.Thus,unlessthecompanywantsto
changeitsbasicnatureandbecomeaconglomerate,itwill“alwaysbeatthemercyofthe
market”.
Oneotherstrategythatismoreesoteric,wouldbetoexpandthealphacomponent
intheregressionequationandminimizethecorrelationcoefficient,“R”.Forexample,a
533

fertilizercompanythatisregisteredontheNewYorkStockExchange,butprimarilymines
batguanoinAfrica,andsellsittotheMiddleEast,mightbesomewhatbufferedfromthe
shocksoftheAmericanmarket.Althoughmarketsaremoregloballyconnected,unusual
circumstancessuchasprotectivelegislation,willimmunizeacompanyfrombeta.Another
exampleoflowcorrelationoccurswhencommoditypricesincertainindustriesrise
contrarytotheeconomy;executiveswilljugglethestrategicadvantagesofthese
associationstoinsulatetheircompaniesfrommarketvolatility.
Theconnectionbetweentheindividualinvestorandcorporatefinanceiscemented
withbeta.Themarketfavorsasectorbecausesalesgenerateincomeatamorerapidrate
thantheoverallmarketcanproduce.Individualinvestorsdirecttheflowofcapitaltothese
companiesbecausetheyofferthehighestreturnfortheleastamountofrisk.Ona
corporatelevel,theindustriesinthefavoredsectorsareoptimizingtheircollectivecapital
structuresbychangingtheriskcharacteristicsofleveragetolowercapitalcostsandraise
profits.Betaintheseindustriesmaybequitelow,buttendsto“overreact”topositive
changesinthemarket.Ultimately,salesaccretionthroughinvestmentinprojectsthat
balanceriskanddiversifyoperations,willexpandthecustomerbase,andcreatea
favorablebeta.
PROBABILITYANDANTICIPATION
“Beta”andtheCAPMhaveatheoreticalbasethatisnotalwaysapplicable.The
marketcanchangeinunanticipatedwaysthatcanleaveanalystsscratchingtheirheads.
Withmorevolatilitycomesincreaseduncertaintyandfunctionsthatmeasurepast
performancearesimplyinadequateasforecastingtools.Eventhemarginalbenefits
equationandEVAareex-postmeasurementsofmovementtowardtheoptimalwithout
referencetothefuture.Whilewecancreateanongoingcompendiumofcorporateresults
andchecktoseeifthecompanyisdoingwhatitneedstodo,dataisreceivedafterthefact.
Undeniably,asystemthatanticipateslargecapitalmovementswouldbesuperiorto
“chasingearnings”.Ifanalysiswereaseasyassightinglargecapitalinflowsand
534

calculatingpayofftimes,boththeriskandreturninthemarketwouldbeminimized;
stockswouldbeliketreasuries,andprofitswouldbelikeclockwork.Althoughleverage
statescanpointusintherightdirection,themarketwillvalueeachstatedifferentlyat
differenttimes,andweneedtogaugethelargereconomyaswellastheindividual
company.
Bycheckingtheleveragestatesofthemostfavoredsectorintheeconomy,wecan
gainsomevaluableinformation,especiallyifthesectorfallsintoapattern.Forexample,if
mycompanyistakingonequitywhilethemostfavoredsectoristakingondebt,Ineedto
lookatmycompany’sresponsetointerestrates.Ifmycompanyhasanall-equitycapital
structureandeschewsdebt,Iobservetheoperatingmomentumofthefavoredsectorand
askquestionssuchas,“Isoperatingmomentumdecreasingonthebasisofmoresaleswhile
operatingmarginsincrease?CanIanticipateahigherEVAbecauseequitygainsaremade
fromretainedearningsandnotfromstockissues?Insomemarkets,leveragestatesinthe
topsectormayformnodiscerniblepatterns:companiesthatincurlargeamountsofdebt
maybeincreasingtheirstockpricesjustlikethosewhoissuelargeamountsofequity.In
suchachaoticsector,itwouldbebesttoavoidinvestmentunlessoneintendsto“getout
fast”,becausethesefirmswillbe“outofsync”withthecapitalmarkets,andasurgein
profitsmaybefollowedbyacaseofclassic“buyer’sremorse”.
PRINCIPLECOMPONENTSANALYSIS
Thediscoveryofleveragestateswasbaseduponpatternrecognitionfromseveral
setsofdata.Inthesamewaythatagamblerchecksoffhorseracingcharts,leveragedata
wasfilteredthroughaseriesofplusesandminusesbeforeitwassubmittedtomore
sophisticatedtesting.Thedatasetexhibitedabalancedarrayofpatternsthroughwhat
statisticianscall“principlecomponentsanalysis”.Thistechniqueestablisheswhichlinear
combinationsofdatawillcreatethegreatestamountofvariationandidentifiescomponents
usinganEigensystem.Eachcomponentisgivenaweightasapercentageofthewhole.
Thegreatestweightisnotthemost“important”component(althoughitoftenis),butthe
535

elementcausingthemostvariationinthedata.Forexample,thefollowingchartappliesto
thedatainthecorrelationstudies:
Table21-3

VARIABLE EIGENVALUE PERCENTAGE
OperatingIncome 2.4335 60.8%
Assets 1.0555 26.4%
Capital 0.39864 9.97%
Sales 0.1124 2.81%
Weknowthatnooperatingincomecanexistwithoutasale,sothepaltry2.81%
contributedtothevariationbysalesdoesnotdiminishitsimportance.Wemerelyclaim
thatanycategorizationincludingtheoperatingincomevariablewillbeheavilyinfluenced
byit.Infact,withmostcombinationsofthreetofourvariables,onevariablewillbe
preponderant,andtheotherswillnotcontributeanequitableshareofthevariation.
However,thefollowingtableappliestotheleveragestatevariables:

Table21-4

VARIABLE EIGENVALUE PERCENTAGE
LTD/CAP 1.1687 29.2%
FinancialLeverageRatio 0.99438 24.9%
Asset/Capital 0.95529 23.9%
OperatingMomentum 0.88154 22.0%

Theseratiosareveryclosetoeachotherandaddsimilaramountsofinformation.They
workwelltogetherasa“team”becausebothnumeratoranddenominatorcontain
interconnectedpiecesofdatathatcontributetothewhole.LiketheROC/ROEDuPont
equationsfromwhichtheywerederived,theleveragefactorsareflexibleandeasyto
manipulate,containingcommondependenciessuchasfixedcosts,interestexpenseand
operatingmargins.Whileequalityineffectivestrengthdoesnotimplythattheseratioscan
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categorizeleverage,theydoformameasuredinterfacebetweenprofitabilityand
investment,albeitanimperfectone.
STATICVSFORWARDLOOKINGRATIOS
Makinginvestmentdecisionsbasedonpastdataisalmostalwaysdoomedtofailure.
Infact,theefficientmarketshypothesisevolvedforthisveryreason-enoughmistakes
havebeenmadewhileobservingsalesandearningshistoriestodecipheracausation.We
termex-postmeasurementstobe“static”,notasanegativeconnotation,buttodeclarethat
moreinformationisneeded.Forexample,thatnetincomeincreasedtwentypercentlast
quarterisa“static”measurement.Nowiftheanalystproclaimedthatnetincomeis
anticipatedtochangeatarateofthreetimesthemarketinthenextquarter,thatwouldbe
aforward-lookingmeasurement.Unfortunately,suchproclamationsmustbeaccompanied
byacaveat,andaresometimesoutrageouslywrongaswell.
Theleverageratios,particularlyoperatingmomentumandthefinancialleverage
ratio,areinherentlyforward-looking.Thederivationofoperatingmomentumincreasesis
basedonthreeyearsofdata,andimpliesahighprobabilityofaconsistentchangein
operatingmargin,especiallywhenmomentumincreases.However,operatingmomentum
byitselfistoovolatiletouseasapredictivetool.Bothincreasesanddecreasescanleadto
moreoperatingriskandthemeasurementcanincreasetenfoldwhenacompanyturns
aroundfromabadyear.Nevertheless,operatingmomentumhasastrongtendencyto
reverttoitsmeansimplybecauseitisindicativeofthetypeofcoststructureinherentinthe
industry.Ifitdecreaseswellbelowitsmeanfortwoyearsinarow,theprobabilityofan
increaseisfairlyhigh.Naturally,ifanalystswillgivetheinvestorasalesforecast,then
operatingincomehasatleastsomepredictability.Infact,asmentionedinprevious
chapters,operatingmomentumwillmimictrueoperatingleverageinthenextyear,aslong
ascostsarestable;thatis,variablecostsremainastablepercentageofsalesandfixedcosts
donotchange.Analogously,thefinancialleverageratiowillmimic%∆ ∆∆ ∆NetIncome/%∆ ∆∆ ∆
OperatingIncomeaslongasinterestexpenseremainsconstant.Onatheoreticalbasis,as
537

longascostsandinterestexpensewerestable,netincomewouldbetotallypredictablefrom
changesinsales.Weknowthataprecisenumberisnotdeterminablebecauseofvolatility
inbothcostsandleverage,butthattheflowofchangetendstoreverttoitsmean.Thus,if
weviewtotalleverageastheproductofoperatingmomentum,andtheoreticalfinancial
leverage,ourequationwouldbe:(% (% (% (% ∆ ∆∆ ∆OperatingIncome/ // /%∆ ∆∆ ∆Sales)x(%∆ ∆∆ ∆NetIncome/
%∆ ∆∆ ∆OperatingIncome)=%∆ ∆∆ ∆NetIncome/%∆ ∆∆ ∆Sales.Inevitably,ahighlyvolatile
electronicscompanywithnodebtcanhavethesametotalleverageasastaidchemical
companythatchoosestofinancewithtoomuchdebt;thetotalriskwillbeimplicitineach
company’sstockprice.Theconnectionbetweentotalleverageandthefirm’scapital
structurewillbereflectedbythreeaspectsoftheratio,%∆ ∆∆ ∆NetIncome/%∆ ∆∆ ∆Sales:
• 1.Thesize(level)oftheratio
• 2.Themagnitudeofitscomponentparts(netincomeandsales)
• 3.Thevolatilityofnetincomeandsalesasmeasuredbytheirrespectivestandard
deviations.
Toexaminereversiontothemean,wewilluseEnescoasanexample:Thisbranded
giftcompanyhadastormyeconomicrelationshipwiththe1990s,andwasnotamenableto
prediction.Tobegin,weobtainafiveyeargeometricaverageofbothsalesandnetincome
usingthe“growthtrend”technique.Thisisourtarget“guesstimate”,whichdoesnothave
tobeprecise;infact,wecanevendropayearthatwesightas“notinthetrend”andadd
anotheryearinitsplace.Thefiguresinthetableareabsolutevaluesfromtherespective
yearandnotpercentagechangesbecausethegeometricaverageisimplicitlydefinedbythe
changebetweenperiods.
538

Table21-5

ENESCO 1996 1997 1998 1999 2000 2001
NET
INCOME
38.4 10.5 -22.4 26.9 15.1 1.1
SALES 845 476 451 384 325 269

Ratherthanchoosetherecessionyearof2001astypical,weoptfor1996to2000becauseit
ismoreintrend.Separatespanscanevenbechosenforeachratioaslongaswekeepthem
intrend.Thegeometricgrowthratewillbetheratioofthelastyearinthetrenddivided
bythefirstyearandthen"exponentiated"bytheinverseofthenumberbetweentheyears
-four.Fornetincomethemethodyields,(15.1/38.4)
.0.25
=0.791883.Notethattheinverse
offour,thenumberofyearsbetweenthefive-yearinterim,is1/4or0.25whichisthe
exponent.Finally,toobtainapercentagerateofgrowth,wesubtractonefrom0.791663to
obtain-0.2081or-20.81%.
Forsales,theratiois(325/845)
0.25
=0.787511.Subtractingoneyields-21.25%.
Thefinaltotalleverageratiois-20.81/-21.25whichisequalto0.97929.Itisthe“nature”
ofEnescotomovetowardthisnumberfromeitheraboveitorbelowit,mostlythrough
changesinoperatingmomentum.
AlthoughEnescowasanextremelyvolatilecompany,wewilluseanearlierperiodto
checkourcalculations,andadditionally,wewillusethefinancialleverageratio
(EBIT/EBIT-I),andnotthetheoreticalratiotoderivetotalleverage.

539

Table21-6

Years FinancialLeverage Operating
Momentum
TotalLeverage
1990 1.0607 -1.59 -1.6865
1991 1.0614 -1.67 -1.7679
1992 1.0388 1.11 1.1549
1993 1.0227 -1.05 -1.075
1994 1.0232 -0.406 -0.4154
1995 1.0845 2.642 2.8658
1996 1.1058 -5.035 -5.568
1997 1.2305 1.375 1.692

Exceptfor1991,eachyearsawamovetowardthemeanof.979,althoughonlyoneyear,
1992,cameclosetoit.Thequestionfortheinvestorandanalystis:givenalevelof
financialleverage,whatoperatingmomentumwouldachievethemeanleveloftotal
leverage?Toanswerthisquestion,wewilluse1992asanexample.Thecompanyachieved
aratioof1.11withanoperatingincreaseof5.32%versusasalesincreaseof4.79%.The
entirebasisofcapitalstructurestrategyhypothesizesthatthestockcouldhavemovedup
onthesepaltryfiguresaloneprovidingthattheywereconsistentenoughtoallow
incrementalincreasesinfinancialleverage.In1992,hadanalystsgivenaperfectsales
forecastof4.79%,ourbestextrapolationwouldhavebeen.979/1.0388=0.9424
Multiplyingthatfigureby4.79%equals4.51%.Theactualoperatingincomeroseby5.32
%.Partoftherisk/returnstructureencouragesinnovativemanagementtotakechances-
suchasincreasingfinancialleveragewhentotalleverageiswellaboveitsaverage.
However,innormalriskenvironments,theimperativemovementisreversiontothemean
540

simplybecausethismeasurementdefinesthenatureofthecompany.Sincevendors
provideaspecificcoststructureandcustomersexpectaspecificpricestructure,companies
mustworkwithinlimitationsandtheresultwillbeanattempttokeepthisratiostable.
Inevitably,thebestruncompanieswilltrytostructuretheirleveragetostayasclosetothe
meanaspossible,whichlendsanairofpredictabilitytothisvolatilecalculation.
THEQUICKPAYOFF
Certainly,themorerapidlycapitalisturnedintoprofit,themorequicklyinvestors
getpaid.Whilewecanmeasurethehistoryofcapitalturnover(Sales/Capital),andeven
salestolong-termdebtratios,eachmarketisdifferent.Often,thebestprospectwillbea
companythatiswellabovetheindustryaverageinLTD/CAP,butmovingbacktowardsit.
Averageanalystswillnotpickuponthemovementandwilldismissthefirmas“debt
ridden”-whichitis-onpaper.Atothertimes,anincreaseofallfourleverageratioswill
provideahighriskleveragestatethatisworthyofinvestment.Inthelattercase,whenan
investorisputtingcapitalintoafirmthatisincurringdebt,heorsheistakingahigher
risk,andishopingforaswitchtoaleveragestateinwhichthecompanyistakingonequity
fromhigherearnings.Thus,morereturnisoftenculledfromthese“debtstates”,simply
becausetheoddsof“losingone’sshirt”aregreater.Unfortunately,thereisnomagic
formulathatwillguaranteeaquickpayoff,butiftheinvestoroperatesinthecapacityofa
quasi-ratingsagency,andusesdefaultprobabilitiestoevaluateafirm,downsideriskwill
bereduced.Inessence,theinvestordifferentiatesbetweena“weak”companywhomust
takeondebttomaintainbasicproduction,anda“strong”companywhousesdebtasa
strategicimperativetofundprojectsandoptimizecapitalstructure.Besidesexamining
marginalbenefitsanddefaultprobabilities,severalothertenetsneedtobeadheredto:
• Operatinghistoryshouldbestrongenoughtogetapreferredinterestrate.
• Salesneedtobeconsistent.
• Thedebtissueshouldbelargebecauseitislessefficienttogotothecreditmarkets
frequently.Moreover,asmallamountofdebtismoreindicativeofafirmthatis
541

lookingtofundexistingassetsandnotpurchasenewassets.Additionally,small
amountsofdebtcanindicatecostoverruns.
• Increasingoperatingmomentumwillleadtoahigheroperatingmargin-whichis
neededtooffsethigherinterestexpenses.
• TakingondebtwhentheLTD/CAPratioisrisingwhilethefinancialleverageratiois
decreasingleadstoriskyimbalancesthatmustbecloselyexamined.These“transition
states”canbeprofitablebutshouldbeavoidedifalargeinterestexpensewillbe
incurredinafewyears.
• Increasesintheassets/capitalratioaregenerallyapositiveindicationwhenlong-term
debtisincurred.Suchanincreasecanbeasignofgreatervendoractivity,alternative
financing,tradecredit,andagreaterreturnoncapital.
Thestudentwillrememberfromearliersectionsthatmostfirmswillmatch
expectedcashflowswiththetypeoffunding.Thisriskadverseapproachallowssteady
inflowsofincometobebalancedbysteadyoutflowsofexpenses-includingsinkingfund
paymentsandinterestexpenses.Therefore“long-termprojects”areoftenfundedbylong-
termdebt,andthatmaybeaeuphemismforanacquisitionthatisnotexpectedtopayoff
immediately.Synergiesinoperationsmaytakeafewyearstoaccomplish,buttheinvestor
doesnotwanttowait.Usually,alargepurchasewillbeaccompaniedbyenough
“hullabaloo”toincreasespeculationinthestock,whiletheinfusionofdebtgivesan
immediateboosttotaxbenefits.However,subsequentyearsmaybelean,withunder
performanceofthemarket.Atthispoint,theinvestorhasoneoftwochoices:check
analysts’opinionsabouttheacquisitionandcoordinatethemwiththefirm’spresent
positioninthebusinesscycle,orleavethestockentirelyifitappreciateswildlyinthefirst
yearafteramajorpurchase;sucha“run-up”maybeaccompaniedbyasell-off.
BARRROSENBERGANDRESPONSECOEFFICIENTS
RiskmanagementwasrevolutionizedbyBarrRosenberg.Thefounderofthefirm,
Barra,Rosenbergformulatedwhathetermed“relativeresponsecoefficients”whichwere
542

weightedvaluationsbetweenanindividualstockandnumerousmacrovariablessuchas
inflation,oran“energycrunch”.Asanexample,ifGeneralMotorsrespondstoanoil
embargofivetimesasmuchastheS&Pindex,theirresponsecoefficientwas“five”.Barr
Rosenbergtheorizedthatbetawasessentiallycomposedoftwoelements:
• 1.Theproportionalcontributionsofmajoreconomiceventstomarketvariance
• 2.Therelativeresponsecoefficientoftheindividualsecuritytotheevent
Whenthecoefficientswereweightedbytheoverallimpactofeachmajorevent,a
“fundamentalbeta”wasderived.Themeasuretowhichtheeconomicimpactofeventscan
beexplainedisthesamemeasuretowhichrelativeresponsecoefficientscanbeinterpreted
-changesinbeta.Therefore,toRosenberg,thetheoryoffundamentalbetaentails
changingcapitalstructureasaresponsetochangingeventsintheeconomy,whichfurther
reflectglobalconditions.
Changesininterestratesandthepotentialforcreditdefaultweighheavilyonmost
companies.Inthecaseofdefault,evenpsychologicalfactorsmayintertwinewithcapital
fundingtodetermineatargetstructure.Asanexample,acompanymaynottakepartin
financingwithlowerinterestratesafterarecoverybecauseitobservesominoustrendsin
fixedassetacquisitioninthenear-term;technologymayberapidlyreplacingthestandards
intheindustry,andthefirmdoesnotwanttoinvestinobsoletemachinery.Bynot
financingwithlowercostdebt,thecompanycaneitherunderfundprojectsorunder
performthemarketbecauseitisnotminimizingcapitalcosts.Thus,extraneousfactors
countagreatdeal.
Rosenberg’sfundamentallyderivedbetasdidoutperformhistoricallyderivedones
inpredictionmodels,buttheinformationanddatarequirementswereonerous:oversixty
ratiosinsevendifferentcategorieswereused.Whiletheaverageindividualstockisabout
thirtypercentcorrelatedwiththemarket(R
2
=0.3),Rosenberg’sderivedbetasimproved
thepredictivepowerofthemeasurementtoforty-fivepercentwithnomarketinformation
543

whatsoever.Whenmarketinformationwasadded,thepredictivepowerwentupeighty-six
percent.
Rosenberg’s“fundamentalbetas”aresimilarto“leveragestates”becausetheyare
drivenbyaprobabilisticresponsetoworldevents.However,theresponseoftheleverage
statesismoredependentoncapitalmarketsandismorederivative.Additionally,leverage
statesarecharacterizedbytheireconomy,while“fundamentalbetas”arecomprehensive.
Asinthecapitalassetpricingmodel(CAPM),thenumberofvariablesusedinforminga
leveragestateshouldbekepttoaminimum.Onlywithafewkeyvariablescanaleverage
statebebothflexibleenoughtocoveravarietyofconditions,buteconomicalenoughto
specifyacapitalstructuretype.Sincecorrelationsinanymarketchangefrequently,the
investorneedstobeawarethattheinteractionbetweenvariablesalsochanges.Leverage
statesattempttoestablishacategorythatisstrictenoughtokeepthatchangetoa
minimum,whiledefiningabroadertrendincapitalstructure.Analyzedinthecontextof
thethreeCAPMvariables,eachtakingonaleveloflow,mediumorhigh,leveragestates
wouldyieldmyriadcombinationsSincechangesintheCAPMandtheoveralleconomy
aresomewhatimplicitintheleveragestates,theaverageinvestorshouldnothavetoresort
tosuchextensivecrossreferencing.
(BacktoTableofContents)
544

22
TECHNICALANALYSISANDCAPITALSTRUCTURE
Academicshavepilloriedtechnicalanalysisformanyyears,claimingthatitwasthe
financialversionof“snakeoil”.Theyportrayitasmathematicalillusion,amethodof
rationalizingaprobabilitythatisalreadyheavilyinthemarket’sfavor.Nevertheless,Wall
Streethascontinuedtoshelloutmillionstoresearchfirmsthatproclaimtheabilityto
chartandpredictthefuturedirectionofastock.Thegistoftheargumentrevolvesaround
whetherchartingandtechnicalindicatorsmerelygiveafalseinterpretationtotherandom
variationthatoccurswhenalargeforcepropelsanobjectinaspecificdirection.For
example,wecanthrowamarbleacrossahardsurfaceandwecancontrolthespeedand
directionofthetoss,butwewillnotknowtheexactlocationofwherethemarblewillend
up.Ontheotherhand,technicalanalystswillclaimthatwithenoughinformationabout
thevarioussubvectorsandvelocityofthemarble,amathematicalconclusioncanbe
drawnaboutthespecificendlocation.Academicswillcounterthatsuchinformationis
concurrentwiththemovementandisimpossibletoobtain-apriori.Ifthisseemslikea
religiousdebatewhereweneedtochooseonesideortheother,considerthefactthatWall
Streetemploysmanytechnicalanalysts,andthatsolidfinancialdecisionshavebeenmade
withtheirrecommendations.Infact,bothargumentshavemeritsimplybecause“the
market’makesroomtoaccommodatethem.
Attimes,thestockmarketcantakeonaneeriecoherence;stockswillfollowa
smoothtrendwithoutmuchdeviationandinvestorschooseasellpointthatyieldsatwenty
percentprofitbeforeamovingaveragebeginsdescending.Justasfinancialmarketsbegin
to“makesense”,anuglythinghappens:theDowdropsbytwoorthreehundredpoints.
Thevolatilityindicatorthat“workedsowellbefore”isnolongeroperable.Thestock
breaksthroughits“supportline”andkeepsmovingdownward.
545

Academicsliketocomparerandomvolatilitytoacointoss.Ifwetossacoin
hundredsoftimes,andputanuptickmarkonacharttoindicate“heads”andadowntick
markfor“tails”,wewillcreateapicturethatlookslikeafacsimileofastockchart.It
trends,itrapidlyrises,anditmakesesotericpatternslike“breakouts”and“triangles”.
Thosewhobelieveinthe“efficientmarketshypothesis”believethatpredictionfrompast
performanceisimpossibleandalludetothe“randomwalk”ofthiscointoss;theybelieve
thatthemarketfactorsinallinformationconcerningasecurityasitmovesupanddown.
Infact,thereiscredencetothistheorybecauseevenasfarbackasthelate1950sandearly
60s,computerscientistswereshowingthatrepeatedpatternscouldnotpredictthefuture
directionofprices.
Severalquestionsneedtobeaddressed.Iftheacademicsarecorrect,howcanmy
back-testingofamovingaveragebesosuccessful?HowcanWallStreetchartistsmakethe
rightdecisionswithmillionsofdollarsontheline?Ifstockpickingismerelyfollowing
trendsbetween“resistance”and“support”lines,whywouldn’titbestandardpracticefor
everyone?Theanswerstothesequestionsinvolveacombinedknowledgeofthereasonsfor
statisticalvariation,andthefinancialforcesthatmoveastockinoneparticulardirection
ortheother.
MAJORFORCES
Whenacombinationofhighproductdemandcoalesceswithlowercapitalcosts,a
competitiveadvantageexiststhatisusuallysectorwide.Ordinarily,acompanywillmove
towarditsoptimalcapitalstructureatthistime,andcomparativelyhigherearningsare
generatedfromsixmonthstotwoormoreyears.Capitalintheformofademandfor
equitywillflowintothecompanyaslongasthecompanymaintainsitscomparative
earningsadvantagewiththemarket.
Technically,theriseinastockpricewillbemirroredbyariseinashort-term
movingaverageabovealong-termaverage.Thatisamathematicalfact.Whatis
uncertainisthelengthofthemovingaveragesthatdetectsthestockmovement.Ifthe
546

stockmovementisslight,itwillbedetectedbyashortinterval-evenbyafewhours.Ifthe
upwardspressureisgreat,afiftydaymovingaveragewouldbetheshort-termindicator
anditwouldmoveabovealongermovingaveragesuchastwohundreddays.
AnotheruncertaintyliesinhowlongtheseforcescancontinueIftheupwards
pressureisgreatenough,andwedetectastockwhosefiftydaymovingaverageisrising
aboveitstwohundreddaymovingaverage,canwepredicthowlongitwillstayaboveit?
Theanswerisaresounding,No!Whathappensisthattheupwardspressurecausedby
earningscreatesamathematicalillusion:webegintomeasuretheperformanceindicator,
thedistancebetweenmovingaverages,andmistakenlybelievethatawiderdistancewill
giveusimmunityfromaquickdescent.Infact,moststockswillmakeseveral“runs”well
abovethemovingaverage,declinetoapointrightaboveit,andthenmakeanotherquick
ascentupwardsAslongasearningsoutpacethemarket,thevariousrunsamountto
statistical“noise”.Whenthis“noise”trendsinasmoothpattern,tradersbelievetheycan
makemoneyby“gettingout”whilevolatilityislow.Thattechnicalindicatorswillworkin
theseperiodsoflowvolatility,addstotheillusionofpredictability,anditappearsthatthe
traderis“outthinking”themarket.However,therealmoneyismadewhenthestockis
belowitslong-termmovingaverageandisbeginningtoriseupwards.Atthistime,“smart
money”,thosewhohaveaninsider’sknowledgeoftheindustry,areanticipatingan
investment“payoff’ingreaterproductdemandandhigherearnings,andareinfusingthe
firmwithcapital.Thetechnicalequivalentofthisriseisillustratedinaseriesofmoving
averagecross-overs,startingoutveryshort-termandgraduallygainingstrengthtowhere
thetrendissustainedbylongerperiodlengthssuchasfiftyandtwohundreddays.Atthis
juncture,therewillstillbealotofmoneytobemadeifthefinancialforces(sales,earnings,
lessdebtetc.)aregreatenoughtopropeltheshortertermaverageabovethelongerterm
forasustainedperiodofsixmonthsormore.
Obviously,theimperativefortheinvestoristodetecttheforcesthatmovethese
averages.Ontheotherhand,tryingtopredictshort-termvolatility,andtakingadvantage
547

ofpricerun-upsonthebasisofhistoricalpatternsisfruitless.Considerthebanksthat
sufferedinthe“creditcrunch”of2007:thesebankshadlowbetasbecausetheygenerally
madeconservativemovementsbasedonthe“yieldcurve”,thedifferencebetweenlong-
termratesandshort-termrates.Banksneedtoborrowshort-termandlendlonginorder
tomakemoney.Whenthecurveinverted,bankstockswentupanddownbyasmuchas
tentotwentypercentinoneday.Thoseinvestorswhomademoneyduringabrieftwo
weekuptrend,wouldsubsequentlyloseitinaone-dayslide.
THEBANEOFVOLATILITY
Ifresearcherscouldpredictthechangesinthestandarddeviationforasecurity,the
marketwouldbefullypredictable.Infact,atmajorfinancialinstitutions,valueatrisk
calculations,alongwithsoftwaresuchasRiskMetrics,trytopredictvolatilityusingan
exponentiallyweightedmovingaverage-usuallyforoneday.However,suchtechniques
areappliedtoassetvalueandnotindividualstockswhichareinherentlymorevolatile.For
stocktraders,thebaneofvolatilityisthecauseofuncertainty.Althoughtechnical
indicatorscancorrectlyrevealpricingpressureineitherdirection,theyfailmiserablyin
tellingthetraderhowlongitwilllast.Forexample,aninvestorcanbuyonehundred
sharesofIBMbasedonashort-term“relativestrength”indicator,andthestockcandrop
tenpointsafewdayslater.The“new”indicatorwillnowdisplayadownwardbias.Inthe
interim(thosefewdays),thestockdidindeedgoup,butthetraderwasn’t“quickenough
onthedraw”tomakeaprofit.
Asareactiontothevicissitudesoftechnicaltrading,WallStreetdevelopedan
adaptive,“survivalist-type”techniquetocircumventvolatility:entertheday-trader.With
aframeworkofonlyoneday,thedaytradertriestoeliminatevolatilitybycatchingastock
ontheupswing,andthenquicklysellingitbeforeanyuncertaintyarises.Theobjectiveis
tocaptureoneday’sgain.Althoughtheday-tradermaymissoutonanyfurther
appreciationofthestock,heorsheissatisfied.Thereason?Onlinetradingsitesallow
traderstoexchangehugeblocksofstocksforasmallcommission,attemptingtoprofitfrom
548

the“assetturnover”.Thus,iftradershaveenoughstock,theycantradefrequentlyandnot
tieupmoneyincommissions.Thistypeofenterprisecanbebothprofitableandnerve-
racking,andthequestionneedstobeasked“sowhyisn’teverybodydoingit?”.Forthe
samereasonthatpeopledon’ttakeoutamortgageontheirhouseandgoplayblackjackin
LasVegas:theriskformostpeopleisfargreaterthanthereward.Awealthytradercan
takeasmallbitoftheportfolioandgodaytrading.Ifheorsheloses,thelossisrelatively
small.Ontheotherhand,ifmiddleclassAmericagambledwiththesizeoftheportfolio
neededtomakemoneyindaytrading,itwouldbeconsideredasickness.Whenthechance
ofloss(risk)isgreaterthantheaveragereturn,aninvestmentbecomesagamble.
SELF-FULFILLINGPROPHECY
Theadventofthe“informationage”hascreatedmorerandomvariationbecause
responsetoworldeventsisinstantaneous.Atonetime,severalvariableswereweighed
beforeafinancialdecisionwasmade,andinvestmentswerefirmlyconnectedtotheir
foundation-asetoffundamentalsthatdeterminedearningspotential.Inrecentyears,
however,economicvariableshavebecomemoreinterconnectedonagloballevel,suchthat
a“meltdown”intheChinesestockmarketwillmoreimmediatelyaffecttheU.S.market.
Thatinterconnectivityhasdemandednotonlymoreimmediatereactiontoevents,buthas
createdmoreriskbyinducingmassivemovementsofcapitalintoandoutofcertainsectors.
Whenallfinancialmanagersactinconcert,thereislessdiversificationofassets,andso
thuswehavethe“techboom”ofthelate1990sorthe“housingboom”oftheearly
millennium.Onamicrocosmiclevel,rumorsaboutspecificstocksandcompanieshave
nearlydestroyedsomeinstitutions(BearSterns),anditisnocoincidencethatonline
technicalanalysiscanmoveastockwhenenoughtradersfollowit.Infact,mostavid
tradershaveknowledgeofaspecificportfolioofstocksthatareespeciallyconfiguredfor
largemovementsupwardsordownwardsandconducivetotechnicaltrading.
Likegolferssearchingforthe“perfect”driverthatputstwentymoreyardsontheir
shots,technicaltradersbecomeobsessedwithfindingtheone“tradetool”thatwillgivean
549

edgeoverthecompetition.Thus,theywillbacktesttechnicalindicatorstoseehowwell
theyworkedinthepast,pagingthroughhistoricaldataandnotrealizingthateachmarket
isdefinedbyadifferentsetofparameters;adifferentyieldcurveisgoingtoproduce
differentresults.Lowinflationrateswillaffectthoseindicatorsdifferentlyfromhigh
inflation.Theobjectivebecomestofindacohesive“exitstrategy”thatenablesaninvestor
togetoutofaninvestmentbefore“othersseethelight”However,thatterritoryismapped
outbythoseinvestorswhohavethemostmoneyandtheshortesttimeframe.Aninvestor
whomakesalargethree-dayprofitandleavesthestock,willhaveanadvantageoverthe
“oddlotter”whowaitsfourdaysandseesabigvolumemovementonthatthirdday.Small
investorssimplymustwaitlongertomakeaprofitbecausetheyhavesolittleinvested.
Thus,ifasmallinvestoristechnicaltrading,heorshemayseearapidriseandfallbefore
anymoneywasmade.Onatechnicalbasis,thestockdidnottrendlongenoughtomake
money,butthosewhospottedthetrendinashorttimeframeendupmakinga“killing”.
Thesamedynamicthatmakeseconomiesofscaleanadvantagetothelargestfirmsinan
industry,giveslargetradersanabsoluteadvantageintechnicaltradingbecauseoftheir
potentiallyshortertimeframe.
EX-POSTPERFORMANCE
Onahistoricalbasis,mosttechnicalindicatorsareexcellenttoolsformappingout
thepastperformanceofastock.Afinancialexecutivecanmatchthedemandschedulefor
aproductlinewiththesupportandresistancelinesforasecurityandviewanycorrelation.
Sincemoststockstrackearnings,theaccelerationofearningscaneasilybecoordinated
withthevolumeflowofcapitalintothestock.Thissamehistoricalcorrelationcanbedone
betweentechnicalindicators,andtheleveragestatesofcapitalstructure.Choosingone
technicalindicator,howdoesitreacttothetransitionofonestatefromanother?
Thesimple“stochastic”indicatorisfamiliartomosttechnicaltraders.“Stochastic”
isawordfromstatisticsthatsignifiesrandomvariation,andalthoughtherearemany
complexadaptationsofthistool,thesimplestversionwaschosentodisplay.Ineffect,the
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indicatorisaratiothatshowshowcloseastockistoitshighestlevel:((ClosingPrice-Low
Price)/(HighPrice-LowPrice))equatesrangewithpricelevelandcanbedoneforany
timeperiod.Valuesof80andoversignifythatthestockmaybea“riskybuy”becauseitis
“overbought”,whileafigureof20representsa“buy”signalbecauseithasbeen“oversold”
andwillriseagain.Sincetherange(distancebetweenhighandlow)cangiveanestimateof
thevariancewhenitissquaredandmultipliedby1/16,theindicatorhassome
mathematicalsubstancetoit.Forourpurposes,afiscalyearwaschosenasthetime
period,andtheleveragestateforthatyearwasmatchedtothestochasticthatwaspresent
atthebeginningoftheperiod,aswellasthestochasticthatwaspresentattheendofthe
period.
Thereaderwillberemindedthatthetypeofmarketandlevelofinterestrateswill
determinetheleveragestateswiththemostpotentialprofit.Itwasourhypothesisthatin
thismarket(onewithrisinginterestrates)companiesthatincurredmoredebtwouldhave
alowerstochasticbecausetheywouldcloseloweronDecember31whenthemeasurement
wasmade.Companieswhowereearningmorewouldincreasetheiramountofretained
earnings,andreducebetaandlong-termdebttocapitalsimultaneously;thesecompanies
wouldclosehigheronDecember31,andalsohaveahigherstochastic.Theparadoxshould
beapparent:ifreducingriskbyloweringbetaissoimportant,whywoulditleadtoa
higherstochastic?Theanswerhastodowithtwoconcepts:concurrentperformanceand
momentum.Whenamarkethasmomentum,investinginastockthatoutperformedthe
otherswillpayoffbecausethatstockwillriseagain.Ifthereismomentuminamarket,
stockswithhighstochasticswillcontinuetooutpacestockswhicharemiredinalower
stochastic.Manyrecentmarketshavemimickedthat“winnertakesall’scenario.
However,anystockthatoutperformsthemarketforanylengthoftimeisalsoatagreater
riskofdropping.Incapitalstructureterms,whenafirmmovesawayfromitstarget
capitalstructure,itspricewillfallandthestochasticalongwithit.Suchaneventoften
occurswhenproductdemandislow,andthefirmisalsoincurringmoredebt.Thusthe
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stochasticisasmuchameasureofperformanceasitisofrisk.Itdoesnotdelineate
betweenthosefirmswhowillcontinuetoperformwellandthosewhoareabouttodrop.
Nevertheless,investinginalowerstochastic“debt”statewouldalsobeapreludetoa
higherpayoffandareduceddebtratiowhenearningsacceleratedandraisedthepriceof
thestock.Ineffect,alowerstochasticwouldpreface“gettinginearly”beforeastocktook
off.Thefollowingtablesshowtheresultofthisbriefstudy:

Table22-1

DEBT STATES
STATE Fin.Lev. LTD/CAP OpLev. Asset/Cap. Start
Stoc.
End
Stoc.
%
Change
1 - + + N/A 66.67 47.83 3.29
2 + + + N/A 45.54 74.51 6.96
3 + - + N/A 35.42 36.23 -14.18
4 - + - N/A 84.29 74.47 -17.21
5 + - - N/A 54.8 55.98 -4.65
6 + + - N/A 74.39 45.64 -37.35

Althoughwehavealludedtotheimportanceofraisingtheasset/capitalratiowhendebtis
incurred,itisnotacategoricalseparator.Intheabovedata,number2andnumber5show
themostpromiseasaninvestmentvehicle,whilenumber6showstheworst.Thestochastic
andpercentagesareskewedeventhoughmediansandnotmeanswereusedtoaverage
them.Thedataisalsomarketdependentandisnotmeanttoguidetheinvestorintoa
decisionbecauseitcanchangeastheeconomychanges.However,sincethesearestates
wherethefirmeitherraisedtheproportionofdebttoequity,orraisethefinancialleverage
ratio,orboth,thelowerstochasticmayimplythattheleveragestatehasmorelong-term
potentialasaninvestment.Theburdenremainsontheinvestortoknowwhichsectorwill
befavoredinthebusinesscycle,andtomatchanalysts’estimatesofearningswiththe
leveragestate.Inordertoprofitfromthetransitiontoanequitybasedleveragestate,
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earningsmustbeacceleratingfasterthanthecostofequity.Atthisjuncture,betamay
decrease,EVAwillriseandthestochasticshouldriseaswell.
Table22-2

EQUITY STATES (PROFIT)
Leverage Fin.Lev. LTD/CAP OpLev. Asset/Cap Start
Stoc.
End
Stoc.
%
Change
7 - - + - 80.79 26.7 -54.99
8 - - - - 78.78 81.81 17.93
9 - - - + 72.22 77.73 -0.17
10 - - + + 77.24 80.78 -0.32

Fromtheabovedata,states8,9,or10seemtoofferthemostmomentumandstability
whilestate7losesitspricestrength.Beforethereaderbeginssellingthisleveragestate,
recognizethatthisdatawasfromaspecificera(1990s)andthatthisstatewasactuallya
“favored”statethreeyearslaterin2002.Leveragestatesareneversetinstonebecausethe
economychangesaroundthem.Theyrespondtoshiftsinthewaythatriskisbeingpriced
bythemarket.Asavvyinvestorwillseethepotentialinatransitionfromadebt-oriented
statetoanequity-orientedoneandinvestwhenthestochasticislowenoughtomakealarge
profit.However,thereisnoguaranteethatafirmwithadebtladenstatewillnottakeon
evenmoredebtandwallowinalowstochasticforthreeorfouryears.Similarly,ifadebt
statetransitionsintoanequityorientedstatewithoutsufficientdemandforthecompany’s
products,thestockcanfallprecipitously.Forexample,whenashiftincapitalproportion
iscausedbyassetsales,thecompanymaynotbegrowingandgeneratingsufficient
operatingincome.Thus,theEVA/capitaldynamicremainsthebestmeasurementoftrue
investmentworth.NotonlycanEVArevealthemismanagementofequity,butitcan
measuretheearningspowerofafirminthemiddleofadownsizingordivestiture.
Onesignoffinancialstrengthisarisinglowstockoveranumberofyears.When
thehighstockisrelativelystable,andthelowstockkeepsrising,therangeofthestock
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narrowsanditbecomeslessrisky.Ineffect,thebetaofthestockisloweredrelativetoits
industrywhichwillbeactualizedbyalowercovariancewiththemarket;thestandard
deviationofthestockdeclines.Ontheotherhand,astockthathasrisenwithalower
stochastic,maybeonitswaydownbecauseaspeculativehighmayhavebeenreached.The
twomostriskyleveragestatesinourstochasticreviewbothhadpricerunupsbefore
falling-whichisindicatedbytheirrapidlyfallingstochastics.Noticethemechanicsinthe
followingexample.
Close-Low/High-Low=70-60/80-60=0.5or50%.Nowifthehighpriceranupto
$100.00:75-60/100-60=.375or37.5%.Thestockwouldhaveincreasedto75whichis
a7.14%gainandyetthestochasticwouldbegoingdownto37.5%,adecreaseof25%.
Obviously,theriskofthisstockgoingevenlowerisveryhighinspiteofthelower
stochastic.Itseemsthatwemeasuredthestockasithitaspeculativehighandthen
descended,butstillhadaprofit“attached”toit.
STOCHASTICCONFORMANCE
Competitioninanindustrytakesplacewithintheframeworkdictatedbysuch
variablesasdemand,earningspotentialandthecostofcapital.Whileitisnotsacrosanct
thatcorporationsmustactinunisontobesuccessful,theopportunitiespresentedtoeach
aresimilar.Itwouldnotbehooveacompanytotakeonmassesofdebtwhenthetop
competitoris“rakinginthedough”andpayingoffitslatestbondissue.Thus,stockstend
toriseandfallasasector,andthatistrueforstochasticsaswell.Oncecapitalisinfused
intoafirm,theturnaroundtimedependson:technology,management,andtheresources
withwhichtheprojectsareendowed.Theprocessissimilarineachfirminthesectorwith
slightdifferencesbetweenserviceandmanufacturingorientations,targetedcustomersetc.
Twonotableexceptionsexisttostochasticconformity.Thefirstexceptionisthat
manycompanieswilloccupyauniqueproduct“niche”.Theyhavediversifiedandthen
specializedinanareainwhichtheyhaveparticularcompetencethatgivesthema
competitiveadvantage.Nucor,forexample,specializesinsteelalloysthathavemadethem
554

lessdependentonsteelasacommodity.Whencommoditypricesgodown,variablecosts
arenotasaffectedastheywouldbewithothersteelproducers.Thesecondexceptionisin
theareaofacquisitions.Manycorporationshavebecomesolargethattheironlyhopefor
growthliesinbuyingothercompanies;theyneedtogrowattwentypercent,buttheircore
industriesmaybegrowingatthesamepaceastheeconomy-fourpercent.WallStreet
dictatesthatthefirmneedstoexpandfasterthantheindustryitself.Thesecompanieswill
generallyseeadecliningstochasticasinitialspeculativerun-upsbegintofalter,andthe
firmmustworktoloweritsprobabilityofdefault.Fromacapitalstructureperspective,
taxbenefitsarerewardedintheyearoftheacquisition,andmarginalbankruptcycosts
mustdecreaseinthenextperiod,orthestochasticwillbemuchlower.Sinceitisdifficult
tointegratealargeamountofassetsrapidly,turnaroundtimesforcapitalwillusually
dictateaslightlyhigherbankruptcycostinthenextperioddependingonthecompetenceof
theintegration.Iftheintegrationissmooth,operatingincomewillbeginrisingalmost
immediately,higherbankruptcycostscanbeavoided,andthestockwillcontinuetorise.
CAPITALSTRUCTURALISM:QUASI-TECHNICALANALYSIS?
YearsagowhentheCAPMwasfirstprofferedbyacademia,betawasaccusedof
beinganotherversionoftechnicalanalysis,exceptthatithadauniversitypedigreeand
camewithasetof“whitepapers”.Thepoliticsofoppositionareespeciallyaptfortherift
betweenWallStreetandacademiabecauseeachpanderstoextremistpositions.Adopting
oppositesidesofanissueallowsdebatetooccur,andwithconflictcomes(hopefully)
profitableresolution.Thesearchtomakefinancemoreobjectiveandscientifichas
progressedintoalinearityofthoughtwhereaspecificpostulateisstakedout,promulgated
andthendefended.Thus,weseemonetaristssquaringoffwithKeynesians,freetraders
andprotectionists,supply-sidersversusrationalists,growthstockinvestorsversusvalue
stockinvestors,adinfinitum.Finance,howeverisprobabilisticandnotdeterministic,and
thereisalwaysroomforanotherlegitimateidea.
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Capitalstructurecanbetechnicaltoolwhenitismatchedwithanindicatorlikea
movingaverage,butinisolation,itisalegitimatemethodofoptimizingthewealthofa
company.Itprofessesnottopredictthepriceofastockbuttopredicttheriskofafirmin
thedomainofseveralvariables-theeconomy,taxes,sales,incomeanddefault.Capital
structuralismrecognizesthatonlystrategiesthatadapttotheconfluenceofrisksfor
economy,industryandcompany,andremainflexible,willultimatelyoptimizewealth.
Thus,inoneeconomymoredebtmaximizesthestockprice.Inanother,onlymergersand
acquisitionswillwork.Inathirdeconomy,diversifyingoperationsandloweringoperating
leverage(andbeta)isthekey.Allofthesestrategieswillhavetheonecommonalityof
movementtowardanoptimaltargetcapitalstructure.Whiletechnicalanalysiscanbe
adaptedtocapitalstructuralism,optimizingcapitalstructureisundertheaegisofrisk
management;eachfieldmakesextensiveuseofthedifferentadaptationsofthestandard
deviation,buttechnicalanalysisattemptstomeasureandpredictperformancewhile
capitalstructuralismtriestosupplytheimpetusbehindwhatisbeingmeasured.
FIGHTINGWORDS:“THEEFFICIENTMARKETSHYPOTHESIS”
Thespecterofthe“efficientmarketshypothesis“hashauntedWallStreetfor
decades.Anotherproductofacademics,itbrieflystatesthatwithmillionsofbuyersand
sellersinthemarket,andeachcompanybeingresearchedextensively,informationtravels
sorapidlythatnoindividualcangainacompetitiveadvantage.Evenrumorsofearnings
deficienciesbecomefactoredintothemarket.Sincemostfundamentalsarepublishedafter
thefact,andsincetechnicalanalystspossessthesamelibraryofindicators,itisnowonder
thatmostmutualfundsunderperformthemarketdespiteaccesstomillionsofdollars
worthofresearch.
Overmanyyearstherehasbeenanupwardbiasinthemarketofapproximately
9.8percentperyear(2008).Theupwardsurgeofabullmarkethasbeenfarmore
frequentthananydownwardshifts,andthreeoutoffourstocksriseatthistime.
Consequently,someofthetoutedsuccessofbothfundamentalresearchandtechnical
556

analysishasdevelopedfromtheillusionthattheacumenoftheanalysthelpedpickthe
“rightsecurityattherighttime”-wheninreality,thestockwouldhaveskyrocketed
anyway.Indeed,BurtonMalkiel,inhisclassicbookARandomWalkDownWallStreet,,
emphasizedthatifanyspecifictechnique(suchasstochastics)workedforanylengthof
time,itwouldcreateitsowndemisebecausethemarketwouldfactoritin.Becausethe
marketkeepschanging,andbecausethemathematicalvarietyoftrends,volatilityand
correlationaresogreat,thereisalwaysoneindicatoravailabletoexploitaspecific
company’ssituation.However,bythetimethis“needleinthehaystack”isfound,the
marketmayhavechangedandthecompanymaynolongerrespondtoit.
Whataboutcapitalstructure?Wouldn’tanefficientmarketfactorinsuch
movement?Infact,itdoes.Evenwhenaninitialinvestmentismade,thetaxbenefitsmay
causesomeupwardmovementinthestock.However,neitherthemarketnortheinvestor
hasanycertaintyastothelengthoftimetheinvestmentwillbegintoproducemore
earnings.Theadvantageofcorporateinsidersisthattheyhaveknowledgeofprojecttime-
frameswheninvestmentsareexpectedtopayoff.Thisinsideinformationisagreat
opportunityforthecapitalstructuralist,becausetheleveragestatecanbematchedwith
publicknowledgeaboutinsidersales.Iftheinvestorobservesastatethatisconduciveto
growth,andcompanyexecutiveshavebeenputtinguptheirowncash,thereisahigh
probabilitythatthefirmismovingtowardanoptimalcapitalstructure.Infact,eventhose
whostronglybelieveintheefficientmarketshypothesiswillclaimthatthistechniquehas
beensubstantiated.
Anadditional“chink”inthearmorofefficientmarketsincludesmomentum.
Severalresearchershavefoundamomentumvariablethatcanbeexploitedinsomestocks.
Stocksthatoutperformthemarketinpriceorearningsforasix-monthperiodtendtodo
betterthanthemarketforanothersixmonths.Manytechnicalindicatorsmeasurethe
forceofmomentumwhichcanlogicallybeappliedtothoseselectstocksthatkeeprising.
Whileanefficientmarketspuristwoulddiscountpricingpressureasrandomvariation,
557

twopointsappeartobevalidintechnicalanalysis:1.Atrendcanbeexploitedforaslong
asitcontinues,and2.Thereisnopredictinghowlongthattrendwillcontinue.Since
manystocksmoveinlargeirregular“jumps”,theapplicationoftechnicalanalysisto
exploitmarketinefficienciesappearstobelimited.However,asamanagementtoolthat
givesdetaileddescriptionofpastperformance,itcanbematchedwiththeforcesthat
affectedstockprice.Losingouttocompetitors,forexample,wouldbemirroredina
downturn.Sectordominationandincreasedmarketsharewouldbeobservedinasurge
upwards.Bycorrelatingperformancetoactionablepolicy,technicalanalysisisan
instructivetool.
THEARTANDSCIENCEOFFORECASTING
Thechainoflogicbehindforecastingbeginswiththefactthatallcompaniesneeda
salesforecasttocoordinatethevariousactivitiesofafirm;planningisessentialtoanyfirm.
Analystshavetakenthisneedonestepfurther:byextrapolatingearningsfromsalesand
thenobservingthecorrelatedmovementofthestockpriceovermanyyears,ademand
forecastmorphsintoastockforecast.However,inthenearterm,theassociationisnot
nearlyasstrongasitisoverthelongterm,becauserandomvariationfromoutsideforces
hassuchastrongpullonthestock.Evengreatfundamentalswillelicitdownwardpressure
inabearmarket.OurownanalysisofEVAconfirmsthisnear-terminabilitytocorrelate
earningswithstockprice.Ifearningsareextraordinarybuttoomuchequityisincurredat
toohighaprice,EVAwilldeclineandthestockpricewillbediminished.Thathighcostof
equityisoneofthose“outsideforces”toconsiderbecauseitispartiallyimposedbythe
relationshipbetweenearnings,interestratesandinflation.
Studentsoffinanceshouldbeespeciallyfamiliarwithforecastingtechniqueswith
thecaveatthatevensteady,lowoperatingleverageproductscannotbeforecastedcorrectly
onehundredpercentofthetime.Althoughpredictionofstockpricesisforeversuspect,
predictingtheforcesthatmoveastockandcombiningthemintoaconsensusthatsmoothes
outinaccuraciesinanyspecificpredictionisstandardforfinancialexecutives.Specific
558

techniqueslikeArima,Box-Jenkinsanalysis,Holt-Winterexponentialsmoothing,and
aboveall-movingaverages-canletthestudentobservetheconnectionbetweendaytoday
activitiesandthelargerfinancialimperativeofmaximizingwealth.Indeed,capital
structurebeginswiththesalesforecastbecausetoomuchortoolittlecapitalraisedwill
causeadeficiencyintherelationshipbetweenearningsandthetargetproportionofdebtto
equity.
Onemajorreasonfordiscrepanciesbetweensalesforecastsandstockpredictionsis
thatsalesaregenerallybasedontheneedsofaneconomicentity-consumer,businessor
government.Noone“needs”tobuyastock-althoughsomepeoplemaythinktheydo.
Sellingtireshasadegreeofpredictability-numberofvehiclesontheroad,season,
structuralchangesinrubberetc.Whiletireforecastingcanbeasophisticatedscience,it
doesnotapproachtherandomvariationsineconomy,psychology,specificindustryand
personalwealththatstockselectionentails.
MOVINGAVERAGESTOUSEWISELY
Sometoolsoftechnicalanalysiscanbeveryhelpfultoanyonewhoneedstospotan
acceleratingtrend.Forexample,youmaydothebookkeepingfora“momandpop”ski
lodgeinVermont.Youwanttocontrasttheamountofcoffeesoldtoskiersinthewinter
versustheamountsoldinsummer.Acoffeesalesmovingaveragewillshowthedifference.
StartinginNovember,theshorttermmovingaverageforcoffeewillrisefasterthanthe
long-termaverage.InDecemberorJanuaryitwillbeabovethelong-termaverage,and
finallydroptowhereitisequaltothelong-termaverageinMarch.Tomeasurethe
acceleration,thebookkeepersubtractsthelong-termaveragefromtheshort-termaverage.
Whenthatnumberisrising,salesareaccelerating.Whentheshort-termaverageisabove
thelong-term,thereisupwardspressureonsales.“Upwardspressure”doesnot
necessarilymeanthatsalesareaccelerating,butthatthereismoretendencytodoso.In
fact,thesetrendsareindicativeofthefirstandsecondderivativesincalculus.Thefirst
derivative(upwardspressure)willshowwhetheranumberisincreasingordecreasing,
559

whilethesecondderivative(acceleration)willshowifthenumberisincreasingatan
increasingordecreasingrate.Thus,understandingtheconceptofcontrastingmoving
averageswillgiveeventhesmallbusinesspersonausableformofcalculus.TheWall
StreetJournalusesthesetodisplaytrendsandmanyotherbusinessesusethemtotrack
salesandinventory.Theexponentialformisself-correcting(recursive),andyetsimpleto
implement,andisdiscussedinthenextsection.
THEEXPONENTIALMOVINGAVERAGE
Thismovingaverageisaveryflexibletool.Unlikemanyspreadsheet-typemoving
averages,itdoesnotneedanyleadcellsbeforeitbeginstowork,anditisadaptabletoany
timeperiodyouspecify.Thebasickernelof“artificialintelligence”isobservedinthe
recursive,orself-correctingbehavioroftheaverage.Likeahumanbeing,“neural
networks”aresupposedtomakecomparisonsbasedonlearnedadaptation.Whilethe
conceptismoreprofoundthanthepracticalcalculusofanexponentialmovingaverage,
thissimplespreadsheetfunctionoffersthestudentanintroduction.
Whenformingaworkingmovingaveragesystem,werepeatthesameprocedurefor
boththeshortandlong-termaverages.Tocircumventtheneedforaleadtime,wecreate
twosmoothingconstantsbasedonthelengthoftheaverage.Thesmoothingconstantis
merely,(2/(N+1))whereNisequaltotheperiodthatyouspecify.Forexample,ifyouwant
theshort-termaveragetobeninedays,thesmoothingconstantwouldbe:(2/10)or0.2.To
illustratetheadvantageofcreatingasmoothingconstant,consideraspreadsheetwherea
movingaveragerequiresaspecificnumberofleadcells.Anytimetheaverageisused,it
musthavethespecificnumberofcellsasa“lead”:Thisexampleisasimplefiveday
movingaverage.
560

Table22-3

EXCELCOLUMN SPREADSHEET EXCELCOLUMN
E1 25 F1(BLANK)
E2 30 F2(BLANK)
E3 35 F3(BLANK)
E4 40 F4(BLANK)
E5 30 F5=SUM(E1:E5)/5
Noticethatweneeded(N-1)blankspotsbeforewecouldbegintheaverage,andthatwe
couldnotspecifyadifferentnumberforperiodlengthlike10,21,or50.Theformulain
cellF5wouldbecopieddowntomatchtheremaininglengthofthedata.Inthestepby
stepprocessIamabouttogiveyou,onlytwoblankspotsareneeded,preferablyatthetop
ofthespreadsheetandsidebyside.Oneblankspotwillbeforinputtingtheshort-term
periodlength,andtheotherforspecifyingthelong-termlength
STEP1:WewillusecellsG2andH2asblanksforinputtingshortandlongperiods
respectively.LabelcellG1“short”andlabelH1“long”.
STEP2.Weidentifyacolumninwhichtoplace(copyfromanotherfileorinputmanually)
ourdata.OurdatawillbegininE2andwewilllabelcellE1“price”.Wecancopydata
fromaCSVortextfilebypastingitintoE2orwecaninputthedatamanually-whichof
course,istediousforverylongsets.Thedatacanbesalesdata,stockprices,currency
exchange,orinventorydata.
STEP3.WeformthefirstoftwoequationsbeginningincellI3.Thefirstequationbegins
theprocessofsmoothing,settingitupagainstitself:CellI3=(2/($G$2+1))*(E2-E2)+
E2.AlthoughthenetoutcomeisthecontentsofE2,thelogicoftheprocessisillustrated.
STEP4.ThesecondequationisinputtedincellI4,onecellbelow.Itusestheanswerin
cellI3tocorrectitself:I4=(2/($G$2+1))*(E3-I3)+I3
STEP5.IncellsJ3andJ4youwillcopycellsI3andI4respectivelyexceptforchanging
thesmoothingconstant.Thesecellswillbeyourlong-termaverages,andthebeginning
561

part(theparttochange)willbe(2/($H$2+1))whichwillrefertocellH2(thelong
period)ratherthanG2(theshortperiod).
STEP6.BothequationsinI4andJ4canbecopieddownforthousandsofcellsifyouwish,
andyoucansavethesetupasatemplate.Fromnowonyoucanjustinputperiodsinto
cellsG2andH2andthencopydataintoE2.Whenyouarefinishedwithanalysis,you
click“donotsave”andyouarereadytoinputanothersetofdata.
STEP7.Toestablishtheaccelerationfactor,wesubtractcolumnJfromcolumnIstarting
incellK3andcopyingdownforthelengthofthedata.K3=I3-J3.Whenthedistance
betweenshortandlongbecomesgreater,thereisupwardspressureonthedata,andvice
versa.
STEP8.Awordaboutperiodlength.Forstocks,manytradersusea50and200day
averageforshortandlongrespectively.Somestabilityoftrendisestablishedwiththis
combination.Thestudentshouldbeawarethatthesmallerthetimeperiod,thegreaterthe
sensitivitytoacceleration.
BRIEFINTERPRETATION
Thegistoftechnicalanalysisistofollowanupwardstrendandsellbeforetherisk
ofadownwardtrendistoogreat.Whiletheinvestorcanobserveaccelerationveryacutely
withsmallaverages(say9and14),heorshewillbetradingfrequentlywithnoguarantee
ofmakinganymoney.Infact,useofmovingaveragescanmimicThreeCardMonte:one
can“uptheante”forabigpaydayifluckfallstheinvestorsway,andthestockstaysina
stabletrend.Inevitably,Gambler’sAnonymousisfullofcertifiedgeniuseswhohavetried
severalsystemsandfailed;temptingfatebydependingononemeasurementinvites
disaster.Whiletheinvestorcanbeawareoftheoveralluptrendbecausethe50-day
averageisabovethe200-dayaverage,thesubtrendscancontinueforweeksatatimein
eitherdirectionandwillbepunctuatedbylargeunpredictablejumps.Inthisgame,the
brokerage(“thehouse”)getstokeeptheircommissionswhiletheinvestor(“bettor”)barely
breakseven.
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PRIMARYTRENDSANDSECONDARYTRENDS
Thecombinedforceofhigherearningsandalowercostofcapitalwillpushafifty-
dayaverageaboveatwohundreddayaverage.Thislongertermtrendistheprimary
trendandismanifestfromafirm’spayoffonitsinvestment(eitherdebtorequity).At
times,speculationcancreatesuchanup-trendsoitismandatorythattheinvestordothe
researchandfindoutwhetherthetrendissustainable.Inthecaseofageneraleconomic
expansion,manystockswilltrendupwardswithoutmuchimpetus,andtheinvestorwants
tobeinastockwhosecompanyisintheprocessofoptimizingitscapitalstructure.The
reason?Thelongertheshort-termmovingaverageremainsabovethelong-term,themore
strengthandstabilitythepricerisewillhave.Acompanythatisdominatingafavored
sectorwillcreatealargedifferencebetweenshortandlongmovingaverages.However,
oncethestockhas“jumpedup”(shorttermaveragemovingabovelongterm),muchofthe
movementwillbeacombinationofsustainabletrendandstatistical“noise”whichwillbe
difficultforeventopmathematicianstodecipher.
Thesecondarytrendsthatareacombinationofvolumegeneratedrisesandnoisecanfool
aninvestorintolosingmoney.Thetimetobeinthestockwaswhentheinitialforceof
earningswaspropellingitabovethelong-termmovingaverage.Inthecaseofaspeculative
run-up,thechartistswillimmediatelylookforanexitstrategyleavingslowinvestors
“holdingthebag”.Ifoneisaddictedtowatchingstocks,investingonthebasisofcapital
structurewillatleastgivetheinvestortimetoleavethestockaftermakingaprofitbecause
thesestockswillberisingforaperiodofsixmonthstotwoyearsormore.Investorsmust
decidewhentogetoutbybalancingtheprofitalreadymadewithriskaversion.Thosewho
arestillgreedyafteratwentypercentrun-upwillkickthemselvesifthestockbeginsto
“tank”.Indeed,investinginthesecondarytrendsisabitlikefast,“Vegasaction”,butthis
authorwouldbenegligent,ifitwerenotincludedinthistext.Whentherisksfaroutweigh
therewards,aninvestmentbecomesagamble,andthestudent/investorshouldunderstand
thedifference.(BacktoTableofContents)
563

23
STATISTICSPRIMER
ThereisavastmarketinAmericaforbadlyappliedstatistics.Whenevertwo
agendascollide,eachadvocatemustproveapoint.Andwhatbetterwaytolendan
ambianceofpseudo-sciencetoone’smethodologythanbyexhibitinganaveragethathasno
realstatisticalsignificance?Infactwhenwespeakintermsofthe“averageAmerican”,it
isanextrememisapplicationofstatisticaltechniquebecausethereissomuchvariation
amongthepopulation.
Andvariationinfinanceiswheretherootofmostproblemslies.Thelargerthe
amountofvariation,theharderitistoproveapremiseistrue;asampletypeandsizemust
mathematicallyadjusttotheamountofvariationorthestudywillbeinconclusive.
Unfortunately,financialdataisusuallyhighlyskewed:thatis-itisnotheavily
concentratedaroundanaveragebuttendstobedistributedwithlargeamountofsample
pointsatoneendortheother.Thus,financeandstatisticsmakestrangebedfellows:
withoutadequatemeasurement,propercapitalallocationcouldneverbemade.However,
veryfewofthemeasurementsarestatisticallyvalidbecauseofsmallsamplesizeandlarge
amountsofvariation.Variationamongstockpriceincreases,forexample,canapproach
twoorthreetimestheaveragewhichrendersmanypricerelatedstudiesinconclusive.
Whenwetrytofitfinancialdatatoa“normal”curve,weareinfact,takingliberties
thataremathematicallyinvalid,butneverthelessmakinganattempttodrawactionable
intelligencefromthem.Andthatistheessenceoffinancialstatistics-topointusinthe
“right”direction.Weconcentratenotsomuchonmeasuringanaveragethatisderivedin
theabsenceofvariation,asfocusingonmeasuringthevariationitself.
Thepragmaticrealityofinvestingistomakedecisionswithinsufficientdata.For
thesmallinvestor,accesstorealtimecorporatedataissimplyimpossible.Theindividual
mustmakeseveraldecisionsbasedonfactsthatheorsheculledtogether.Iftheindividual
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istobeguidedcorrectly,anystatisticallibertieswetakemustbeusedtoavoidexcessive
riskratherthantospeculateonlargereturns.Throughoutthisbook,thestudent/investor
isencouragedto“diversify”indicatorsandusemanydifferenttypes.Inmostcases,the
samplesizewillbeinadequatetodrawfirmconclusions.But-ifseveralmeasurements
pointusinthesamedirection,theinvestorcanbesatisfiedthatarationaldecisionwas
madegiventheavailableinformation.
THEMEAN,MODEANDMEDIAN
MEAN-Thearithmeticaverageofapopulationisitsmeanandisthemostused
measurementinstatistics.Thesumofanysequenceofnumbersdividedbytheamountof
figuresinthesequence(samplesize)willyieldthemean.Thefollowingexampleisa
sequenceofnumbers:7,17,14,32,60,3,21.Wecounttheamountoffiguresinthe
sequenceandobtainasamplesizeof“7”.Wethensumallofthesequenceanddividethe
samplesizeintothesum:(7+17+14+32+60+3+21)/7=22.
MEDIAN-Whenasampleofnumbersisarrangedfromlowtohigh,themedianis
themidpointwithanequalcountofdatapointsbothlowerandhigher.Inthesample
above,wearrangethesequencefromlowtohigh:3,7,14,17,21,32,60.Sincethereare
threenumbersbothlowerandhigherthan17,thatisourmedian.Ifthesamplewerean
evennumber,sayeightinsteadofseven,thetwonumbersinthemiddlewouldbedivided
by2.Inthatcase,therewouldstillbethreenumbersbothlowerandhigher,butthe
medianwouldbeanaverageofthetwomiddlenumbers.
MODE-Themodeisthemostfrequentnumberencounteredinasample.Thus,in
theabovesample,allentriesareuniqueandthereisnomode.
Sincefinancialdataissoheavilyskewed,inmanycasesthemedianisafarbetter
indicatorofdistributionthanthemean;themedianbetterincorporatesinherentvariation.
However,theflexibilityofwhatistermed“parametricstatistics”,definestherelationship
betweennumbersthrough“parameters”suchasthemean,anddictatesabalanced
approach;any“statisticalsignificance”istestedbytheamountofvariation.
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Whenapopulationis“normal”,themean,medianandmodewillbethesame
number.Infinance,populationsareoften“skewed”andheavilyweightedinonedirection
ortheother.Infact,datapointswilloftentakeonthecharacteristicdepictionofa
“barbell”andbeheavilyweightedonbothsideswithfewpointsinthemiddle.This
“bimodal”distributionisdifficulttointerpretbecauseitslackofcentraltendency
eliminatesthestatisticalsignificanceofmeanormedian.Thefollowingdistributionsshow
thelocationsofmeaninrelationtomedian.
Figure23-1

Figure23-2

Mean Median
LEFTOR"NEGATIVE"SKEW
Mean,Median,andMode
NORMALDISTRIBUTION
566

Figure23-3

Inabimodaldistribution,itappearsthattwoseparatepopulationsexistwhichmakesit
difficultfortheanalysttodeterminesignificantrelationships.Inthemarketof2005to
2007,forexample,anyoilrelatedstockwasdoingquitewellwhiletherestofthemarket
laggedbehind.Anyrelationalstatisticbetweenthetwosubpopulationssuchastheamount
ofassetsorsaleswouldhavebeeninsignificant.Onlythetypeofindustryactually
mattered.
Figure23-4

THEVARIANCEANDASSORTEDADAPTATIONS
BIMODALDISTRIBUTION
Mean,Median,Mode
RIGHTOR"POSITIVE"SKEW
Median Mean
567

THEVARIANCEThevariancemeasuresthedeviationofindividualobservations
aboutacentralvalue.Mostdatapointswilltrendtowardeithergreaterorlesserdistance
fromacentraltendencyandthevariancemeasuresthisdistance.Ineffect,itistheprime
indicatorofriskandusedtocompareuncertainoutcomeswiththe”normalcy”and
implicit“certainty”ofthecentralvalue.
Tomeasurethevariance,wesumthesquaredvaluesofdistancesfromthemeanof
eachdatapoint,andthendividebythesamplesize.“∑ ∑∑ ∑”istheGreekletter“epsilon”
whichdesignatesthateachoperationinasequenceshouldbesummed.ForexampleifXis
anumberinthesequence(1,2,3)andafunctioncallsfor∑ ∑∑ ∑

(X+2),wewouldproceed:
(1+2)+(2+2)+(3+2)=12.Theformulaforthevarianceis∑ ∑∑ ∑(X-µ µµ µ)
2
/N.Inthisfunction,
Xisequaltotheindividualdatapointinthesequence(sample),µ µµ µisequaltothemeanof
thesample,and“N”isequaltothesamplesize.Thus,eachdatapointissubjectedtothe
sameprocess,andthentheprocesseddatapointsaresummed.Inasamplepopulationof
(1,2,3,4,5),withameanof“3”,theprocesswouldbe(1-3)
2
+(2-3)
2
+(3-3)
2
+(4-3)
2
+(5-3)
2
/
5whichis10/5or“2”.ThesymbolforthevarianceistheGreekletter“sigma”squared,
orσ σσ σ
2
.
STANDARDDEVIATION-Thestandarddeviationismerelythesquarerootofthe
variance.ItsGreeksymbolistheletter“sigma”,σ σσ σ.Itismorecommonlyusedinfinance
thanthevariancebecauseithasacloserelationshipwiththemean,andcanbeusedin
predictiveforecasting.Ifthereaderrefersbacktothe“normal”distribution,eachpoint
withinthedistributionissomeamountofstandarddeviationsawayfromthecenterwitha
specificlevelofprobabilityattachedtoit:thatis-theprobabilityofbeingonaninterval
betweenthemeanandacertainnumberisbasedonthenumberofstandarddeviations
awayfromthemean.Intheabovesequenceof(1,2,3,4,5),wefoundthatthevariancewas
“2”.Nowthestandarddeviationis√ √√ √2,or1.41.
THECOVARIANCE-Attimes,theanalystneedstodeterminetheriskofa
combinedpopulation,examiningwhetherthecombinationreducesriskorincreasesit.A
568

muchappliedadaptationofthevarianceistermed“thecovariance”Forexample,ifIam
anoperationsmanager,Imightwantlessriskbetweenthereturnsfromproductline#1
(1,2,3,4,5),andproductline#3(6,7,8,9,10).
Iknowthereturnfromproductline#1alreadybecauseithasthesamemeanasin
thestandarddeviationexample,(3).Inowobtainthemeanforproductline#3and
determineittobe“8”.Ithenobtainasum(notsquaredthistime)oftheproductofthe
deviationsfromtherespectivemeansanddividebythesamplesize.Ineffect,Itakeeach
individualnumberinonesequenceandsubtractitfromthatsequence’smean,andthen
multiplyitbythesameoperationdoneoncorrespondingnumbersinthesecondsequence.
Ithensumeachproductanddividebythesamplesize.Theformulais∑ ∑∑ ∑(X(i)-µ µµ µ(i))(X(j)-
µ µµ µ(j))/N.Inthisformula,theparenthetical“i”and“j”representthetwodifferentsamples.
Eachsamplepointinonepopulationshouldhaveacorrespondingentryinanother
populationanditbehoovestheanalysttodropdatapointsifonepopulationislargerthan
theother.Workingthisexamplethrough:((1-3)(6-8)+(2-3)(7-8)+(3-3)(8-8)+(4-3)(9-8)+
(5-3)(10-8))/5=(4+1+0+1+4)/5=2
Thecovarianceisthesameasthevarianceinthiscaseandthetwostandard
deviationsarethesameaswell.Althoughthenumbersinthesecondsequenceweremuch
biggerthanthefirst,theriskofachievingthemwasthesamesimplybecausethedistance
tothemeanwassimilar:eachnumberincreasedby“1”inthesecondsequencejustasthey
didinthefirst.Intermsofrisk,onewouldwantthelowestcovariancepossiblewhichis
achievableifsomenumbersrisewhiletheircorrespondingnumberfalls.Infact,apositive
covarianceindicatesthetendencyforthepopulationstorisetogether,whilelowerriskis
indicatedasthecovarianceapproacheszero.
DOWNSIDERISK-Byexaminingthepopulationinpartsthatareaboveorbelow
acertainvalue,theanalystcreatesathresholdlevel.Downsideriskmeasurements
establisharisklevelthatiscustomizedtotheriskaversionofthepractitioner.Thesemi
variancesumsonlythosedatapointsthatarelessthanthemean,butusestheentiresample
569

sizeforthedivisor,“N”.Thus,iffewpointsaresummed,thedownsideriskwillbe
negligible,evenas“N’,thesamplesize,islarge.Thelowerpartialmomentsindicatoralso
sumsthosepointsthatarebelowauserdefinedthresholdlevelwhichissubstitutedforthe
meaninavariance-likefunction.However,thelowerpartialmomentsfunctioncanbe
carriedtothethirdfourthorfifthpowersatthediscretionoftheanalyst.
Tousethesemivariance,weformafunctionthatwillyieldtheriskofbeingbelow
themean.Thefunctionissimply∑ ∑∑ ∑(µ µµ µ(i)-X(i))
2
/N,withX(i)<µ µµ µ(i).Achosentargetlevel
canalsobesubstitutedforthemean.Inthedatasequence(1,2,3,15,30,40),15.17isthe
mean,andweonlysumthosedatapointslessthanthatnumberintheoperation:Semi
variance=
((15.17-1)
2
+(15.17-2)
2
+(15.17-3)
2
)+(15.17-15)
2
/6=(200.79+173.45+148.11+
0.0289)/6=87.06
Thelowerpartialmomentwillyieldthesameresultsasthesemivariancewhenthe
thresholdlevelissettothemean,andthefunctionissquared.Thefunctionis:∑ ∑∑ ∑(X(i)-
T)
M
/N,where“T”equalssomethresholdvaluethattheuserwantsto“beat”,and“M”isa
valuegreaterorequalto“2”.Noticethatthemeanisnowheretobefoundandthatthe
thresholdvalue,“T”,replacesit.“X”arethosevalueslessthan“T”.Todifferentiatethe
twofunctions,wewillsetathresholdrateof“7”whichisnotpartofthedatapoint
sequencefromabove:((1-7)
2
+(2-7)
2
+(3-7)
2
)/6=77/6=12.83.Noticealsothatthe
differenceissetupforthepossibilityofraisingittothethirdfourthandhigherpowers.
Whilethesemivarianceisalwayssquared,thepositionsofthemeanandindividualdata
pointsinthedifferencingdonotmatter((µ µµ µ(i)-X(i))
2
=(X(i))-µ µµ µ(i)) )) )) ))
2 22 2
) )) ).However,sincethe
lowerpartialmomentsfunctionmaybecubed,thedifferencingpositionmattersandthe
individualdatapointissetuptosubtractthethresholdamount.
Usually,bothofthesefunctionswillbecomparedamongalternativepopulations
(portfolios,cashflows,stocks)andwhenthetwopopulationshavesimilarstandard
deviations,thedecidingfactorcanbetheirdownsiderisk.
570

ANNUALIZEDVOLATILITY-Often,weneedtoconvertdatawithouthavingthe
actualsample.Forexample,wemayhavemonthlydatabutwewantayearlyvalueforthe
standarddeviationorviceversa.Byusingthesquarerootoftheperiodoneisconverting
to–intermsoftheexistingdata-wecanmaketheseconversionseffortlessly,butweneed
torecognizethatanyconversionwithouttheactualdataisa“guesstimate”atbest.The
keytoconvertingvolatilityliesinconvertinganexistingperiodtothenewperiod,finding
itssquareroot,andthenmultiplyingtheexistingstandarddeviationbythatnumber.The
periodtowhichoneisconvertingisexpressedintermsoftheperiodictypeofdataone
currentlypossesses.Thus,ifIcurrentlyhaveweeklydata,andIneedayearlystandard
deviation,Iconvertoneyearintoweeks,whichisfifty-two.Ithentakethesquarerootof
fifty-two,andmultiplytheweeklystandarddeviationbythatnumber.Asanextreme
example,ifIwantedtoconvertfrommonthlytomillennial(1000years)data,Iwould
expressthemillenniumintermsofmonths:12months=1yr,12000monthsequalone
millennium.Thus,Iwouldmultiplymycurrentmonthlystandarddeviationbythesquare
rootof12000.
Naturally,shortertimeframeswillleadtomoreaccurateestimates,andthelongest
timemostanalystswillconvertisdailytoannualdata.Followthelogicbehindthese
conversions:
Annualtomonthly:=(annualstandarddeviation)(√ √√ √1/12))
Monthlytodaily=((monthlystandarddeviation)(√ √√ √1/30)
Dailytoyearly=(dailystandarddeviation)(√ √√ √365)
ESTIMATEDVOLATILITY-Thistoolisavaluable,littleknown,quickestimator
ofastandarddeviation.Itneedstobeusedcautiously,however,becauseitassumesa
perfectlynormaldistributionwhichisrarelythecase.
• 1.Subtractthelowestpointfromthehighestpointtodeterminetherangeofthe
distribution.
• 2.Squarethisrangeandthenmultiplyitby1/16ordecimally,0.0625.
571

• 3.Thisresultingfigureistheestimatedvariance.Wetakethesquarerootofthis
numbertodeterminethestandarddeviation
• 4.Informulatermsitis:0.0625(range)
2
=variance,thus:√ √√ √(0.0625(range)
2
)isthe
estimatedstandarddeviation.
Example:Ahighlyskewedpopulation-(7,8,14,21,56).
• 1.56-7=49,whichisthehighminusthelow.
• 2.0.625(49)
2
-150.0625=Variance
• 3.√ √√ √150.0625=12.25=Standarddeviation
Sincetheactualstandarddeviationis18.1andnot12.25,thestudent/investorcandetect
thediscrepancyfromthehighskewofthepopulationwithtwoclosenumbersatthelow
endandanumbermorethantwiceanyotheratthehighend.
SAMPLESTANDARDDEVIATION-Insmallsamples,usuallylessthanthirty
elements,thesamplesizeneedstobeadjustedtoincreasetheaccuracyofthecalculation.
Wesimplyreduce(N),thesamplesizeby“1”andproceedasnormal.Theformulais
modifiedas:
∑ ∑∑ ∑(X-µ µµ µ)
2
/(N-1)forthesamplevarianceandtheapplicationofasquarerootforthe
samplestandarddeviation:√ √√ √(∑ ∑∑ ∑(X-µ µµ µ)
2
/(N-1)).Thus,ifthesumofsquareddeviations
was60,andthesamplesizewas15,wewoulddivide60by14andget4.2857forthesample
variance.Obtainingthesquarerootwouldyield2.0701.
Notethatthesmallervalueof“N”,pusheduptheexpectedvolatilityofthenumber.
Ifthedenominatorwere“15”andnot“14”,thevariancewouldhavebeencalculatedas
“4”;thesmallersamplesizeaddedsevenpercentofvolatilitytothecalculation.
THEMEAN-VARIANCE-Thisisamajorbutoftenneglectedindicatorofrisk.It
isagreatequalizerbetweenhighreturninvestmentsthatarevolatileandlowerrisk,
“safer”investments.Inanysample,wemerelysubtractthestandarddeviationfromthe
meanandcompareittoanotherpopulation.Thefunctionis(µ µµ µ-σ σσ σ).Thehigherthe
number,thegreaterthecombinationofreturnversusrisk.Althoughthisindicatorgivesa
572

veryaccurateassessmentoftherisk-returntradeoffwhenpopulationshaveasimilar
magnitude,itislessaccuratewhencomparingasmallreturntoaverylargeone.The
followingexampleshowsthisdivergence:XandYaretwodifferentstocks.Xhasamean
of20%forareturnandastandarddeviationof24%.StockYhasameanof6%anda
standarddeviationof8%.Thecomparisonis:(20-24=-4)<(6-8=-2).Bythisrule,
stockYhasbetterrisk-returncharacteristicseventhoughtheinvestorwouldforego14%
inpotentialreturns.Thenextindicatorbetterclarifiesthetradeoffwhentwopopulations
aredivergent.
THECOEFFICIENTOFVARIATION-Toovercomethelimitationsofthemean
variance,wemerelydividethemeanintothestandarddeviation.Thefunctionis(σ σσ σ/µ). µ). µ). µ).
Thisindicatorwillassesswhethertheextrareturnisworththerisk.Alowervaluewill
indicatebettercharacteristics.Intheaboveexample,StockXhasacoefficientofvariation
of(24/20)=1.2.StockYhasacoefficientofvariationof(8/6)=1.333.Thus,bythe
coefficientofvariation,StockXisabetterchoicewithmorepotentialreturnandlessrisk
associatedwithit-incombination.Byriskfactorsalone,anypopulationwithahigher
standarddeviationismorerisky.
WORSTCASESCENARIOS-Neitherthemean-varianceruleorthecoefficientof
variationcoverallriskscenarios.Attimes,theanalystmaywanttomakeprovisionsfor
thestatisticallyworstcasescenariothatwouldoccurbychanceonepercentofthetime.By
multiplyingastandard,statisticallyderivednumberwiththestandarddeviation,andthen
subtractingthatproductfromthemean,theanalystwillproduceanestimateofaworst
casescenario.Thestandardnumberscoverspecificpercentagesofa“normal”population
andsothistechniqueshouldnotbeappliedtohighlyskeweddata.Thesestandard
numbersareasfollows:
573

Table23-1

NORMALDEVIATES
PercentageoftheCurveCovered Standardnumber(NormalDeviate)x
STD.DEV.
90% 1.64
95% 1.96
98% 2.33
99% 2.57

Figure23-5

Thesestandardnumberscoverthecurvefromthemiddle,leaving(1-Percentage/2)on
eachside.
Thus,asanexample,ifIhaveastockwhosemeanyearlyincreaseis10%witha
standarddeviationof20%,andIwantedtofindouttheworstcasescenariothatwould
happenonly5%ofthetime,Iwouldmultiply0.2by1.64whichisthenormaldeviateat
90percent,andthensubtractthatproductfrom0.1.Thefunctionyields,0.2x1.64=0.328,
(0.1-0.328=-0.228)or-22.8percent.Foreveryfiveoutofonehundredperiods,Iwould
5% 5% 90%
1.64
574

expectalossof22.8percent.Noticealsothatwhilefivepercentofthecurveisuncovered
onthelowerside,theuppersidehasacompanionareaoffivepercentthathasamirror
probability.Likevolatilityestimations,theaverageinvestorshouldbewaryofsuch
forwardlookingstatistics.Althoughanentirebranchofriskmanagementisdedicatedto
thistypeofanalysis(Valueatrisk,betterknownas“VaR”),itisusedincombinationwith
severalotherindicators(exponentiallyweightedmovingaveragesandMonteCarlo
analysis)todiversifyawayitsmajorpremise-thatthepopulationisconsidered“normal”,
ararityintheworldoffinance.
ACCOUNTINGFORADDITIONALRISK:COMBININGSTANDARDDEVIATIONS
Whenunitsaresimilar-dollars,widgets,boardfeet,butnotpercentages-wecan
addstandarddeviationsandsometimesreduceriskbycombiningtwoormorepopulations.
Thecovariancebetweenthepopulationsbecomespartofthecombinedstandarddeviation
anddeterminestheamountofriskreduction.Ineffect,thisreductionformsthefoundation
for“modernportfoliotheory”aconceptthatisstillasvalidtodayaswhenHarry
Markowitzfirstproposeditmanyyearsago.Infact,almostalldiversificationhasthe
mathematicalconceptofcombinedstandarddeviationsasitspremise.Riskisreducedby
theapplicationoftwoprinciples:1)Thesamplesizeisincreasedand2)Therelationship
betweenthepopulationsisopposed;asonemovesup,theothermightmovedown,oreven
notatall.
Toformacombinedstandarddeviation,westartbyformingavariancebyadding
theseparatevariancesofthepopulationsandthenaddingthesummationofallpossible
combinationsofcovariances,multipliedbythenumber“2”.Thefunctionisdefinedasσ σσ σ
2
(i)=varianceofpopulation(i),andσ σσ σ
2
(j)=varianceofpopulation(j).Theseare
combined:
σ σσ σ
2
(i)+ ++ +σ σσ σ
2
(j)+(2)(∑ ∑∑ ∑COVij)Justaswithanyvariance,wemerelyapplythesquareroot
tothefunctiontoobtainastandarddeviation.Thisnextexampleformsaportfolio
575

betweenstocksX,YandZ.Inthiscase,wewillhaveasumofthreeseparatevariancesand
covariances.
Table23-2

Three
Populations
X Y Z Portfolio
Year1 1 12 30 43
Year2 2 7 41 50
Year3 3 14 49 66
Population
Means
2 11 40 53
StandardDev.
(Sample)
1 3.605 9.54 11.79

Table23-3

Combinationsof
Covariances

COV(X,Y) 0.9998
COV(X,Z) 9.5006
COV(Y,Z) 6.499

FormulafortheVariance:σ σσ σ
2
(i)+ ++ +σ σσ σ
2
(j)+(2)(∑ ∑∑ ∑COVij)
=(1)
2
+(3.605)
2
+(9.54)
2
+(2)(0.9998+9.5006+6.499)=
139.006,=√ √√ √139.006=11.79=Thesameastheportfoliostandarddeviation.
Thereaderwillobservethatthelargestamountofvariancewasderivedfromstock
Z,inadditiontothelargeamountofcovarianceamongthecombinations.Hadsomeofthe
numbersdeclinedasothersrose(asinthecaseofY)thestandarddeviationmighthave
beensmaller.Obviously,whenmorecovariancesareused,aspreadsheetisthebesttoolto
calculatethem.Infact,usingthisformulawillshowtheimpactofanyportfoliodecision
fromaperspectiveofrisk.
576

PREDICTIONANDVARIANCE
Statisticianshavefoundthatwhenasamplepopulationislargeenough,afairly
symmetricalcurvedevelopswiththemeaninthecenter.Eachstandarddeviation
representsaspecificpercentageofareaofthatcurve.Multiplestandarddeviationscanbe
matchedwiththecoverageofastandardareawhichwasthebasisfortheformationof
“normaldeviates”inthe“worstcasescenario”analysis.Whilewecanusethis“normal”
curveforestimationsandpredictions,wemustbecognizantthatfinancialdataisusually
highlyskewedCreatinga“ballpark”estimateisbetterthanhavingnoneatall,onlyifwe
haveothercorroboratingmeasurementsthatdiversifyandvalidatetheanalysis.
Evenmoretenuousthantheshapeofthecurveisthefactthatwearemaking
determinationsfromhistoricaldata.Incaseaftercase,historicaldatawillmisdirectthe
analystunlessitisweightedwithmorerecentdata;hencetheevolutionoftheEWMAor
“exponentiallyweighted”movingaverage.Althoughthecapitalstructuralistavoids
makingpredictionsandconcentratesondetectinganenvironmentthatisconduciveto
earnings,heorshewillneedtomakethembecausecustomers-aCFO,abiginvestor,ora
pensionfundmanager-cravecertaintyandexpectthem.Thus,theanalystshouldavoid
anydependenceonforecasts,butwelcometheirinformationalcontent-cautiously.
CONFIDENCEINTERVALS-Onceameanisdetermined,itmayormaynotbea
goodestimatorofapopulation,dependingonthesizeofthevarianceandbydefault,the
standarddeviation.Thenormalcurvetheoreticallycoversanentirepopulation.The
mean,plusonestandarddeviationcoversapproximately68%ofthenormalcurve.
Moreover,95.5%ofthepopulationlieswithintwostandarddeviationsofthemean,and
99.7%lieswithinthreestandarddeviations.Thusonanormalcurve,ifIhaveameanof
“7”,andastandarddeviationof“2”,99.7%ofthepopulationwillbebetween(7-3(2))and
(7+3(2))orthenumbers“1”and“13”.
The99.7%leavesjust0.3%or0.003(decimal)intotalareaontheendsofthecurve
thatareuncovered.Oneachend,therewillbe(1-(percentcovered/2))or(1-(0.997/2))=
577

0.15%ateachend.Someconfusionexistsamongstudent/investorsastothecoverageof
standarddeviations,andonemustrealizethatthecoveragegoesinbothdirections:
Figure23-6

Rememberthattheliteraturealwaysregardsstandarddeviationsaseitheraddedtoor
subtractedfromthemean.Thuswhenwespeakoftotalareacovered:,2σ σσ σcoversatotalof
68%,and4σ σσ σcoversatotalof95.5%.Finally,6σ σσ σcoversatotalof99.7%.
Statisticianswilloftenrefertothepositivevariantofastandarddeviation(thearea
greaterthanthemean)withoutregardtoitsopposite,thenegative,andthetotalarea
covered.Weoftensay“within”suchadistancebutinactuality,wemeanthatthedistance
coverstwicethereferencebecauseitappliestobothsidesofthemean.Thus,ifa
statisticiansaysthatacertainnumberis“within”2.5standarddeviationsofthemean,the
totalcoverageistwiceasmuch-orfivestandarddeviations.
Anothermisconceptioncanbemadeabouttheareanotcoveredbythestandard
deviations.Manyfalselybelievethatthepercentagenotcovered(0.3%intheabove
example)liesatoneendofthecurveortheother.Infact,weneedtodividethisareaby
twoandrealizethatthispercentagewillexistatbothendssinceweexpandfromthe
1 13 7
99.7% 3Std.Dev. 3Std.Dev.
0.15% 0.15%
578

centrallylocatedmean.IfIam“within”twostandarddeviationsofthemean(orcovering
fourstandarddeviationsintotalarea),it